All Forum Posts by: Sean Ross

Hello @Laura Yazdi,

This is anecdotal, but we're seeing our 1031 clients flee from the higher-tax and higher-regulation parts of the country to places like TX, NC, GA, FL, AZ, etc.  Lots of West Coast capital going elsewhere.  We hear lots of complaints about landlord laws, delinquent tenants, and homeless encampments causing trouble/damage. 

Maybe there is wisdom in the crowd. Again, just anecdotal. 

Here are some things to consider about 1031 exchanging in and out of California specifically:

1. California Clawback Provision - California Franchise Tax Board has rules about investors who sell and 1031 out of state.  In short, they're going to require you to file a new form each year to update them on the investment.  If you ever recognize capital gains down the road in another state, they want their cut.  Failure to file the form (#3840) will result in retroactive tax recognition in California. 

2. California tax burden - Due to the clawback provision, you don't get a full break from the higher income taxes in California if you sell in another state later after a 1031 exchange.  You'll still likely get some lower taxes, since some of the gain will be accrued in another state, but you still need a good tax accountant here.

3. CFTB review of 1031 exchanges - California Franchise Tax Board is even more diligent than the IRS when it comes to scrutinizing 1031 exchanges.  No matter how you 1031 in CA (inside or out), you really need to dot your "i"s and cross your "t"s. 

We do tons of work in CA. If you don't already have a preferred 1031 intermediary to work with, we'd be happy to give you a free consult whenever you're closer to making a decision.  If you do already have one, I'm happy to be a second opinion. 

Hello @Gabriel Zepeda,

As @Andrew Abeyta correctly mentioned, there is not a direct and clean way to use 1031 exchanges to pay off debt on your existing portfolio.  1031s are great for lots of things, and they're really important to serious investors; however, they are not very useful as a tool for deleveraging. 

Rather than taking out some boot from your sale to pay off debt, you could take a detailed look at your financing math after buying a new property and then strategically refinance to replace expensive debt with cheaper debt, but this is not very easy in today's rate environment. 

If you do decide to have a "partial" 1031 exchange and use some of your 1031 sale proceeds to pay off debt on other assets, you'll just want to make sure that the improvement in cash flow offsets the tax liability that you incur from your partial exchange AND the lower rents from potentially buying a less valuable property with your partial 1031 exchange. 

Otherwise, you're looking at trying to buy the best cash-flowing property with your 1031 exchange so that you can use the monthly income stream to pay off your total debt a little bit faster.  

Hello @Nancy Chawla,

You will still need a 1031 exchange for the half of the home that has not been treated as your primary residence.  It doesn't matter whether you qualify for Section 121 treatment on the other half, which I hope that you do. The tax exemption for Section 121 will not apply to the investment/rental portion. 

Here's how the 1031 rules break down for the rented-out $500K portion of your two-family home:

1. Unless you specifically took out a mortgage that is only applicable to the primary residence portion of the home, then the mortgage will be split pro rata between the two halves (so $150K each, in this case). 

2. When you sell, the $150K will be paid off at closing, only leaving $350K to be used in the exchange (I am ignoring closing costs in this breakdown). 

3. If you don't want to take out debt on the 1031 replacement property, then you can supplement $150K from the proceeds of the personal residence half -- or from any other source that you like. This way you can bring $500K of total down payment on the new property. 

Technical point: While you will technically incur "mortgage boot" by not replacing the debt in your new property, using another cash source to replace your debt gives you a "boot offset"; meaning you won't incur tax on the mortgage boot by doing this. 

Now, 1031/121 splits are common.  But, they're fraught with little nuances that depend on your circumstances. If you are not already working with a Qualified Intermediary on this, I'd be happy to give you a free consult to walk you through the details of your case.  If you are already using one, I'd be happy to act as a second opinion for you. 

Appreciate the good vibes, @Wyatt Wolff !

What kind of loans do you provide?  We can discuss further in a private feed if you'd prefer so we can keep this post discussion focused on Michelle's questions.

Yes, you absolutely can trade out of a condo and into a SFH or MFH, @Michelle Pepe. 

Where to Start With Your 1031:
1. Fact finding about 1031s, like you're doing now
2. Start looking for your replacement options early
3. Go under contract to sell
4. Pick a QI to work with; they should hold your hand through the rest.  

For first-timers, what normally causes the most heartburn is the rule that you have to formally identify what you want to buy within 45 days of your sale. 

I'll send you a PM; we have a lot of resources and guides for realtors specifically.  Also, one of my best officers is in NC, she's a Certified Exchange Specialist, and I'm sure she'd be happy to be a resource for you/your clients moving forward. 

(As an aside, I like the colorful phrase "death trap of taxes")

Exactly.  The mortgage has nothing to do with your basis or gains calculations. 

@Andrew C.,

When you 1031, you carry your adjusted tax basis from the old into the new.  If you trade into a more valuable property, as you did here, the increase in value is added to your old basis.  

