1031 Exchange 'Nuts & Bolts'

1031 Exchanges
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1031 Exchange 'Nuts & Bolts'

John Alosio
Rental Property Investor · Stroudsburg PA · Member since 2020 · 119 posts · 74 votes

Greeting BP community,

I have a question about the 1031 exchange

I understand the main concept but I am having trouble wrapping my head around the mechanics.

My situation: I currently own a duplex that I have lived in for over 2 years. I am looking to sell and flip it into another owner occupied Multi. When I sell, I am exempt for 50% of the capital gains. I’m looking to 1031 the other 50% into a larger house hack.

Question: When 1031ing these investment gains into the new property, I understand that all of these funds must go into the purchase of the house. What exactly does that mean? The full amount has to go into the down payment? Can I use it towards the closing costs / cost of procuring the 1031?

So I have a lot of numbers floating around in my head.

Lets say I sell the house for a combined gain of $100k.

$50k tax exempt - $50k 1031 exchanging

Lets say the new prospective 4-plex costs $500k ($375k investment - $125k owner occupied)

Now I have to figure out the minimum down payment I need to satisfy the $50k threshold.

My head is spinning just typing this up. I hope my question is making sense. Any help would be much appreciated.

Thank you all in advance.

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
5y

@John Alosio I think we just connected so I'll forward a paper to you that will sort it all out easily for you.  The brain seizure is that you're combining several things that don't really combine well.

You've got the Primary/investment distinction down.  You will get to take the $50K of profit (50% of the gain) tax free.  And you can do a 1031 on the other 50%.. But here's where it's getting a little confusing for you.

In order to defer all tax you must purchase at least as much as your net sale.  and you must use all of the net proceeds in the next purchase or purchases. (remember these actual numbers are just 50% of the net sale of the entire duplex and 50% of the proceeds).  And yes you can use your proceeds for both down payment and qualified closing costs.

Your actual gain is sort of irrelevant on the 1031 side.  The IRS simply says that to do the 1031 you must purchase as much as your net sale and use all of your net proceeds.  Any amount you purchase less than your net sale or any amount of cash you touch (only on the investment side 50%) they say is profit.  

So if you just stay focused on this two part rule it sorts itself out pretty quickly for you.  

Unfortunately the one number that's missing from your list is the net sales price is your net sale price.  So let me just plug in a number - $300K.  You sell your old duplex for $300K.  That means that the investment portion of the sale (the net sale number for 1031) is $150K.  And you walked with $50K in cash (the net proceeds on the 1031 side.

All you must do to defer all tax is purchase at least $150K in investment real estate using $50K of cash.   So your example of a 4 plex where the investment portion is $375K is perfectly fine.  Your down payment and closing costs on this will certainly exceed the 1031 cash.   Perfect exchange!!!

End of story - $50K goes into your pocket with no tax and no requirements.  $50K purchases a $500K 4 plex through a 1031 exchange.  that you will be using 1/4th of as a primary residence .  The holy grail of investing - Kudos!!!!

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  • Will Fraser
    Real Estate Broker · Salt Lake City & Oklahoma City · Member since 2018 · 3k+ posts · 2k+ votes
    5y

    Hey @John Alosio, I'm stumbling over step 1 here -- are you positive that you can to an exchange on an owner occupied property?  

    I know a key with 1031 exchanges is the intent of the property, and that's why a red flag goes off in my mind regarding owner-occupied Plexes . . .

    0Reply
  • John Alosio
    OP
    Rental Property Investor · Stroudsburg PA · Member since 2020 · 119 posts · 74 votes
    5y

    Hi @Will Fraser

    Am I positive? Absolutely not. From my research I could have swore I saw that it is possible. Please anyone feel free to school me on this subject.

    0Reply
  • Will Fraser
    Real Estate Broker · Salt Lake City & Oklahoma City · Member since 2018 · 3k+ posts · 2k+ votes
    5y

    I recently started my first 1031 exchange and have enjoyed the guidance I've gotten from the QI I'm working with.  I'll DM you his contact in case it would be useful for you.

    1Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @John Alosio

    You are 1031 the half of the duplex that you rented out.  That is the investment part.  The rest is the usual 1031 requirements about re-investing all that was invested before...  I’m not a 1031 specialist so I don’t have it at the top of my head.  As I recall it just two major rules.

    Perhaps think about doing a regular investment property. Then, apply to your duplex.  Duplexes are just more complex since your investment portion has to be calculated.

    I’m sure Dave foster will be along to explain

    0Reply
  • Jon Taylor
    Pasadena, CA · Member since 2019 · 136 posts · 148 votes
    5y

    @John Alosio 

    You're on the right track.

    You've done a good job of separating the primary residence from the investment property in your mind. A few additional things to consider. Let's continue to keep them separate for the purposes of this scenario.

