sell or keep rental?

Question

Paid 70k for the house about 2 years ago and its worth about 135k now. It cash flows about 400 a month but its an old home. Figure I would owe about 15k in income taxes. Rent is $1000 a month.

Its very tempting to take the profit and I would not have to deal with tenants any more with that house or worry about repairs. I have 4 rentals now and looking to build my own house so could use the money. Figure if I can make 50k thats about 10 years of cashflow upfront.

Clayton Mobley · Answer

Sorry for the second post, but I thought I should have included a quick note about the whole 1031 process, in case that isn't  an option you've had experience with yet:

If you do go the 1031 route (partial or full), bear in mind that you need a QI before you get started. You can't take any cash for the sale directly, it all has to go through the QI. You also have to adhere to some strict timelines - identifying potential replacement props within 45 days of selling your current prop and then purchasing your replacement within 180 days. If you intend to go this route, I'd recommend starting your research well before you put your prop on the market to ensure you have the time to find replacement props that meet your criteria without having to settle for something less lucrative just because you've run up against the 45 day deadline.

I won't get into all the rules about property selection here, but if you're not familiar with those requirements I'm happy to elaborate further.

1031s are hugely powerful, but they are NOT a DIY process. In your case, it's definitely an option worth considering, but don't skimp on getting a professional QI to make sure everything goes smoothly.

Clayton Mobley · Answer

@Jimmy S. It's unusual to see a post where someone actually has two decent options! I agree with @Eric James that this prop is ripe for a 1031. You've had it more than a year and clearly intended to hold it as an investment (not a flip), and you would be able to parlay that $135k into a great property in various markets (here in Bham you could get a solid B+ turnkey for that amount for sure).

I suppose, however, that this is a matter of your priorities. Common wisdom here will always be not to give money to the IRS unless you have to. HOWEVER, if having the $50k in cash is more important to you than giving up $15k, then selling and taking the profit might be worth it. Bear in mind, however, that you'd need to deduct any depreciation for the past two years from your current $70k basis (whether or not you actually took that deduction is irrelevant, the IRS will still 'recapture' that money because you could have taken it), which might mean you actually have a bigger gain, and a higher tax bill. But, you also get to add in any substantial upgrades or rehabs you did, so that might be a wash depending on your numbers.

The other option could be to do a partial 1031, wherein you exchange for a property worth less than $135k (if you find one with good numbers) and then take the remaining profit as 'boot'. You would still pay capital gains tax on the profit you take, but you'd be sheltering part of your gain. If you actually only need $25k, for example, you could exchange for a prop worth $105k, shelter that first $35k in gain (assuming no basis adjustments), and pay the tax on the remaining $30k (approx $4.5k assuming 15% CG) and net $25.5k for your new build. Of course, nothing is quite that simple and any basis adjustments or debt that you carry on the current prop will make things a bit more complicated, but that's where a Qualified Intermediary comes in.

Truthfully, you are cash flowing nicely on the current prop, and could likely afford a good PM to take the stress out of the investment and still net a good amount. It's all about what your priorities are. The easiest option is to keep it and get a PM. If your priority is building your portfolio while preserving capital, a 1031 is the way to go. If just need a big chunk of cash, you can sell and eat the taxes. Or you can do a partial exchange and split the difference.

Sounds like you have some decision making to do - good luck!!

Clayton

Bill Exeter · Answer

Hi @Clayton Mobley,

You are right on the money.  It is the intent that counts.  You could 1031 Exchange into a property and hold it as rental, investment or business use property for a couple of years (ish) and then change you intent and move into it later, but if your original initial intent is/was to use it as your primary residence it would not qualify for 1031 Exchange treatment.

The PLRs mentioned above do have the same intent requirements.  You must still hold/use the property as rental, investment or business use.

Clayton Mobley · Answer

@Jimmy S. I noticed that your plan is to eventually live in the new build and (@Bill Exeter please correct me if I'm wrong here) that seems like the type of 'intent' that might not fly for a 1031. You have to exchange investment properties, so primary residences don't qualify. I am not as up on the intricacies Bill mentioned (naturally, him being the pro here), but I always love a learning opportunity. Bill, do the PLRs you mentioned have the same kind of 'intent' requirements as a standard 1031? ie if the taxpayer's intent is to live in the property, is an exchange still an option? What if they intend to hold it as a rental for a few years prior to conversion? Lay the knowledge on me, man!

Clayton Mobley · Answer

@Stephanie Potter thanks for the shout-out! Always nice when people appreciate my endless ramblings ;)

Eric James · Answer

I would sell it, do a 1031 exchange, and buy a more expensive rental that cash flows even better. If you're tired of 'being a landlord' you could hire a PM.

Clayton Mobley · Answer

@Bill Exeter Thanks for clearing that up - always happy to learn from a pro!

Clayton Mobley · Answer

Uh oh, double post again - but I see that @Andrew Johnson brought up a really great point: what is the life on those big capex items? If you're going to be out several $k in the next year or two for a new roof or HVAC anyway, the sale might become a more attractive option. You say the prop is old, so does that mean you're staring some big expenses in the face that you could potentially avoid by selling? If you keep the property, will you end up paying almost as much in upgrades and repairs in the next five years as you would pay in taxes if you sold now? Awesome point Andrew, definitely worth consideration.

Bill Exeter · Answer

Hi @Jimmy S.,

You are essentially trying to sell an existing rental property and then 1031 Exchange into a property that you already own by paying for improvements to the property.  Technically, it would not qualify because you must 1031 Exchange into property that you do not already own.

However, in this case, the IRS has issued three (3) Private Letter Rulings (PLRs) that address the issue and essentially did allow the taxpayers to do just that.  There will be risk involved, and the more that you stray from the way the PLRs were laid out the more risk you will have.  But, in theory, it can be done.

We actually administer one or two each quarter for clients, but you have to be willing to accept some degree of risk that the IRS could disqualify your transaction.

sell or keep rental?

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