Fix up/Rehab an old Rental House and "Flip" to 1031 exchange?

4 Replies

We have an old rental house that is not generating the Cap I'd like.  

I think that if I rehabbed the property new kitchen, landscaping etc, it could sell for a lot because the area is highly desired.  

Would it make sense to rehab the property for a couple months, list it, and 1031 exchange it for a multi-unit?  Would the capital gains taxes be 100% tax deferred?

How does this end up being paid if I eventually sell the multi-unit that I 1031 it into?

Your capital gain tax, depreciation recapture tax and Medicare Surcharge (Obamacare tax) would all be deferred as long as you acquired one or more replacement properties that were equal to, or greater than, the net sale price of your  relinquished property and you reinvested 100% of your net cash proceeds held by the Qualified Intermediary. 

You could defer the payment of these taxes indefinitely if you continue to exchange throughout your lifetime.  Your heirs will receive a step up in cost basis upon your death, and none of these taxes will ever be paid.

Excellent response thanks Bill. That sounds so enticing. So basically as long as I don't sell in my lifetime there will be ZERO cap gains taxes/ depreciation recapture.  

Sounds so good... I didn't know about the inheritance part for heirs too.  What exactly does step up in cost basis mean?

@Will F.  

You are most welcome.  I'm glad the post was helpful.

Investors often view the 1031 Exchange merely as a transactional tool that is used to defer the payment of their taxable gain on a specific transaction.  They fail to see that it is actually a wealth building tool if used over ones lifetime. 

As long as an investor continues to 1031 Exchange throughout their lifetime they will continue to defer the payment of their capital gain, depreciation recapture, and Medicare Surcharge (Obamacare) taxes, and then their heirs will receive the "step-up" in cost basis so that the depreciation recapture and capital gain taxes are completely eliminated.  We have a morbid sense of humor.  We refer to this as "swap 'til you drop" tax planning.

The reason that the heirs receive the step-up in cost basis is because the value of your property is included in your estate for estate tax calculation purposes, so they can not double tax you by also computing capital gain taxes.  In reality, the vast majority of us will never pay inheritance taxes because we each get a $5.3 million estate tax exclusion ($10.6 million for a married couple), and those of us who "swap 'til we drop" will never pay depreciation recapture taxes. 

Let's assume that you acquired a property many years ago for $100,000.  The $100,000 is your original cost basis.  Let's assume that over these many years you depreciate the property on your income tax returns by $80,000 so that you now have a remaining cost basis of $20,000.  This $20,000 is your adjusted cost basis.  Let's further assume that the property is now worth $1,000,000 today, and you pass on today.  Your heirs will inherit the property and their cost basis is "stepped up" from your adjusted cost basis of $20,000 to the fair market value today or $1,000,000.  In other words, they could sell the property the day after your death for $1,000,000 and since their cost basis has been stepped up to $1,000,000 they will pay no taxes.  Now, if they hold the property and it increases in value to $1,250,000, and then they sell, they would only have to pay taxes on the $250,000 gain since they inherited the property from you.

Wow @Bill Exeter  you are MUCH better at explaining this than my CPA.  Thanks for your help.

I also didn't realize that you don't pay up to $5.3 mill for inheritance tax.  I'm in my early thirties so I'm guessing things might change when I'm ready to hit the hay (morbid sense of humor appreciated)

Thanks also for the example!

Favorite part: "swap 'til you drop"


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