This might be too obscure a topic for this forum, but does anybody have experience with this sort of exchange? I'm hoping to get some opinions as to whether this is a good strategy to transition out of the landlord business. We manage two properties ourselves and are looking for a way out that allows us to defer capital gains and depreciation recapture taxes indefinitely and create a more passive income stream. Any anecdotes and advice appreciated!
My starting point would be to run a test tax scenario in which you sold just one of the properties. Use a realistic sale price, but be sure to include all your capital improvements, so you know how much capital gains you are looking at in addition to the depreciation recapture. Use real numbers for your income in that test scenario, and if it's an option for you to make a sale of one property in a year when your income is low enough that you can realize most/all of the capital gains at 0% then that could be a strategy to pursue instead of a 1031 exchange. If you can't get your income low enough and/or the capital gain itself to make that strategy work, then the 1031 will be more appealing. You'd still have the depreciation recapture to realize with this strategy, but running the numbers will give you an idea of the total tax liability you looking to avoid.
We are lucky to live a VLCOL area and have a handful of properties that cost relatively little. With our low expenses and ability to control income in retirement, we may be able to unload ours one or two per year and not need to mess with a 1031x.
The next thing is to identify a type of property that you'd want to exchange into. My understanding is the "like-kind" requirement is fairly generous. I don't think you can just 1031x into index funds.... but farm land, lake house for short-term rental, apartment complex, commercial real estate are all options. Have you identified a type of property that would meet your needs of a more passive investment?
Some of those investments may be more passive. But they may only be more passive because you make the decision to hire out the management, which is going to mean a lower return. And if that's the case, then you'd probably want to run the numbers on how well your current investments would perform if you hired out the management and made them more passive that way.
Another factor in your decision could be how long you have left before the two properties you have are fully depreciated. If you are set to soon lose the shield provided by the depreciation of your 2 current investments, that could affect your decision differently than if you still have another 25 years. How that current depreciation schedule matches up with my life expectancy and overall life plan would affect my decision.
Another factor that may affect how much of a hassle a 1031x would be is how easy it would be for you to unload both of your current properties at the same time, at least approximately, to stay within the time requirements. In general how easy will it be to sell them both quickly. This may be worth a call to a 1031x administrator to get details on how your fees may differ if you were able to sell them both close to the same time and roll the sale of both into the same target property. It could be the case that since you are starting with 2 it doesn't matter as far as the fees are concerned. For example if you found a 200 acre farm with a price that would exceed the combine value of both your properties it may serve as a good target property for the exchange. But would you need to sell both and then exchange into the farm within the time frame? Or would it be possible, in the case when you couldn't sell both in a narrow time window, to exchange just one into the farm at that time and then exchange the second property (via a second 1031x) into the same target property? I'm guessing that would not be possible if you took ownership of the whole 200 acres farm as part of the first 1031x. And splitting up the target property, whether it's a farm or a commercial property with multiple buildings/components may be possible in some cases, but in others may not be something you could count on.
In general, I think it's a good option to consider. We certainly have it on our radar as an option when/if we transition out of the business. Let us know if you dig up any additional details on the strategy.
