Some help trying to wrap my head around 1031 with boot involved

[Vince Light]

Hello everyone!

I am looking for some help trying to wrap my head around the complexities (to me, anyway) of a  partial 1031 with boot being pulled out. Here is the situation...

Currently close to closing on the sale of an investment duplex property in Texas. We did a cash out refinance on this property a couple of years ago and used the proceeds for both improving the duplex as well as acquiring and setting up a separate STR. That STR resulted in some resulted in some extra debt that we are now selling the duplex for in order to clear out from. We chose to sell the duplex and have a buyer... So not questioning the wisdom of selling that (I know it is horrible timing but it is what it is). That sale is going to result in a hefty gain since I have owned the property for 20+ years.

The basic numbers are:

Original 2001 purchase price: $155k

Sale price: $750k

Current mortgage to pay off: $315k (included approximately $100k original balance due plus $230k cash out) 

Amount due to me after sale: $345k

Additional debt to pay off: $90k

I am also planning on keeping an emergency fund cushion from the sale proceeds.: $TBD

So after laying all this out there... I am trying to figure out a 1031 into a new property fits into the picture... 

My understanding of 1031 with a boot is that the boot is taxed. The costs to sell and original $100k from before the cash out refinance are not taxed (I know additional improvement expenses and such can also be deducted but will deal with a tax professional for that). For the sake of simplicity, let's just say I will have a $550k gain. 

Let's say I want to use some of the remaining proceeds to put a 20% down on a $350k property ($70k). would the new $350k debt be deducted from the $550k gain for calculating 1031 tax savings? Or would only the $70k I put as down payment? If I am only re-investing that $70k from the gain, what are the tax ramifications?

See there... I just got my brain tied in knots again trying to figure out how to even explain the s(h)ituation...

Any help in clarifying would be greatly appreciated.

Vince

[Melissa Hartvigsen]

Hello,

If I were in your shoes, I would send this directly to my QI, and let them give me the breakdown. Mine did this for me multiple times when I wanted to run numbers on possible replacement properties and options.  They answered my questions. I ended up with a little boot, and gave me a reasonable estimate of what I might owe come tax time.  I live in Oregon and paid the state 9.9% in taxes on top of the federal rates.

Quoting a handout that my QI gave me: "The amount of Gain you pay depends on the State and the type of tax you are exposed to. Each State has its own State tax that is applied on top of the federal tax. Depending on the State of disposition and the type of Gain, combined rates can climb to more than 50% if Alternative Minimum Tax is applied (26-28%).

What does it cost?

Federal
Appreciation 20%* 
Depreciation 25%*

* The federal rates quoted are for properties held for more than a year and held for investment. Properties held for investment for less than a year or properties held for resale are taxed at normal income tax rates."

The gain is added to an investor’s income for a year and the appropriate tax rate applicable. In some cases, the Alternative Minimum Tax may apply to gains."

Best wishes,

Melissa

[Jon Taylor]

@Vince Light

I'm sure others will chime in here, but there are a few basics to square away.

In order to fully defer your tax liability you will need to do two things: 1) replace the net sale price and 2) redeploy all of the net proceeds from the sale into the new property(ies).

A remaining balance in either category area will result in boot - which is taxable.

Using your numbers above, it appears to me you'll need to purchase a new property (or combine multiple properties) totaling $750k *less selling expenses*). You also need to use the entire net proceeds $435k (by my math: $750-$315). The $90k debt that you reference does not apply if the loan is not collateralized by the property you are selling.

Example: Using rough math, if you purchase a $650k property with $435k down, your taxable boot would be $100k.

If you purchase a $750k property with $335k down, your taxable boot would be $100k.

The gain only comes to play in the event that your boot exceeds your gain. In that case, your taxable gain would be your total gain (this scenario is highly unlikely to occur).

[Vince Light]

@Melissa Hartvigsen Thank you for passing along the information and your experience. It is helpful! I’m in Texas so mo income tax, fortunately (but don’t get me started on property taxes!)…

@Jon Taylor Thanks for your response. I am not looking to defer all of the taxes. That $90k debt I referenced is not mortgage related. So that’s why a partial 1031 is being considered.

Based on both answers, it sounds like gain is reduced only with the amount of gain spent/redeployed into another like kind purchase… Right?

How does the total cost of the new property play into a partial 1031?

[Whitney Nash]

Hello @Vince Light

I understand that you want to retain some proceeds and expect to pay taxes on it. To help explain things, though, let me start with how to have full tax deferral and work my way to that. 

When doing an exchange, for tax deferral there are three numbers to keep in mind. You also what to think 'exchange up'.

1- Buy replacement property that is equal or greater in value (less allowable closing costs) than what you sold. This can be done by buying more than one property, if needed.

2- Acquire debt on the replacement property(ies) in an amount that is equal or greater than what will be paid off of the relinquished property. This can be accomplished with a loan and/or bringing cash to the table. 

3- Put all of the proceeds from the sale of the relinquished property into the exchange account and then use it towards the purchase of the replacement property(ies). 

Any difference to any of these numbers is taxable boot. 

So, if you sell for $750k and your closing costs are an estimated $50k, then you need to buy something worth $700k or more (again this can be across more than one property.) If your debt pay off is $315k, then you need to get a loan or bring cash to the table that is $315k or more. And, if after the debt and closing costs are paid you have $385k in proceeds, then you would need to use all of them towards the replacement property(ies) purchase. Again, any difference in any of those numbers is taxable, so you'll want to make sure that doing an exchange makes sense. If you're only reinvesting $70k and buying one $350k property, then it doesn't. If you're going to buy more properties and put more of the proceeds down, then it might. If you reach the purchase and debt numbers but only want to reinvest say $300k of your proceeds and retain $85k for a personal cushion, then I think it makes sense.

[Vince Light]

@Whitney Nash Thank you very much for clarifying and explaining this... This gives me a lot to consider and think about.

[Dave Foster]

@Vince Light,

Your gain is determined by the difference between your adjusted cost basis and your net sales price

Purchase price + improvements -depreciation =Adjusted cost basis

Contract price - closing costs/commissions (not mortgage payoff) = net sales price

The difference is your gain.  So your sale is made up of two things - Basis and gain. Gain is taxable and basis is not

That's the accounting geek part.  Now here's where it gets tricky

When you do a 1031 exchange you have the two-fold requirement that @Jon Taylor nailed.

You can purchase less than you sell and you can take some cash out.  But when you do the IRS says you are taking gain!  We want to say that we are taking our basis first because that would not be taxable.  But the IRS simply says, "NO".  When you take cash (boot) from a 1031 it's always profit first.

Now it becomes an easy calculation - Take cash (boot) from an exchange and pay tax on that amount.  But shelter any remaining gain in your 1031 exchange.