Take the Tax Hit or 1031?

66 Replies

I have a problem and would love to hear some opinions on this.
Here is the scenario: a $1.5M tax exposure (net profits on sale of property) and a lack of desire to pay Uncle S. and CA 50% of that ($750k).

So the question is, would you pay the tax and keep gong or would you 1031 exchange this into a buy and hold deal (perhaps commercial deal or 100+ unit apartment building) to avoid the tax?

If you pay the tax, keep in mind you would have until next year to pay it so perhaps take the $1.5M and reinvest into more deals that would net profits to pay s the tax so at the end of the day, perhaps you would still be left with $1.5M or 1031 and with the buy and hold, obtain cash flow passively to semi passively for years to come and not pay any tax.

Your thoughts are appreciated.
- Will Barnard

Wish I could give you some wise advise, but I am unable to and would love to figure out how to have this issue in the near future. :)

Best of luck!

Wouldn't you always 1031?

1) you pay the taxes at a future point in time when you are in a lower tax bracket or more favorable jurisdiction? E.G., move to Texas without any state income tax, and then sell your property in California? how would that work?

2) 1031 lets you benefit from a greater amount of passive income than you otherwise would have been privy to? In no circumstances would it be less income? As your investable base will be higher.

3) is there a flaw in your logic, when you say you will flip more properties in order to pay the tax bill -- those flip gains are also taxable. So are you undercounting your tax bill?

4) I would have to think the 1031 is a compounding benefit. But your ability to earn for a year to pay the prior year tax bill is a looper. I need to think about this out loud...

Say you have $1.00 value, that doubled off $0.50. with your 50% tax rate, that is $0.50 gains taxed at 50% = $.25 liability. So no matter what path you choose, that's your tax liability today.

Now say you 1031 and compound it.. after a year you have $2 value, and after year 2, you have $4 value. You cash out, and owe your original $0.25 liability + 50% ($4 current value - 1 today value) = $1.75 total tax liability. $4 current value = $1.75 = $2.25 net value.

Now say you paid your taxes after a year. So after a year you still have $2 value, but you pay the $0.25 original liabilt, *as well as* the $0.50 new tax liability on the Year 1 gains. ThSo your $2, less $0.25, less $0.50 = $1.25. You compound that $1.25 in year 2, for $2.50 value. You cash out, and your taxes are 50% ($2.50-1.25) = $0.625. Your net value now is $2.50 - $0.625 = $1.88.

Thus, 1031 resulted in greater value.


as far as (4) above goes, I think this is the compounding benefit: You are compounding off a larger base via the 1031. Ultimately, you will cut your final value in Year 10 by half, regardless of whether you did 1031 or paid taxes today. Its better to cut a larger number in half, than a smaller number in half.


Agree/disagree? I could be wrong. Don't make a $1.5MM decision off my little blog post.. I've been working late.

The elementary school principal in me says "pay the taxes" because that will pay for TEN teacher's salaries for a year, but my investor mindset can't imagine paying that much if you don't have to.
IMHO, it all comes down to what kind of property you've got and what kind of property you want. If you stay in the same lane, you can avoid the taxes, but if you've just gotta change lanes to get around the slow driver, you may reach your destination more quickly. Look at all of the potential like kind properties, and stay in the slow lane (avoiding taxes) if the numbers look right. If the like kind properties that you've identified don't pan out to be racey enough after doing your due diligence, then turn on your blinker, get into the fast lane and buy what you really want. And if you do have to pay the taxes, feel good knowing that a large percentage of your CA taxes pays for teachers.

I would say 1031 into the larger property. You can 1031 into multiple properties by the way to diversify your portfolio if you like and can later refi out some of that equity tax free.

I wouldn't pay uncle same 750k as that is crazy talk. If Will you still want to do the flips and you have plenty of sources of people to give you the funds to do that then by all means 1031 the gain so you pay not tax on your own.

Leave eventually to your heirs as a stepped up basis and wipe out all the junk that's built up over the 1031's over time.

Great question. Years ago I had a client with a similar issue (much smaller numbers). I can't remember why but in the end his CPA explained he couldn't do a 1031. If I had a choice, I would do the 1031 and defer the gain.

Will the thought of giving Uncle Sam 750k in one pop is really sickening! I would avoid this any way you can.

1031 into a large complex that will produce some nice additional passive income, something you can hold for the long haul, and like Joel said you can pass it on to whomever and they then have the option of holding it or selling it and not paying nearly as much taxes in gains due to the step up in cost basis!

