1031 Exchange VS Paying Taxes

[Pesi S.]

Hello

I am a novice investor and wanted to understand when is a 1031 suitable to do and whether sometimes it is more suitable to just pay the taxes especially with the current uncertain economic environment and governmental restrictions and difficulty in rent collection. If anyone can shed some light on below appreciate it

1) 1031 requires you to buy another property at the same or greater value of current property. So if I have purchased a property for say 200K and made 50K down and took a mortgage of 150K and if I sell it for 300K then the new property or properties need to be of at least 300K or more in value to get the full tax benefit. Otherwise you will be taxed at whatever amount you pulled out

2) You need to identify new property within 45 days of sale and close on it within 180 days from sale. In good areas and in a market like current one this is a daunting task to achieve unless you are lucky.

3) What scares me that now you have to take all your equity, profit and also maintain the same level of loan and buy a new property at a high inflated price in a high market. Getting Value or discounted deals is difficult under a deadline and you might be forced into buying something just to meet deadline

4) Should the market tank after you buy the new property then the whole 1031 purpose gets defeated

5) When the agents, buyers, sellers come to know you are into 1031 and are facing a deadline, then they try to take advantage and squeeze you from all sides.

6) You also have costs of selling/buying again and 1031 Intermediary

From a tax perspective, I am given to understand that

1) I will pay 15% flat tax on the gains. Gains is Purchase Price + All Expenses - Selling Price. So if my purchase was 200K , my expenses in buying/selling are say 30K and Sale Price is 300K then my profit is 70K and i pay 15% tax on 70K

2) Depreciation recapture tax. If I took depreciation of say $4000 a year and held the property for say 5 years then 20K would be added to my income and i would pay income tax at around 22-25%  on 20K.

3) Apart from the above are there any taxes on state/city level also  and if so what are they and how are they calculated. 

Thank you

[Dave Foster]

@Pesi S.

1. Correct if you want to defer all tax.  But you can purchase multiple less expensive properties.  It is the total amount you purchase that count's.  

2. Correct.  But you can go into contract before your sale even closes.  You can sell your property contingent on finding a new property.  Plenty of ways to mitigate that.  Less than 10% of my clients fail to close on a suitable replacement property.  And we tell them to never never never accept a bad property as a replacement.  There's no penalty for starting and not completing a 1031.

3. You technically don't have to replace the loan.  You have to purchase at least as much as your net sale and use all of the proceeds in the purchase or purchases if you want to defer all tax.  But you can do a partial exchange and pay some tax.  And you can bring in outside proceeds of your own so you don't have to carry the same amount of loan.  And you can use the proceeds in any way you want.  So you could buy one replacement with little or no debt (now it's safe from risk).  And buy a second with maximum leverage (getting the higher roi of leverage).

4. No.  As long as you never sell your 1031 is never compromised.  I have many investors who's wealth on paper dropped 80% in 2008.  5 years later they were more wealthy than ever because they simply held on and never sold.

5.    Very seldom.  And you don't have to notify them until at the closing.  You can make your 1031 completely anonymous to the buyer or seller.

6. You have all the costs of selling anyway.  The 1031 is generally the cheapest thing on your settlement statement.  An exchange of less than $1 mil is going to cost you $750 - $1000 for a high quality nationwide company.

7.  15% federal.  Don't forget NJ.  They'll want theirs too if you don't do the 1031.

8. Correct.  And even if you didn't take depreciation you have to recapture it - Hows that for a sneaky IRS trick.  It is almost always recaptured at 25%.

9.  Sometimes there are state transfer taxes and maybe a local sales tax.  These are state by state and your accountant or the title company or attorney you work with can help you sort that out.

So the answer to your question would be to ask two more questions.

1. Am I willing to spend $750 to potentially save $20K?

2. Am I going to purchase new investment real estate?

If the answer is yes then a 1031 is probably appropriate.  They're not all that cumbersome.