Hi Fellow Investors,

I have a friend here in the state of Washington interested in selling their 4plex that they’ve lived in for almost 3 years. What is the best way for them to go about selling this property and will they have to pay capital gains tax?

Also what are her options with using IRA or 1031 exchange? She's unsure of how those could work.

If you know of any good books, articles, or forums to read up on please refer those as well.

I’m just trying to help her get more information on this before they move forward with selling their property and this is something I’d like to know about for my properties in the future.

Thanks in advance!

Originally posted by @Victoria C. :

Hi Fellow Investors,

I have a friend here in the state of Washington interested in selling their 4plex that they’ve lived in for almost 3 years. What is the best way for them to go about selling this property and will they have to pay capital gains tax?

Also what are her options with using IRA or 1031 exchange? She's unsure of how those could work.

I would have a local broker do a CMA for her on the value and then refer her to a Q.I (Qualified Intermediary) for the 1031 exchange.

But if she lived there for 2+ years, she should be able to avoid the capital gains tax unless its a substantial windfall, thus negating the need for a 1031 exchange. I know with the new tax law, it might be 4-5 years now instead of 2, but that would be a great question for a CPA.

@Marc Middleton I'm still getting used to all of these real estate terms, what exactly is substantial windfall? I'll definitely have her check with a CPA about the new tax law. She does currently have someone doing the CMA for her though, so I think she's started off on the right foot!

In selling this it would most likely be a profit of over 300k. 

@Marc Middleton the law didn’t change. It was proposed but not accepted :) yeah !!

Is your friend wanting to go to another piece of real estate with the proceeds of the potential sale? Do they need the cash? Could do a 1031 exchange for the portion of the property that they didn’t live in. Avoid tax and roll those proceeds into other investment property... Could also potentially exchange to a DST if they qualify - avoid tax and get income off of passive real estate.

I’d talk to a qualified intermediary about 1031 exchange options as well as their CPA about what the potential gains look like if they don’t exchange.

Definitely some planning that needs done :)

Originally posted by @Bethany Rankin:

Marc Middleton the law didn’t change. It was proposed but not accepted :) yeah !!

 I thought the new law changed the capital gains exemption from 2 years out of 5 as a primary to 4 out of the last 5? If not, great for all of us down here in Florida :-) 

Definitely call a CPA regarding your friend. If they have a broker doing a CMA, they should know the laws for your state and should be able to recommend a Q.I if she needs one.

@Joshua Wright they do want to invest in more properties, but probably wouldn’t do it right away. They are moving soon and were thinking of using some of the cash towards a new property to live in and in the future putting the rest of it towards a new investment property. 

Also from what you said it seems like in a Multifamily property they would still need to pay capital gains tax for the other three units they didn’t live in?

What is exchanging to a DST?

These responses are one of the reasons why I love this site. I am able to learn so much just from a simple post!

@Victoria C. , the best thing to do if they lived in this property for the last 3 years is to sell it. They owe no capital gains on the profit up to $250,000 if they are not married and up to $500,000 if they are married.

I don't think it would be eligible for a 1031 Exchange - at least not all of it, and they would just be kicking the tax down the road, rather than writing it off completely.

Because its a four unit and she's only living in one unit, only that one unit would get the section 121 exclusion.  That's the "if you've lived in it for two of the last five years you can exclude $250K (single) or $500K (married filing joint) from capital gains tax" rule.  This law did not change in the new tax law, though a one point there was consideration of changing it to five of eight years.  The proceeds from the other three units could use a 1031 exchange into a new property to defer capital gains.  I've been looking into this, though in the opposite direction.  I.E., sell a primary and use 121 to exclude tax and sell a rental and use a 1031, and then buy a multi and live in one unit.  I've found it is possible to combine these.

The 121 exclusion applies regardless of what they do with the money.  The 1031 exchange requires they by a new investment property.  Both have timelines they need to be aware of.  If they do not want to buy a new investment property they're stuck paying capital gains tax and the tax on unrecaptured depreciation on the three rental units.

