Author Topic: Questions/Advice about Rentals -> 1031 Exchange -> Rental -> Primary Residence  (Read 5639 times)

CowboyAndIndian

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I have some questions whether it makes sense in a 1031 exchange of a couple of rental properties, renting the exchanged property and then converting the exchanged property into a primary residence.

I presently live in NJ and plan to move to FL in a couple of years. I have found property in FL , that I would like to pay for using a 1031 exchange using two properties that I presently rent out.

Once I buy the property in FL, I will rent it out for about 18-24 month, until I am ready to move there. When I move to FL, that house will becomes my primary residence.

  Rental A: Present value $150k.
            Bought for $57k in 1993.
            Rented out from 1998 till now.
            Depreciation claimed from 2000.

  Rental B: Present value $100k.
            Bought for $47.5k in 2010.
            Rented out from 2010.
            Depreciation claimed from 2010.

  Property FL: Present value $275k
               Rent from 2015 for 18-24 months


The plan would be as follows
    - Sell Rental A and B with funds going to a Qualified Intermediary (QI)
    - Buy FL property within 180 day deadline of first rental sale.
    - Rent FL property for 18-24 months.
    - Move to FL and make this property my primary residence.

Since DW and I will be at a high tax bracket for the next two or three years, I would like this transaction to legally minimize taxes.

So, my questions:
  • Is this a feasible plan? Do you see any holes in it?
  • How much does an 1031 exchange cost?
  • Do I need a lawyer for the 1031 exchange or will the exchange company (QI) suffice?
  • What taxes will I have to pay at the time of 1031 relating to the sale or is it completely tax free event?
  • What taxes are due of the sale of the FL property if it is my primary residence for at least 5 years?
If anyone can point me to any resources, I would appreciate it. Being a software  guy, I have googled, but not being an Accountant/CPA I am not sure I understand  all of the nuances.

I would appreciate the opinion of wiser folks on this forum.

Cheddar Stacker

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This post will explain it better than anyone here can. No offense intended to anyone here, but this is a well written summary that I found by reading here, and I've linked to it before.

Here's a recap:

-The depreciation recapture would become taxable (at a maximum rate of 25%) when you sell the primary residence after living there at least 2 years.

-Any gain on the new residence from the time you move there until the time you sell it (as long as you live there in 2 of the 5 years leading up to the sale) would be excludable from taxable income.

-Any gain on the new residence before the time you move in as your personal residence is fully taxable. This includes the deferred gain from the NJ properties.

Since DW and I will be at a high tax bracket for the next two or three years, I would like this transaction to legally minimize taxes.

So, my questions:
  • Is this a feasible plan? Do you see any holes in it?
  • How much does an 1031 exchange cost?
  • Do I need a lawyer for the 1031 exchange or will the exchange company (QI) suffice?
  • What taxes will I have to pay at the time of 1031 relating to the sale or is it completely tax free event?
  • What taxes are due of the sale of the FL property if it is my primary residence for at least 5 years?
If anyone can point me to any resources, I would appreciate it. Being a software  guy, I have googled, but not being an Accountant/CPA I am not sure I understand  all of the nuances.

I would appreciate the opinion of wiser folks on this forum.

I won't legally minimize taxes, it will legally defer taxes until a later date when you will likely be in a lower tax bracket. Maybe that's what you meant, not sure. But the thing that stinks is you will end up with a $200K-500K gain at some point which will put you into a high tax bracket anyway. The only potential caveat is if you don't sell the primary residence and leave it behind in your estate at which point it may receive a step up in basis and some (maybe all?) of the gains would be washed out and never taxed. Now you're getting into estate planning though and that's a whole other conversation.

Answers to questions:
1) Yes, it's feasible as a tax deferral vehicle. I don't see any holes.
2) Variable. Potential legal, QI, and CPA costs. The only thing you MUST pay for is the QI, the rest is at your discretion. The QI is simply holding your money, pushing some paper and giving some advice. I don't know what they charge but I would guess not much more than a title company, so maybe $1-2K?? Ask around.
3) Need, no. If you hire a good QI they should be able to handle all the intricacies.
4) Tax free event if done properly. One key which you've covered is you have to upgrade. $150+$100=$250 < $275. If you downsize, you pay taxes on the transaction. Same thing goes for debt I believe, so I don't think you can bring a ton of cash to the table and leave with less debt than you started with.
5) See my notes above. Any and all gains before the day you move in.

