If you read about the 1031 exchange, you’ll immediately think it’s the greatest thing on earth for real estate investors. What’s not to like about paying zero capital gains tax after the sale of a property? The government already taxes real estate investors through an annual property tax and a transfer tax upon sale. Having to pay capital gains tax on the way out can be very painful, especially since prices have surged to all-time highs in many areas of the country.
But I don’t mind paying taxes. After all, taxes help keep our country running. I just mind paying an amount much greater than 30% on gains or income earned. In other words, after you start making over $300,000 as a single person or $500,000 as a couple, based on our current tax rules, it doesn’t make sense to kill yourself at work to make much more.
Making more than $300,000/$500,000 won’t increase happiness because you can buy pretty much anything you want at this level. And since you’re no longer gaining more happiness, you’ll start losing happiness once the government starts siphoning a larger percentage each minute you spend away from your family chasing the all mighty dollar. Trust me, there are plenty of miserable couples making $500,000 a year.
For those on the fence about conducting a 1031 exchange, here are some reasons for not proceeding.
What Is A 1031 Exchange
A 1031 Exchange allows an investor to “defer” paying capital gains taxes on an investment property when it is sold, as long as another “like-kind property” is purchased with the profit gained by the sale of the first property.
To do a 1031 exchange effectively, you must exchange one property for another property of similar value. Further, the purchase price and the new loan amount has to be the same or higher on the replacement property.
In my case, I had to find a single family or multi-unit property worth at least $2,740,000. I could find a property worth less than $2,740,000, but then I’d have to pay the capital gains tax on the difference in sale price and purchase price of the new property known as “boot.”
The property owner has 45 calendar days, post-closing of the first property, to identify up to three potential properties of like-kind. After the properties are identified, the investor has 180 days to make the purchase and initiate the exchange OR by the due date of the income tax return with extension, whichever is earlier.
Finally, you’ve got to pay a Qualified Intermediary anywhere from $1,000 – $3,000 to hold your proceeds (you never get to see or touch the proceeds from your home sale) to conduct the exchange. If you are unable to identify and buy a new property, you lose that money and all that time.
Main Reasons Not To Do A 1031 Exchange
* You don’t mind paying taxes
* You haven’t found the right property
* You want to reduce exposure to real estate
* You want to simplify your life
* You’ve lived in your rental for at least two of the past five years and can take advantage of the $250K/$500K tax free profits
For a guy who wanted to de-risk and simplify life, trading one expensive SF property for another expensive SF property just to save on taxes wouldn’t achieve my goals. I felt a little like I escaped death, having gone through the financial crisis with a huge mortgage, and coming out unscathed. Further, I’m focused on freeing up as much time as possible to take care of my family.
With an equally expensive San Francisco property out of consideration, I looked at Honolulu property, where we’re considering moving back once our son is eligible for kindergarten in 2022. Given Honolulu is cheaper than San Francisco, we’d end up buying an even larger property to manage than the one we have in San Francisco. Or, we could buy our retirement dream home near the beach, but it would have to be rented out for at least one year, if not two years for it to be considered rental property by the IRS.
Dream property in Kailua, Oahu, but this one costs over $15M
Finally, I asked RealtyShares whether they had any properties on their platform eligible for a 1031 Exchange. At the time my house was to close, they said they didn’t, but that something was in the works. About a month after my transaction closed, they sent me an e-mail saying they had launched their first 1031-eligible property, a 272 unit multi-family project looking to raise $4,500,000 in Houston, Texas with an 8-year holding period, and a 13% target IRR.
I’m fine with an 8-year holding period (longer the better so I don’t have to think about redeploying capital and paying taxes), but with $2,740,000 million to put to work, I would take up more than 50% of the deal size. I don’t recommend anybody account for greater than 10% of any deal due to concentration risk. Further, think about how stressed I would be before, during, and after Hurricane Harvey hit.
As I thought about this close call, I realized the primary purpose of de-risking and simplifying life is to minimize stress. Up until my son was born, almost all the stress I had was dealing with maintenance issues and tenants.
I already got rid of work stress in 2012 by negotiating a severance. I got rid of money stress by hitting a net worth target and reaching a passive income goal. Online work is not that stressful because writing comes easy to me and there are only a few truly thoughtless people who like to say unthoughtful things.
From a financial perspective, although the gross gain from selling my rental home was ~$1.22M and ~$1.8M hit my bank account after years of paying down the mortgage, the taxable gain is much less due to the $250K/$500K tax-free gain exclusion, selling expenses, and home remodeling expenses.
