1031 Exchange Scenarios, need some advice

10 Replies

Hi everyone,

I have a SFH (it's been rented out for about 7 years) and I want to 1031 exchange it in the semi near future. I have a few questions and wanted some insight into the implications of a few scenarios I'm considering and would love some feedback and advice if any of these are viable, pros/cons. Thanks in advance!

Property: SFH, been rented out for last 7 years (used to be my primary residence).

purchased: 400k, plan on selling for $800k, 20% down at purchase time + 100k rehab done.

Question #1: If I sell for $800k ,minus closing costs/real estate fees, does my 1031 property I find have to be of equal or more value? Can I take out my original downpayment in doing the 1031 exchange?

Scenario #1:

Sell SFH, buy 2 properties:

property 1: small multi-family unit

property 2: SFH

3 years down the road I decide I want to move into that property #2 the SFH. Can I do this?

If I can and then sell it 4 years later, can I get the capital gains exemption when I sell it? If so how does that work? Is it pro-rated for the time I resided in the home? 

Scenario #2:

Sell SFH, purchase 10 smaller properties

If I sell these 10 smaller properties at some given time separately in the future, do I only pay the deferred taxes on that portion of the 1031 that was allocated for each home? Example, I decide to sell only 1 of the 10 properties that were purchased for the 1031 exchange and I decide to pay taxes on it. Assuming that each property is equality valued at the time of purchase do I pay taxes on 10% of that tax deferral on sell of my SFH?

I need to offload this property in the future but I'm just not sure what my strategy and plan is going to be so any useful advice is much appreciated. Thank you everyone!

@Esther Thomas I think you will like most of the answers to your questions:

Question 1: Sorry, yes you need to replace at least as much value as your current prop (net closing costs etc). So if you sell for $800k, you need to get a new prop for $800k (ignoring closing costs just for clarity). You also need to replace at least as much equity. So however much equity you have in the prop (at least $400k by the sound of it), you will need to have at least that much equity in the new props. 

So, for example, if you originally had a loan for $320k (80% of 400k) and you've paid it down to 200k (just guessing, not sure how long you've owned it), you now have a prop worth 800k of which 200k is debt and 600k is equity. Your new prop(s) need to be worth at least 800k AND have at least 600k in total equity. So you can't sell the 800k prop, pay off your 200k loan, and then use the 600k to buy a new prop through the 1031. Well, you can, but you will pay taxes on that 200k of debt reduction -  the IRS sees debt reduction and cash as the same in terms of their benefit to you. 

That 800k of value (including 600k or more of equity) can be spread around to multiple props. So if you wanted a big portfolio, you could use the 600k as down payments on several properties, buy maybe one or two in cash (in cheaper markets), and use financing to leverage your current capital into a much bigger investment. You're in a great position with tons of options for building your REI portfolio.

Scenario #1: Yes, you can move into a property purchased as an investment. There's no hard and fast rule, but most investors agree that the IRS won't look askance at you as long as you hold a prop purchased through a 1031 as a rental for at least 12-18 months (which you plan to do anyway). The Sec 121 exemption requires that you have lived in the prop for at least 24 out of the 60 months prior to selling and have owned the prop for at least five years in total (because you bought it through a 1031). Your scenario meets both those requirements, so yes you would be able to take a partial Sec 121 exemption, prorated for the portion of time you lived in it vs rented it during the five years prior to selling (called a mixed-use property). 

Since you're guessing four years here, I'd say stay one more year and qualify for the whole thing if getting some tax-free cash is your goal. But remember that only capital gains can be excluded under the 121, not deferred depreciation recapture, so you'd need to speak to a CPA about your specific situation to make sure you know what's what. 

I will also note that there are a couple different ways to take advantage of both the 1031 and the 121 at the same time, and depending on your situation you might find another option more beneficial. Here are two helpful articles that may be of use: http://www.exeter1031.com/application_sections_103... and this: http://www.exeter1031.com/article_overview_1031_12...

Scenario #2: Yes, you can sell this prop and buy 10 smaller props (in this case would be worth $80k each, which is doable for cash flow props in good markets). If you later (again wait 12-18 months to keep the IRS happy) decide to sell one, then you are only liable for the proportionate amount of deferred gain (so yes, 10% in this case). Of course, it will be a little trickier than those nice round numbers, so definitely make sure you have a good CPA on your team. 

Also, remember that there is no limit to how many 1031s you can execute. So if you decided to sell one or more of the properties down the road, you could do so through another 1031 and continue to defer taxation. In fact, it is technically possible to defer taxation indefinitely if you play your cards right.

I'm sure some much brighter minds than mine will pipe in on the thread at some point, so always defer to advice given by Qualified Intermediaries or other 1031 professionals. I (personally) and my clients use the 1031 process regularly and I definitely make it my business to understand the ins and outs, but I am a turnkey provider (and BP addict, clearly), not a 1031 pro ;) 

If you are considering selling soon, remember that a 1031 requires that you have a QI on your team before you get started, and there are plenty of timelines and rules to adhere to. So if you're thinking of selling soon, I'd make vetting your QI your next step.

Best of luck!

