1031 Exchange Scenarios, need some advice

[Esther Thomas]

Hi everyone,

I have a SFH (it's been rented out for about 7 years) and I want to 1031 exchange it in the semi near future. I have a few questions and wanted some insight into the implications of a few scenarios I'm considering and would love some feedback and advice if any of these are viable, pros/cons. Thanks in advance!

Property: SFH, been rented out for last 7 years (used to be my primary residence).

purchased: 400k, plan on selling for $800k, 20% down at purchase time + 100k rehab done.

Question #1: If I sell for $800k ,minus closing costs/real estate fees, does my 1031 property I find have to be of equal or more value? Can I take out my original downpayment in doing the 1031 exchange?

Scenario #1:

Sell SFH, buy 2 properties:

property 1: small multi-family unit

property 2: SFH

3 years down the road I decide I want to move into that property #2 the SFH. Can I do this?

If I can and then sell it 4 years later, can I get the capital gains exemption when I sell it? If so how does that work? Is it pro-rated for the time I resided in the home? 

Scenario #2:

Sell SFH, purchase 10 smaller properties

If I sell these 10 smaller properties at some given time separately in the future, do I only pay the deferred taxes on that portion of the 1031 that was allocated for each home? Example, I decide to sell only 1 of the 10 properties that were purchased for the 1031 exchange and I decide to pay taxes on it. Assuming that each property is equality valued at the time of purchase do I pay taxes on 10% of that tax deferral on sell of my SFH?

I need to offload this property in the future but I'm just not sure what my strategy and plan is going to be so any useful advice is much appreciated. Thank you everyone!

[Dave Foster]

@Daniel Dietz, The hold period qualification is the 5 years prior to sale.  the proration requirement is all the gain prorated between all the qualified use (as a primary residence) and non-qualified use (as an investment property.  So in your instance it will make a huge difference whether you use the property as investment for 1 or 5 years.  If you use it as investment for 1 year and then change your intent and move into it for 5 years and sell you would get 5/6ths of the gain tax free.  And like @Wayne Brooks said you would pay depreciation recapture.  However if you held the property as investment for 5 years and then moved into it.  You would only get 5/10ths of the gain tax free.  There's some strategical thinking to be employed here.

@Esther Thomas, Very thoughtful questions well addressed as always by @Clayton Mobley.  I would add one thing regarding equity and reinvestment.  Trying to plan your reinvestment so you have the same equity is a difficult and unnecessary thing to do.  The easier way think of the reinvestment requirement - whether buying 2 or 10 replacement properties- is to think of it as a two part requirement.  If you want to defer all tax you must purchase at least as much as your net sale (contract price minus closing costs) and you must use all of your net proceeds (net sale minus any mortgage paid off) in the purchase or purchases.    

I think it's much easier to think of simply spending all the proceeds since if you buy multiples as Clayton said you may want to allocate your proceeds so that a few properties you buy for cash or with minimal leverage.  And a few properties you may want to buy with minimum down and maximum leverage.  This will in theory leave you with the same equity but it could also leave you with some properties with more and some with less equity.   You can also add your own cash to the purchases and that would actually increase your equity.

The strategy above of selling and 1031ing into multiple properties with some of the purchases paid for in cash and some with maximum leverage is a great late market strategy that lets you protect some properties from debt risk while still letting you aggressively use leverage on others.  

Your strategy of later converting a property from 1031 investment to primary residence and sheltering part of the gain is a good one as well.  Note that you can sell a property under the sec 121 primary residence exclusion once every two years.  So it is possible for you to have several 1031 rental properties (preferably really nice investment properties located near beaches or ski resorts :) that you can transition into hold and sell taking the 121 portion of profit tax free each time.  Not a bad post retirement job at all.