Writing for some clarification on how the 1031 actually works — plan to use it for the first time in the coming weeks.
Let’s say I’m selling a property for $200k, with roughly half as proceeds and the other half going back you pay off the mortgage. I haven’t lived in the house in 2 out of last 5 years but have owned it for more than 1.
If I want to defer all taxes, I must exchange for a property worth >$200k. But, what if I decide to exchange it for a property that I buy for $120k? In other words, how do I determine what portion for the original cap gains hit I’m eligible to defer if I don’t meet or exceed the sale price of the relinquished property on the newly acquired one?
@Tyler Cote , The 1031 sounds right for you. But the reinvestment criteria may trip you up. Unfortunately the calculations are pretty easy - and not in your favor.
In order to defer all tax you must purchase at least as much as your net sale and use all of the proceeds in the next purchase or purchases. For you that means you would need to purchase at least $200K in real estate using $100K of proceeds to do so.
You can purchase less than you sell and you can take cash out but the IRS says that when you do that you are taking profit and .you would pay tax on the difference until you have recognized the full amount of your gain. So if you only purchase the one property for $120K you would potentially pay tax on the difference between $200K and $120K. In other words you'd pay tax on the $80K difference. If your gain was only $60K you'd pay tax on all $60K. If your gain was $100K you'd pay tax on the $80 Difference but would shelter the tax on the remaining $20K of gain.
In essence the IRS doesn't care how much your profit is. If you purchase less than you sell or take cash out they will consider all of that profit until you've recognized all of your profit.
I'm asked the question all the time about original capital or down payment and how those aren't taxable. And you're right. But when you do a 1031 and take money out or purchase less than you sell the IRS says you are not taking out your original capital. You're taking out profit. And they somehow win just about every argument.
One thing you could do would be to use your proceeds as two down payments and purchase an additional property so that you use all $100K in proceeds and buy two properties that total at least $200K.
I'm Also trying to find the answer to a 1031 exchange question. please help me clarify this.
If I sell my property, am I able to use all that money on the construction of a new house? Of equal price or higher to the property I just sold? Could this process be use as the 1031 exchange?
If it is the sale and purchase of an investment property, not a personal residence, then yes you could buy a lot and build.....but you’d still have to have the property Completed within the 180 day replacement period. And it couldn’t be on a parcel you already own.
Thank you for your response Mr. Brooks.
@Adriana Cardenas , yep @Wayne Brooks is exactly correct. The way you do it is to find a builder who will retain ownership of the lot and build a house on it while you are in contract to purchase the completed product. You go into contract with a series of earnest money draws and as soon as the house is complete (within 180 days after the closing of the sale on your old property) you take title to the new property. If your exchange can over the entire purchase then your original earnest money is refunded to you.
Here are a few tips for your 1031 exchange -
- The cost of the replacement property must be equal to or greater than that of the relinquished property. So, if you sold your property for $200k, the replacement property must also worth $200k or more.
You can't exchange personal properties (residence or vacation homes) using a 1031 exchange. Only investment properties qualify for a 1031 exchange.
The debt on the relinquished property must be equal to the debt on the replacement property.
- In case you acquire a property of lesser value, that would result in a boot and your exchange will no longer be valid.
@Lisa Taylor , some good points for @Tyler Cote . But your last one is not correct. The IRS does not care about the level of debt. As long as you purchase at least as much as your net sale and use all of the net proceeds from the sale he will defer all tax. You do not have to replace debt for debt. You can use any other source of cash that you want. Most people don't have the cash to supplement from somewhere so they end up replacing all debt. And this is why it's a very common misperception. But technically you don't have to replace debt. You only need purchase at least as much as your net sale and use all of the net proceeds in the purchase or purchases.