OT: 1031 Exchange

[Jeffreauxdawg]

Do we have any experts on the board? Even better any qualified intermediaries? If not, I am sure there are enough real estate moguls on here to chime in.

Here is the scenario. Contracted to build a house last September (2020) and we locked in the price and paid a 5% deposit to the builder at that time. We made selections/upgrades in December and put another 3% or so deposit down based on the upgrades. The home is finally nearing completion and we have a close date of 10-21-21. Throughout the last year, the area we are building has become one of the hottest housing markets in the country. The day we close we will have approximately 50% equity in the house.

We were originally supposed to be in the house in June, but delays have pushed it back. Our lease ran out and we ended up buying an investment property a couple hours away from where the new construction is being built. We have been living in the investment property for a couple of months and have fallen in love with this town. Turns out it's the best school district in the state and the kids are thriving quickly. We are about 95% sure we are just going to stay here and figure out how to sell the new construction without getting our faces ripped off.

Here are my options.

1. We could sell the new construction immediately after closing, but we would have to pay short term capital gains (I think, or is it possible that because the original contract is over 1 year old at that time it would qualify for long term capital gains?) After state and federal taxes, we would be looking at a 44% tax hit on our profits... No thanks.

2. We could rent the house out for at least a year and then sell the home and pay long term capital gains tax on it when we sell (Currently that would be a 26% tax rate after state taxes.) Obviously a better option, but I also have a fear that in a year there could be no such thing as a short or long term cap gains tax, everything will just be taxed as ordinary income.

3. We could rent the house out for a short period of time 3-6 months and identify another property or properties to use all of the proceeds on in a 1031 exchange. Pay zero taxes for now and leverage that money a whole lot more... The tax man will always cometh, but we could effectively have double the portfolio by using the 1031.

Obviously option 3 makes the most sense. There are some definite mechanical hurdles as well, but for me right now the main question is:

If I use a 1031 exchange with short term cap gains and put it into something I hold long term, will I always have to pay short term cap gains rates? Or will it eventually kick over to long term gains after 1 year. For example.

If we have $100k in short term cap gains put into the 1031 exchange on January 1 2022. Buy a $500k investment property on Feb 1 2022. And sell the investment property on March 1 2023 for $600k. We would have $200K in cap gains. Is the whole amount long term, short term, or is it 50-50 because the original $100k will always be short term?


Sorry I know this is long and probably not interesting to most. But I have made several calls this week to CPA's and 1031 experts at title companies and not a single one has returned my call yet (Seems like it's not just a shortage of restaurant workers.) If there happens to be a 1031 professional on the board, I will be glad to reach out directly and pay for some services if that makes sense.

Gracias amigos.... Now back to bitching about football and academic rankings.

 

[stateu1]

The gain would convert to long-term.

Question though: The 50% equity is really irrelevant. Would your selling price exceed actual COST by that much? Your gain would be selling price less cost.

ETA: Don't forget the 3.8% Obama care tax if you're income is high enough.

 

[patdog]

Wow, that's a lot. My general comments:
Since you've never lived in the house, it wouldn't qualify for the sale of home exemption (I know you didn't even ask that, but i'm just thinking it through)
I believe the 1-year starts when you take possession of the house, not when the contract was signed. Not 100% positive and not going to research it.
If you do a 1031 exchange, most any decent sized bank wan be the intermediary. Regions for sure.
Be SURE you meet the deadline dates to identify the replacement property and to complete the purchase of the replacement property. If you're 1 day late, there is no like-kind exchange. Again be SURE you meet those deadlines.
As long as you hold the replacement property for at least 1 year, any gain will be capital gain. Doesn't matter that a short-term gain was rolled into it.

Hope that helps.

 

[stateu1]

Also, I have a qualified intermediary as one of my partners. I have a good relationship with another here locally that handled the 1031 I did earlier this year.