For example, theoretically, I could pay no capital gains tax if I spent $600,000 remodeling the house and $150,000 selling my house because when you add the $500K tax-free exclusion, the total is $1,250,000, or more than the gross profit I received.
In this example, the negative of not paying taxes means the gains weren’t much greater than the tax-free gain exclusion amounts. But at the end of the day, I’m left with $1.8M in the bank versus $305,000 when I first put the 20% downpayment in 2005.
I’ve set aside $150,000 for capital gains tax (federal + state) next year, but hope the actual tax bill after deducting all my home remodeling and selling expenses will be much less.
Focus On What’s Most Important
For all of you considering doing a 1031 exchange, consider these thoughts:
1) If you cannot find the right property to reinvest the proceeds, don’t do a 1031 exchange. It would be foolish to try and save on taxes, but then lose principle value because you bought the wrong property at the wrong time in the cycle. You might feel a lot of pressure to identify three properties to purchase in 45 days and pay a bad price because you’ve got to close within 180 days.
2) Don’t let your tax bill dictate your decisions. A large tax bill is usually great because it means you made an even greater profit. I remember plenty of folks during the 2000 dotcom bust who refused to sell their stock after they exercised their options because they wanted to let things ride. But when their stock eventually went to zero, not only were they left with nothing, they also had to pay taxes on the difference between the exercise and the strike price at the time.
3) Focus on lifestyle first, money second. Your real estate investments should serve you, not the other way around. Even if we found our dream home in Honolulu, we wouldn’t move because we don’t want to leave our lifestyle in San Francisco just yet. We just finished completely remodeling our house. We have our doctors we’ve trusted for years and a pediatrician and ophthalmologist we like for our son. We’ve got a set of friends we enjoy hanging with. And we’ve also scoped out and applied to several pre-schools too.
4) Will you really be able to hold on forever? A 1031 Exchange allows you to delay paying your taxes. It doesn’t eliminate your capital gains tax. Only if you never sell your 1031 exchanged property or keep on doing a 1031 exchange, will you never incur a tax liability. You can pass on your property to your children who get to step-up the value to current market value so they never have to pay taxes on your property either. It’s only after your assets exceed the estate tax limit ($5.49M individual, double for a couple) do your heirs need to pay ~40% tax on anything over. The median holding period for property in America is between 7 – 8 years.
5) Do you really need the rental income? A 1031 exchange is exclusively for rental properties, not primary residences. Therefore, the primary reason to own rental property is for income. Income streams can change over time, as they have for us. I thought we would need the rental income forever because we never wanted to go back to work. Little did we know that during the three years we tried renting out the house, our online income grew to the point where we definitely don’t need rental property anymore. Even if our online income was slashed by 80%, we still wouldn’t need any portion of our rental income in our passive income portfolio.
The decline in SF rent in June 2017 when I tried to rent out my house is finally showing up in the data in October 2017.
A Simpler Life Feels Great
In a perfect world, I would have 1031 exchanged all the proceeds into a diversified private real estate fund that returned at least 10% a year forever, guaranteed. Alas, I was unable to find such an opportunity. I’ve already redeployed over half the proceeds in 100% passive investments. The remaining proceeds will more than likely stay liquid in order to finally buy that dream home in Hawaii one day.
Readers, have you ever done a 1031 exchange? How did you decide which property to invest in? Did you set up a 1031 Exchange and end up not following through? If so, why not?
This is really refreshing to read! I’ve read that 1031 is like one of the best things that you can have access to as an investor. But as you pointed out above, it could cause a lot of stress and headache.
Mr. FAF and I have no rental property at the moment. But since I like to think ahead, I’ve been wondering what I’d do if I buy rental properties but don’t want to keep them anymore. It could be a blessing or a curse!
I can’t speak to real estate but many states have something similar in the reverse for a car purchase where the purchase tax is refunded if you sell your old car in x days of purchase. You run into some of the same questions… ultimately taxation is a consideration but it’s one of the lesser ones when making a large purchase. Don’t let the tax wag the transaction dog. Make the decision to do something and then consider taxation, don’t use tax to make the decision.
I did a 1031 exchange when we sold our rental home and purchased a duplex nearby. This one should work out because we’re going to move into the duplex next year. We’ll convert it to our primary residence and the capital gain exclusion should kick in after 5 years.
I’m also selling our 1BD/BA rental condo and I’m thinking about doing the 1031 exchange into real estate crowdfunding. I’ll call RealtyShares and see if they still have something. The gains is around $140,000 so not that much. It has to be the right sponsor, though. It would be good for us to delay the capital gains for 8 years. Mrs. RB40 should be retired by then and our earned income will be lower. I would be okay with cashing out now and just paying the tax as well.
