1031 exchange and Brrrr.

19 Replies

Yes, 1031's usually imply a minimum of two years' ownership. To receive the full benefit of a 1031, your replacement property should be of equal or greater value. You must identify a replacement property for the assets sold within 45 days and then have it wrapped up within 180 days. There are definitely restrictions regarding 1031's so I would check with your local institution to find out their requirements. Also, I believe that money typically goes into a separate account to be used for the new property.  It's not like you just have cash in hand when you are selling your property.

@Matt Westphal 2 basic rules to the 1031....

1) you must put All the cash from the sale of the first into the replacement property

AND

2) the purchase price of the replacement must equal or exceed the sales price of the first property (less actual selling costs).  

Assuming you have a mtg on the first property, you can’t use just your equity/cash from the sale to buy all cash.

@Matt Westphal , The two rules @Wayne Brooks just gave you are all you need do to avoid all tax.  It's not quite a simple as only putting your equity in the replacement property.  There is no specific requirement to replace debt.  You can bring in your own cash if you want.  But any amount you purchase less than you sell or any amount of cash you take out is considered to be profit first and it's taxable.  Most people don't have access to that cash so they take out new debt

One of the most powerful aspects of the brrr strategy is the ability to r(refinance).  This lets you pull cash out to then reinvest in new properties - these will probably have mortgages that you will later refinance once you've "R" (rehabbed).  

One opportunity you have right now if you don't have debt would be to take the 1031 and instead of purchasing one replacement property for cash - purchase two properties using the cash proceeds from the sale as down payments.  Or if you did have debt on the old property and can qualify you would use whatever cash is generated as down payments on more than one replacement.  This jump starts the brrr process much more quickly.  And it probably lets you stay at a price point where you can maximize your value add efforts.

@Dave Foster Thanks Dave! So I have two properties here in Vegas I plan to sell each worth about 250k I put 20 percent down and have owned them for about 3 years . Should clear about 140k with an additional 65k cash to invest . So I definitely dont have enough equity to pay 250k cash for a house . Are you suggesting I do a conventional loan on multiple properties with a larger down payment . Eg. 50 percent down on a 250k house. Then refinance after rehab and rent? Thanks again

@Matt Westphal

Matt, if you well $500k worth of properties and only buy $250k worth you’re not going to save any taxes. You’re taking $250k out that way, so the first $250k worth of gains are going to be taxable. 

You could sell one and buy one or sell two and buy two, but what’s the purpose unless you’re switching markets?

If you’re trying to reduce the number of rentals or debt you might consider selling the one with the smallest gain and only exchanging the other one? It doesn’t sound like you have a massive taxable gain. 

@Matt Westphal

Makes sense. Then your choices are... Sell both and buy  1 x $500k property, sell both and buy 2 x $250k properties, or exchange 1 for 1 x $250k property and sell the other one outright and pay taxes on it. 

Exactly right @Matt Westphal , Purchase multiple properties using your proceeds as down payments.  As long as you purchase at least $500K ish and use all $140K ish in the purchases you'll defer all tax.And you can allocate the proceeds in any way you want.  So they don't have to go equally into any purchases.

To really kick start your brrr thing I'd look for real value add opportunities and use that $65K as your rehab money.  Maybe that only gets one or two done.  But remember you're going to refinance as soon as possible after the rehab is complete.  So you'll be using your $65K on one big rehab but replacing it with the refi to go to prop 2.  Or maybe the refi gives you enough to pay back the $65K and rehab the next one.  

You could also do exactly what @?Bill Brandt is saying and separate the sales.  Do them one at a time - again using your $65K as rehab money.  When complete refi pull the money out and sell the second property and do the same.

That's how it works.

Matt, you could consider using an Improvement Exchange.  I didn't see anyone mentioning this option.  This is where you use a 1031 exchange to sell an existing property and purchase/rehab the replacement property.  You will have to complete the purchase/rehab within 180 days of selling the relinquished property, so planning is key.  Since you have two properties, you could do this type of exchange per property, or combine the two into one larger property. The investment in the replacement property must be more than the selling price of your relinquished property to avoid any taxes.  If you are interested in this option, you should contact an exchange intermediary that does these kinds of exchanges and they can walk you through the process to see if this type of exchange works for you.  

Great option @Bob Norton .  One key to the improvement exchange is that the client still cannot exchange into improvements on property they own.  So @Matt Westphal can't just sell and buy in the 1031 and then use the proceeds for improvement also.  The QI has to set up a single member entity called the exchange accommodating title holder (eat).  The eat holds title while the property is improved by the client who is in control of the property.  During this time the exchange proceeds can be used both for the purchase by the eat and the improvements by the client.  As soon as the improvements are complete (and within the 180 days you reference) the client will take title from the eat at a purchase value that also includes the improvements.

Improvement exchanges are a little more complicated and pricey but for large improvements can be a great option.

Hi All, I wanted to inquire to this group about a similar strategy that this thread tip-toes on but doesn't directly address. Could I use a 1031 then a BRRRR to free up capital?

