Capital gains tax vs. 1031 exchange

Carolina S. · 2024-04-02T20:44:35-07:00

Hello BPs community, thank you in advance for any thoughts shared. I just sold a rental property which had quite a bit of equity from appreciation and principal pay down through the years. I have it all set up for a 1031 exchange and I am now under the 45 day countdown. At the same time, I am also using this opportunity to move that capital into an LLC, and would look to extra financing to purchase a new property or properties of equal or higher value (per 1031 exchange requirements). The downer is that financing through an LLC would mean "commercial loan" which has a high interest rate of nearly 9% in today's high rate environment. I'm likely staring at negative cash flow net of that high rate, or at best breakeven. Of course, to complicate matters (and here starts my dilemma), I am also rebuilding on my primary residence. I can rebuild it through financing it or through using the proceeds from the rental I just sold that is currently marked for 1031 exchange. If I finance the rebuild then the 1031 exchange presents some challenges (I will need to land a property that cash flows or breakeven so that I can get the loan for my rebuild, or banks will count that debt against me). The alternative is I pay cap gains taxes and dump the capital into my rebuild project on my primary which would allow me to rebuild without any financing at all. This will force a lot of equity into my primary especially once the rebuild is complete. This would also allow me to keep my primary at a low rate loan. However, I would miss out on the benefits of 1031 (deferring taxes and having more capital to invest). Which is the better route? How are folks navigating 1031 and high financing rates vs taking capital gains hit and having pure cash on hand to redeploy elsewhere (in my case, rebuilding on my primary residence)? I’m thinking I can explore a home equity loan latter when I am ready to invest again. Thoughts? Thank you!

Melanie P.Pro Member

Rental Property Investor · Member since 2023 · 1k+ posts · 922 votes

2y

You will also owe depreciation recapture tax.

Your post is rather difficult for me to understand. If you're doing a 1031 exchange you'll have to close in the same name that the property you are exchanging was in. Are you working with a 1031 agent?

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Carolina S.

OP

Real Estate Agent · Vienna, VA · Member since 2019 · 11 posts · 5 votes

2y

Quote from @Melanie P.:

You will also owe depreciation recapture tax.

Your post is rather difficult for me to understand. If you're doing a 1031 exchange you'll have to close in the same name that the property you are exchanging was in. Are you working with a 1031 agent?

Thanks for your response. Yes, I', working with a 1031 agent. I'm basically looking for input in the following:

Option 1: Buy a couple of properties and split the money from the 1031 exchange for the down payments. I'm looking at a $600k price point each. Which means I will still need to finance about $400k for each property at about 9% rate (the rate is high because we'll using a commercial loan as we'll be purchasing the properties under an LLC). This gives me very little or zero cashflow on the properties. At this time, I'm not looking to invest out of state.

Option 2: Pay capital gain taxes and use it to finance my primary property renovations. I still have a mortgage on the primary of about $450K at a 3.8% rate. If I finance the renovations, I would be able to keep that rate. The renovations will increase the value of my primary from $800k to about $1.6M. However, there will be a lot of equity trapped in my primary. I know I could look to refi to get the equity out but then I would loose the 3.8%. Would it be worth paying capital gains then?

If I decide to go with option 1, I will have to borrow the money for the renovations at my primary and it may make it harder to qualify for a loan given the little or no cashflow.

Thanks!

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Nick Maugeri

Real Estate Broker · Modesto, CA · Member since 2023 · 192 posts · 77 votes

2y

Quote from @Carolina S.:

Quote from @Melanie P.:

You will also owe depreciation recapture tax.

Your post is rather difficult for me to understand. If you're doing a 1031 exchange you'll have to close in the same name that the property you are exchanging was in. Are you working with a 1031 agent?