Win win!


@Will Barnard ,

1031 into another property is my vote. Defer the heck out of those gains. lather, rinse, repeat. Is the property in CA? If not MOVE and then sell.

My vote is 1031 into other properties. Plural. The stepped up basis is also a great idea.

Another though is possibly consider a Family Limited Partnership(FLiP). You can gift at a discount AND you can spread that gain between family members to lower the taxable amount.

@Arjun K. ,

If the property was in CA, he would be subject to CA tax on the gain.

Thanks all for the input, much appreciated. It appears most are for 1031, however, none of the great responses above have made it possible for me to make a definitive decision.

Let me also add the following fact. My intent was to take a large portion of the $1.5M and use for lending, thus creating semi passive income. By doing a 1031, that money goes into a property and I don't have any of it for the lending portion of my business. With that new info, everyone still on the 1031 wagon?

Steven, I have considered the FLP before and my accountant suggested against it before, stating it is best used for larger sums of money. In this case, it may qualify and would like to get more of your input on how to best structure it and diversify tax liability to lower tax bracket family members like children.

I don't know much about 1031 so I could be way off. However, is it possible to take the 1.5 mil, buy a property all cash using a 1031, wait the year to meet seasoning requirements, and then cash out refi the property? You wouldn't be able to take 100% out obviously, but 75% out with 25% equity is better than 50% to Uncle Sam.

@Will Barnard let me be the first to say Congratulations! It's a good Problem to have.

It sounds like you are past the point of moving in for a couple of years? (250-500K exclusion depending on marital status)

I'm sure you have already considered if you need the income on your returns?

Reading your comments above it sounds like you want to add to your lending business and not wait for a refi on the 1031?

i like @Joel Owens stepped up cost basis advice

However, because you want to add to the lending side of your business, maybe the best strategy would be a blend of both.

You do not have to spend all of your 1031 funds. However any amount not spent will be considered cash boot and will be subject to capital gains taxes and any applicable recaptured depreciation. For example: The Relinquished (sold) property is sold for profit of $1,500,000.00. The Acquired (bought) property is bought for $750,000.00. The $750,000.00 would be considered cash boot and would be taxable. (this is for the benefit of the audience, you know all this;)

Originally posted by Will Barnard:
Steven, I have considered the FLP before and my accountant suggested against it before, stating it is best used for larger sums of money. In this case, it may qualify and would like to get more of your input on how to best structure it and diversify tax liability to lower tax bracket family members like children.

I don't know why your accountant advised against one. They are VERY useful tools not just for estate planning but family planning in general. Better than a trust as you can always amend the organizing documents. You can also utilize different corporations for ownership.

Yes, a 1031 waiting a year, I'm pretty sure though that you will save immensely by waiting the year. Also, you can implement leverage.

Another strategy might be to not do a full 1031 exchange. Maybe only roll over half the gain.


I see this as both an opportunity cost and lifestyle decision, Will.

If you pay the taxes, you’ll have $750k left over and the freedom to use it for anything you want. I know you flip homes and occasionally lend money. If you like doing this, and see a future of being able to grow the money quickly, then pay the tax.

One problem with a 1031 exchange is that it locks you into investments you might not really want. You certainly wouldn’t have the freedom to flip or loan the money. In effect, you have the choice between $750k tax free (the half left over after paying the taxes) that you can use for anything you want or locking the entire $1.5M into investment(s) you made solely to avoid taxes.

On the other hand, if a buy and hold commercial deal or 100+ unit apartment building is something you wanted to do anyway, and not just to avoid the tax, then the 1031 exchange would make sense. I’m generally not a fan of putting taxes at the front of all other investment decisions and I think that’s what you’re wrestling with.

Not a clear answer since the decision is not completely financial. Just helping to help clarify.

Also, for what it’s worth, you’re not locked into hard RE assets. Being a passive cash-flow investor, I would throw oil and gas into the mix. These are generally considered like-kind investments too.


A guru once told me you could 1031 into deed of trust, anybody know if that's true?

Updated about 5 years ago

Maybe I answered my own question. Interestingly, you can exchange real property into a long term lease, but any form of indebtedness seems to be out. according to first american title: http://www.ncs.firstam.com/socal/exchangetopic.cfm?exch=Like_Kind

Will, I did a 1031 with a $700,000 property in 2010 and did another 1031 in 2012 with a $360,000 property. I also did a 1031 back in 2007.

