question regarding 1031 Exchange

7 Replies

Hi everyone.  I bought a rental residential property for about $500k, and I estimate it will sell for about $1 million.  The property needs to be repaired in order to be sold.  The estimated repair cost will be about $100k.  I also need to do a 1031 Exchange.  For simplicity, let's just say that I will net $500k after the sale (after putting in $100k for repairs).  I believe that in a 1031 Exchange, all of that $500k net gain will need to stay in escrow and be moved to the new property.  I'm told that I cannot touch any of that $500k net gain.

Here's the problem.  I do have the $100k for repairs but I don't want to fork out $100k to put into this rental property for repairs because my $100k will be tied up and be stuck in the next property due to the 1031 Exchange.  If I do put in $100k for repairs, is there a way for me to get this $100k back into my pocket during the 1031 Exchange process, so that it doesn't go into the next property?  If not, how can I spend $100k of repairs and not have this $100k be tied up into the next property that I purchase, which will be a 1031 Exchange?  Thanks.

@Christine N., when did you buy the property? If you bought with the intent to flip, you won't be able to do a 1031 exchange.

If you can do a 1031 exchange, you'll be into the property for $600k and will be selling for $1 MM.  That means you need to buy a property for $1MM, which at 30% financing is a $700k loan, which will give you your $100k in cash back that you invested in the property when you purchase the upleg in the 1031.

@Christine N.  So there is some missing information here that is important so we can advise you. I agree with @Scott Wolf, if this is a flip, a 1031 would not work.  Has the property been tenanted and if so, when was it placed in service?  Taking money out for maintenance can trigger a boot if you are not careful!  I always like to loop my favorite 1031 guy, @Dave Foster on posts such as this.  He has helped many of my clients and is an expert who is also willing to help break it down to where it makes sense and keeps you straight with the tax man.  Dave?

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Hi @Christine N.

Your Gross Sale Price is $1.0 million.  Your Net Sale Price after certain (not all) routine selling/exchange expenses will be about $950,000 (ish).  $950,000 (ish) is the "top level" magic number that you need to reinvest to defer all of your taxes.  Pulling $100K out to cover costs to get the property ready for sale will be taxable boot.  The "bottom level" magic number is your Net Equity or Cash that will come out of the sale.  100% of the Net Equity would be held by the Qualified Intermediary and then reinvested in your replacement property.  The replacement property should be acquired for $950,000 or more (trade equal or up in value based on the net sale price) and all of the $500,000 in Net Equity should be reinvested.  There are ways to pay for the repair costs through debt, but it creates more debt in your investment property.  

Thanks for that shout out @David Vanlandingham.  

@Christine N., Bottom line - You want your repair money back.  

The requirement to defer all tax is to purchase at least as much as your net sale (contract price - closing costs AND use all of your cash proceeds to do that.  

You can purchase less than your purchase and you can take cash out.  But the difference would be taxable.

If you have a $600K basis in the old property ( purchase + the improvements and ignoring depreciation for the moment) and you sell for $1 mil (after closing costs) then your total gain is $400K

If you want your 100K back here's a couple options:

1. Simply take $100K from the sale.  This would be taxable (the IRS says that the first money you take out is always profit) but you would still shelter the other $300K of gain in the 1031.

2. Complete a full 1031 and use all of cash to purchase at least $1 mil in replacement property.  and then do an immediate cash out refi.  A refi is not taxable but puts the money in your pocket while the rental of the property covers the mortgage.  

Just make sure your intent is to hold the property for investment use and not to fix and flip as others have said.

@ Bill Exeter:  Thanks for your response.  You mentioned:

"There are ways to pay for the repair costs through debt, but it creates more debt in your investment property."

That means I can get a loan on the house for $100k, use the funds to repair the house, and then, when the house is sold, the lender gets their $100k back. That way, I don't use up my $100k. If that's the case, can I get a personal loan from a friend of mine or a loan from my LLC, then, put a lien for $100k on the rental property, then, instruct the Title company to pay my friend (or my LLC) back the $100k when the house is sold? Or does the lender of that $100k have to be a financial institution?


BTW, the rental has been bought years ago, and I have had several tenants in it before.


@Dave Foster:  Thanks for your response.  This is not a flip.  You mentioned:

"If you want your 100K back here's a couple options:

1. Simply take $100K from the sale. This would be taxable (the IRS says that the first money you take out is always profit) but you would still shelter the other $300K of gain in the 1031.

2. Complete a full 1031 and use all of cash to purchase at least $1 mil in replacement property. and then do an immediate cash out refi. A refi is not taxable but puts the money in your pocket while the rental of the property covers the mortgage."

I don't like option #1 because I would have to pay tax on the $100k.  I prefer not to use option #2 because it may take over 6 months from the sale of the rental property until I can refi to get my $100k back.  So I pose the same question that I asked Bill Exeter:

What if I get a loan on the house for $100k, use the funds to repair the house, and then, when the house is sold, the lender gets their $100k back. That way, I don't use up my $100k. If that's the case, can I get a personal loan from a friend of mine or a loan from my LLC, then, put a lien for $100k on the rental property, then, instruct the Title company to pay my friend (or my LLC) back the $100k when the house is sold? Or does the lender of that $100k have to be a financial institution like BofA, Wells Fargo, etc.?

@Christine N., Yes that would be another way of doing it. Its not prohibited but...  You'd want to be careful to keep pristine records that the loan went to real estate expenses!  As the IRS is prone to be suspicious of refinances right before a sale and 1031.

And certainly the loan would need to be recorded and paid off on the settlement statement. 

If I'm not mistaken Compass Real Estate has a concierge program that is actually a model of this.