How to sell with low tax bill - 1031 or 121?

Question

My parents bought their primary residence 30 years ago for 250k. It has appreciated to 1M. For the past 5 years, they've renting it out and have been living somewhere else.

They want to sell it in a way that has the smallest tax bill.  They plan on buying multiple properties with the proceeds, and use the passive income to fund their retirement.

They want do the 121 exclusion for 500k as a married couple. So move back in and live there for 2 years. Sell it for 1M, cap gain of 750k. 500k gets excluded. So pay taxes on 250k.

Or, they could sell it right now and 1031 it into multiple houses. Since it's 1031, they pay no tax at all.

Seems to me that 1031 is the smarter way to go here. Did I get that right?

Tony Kim · Answer

I think Dave makes some very good points. 45 day identification might seem tough, but it's actually not all that bad. When I did my exchange, I felt some pressure, but I found a property within just a few weeks. Also, keep in mind that you can start searching well before you close escrow on your existing property. There is very little downside to going into escrow under the assumption that you'll be doing a 1031 exchange because there is no penalty for not making an exchange. Also, if for any reason you change your mind before closing escrow, all you need to do is have the escrow instructions amended and the QI fee portion will be removed (which relatively speaking, is very small).

Also, since your parents are looking for steady retirement income, if the worst case scenario happens and you are unable to find anything or if the exchange will not be sufficient, there are alternatives to direct ownership, like a DST which can be used to fill in any gaps. Heck, for truly passive income, you can do the entire exchange with some carefully selected DSTs from a trusted broker or sponsor.

Dave Foster · Answer

Account Closed, One nice thing is that there is no penalty for not completing a 1031 exchange.  And it is possible to do a partial exchange and only pay part of the tax.  So all is not lost if the deadlines get in your way.

Honestly though the 180 day deadline is almost never a problem (except for new construction).  The problematic time line is the 45 days to identify because after day 45 you can't change the list.  So most of our clients will try to get under contract during the 45 day period or even before their old property closes.  This can mitigate a lot of the stress.

Since there's no penalty for starting and not completing a 1031 it's important to keep in mind that you don't want to force one to the finish.  No one ever went broke paying tax on profit.  And it's not the property you don't get that kills you.  It's the one you get that you shouldn't have that kills you.

We just did an anecdotal survey on our exchanges and found that only around 7% failed.  And some of these were strategic.  So while your concerns are valid, it's not as difficult as it might appear.  It's like you said - You have to be focused and not dally.

In your case it's a trade off - spending a couple of years for a partial tax benefit vs working a little harder but getting full relief now with the 1031.  I think everyone has a different threshold for that kind of thing.

Dave Foster · Answer

Account Closed, If they move back in now they would not get the full 121 exemption.  When you convert a rental to primary (even it if started as your primary a while back) you have to recapture all depreciation (5 years worth) and you have to prorate the gain between the period used as a rental and the period it was their primary residence.

So there is still probably some very good benefit to moving back in and getting at least part of the $500K.  But the other problem is that if that property continues to appreciate all of the gain would be taxable since they'll could be over the $500K limit even with the proration.

So there will be tax if they go the primary route and it will take time.  The 1031 opportunity would be now and it would fully defer all gain and depreciation recapture.

Account Closed · Answer

thanks for the comments guys. very helpful

Account Closed · Answer

Thanks @Dave Foster

What are the cons of doing the 1031? Let's say they swap it for 3 properties. The only con I see is that all 3 properties need to close within 180 days. If we miss the deadline, the tax bill will be hefty. So we need to have our acts together, not waste any time, and hope the seller of all 3 properties are also quick.

I've never done a 1031 exchange before. Is this a real concern?

Account Closed · Answer

thanks Dave. So isn't that an argument for 1031 instead of 121? Seems like with 121, even the best case scenario, we're talking about paying taxes on the $250k cap gain (ignoring depreciation recapture and proration)

While with 1031, we're not paying taxes at all.

James Free · Answer

Tony and Dave are covering it well. I'll admit that a risk with a 1031 is that you overpay for the new property because you're afraid to miss your window.

A big unmentioned concern about the 121 plan is that they actually have to move into the house for two years. Do they want to do that? That's a big life change and a lot of inconvenience (if they're like my parents, they have a LOT of junk by this age) just to play the tax game.

Your parents should be at a stage in life where they are enjoying their wealth, not jumping through hoops to manage it.

Dave Foster · Answer

Account Closed,  You're absolutely right.  If they have no need for free cash with some tax the 1031 is the way to go since it will completely avoid all tax.

Wayne Brooks · Answer

Yep, the 121 exemption would limited to  32/2 (prorated), or about 1/16 of the gain.

Basit Siddiqi · Answer

As others have mentioned, you won't be entitled to the full 121 exclusion since the property was a personal residence turned rental property turned personal residence.

How to sell with low tax bill - 1031 or 121?

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