Disclaimer-I've been involved from the CPA side on a few of these. I've done a little research, made a few calculations, and given some advice. This is a niche thing, and I'm not an expert. Anything I said above is to the best of my knowledge, but there might be an error or two. If anyone wants to contradict anything I said, don't hold back because you might be right and I might be wrong.

Unless you are supremely confident, I would hire a CPA (with 1031 experience) for your 2015? tax return (The year of the sale). As you can tell by the disclaimer, I've done this before and I'm still not supremely confident in my knowledge. The deferred gain calculation is not simple or even really all that logical so it can be screwed up. A big enough mistake there could lead to a large penalty and interest due to the IRS if they ever figure out your mistake.

Good luck!

CowboyAndIndian

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Wow!

Thank you very much Cheddar.  I am blown away by the knowledge, kindness and helpfulness of your response.

I will read Kitches article in detail.

CAtoTX

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A couple of additional comments:

In the good old days, converting from a 1031 to a personal residence and then using the exclusion was a great plan and many retirees were moving from rental to rental every two years...and the IRS quickly figured out what was going on and closed that loophole.  Now, as the previous poster said, gain exclusion is limited.

I have done a 1031 exchange and did not need an attorney...the QI was great and handled everything.  Just be aware of the deadlines to identify replacement property and close escrow.  The IRS is looking closely at 1031 exchanges and will jump to DQ them if you haven't followed every rule. Plus your QI must indeed be QUALIFIED and the rules there are strict as well...can't have been your accountant, your broker, etc. 

Be aware that some states are enacting a "clawback" provision if you buy replacement property out of state.  California, for example, recently enacted a requirement that you must file a form with them each year after the 1031 is completed until you sell the out-of-state replacement property...and then they will have their hand out for their share of the tax. 

CowboyAndIndian

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Thanks CAtoTx, sorry for the late response.

As you mention, I am worried about the deadlines and how to make the 180 day deadline. One of the houses is easy to sell, Rental A, which has more depreciation/gains.
The other may be harder to meet the 180 day deadline (but may not have large tax consequences if I do not add in 1031).

Do you have any suggestions for a QI?

Clawback! Wow, will check if NJ has something like this. I hope not...

CAtoTX

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A would ask a local CPA or broker for a referral for a QI.  Make sure to get more than one name and ask a lot of questions.  Definitely raise your concern about the 180-day closing deadline.  You can identify more than one replacement property even though you may only close on 1, so that gives you some leeway. 
In my case we had our eye on a property we wanted to buy and put ours on the market almost simultaneously with making an offer on the new place.   
Good luck! 

maki

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+1, mostly to follow, as this is something i am interested in, too. and cheddar's response is nothing short of amazing.

tct

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I read the post that Cheddar posted a link to.  It was a good read, however the portion related to converting a rental, previously involved in a 1031 exchange, to a primary residence appears to have mistakes.(or maybe I'm not understanding):. See the following excerpt, the dates used in the example don't seem to match the dates used in calculating the result. It also seems to imply that you won't be taxed on appreciation during the years prior to the 1031 exchange. Seems to good to be true.

Example 2d. Continuing the prior example, assume that Harold’s original ownership since 2000 was of an apartment building, and in early 2011 he had completed a 1031 exchange to a single family home, with the ultimate intention of moving into the property as a primary residence to claim the capital gains exclusion. Even if Harold moves into the property in early 2013 and lives there for 2 years, he will not be eligible for any capital gains exclusion until 2016 (five years after the 1031 exchange). At that time, he can complete the sale and be eligible for the exclusion. He will still have 4 years of nonqualifying use (2009 after the effective date, though the end of 2012 when the property was still a rental), but will now have 12 years of qualifying use (2000-2008 inclusive, and 2013-2016), which means 12/16ths of his gains will be eligible for the exclusion and 4/16ths will be deemed nonqualifying use capital gains and subject to taxes (in addition to any depreciation recapture).

