Selling a Rental, taking some Boot?

Question

Hello, first time posting here.

I'm contemplating the sale of a rental property I own. I have a net equity (after commission + repair allowance) of $116k in the property. The home is worth 300k. I'm wondering if a 1031 exchange is appropriate, given what I want to do:

1.  Of the $116k, I want to pay off ALL of my non mortgage debts with $35,000. This is necessary for me to improve my DTI so that I can qualify for step 2:

2. Purchase a multifamily property around $320k with the remainder of the equity (approx. $80,000 down). I am targeting cash flow, which would be much better in multifamily in the markets I'm considering.

I have a wide degree of latitude with how my Business Schedule C looks (whether or not I maximize write offs to reduce my tax bill or keep the number high to improve loanability). I've read in some places that a married couple filing jointly pays a 0% capital gains tax if they earn under $77k or so per year, which we should be able to reflect on our Schedule C with appropriate write offs. Does this ALSO apply to the sale of investment real estate? If so, does the net proceeds from the property sale contribute to this number, or is this just in reference to our AGI as a household?

I'm trying to avoid paying taxes on cash boot, if possible. And, if I can avoid a 1031 entirely so that I have more time to locate the replacement property in our slim market, that would also be ideal.

Anyone out there with knowledge of 1031s, taxes, etc?? All opinions and suggestions welcome!

Thanks very much!

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Nick Boyd · Answer

Dave,

I talked with two accountants RE: the 0% Capital Gains tax rate for married couples. Here's what I took away:

If you make $0 per year as a married couple filing jointly, and sell an asset that would be taxed at the long term capital gain rate, you are in the 0% tax bracket up to $77,200. No 1031 would be needed, except to avoid depreciation recapture (and state taxes?). In this scenario, if the asset sells for $77,201, the entire amount is taxed at 15%. To me, it sounds like any combination of the seller's AGI/Schedule C(?) income + the real estate or asset being sold must be under the income threshold in order to have a 0% capital gains tax. Another example would be $40,000 in Business Schedule C income + net real estate proceeds in the amount of $32,000 results in 0% capital gains tax on the real estate. If it sold for $1 more, the entire $32,001 would be assessed a 15% capital gains tax. Is this your understanding, too?

At this point, if my understanding is correct, I'm thinking about just exchanging ALL of the proceeds into a new multifamily property since we should still be able to qualify for it. Trying to juggle the opportunity cost of paying off ~$40k in debt at the expense of purchasing at a $160k higher value (40k x 4), and having greater cash flow to service the debt that we'd still be carrying. I know that's more of a financial planning question but... what do you think about all of that?

Dave Foster · Answer

@Nick Boyd, it would be worth your while to explore this with your accountant.  Depending on when you moved into the new property.  There's not going to be much gray area given that you actually moved on a date.

Tax free is always better than tax deferred.  But you don't want to forget that a 1031 would also let you defer depreciation recapture.  But a 121 exemption sale will not.  And, if you do qualify for the 121 exemption you can also do a 1031 along with that to defer depreciation recapture if it's significant enough or if the amount of gain exceeds the 121 limits.

Dave Foster · Answer

@Nick Boyd, Hard to say at this point.  Equity doesn't equal profit.  Equity is not taxable.  Only profit is.  Your profit is determined by starting with your original purchase price + capital improvements - depreciation.  This equals your adjusted cost basis.  Subtract the adjusted cost basis from your anticipated net sale and you get your profit which is taxed as two things - capital gain/ordinary income, and depreciation recapture.

Unless you're selling the house for a loss you will not escape depreciation recapture unless you do a 1031.  As far as the rest of the profit, the sale of a house creating a capital gain will have an impact on your taxable income.  It is not limited to one schedule although rental real estate owned is usually on your schedule E.  So it's likely that you'll not escape into the 0% tax bracket (check with your accountant).

In order to defer all tax in a 1031 you must purchase at least as much as you sell and use all of the proceeds from the sale.  You can purchase less than you sell and you can take cash out.  But when you do the difference is taxable.  So if you pulled $35K out you would pay tax on that amount.  If your total gain was $100K then you'd be paying tax on $35K but sheltering the tax on the remaining $65K.  So it could be worth it to do a partial exchange and take the boot to pay the tax.

Most folks will complete a full 1031 exchange and then do a refinance of the new property after the 1031 is complete.  They use the refi money to pay off those other debts because refinance money is not taxable.

So you need a few more numbers from your accountant to see what's the best course for you.

Dave Foster · Answer

@Nick Boyd, that's what I was afraid you'd hear.   Count on Congress to advertise 0% and then say "just kidding"!!

If you take out that $40K you're looking at tax of say $6Kish which isn't insignificant.  And you're looking at the lost opportunity to generate income off the $40K.  So that's a double whammy.  Plus consumer debt has a way of creeping back into your life without a failsafe.  If that $40K is out of your reach in income producing real estate then the creep is less likely.

Pay your debts down as you go and you'll be painfully reminded of how good discipline is each month.  Build your wealth slowly and surely and you'll avoid "Lotto syndrome" and appreciate and hold more tightly your income.

It's not FIRE but it will snowball and benefit you greatly over the years.  Good Plan!!

Nick Boyd · Answer

Thanks again Dave, I really appreciate the insight. Since I converted the property into a rental in 2016, and the structure value (separated from land value) at that time was $145k, my depreciation schedule should be $145k /27.5 = $5,272 per year. This over 3 years = 15,816. Federal Depreciation Recapture = 25% or $3,954. I can live with that!

Regarding the capital gains, though: I was not working much in 2018 and reported a very low income. It has taken me a while to build my income back up, but 2019 will also show a sub $77k income as a married filing jointly. Am I exempt from the capital gains tax on real estate based on this? I've seen numerous charts that state Married Filers are exempt from 0 to 77k, pay 15% from 77k to 250k, and 18.8% to 23.8% as you go up from there.

Could I just pay depreciation recapture given this information??

I bought the home for $205k in 2014, made very minimal improvements to it, and could sell it now for $295k. My debt is $175k on it, and my net adjusted basis is $189k.

Thanks very much again,

Nick Boyd · Answer

Thanks Dave! This is all very helpful information.

I have one follow up question for you:

My wife and I bought this home as our primary residence in 2014. We occupied it in 2014, 2015 and 2016. We bought our current primary in 2016 and have lived in this new house since.

Since we can technically answer "Yes" to the question, "Did you live in the home during 2 of the last 5 years," should we be OK to skip the 1031 entirely and just sell under IRS 523?

Or are exact days of residency counted?

Selling a Rental, taking some Boot?

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