I recently sold two of my rental properties (number 5 and 13). I was thinking about completing a 1031 exchange when I sold those rentals, but I ended selling them and keeping the cash. There are a few reasons why I decided not to do a 1031 exchange, and most of them had to do with not being rushed into buying a replacement property. When you do a 1031 exchange you have 45 days to identify a replacement property or properties, and you have to buy properties that are at least as much as what you sold your previous property for. Since I am not buying rental properties in Colorado at this time, that means I would have to find replacement properties in a new market, with a new lender, and have very little time to do it. I will have to pay more taxes by not completing a 1031 exchange, but that doesn’t mean I will not be in as good of a financial position. By rushing to buy new properties, I may not purchase as good of a deal or may not learn a market as well as I would like before investing.
▼ Continue Reading Below
What are the basics of a 1031 exchange?
A 1031 exchange allows an investor to sell one or more investments and buy new investments without paying taxes on the gain. 1031 exchanges can be tricky and complicated, so always talk to an accountant or lawyer when completing one! 1031 exchanges can be used on many types of investments, but since this is a real estate blog I will only discuss their use with rental properties. When you sell a rental property you have to pay taxes on the profit you make and any recaptured depreciation. Rentals have amazing tax benefits and one of those is depreciating the structure’s value. When you do a 1031 exchange you may be able to avoid paying taxes on any of the profit and the recaptured depreciation. Here are the basic guidelines:
- You can sell one property and replace it with one or more properties
- The new properties must be worth at least as much as the property you sold (if you sold a house for $200,000, the new properties must be bought for at least $200,000).
- Any cash you receive from the sale of properties would have to be used to buy the new properties.
- An intermediary has to hold all the cash from the sales until it is used for the new purchases.
- You do not pay taxes on the recapture of deprecation, but your depreciation schedule does not start over. If you depreciate $50,000 off the structure of a property, that $50,000 would carry over to the new property. If the value of the new structure was $100,000, you could only depreciate $50,000 of it.
How much did I make on my rentals and how much in taxes will I pay?
I sold rental property number 5 and rental property number 13. If you listen to last week’s podcast, I talked in detail about my rentals, flips and current state of business. I sold rental property number 5 for $199,500, bought it for about $88,000 (in 2012) and had about $30,000 in fix up and selling costs. I made about $80,000 on the property in profit thanks to buying below market value and appreciation in our area. I was able to pay off my loan on the property and came away with over $120,000 in cash.
I bought rental property number 13 for $120,000 last year (2015) and sold it for $184,000. I put about $20,000 into this property in repairs and selling costs. I made about $44,000 on this property after all the costs. I was able to take home about $70,000 in cash after paying off my loan. I will have to pay taxes on the profit I made on both properties and any recaptured depreciation. According to my accountant I would pay:
The depreciation recapture of the gain would be taxed at a 25% rate. If the gain is more than the depreciation you have taken, the rest of the gain would be taxed at a 15% rate. Also don’t forget about the Colorado rates which are 4.63%.
I will probably pay about $18,000 in taxes on the first sale and about $10,000 on taxes on the second sale. I was able to take out about $190,000 in cash from the sale of both properties and I will have to pay $28,000 in taxes from those sales. If I would have done a 1031 exchange, I would not have had to pay any taxes and saved the $28,000. No one likes to pay money to the IRS, but I am okay with taking the tax hit because of the flexibility it gives me.
Why didn’t I complete a 1031 exchange when selling my rental properties?
$28,000 is a lot of money and I would have loved to save that money, instead of eventually paying it to the government. However, the 1031 exchange is very restrictive in how I can buy properties. Here are the main reasons I did not do a 1031 exchange on my rentals.
- I am not buying rentals in Colorado anymore. I want to buy properties in Florida, but I am not quite comfortable buying there yet.
- I would have to buy houses for at least as much as I sell my properties for. If I would have exchanged rental property number 5, I would have had to buy properties worth at least $199,5000 and use all the $120,000 cash to buy those properties.
- The properties I want to buy would be in the $100,000 range, so I would have to buy at least two properties for every property I sold.
- Since I have to spend just as much as I sold the properties for, I would have to get loans on the new properties or use a lot more of my cash to buy them. I have not solidified a good relationship with a local lender in Florida yet.
- My flipping business has been going great, but it takes a lot of cash to operate. I had from 8 to 12 flips at all times this year. Having that extra cash means I can flip more houses and make more money.
I did not want to rush buying houses in a new market that I was not comfortable in yet. I really like the Florida market, but I have not had time this summer to find a really good lender or look for awesome deals. One reason I have done so well with my rentals is I always get an awesome deal when I buy them. While I may have to pay the tax man almost $30,000 next year, I will more than make up for that savings when buying one or two rentals that are awesome deals, instead of rushing into purchases. If I can flip one more house because of the cash I have available, that would more than make up for the $30,000 tax bill as well.
I think a 1031 exchange is a great way to defer taxes, but it was not the right move for me at this point. I can put that cash to better uses in my flipping business and I will not be rushed into buying rentals that are not great deals. I sold these rentals because I was not getting that great of a return based on the cash I had tied up in them. If I do find some awesome deals and a good lender in Florida, I could buy three or four properties with the cash from just rental property number 5. I may sell one more property in Colorado, but I have not decided for sure if I want to do that yet. The house had a tenant who may be moving out and it is in a small town that had a less stable market than where most of my properties are. Since I am in a better position with my cash and flipping business, I may use a 1031 exchange on that property if I figure out exactly what I want to do in Florida.