Ex: $200K sale on relinquished property with $120K equity, purchase $200K replacement property 'all cash' with $120K 1031 proceeds and $80K personal savings, BRRRR the replacement property and eventually get an ARV appraisal of 240K, Refi with a note of $180K (75/25 LTV), replace the 80K in savings and you are left with $100K cash with zero strings, restrictions or tax implications. (I've ignored the BRRRR rehab budget but this is just a hypothetical).

I suppose it would be much simpler to just cash out refi the existing property to free up $60-70K capital but perhaps the terms are considerably less favorable? Another scenario where this example can be useful is to expand options for the 1031 replacement property. I recently completed a 1031 where I was only searching for properties that were priced at 4x of my 1031 equity because the only plan I had in mind was conventional financing with 25% down on a multi-unit. Evaluating cheaper BRRRR properties would have widened my horizons and I could have possibly landed a better deal. Looking forward to your input. Thanks!

@Brian Moore , 1031 exchanges and the BRRRR (buy, rehab, rent, refi, and "re-evaluate to see if it's time to sell and 1031) strategy work perfectly together. Both of your points speak well to the opportunity to combine BRRRR and 1031. There's some things you have to pay attention to.

1. In order to completely defer tax in a 1031 you must purchase at least as much as you sell.  So when selling an appreciated asset you may need to look at purchasing more than one value add properties in order to reach your reinvestment target.  Unless you're doing an exotic form of exchange like a reverse exchange you can't use 1031 proceeds to fund improvements.  So the purchase prices will have to eat up your exchange.

2. Your scenario of rehab first and then refi holding afterward is just fine.  The IRS gets very skittish when you refinance right before a sale.  The interpretation can be that you only refinanced to get at the profit ahead of a sale and 1031.  So that's a path that should be avoided.  However, a refinance after a 1031 is completed is not a problem at all as you are no longer accessing profit.  Instead you are borrowing using your equity as security.

Originally posted by @Dave Foster :

@Brian Moore , 1031 exchanges and the BRRRR (buy, rehab, rent, refi, and "re-evaluate to see if it's time to sell and 1031) strategy work perfectly together. Both of your points speak well to the opportunity to combine BRRRR and 1031. There's some things you have to pay attention to.

1. In order to completely defer tax in a 1031 you must purchase at least as much as you sell.  So when selling an appreciated asset you may need to look at purchasing more than one value add properties in order to reach your reinvestment target.  Unless you're doing an exotic form of exchange like a reverse exchange you can't use 1031 proceeds to fund improvements.  So the purchase prices will have to eat up your exchange.

2. Your scenario of rehab first and then refi holding afterward is just fine.  The IRS gets very skittish when you refinance right before a sale.  The interpretation can be that you only refinanced to get at the profit ahead of a sale and 1031.  So that's a path that should be avoided.  However, a refinance after a 1031 is completed is not a problem at all as you are no longer accessing profit.  Instead you are borrowing using your equity as security.

Hi Dave - you seem to be extremely knowledgeble on the 1031.  I've got a scenario I'd like to run by you.  

I have a property that I Brrrr'd about a year ago and now looking to sell and interested in using the proceeds in a 1031 exchange.   

To use simple numbers, let's say I purchased the property for $50k, Brrrr'd it and now have a $80k mortgage after $100k ARV appraisal. So now if I sell the property for $100k, I assume it'll trigger a $50k gain on sale, right? But I will only be receiving $20k in cash from the sale. Is there a way to defer the full $50k "profit" using 1031 or am I stuck only being able to apply the $20k that I'm receiving in cash?

Thanks so much for sharing your expertise!

Hi @Peter Davis - If you purchased for 50K and you sell for 100K, your capital gain is 100K minus 50K minus capital expenses you made to improve the property minus closing costs on both sides of the deal. If these are your real numbers, you might not have enough gains to even justify doing a 1031. 1031s cost $600-700 and have timeline restrictions so you may want to just pay the tax. However if your numbers are much larger than this and you feel 1031 is the right strategy, the capital gain from the calculation above is the amount that must be carried forward into the next deal in order to defer all capital gains taxes.

@Peter Davis , The requirements to defer all tax in a 1031 are to purchase at least as much as you sell (100k minus closing costs) and use all of the proceeds from the sale in your subsequent purchase ($20K ish).

So if you did a 1031 and purchased at least $100K in real estate using all $20 K in cash you would defer all tax,

That is the beautiful thing about a refi and 1031 working together.  The refi is not a taxable event.  It doesn't impact your gain or your reinvestment requirements.

You want to make sure that your refinance doesn't come to close to your sale or the IRS could determine that you were only using the refi to pull out profit ahead of a 1031.  But it's a small worry.  And it sounds like theres some water under that bridge.

@Brian Moore is right - your gain is around $50k minus closing costs and your capitalized improvements.  But you'll also have a little increase of the depreciation recapture for the one year.  It's probably only around $2k but that's still $400 - $750 of tax depending on where you live.  Definitely do the calculations to make sure it saves you money.