1031 Exchange - Questions from a n00b

[Latimer Luis]

Hi all, I am new to REI so be easy on me pls. :) this is my first post. I sold my bay area condo in 2013 not knowing the appreciation would balloon over the last 5 years. I was debating on renting it out at the time, but opted to sell because I was scared of having less than $15K in my savings after upgrading to a much larger and more expensive SFH. Probably the wrong move, now that I look back. So where am I going with this ... I just read about 1031 exchanges and now Im curious to know more about it. if I had known about this then, I might have made a different decision. Hoping to get insight from you experts. If I kept my condo as an investment property, would I have been able to 1031 exchange it today for an out of state property knowing the original loan terms were for a primary residence? Secondly, if after some time (lets say 5 yrs or so of renting it out) I made the NEW property my primary residence, would I then be liable for the capital gains tax? Thanks in advance!

[Clayton Mobley]

@Latimer Luis There are a couple moving pieces here, so I will try to make this as clear as possible :)

If you had rented it out instead of selling, holding it as a rental until today:

Yes, you could have executed a 1031 to exchange the property into (I'm guessing) a whole little portfolio of properties. There are lots of rules and regs with the 1031, but it doesn't have to be 1-1. If your SF prop was worth $1.5mil by now, you could use that money, tax-free, to buy as many other props as you wanted. Sorry, I feel like this is salt in the wound at this point.

Even though you bought it as a primary, five years of using it as a rental would qualify it as an investment property and allow you to use the 1031.  I am hoping (really I am) that you took the Sec 121 exemption mentioned in the previous comment and took the $250k (single) / $500k (married) of tax-free capital gains when you sold, since you lived in the property (assuming you lived there at least 24 months out of the previous 60).

If you had used the 1031 and then, five years later, decided to sell the replacement property (not your stated scenario, but an important thing to note):

Since you bought it and held it as an investment for five years, you could sell it through another 1031 and leapfrog into another investment property tax-free (there is no limit on how many 1031s you can execute). 

OR

If you decide to move into that replacement property five years after purchasing (your stated scenario):

No, you do not automatically become liable for the deferred tax if you decide to convert a 1031 prop into your primary. However, when you sell that property you have some decisions to make.

If you decide to move into the house after those first five years, instead of selling, then you have converted it into a mixed-use property. If you continue to live in it for two years (satisfying the Sec 121 requirement mentioned above) then you have the option of combining the Sec 121 exemption and the 1031 exchange when you sell it. Since you bought it under a 1031, you need to have owned it for at least five years, but your scenario already covers that period, so you're fine there. 

Basically, if you bought it under a 1031, held as an investment for five years, then moved in and stayed for at least two years, you would be able to take a prorated exemption under Sec 121 for tax-free capital gains (prorated based on the amount of time you lived there vs held it as a rental) and use the remaining value in another 1031 exchange. This would allow you to continue to defer taxation on both the sale of the SF condo and this new replacement prop, and get a little tax-free cash as well under Sec 121.

If you decide to sell it outside of a 1031 exchange:

Now you become liable for the deferred taxation. It's a bit of somewhat complicated math, but the tax basis of your SF condo (that you sold under a 1031 in our hypothetical scenario) is rolled into the replacement property. This basically means that if you sell the new property outright, you end up paying the taxes on both that sale and the sale of the SF condo (here's a link: https://apiexchange.com/replacement-property-calcu... )

So, if you sell that new property outside of a 1031, the tax man comes a'calling.  You could still qualify for the partial 121 exemption mentioned above, but you'd be liable for the remaining capital gains and deferred depreciation recapture tax.

So basically, yes, you missed out on a big opportunity here, but there's no sense worrying over it now. Chalk it up to a learning experience! What you know now is that the 1031 is a massively powerful tool for RE investors and it pays to understand how it works. As I said, there's no limit to how many 1031s you can execute, so you can potentially (and many people actually do this) continue to leapfrog from one property to the next (after holding for a sufficient period, usually 12-18 months) without paying taxes, indefinitely. Then you leave your final properties to your heirs, who receive a stepped-up tax basis (equal to the current market value) when you die, meaning if they sell the properties the day after you die, they would essentially pay zero taxes. It's a strategy I charmingly refer to as "1031, 1031, Die", but I digress.

The 1031 is a bit complicated and when combined with the 121 exemption, even more so. BUT you are required to have a Qualified Intermediary on your team anyway, so they will make sure everything is as it should be. So, keep this learning experience in mind next time you have some appreciated property to sell -  it can save you tons of money and, more importantly, keep that capital working for you.

Sorry for the bummer post,

Clayton