Possible 1031 trap/backfire?

1031 Exchanges
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Possible 1031 trap/backfire?

Matt W.
Rental Property Investor · Member since 2018 · 157 posts · 83 votes

Hi BP, 

I've heard different answers about 1031s so I'd love some clarification: (using simple numbers and assuming I hold for 2 years, leaving out depreciation and selling costs, and making the differences in purchase prices extreme to illustrate the different ideas).

Say I buy house A for 100k cash, and sell 2 years later for 200k (100k gain), then do a 1031 exchange of all 200k as 10% down on a $2,000,000 house B (I know this isn't realistic, but using it for the sake of illustration). Now, after another 2 years, I sell the $2 million house B for $2,100,000 ($100k gain again) but this time just cash out and don't do a 1031.  So as I understand it, I'd owe taxes on the house A $100k gain and the house B 100k gain, so 200k total taxable gain. 

A friend (who seems smart about real estate) tells me that in the example I used, the taxable gain would be the difference between the sale price of house B and the original purchase price of house A ($2,100,000-100,000=2,000,000 taxable "gain"). So at 20% LTCG tax rate, you would owe $400k, completely negating the actual $200k gain and owing an additional $200k!

So to me this seems crazy and not how it should work, but maybe I am missing something? If his version is true, you could 1031 so many times or to such high values that you would owe many times more in taxes than you ever made in gains, which seems completely backwards to the core concept that you only pay taxes when you profit. 

Thanks in advance!

(Edit: changed the value of house B from $1MM to $2MM to illustrate the extreme problem more clearly.)

@Dave Foster

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Ash Hegde
Lender · Fort Lauderdale, FL (Lending in FL CT GA MI PA) · Member since 2022 · 470 posts · 349 votes
3y

Your understanding is correct. In your example, you are going to defer 100k of gain on the sale of house A, so you have 100k less in tax basis on house B, which would be 900k. When you sell house B for 1.1m, your gain will be 200k. 

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  • Ash Hegde
    Lender · Fort Lauderdale, FL (Lending in FL CT GA MI PA) · Member since 2022 · 470 posts · 349 votes
    3y

    Your understanding is correct. In your example, you are going to defer 100k of gain on the sale of house A, so you have 100k less in tax basis on house B, which would be 900k. When you sell house B for 1.1m, your gain will be 200k. 

    2Reply
  • Bill B.
    Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
    3y

    This is your chance to be the friend who is smart about real estate to your friend. Who knows how much they’ve lost because of their misunderstanding of this rule. 

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

    @Matt W., your friend owes you the beer!  In your original 1031 you had a basis of $100K and sold for $200K.  So you deferred 100K of gain and you then purchased $900K of additional basis (total $ 1 mil).  When you sold the second house your basis was $900K and you sold for $1.1K.  That's a gain of $200K.

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  • Carlos Ptriawan
    Member since 2019 · 7k+ posts · 4k+ votes
    3y
    Quote from @Matt W.:

    Hi BP, 

    I've heard different answers about 1031s so I'd love some clarification: (using simple numbers and assuming I hold for 2 years, leaving out depreciation and selling costs, and making the differences in purchase prices extreme to illustrate the different ideas).

    Say I buy house A for 100k cash, and sell 2 years later for 200k (100k gain), then do a 1031 exchange of all 200k as 10% down on a $2,000,000 house B (I know this isn't realistic, but using it for the sake of illustration). Now, after another 2 years, I sell the $2 million house B for $2,100,000 ($100k gain again) but this time just cash out and don't do a 1031.  So as I understand it, I'd owe taxes on the house A $100k gain and the house B 100k gain, so 200k total taxable gain. 

    A friend (who seems smart about real estate) tells me that in the example I used, the taxable gain would be the difference between the sale price of house B and the original purchase price of house A ($2,100,000-100,000=2,000,000 taxable "gain"). So at 20% LTCG tax rate, you would owe $400k, completely negating the actual $200k gain and owing an additional $200k!

    So to me this seems crazy and not how it should work, but maybe I am missing something? If his version is true, you could 1031 so many times or to such high values that you would owe many times more in taxes than you ever made in gains, which seems completely backwards to the core concept that you only pay taxes when you profit. 

    Thanks in advance!

    (Edit: changed the value of house B from $1MM to $2MM to illustrate the extreme problem more clearly.)

