cap gain tax if not 100% of the proceeds go into another house

[Ingrid B.]

Greetings. I own a property that I am planning to sell, it will have long term cap gain. I don't certainly want to invest all 100 % of the proceeds into another property. Say only 50% of the proceeds goes into another investment house. Would the taxable part be then the other half plus "half" of the depreciation? Or are we still responsible on paying the cap gain tax on half of that proceeds plus "full" depreciation?

When we purchased this house few yrs ago we put 20% down. Assuming we want to just get that original down payment back after closing, is it taxable? 

Lastly, I am also considering to buy flipper house. Does 1031 allow investor to buy and sell homes < 1 yr? What's the tax treatment?

Thank you.

[Clayton Mobley]

Hey @Ingrid B. welcome to BP!

So as Frank pointed out, and it seems you are already aware, if you do not transfer 100% of the value of your existing property into a new property, you have to pay taxes on the 'boot'. It does not matter what you put down, it only matters what you gain is. 

So, for example, if you didn't do a 1031 and sold a prop you bought for $100K for $500k, then you'd have $400k of taxable gain. However, the amount of depreciation you could have taken (the IRS doesn't care if you actually took the deductions or not) over the years is 'recaptured' at a max tax rate of 25%. So if the depreciation you could have claimed while you owned the property was $80k, then your tax basis is actually $20K ($100K - $80K), and your gain is $480K ($500k - $20K basis). You'd owe $20k in depreciation recapture on that first $80k of gain (25%), and the remaining $400K of gain would be taxed at the normal long-term CG rate for your income tax bracket, most likely 15% ($60K), for a total tax bill of $80K. 

Now, assume that you reinvest 50% via a 1031, using the same example as above (and assuming no mortgage debt just for simplicity). Your original purchase price is $100K, the total amount of depreciation you could have claimed is $80K, which brings your basis down to $20K. Your sales price is $500K, so your net gain is $480K, same as above.

If you only reinvest $250K of your proceeds via a 1031, you are keeping $250K in boot because the $20K basis is rolled into the replacement property. Of that $250k, the first $80K is taxed at 25% to recapture depreciation ($20K). The remaining $170K is taxed at your long-term CG rate, likely 15% ($25.5K), so you'd owe $25.5K + $20K = $45.5K in taxes on the boot you kept, while sheltering the remaining $230K in gain from taxation. 

Depreciation recapture is prioritized, so if you only kept $80K of gain as 'boot', you'd still owe $20K for recapture, but you'd be sheltering the remaining $400k gain from CG taxation. 

If you only wanted to get your 20% down payment back, you would pay the 25% recapture rate on all of it in the example above (because 20% of the $100k purchase price is $20K, which is less than the $80k in depreciation). Basically, until the amount of boot you keep exceeds the amount of depreciation on the property, you pay the 25% rate on all of it. After the boot exceeds the depreciation, the remaining gain is taxed at the CG rate. 

If there's a certain amount of cash you need, you'll actually have to keep a good chunk more than that in boot in order to net the right amount after taxes. In the example above, you'd need to keep $27K in boot to net $20K after taxes ($27k - ($27K * 25%) = $20,250), and that's just a waste of money.

So, if you only want to do a partial exchange you need to consider how much money you're giving up. $45K is still a lot of money to leave on the table (any amount is too much!). Is there a reason you need the cash that isn't for reinvestment? If so, and the current property is still performing, could you take out a HELOC or refinance somehow? If not, could you execute a 1031 for the complete value, upgrade and/or expand your portfolio in the process, and then refinance the new property afterwards to pull out cash? Consider all your options before giving up capital to the IRS.

With regard to your other question: no, a flip is not eligible for a 1031 because it is not a long-term investment. In order to qualify, you must be able to demonstrate your intent to hold the replacement property for the foreseeable future. There's no specific rule, but generally it's more than a year. A flip is mean as a short-term investment and therefore is not 1031 eligible. However, if you wanted to buy a fixer upper for rehab and rental, that is a long-term investment and would qualify. If you ended up selling it a few years down the road, you could potentially execute another 1031 to continue taxation deferral. 

A 1031 is a powerful tool, but you do have to mind you p's and q's. A good Qualified Intermediary is a MUST (both legally and because it's a confusing process). I'm hoping these examples were more helpful than confusing, but please feel free to ask any questions or clarify anything I didn't word very well. There are a number of great QIs here on BP and endless threads about 1031 exchanges, so do your research and reach out to professionals who can point you in the right direction.

Best of luck!

Clayton