When Doesn't it Make Sense to do a 1031 Exchange

8 Replies

I hear a TON about how 1031 exchanges are a great way to defer taxes + grow your portfolio faster. I've never done a 1031, but understand the logic and benefit behind them. I also understand some of the restrictions associated.

On the flip-side, I haven't heard many negative things about 1031s (other than the obvious restrictions).

Are there situations where it's better to avoid a 1031? Maybe if you don't have much equity? What other negatives exist with 1031s?

Thanks!

@Ben Hutto , Sometimes it's actually beneficial to do an exchange even if you don't have any equity because equity is not a determiner of gain. It is possible to have refi'd something to the point where there is little equity but a lot of gain. Similarly it is possible to sell a long held property at a loss but still need to do an exchange to avoid depreciation recapture.

But those are more reasons to do an exchange.  When not to do an exchange:

1. If there is no gain and no depreciation to recapture.

2. If you have pent up losses that can offset the gain.

3. If you can't find a suitable replacement property

4 If you are determined to leave real estate investing.

5. If the gain is small enough that it is more hassle than it's worth.

6. If you like to pay taxes  and would rather build highways and buy guns than invest the money for yourself :)

@Dave Foster , thank you for your response/organizing it simply. This all makes sense!

Do you mind answering a follow up question to point #5?

Let's say you use a 1031 with Property A to obtain Property B. Let's call the gain X for simplicity. X is worth the exchange, or you wouldn't have done it to start with. 

Now, let's say you find Property C, but if you were to exchange Property B, it'd be a wash with no gain.  It still may be a good idea to use an exchange to preserve the tax deference on X, correct?

I know this doesn't account for all of the factors, and is probably an oversimplification. 

@Ben Hutto , Yep that's exactly right.  When you do a 1031 the basis of the old property follows into the new property.  So if there was a $100K in the X transaction  you could sell B for exactly what you paid for it and there would still be a $100K residual gain from the first 1031.  So the more 1031s you do in sequence the more sense it makes to continue.  That's the beauty of the compounding profit on profit from reinvestment.

@Ben Hutto

Dave hit on all the main points.

To add to point 5 from Dave - the tax deferral from the 1031 has to be greater than the cost of the 1031 itself at a minimum.

The use of a 1031 intermediary can range from $750 - $1,250 for exchanging 1 property for another(from prices that I have seen).

The cost of the tax preparer having to figure out this whole mess I would have to guess to be between $250 and $500

with a cost of $1,000 - $1,750 for the 1031 exchange - and a tax rate of 15%(not assuming depreciation recapture and assuming you are not in the top bracket and not considering state taxes) - you should have atleast a 10,000 gain before considering doing a 1031 exchange.

Updated about 2 years ago

When I mentioned $250-$500 for tax prep. I meant the additional cost of paying your accountant for including a 1031 with your return.

@Basit Siddiqi

That makes sense to me. Thanks for the input.

I knew there was a cost associated with a 1031, so adding a price range is helpful.

It sounds like the determining factor(s) are usually how much you'll gain with the exchange (no surprise) and/or if you have tax deferred gains from previous exchanges.

Are the intermediaries paid from the gain or is that something you pay separately for?

Thanks again!

@Ben Hutto This is a great thread! Did you ever find out if you can pay the intermediary from the gain? Or does anyone know. We are thinking of doing a 1031 on a rental that we will profit 15-20k and we have had it only 2 years. I’m trying to figure out what the cost will look like compared to paying taxes. Any thoughts @Dave Foster ?

@Rachel Pivonka and @Ben Hutto , Sorry Ben I didn't ever see your question.  So thanks Rachel for re-energizing the thread.  There's not any industry standard.  A lot of  QIs will charge  you in advance to ensure their fee.  Nothing wrong with that.  We choose to have the 1031 fee placed on the settlement statement so it becomes a cost of sale.  If the sale doesn't happen the client doesn't pay.  We don't have anything to refund.  And since it's on the settlement statement it does indeed come from the gain.  All in all better for all.

Rachel, you have the fortune to be in a tax free state.  So if your property is also located in a tax free state you won't have any state tax.  You'll only be dealing with federal gain at 15% and two years of depreciation recapture.  Your gain would generate around a $3000 tax plus depreciation recap.  Figure your exchange cost around $750ish. So a 1031 might indeed be worth it if you were wanting to continue owning real estate.  2 or 3 grand of saved taxes  is real money.