All Forum Posts by: Sean Ross

@Ed Ma, 

I want to second @Nathan Gesner's advice here -- perhaps only sell if you are relatively confident in your landing spot being an improvement for you. 

It's harder to finance good properties right now for obvious reasons, and if you go NNN or DST then you need to be very clear about the costs (upfront and ongoing) that might eat at your returns.

Since you mentioned NNN, I'm guessing that you aren't in love with actively managing property in perpetuity moving forward. There are lots of options for you there via 1031 exchange if you can be confident in what you're looking to replace your investment with and why.

If your rental is in CA, then you'll have the issue of giving up the low property tax base.  If you want to 1031 exchange to a property outside of CA, then you'll want to be careful about how the California Franchise Tax Board makes 1031s more difficult (no surprises there) when leaving their jurisdiction. 

As a 1031 QI, I'm obviously a fan of 1031 exchanges.  But only in the right circumstance.  Maybe selling into something with better numbers or lower headaches is the right decision for you, however I want to encourage you to speak with a few different experts along the way so that you can account for all of the important variables. 

 @William Coet, there is a lot going on with this potential scenario and I want to second the other advice being given here -- tread very lightly with specific tax advice for specific transactions, especially with seller financing. 

At a general level, capital gains taxes are recognized when the income from sale is received -- so a seller pays a pro rata share of capital gains on the purchase price as payments on the note are made.  However, they are also likely recognizing interest income (ordinary income tax rate) with each payment received, and most importantly they will recognize 100% of their recaptured depreciation in the year of sale. Recapture depreciation does not prorate over time across an installment note. 

Your seller should work with a competent CPA to thoroughly think through any potential sale with a carryback note. 

@Melanie Wilmesher, if your seller is planning on doing a 1031 exchange coming out of any potential transaction, he is going to find problems with an offer that hinges on seller financing.  It's not impossible to do a 1031 exchange out of a property while carrying back a note, but it's complicated enough -- if you're going to make the deal attractive to him, find out if he plans on looking at a 1031 and come prepared with information to help him navigate the hurdles that come with the seller financing. 

@Robert L.,

This is a really important question.  QI failures can fall into several categories: scammers who steal money or information, ineffective operators who can blow your Exchange and get the IRS after you, weak QI infrastructures that don't have adequate insurance or safety protocols against outside fraudsters, etc. 

It's a lot to navigate. Not enough people ask the questions that you're asking.  

How to find a reputable QI:

- reviews and Google searches are a good starting point, but not the end of the road

- referrals from a source you trust

- call and speak to your prospective QI. Ask for proof of insurance.  Ask for details about security.  Ask for references. Find out where they are holding your funds. 

- There are a lot of good folks on BP who have been in the game a long time and can vouch for different QIs

As for your DIY model: you can't do 99% of exchanges on your own, the IRS won't let you.  It's why companies like ours exist - we are creatures of the tax code.  You need an independent third party to act as QI.  And, even if you could, you wouldn't want to.   1031 rules are opaque and deeply unintuitive when taken as a whole.  The room for error is very large.  Lots of trip wires.  

Do you know what your tax liability would be if you sold without a 1031?

There are

@Spencer Speckles,  there are additional complications if you try to carry back a note while performing a 1031 exchange.  Lots of tripwires from the IRS.   If you're looking to do a 1031, this adds one more reason to shy away from the seller financing. 

 @Forrest Brown,  

I'm never a fan of telling anyone that writing a check for taxes is the best idea, but it does depend on your goals and your potential tax liability upon sale.  If you're total taxable gain is relatively small, then it is easier to justify paying the tax and avoiding the headache.  If your total taxable gain is not small, then obviously you're going to see more value from going through annoying compliance with California. 

Do you happen to know what your tax liability upon sale would be?  It's appreciated a little less than $200K with $115K worth of improvements, but how much depreciation have you taken?

When you look at your tax liability, consider that your depreciation will be recaptured at 25% federally.  The long-term capital gains will be at 15-20%.  You'll likely pay an extra 3.8% on some (or all) of the profit from the Net Investment Income Tax.  And all of those forms of income will face additional taxes from California, which I believe top out at 13.3%.   

Once you have the number of your potential tax hit (and, by extension, how much you can defer with a 1031 exchange), you can compare that to the effort you'd have to make to comply with California.

When it comes to making sure that your potential exchange is buttoned down, that is largely a matter of working with the right QI partner. 

@William Coet,

as @Chris Seveney and @Kevin Sobilo mentioned, they very likely are either (A) already diversified, or (B) committed to real estate philosophically, or most likely (C) the tax advantages that come with owning and depreciating property, had done prior 1031 exchanges, etc. 

@Forrest Brown,

In addition to the other advice and variables you're juggling here, you should know that California makes it a little more difficult to sell and 1031 exchange out of state.  (Not really a surprise that CA makes life a little harder)

The California Franchise Tax Board will require that you file a new form every single year (Form 3840) in which you detail what you did with your sale proceeds, where they are invested, and whether you ever recognized income from your sale or any subsequent sale.  

If you ever do recognize income down the road or fail to file Form 3840, then the CFTB will come after you for the taxes that you should have paid when you sold in North Park. 

The CFTB also happens to be even more rigorous than the IRS when it comes to auditing and reviewing 1031 exchanges.  

Now, the Form 3840 really isn't that hard to fill out.  But if you decide to sell then you need to make sure you're dotting "i"s and crossing "t"s.  Your exchange needs to be buttoned down.  

@Madhur Mehta,

If you're going to sell (and 1031 exchange) into a new property, it makes sense in this market to be very confident in whatever you find as a new property.  Financing costs are much more expensive than they were a few years ago, and you just never know when a property is going to be a maintenance headache or you happen to switch to a market where rents happen to fall over the next 12-18 months.  A little bad luck and all of the sudden you're not cash flowing at all. 

(Doing your homework ahead of time will have another benefit in that it will make your possible sale/1031 exchange much more smooth if you don't have to fight the 45-day deadline to find new property)

@Zachary Gilula,

Always nice to see more investors from the Mile High. 

As Bill mentioned, syndications mostly don't structure themselves in a way that is conducive to a 1031 exchange.  There are some very notable exceptions, and I'll send you a few deal syndicators from around the country that are reputable and 1031-friendly via PM. 

You've already got one bird in the hand, so to speak.  I would do careful research before jumping and doing a 1031 exchange. If you do find a great investment opportunity, you'll want to refinance rather than selling unless it's 1031-friendly.