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Can We Defer A Big Tax Bill With A 1031 Exchange?

by retirebyforty on June 30, 2014 · 15 comments

in real estate, rental property, tax

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As our regular readers know, we just sold our 4-plex and a rental home. The good news is we made a profit on both these transactions, but the bad news is we’re going to have a hefty tax bill next April. The rental home in particular has quite a bit of gain because we had it since 2000. It was our primary residence until 2007 when we moved to our current condo. One way to defer paying the tax is to use the IRS 1031 exchange and I thought we’d go over it in detail today.

Rental Home History

Here is the history of our rental home. We purchased the home in 2000 for $210,000 and it was our primary residence until 2007*. We rented it out when we moved to our condo because we wanted to try being a landlord. All in all, it has been a good experience, but the main problem is that the home is 30 minutes away by car. It’s a pain to drive out there every time there is a problem. We had a nice family in the place for 5 years, but they refused to pay higher rent and moved out earlier this year. It was also a good time to sell because the Portland housing market is doing pretty well.

*This house was rented since 2007 so it’s not qualified for the 121 exemption. That exemption means you don’t have to pay tax on any profit up to $500,000 if the home is your primary residence for at least 2 out of the last 5 years.

  • Purchased price: $210,000
  • Depreciation taken: $35,000 (Tax deduction over 7 years.)
  • Sale price: $345,000
  • Fees: about $20,000
  • Profit: sale price – fee – (purchased price – depreciation taken)
  • Estimated profit: $345,000 – $20,000 – ($210,000-$35,000) = $150,000

defer tax rental property 1031 exchange primary residence

The Tax Problem

At first glance, it might seem like a non issue. The profit is not huge and it will be taxed at the long term capital gain rate of 15%. However, Oregon tax long term capital gain at the same rate as income tax. That’s another 10%! Also, the depreciation taken would be taxed at 25%. Lastly, the capital gain would push our income up quite a bit and we’d lose the child tax credit and various other tax benefits.

Needless to say, this is getting complicated and I’ll have to hire a tax accountant next year. Meanwhile, I plugged this info into 2013 TurboTax to get an estimate. According to TurboTax, we’d have to pay about $45,000 more in taxes next year. That seems really high to me, but I trust TurboTax. $45,000 is a lot of money to send to the IRS and we will try to defer it if we can.

Additional tax in 2015: $45,000 if the 1031 exchange is not successful.

1031 exchange

Disclaimer: I’m not a tax adviser so I could be wrong on some of the finer points here.

One way to defer the tax is to take advantage of the IRS 1031 exchange rule. Basically, you can sell your rental and roll all the proceeds into another rental property. You don’t have to pay tax until you cash out at some point in the future. When we close on the rental home, the proceeds is sent to an exchange service company. We’ll work with them to roll everything into a new rental property. As I understand, the replacement property has to be worth more than the previous property. If you receive any money OR reduction in mortgage loan, then you’ll have to pay tax on that amount. It’s a bit tricky so you’ll probably want to work with your tax adviser if you’re thinking about this.

Here are the important dates.

  • Closing date: June 20, 2014
  • Identification period: August 4, 2014. We have 45 days to identify some replacement properties. We can put as many properties as we’d like on this list.
  • Exchange Period: December 17, 2014. We’ll have 180 days to close on one of the properties on the list.

The problem now is the Portland housing market is too hot… The houses sell very quickly and the prices are pretty high. There are only 3 homes for sale in the area we’re looking and there are various reasons why they’re still on the market. Oh well, we’ll give it a try and see how it goes.

Cost: The exchange service company charges $750 to service the fund. If we close on a replacement property, then it will cost another $250 to disperse the fund. So $1,000 total if all goes well.