 

[johnson86-1]

This is a minor issue, but if you are going to rent for a few months and try to do a 1031 (or for a year to get capital gains), if you already have financing lined up, you probably made a representation that you were going to use the home as a primary residence. If you are going to rent it out immediately without ever moving in and are not willing to commit some mortgage fraud, you are probably going to have to get a different loan, possibly with a higher mortgage.

 

[dawgman.sixpack]

What about

living in the new construction for 6mos to a year and then sell the house as your primary residence and it would not be subject to any additional taxation.

Do we have any experts on the board? Even better any qualified intermediaries? If not, I am sure there are enough real estate moguls on here to chime in.


Here is the scenario. Contracted to build a house last September (2020) and we locked in the price and paid a 5% deposit to the builder at that time. We made selections/upgrades in December and put another 3% or so deposit down based on the upgrades. The home is finally nearing completion and we have a close date of 10-21-21. Throughout the last year, the area we are building has become one of the hottest housing markets in the country. The day we close we will have approximately 50% equity in the house.

We were originally supposed to be in the house in June, but delays have pushed it back. Our lease ran out and we ended up buying an investment property a couple hours away from where the new construction is being built. We have been living in the investment property for a couple of months and have fallen in love with this town. Turns out it's the best school district in the state and the kids are thriving quickly. We are about 95% sure we are just going to stay here and figure out how to sell the new construction without getting our faces ripped off.

Here are my options.

1. We could sell the new construction immediately after closing, but we would have to pay short term capital gains (I think, or is it possible that because the original contract is over 1 year old at that time it would qualify for long term capital gains?) After state and federal taxes, we would be looking at a 44% tax hit on our profits... No thanks.

2. We could rent the house out for at least a year and then sell the home and pay long term capital gains tax on it when we sell (Currently that would be a 26% tax rate after state taxes.) Obviously a better option, but I also have a fear that in a year there could be no such thing as a short or long term cap gains tax, everything will just be taxed as ordinary income.

3. We could rent the house out for a short period of time 3-6 months and identify another property or properties to use all of the proceeds on in a 1031 exchange. Pay zero taxes for now and leverage that money a whole lot more... The tax man will always cometh, but we could effectively have double the portfolio by using the 1031.

Obviously option 3 makes the most sense. There are some definite mechanical hurdles as well, but for me right now the main question is:

If I use a 1031 exchange with short term cap gains and put it into something I hold long term, will I always have to pay short term cap gains rates? Or will it eventually kick over to long term gains after 1 year. For example.

If we have $100k in short term cap gains put into the 1031 exchange on January 1 2022. Buy a $500k investment property on Feb 1 2022. And sell the investment property on March 1 2023 for $600k. We would have $200K in cap gains. Is the whole amount long term, short term, or is it 50-50 because the original $100k will always be short term?


Sorry I know this is long and probably not interesting to most. But I have made several calls this week to CPA's and 1031 experts at title companies and not a single one has returned my call yet (Seems like it's not just a shortage of restaurant workers.) If there happens to be a 1031 professional on the board, I will be glad to reach out directly and pay for some services if that makes sense.

Gracias amigos.... Now back to bitching about football and academic rankings.

 

[patdog]

I don't think it would be mortgage fraud as he did legitimately intend to live in the home. But yeah, definitely let the lender know before you rent it out. If he's going to do a 1031 exchange, I'm not sure he needs to rent it out though. Just sell the house and do the 1031 immediately.

 

[patdog]

Generally, you have to live in the home for 2 years to be able to exclude gain on the sale of your residence.

 

[stateu1]

Generally, you have to live in the home for 2 years to be able to exclude gain on the sale of your residence.

The gain can be prorated based upon the time you actually lived there.

 

[Jeffreauxdawg]

****. Forgot all about the 3.8%.

I think we would be around that 50% mark on the gain. The same model home on the same street just sold for 49% more than we will pay for our house. We have a few more upgrades (expanded master and dining rooms for a little extra square footage, extra garage bay, solid core doors, quartz throughout, etc.) I figure if we listed it we would go 5-10% higher than the one that just sold and that would offset realtor expenses and closing costs. We also have the option of selling it without a realtor. So many people are wanting into the neighborhood (all folks fleeing from CA) that we are having people reach out directly. A couple from Sacramento contacted me 2 days ago and want to go on the home inspection with me to see about making an offer... It's silly.

