Is a 1031 exchange a good idea in this situation?

Question

Hi everyone,

Would love your thoughts on a potential 1031 exchange. In 2021 I purchased a property in Gary, IN, for $58k on a conventional mortgage. Now it seems the property could be worth $90k-$100k, while the remaining mortgage is just at $43k—leaving me anywhere from $40-50k of equity in the property.

I'm just starting out in my real estate career and own only one other property, so recapturing this equity via a 1031 exchange—with an eye to financing two more properties or a duplex—sounds really attractive. What would be the pros and cons of doing a 1031 exchange with this property right now?

Thanks so much for your thoughts, Jon

E.J. McCaffrey · Answer

A 1031 is potentially a good option, but you may want to compare that to some other options that allow you to access your equity, defer taxes, or reinvest in real estate. One option would be a cash-out refinance, whereby you refinance the property and take tax-free cash to reinvest. This allows you to keep the property, benefit from appreciation, and avoid the strict 1031 timelines. However, it does increase your mortgage payment, so it works best if rental income can cover it. Another option is a HELOC, which lets you borrow only what you need rather than taking a lump sum. This is a flexible way to fund another property purchase but may come with higher interest rates.

If you’re determined to sell, doing so via an installment sale (seller financing) allows the buyer to pay in installments, spreading out capital gains taxes over time while providing you with passive income through interest. This strategy works well if you’re selling to an investor who prefers owner financing. Finally, if the gain is relatively small, simply selling and paying the taxes may be a practical choice. While you won’t defer taxes, you’ll have cash available to reinvest in things other than real estate.

Note: This information is for educational and informational purposes only and does not constitute legal, tax, financial or investment advice. No attorney-client, fiduciary, or professional relationship is established through this communication.

William Whitley · Answer

Good morning, Jon,

While I am familiar with the ins and outs of 1031 exchanges from an educational standpoint, I have not personally been involved with one. However, if done correctly according to all the guidelines and requirements, the advantage is that you defer taxes on capital gains and you also defer taxes on recapture of depreciation so long as you meet the timeline requirements, the similar property replacement requirements, the qualified intermediary requirements, and you personally are never in possession of the equity, hence the QI. There may be a few more requirements I’m not remembering. The important thing is both to know the exact process beforehand and get as much lined up as possible before launching the process.

Something to consider, the depreciation recapture is usually deducted from the basis of the acquired property, since you are deferring taxes on that depreciation recapture. As such, however much accumulated depreciation you are transferring, that will typically reduce your basis on the acquired property so that when you ultimately sell that acquired property (assuming you don’t do another 1031 exchange), it would effectively increase your capital gains, though accumulated depreciation on the acquired property would be adjusted out of that. When you sell (not exchange) an investment property, you typically pay taxes on two things at different rates: recapture of accumulated depreciation and capital gains.

The 1031 exchange process can be quite complex, and you need to make sure you do everything correctly including meeting all the timeline requirements to avoid having it disqualified.

I hope that is helpful.

Alex Olson · Answer

The short answer is you have a lot of unused equity in that property. I would look to 1031 exchange into a multifamily property and continue to grow your portfolio. You can do that in your own market or look to a market in the midwest like Kansas City to see what kind of returns you can get with your equity. Having a 1031 exchange focused real estate agent is powerful. Happy to help you look at the KC market if you have interest.

Tim Delaney · Answer

Don't forget to factor in cost of sale - even if you are avoiding capital gains taxes you still have commissions and transfer taxes. Is the left over cash realistically going to get you two cash flowing assets?

What is your current cash flow and how would that compare? Is there still appreciation potential on this property or the future acquisitions?

What is your long term goal? Do you need/want the cash flow or are you more focused on long term appreciation and wealth building?

Lots of questions, not many answers, sorry. But no one can really give you good advice on this because we don't know your personal situation, your goals or the market you are in.

Dave Foster · Answer

@Jon Haney Ultimately, you want to make decisions that align with your future goals as an investor, and how hands-on or off you would like to be.

If you decided to sell and do a 1031 exchange, it would let you defer all of the tax and depreciation, and use it to your benefit by purchasing investment property for equal or greater than what you are selling.  A 1031. exchange is perfect for the scenario you are describing.  We would call this a "diversification" exchange.  You sell one highly appreciated property and use the equity as down payments to purchase multiple replacement properties.  Just pay attention to your debt levels so you don't get over-extended.  And this is an awesome growth strategy

The most common concern investors have with the 1031 exchange is the time constraints. You have 45 days from the day you sell your relinquished property to provide a list of potential replacement properties and a total of 180 days, again from the sale of your relinquished property to complete your exchange and take title to the new property.

This can feel daunting. But an easy way to simplify this process is to shop around for properties you might like before even selling your relinquished property. And to make it even easier, get it under contract.

The 1031 exchange requires the use of a 3rd party called the qualified intermediary.  They should be your guide through the process.  Done correctly, your 1031 exchange should be seamless and almost invisible (except for the tremendous savings).

Tim Delaney · Answer

HELOC's are great for short term investments (less than a year), but I would not use a HELOC as the downpayment on another house. Interest rates can change or banks can call HELOCs due. You may also struggle to find a lender willing to do a HELOC on an investment property. You could do a home equity loan, but just remember to calculate that monthly payment into your cash flow numbers on the existing house or the new house.

Jon Haney · Answer

Hi E. J., thanks for the help. Maybe doing a HELOC would be the best way to go so I can keep the property (which really has done well for me over the past four years, currently has a paying tenant, etc.). Thanks for reminder that there are other options available!

Henry Clark · Answer

OP. Sit down with a Qualified 1031 Intermediary and tell them what you want to do.

1.  Let’s say you sell for $100k.  Let’s keep simple and forget selling costs.  You then have to buy for that same cost or higher.  Say you buy for $110k.  You have to bring $10k to the deal.  2.  Same as above. But you only find a new property for $90k.  The $10k difference is all considered incomes.  No cost basis is applied.  3.  Say you sell then want to buy 2 properties.  Understand the time frame to identify the two new properties.  It is pretty tight.  You won’t have as much leverage to walk away from a deal.  Thus you won’t make as good of a deal.  4.  Compute the difference between selling and 1031 versus using your current investment as cross collateral for your new purchases.  You would need to stay with your same lender.  5.  You could do a reverse 1031.  Buy first then sell.  Since you control selling your property takes some of the timing pressure off.  But you need to work with a lender since you won’t have the cash available to make the purchase.

Jon Haney · Answer

Hi Tim, thanks for replying and helping me think things through.

My current cash flow on the property is around $400/month, so I would need to find a duplex that could increase that cash flow. As the property is currently situated in a class C neighborhood in Gary, I'm not how much more appreciation will occur over the next period—I know that many home prices in the area have been falling there recently.

My long term goal is more focused on appreciation and wealth building, not necessarily cash flow (although that's been nice in the short term).

I'm thinking about using the equity to fund a downpayment on a duplex in the Detroit area or upgrade to a nicer area of Gary.

Is a 1031 exchange a good idea in this situation?

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