Thanks for your response. Yes, I', working with a 1031 agent. I'm basically looking for input in the following:

Option 1: Buy a couple of properties and split the money from the 1031 exchange for the down payments. I'm looking at a $600k price point each. Which means I will still need to finance about $400k for each property at about 9% rate (the rate is high because we'll using a commercial loan as we'll be purchasing the properties under an LLC). This gives me very little or zero cashflow on the properties. At this time, I'm not looking to invest out of state.

Option 2: Pay capital gain taxes and use it to finance my primary property renovations. I still have a mortgage on the primary of about $450K at a 3.8% rate. If I finance the renovations, I would be able to keep that rate. The renovations will increase the value of my primary from $800k to about $1.6M. However, there will be a lot of equity trapped in my primary. I know I could look to refi to get the equity out but then I would loose the 3.8%. Would it be worth paying capital gains then?

If I decide to go with option 1, I will have to borrow the money for the renovations at my primary and it may make it harder to qualify for a loan given the little or no cashflow.

Thanks!

Option 1: Seek out a portfolio lender and/or look at better asset types - commercial.

Option 2: Heloc is better for this. You take a HELOC for your primary renovations at 7%, invest the funds from option 1 to cover the payments of the HELOC. Refinance post rehab, have the higher rate but apply option 1 cashflow to cover the increase. We aren't playing the game of whoever has the lowest interest rate.

To determine if capital gains are worth paying today you should do an analysis for IRR or NPV across a cost benefit.

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Bill B.

Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes

2y

What's the purpose of using the LlC other than to make it harder and more expensive? It will have to be a pass through/disregarded LLC to keep the tax payer the same and the 1031 valid. I "hope" you are not married or it will make it very difficult as you can't have a disregarded multi-member LLC except in community property states. And I don't think Va is one.

Do the math and the answer will probably be obvious.

Figure out the state and federal capital gains tax and depreciation recapture after selling costs. That's possible savings. Is that enough to proceed? If so, is it even possible to use an LLC in your case? If so, how much is it costing you? $800k at a couple extra percent means it's costing you AT LEAST $16k PER YEAR in additional interest. What are you getting for that? I don't think you're getting $2k worth of benefit, much less $16k every single year.

Personally I'd do a 1031 to save $40k, I'd skip the LLC, increase the limit on my umbrella, and call it a day. These are all assuming there's a problem with the current rental or the new properties are amazing. Otherwise I'd keep he current property and get a heloc on it or my primary. Don't over complicate it. Good luck.

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Maureen McCann

Investor · San Diego, CA · Member since 2024 · 78 posts · 54 votes

2y

Carolina...Welcome to BP! There are many good comments and advice in this thread. Another angle to consider is to look for turnkey companies that are selling completely renovated properties and have also bought down the interest rate. I have seen several offers from operators around the country who are offering interest rates of sub 6% for a 30-year fixed mortgage with a 20% down payment required, NO POINTS. Some of these operators are in FL, TN, and AL.

One idea is to proceed with the 1031x, save on the capital gains, parlay your proceeds into income-producing properties, and capitalize on the low-interest rate offered by these operators. You can acquire the properties without having to use a portfolio loan and avoid the higher interest rate.

To remodel your primary home you could access the home's equity to cover the cost of your remodel. What you would want to evaluate is the income generated from the income-producing property(s) to see if the income from your rentals would cover the cost of your new HELOC payment. If the math works then it works. I have a lender who could walk you through this type of scenario to help you make your decision. I am happy to make the intro to have an exploratory conversation.

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Mark H. Porter

Investor · SC NC, VA · Member since 2020 · 1k+ posts · 756 votes

2y

Quote from @Bill B.:

What's the purpose of using the LlC other than to make it harder and more expensive? It will have to be a pass through/disregarded LLC to keep the tax payer the same and the 1031 valid. I "hope" you are not married or it will make it very difficult as you can't have a disregarded multi-member LLC except in community property states. And I don't think Va is one.

Do the math and the answer will probably be obvious.

