Just to make sure we are on the same page, a 1031 exchange can not be used for property you purchase to rehab and flip. Flip property is dealer realty and not eligible to participate in a 1031 exchange.
Let’s say that you buy a house for 10K, spend 35K on rehab, then rent the property to your tenants. After a couple of years, you decide to use the equity in your property to upgrade your rental portfolio.
A 1031 exchange is perfect for this situation. It is not clear from the situation you outlined whether there was financing used in your purchase and rehab. From the low numbers involved, I will say no. So you have a free and clear property with an adjusted basis of $45K (ignoring depreciation to keep the illustration simple) that you plan to sell to your tenant for $85K, so you have no sales commission or other selling costs. Let’s assume that your price is about 10% below market, so the buyer agrees to pay all of your settlement costs to lock in your below market price.
When do I file for the 1031 exchange?
You don’t “file” for an exchange. You contact a qualified exchange intermediary (QI) and open an exchange escrow account. The QI will help you draft an exchange escrow agreement that you will sign, the QI will sign, and the buyer of your relinquished property will sign. Once you are at settlement, the settlement attorney will follow the instructions in the exchange escrow agreement and deposit the exchange proceeds with the QI.
The time to get the ball rolling with your QI is after you have a purchase and sale agreement on your relinquished property but before you go to settlement.
For the property in our example, you will have net sale proceeds of $85K forwarded to the qualified intermediary. Note that this number is your entire equity, not just your profit. If your property was mortgaged to finance the property purchase and rehab, then your loan will be paid from the settlement proceeds. Whatever is left over (your equity) is forwarded to the QI to be deposited into your exchange escrow account.
Then I find a property with in the time line given and this property is selling for 75k. Do my proceeds of 40k go to the down payment of the new property and I get another mortgage for the 35k? How does this work?
In our example, your net sale proceeds of $85K are applied to the purchase of the replacement property and most settlement costs. Since your exchange funds are sufficient to complete the purchase of the replacement property, no new debt or additional funds are required at settlement.
However, since you are trading down in value, whatever exchange funds that are left over after the replacement property has settled are distributed to you as cash “boot” and taxed, first, as unrecaptured depreciation at 25%, then any remainder taxed as long term capital gain.
The recaptured depreciation is added to the cost basis of your replacement property.
If, instead, your replacement property value had been $150K, then the $85K in your exchange escrow account will have to be supplemented with enough cash or new debt to make up the difference and to cover settlement costs. Note that in a delayed exchange, you are not required to bring new debt to the settlement table, nor is the new debt required to equal or exceed any old debt on the relinquished property.
Lets say the same senerio but insted of buying a 75k house I buy a 35k house then what?
The situation is the same as above. The difference is that now you will have around $50K (less after closing costs) in taxable cash boot instead of only $10K. Since the amount of cash boot received exceeds your total capital gain, only so much of the $50K that represents your taxable capital gain will be taxed. Because you are paying all the taxes due in a taxable sale in this situation, you have nullified the exchange. In other words, by trading down so much, you could have saved yourself the exchange fees you incurred because you got no tax benefit from the exchange in the first place.