Housing Issue

We also have an upcoming problem with our housing. Currently, we are living in a 2 bed/2 bath 1,000 sq ft condo and it’s getting a little tight. My mom is staying with us for 6-9 months at a time and she is sharing a room with our 3 year old son. That’s not a problem right now, but in a few years, he’ll want his own room. This is another motivation for us to do the 1031 exchange. We can buy a replacement property and rent it out for a few years, then move in at some point. We’ll have to use the replacement property as a rental for at least 24 months for the 1031 exchange to be valid according to the IRS.

The additional motivation here is the possibility of using the $500,000 primary residence exclusion. That rule indicates you can sell your primary residence and won’t have to pay any tax on the profit up to $500,000 (for couples.) My plan is to move into the replacement property and live there for at least 5 years. That way we can avoid the bulk of the tax. We’d still have to pay 25% tax on any depreciation taken when we sell, but I’m fine with that. If we live there for less than 5 years, then the capital gain tax would be prorated. That shouldn’t be a problem because I promised Mrs. RB40 that we’d stay put until Jr. finishes high school if we move to the replacement home. That’s 15 years from now if everything goes according to plan. Of course life never really goes as planned, so who knows how it will turn out.

Anyway, I think it’s fair for us to try to take advantage of this primary residence tax exclusion. We lived in the rental home for 7 years and rented it out for 7 years. Most of the gain was from when we lived there so it seems a bit unfair for us to pay tax on all the gain.

What do you think of this plan? For the experts out there, am I missing anything?

Alternative – We are looking at a small duplex where we can rent one of the units as a vacation rental when my mom isn’t here.

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{ 15 comments… read them below or add one }

so June 30, 2014 at 6:16 am

From a strategic standpoint this makes little sense, you are selling high but buying higher. If the market’s really that hot, you’ll probably be overpaying by a fair amount on the new property (plus closing costs, etc.). It seems backwards to overpay on a new place for the benefit of a $45,000 tax deferral, some of which may be eliminated by the 121 exclusion.

From a tactical perspective, be sure you understand your basis in the new property for depreciation purposes.

Overall, letting the tax tail wag the dog is never a good strategy.

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retirebyforty June 30, 2014 at 9:15 am

The 121 exclusion only look back 5 years so it’s not going to help with the tax. I’d probably bite the bullet and pay the tax if we didn’t also need a bigger living space. Since we are looking for a new house, the 1031 exchange kills two bird with one stone. You’re right about letting the tax tail wag the dog. I always have a hard time with that.

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Crass Cash June 30, 2014 at 6:38 am

Great article on explaining the dates! Those can seem to be quite confusing, but you laid it out very orderly. I’ve looked into do this myself eventually, so thanks for the post!

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SavvyFinancialLatina June 30, 2014 at 7:03 am

Great informative post! Taxes are awful. I really hope you can avoid paying as much tax as possible.

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Chad June 30, 2014 at 8:44 am

Slight error in your math equation. Take out the parenthesis or change the + 35,000 to – 35,000. The final answer is correct. How you have it written out is 345,000 – 20,000 – (210,000 + 35,000) which is 345,000 – 20,000 – 245,000.

Good article on how the avoid the $45,000 in additional taxes. No one wants to pay that much more in additional taxes if you don’t have to do it.

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retirebyforty June 30, 2014 at 9:15 am

Thanks for the correction. I updated the article. $45,000 is a huge tax bill. That’s more than my take home this year….

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Rose June 30, 2014 at 3:29 pm

I have read an article from Bankrate.com regarding the capital tax gain at 0% if you are in the 10 -15% tax bracket rate on ordinary income. See below.
http://www.bankrate.com/finance/taxes/no-capital-gains-due-for-some-investors-1.aspx

Please let me know your thoughts.

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retirebyforty July 1, 2014 at 10:35 pm

Yes, we didn’t have to pay any tax on our dividend in 2013. The income from the rental sales will push us up the tax bracket so we will have to pay 15% capital gain tax this year.