While others on here talk about "deferring" taxes, you can actually avoid taxes if you let the properties you buy in a 1031 go to your descendents as the property gets a whole new basis. But verify this with your accountant.

What kind of property you buy is up to you, but if you pay all cash, then you can borrow against it to make loans. If you can borrow at 4.5% and loan it at 10-12%, you have a nice income. Plus the interest you pay on the money you borrowed is deductible on your Schedule C.

Remember what Rich Weese said, have half your long term rentals financed to the "hilt" and the other half "free and clear." Unfortunately for me, I am at about 75% to 25%, with the 75% being Free and Clear. Then again, I have kids older than you Will, so retirement is looking good.

On a side note, if you do a 1031, use a reputable company, I use First American Title, Exchange Department. A few years ago, a small Escrow Company here in Orange County that also did 1031 exchanges, was owned by a person who found out they were dying of cancer, so one day, ALL the money in the escrow exchange account disappeared, along with the owner.

So my advice is to do the 1031, the government did NOT take any risk and does not deserve that large of a chunk of your profit. But taxing Capital Gains is a subject that belongs in another thread.

By the way, when I lived in Colorado, I still had to pay California Income Tax on my California rentals. I paid the Colorado income tax first, but with Colorado being around 4%, I had to pay the difference between the CO rate and the CA rate, to California.

@Will Barnard - is this one of your big ticket flips? If so, 1031 would be prohibited. See "flips" in this next link:


Now, if not a flip, then it makes sense to try to defer taxes. As mentioned in a post above, you don't have to roll everything into the replacement purchase, but the IRS will assume that you rolled in all of the basis, so that anything not rolled into a replacement property will be classified as boot. You'll pay taxes on the boot.

Steve, unfortunately "flips" are not defined. Would the IRS say a property bought as an investment, imprroved, and held for 13 months or more qualify? Would they question intent? Say the intent was to do exactly as described? What if the holding period was 6 months or 25 months? Does the code or case law spell this out?

This is a little out of my league right now, but the one thought I had was this: Why not 1031 into a poorly performing apartment complex (w/ financing), get it up to snuff, then cash out refi based on a new appraisal after it's performing well? Then use that money to invest in the notes, or more flips. It seems like that would offer many of the benefits of flipping in adding value, shorter term payoff, and I'm sure the joy of taking something broken and making it shine, as well as the tax advantages of buy and hold.

Out of topic:
@Harry M. , please check your profile image. Thanks.


@Uwe S. - Just PM'd you to get clarity...

If I am lucky maybe one day I will have this "problem". So, from a novice standpoint, I would say 1031. My thoughts on taxes boil down to one sentence (whether right or wrong I don't know): they can take anything they want from me once I die:).

CA--wow..WHAT a state. I have read so much I know I would not want to live there, but there are a lot of opportunities to be had. So, I guess that is a trade-off. Everytime you see articles on CA, you read about people leaving the state due to the tax situation there. In lovely SW FL, we don't have any state income tax (yet). I understand your post is regarding federal taxes though.

My uncle lives in SO CAL, and he amassed a fortune in real estate. I don't believe he ever sold a single property, though if he did I know without a doubt he did a 1031. Don't all the gurus chant "1031"?

So, my friend...from a novice new investor...my vote is 1031.

John Thedford

John Thedford, Real Estate Agent in FL (#BK3098153)

Originally posted by Will Barnard:
Carl, yes, I could buy all cash, then cash out refi in a year, but would need to wait a year! Also, I would be limited to buying only a 1.5m property and not get to app,y leverage.


How about 1031 into an income property for cash. Get a HELOC on it immediately after purchase. Use the HELOC money for your lending business. Refinance a year later. Is this option available?

I know u don't get the leverage benefit of the 1031, but u don't have to pay any taxes either.

I still say you 1031. The deferred gain versus no gain language is just use of words.

The gain is not technically wiped but deferred over the years UNTIL you leave it in the stepped up basis and then it gets wiped out. So technically it is deferred until it gets wiped out at a later date if you set things up right.

As amounts gets larger it can get harder and harder to double your money. Will also probably had some great deals before the market heated up and if he paid 750k in tax now it would be much harder to get to that 1.5 again from the 750k than it was before.

I don't know why you couldn't as mentioned get a big apartment complex and 1031 into that where it has 60% occupancy and turn around and improve the value substantially and then refi out later when holding.

The refi is considered a loan when you pull the money out so no tax.

Not a tax expert or 1031 expert but I just couldn't stomach giving that kind of money to a government that that can't even spend 1 dollar correctly.

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