 

[Jeffreauxdawg]

Yeah. It's a couple of hours away from where we are now and we don't want to yank the kids out of the school. As the neighborhood has been built its filling up completely with douchebags from California. I honestly don't know if I could make it the full 2 years. We talked with the lender. Because of the delays and starting the kids in another school district, he felt it's no biggie to let do a short term lease until the end of the school year. But we will probably have to make a change to the mortgage if we go longer than that.

Just sent a DM stateu1. I would love to talk to your colleague.

 

[LittleBigDog]

If it was me, I would enter into a lease/option...

...require at least a minimum of $10,000 for interested party to enter into a two year lease option with a sales price at current market and rent at market rates.
example:
a) $10,000 to purchase an option to buy house within two years at current market rate. The $10,000 would be applied at closing.
b) the party then rents house at current market rate until such time that the option is exercised. My lease/purchase contracts always require purchaser to account for all costs associated with the upkeep and maintenance of house (insurance, taxes, hvac, maintenance, lawn, etc)
c) if purchaser fails to exercise option within two years, you pocket the $10,000 and all rents
d) if purchaser breaches on rent and you evict, you pocket the $10,000 and all paid rents

Never can you 1031 a short term capital gain. The IRS will disallow the exchange. Short term gain cannot be deferred into long term gain. That is why the rule of thumb (but not explicitly stated) is a relinquished property must be held for at least a year and one day.

 

[LittleBigDog]

I should add that options prices have risen substantially...

...the floor for options used to be $5,000...now it is $10,000. My most recent lease/option was $40,000. Things have gotten squirrely. With hedge funds buying up all the single family homes they can find...and stimulus...and hell knows what else...the market is way too hot. It will reset, but when is anyone's guess.

 

[Jeffreauxdawg]

Great info, thanks. In my readings I saw that the IRS doesn't have a hard and fast rule on the holding period. It just has to be proven that the house is an investment property by collecting rent for a significant period of time. I have seen six months to 24 months in various cases.

I appreciate all of the information. I have a feeling I am heading into the long term rental business with this booger for a year or two.

The IRS has also taken the position that if replacement property is disposed of immediately after the exchange, the property would not be viewed as being held for a qualified purpose (investment) under IRC section 1031. (See Revenue Ruling 75-292). Courts have been more liberal on the issue of how long a Taxpayer must hold a relinquished property to prove investment intent (See 124 Front Street Inc. v. Commissioner, 65 T.C. 6 (1975)) but tend to agree with the IRS on disqualifying an exchange when the replacement property is disposed of soon after acquisition (See Black v. C.I.R. 35 T.C. 90 (1960)).

 

[aTotal360]

Even if its a second home loan, all he has to do is "commit" to living in it for 14 days a year. He can't have it under a property manager either. I believe it has to be more than 60 (or 80) miles from the other property as well.

 

[LittleBigDog]

The IRS will not allow someone to change tax consequences in a 1031...

Great info, thanks. In my readings I saw that the IRS doesn't have a hard and fast rule on the holding period. It just has to be proven that the house is an investment property by collecting rent for a significant period of time. I have seen six months to 24 months in various cases.

I appreciate all of the information. I have a feeling I am heading into the long term rental business with this booger for a year or two.

The IRS has also taken the position that if replacement property is disposed of immediately after the exchange, the property would not be viewed as being held for a qualified purpose (investment) under IRC section 1031. (See Revenue Ruling 75-292). Courts have been more liberal on the issue of how long a Taxpayer must hold a relinquished property to prove investment intent (See 124 Front Street Inc. v. Commissioner, 65 T.C. 6 (1975)) but tend to agree with the IRS on disqualifying an exchange when the replacement property is disposed of soon after acquisition (See Black v. C.I.R. 35 T.C. 90 (1960)).

ie...short term for long term. That is why, though not explicitly stated, one year and one day is the best rule of thumb for how long a property must be held before being relinquished. I feel your pain...in that there are few if any experts regarding 1031 Exchanges...but many opinions. And, most of those opinions are incorrect.