Whoa I think this exact post got posted two places.  Here's the response I posted in the other forum.

@Victoria Crump your friend will benefit from a portion of that property being tax free as their personal residence for 2 out of the previous 5 years.  @Marc Middleton the law did not change for the 121 primary residence exclusion - thank heaven!

However, Unless they have lived in the whole thing what they really have is a split use property. They have lived in 1/4th so 25% of the sale would be their primary residence and tax free is the gain falls under the maximums. The other 3/4ths of the property is an investment property and I'll bet they've been declaring rent and depreciating and writing off expenses on it for their period of ownership. so 75% of the sale is an investment property and subject to capital gains tax and depreciation recapture unless they do a 1031 exchange and defer the tax on that portion.  @Mindy Jensen , shame on you - we can always find a way to squeeze a little 1031 tax deferral in the mix :)

The sale of a property like that is very easy for an experienced team. You'll market it just like you always would. In situations where we act as the QI we work with the clients accountant to get a determination of the %breakout of primary/investment. And then the closing docs reflect those percentages. the client gets the tax free portion immediately. And the remainder goes into the exchange account for them to buy their replacement property.

Split use properties are an incredible opportunity to get some tax free money and defer the tax on the rest so you can leverage your investment portfolio also. Well done.

@Victoria C. I checked with my QI and was told that they could definitely do a 1031 exchange on the portion that is investment property. She also said that they wouldn't owe tax on the sale of the "personal residence" portion of the property as long as the gain on that piece wasn't over $250k for Individual / $500k for Joint.  

Your friends will be able to take the proceeds from the sale that is attributable to their "personal residence" and buy whatever they want. The bigger issue is what they do with the proceeds from the "investment" portion of the property. If they don't want to exchange into more investment property right away, they'll end having to pay taxes.

But there are options they can explore. DSTs are just one of the options. It stands for Delaware Statutory Trust and is a trust / pass through entity in which a sponsor (think big real estate investment corporation) buys institutional property (apartments, self storage, commercial, medical office, etc) and then sells interest in the Trust/Property to investors. DSTs are 1031 eligible and can work great for people looking to avoid tax on their sale and just want hands off real estate plus the income. 

However, pros and cons... In your friends' case, that might be liquidity. DSTs are not liquid like any other real estate. So if you're friend put the proceeds there, for the most part they can't get their money back out until the sponsor sells the investment property at some point down the road (time frames vary by DST, but for sake of this feed..lets say 7-8 years on average). Your friends would really need to think about their time frame and wants. But it can be a good solution. I can message you an article or two to check out on these if you want.

Dave, I started thinking about it and I'm glad you chimed in. I've never had this experience personally and it makes sense that a portion is available as a 1031. Wishful thinking that it could all be written off. OP,go with Dave's great advice.

Originally posted by @Victoria C. :

@Joshua Wright they do want to invest in more properties, but probably wouldn’t do it right away. They are moving soon and were thinking of using some of the cash towards a new property to live in and in the future putting the rest of it towards a new investment property. 

Also from what you said it seems like in a Multifamily property they would still need to pay capital gains tax for the other three units they didn’t live in?

What is exchanging to a DST?

These responses are one of the reasons why I love this site. I am able to learn so much just from a simple post!

 If they are not planning to get back into real estate investing right away, the best option would be to consider a Monetized Installment Sale. This is a way to structure the sale so that the seller gets cash at closing and can defer the capital gains tax and depreciation recapture for 30 years. This would let the seller sit on the sidelines while waiting to find their next deal. And they would be able to go into the next deal with an all new basis and fresh depreciation. With a 1031 your gains and depreciation are rolled forward into your next property.

Hi @Victoria C. , I just sold a highly appreciated rental property in the Bay Area last year using a "Monetized Installment Sale". This deal structure let me get cash at closing and defer the capital gains and depreciation recapture for 30 years.  This gives me flexibility in choosing "where" to invest, and not stuck with another real estate purchase in a red hot market.