Rental Property Investor · Member since 2018 · 11 posts · 12 votes
Here's one for the seasoned investors and tax experts out there. Trying to verify something:
I have a rental property that is fully paid off that we are considering selling. Based on what I've gleaned online, it appears that we CANNOT use the proceeds (it's worth about $100K above our original purchase price) in a 1031 Exchange to pay off the mortgages on a couple of our other, existing rental homes. If we went that route, we'd have to pay capital gains.
So, as I understand it, in order to escape paying 15% in capital-gains taxes on the profit, the proceeds from the sale can only be used to purchase another property of equal or greater value, and only within six months, per 1031 Exchange rules.
Does that sound accurate, or am I whiffing somehow?
@Steve Elling Yes, that is correct. You cannot use the CG to pay off properties you already own. In order to use the 1031, the property has to have been held as a long-term investment (ie not a flip and not your primary residence) and you must replace its value AND its Equity (ie you cannot just replace with another prop worth the same amount but mostly funded by debt in order to pull out cash).
The rules for timing with the 1031 are as follows:
1) you must identify up to three replacement properties within 45 days of CLOSING on the sale of your current prop. 'Identify' doesn't just mean you make a list for your own notes, you have to have Qualified Intermediary in place and they need to be aware of, and properly document, your selections.
2) you must purchase your replacement property within 180 days CLOSING on the sale of your current prop.
Why am I yelling about closing? Because your clock doesn't start ticking until you sign those papers, so many folks start their replacement prop search before they're even officially on the market to give themselves a little extra time. Esp if you think your current property will sell quickly, you need to be prepared to make a move on a replacement prop asap
@Steve Elling Yes, that is correct. You cannot use the CG to pay off properties you already own. In order to use the 1031, the property has to have been held as a long-term investment (ie not a flip and not your primary residence) and you must replace its value AND its Equity (ie you cannot just replace with another prop worth the same amount but mostly funded by debt in order to pull out cash).
The rules for timing with the 1031 are as follows:
1) you must identify up to three replacement properties within 45 days of CLOSING on the sale of your current prop. 'Identify' doesn't just mean you make a list for your own notes, you have to have Qualified Intermediary in place and they need to be aware of, and properly document, your selections.
2) you must purchase your replacement property within 180 days CLOSING on the sale of your current prop.
Why am I yelling about closing? Because your clock doesn't start ticking until you sign those papers, so many folks start their replacement prop search before they're even officially on the market to give themselves a little extra time. Esp if you think your current property will sell quickly, you need to be prepared to make a move on a replacement prop asap
Now, as for the value - you can technically buy a replacement prop worth less than your current property, or buy another one but use mostly debt in order to pull out some equity, but any cash (equity) or debt-paydown that you net at the end of the transaction is taxable (called 'boot'). So if you have a $400k house and it's all equity, you need to put all $400k into the new prop to avoid CG. You can buy another house worth $200k and keep $200k, but you'll pay taxes on it. You could buy a prop worth $400k but finance $300k of it, but you'll pay taxes on that $300k since you're keeping the cash from the sale and replacing it with debt.
Also, bear in mind that you're not just deferring CG taxes, you're also deferring your depreciation recapture, which is taxed at 25%. So if you've had this property a good long while and have held it as a rental (I assume if you're looking at the 1031 and it's free and clear), then you may have a big tax bill coming just from the depreciation side. Remember, it doesn't matter whether or not you actually take the depreciation deductions on your taxes. The IRS only cares that you could have taken them (so always take them!).
Using the $400k prop example above, if you've held it, let's say, 15 years (to pay off a 15-year note), your depreciation deductions amount to a little more than $218k ($400k/27.5 depreciation schedule for real prop * 15 years held as a rental). Of course, the real math will be more complicated since the valuation of your prop has changed over time, but let's keep it simple. Taxed at 25%, that comes out to $54,545, a pretty hefty price tag even without considering the CG.
Maybe you've not had it as long, it's not worth as much, etc, so your bill will be lower, but the point remains - you have more than CG taxes to worry about, so even if it would be nice to have that equity in cash, it's better to roll it all into a new prop than to give that much away to Uncle Sam.
Bright side is, you can keep executing 1031s until you die (ie never sell your investment props outside of a 1031), leave your final props to your heirs (who receive a stepped-up tax basis equal to the prop value at the time of your death) and actually completely avoid those CG and DR taxes entirely - for you and your heirs (a little strategy I like to call '1031, 1031, Die').
So long-story not-so-short, you are correct in your summation. In order to completely defer taxation you need to purchase a replacement prop (or props if you have a lot of value to use) of equal or, greater value (with equal or greater equity, as well), within six months of CLOSING on your current prop (but you must identify your three options within 45 days of closing). You also MUST have a qualified intermediary working with you before you sell your current prop. If you don't have a QI working on the exchange to make sure everything is documented correctly (and most importantly that none of the proceeds from the sale land in your bank account), the 1031 is void.
Sounds like you're in a good position with an appreciated property. If you can make it work, the 1031 is a really powerful option. I'd say research QIs here on BP and talk to a pro to make sure all your ducks are in a row.
If you don't know already, you can't receive the proceeds from sale, it needs to go into an exchange/escrow account until the purchase of the new property.
Thanks for the shout out @Jaysen Medhurst. Don’t get too intimidated @Steve Elling 1931s are a pretty straightforward process. And you’ll be guided by the qualified intermediary throughout the process. I’ll pm you with additional resources.
If you want to pay off existing mortgages and sell that property you can complete the 1031 and then refinance the new property and use the refi to pay off the other loans. You still have a property with debt but you’ve strategically consolidated that debt and risk into just the one property. Not a bad strategy.
Dave, I can see why you are the 1031 sensei around here.
That re-fi option following the exchange is brilliant.
I think you've rightly figured out my plan here -- the whole idea is loan consolidation. Three of my four SFH rentals have smallish mortgages, and the fourth is paid off. Sell the latter and pay off the former, then we'd have only the single re-fi loan on the "new" house to pay.
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