1031 Tax Exchange and ultimately keep the cash in a bank account?

Question

So I'm selling one of my rental properties for about a $15K gain in order to put some extra reserves into my pocket to help support buying more properties. I wasn't planning on doing a 1031 exchange as I need the cash in a bank account and not as equity tied up into a property. However, I'm trying to figure out if this strategy will work:

I am all in the property for $30K and am selling it for $50K with about a $15K net gain after closing costs, can I 1031 this into another property selling for $30K if I end up paying all cash for it? ( I was told you can only roll this into a larger valued property - however, I'm not clear on if that is the case or if it simply needs to be able to support 100% of the proceeds from the exchange). I would use the $15K gain from the original sale plus another $15K of my own cash to purchase the new property.  This new property is worth about $50K and I would hope to then refinance the new property and put a $35K mortgage on it about 2-3 months down the road. I've now pulled 100%+ of my capital back out of it including the $15K that was tax deferred.  If that process worked I would still be able to have the $15K in a bank account and successful deferred the profit from the sale.

What part about this process may not work? I tried asking a lawyer but they didn't seem to grasp what I was attempting to do. He simply said you can't keep cash that you are trying to 1031 into another property which lead me to believe he just didn't understand how I buy properties.

Wayne Brooks · Answer

You're only looking at $2250-$3000 in tax.  The 1031 exchange fee and refinancing costs would be that much.  Just sell it, pay the tax, and use your money.

Chris Heeren · Answer

Thanks for clarifying, that makes perfect sense and is the first time I've heard of it.  If my house sells in January but before I have done my 2016 taxes, I was at first thinking of not taking any depreciation in 2016 to avoid paying that higher 25% rate, though it also sounds like even if I don't claim it as depreciation, I would still be taxed at that higher rate for the portion I should have claimed. All great information to know

Dave Toelkes · Answer

Chris,

When the sale of your rental property is a taxable event, you will pay a tax on all the depreciation your took or should have taken during your holding period.  If you only held the property one year and a day prior to the sale, then you should have taken the allowed depreciation for that one year.  The tax on the depreciation is the same as your marginal tax bracket rate, but capped at 25%.  In your example, if the depreciation you took or should have taken was $1000 during your one year and a day holding period, then the tax on that depreciation will be $1000 times your bracket rate but no more than $250 ($1000 x 25%).

If you did not take the full depreciation expense that you were allowed to take, you will still be taxed on the depreciation you should have taken but didn't.  If you took more depreciation than you were supposed to, the 25% tax rate only applies to the straight-line depreciation you should have taken, while the excess depreciation will be taxed the same as your other ordinary income without regard to the 25% rate cap.

Any capital gain due to appreciation will be taxed at the long term capital gains tax rate applicable to your tax bracket.  Your total tax bill on the sale of your rental property will be the tax on your long term capital gain plus the tax on the depreciation.

Does this answer your question?

Wayne Brooks · Answer

The depreciation recapture is taxed separately from the cap gains. The depreciation recapture is taxed at 25% of the depreciation claimed/available. The cap gains doesn't include the depreciation.

Chris Heeren · Answer

@Wayne Brooks

I'll learn how depreciation works after I walk through my 2016 tax return.

However, I'm not quite sure I understand what you mean by depreciation recapture at 25%.I bought this property in November of last year and had next to no depreciation claimed in 2015 so that shouldn't be a factor in this case.  Though hypothetically, If I bought a house with the building portion calculated at $27,500 and claimed $1,000 of depreciation the first year. Then when I sold the property wouldn't I pay taxes on the different between the purchase price and sale price + the $1,000 depreciation? ( I realize there may be 5 yr and other deprecation schedules that may also apply) I don't understand what you are applying the 25% towards and was assuming I would need to pay tax on ALL claimed depreciation over the life of the property.

Chris Heeren · Answer

@Jeff B.

Well based on what I've just heard in this thread I could still do what I originally wanted to do. I would just need to ensure that the new property is purchased at a higher price than the one I'm currently selling (which means buy 2 or more properties).  I still have to do some research on if there are rules about the mortgage on the new property, there is some discrepancy between the posts above. If I need to ensure the mortgage is of equal value or larger it makes the process more difficult, if I only need to ensure that the equity is equal or greater, then I think this could still be a great strategy.  Also, the taxes I'll be paying are less than I thought so that also ways in on if it even makes sense to purse going forward.

Wayne Brooks · Answer

Yes. Forgot to mention, you will have depreciation recapture at 25%, for depreciation you've claimed, or should have claimed, also.

Jeff B. · Answer

Hopefully, you can see now that you didn't understand 1031- - best wishes.

Chris Heeren · Answer

@Wayne Brooks

I'm a huge newbie when it comes to selling house and have a lot to learn. I currently own the property in a Single Member LLC and have owned the house for over 1 year. I was under the impression that the gains would roll over to my tax return and get taxed at the highest rate in my tax bracket. Based on your comment I'm assuming this is incorrect and I would only pay a 15% cap gains tax on the property? If so, I would agree that paying $2250 is the best way to go and also for probably most of my properties in the future.

1031 Tax Exchange and ultimately keep the cash in a bank account?

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