Keep or sell Hawaii home to avoid capital gains/1031?

10 Replies

My wife and I bought our first home in Hawaii in 2012 at the bottom of the market. We lived in it and rehabbed for the first five years. After we realized that it had increased significantly in value, we decided to use our equity as leverage to buy another home. We rent out the initial 2012 purchase and have a small cash flow, but now the market is hot and the house has almost doubled in value. From what I understand about capital gains, as long as you live in the house 2 out of the last 5 years from the point of sale, you can avoid paying capital gains without using a 1031 exchange. Is it smarter to unload the house now and invest in something with more cash flow in a down market, or hold onto it and keep it as a part of the portfolio?

Hi @Joseph Getgen

If it's a single family home, I'd sell it. SFH in Hawaii aren't very good long term investments, unless they are nonconforming and have multiple units. I am certain you could take the equity and have significantly higher returns on a different type of property (condo, duplex, multifamily, etc.). If you do move your money into something else, make sure your realtor knows what they're doing when it comes to investing.

I'd estimate that only 10% of realtors in Hawaii own an investment property.  Of that 10% only a handful invest on purpose.  In other words they know what they are doing and have a plan.  But yet many realtors give advice to their clients about investing.  We meet too money people who have under performing properties and say they're realtor told them it was a good investment.

You are correct about the 2 out of 5 years.  As long as the gain is less than $500k.  It should be tax free, but consult a tax professional.

Agreed, except you will have to “recapture” the depreciation you claimed, or could have claimed, over the past 2 years or so....not a big tax bill. 

@Isi Nau thank you for your input. I would have to speak with our cpa about depreciation, but I have been leaning towards selling. The limited cash flow makes it difficult to grow my portfolio in Hawaii’s market, so hopefully I can trade up to be able to expand. My agent has investment properties as well and she knows quite a bit.

@Joseph Getgen welcome to BP! There is a wrinkle or two with "2 out of 5 rule" so please speak with you accountant. As far as selling is concerned if you can leverage the invested amount by increasing doors and rents that can make selling worthwhile; otherwise you can use it to finance a new property and have both. 

I would only sell if there was an opportunity for a bigger return. Sell SFR and buy a six-plex or more. You might also use the property as a short term rental-should be ideal in Hawaii?

Lots of alternatives. All the best!

@Joseph Getgen Wayne is correct. If you did claim any depreciation then that would reduce your total basis (total amount invested in the home). BUT you can still exclude a 250k or 500k gain (if married filing jointly). So, if your gain isn't more than that it doesn't matter.

If you are renting it out, I would absolutely sell while you still meet the 2 of 5 year requirement. This is the strategy I use for my primary residences.

@Joseph Getgen , If this property was cash flowing strong and providing a superior ROE then I'd be tempted to say hang on.  Because you'll always have the opportunity to do a 1031 exchange to sell it if that changes in the future.

But in your case it's hard to imagine that your NOI has jumped as dramatically as the property value and by default you have a bunch of trapped equity that could be producing in another property. A refi would fix some of that. but...

I'm with @David Lilley .  I'm so very fond of tax free that almost anytime I have that choice I take it.

If you find that depreciation is more significant than you thought you could always use a hybrid approach and do both a 1031 exchange and a primary residence exemption.

All you do is start a 1031 exchange but take out an amount equal to the gain that you would have gotten in a primary residence exclusion sale.  This is called boot when it's taken in a 1031 exchange.  But because you also qualify for the primary residence exclusion your account reconciles it as tax free.  meanwhile you go forward in the 1031 and shelter the depreciation recapture.  That's kind of a best of all worlds scenario. 

The tax free cash can go into new purchases if you desire.  But because it has no gain associated with it you're getting more depreciable basis in the new property.  And with no depreciation recapture because of the 1031 you would have no tax bill.

So your end sum in that scenario would be - No tax, some tax free dollars, continued depreciation from old property, additional depreciable basis so more tax write off in the future.

I just talked myself into it - that's what I'd recommend if depreciation recapture is anything significant.

@Joseph Getgen

Hawaii homes are not good generators of cashflow due to low Rent-to-Value Ratios. Aside from that and to answer your questions. I am very against the 1031 exchange. The 1031 exchange is a method of pushing forward the taxes due on the capital gains of a property. You have 45 days to identify replacement property that 180 to close on said property(s).

Its a way of kicking the can down the road with taxes. I personally that you have to pay taxes at some point unless you are going to take it to the grave with you which is not very practical due to the following.

1) The 45 days is almost impossible to execute. To be able to line up a deal that is “hot”. Experienced investors spend an average of 18 months to find that elusive first apartment. Now if you are buying lukewarm deals… then be my guest. But in this seller's market, I think its a way to lose everything.

2) Most investors that I work with are high net worth and able to cashflow income minus expenses over $30k a year and have over 50K of liquidity on hand. I believe that most people, unless they are talented at being an elite investor, should just be an LP role in a syndication due to the scalability and being able to spread their capital across different leads, business plans, asset classes, and geographical locations. That said a 1031 exchange will not allow you from going from real property to an LLC (ownership in a syndication). Although you could do what is called a Tenant-In-Common (TIC) arrangement where an investor has 1031 exchange funds and wants to parlay that money into a syndication. It's possible but from the syndicator's perspective a lot of unneeded work when you can just raise the funds the traditional way. Caveat: if you are bringing in a huge amount of money say 50% of the raise then that might tip the scales in your favor)

There are reverse exchanges and other more exotic exchanges but I personally not sold on the concept when the IRS comes knocking. I am not a tax professional but I feel it is tax evasion.

As a LP investor in syndications deals large enough to pay a guy 5-10K we do cost segregation in order to get bonus depreciation and write off a huge portion of the taxes from exiting the last deal. Basically bones depreciation has made 1031s obsolete.

@Lane Kawaoka Sorry you had such a problem with your 1031 a few years back. There’s approx 500,000 successful 1031 clients last year who would disagree with you.  

But the real question was not should @Joseph Getgen  skip the 1031 and invest in your syndication.  It was should be keep his Hi property or sell and take the primary residence exclusion .  Your answer to that was well said.  

The only reason a 1031 would ever come into play would be to defer depreciation recapture or if he kept the HI property past his eligibility for sec 121.

Nice thing is if he takes the 121 exclusion he will have tax free dollars to invest in syndications.  That’s the way to minimize taxes and maximize return.


1031s are very well established with the IRS. Reverse or otherwise, it is clear what is allowed. 

I get the impression you just do not like 1031s. If that is the case, fine. That does not mean the IRS has an issue.

Free eBook from BiggerPockets!

Ultimate Beginner's Guide Book Cover

Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks and techniques delivered straight to your inbox twice weekly!

  • Actionable advice for getting started,
  • Discover the 10 Most Lucrative Real Estate Niches,
  • Learn how to get started with or without money,
  • Explore Real-Life Strategies for Building Wealth,
  • And a LOT more.

We hate spam just as much as you