1031 Exchange and avoiding capital gains

7 Replies

I'm somewhat familiar with the tax advantages of a 1031 exchange. It's awesome that the government put this act into effect but I do have some questions about the full process. My current understanding: in order to avoid paying capital gains, one has 45 days to target another property to roll the proceeds of the original sale into. Question 1: Do I only have to use the proceeds to purchase on the second property or the total equity including purchase price of original property?

Now let's say I continue to implement this process of selling and using the proceeds to roll into another property. Question 2: what are the limitations if any, regarding the price of the second home purchase? Does it have to be more expensive than the previous property?

Again, let's say I continue to carry out this process and I'm 7 properties deep and on the sale of the 7th property I do not purchase another property in attempts to avoid capital gains. Question 3: Do I pay CG only on the proceeds from the sale of 7th property or on all the previous sales as well?

Thanks for reading the post and for sharing  your experiences with me. This forum is awesome! Keep it up Brandon and Mindy...

@Caleb Dryden

Question 1 & 2: I'll walk through an example, as I think that will better answer your question!

You have a property worth 150k which you bought for 100k (I'm assuming all cash for simplicity). This means you have 50k of capital gains built into your property. 

If you were to sell the property for $150k, you would have $50k of capital gains.

Let's say you identify a property with the time limit that you purchase for 130k. The difference between the proceeds of the previous house, and the purchase price of the new house ($20,000 in this case...150k-130k) would be applied first to the capital gains. You would incur $20k in capital gains in this example.

In general- to avoid capital gains taxes, the new house has to be more expensive than the old house.

Question 3: Let's say you bought the original house for $100k. It gained 50k (now worth 150k) and you did a 1031 exchange for house 2, for which you paid 150k. You continue this 7 times and now you have a property worth 450k. If you only put in 100k (the amount to buy the original house) and the rest was all appreciation of property- the whole gain ($350k) would be subjected to capital gains.

@Caleb Dryden , 1031 exchanges are an awesome tool.  And while the govt graciously has given us this tool (the statute first went in 1920ish) the IRS does not necessarily like it.  So they don't make it as easy as they could or market it for folks.  So congratulations on finding it.  Here's some brief answers and I'll PM you to get some more resources in your hands.

1. In order to defer all tax you must do two things:  First you must purchase at least as much as your net sale (the contract price minus closing costs).  Second you must use all of the net proceeds (the cash after mortgage is subtracted from the net sale) in your purchase.  You can purchase less than what you sell.  And you can take cash from the sale.  But the IRS views that as taking profit and wants the difference to be taxable.  

2. See #1 I think.  there is no maximum purchase amount.  And it doesn't have to be one for one.   You can sell one and buy several.  And you can sell several and buy 1.  But the valuations have to be what I described in #1 if you want to defer all tax.

3. When you do a 1031 exchange what you are really doing is carrying over the basis in the old property into the new property.  Say you sell a $200K property with a $100K basis and you purchase a $200K property.  You still have a basis of $100K in it.  So if you sell it the day after you're purchase you still owe the same $100K.  If you do this for years then there can be quite a bit of deferred tax.

Most investors will then do a last 1031 into something passive that requires no management and simply provides cash through the remainder of their lives with the returns from the deferred tax making up a large % of their retirement income.  When they die their heirs get a step up in basis so the tax disappears for the heirs.  That's just one of the 1031 strategies at your disposal.

That's exactly what I was wondering. Thanks for the explicit response. I feared that would be the case but such is life. Is there an advantage to paying the capital gains immediately after a sale vs. using those funds to purchase a more expensive property and down the road pay for the whole gain down the road? Other than by holding off on paying for capital gains allows you to keep more money for a bigger purchase?

@Caleb Dryden , Imagine that you had a job where you took 20% of your $100K income and invested it every year and made 10%.  The first year you would invest $20K and make 2K in interest.  the second year you would make $2,200 off the  first amount and $2000 of  the second.  the third year you would make $2420 off the first and 2200 off the second and 2000 off the third.  You get the point.  It's compound interest.

You're not just saving tax.  Your using the tax to compound your return.  If you want to at the end of the game you can pay the tax just off the additional profit you've made from the tax.  

The 1031 involves timing and discipline.  It's not always right to do but it's always right to consider.

@Caleb Dryden there is another method.  Been used since 1996.  You sell your property and set up a tri-party agreement through a trust where you are the noteholder. All of the capital gains are tax deferred.  You will only pay tax on what you personally take from the trust.  If you buy property again, buy using the trust and those funds will still not be taxed.  Keep some or all of the money invested if you like, or use some to purchase investment property again.  Power is yours, without 1031 timelines.

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