What is the capital gain when 1031'ing out of a house hack?

Question

Hi gang!

I have a few questions regarding executing a 1031 while selling a house-hacked duplex. If you're a 1031 professional dispersing advice to attract clients, please have at it!

I'm going to simplify the numbers, but here's the deal:

Three years ago, I bought a duplex for $400K and put 25% down. I then spent $50K renovating the property. This year, I'll be able to sell it for $500K.

By my math, the total capital gain is $50K because the sale price is $500K and the cost basis is $450K. (Let's just set aside the cost of the sale, depreciation, etc.) Because half of the duplex was my primary residence, I can take half the capital gain, or $25K, tax-free because of the personal deduction. The remaining $25K is subject to capital-gains tax.

Am I correct so far?

Here's where I get confused: how much of the proceeds do I have to put into an up-leg to avoid paying tax on that $25K? At the time of sale, the outstanding loan balance will be about $280K, so my proceeds will be about $220K. I'm assuming that, since only half the duplex was considered an investment property, I only have to use half the proceeds to buy the up-leg. And likewise, the loan I have to take need only be for $140K, half the loan balance when I sell.

So am I correct that, to avoid capital gains tax on $25K, I need to put $110K down and take a loan for at least $140K on an up-leg property?

What happens if I buy an up-leg with $50K down and a $140K loan? Then I'd have $60K in boot, right? That's more boot than capital gains!

Somebody please clear this up for me!

Thanks so much!

Jon

Whitney Nash · Answer

Hello @Jon Schwartz

@Bill Brandt is right, it may not be worth it to do a 1031 exchange if your gain in $25k and you'd be deferring about $3750, depending on how all the numbers flush out (and none of this is including closing costs). The exchange fee to the QI will also eat into that a little. You would be deferring depreciation recapture too, which is helpful, but again, is it helpful enough? Some people think that it is because the don't want the tax man to have any of their money, but it depends on if you think it's worth it. Per the numbers in your last sentence, it wouldn't qualify for full tax deferral because you are not exchanging up in value and would create boot. I would only do an exchange if the numbers really make sense for what you're trying to accomplish and you plan to exchange up. You may want to consult with your CPA/tax preparer.

Dave Foster · Answer

@Jon Schwartz,

You are spot on with your assessment.  If you've attributed 50% of the property to your primary and 50% to your investment.  then 50% of the net sale needs to be 1031'd.  and 50% of the net cash needs to be used in that purchase.  You'll need to use the net cash of $110K to purchase a property worth at least $250K (50% of the entire property).

Here's the opportunity for you if you want - You do not specifically have to replace the mortgage.  You can add your own money to reach the reinvestment target.  All you must do is purchase at least as much as your net sale ($250K) and use all of the net proceeds ($110K).  You could add the $110K that comes to you tax free and end up with $220K to purchase a $250K property to complete your 1031. And end up with your replacement property owned free and clear.  Or you could take a loan out for the balance and use the tax free $110K however you want.

Yah gang - two years of depreciation and a $25K gain in CA might be enough to make a 1031 worthwhile.  It wouldn't surprise me if the tax is greater than $10K.  CA does love their tax.

But you are also correct that if you only put $50K down you would have boot of $60K.  and that would wipe out your tax savings.  Your options would be to go ahead and put more down so you use up all of your cash.  Or to purchase a second property with the remaining $60K and a mortgage if needed.  Or the $60K and the $110K that you get tax free.

Linda Weygant · Answer

Make you a deal.  I won't act like an agent and throw around incorrect advice when it comes to buying and selling real estate.  You agree not to throw around incorrect tax advice. Deal?

Matt Devincenzo · Answer

This isn't correct, the gain attributable to the primary residence isn't taxable under the 121 exclusion. But the other half attributable to the investment unit is.I'm sure @Dave Foster can help with the original question...and since @Jon Schwartz is in LA I'm guessing his numbers may be small rounded values and just for discussion...but the actual values are probably 3X-4X what he posted.

Arthur Schwartz · Answer

If I understand, the 1031 exchange is better when there's significant equity.  Here the equity seems "slim to none" so it seems better to simply sell, pay the taxes, and enjoy a great night out on the town.  My calculation of capital gains would be 500,000 * 95 = $475,000 after closing costs (reduced commissions if you are a realtor) less $450,000 or $25,000.  Add three years of depreciation to that; multiply by your marginal federal and state tax rate, and the taxes are probably modest.  You may want to consult with a CPA for an exact number, but If it were me, I would rather pay the modest taxes and enjoy the money from the sale.  (PS it could be important of the $50K in renovations were considered to add 100% to the value of the property, or only partly.  Again, it's an issue for a CPA).  Good luck!

Jon Schwartz · Answer

@Ryan Thomson, I don't think that's true. It's a duplex; I lived in half. My accountant has been treating the property as half primary residence, half investment property since day one. So half of gains aren't taxable as capital gains and the half are.

@Whitney Nash, thanks for the response! I'm going to message you.

@Bill Brandt, the actually numbers are about 4.5x what I posted here, and I took bonus depreciation.

Ryan Thomson · Answer

Even bigger thing to consider. Did you live in this house hack for at least two of the last 3 years? If so - none of those gains (up to 250k if single) are taxable anyways.

Bill B. · Answer

Let’s assume you do find 2 realtors to work for free in a market with no closing costs. You’re doing all this work to save 15% tax on $25k? ($3750). You’re also going to have 25% recapture in about 3.6% times 3 years times 80% of $200k. Maybe another $4800. Hardly seems worth it.

Of course california’s gonna reach in your pocket too but they would follow you to the grave to collect their money if you do a 1031. Personally I wouldn’t bother unless the timing randomly works out perfectly. You’re more likely to make a $7k mistake rushing the buy.

Ps. You’re also right about the boot. If it’s larger than your gain there’s no reason to 1031, another reason to skip it. Not being forced to borrow today, you could easily have $7k in extra financing costs.

What is the capital gain when 1031'ing out of a house hack?

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