I don't know what your depreciation was, but let's imagine that your old basis before the 1031 was $150K.  That's carried over.  The increase from $300K to $500K in property value (+$200K) is added to your old basis, giving you a starting basis of around $350K on this hypothetical scenario.  

If you sell now without a 1031, they'll take that new sale price and compare it to your new adjusted basis; the difference is your total gain,  split between long term gain and recaptured depreciation. 

If you 1031 again, you'll carry the updated adjusted basis into the new property. 

How the new property gets depreciated after a 1031 depends on whether you elected to keep your old schedule after your Exchange.  So you'll need to look closely at that to accurately determine your new basis.

Work with a good tax accountant on this.   Let me know if you need some good options here; we work with quality accountants all around the country.   

@Seo Hui Han,

You certainly can 1031 exchange from your current commercial into a multifamily; no technical issues there.

To speak generally, multifamily properties tend to have more stable cash flow but lower income potentials than commercial. Commercial also tend to have longer leases and the tenants usually take care of more day-to-day stuff. 

Would you be managing the multifamily yourself? If you don't cash flowing will be harder.  If you do, you just want to make sure you're up for the management complexity (tenant communication, multiple leases, maintenance, etc)

If you want to unload your commercial property, remember that you can 1031 into all kinds of different assets, depending on what matters to you most. You mention cash flow several times, so I wonder if that's the most important variable for you...? There might be cash flowing options for you that are less hassle than multifamily. 

Other notes:

- you certainly can, but don't have to, keep the same equity ratio when you 1031.  It's much harder to deleverage in a 1031, but you're in a good enough equity position that doesn't seem like it's a top concern here. 

- if you're buying and selling in California, just know that the California Franchise Tax Board scrutinizes 1031 exchanges more than any other agency in the US, even more than the IRS.  You want to work with a QI that has a lot of experience with the CFTB.  Happy to go through a free consultation with you on this front. 

This is spot on correct.  Especially in today's interest rate environments.  Qualified Intermediaries make a significant portion of their revenue on the interest held on their funds. In the long post-2008 stretch when interest rates were very low, almost no QIs paid interest because there simply wasn't much.  The past few years are different. 

No major QI firm, not even my own, advertises about paying interest on deposits (the IPX website, for example, has no info on this). But almost all of us do pay interest. It's also very often negotiable, especially if you exchange at volume or with larger properties. 

However, I want to stress that fees and interest on deposits are very bad leading variables when picking a qualified intermediary.  The difference between a $1000 exchange and a $1500 exchange is insignificant when compared to the tax hit if your exchange is done improperly.  Same goes for earning $0 on interest vs earning $1300 in interest during your exchange.  

Bad, lazy, or uninformed QIs make mistakes that can get investors on the wrong side of the IRS.  These mistakes cost tens of thousands of dollars and are extremely stressful.  Corrupt QIs have been known to run away with client money before, or to invest their clients funds in inappropriate ways. 

Ask for interest; it's a good idea.  But ask for interest after you've found a QI that takes their job extremely seriously, offers legitimate client service, and has a verifiable track record. 

@Robert Weissfeld, 

Yes, you can sell, cash out half, and 1031 exchange the other half.  The half of the duplex that you are living in will qualify for Section 121 exclusion if you've lived in it for at least 24 months out of the prior five years.  This exclusion allows you to ignore up to $250K of capital gain (or $500K if married filing jointly) on the half that you live in.  Huge benefit. 

You can't directly 1031 into another primary residence.  As Dave points out, only real estate held for business or investment use qualifies for 1031.  

You can move into the new property after holding for investment initially.  The safe rule of thumb here is to treat your new property as an investment for at least 24 months before moving in, AND making sure to rent out the new property for at least 14 days per year while it's an investment. 

You can buy the new investment, then move in, and then sell, and then get some tax benefits.  Let's suppose you find a property via 1031, then rent it out for a few years before moving in.  All good - no issues there.  This happens all of the time.  The suppose you live in it for another couple of years and sell again -- do you get the Section 121 exclusion?  Yes, but not entirely. 

This gets a little wonky, but the IRS is going to look at that future sale and allocate the built up capital gain pro rata  between the amount of time it was a primary residence vs the amount of time it was a rental.  Here's a scenario: you rent the property for two years, then move into it for three years.  If you sell that property at a $200K gain, for example, then only the gain allocable to the three years is eligible for exemption under Section 121, and the gain allocable to all of the rental years even going back to your original duplex will not be exempted under Section 121.  In this scenario, you're likely only able to use the exemption for less than half of the $200K gain. 

One more thing:  you will never be able to exempt the depreciation recapture in the future by selling as a primary residence.  That recapture will be taxed at 25% regardless of how long you lived in the new property.  

All this to say that you should work with detail-oriented experts if you really want to go down this route, because it's easy to get a little sloppy and end up with a much bigger tax bill than you expected.