 

[stateu1]

ie...short term for long term. That is why, though not explicitly stated, one year and one day is the best rule of thumb for how long a property must be held before being relinquished. I feel your pain...in that there are few if any experts regarding 1031 Exchanges...but many opinions. And, most of those opinions are incorrect.

I get what you are saying, and I've reached out to a couple people more knowledgeable than I, but I just do not understand the theory here. The cost basis and the holding period of the original property carryover to the replacement property (you're merely deferring the gain), so as long as the TOTAL holding period of both properties exceed 1 year, then why do they care?

ETA: I can see why they'd care if you turned around and sold the replacement property in less than a year. If held more than a year, the isn't the IRS in the exact same position?

 

[LittleBigDog]

I get what you are saying, and I've reached out to a couple people more knowledgeable than I, but I just do not understand the theory here. The cost basis and the holding period of the original property carryover to the replacement property (you're merely deferring the gain), so as long as the TOTAL holding period of both properties exceed 1 year, then why do they care?

ETA: I can see why they'd care if you turned around and sold the replacement property in less than a year. If held more than a year, the isn't the IRS in the exact same position?

Your question is logical and sensible...but a common misunderstanding. The IRS considers the transactions independent of one another. The 1031 tax code only allows for the deferment of the taxes from the gain on an independently relinquished property into an independently acquired replacement property(or properties). Therefore, the ordinary tax (short term gain computed at tax payers ordinary bracket) on gains of a property held less than a year cannot be deferred into long term gains even though the replacement property(or properties) are held for a cumulative period of one year or more. The relinquished property is an independent transaction and must be held for a period of one year and one day (again, that is the rule of thumb not explicitly stated in the IRS code).

 

[CoastTrash]

I get what you are saying, and I've reached out to a couple people more knowledgeable than I, but I just do not understand the theory here. The cost basis and the holding period of the original property carryover to the replacement property (you're merely deferring the gain), so as long as the TOTAL holding period of both properties exceed 1 year, then why do they care?

ETA: I can see why they'd care if you turned around and sold the replacement property in less than a year. If held more than a year, the isn't the IRS in the exact same position?

I don't like taxes as much as the next guy, but you're making a big lick here. Certainly fine to legally minimize taxes but it's not the end of the world to just pay the short term cap gain and take your profit, which I presume is substantial if you're property is up 50%. Just ask yourself if you're willing to sell the house for the aftertax gain. Sounds like you've hit the jackpot - you found a better place for your family and are able to sell the property for a handsome gain.

 

[dudehead]

Also remember that the relinquished property must be held for investment and a personal residence is not held for investment. So yes, rent it for a year or so as investment property, then do the exchange.

 

[Jeffreauxdawg]

Fortunately, we are in a position where we can hold the house for a year or two as a rental. I have run the calcs and just by holding it for a year and selling as a long term gain vs short term gain, I would net an extra 25% assuming a flat market. That's a solid return and I don't think I can find that kind of risk adjusted return anywhere else.

The real opportunity lies in the exchange. If we can complete a 1031 exchange into rental properties, at a 20% down leverage, I would effectively double my real estate portfolio overnight. I'm still really bullish on housing. I don't think we are going to see the crazy returns that happened in the last 14 months or so, but the market is still severely undersupplied and it will take a decade to correct.

The reality is it have been incredibly fortune on this deal, now I am going to take advantage of it as shrewdly as possible.

Thanks to all for contributing. This thread has been eye opening and considering that I have been ghosted by the local CPAs and title companies I have called, the SPS network has come through. I now have a plan to move forward with that makes us comfortable.

 

[stateu1]

The contact in my firm confirms that the short-term 1031 is a no go. I learned something as well.