Figure out the state and federal capital gains tax and depreciation recapture after selling costs. That's possible savings. Is that enough to proceed? If so, is it even possible to use an LLC in your case? If so, how much is it costing you? $800k at a couple extra percent means it's costing you AT LEAST $16k PER YEAR in additional interest. What are you getting for that? I don't think you're getting $2k worth of benefit, much less $16k every single year.

Personally I'd do a 1031 to save $40k, I'd skip the LLC, increase the limit on my umbrella, and call it a day. These are all assuming there's a problem with the current rental or the new properties are amazing. Otherwise I'd keep he current property and get a heloc on it or my primary. Don't over complicate it. Good luck.

Listen to Bill! The only LLC you'll be able to form is a "disregarded" LLC, which means it gets traced back to your SSN for 1031 purposes since the original property was in your name. Personally, I didn't have a property in an LLC until I had 22 units. I seem to remember that I didn't even have a business card until then either.

You are VERY late to the game to be making these decisions. I've done quite a few 1031's and each time I had my three targets already picked which means they were less than two weeks from being signed when I closed on my downleg. your QI should be telling you to hustle right now.

The 9% rate isn't the only piece of the pie. Amortization length along with any DSCR requirements comes into play also to determine what kind of down payment requirement you may have to meet. My long-time bank came at me in October when I was doing a single tenant commercial purchase with 7.95%, 22-year amortized, 25% DSCR so to get a deal I needed 32% down. Commercial lending is getting VERY complicated as lenders are seeking more capital to beef up their coffers.

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Dennis Bragg

San Diego, CA · Member since 2024 · 88 posts · 67 votes

1y

Hey @Carolina S.

Thanks for bringing up such a nuanced situation.. these kinds of decisions can get pretty overwhelming with all the moving parts. Since your post is a bit older, I stumbled upon it while researching strategies for navigating 1031 exchanges in this tricky high-interest-rate market. It seems like a great time to revisit the conversation, especially considering how rates and market conditions have shifted over the past nine months. I'm curious how you ended up handling it?

Your dilemma boils down to two priorities: maximizing your investment growth versus creating financial stability for your personal residence. Here’s how I’d think about it:

Option 1 - Proceed with the 1031 Exchange:
The main advantage is deferring those capital gains taxes and keeping more capital working for you. However, as you mentioned, financing through an LLC means commercial loans, and 9% rates are nothing to sneeze at. One pssible workaround might be exploring smaller community banks or credit unions. I've had some success steering clients toward portfolio lenders who can offer more flexibility than the big banks.

Another thought: have you considered diversifying into asset classes that might generate better cash flow even in today’s environment?

Option 2 - Focus on Your Primary Residence:
This is a more conservative route but could make sense if the primary home rebuild adds substantial value. You'd avoid higher financing costs for your personal project and simplify your financial picture. The trade-off is losing out on potential growth from a reinvested 1031 exchange, but if you're thinking about a HELOC later to invest again, this could bridge the gap.

What I’d do in your shoes:
If it were me, I’d run the numbers on a worst-case scenario for each option. What happens if rents stagnate or even drop? How much equity is “trapped” in thier primary residence after the rebuild? When I worked with a friend in a similar situation, they ended up splitting the difference by moving forward with the 1031 for just one property instead of two. This allowed them to keep part of their funds liquid for their personal project while still deferring some taxes.

Also, I noticed some great advice in earlier replies, particularly about HELOCs and the pitfalls of LLCs for 1031 purposes like @Maureen McCann explained it perfectly. One additional thought: a disregarded LLC might work for you if structured correctly. However, if it's not necessary for liability protection, you might avoid the headache altogether and just beef up your umbrella insurance policy.

What’s your take on this now? Did you decide to go all-in on one of these options, or are you still weighing them both? Curious to hear how things turned out and whether any unexpected challenges came up in the process.

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Capital gains tax vs. 1031 exchange

Capital gains tax vs. 1031 exchange

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