I talked to RealtyShares and their minimum for 1031 exchange is a million dollar. What the heck? That’s way high. Other outfit has smaller minimum – $100,000.
*I realized the primary purpose of de-risking and simplifying life is to minimize stress.*
Agreed – a 1031 exchange isn’t everyone. Hubby and I looked into it a few but nights ago. It sort of reminds me of an excuse for more spending and more stress. Taxes shouldn’t dicate everything. Saving $100k by putting a lot more money forward, into RE costs, tied up may not be worth it to everyone.
1031’s seem like they can be good if you want to upsize but like you said, simplicity is sometimes a better option.
Personally I don’t own any rental real estate yet but likely would prefer simplicity.
Sam,
You mention the $250/$500K exemption on the sale of your SF investment property.
I didn’t think this applied to rentals???
Can you elaborate a bit more on how this applies to the rental?
Dom
Sure. The exemption applies if you lived in the house for 2 of the past 5 years. So you have a window to do a 1031 Exchange or take advantage of the tax free profits up to $250K/$500K, and pro-rated. I’ll add this to the post.
After 5 years of being a rental without living in the home, then it makes more sense to do a 1031 Exchange. But, not always.
Related: Clarifying The $250,000 / $500,000 Tax Free Profit Benefit In Real Estate
good thoughts we are thinking of the same with our other menlo property – 1031 exchange into something bigger with alot of CFs…
Always nice to see a differing take on a regularly accepted practice. I think most RE investors are obsessed with the idea of trading up all the time!
U metioned that the capital gain taxes will be reduced by the remodeling you have done in the past. Had you not been deducting the remodeling/repair amount along with depreciation over the years and reducing your taxes?
No. Because I lived in the house for 10 out of 12.8 years of ownership. For the 2.8 years of renting out the house, I deducted whatever I was allowed to deduct.
But for the remaining years I rented the house, there is depreciation recapture.
Also something to consider, and i would be interested to get your take Sam, it taking out a second mortgage on property where you live, thereby increasing your cost basis. Since the mortgage interest is tax deductible up to $1M, redeploying that into another real estate investment. Obviously this is a max leverage play that is stupid to do with non-income producing properties, but its a tactic we are using in a very expensive market. So far we have a triplex and a duplex, sitting our 65% improved LTV ($2M worth of property), total mortgages between properties is equal to 80% of gross rent (a bit of a margin), plus we live rent free. If you can get over the eye popping leverage then it works…..so far.
On your questions:
We have not owned a rental property before, so we haven’t had an opportunity to consider utilizing the 1031 exchange.
Colleagues have utilized the method before for a handful of properties and have said it’s an effective tool; they also said it tends to be “raved” about quite a bit in the real estate investment community. (I’ve seen it frequently in books, but can’t comment as an active, single property investor…all our real estate exposure is via REITs).
Great coverage. It’s worth noting that readers of your posts know you have been thinking about Hawaii Real Estate or a future move there. I’d love to read about you making the move at least as a summer home, think of the inspiration you would gain for your writing work with that perfect breeze and ocean sounds. Me personally -I plan on becoming a Sonoran desert dweller part time, I’d like to learn from your experience ahead of time.
Can’t let taxes be the deciding factor as to how you reinvest your proceeds. The 1031 exchange can be a powerful weapon when you are in accumulation mode. It sounds to me like you sold the property to lower stress overall so I would not be reinvesting into more property since that was your initial plan. Having a huge tax bill means you made a great investment.
No way would I want to feel forced into buying something in this market in the ludicrous time requirement needed to reap the benefits.
Hi Sam, did you account for all the depreciation expenses that offset rental income during the years the property was rented out? The depreciation expenses reduce your cost basis, which would increase your capital gains. You may want to watch out there if you didn’t account for it. For example, if you bought the property for $1.5 million, made capital improvements of $300k, and then rented it out for 3 years, you would have used (($1.5 million + $300k)/27.5 years)*3 years = $196k of depreciation expenses. This would add another ~$72k to your tax bill, assuming you are in the highest tax bracket (20% LT cap gain + 3.8% Obamacare + 13.3% CA state = 37.1%).
The crushing tax rate is a huge deterrent for me to sell any appreciated assets.
Indeed. But don’t forget, the depreciation expense shields taxes that would have to be paid on rental income.
