Sell or 1031 Exchange?

Question

I have a townhome in LA that a family member is vacating soon. Ive owned it for 7 years and have healthy equity in it. I also have an investment property in Maryland so being a landlord isn't new. I don't want to fix up the LA property and maintain it with tenants especially as it's subject to a lot of HOA rules. Im looking at doing a 1031 exchange and purchasing a couple of row homes or even a multi unit back in MD.

Looking for some thoughts from the community as this will be my first exchange and I'm trying not to misstep just because Im eager to get out of the LA property to avoid renting it.

Anything to be concerned about? Silly to not keep property in the LA market? Back of the napkin math, I think I'd cash flow more getting into new Maryland property than keeping this...at least in the short term.

Bill B. · Answer

Has your relative been the only tenant? Is there anyway to avoid the normal taxes involved? How much gain do you think you’ll have after selling costs if you sell? How much depreciation have you take. and how much tax will that involve? Don’t forget to calculate California’s big cut. And if you do a 1031 out of California they’ll want their cut if you ever sell. Might make a good hold until you die, or eventually turn it in to your retirement home type property.

If you wouldn’t buy this property at its current market value if you didn’t already own it, it’s time to sell especially as an out of state landlord in California, you are hated.

TLDR: Most likely it’s time to sell. Calculate your gain after selling costs times 15% plus the California rate. Calculate your depreciation times 25%, ask your tax expert if California wants a cut of this too but knowing California, probably. Those 4 numbers added together are your tax liability and your possible savings by investing in MD instead of selling. If you’re going to buy in MD regardless I think it’s an obvious yes. If you weren’t planning on it, would you do it with a discount of the taxes saved?

good luck.

Dave Foster · Answer

@DC W., You've got a well thought out rationale in place.  The only issue would be how strong your case is to do a 1031 since a family member is living there.  Property that generates rent and that the owner has personal use of (your family member) can qualify as investment for a 1031 exchange easily enough.  The IRS though has not looked so kindly at properties where this no rental income and substantial personal use.  So this is a hurdle you'd need to address.  But there are some ways to strengthen your intent argument.  I don't see it being a game stopper.

If the market is telling you that a different geography and. product is the way to go then the 1031 is the tool to get you there without losing a lot of that hard earned gain to taxes.

Alex Olson · Answer

@DC W. I would look to 1031 exchange into the midwest market if you want cash flow, landlord friendly laws, and lower taxes. I am in the KC market if you want to talk further about it. There are a lot of California investors investing in multifamily here.

Bradley Buxton · Answer

@DC W.

Despite what people say about CA there are still a lot of people that want to live there and there is money to be made in real estate. The question might be does the appreciation outweigh the headache? Can you 1031x into something that might continue to appreciate, offer more cash flow, and less headache. I talk with many CA investors that are just ready to leave with the equity and move to a more landlord friendly state like Nevada.

Talk to a CPA and a QI about options for the exchange.  They will be able to tell you how to defer the most in taxes.  Happy to provide some resources if you need.

Sean Ross · Answer

DC W,

I'm wondering if you have reported the LA property as an investment property on prior tax returns during the past 7 years?  Has the family member been paying rent?

Regular vacation properties and second homes can struggle to qualify for a 1031 exchange, but this property in La sounds like it might live in a gray area.

Your first step is to make sure that this property is a good candidate for an exchange. My initial inclination is to think that this property will qualify, but more info is needed to know.

You can certainly execute at 1031 Exchange where you trade out of California and into a new property in Maryland (or any other state).  However, the California Franchise Tax Board is going to make life a little bit difficult on you when you do this. They're going to require that you file a form with them every single year (it's Form 3840) and on this form you need to report back that you still own the new investment property, and that you haven't sold it and haven't received the income from the sale.

If you do receive the income from the sale or if you fail to file the form, the California Franchise Tax Board will then try to retroactively claw back the taxes that you would have paid when you initially sold in LA.

This form is not very difficult to fill out, but it is important that you do it on time each year following a 1031 exchange that leaves CA.

Sell or 1031 Exchange?

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