1031 Exchange when I have no proceeds at settlement due to big refi in the past

Philadelphia, Pennsylvania
1031 Exchanges
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1031 Exchange when I have no proceeds at settlement due to big refi in the past

Account Closed
Property Manager · Philadelphia, PA · Member since 2021 · 7 posts · 7 votes

Here is my situation:

I bought an investment property and improved it.  All-in for $200k cash.  I refinanced it and have a mortgage on the property for $450k.  I'm planning on selling it now and it should sell for about $500k or less.  Assuming $50k in closing costs, I should have $0 in proceeds from sale or even bring money to the table to pay off mortgage.

Net Sales Price will be $450k ($500k less $50k closing costs)

Cost basis is $200k (assume its already adjusted for depreciation for simplicity)

Capital Gain is $250k 

Am I right to not include the refinance proceeds in the above scenario when calculating capital gains?   If so, I want to do a 1031 exchange to avoid capital gains tax.  Would that be possible?  If so, how does the refinance play into that?  Also, the fact that I won't get proceeds from settlement.  

I feel like I'm missing something here.

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
3y

@Account Closed, To completely defer all tax you must purchase at least as much as your net sale ($450K) and use all of the proceeds ($0 in this case) in the next purchase.  Your refi eliminated your equity.  But that refi does not count as profit.  Profit is the difference between your adjusted cost basis and the net sales price.

Unfortunately this isn't a completely uncommon scenario.  It can happen when you have aggressively refinanced to squeeze out equity.  And it happens in the tailspin of a falling market where the value has dropped below the mortgage.  I've had clients bring money to the table in order to sell their property and start a 1031 (not nearly as much fun as having taken out a refi :).

You'll need to have some other cash to use as a down payment now. Or there is a Delaware Statutory Trust product called a Zero coupon DST. That doesn't pay monthly but absorbs 100% of your debt and uses all cash flow to pay off the institutional debt on the property. These can be a real benefit in the right circumstance to absorb that debt.

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  • Renee Riley
    Rental Property Investor · Hampton, VA · Member since 2023 · 6 posts · 0 votes
    3y

    First, I’m not sure the timeline on this question. But I will try to give you my thoughts on it. Don’t quote me but I don’t think you can use any of the expenses of closing as a basis for your 1031. You can deduct those expenses, but I don’t think you can include them as a basis. I have previously utilize the 1031 tactic and Loved it. I had a business and I sold and used the 1031 for rental property. From that time till this I made money. And many times I’ve come away from the closing table having wrote a check rather than receive one.  But the 1031 allowed me to get more investment property consequently receive income from that exchange. It’s 20 years later, I’ve gotten many deductions against the bases that I exchanged 30 years ago and actually have losses that I’ve accumulated from the purchases or (rather exchanges ) that I did and still benefiting.

    I believe I would use the exchange in anyway that you can. Your capital gains are deferred, and you can take care of them in the interim.


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  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    3y

    @Account Closed

    right... the refi doens't count.  profit is sale price less your cost basis.  For this discussion, the refi mainly has nothing to do with anything.  To avoid having "boot" (cash left over), you need to reinvest the entire value of the transaction.  In a 1031 you are exchaning for something of equal or higher value --- "up or over."

    You may not "get" anything, but you are deferring your tax liability...  Unless you wanted to pay some tax, you were never going to "get" anything in a 1031 exchange.  Its all going to move over to the next property.

    Hope that helps.

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  • Haresh Patel
    Investor · Irving, TX · Member since 2015 · 34 posts · 16 votes
    3y

    @Tim Cao why sell if you are not going to get any cash left at close? You already have pulled out what you put in it and more. Let it ride out for infinite returns.

    1Reply
  • Bill B.
    Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
    3y

    If you sell for $450k net, you have to buy something for $450k if you want to avoid all taxes. That means you’ll have to bring $90k to the table. Use some of the $450k cash out refi proceeds. Your lender made an error giving you 90% unless values are collapsing in your market. 

    Every dollar you take out will be considered capital gains or depreciation recapture. If you have “spent” the entire $450k you’ve taken out and have zero personal cash you will not being a 1031 exchange unless you find a partner with cash. 

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  • Allan C.
    Rental Property Investor · Member since 2018 · 826 posts · 810 votes
    3y

    @Tim Cao what you’re missing is asking yourself what you did with the $250k cash you received from your refi. Essentially that is your capital gain that you got an advanced payment on. If you reinvested it into a profitable deal then great. You’ll still want to 1031 to defer cap gains even if you don’t have sales proceed to show for it.

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  • Bill ExeterBusiness Member
    1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
    3y

    @Account Closed, 

    Yes, you can sell and do a 1031 Exchange with no equity.  We refer to it as a Zero Equity 1031 Exchange(tm).  It will work like any other 1031 Exchange.  You are essentially selling a property that ends up being 100% debt with no equity.  You will acquire a replacement property for about $450,000 (or more).  Remember, doing a 1031 Exchange should put you in a better position once the dust settles (only you can define what a better position is). 

    Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews
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  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    3y

    @Account Closed, To completely defer all tax you must purchase at least as much as your net sale ($450K) and use all of the proceeds ($0 in this case) in the next purchase.  Your refi eliminated your equity.  But that refi does not count as profit.  Profit is the difference between your adjusted cost basis and the net sales price.

    Unfortunately this isn't a completely uncommon scenario.  It can happen when you have aggressively refinanced to squeeze out equity.  And it happens in the tailspin of a falling market where the value has dropped below the mortgage.  I've had clients bring money to the table in order to sell their property and start a 1031 (not nearly as much fun as having taken out a refi :).

    You'll need to have some other cash to use as a down payment now. Or there is a Delaware Statutory Trust product called a Zero coupon DST. That doesn't pay monthly but absorbs 100% of your debt and uses all cash flow to pay off the institutional debt on the property. These can be a real benefit in the right circumstance to absorb that debt.

    The 1031 Investor5140 Reviews
    WebsiteView Page
    2Reply
  • Account Closed
    OP
    Property Manager · Philadelphia, PA · Member since 2021 · 7 posts · 7 votes
    3y

    Thank you all for the responses.  I have a much better understanding of my situation now.  It sounds like I have to buy enough real estate that is equal to or greater than the net sales of the property I am selling AND spend all proceeds.  In my case, since I have no proceeds, I just need to satisfy the former.

    To shed more light into my situation.  Yes, I refinanced at the top of the market, and prices look like they are falling or will be falling.  I am trying to be conservative with my estimates.  The refinance proceeds have since been invested into other income-producing rental properties.   

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