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T3 June 30, 2014 at 12:26 pm

After I did the research on capital gains tax a week ago, we decided to sell our Washington condo rather than renting it out since we just bought our dream house. We bought the condo 2 years ago in a low market so we’re making a good profit and I just didn’t want to get stuck paying capital gains tax.
We’re also selling two rental properties in Virginia, but the “profit” should equate to $0 on both of those, fingers crossed that we get to the zero point though. If we were going to make money on one of those, we’d sell it this year since we lived in the property that increased in value for 1.5 years out of the last 5 and I was required to move due to work so there is an exception that prorates the max profit. Then we’d keep the condo and rent it for two years so we could use the sale of your home exclusion again (you can only take it every two years). Was that confusing?
You’re awesome, this is great info that applies to your situation and reinforces all the research I did. Would love to see even more info on what the tax rate would be if you had to pay short term capital gains. And how much you saved taking the depreciation all those years (was it worth it since you’ll have to pay the 25% tax on that?).

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retirebyforty July 1, 2014 at 10:34 pm

Taking depreciation is not an option. The IRS assume you took it and you’ll pay the 25% tax when you sell. Check with your tax accountant. Good luck with the sales in Virginia.

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Wade July 1, 2014 at 1:53 pm

This fails my “keep it simple” plan. I’m curious why you sold the rental to buy another at a higher price?

I would pay the tax, power the other $105k into some low cost index mutual funds and breathe easy. Less is more.

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papadad July 1, 2014 at 5:25 pm

I agree with Wade. The mere fact that the property selection is limited and hot in Portland right now says you will likely make an error on the new buy – either paying too much, or not getting what you really want/need, or some combo of both – especially since you are now on a specific timeline, the likelihood of making an emotional (but possibly unwise) decision is much higher.. Not to mention the “new” game clock that you will be undertaking to reach the various long term vs short term capital gains rules…. you’re letting the tax tail wag the dog.

I was back in PDX this past week and you are right – the market is tight. I would opt to pay the taxes and be free and clear of the headaches. I did something similar a few years back and no regrets. Bought a new place (paid cash) and have not looked back.

Hope to look you up next time in PDX….are you open for a free cup of coffee/tea to frequent readers? Great content in this post, by the way.

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retirebyforty July 1, 2014 at 10:40 pm

The main reason is we’re planning to move in a few years anyway. Might as well try to take advantage of the 121 exemption ($500,000.)
Yes, it’s more complicated, but it could be quite profitable.
Yeah, it’s tough with the market so hot. If we can’t find the right property, we’ll pay the tax and wait for a downturn.
Sure, I’m open to meet up. Let me know next time.

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Dave Foster July 1, 2014 at 5:46 pm

As a qualified intermediary for 1031 exchanges I found your article and the associated responses to be fascinating and insightful. Your game plan, should you choose to execute the 1031 exchange, is solid. I think you’ve identified the true key points which are
1. The 121 exemption is not available on this house.
2. The 1031 will defer a lot of tax into a new investment property.
3. You will have the opportunity to once again change the use of the property into your primary residence and thus eliminate the tax entirely.

I’m seeing this post after your closing date so the issue with you might be moot but the assumption that someone should simply pay the tax because of the fear of not finding the right next property or the difficulty of following the process just doesn’t hold weight when looking at the history of wealth building in America. Fortunes have been built and passed on to multiple generations using tax deferred strategies that have actually eliminated the taxes for future generations. What you stand to lose by not doing the exchange is not just the tax of $45,000 it is the lost return on that 45,000 for 15 oe twenty years. How many times will $45,000 double over the life of an investment at X%? Is it twice or three times – just depends on the interest rate doesn’t it. But what if it doubles only twice. That $45,000 becomes $180,000 and that’s money that could then go your heirs tax free for them to begin the same building process.

Your financial advisor would never let you get away with just paying the tax on something when you can defer it in a retirement account. Why would you want to do that when the same opportunity exists outside your retirement account.

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retirebyforty July 1, 2014 at 10:45 pm

Thank you for your input, I really appreciate it. It’s really encouraging to hear from a professional. You’re right about the lost return on the $45,000. I didn’t think of it that way, but that’s a great way to put it.

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