1031 Exchange - Capital Gains Question

8 Replies

Situation;

I have a rental property bought in March of 2012 for the amount of $220K.

(Initially used as Primary Residence until Oct of 2017)

Before moving out, In January of 2017, I did a cash-out refinance, and the new loan balance is about $315K.

(The cash out money I used to by another house)

The current property value is about $560K-$590K.

Now, I'm planning to sell my rental and do a 1031 Exchange to deferred  paying taxes.


Problem/Question;

(Here's the part I'm not sure how it works)

Since my base price is $220K, which means I have approximately $315K in gains after paying fees/commissions.

But the existing loan is $310K, which means in closing I will clear approximately $220K.

There is a difference of $95K compared to my true capital gains.

Then, do I have to come up with another 95K to add to my $220K if I have to do a 1031 exchange?

 How will this work? How should I proceed with this?

Is 1031 Exchange even an option or should I just pay capital gains?

Thank you all for responding...

@Daryl Demz , It works a little different than you're thinking.  In order to defer all tax in a 1031 you must do two things:

1. Purchase at least as much as your net sale.  This is the contract price minus closing costs and commissions.  Let's call it $530K based on your example.

2. You must use all o your net cash .  This is the net sale minus the mortgage payoff - In this example $530K - $310 = $240K cnet cash.

To defer all tax you must purchase at least $530K of investment real estate using all $220K of net cash.

You can purchase less than you sell and you can take cash.  But you will be taxed on the difference.  The IRS says that when you do a 1031 exchange any amount you pull out either by purchasing less or by taking cash is first going to be profit.

So if you purchased $500K you would pay tax on the $30K difference but shelter the rest of your gain in the 1031.

Debt really doesn't matter.  You simply have to use all of the cash and purchase at least as much as you sell.  If you refinanced too high that doesn't squirrel your exchange.  It simply means you have to either come in with cash of your own or take out an equivalent mortgage on the new property.

Whether it's worth it to you or not is subjective.  Your gain is actually going to be more than the $315K because of depreciation recapture of aroun $13K/year.  And you live in the second highest taxed entity in the world.  So figure you could end up  paying around 30% of your profit to the fed and state of CA. That could be north of $100K.  

Don't know about you but that would be worth it for me if I was wanting to continue investing.

One thing to look into is if you quality for the section 121 exclusion ( as this house was you residence for 2 of the last 5 years, at least until January 2020).  And while you would still have to recapture depreciation, it has the potential to exclude 250k or 500k of the capital gain.  Thought there is also potential to combine section 121 and 1031, but this all is fact specific and I would suggest talking with a tax professional.

@Dave Foster , I really appreciate your brief explanation. Thank you so much!


@Dave Peirce , I looked into section 121 exclusion already, but since I purchased it when I was single and only stayed their as married for 6 months, I would still end up paying some capital gain taxes.

@Daryl Demz , You may have just stumbled onto the mother lode then.  If you do qualify for the primary residence exemption for yourself as singe you still get the first $250K of profit tax free.  And since the property is an active investment property you could 1031 the rest.  So part of the gain would be tax free and the rest would be tax deferred.

That would change your reinvestment target dramatically.  

Originally posted by @Daryl Demz :

@Dave Foster , that’s a really great info.

I actually asked a CPA earlier this year (paid him really well too for his time) about which option is the best route to take but I did not found this answer from him.

 Yes, 

1) Use sec 121 to defer 250k of gain

2) Use 1031 exchange to defer the rest. 

This is very common strategy. 

Too bad you didn’t “live in sin” as my in-laws called it. If your current wife had lived in the house for 2 years you would qualify for the $500k tax free gains even if she didn’t own it for 2 years, or at least that’s what Mr. Google says...


The IRS allows married couples to exclude up to $500,000 of gain on the sale of a home if:

1) The married couple files a joint return for the year,

2) Ownership. Either spouse (or both spouses) owned the home for at least two years during the 5-year period ending on the date of sale,

3) Use. Both spouses used the home as a principal residence for at least two years during the 5-year period ending on the date of sale, and

4) Neither spouse excluded gain from the sale of another home during the 2-year period ending on the date of sale.

So the additional questions that must be answered for your specific situation are

1) Did you use her residence for 730 days in the last 5 years?

2) Did you claim the exclusion on a residence you sold during the past two years?

If either spouse does not meet all the requirements, the couple can exclude the total of the exclusions that each spouse would qualify for if not married and the amounts were figured separately. For this purpose, each spouse is treated as owning the property during the period that either spouse owned the property. Exception: Taxpayers who do not meet the ownership and use conditions may qualify for a reduced exclusion.

You can also see: http://www.irs.gov/publications/p523/ar02.html#en_US_2014_publink10008997



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