CowboyAndIndian

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Just an update on the 1031 exchange process

  • Downpayment has been made on the condo I'm buying in FL. It is still under construction and expect it to be done in January 2017. Closing should be late Jan or early Feb 2017
  • Rental A has been sold to the tenant for $153k. Prices jumped in the last year so I got more than I expected. It was a relatively easy experience, couple of meetings with the tenant and negotiation by email. There were no realtor fees, but the tenant got a price break for the amount. Overall a win/win for both tenant and me. They got a great deal and I get rent till closing without any of the hassles of selling a house.
  • Rental B has just been listed with a realtor. Spent some time painting the apartment. Hopefully it goes on the MLS this weekend. Looking at the prices, I'll probably break even on the sale (get back what I paid on the house). Of course, I got a few years of rental income.... 
  • Have picked a 1031 company (1031esi.com)

Wish me luck!


CowboyAndIndian

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CowboyAndIndian

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Some advice I found on my QI's FAQ Page (http://1031esi.com/faqs.html)

Quote
There are safeguards a taxpayer should consider when selecting a Qualified Intermediary. 
These safeguards include:
(1) depositing the taxpayer’s funds in FDIC insured accounts;
(2) depositing taxpayer funds in accounts that are principal preserved and liquid;
(3) depositing taxpayer funds in segregated accounts under the client’s name and federal identification number;
(3) requiring dual signatures within the Qualified Intermediary company and, where practical, the signature of the taxpayer for any withdrawals;
(4) ensure the proper wording is contained in the Exchange Agreement to protect the taxpayer’s funds from a Qualified Intermediary bankruptcy;
(5) the use of a Qualified Escrow and Trust Agreement;
(6) the use of a Security or Guarantee Arrangement; and/or
(7) deposit taxpayer funds in a financial institution selected by the taxpayer.

I posted this in response to a question there, but thought it of enough value to repost here.

CowboyAndIndian

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Present status.

Rental B sold for much less than I expected. It did not have any gains, but a loss. Doing the numbers, I decided that this sale did not create any tax burden, so I decided to do it outside the 1031 exchange.

Rental A has been sold, closing is on November 1st. I should have ample time before the expected closing of my condo in FL (expected late Jan, or Feb).

I notified my QI about the sale after the mortgage contingency period was over and they have sent me a contract for the exchange. I am quite happy with my QI, They are a smaller company and any questions have been responded to within a couple of hours.

Like RobrBaron stated in his awesome post (linked about a couple of posts above), the fees are about $1000 for the first property and $450 for each additional one.
« Last Edit: October 12, 2016, 01:23:05 PM by CowboyAndIndian »

CowboyAndIndian

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Rental A has been sold, closing is on November 1st. I should have ample time before the expected closing of my condo in FL (expected late Jan, or Feb).

We closed today on Rental A.

So weird, walking away without any money. The money was sent to the QI.

I'll know in another 4 months if the 1031 QI is good and if I have any issues.

CowboyAndIndian

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Do I understand the rules correctly:  If the OP moved back into rental A for 2 years they can then exclude all the capital gains from taxation because it originally started as a primary residence but they would still have to pay for depreciation recapture?

Good question. I am the OP, but not knowledgeable to answer that....

CowboyAndIndian

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Sorry for necro-posting to this thread. I just thought I would provide closure on this thread.

The 1031 is complete!! We have one potential tenant for the replacement property, so we should be renting it out from June 1st.

The exchange was professionally done by my 1031 company (1031esi.com) and it cost about $1k. The closing on the new place was exceptionally easy. At the closing, the title company agent said that she had done multiple 1031's, but this was the best(easiest) one of all. I guess a lot of credit is due to the folks running the exchange who did a great job.

The hardest part of the 1031 exchange was the mental stress due to the fact that you do not recieve the money for the sale. For the week before the closing of the replacement property, I could not sleep nights worrying if my money had disappeared.

Many thanks to Cheddar whose seal of approval at the beginning of this thread gave me the confidence to go thru with this process.
« Last Edit: May 08, 2017, 04:37:51 PM by CowboyAndIndian »

Cheddar Stacker

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Congrats. I'm sure it feels great to avoid that tax bill.