    • You sold an investment property for a gain of $50k. That is an important number for tax purposes, but you need additional numbers to understand the 1031 exchange implications. In order to satisfy the 1031 exchange, you need to replace the equity and the total value of the sale of your investment property less any transaction-related expenses. 
    • So, your gain is only relevant as you weight the cost of cashing out. But it is not factored into the reinvestment rules for the exchange. In other words, your equity and your debt need to be reinvested into the quadplex. 
    • If you want to provide those numbers, we can continue to model the scenario. 

    Make sense?

    2Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    5y

    @John Alosio I think we just connected so I'll forward a paper to you that will sort it all out easily for you.  The brain seizure is that you're combining several things that don't really combine well.

    You've got the Primary/investment distinction down.  You will get to take the $50K of profit (50% of the gain) tax free.  And you can do a 1031 on the other 50%.. But here's where it's getting a little confusing for you.

    In order to defer all tax you must purchase at least as much as your net sale.  and you must use all of the net proceeds in the next purchase or purchases. (remember these actual numbers are just 50% of the net sale of the entire duplex and 50% of the proceeds).  And yes you can use your proceeds for both down payment and qualified closing costs.

    Your actual gain is sort of irrelevant on the 1031 side.  The IRS simply says that to do the 1031 you must purchase as much as your net sale and use all of your net proceeds.  Any amount you purchase less than your net sale or any amount of cash you touch (only on the investment side 50%) they say is profit.  

    So if you just stay focused on this two part rule it sorts itself out pretty quickly for you.  

    Unfortunately the one number that's missing from your list is the net sales price is your net sale price.  So let me just plug in a number - $300K.  You sell your old duplex for $300K.  That means that the investment portion of the sale (the net sale number for 1031) is $150K.  And you walked with $50K in cash (the net proceeds on the 1031 side.

    All you must do to defer all tax is purchase at least $150K in investment real estate using $50K of cash.   So your example of a 4 plex where the investment portion is $375K is perfectly fine.  Your down payment and closing costs on this will certainly exceed the 1031 cash.   Perfect exchange!!!

    End of story - $50K goes into your pocket with no tax and no requirements.  $50K purchases a $500K 4 plex through a 1031 exchange.  that you will be using 1/4th of as a primary residence .  The holy grail of investing - Kudos!!!!

    The 1031 Investor5137 Reviews
    WebsiteView Page
    4Reply
  • John Alosio
    OP
    Rental Property Investor · Stroudsburg PA · Member since 2020 · 119 posts · 74 votes
    5y

    Thankyou all so much for your helpful insight!

    For purpose of this model:

    Current debt: $135k

    Sale price $250k

    Gains after closing: $100k

    Investment gain to 1031: $50k

    New 4-plex price: $500k

    New investment cost: $375k

    New primary cost: $125k

    @Dave Foster

    I think I follow. Aside from one thing. I’ll
    have to come out of packet to cover the ¼ of all cost of the new 4-plex correct? By my math, according to above model, that would be:

    $50k (exchanged) + $16.5k (OOP) = $66.5k all in.

    How then would I figure my down payment before I know what closing would cost?

    Do I estimate and hope it hits close? My main goal is to squeeze out as much of the tax exempt gains as possible.

    Thanks again!

    0Reply
  • Jon Taylor
    Pasadena, CA · Member since 2019 · 136 posts · 148 votes
    5y

    @John Alosio

    • Reliquished Property Current debt: $135k / 2 = $67.5k
    • Relinquished Property Sale price $250k / 2 = $125k
    • Relinquished Investment Property Equity = $57.5k
    • Estimated Closing Costs ($7500)

    ------

    • Replacement Property Cost: $375k

    Let's estimate $7k for closing costs (probably high), you'll have approximately $50k of cash in the QI when you sell and pay off your mortgage. 

    You'll need to invest all of that equity into $50k into your replacement investment property while acquiring at least $125k worth of property ($375k is significantly over the minimum requirement). 

    You'll either have to come out of pocket or acquire financing to cover the balance between the $50k of equity coming from your current rental and the $375k price. You won't have to add any cash to the deal if you can acquire $325k of financing (approx).

    If your closing cost estimate was off, it would impacts the equity number slightly, but wouldn't change the strategy or cause much of a difference in your decision-making criteria.

    1Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    5y

    @John Alosio, If only using the $50K in cash from the investment side is your goal then you're probably better off looking at what size property you can get using $50K in cash.  That's a 20% down payment on a property for $250.  Since your investment sale was $125 that would totally cover your reinvestment.  and you'd have to come out of pocket for closing costs.  So maybe you look at a property for around $200K.  If that is a 4 plex then you can still use one unit as your primary.  And the other 3 (total of $150K) still cover your reinvestment target.

    The 1031 Investor5137 Reviews
    WebsiteView Page
    2Reply
  • John Alosio
    OP
    Rental Property Investor · Stroudsburg PA · Member since 2020 · 119 posts · 74 votes
    5y
    Wow. Really helpful advice. Thank you all for your time. I am so grateful to have BiggerPockts as a resource.
    Now I'm prepared to make some well informed moves.

    Much love to you all.
    1Reply
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