Yes, the depreciation expense shields taxes during the years you are collecting rent, but eventually you pay them back when you sell the property since your property didn’t actually depreciate, it appreciated…
I have rental properties in the Bay Area as well, so I just read up a little more on the tax issue. It looks like the depreciation recapture is taxed at ordinary income tax rates, which are even higher than long-term capital gains rate (you’re probably in the 39.6% + 13.3% = 52.9% tax level). Makes sense since when the depreciation was expensed, it was saving taxes on income at the ordinary income tax rate. You actually pay more in tax than you retained in tax savings if your ordinary rate now is higher than the years you were expensing.
Financially speaking, the most optimal thing to do would be to pass the property on to heirs, who get a step-up in basis and won’t have to pay any tax. And Trump might eliminate the estate tax (of course it may just be reinstated after the next election – yeesh). This is the big reason why I find it really hard to sell greatly appreciated assets if I don’t foresee ever needing to use that money. In your case, the hassle factor may outweigh the hundreds of thousands paid out in taxes.
Indeed. At the end up the day, everybody has to ask themselves how much is enough. $10 million? $25 million? $100 million? Does having two heirs and 10 properties make sense? For some, yes. For me, no. After a certain point, any more doesn’t change the quality of your life. It actually may start to hurt. Can’t take it with you as the Egyptians said.
The best benefit of financial independence is freedom to do whatever you want, always. I hope people don’t lose sight of this message.
I wonder if the estate tax gets repealed, there will actually be some super wealthy people who will try to die before the next administration… Hmmm. Of course not. If you are super wealthy, your goal is to live as long as possible!
I guess this means you are now officially beyond the “Always be Grinding” stage of your life :-)
This sounds similar to Canada, except if you have a primary residence you pay zero capital gains tax at all when you sell. This is probably one of the reasons why Vancouver is now the most unaffordable city in North America (when average household income is accounted for).
That home in Kailua looks amazing- oceanfront! Is that the neighbourhood you would be looking at if/when you would move to Oahu? I hear the Diamond Head area is also very nice.
For my scenario a 1031 was a nice program to take advantage of.
All the “more simplicity” and “do I want to be a renter” questions had already been asked and answered.
We wanted to get out of some midwest property as we had moved to west coast and were not close enough to properly manage. We still enjoyed the benefits of being landlord and a positive cash flow.
Once here, we were able to learn market and find similiar property and terms. The 1031 exchange did allow for a more painless transition and the delay of cap gains is nice. I fully envision a lower income when we want to sell and we may even live in it for a few years to turn some gain into a tax free exclusion.
Probably would have done the transaction with out the 1031 being available, but hey – more gravy is a good thing right?
I did a 1031 exchange last year. We sold our condo and exchanged for a duplex. The return on the duplex was much better than the condo for many obvious reasons. Overall I am happy with the exchange.
I do find multi unit tenants to be more demanding. Single family tenants are usually very independent.
One way to minimize stress of 1030 is to extend the selling escrow. You let your buyer have a 2-3 month escrow after removing contingency. This way you lock in your sell, but give yourself and then 2 more month to close while you identify you next property. Essentially you get about 3 month to identify 3 properties. It was still stressful. In theory you can negotiate more time with the party buying your property thereby minimizing the time pressure.
I am in contract now for another tenant occupied fourplex. Seems like trouble tenants. Need to find an excuse to get out of this contract.
The purpose of our money is to help secure our happiness, and you seem to be doing just that. Good job not letting the tax tail wag the dog and doing what made sense for you instead.
My aunt did a 1031 exchange and it worked out well. She did it because I was her niece and could be trusted as a tenant and property manager. It was perfectly timed because I didn’t want to rent a small room in a bigger house anymore and she didn’t want to immediately pay capital gains tax on the sale of her rental house.
FS,
It would be interesting to see a post with your excellent thought process and insight on the proposed tax law changes. I read that there is proposal to change timeline to legally convert an investment property to primary home from 2 out of 5 yrs to 5 out of 8 yrs.
Ouch – that hurts my plan.
I own a company in which the only asset is a building (approx. valuation of $1.2 million) and generates net rental income (approx. $35,000 annually). Thinking of selling the building to buy another business which does not have any real estate assets only goodwill and strong income history. Basically exchanging a tangible asset with high R/E taxes and limited income potential to purchase a business with no assets and a much higher rate of return. Thoughts Mr. Samurai?
My 1031 exchange ten years ago was the sale of the final piece of a three building seven unit complex exchanged for a 2% tenant-in-common interest in a day care center six states away. The income isn’t as high as the active landlord decade, but the stress of cashing the monthly checks is infinitesimal. The transaction was the fall back when none of the locally available properties suited me.