Clayton

Clayton, thank you for your fast and detailed reply! Its' definitely a huge help, informative, and I'll follow up with others but a great start in detangling the mystical 1031 world! :) Thanks again.

As a 'side question' to what Esther is asking here;

Say I have a rental and I do a 1031 to a new rental for say 1-5 years and THEN move into it for at least 5 MORE years personally. Since I would have lived there for ALL 5 of the last 5 years, does the 'pro-rating' of the 'rental to personal' time portions go away?

Thanks, Dan Dietz

To be clear, when you sell the property you later move into, the 121 exclusion would only apply to, or part of, the gain on That property.....whatever gains/depreciation recapture deferred in the 1031, attributed to that property would still be due.

@Daniel Dietz , The hold period qualification is the 5 years prior to sale.  the proration requirement is all the gain prorated between all the qualified use (as a primary residence) and non-qualified use (as an investment property.  So in your instance it will make a huge difference whether you use the property as investment for 1 or 5 years.  If you use it as investment for 1 year and then change your intent and move into it for 5 years and sell you would get 5/6ths of the gain tax free.  And like @Wayne Brooks said you would pay depreciation recapture.  However if you held the property as investment for 5 years and then moved into it.  You would only get 5/10ths of the gain tax free.  There's some strategical thinking to be employed here.

@Esther Thomas , Very thoughtful questions well addressed as always by @Clayton Mobley .  I would add one thing regarding equity and reinvestment.  Trying to plan your reinvestment so you have the same equity is a difficult and unnecessary thing to do.  The easier way think of the reinvestment requirement - whether buying 2 or 10 replacement properties- is to think of it as a two part requirement.  If you want to defer all tax you must purchase at least as much as your net sale (contract price minus closing costs) and you must use all of your net proceeds (net sale minus any mortgage paid off) in the purchase or purchases.    

I think it's much easier to think of simply spending all the proceeds since if you buy multiples as Clayton said you may want to allocate your proceeds so that a few properties you buy for cash or with minimal leverage.  And a few properties you may want to buy with minimum down and maximum leverage.  This will in theory leave you with the same equity but it could also leave you with some properties with more and some with less equity.   You can also add your own cash to the purchases and that would actually increase your equity.

The strategy above of selling and 1031ing into multiple properties with some of the purchases paid for in cash and some with maximum leverage is a great late market strategy that lets you protect some properties from debt risk while still letting you aggressively use leverage on others.  

Your strategy of later converting a property from 1031 investment to primary residence and sheltering part of the gain is a good one as well.  Note that you can sell a property under the sec 121 primary residence exclusion once every two years.  So it is possible for you to have several 1031 rental properties (preferably really nice investment properties located near beaches or ski resorts :) that you can transition into hold and sell taking the 121 portion of profit tax free each time.  Not a bad post retirement job at all.

Thank you all for this info. One last follow up question, I'm assuming if I need a place to park this tax deferral, I can't sell my property and 1031 exchange to part of a syndication, and then when I do identify the actual property I want sell my stake in the syndication and use that to purchase my end goal property? I'm just thinking of ways to buy myself time. 45 days to identify the 1031 property is stressful and I definitely don't want to make a bad purchase decision because of timing. Also I hear there's a reverse 1031 option where I can purchase the 1031 property first and then sell my originating property? My house that I'm considering 1031, I think time on market will be short. It's in a pretty "high demand" area in Silicon Valley so I don't foresee an issue selling it, it's more about identifying the replacement property that will be challenging. Thanks!

I am very against the 1031 for investors moving toward syndications and not being the day to day operator. Let me know if you are interested in talking this through. But as someone who traded 2 seattle properties for 9 turnkey rentals I can say it was a mistake.

@Esther Thomas , You can't exchange into a syndication as part of a 1031 exchange.  Syndications are generally set up as LLPs or LLCs and what you are purchasing is an interest in a company rather than an interest in real estate which is required by 1031.

You can certainly sell and invest in a syndication.  But I don't think they'll be letting you take your money out shortly anyway.  And you'll pay the tax.  I think @Lane Kawaoka may have missed the posts where your original intent was to buy a fixed asset and later convert it to a primary residence.  Contrary to his statements, the 1031 exchange is the only way to go to make that happen tax advantaged.

So that's a non starter any way.  But in addition to that you don't want to exchange into a "place holder" that you shortly sell.  Because this would appear that you did not purchase your replacement property with the intent of holding.  And that could jeopardize your exchange.

Don't get target fixation on the 45 days.  That's more time than you think if you're focused and using good professionals to help you find your next property.  Treat it like a motivation and not a barrier :)

@Esther Thomas I am by NO means an expert on 1031s - I am just starting to look into them more to be knowledgeable as I talk to 'reluctant sellers due to the high tax burden of selling' - but I HAVE done a lot of research here and otherwise. 

It *seems* like from what I hear from friends selling in your area that a Reverse 1031 Exchange deserves strong consideration. 

Part of what I am running into is the sellers that I tell about 1031s say "how will I find something soon enough", so I am working on the idea of the Reverse 1031 too. Essentially finding an replacement property and line things up first. 

Just a thought, Dan Dietz