At what price point is it worth doing a Section 1031 exchange?

Question

I live in CA and have owned several rentals in central PA for four years. It's in an area that is known to cash flow, but not appreciate due to a declining population. I've been thinking about selling a rental or two (with or without taking advantage of Section 1031)...

At what price points does it make sense to pay a Section 1031 intermediary to do a S1031????  50K? 100K? 500K? 1M?  How much does it cost?

The option would be to hold onto the rentals until I die.

Dave Foster · Answer

@David Lao, PA does indeed not allow 1031s on the state level and exempt state taxes.  But that's not all of the story.  In most situations where you live in one state and have rentals in another the way that taxation works can be a huge surprise gotcha.

Most states where you reside will give you credit for taxes paid in other states.  But if the tax you would pay in your home state is more than the state where your rental is located is then they will want to collect the difference.

So while it's true that you will pay PA taxes with or without a 1031, there's more to the issue than that.  PA tax is a flat 3.07%.  If you focus on that only you could very well end up paying an additional 9.6% in CA tax if you don't do the 1031 (thanks in small part to the "I can't make this up... Mental Health Services tax to CA residents).  That's a surprise a lot of folks overlook or don't realize.

So for you, being a CA resident makes the calculation of your gain and potential tax even more important.

@Basit Siddiqi and @Bill Brandt, give you some great analysis on $ and cents and evaluating that.  You don't want to forget the 25% depreciation recapture that  they mention as well.  An exchange of $750 or so in the central-eastern states should be stacked up against the tax potentially due for sure.

You're looking this very strategically.  You've left your three main options open - 1. no 1031-take profit pay tax.  2. 1031 pay PA 3.07 of profit.  3. hold till death.

1. locks in the profit but it's less net and you're still stuck finding a place to put the net dollars.  But you do have more options other than just real estate.

2. Keeps you in real estate but allows you to use all dollars so you continue garnering the compounding interest (that's the most powerful source of ongoing gain).  And 1031 allows you to reposition into areas or types where you can capture more appreciation or roi.

3. A great thought if they're performing.  But years of net income can be eaten up quickly in some hefty cap ex that comes up every decade or so.  As opposed to a 1031 into more stable properties or a larger property with lower maintenance.

Basit Siddiqi · Answer

@David LaoThe cost of a 1031 exchange is normally around $750 - $1,500 depending on how many properties are being exchanged.There is also the "cost" of the hassle of finding a new property and closing on it.

I would compare this cost to the tax being deferred.If the tax deferral is $1,000 - you likely don't want to do a 1031 exchange.However, if the tax deferral is $10,000, it makes more sense to do a 1031 exchangeIf your tax deferral is $100,000, it is a no brainer to do a 1031 exchange.

Bill B. · Answer

It’s not the price point that determines the savings. It in net capital gain (maybe you have almost none from the sound of it?) and nit having to pay 25% depreciation recapture. (A good guesstimate is tax = 1% of the original building cost (total minus land) every year held.

1031’s are relatively cheap. Figure $1,000 give or take a few hundred. So you have to figure out when that is money well spent. A $5k liability? A 10k liability?

Bill B. · Answer

You should have been depreciating your property every yer you owned it. It’s depreciated over 27.5 years so 3.636364% per year. (Of the building value not the total which includes land.). When you sell, you’ll owe a 25% tax on all that depreciation. So 25% of 3.636364 is owed in taxes. Or 0.91% per year. Using 1% gives you a good rough estimate and your actual taxes will be about 9% less, so you won’t be mad at my quick guess.

Pa. If you haven’t been depreciating the property, the IRS is going to pretend you have and make you pay the taxes anyway. So if you haven’t you might want to get with a cpa that can help you amend your previous tax returns. Otherwise your going to have to hold or exchange until you die or pay taxes on a deduction you never took.

Bill Exeter · Answer

Hi @David Lao,

The comments above are right on point.  You should compare the cost of doing the 1031 Exchange to the actual amount of Federal and state taxes that you would pay if you do not 1031 Exchange.  Remember, PA is the only state that does not recognize the 1031 Exchange so you will pay state taxes regardless.

Joe Splitrock · Answer

Be aware that a 1031 delays taxes and transfers basis. That means you transfer in your used depreciation and it leaves less appreciation available on the new property. If your appreciation is small and you are just transferring basis, there may not be much benefit for the cost. I have done 1031 and sold outright. Run the numbers and see what makes sense. Not to state the obvious, but the larger the taxable gain, the more the benefit. If the gain is marginal, it may not be worth the effort.

David Lao · Answer

@Dave Foster @Basit Siddiqi @Bill Brandt @Bill Exeter

Thank you all so much for the info. I've learned quite a bit!

Bill B. · Answer

I guess that’s a weird upside to high taxes. With only rental income and lots of depreciation I’ve been in an effective rate of 11% (and no state income tax) it’s painful to take that depreciation recapture back.

Glad to hear you’ve been taking it. I’ve heard too many stories of people who didn’t know about depreciation or thought it was optional.

Gl

Michael Lynch · Answer

Consider not only the costs for the year in which you will either sell or exchange, but also the costs in future years. What tax brackets will you be in in the various years?

This has become especially important as the likelihood of tax law changes has increased. Our new President has proposed that capital gains be taxed at ordinary income rates if your taxable income is over $400,000, so, in certain situations, it might be better to incur a capital gain now (before the law changes) than later (ie, when you eventually sell the replacement property).

Much further down in the likelihood of actually happening, President Biden also backs eliminating like-kind exchanges, lowering the estate tax exemption, and taxing untaxed appreciation upon death.

https://www.forbes.com/sites/r...

https://www.natlawreview.com/a...

All of this is part of your consideration.

Ola Dantis · Answer

We are closing on a multifamily deal right now and one of our partners is bringing 1031 capital.

I've got to say, a learn a lot more about 1031 reading this thread.

At what price point is it worth doing a Section 1031 exchange?

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