    @Dave Foster


     here is the logic if you are programmer :

    Gain Simplified = ( Sold Price Property A - Cost Basis Property A) + ( Sold Price Property B - Cost Basis Property B) + ( Sold Price Property n - Cost Basis Property n)





    0Reply
  • Matt W.
    OP
    Rental Property Investor · Member since 2018 · 157 posts · 83 votes
    3y
    Quote from @Carlos Ptriawan:
    Quote from @Matt W.:

    Hi BP, 

    I've heard different answers about 1031s so I'd love some clarification: (using simple numbers and assuming I hold for 2 years, leaving out depreciation and selling costs, and making the differences in purchase prices extreme to illustrate the different ideas).

    Say I buy house A for 100k cash, and sell 2 years later for 200k (100k gain), then do a 1031 exchange of all 200k as 10% down on a $2,000,000 house B (I know this isn't realistic, but using it for the sake of illustration). Now, after another 2 years, I sell the $2 million house B for $2,100,000 ($100k gain again) but this time just cash out and don't do a 1031.  So as I understand it, I'd owe taxes on the house A $100k gain and the house B 100k gain, so 200k total taxable gain. 

    A friend (who seems smart about real estate) tells me that in the example I used, the taxable gain would be the difference between the sale price of house B and the original purchase price of house A ($2,100,000-100,000=2,000,000 taxable "gain"). So at 20% LTCG tax rate, you would owe $400k, completely negating the actual $200k gain and owing an additional $200k!

    So to me this seems crazy and not how it should work, but maybe I am missing something? If his version is true, you could 1031 so many times or to such high values that you would owe many times more in taxes than you ever made in gains, which seems completely backwards to the core concept that you only pay taxes when you profit. 

    Thanks in advance!

    (Edit: changed the value of house B from $1MM to $2MM to illustrate the extreme problem more clearly.)

    @Dave Foster


     here is the logic if you are programmer :

    Gain Simplified = ( Sold Price Property A - Cost Basis Property A) + ( Sold Price Property B - Cost Basis Property B) + ( Sold Price Property n - Cost Basis Property n)






     Where does "property n" come into it? Obviously I'm not a programmer!

    0Reply
  • Carlos Ptriawan
    Member since 2019 · 7k+ posts · 4k+ votes
    3y
    Quote from @Matt W.:
    Quote from @Carlos Ptriawan:
    Quote from @Matt W.:

    Hi BP, 

    I've heard different answers about 1031s so I'd love some clarification: (using simple numbers and assuming I hold for 2 years, leaving out depreciation and selling costs, and making the differences in purchase prices extreme to illustrate the different ideas).

    Say I buy house A for 100k cash, and sell 2 years later for 200k (100k gain), then do a 1031 exchange of all 200k as 10% down on a $2,000,000 house B (I know this isn't realistic, but using it for the sake of illustration). Now, after another 2 years, I sell the $2 million house B for $2,100,000 ($100k gain again) but this time just cash out and don't do a 1031.  So as I understand it, I'd owe taxes on the house A $100k gain and the house B 100k gain, so 200k total taxable gain. 

    A friend (who seems smart about real estate) tells me that in the example I used, the taxable gain would be the difference between the sale price of house B and the original purchase price of house A ($2,100,000-100,000=2,000,000 taxable "gain"). So at 20% LTCG tax rate, you would owe $400k, completely negating the actual $200k gain and owing an additional $200k!

    So to me this seems crazy and not how it should work, but maybe I am missing something? If his version is true, you could 1031 so many times or to such high values that you would owe many times more in taxes than you ever made in gains, which seems completely backwards to the core concept that you only pay taxes when you profit. 

    Thanks in advance!

    (Edit: changed the value of house B from $1MM to $2MM to illustrate the extreme problem more clearly.)

    @Dave Foster


     here is the logic if you are programmer :

    Gain Simplified = ( Sold Price Property A - Cost Basis Property A) + ( Sold Price Property B - Cost Basis Property B) + ( Sold Price Property n - Cost Basis Property n)






     Where does "property n" come into it? Obviously I'm not a programmer!


     n just meant if you do n times of 1031. It's the diff between cost basis and selling price that you have to pay.

    1031 is actually a swapping debt , with the same LTV structure.

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