How does a 1031 Exchange work with a VA Loan?

Question

Hello! I'm curious how a 1031 Exchange works. What are the ins and outs of doing one? I have a property that I purchased years ago with a VA loan before I found bigger pockets. Knowing what I know now, that property is simply bleeding me of money. Running the numbers, I simply need to sell the home, but listening to an old BP podcast, someone had brought up a 1031 Exchange. My initial plan was to sell the home, and use those funds to help fund an investment property. How does the 1031 Exchange work?

My understanding is that you can use it toward another home and pay taxes on that later. I'm sure I'm oversimplifying it, but based off my intent, how can I use this to my advantage or is this even feasible? Does it make sense to sell or do a 1031 Exchange instead?

Bottom line: I want to get rid of this house in my portfolio and invest in a different property out of state. Whether I use the money from this sale toward another investment property or do a 1031 Exchange, I'm open to it. Also, because this property was purchased through a VA loan, does this complicate things? If I do a 1031 Exchange toward another property, is my VA loan still tied up? Ideally, I'd like to free up my VA loan as well!! Thanks in advance!

Marc Estepa · Answer

@Richard Roman - I KNOW RIGHT?! Where was BP 20 years ago when I was trying to be an adult?! I ask questions and I receive the best education ever. I can’t stop taking all of this in. The real estate investor community has been nothing but helpful to me and I can’t be any more thankful. I’ve learned more in 3 months than I have with real world experience in 20 years!

Richard Roman · Answer

@Marc Estepa Just a bystander here...This is all great information!!!!!!! I have nothing to add here but I just wish you the best.

Marc Estepa · Answer

@Dave Foster, whoa. You’ve SOLD me! I’m super new to BP and have found myself trying to fix a lot. I’m going to shoot you a note in a bit

Chris Mills · Answer

@Marc Estepa You're in good hands with @Dave Foster, so I won't go into too much more here. You asked me about the limits of the replacement property and repairs, and I'll tell you that if the hoarder house just needs a lot of cosmetics and TLC you may be ok. There's a very specific timeline to adhere to getting the work done that Dave will recap with you. You also mentioned the FHA 203k, which is an owner occupied program. The IRS definition of "like kind" replacement property is pretty broad, but the replacement property does have to be an income property. Can't do a SFH that you live in. If it's a 4 unit and you live in one unit, I believe you can do it, but you won't get the full benefits of the 1031.

Marc Estepa · Answer

Thanks @Chris Mills! If I can’t use it toward my primary residence, that just means I can continue forward with the FHA 203K loan and use the 1031 exchange toward another home! That’s actually good news! Appreciate the knowledge truly. Starting out, I feel like I’m just gathering knowledge all the time so I know how to properly use my options. It’s overwhelming. People suggest different options and I’m just sitting here writing them all down and then asking the stupid question, “what’s an FHA 203K loan? What’s a 1031 exchange?” I’ll make sure to always pass the knowledge back to the community. Everyone has been nothing but helpful.

Dave Foster · Answer

@Marc Estepa, It's not just an issue of the property not appreciating. During the last 10 years it has received the tax write off of depreciation - a pretend game where the IRS gives you a write off of a % of the property each year but wants it back when you sell.If you sell without a 1031 you could easily be taxed on $70 - $80K of depreciation recapture because it's been a rental for so long. And depreciation recapture is at 25%. So without a 1031 exchange count on maybe a $15K - $20K tax bill.That's enough to say "ouch" in anyones book. I'd look seriously at doing a 1031 to avoid that hit.

Marc Estepa · Answer

@Dave Foster, thanks for the note. I haven’t studied anything yet - I’m actually posting here while I’m at work 😬. Anyway, the home has NOT appreciated. In the 12 years I’ve owned it - I’ll be lucky for it to break even. As it stands, I bought for $242 and 2 realtors are telling me it might be worth $230-240K. I owe $200K currently. I’m starting to think this is NOT an option. Thoughts?

Marc Estepa · Answer

@Scott Wolf, I WISH it would’ve appreciated. I bought in 2008 and the market crashed. I thought it would be the base I would be stationed at forever, so I bought in an exclusive part of this neighborhood. As the Soldiers started coming back from deployments with money in their pockets, homes were in high demand, and the builder bought more land behind me and built CHEAPER homes bringing down my property value further. It’s been 10 years since I first started renting it out, and it’s bled. I bought for $242 and 10 years later, 2 realtors are telling me it might be worth $230-240. I hate it. So based off what you’re saying, I CANNOT do a 1031 exchange correct?

Marc Estepa · Answer

@Chris Mills, thanks for the knowledge! Does the replacement property need to be similar in value and condition? Can it be out of state? Are there any limits to the replacement property? What if the home I’m eyeballing is a hoarder house and in need of repairs and remodel? Sorry for all the questions. As for the VA, does this free up that loan? The 1031 exchange seems relatively easy on the surface. I am eyeballing a property where I am stationed now that is in need of repair. I am in the process of getting prequalified for a FHA 203K loan and was warned about how complicated it is. I’m all about the easiest way possible without headaches. I’ve been so tunnel focused on the task at hand of getting prequalified for the FHA loan, I didn’t even look at other options. To answer your question, this home has been a rental for 10 years. I bought it before I found bigger pockets and bought at the top of my price range, so the numbers don’t work for a rental.

Dave Foster · Answer

@Marc Estepa, The 1031 is a process that allows you to sell investment property that is either appreciated or been depreciated substantially so there would be tax due upon the sale. The 1031 lets you move that gain into the new property and indefinitely defer the payment of the tax. The VA loan does not matter. It is the use of the property that is important. Any property held for productive investment use can be exchanged for any other type of investment property. All loans are paid off as part of the closing. So selling this property would free up your VA loan again. However, understand that you cannot use 1031 proceeds to purchase a primary residence. It must be used to purchase investment real estate.Theres some other nuanced regs that apply. I sent you a pm to provide you with a paper that discusses more thoroughly. Looks like this would be a good plan for you.