1031 Questions - Buy Cheaper/Smaller Homes?

13 Replies

I'm looking to sell a home worth 385K (that I bought for 306K) and net about 100K on the sale. 

I started investing in cheaper markets where homes are 100K and under. 

If I do a 1031 Exchange, could I use the 100K to buy a smaller home or multiple smaller homes or do I need to put it into an equal or larger purchase? 

All the above.  If you want to defer the capital gain you need to buy at least greater than your cost basis(ask your CPA).  Assuming your cost basis is $350K and you got one for less say $300K, not total of several > $350K, you still have $50K +recaputuring depreciation claimed in the past report on your 2017 Fed & State tax rate. If you purchase one >350K it is safe to say the capital gain is delayed under present rule.

1031 is being challenged and debated in Congress to do w/o as a loop hole. In the past it was very loose. 

Coordinate with a local 1031 exchange and your CPA.

@Sam Shueh   

Just want to confirm I read that right. So you're saying I can take partial of that amount? So if I buy a home and only spend 40K of my 100K, then I will only be taxed on 60K? 

Yes, plus recaputure of depreciation you have deducted in the past. Say last 10 years you claimed 20K you will give it back to Feds and local. But selling cost is deductible as expense when you sell.

It is not a 100% sure thing but you do pay less income tax if executed properly. 

@Chris Ayers When completing a 100% tax deferred exchange the requirement is that the taxpayer trade up or equal in value. You have no limit to how many replacement properties you purchase. You could sell and invest in three or four smaller less expensive homes if you’d like.

If you decide to not trade equal or up in value, you could trade down, but you will most likely see a tax and depreciation recapture liability on the portion that is not replaced. Only your tax advisor can determine how much that liability may be but it is an option.

@Chris Ayers , The easy way to think of the reinvestment rules is as a two part rule.  In order to defer all tax you must

1. Purchase at least as much as your net sale (contract price minus closing costs and commissions).  In your case maybe $360K if your contract is for $385.

2. You must use all of your proceeds in the next purchase or purchases (the net sale minus any mortgage payoff).  For example purposes say that is the $100K.

You don't have to purchase as much as you sell.  You do not have to use all of the cash but whatever you buy down or whatever cash you take out you will be taxed on that difference.

In your $40K example that is only correct if you purchased at least $360K.  If you used $40K but purchased at least $360K of property you would only be taxed on the $60K.  But if you literally wanted to purchase only a cash house for $40K you're buying down so much that there would be no tax benefit.

You do not have to allocate that cash in any specific manner however.   So what many of our clients will do is to use that $100K to purchase 4 $100K properties with 25% down on each.  Or buy a $40K house for cash and use the $60K as down payment on something else.

@Lauren Speidel Thank you

@Dave Foster  I was hoping to buy 4 $100K properties in the scenario like you mentioned, but I'm worried about finding 4 good deals in the time frame. Don't understand when you say if you buy 1 home in cash then there would be no tax benefit.  

@Chris Ayers , That is because the requirements are that in order to completely defer all tax you must purchase at least as much as you sell and use all of the proceeds.  If you sell for $360K and buy for $300K the IRS looks at that $60K a a form of taking profit.  So you would pay tax on the $30K but shelter the rest of the gain.  Same thing if you took $30K in cash and only used $70K to purchase $360K in real estate.  That $20K is taxable and you shelter the remainder in the 1031.

So your scenario was to sell for $360K and buy one property for $100K cash.  You used all of the proceeds no problem.  But you bought $260K less than what you sold.  So you would pay tax on that $260K if there was that much profit in the sale.  If there was more than that amount in profit you would shelter the rest.  But I think you see why buying that little probably wouldn't result in a tax saving so no motivation for 1031.

Buying 4 properties in the compressed time frames can seem daunting.  But there's ways to stretch that out.

1. Find a portfolio of several that you can buy with one fell swoop.

2. Go into contract for your purchases before you even close the sale of your old property by...

     selling your's with a closing date contingent on you finding suitable replacements.

     buying properties with contingencies or you selling yours.

3. Start shopping well before your sale and have multiple trusted bird dogs looking for you.

4. Remember that you don't have to have your new properties under contract by day 45, only identified.  Yes after that day the risk increases.  But you could go into contract within day 45 and take 2 or 3 more months to close.  That is a 4-5 month time between sale and close.  And when you think about it.  That's probably longer than the normal time it takes.  The risk is somewhat real.  But it is more perception than not.

@Dave Foster   I think I understand now. Thank you. 

I guess I'll scope out the market around then to see if there are any multifamilies going for around 350K and if so I'll try it.  If not, I'll just take the hit and use it how I please. 

@Chris Ayers , That's exactly the attitude to have.  A 1031 should never be the cause of a bad business decision.  At the worst, starting the 1031 is an incredibly cheap way to buy some time to see what makes sense.  $750 buys you 45 more days of  due diligence.  And there's actually a bonus in starting an exchange round about this time of year.  When it dies if it dies after day 45 it will die in 2018 so you can adjust the tax payment to 2019.

@Dave Foster Unfortunately I won't be able to sell until the tenants are out in June. Good thinking though. 

Is $750 the rough cost estimate of a 1031? 

@Dave Foster I thought the value of a like -kind 1031 exchange depended on the cost basis/sale price of the property being sold. If there is nowhere to offset the gain, isn't the taxable gain on the difference between the two the number that determines the value of doing a 1031? Is there a recapture of  depreciation if you are simply carrying the cost basis/depreciation over to the purchased property(s)? I also have not heard anyone mention that a 1031 is not a tax write off only a tax deferral. 

Can you identify on more properties than you actually close on? What if you identify on multiple properties and close a few less then what you identified on, but put more money down on each and the basis was more than what was sold, thereby eating up all the proceeds from the sale, will that keep you from having to pay taxes?

@Chris Ayers , sure $750 will get you a good exchange from a national QI service.  You've actually got plenty of time then to suss out the market pending your tenants leaving.  Another option you might have depending on the numbers would be a reverse exchange that you set up with your QI who takes title to your replacement property and holds it while you sell your old property.  It takes a lot of guess work out of the 1031.  But it's more expensive.

@Sam C. , Sure the immediate value of a 1031 going to be the tax saved which is the tax on the difference between your net sale and adjusted cost basis.  This gain consists of two parts - profit and depreciation recapture which are taxed differently.  The 1031 defers both.  In a 1031 actually what happens is that your basis transfers over to the new property.  If you buy new property more than what you sold then you get additional depreciable basis.

Yes the 1031 defers payment of tax on gain from real estate sales.  But it defers it indefinitely.  And there are situations that can be orchestrated where that tax never has to be paid. 

@Kevin R. You can identify more than what you actually purchase.  As long as you purchase at least as much as your net sale and use all of the proceeds from the sale you will defer all tax.  There are limits on the scope of your list of potentials:  If you name 3 or fewer potential replacements it doesn't matter how much they are worth.  If you want to name more than three then the total value of your list can be no more than 200% of the value of what you sold.

Great questions everyone.  PM me for a white paper on the process if you'd like.

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