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I have a friend who has built a house and realized he spent waaay too much and may not be able to afford the mortgage now (at least long term). The house is almost finished and if he were to sell it would realize about a 400k gain that obviously he doesn't want to pay tax on. He asked me a couple of questions about doing an exchange and how they work.
I did some reading from links posted here but am unclear on a couple of things.
I realize the trade has to be for similar or like properties but does that mean in price or just that it has to be residential for residential? And, if he takes the gain and sinks all of it into the new property does that take care of it?
I just want to be able to give him a general idea of what will work for him at this point before he really gets in trouble...
I'm aware this is a forum and all advice is not legally binding nor any warranty is expressed or implied but would like some ideas.
10-31's have to be real estate for real estate. You can trade one investment for another so he could get land, rental homes (up to 3 I think but check on it). He cannot purchase a primary residence with it, but he could buy a home, rent if for 6 mo. or a year, and then move into it thus avoiding taxes. Check with an accountant and see the length of rental they recommend as I've heard many different answers.
You should verify this information with a local real estate attorney or title company depending on which your state uses. Find one that is familiar with 10-31's, inform them of you intentions, and in exchange for helping then use that attorney to close the transactions.
Happy problem to have. How to minimize your taxes on a $400K gain!
As you are aware, the 1031 program only delays the tax liability. As an additional scenario, your friend could consider moving into the house and making it the "principal residence" for twenty-four months. If the house is sold after the twenty-four month residence requirement, your friend is able to exclude $250K of the gain if filing as single or $500K if filing jointly.
Of course, with this option, he will have to pay the mortgage for at least twenty-four months. But if he does a 1031, he has to re-invest all of the proceeds that he wants to delay the taxes on, so I assume that there would be some financing costs on that "basis" money.
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I think it also depends on whether this was a home built as his primary residence (did he get the mortgage as an owner or investor?). In order to "convert" it into an investment he would need to offer it for rent for a period of time.
His intention was to build the house and live in it for 2 years and sell it and do another but now that the house is almost done he's realized with the coming downturn in building (which is what he's in) he may not be able to pay for it for 2 years, not to mention he spent WAY more than first anticipated. It's financed as owner/builder primary residence. He is willing to take his gains and put them in another property, no problem and was hoping a 1031 would might save him from gains tax (the 400k or so). If it only delays the tax I'm guessing he would be ok if he holds the next house for 2 years and then uses his 500k exemption.
I intend to suggest he consult a CPA but would like to let him know if it's worth spending the money on the CPA to confirm it's doable so any ideas are helpful.....
His intention was to build the house and live in it for 2 years and sell it and do another but now that the house is almost done he's realized with the coming downturn in building (which is what he's in) he may not be able to pay for it for 2 years, not to mention he spent WAY more than first anticipated. It's financed as owner/builder primary residence. He is willing to take his gains and put them in another property, no problem and was hoping a 1031 would might save him from gains tax (the 400k or so). If it only delays the tax I'm guessing he would be ok if he holds the next house for 2 years and then uses his 500k exemption.
I intend to suggest he consult a CPA but would like to let him know if it's worth spending the money on the CPA to confirm it's doable so any ideas are helpful.....
Sounds like there are many possible scenarios and seeking good tax advice is most likely the best way for he to analyze his options.
Would you answer a curiousity question for me? Is there any extenuating circumstance as to how he could build a house, spend over-budget and still be able to make any profit in this downturning market, much less $400K or so?
If your friend "makes" $400,000 on the tranaction (I don't know how much he would actually profit after the expenses are deducted, an important consideration), or for that matter any amount of money that is, in fact, profit on the transaction, and which does not go into the exchange property, this is called "boot." It is taxable money (forget at what rate -- regular income I believe).
Sounds like there are many possible scenarios and seeking good tax advice is most likely the best way for he to analyze his options.
Would you answer a curiousity question for me? Is there any extenuating circumstance as to how he could build a house, spend over-budget and still be able to make any profit in this downturning market, much less $400K or so?
Well it's like this, in the current market (here) cheap houses and real expensive houses are selling just fine, the middle is dead as a doornail. He's playing in the high dollar range (again for here). I think he originally expected to have somewhere between 390-430k into it but since he intended to live in it well, you know how it goes....
Being the kind of builder he is which is very anal about how things are done and he uses very few subs, and since all I've ever seen him do is absolutely top drawer work I have very little question the house will sell for somewhere around 900k.
I believe, for the 250k/500k tax exclusion, property must be primary residence 2 of the last 5 years. So, he could rent it out for a couple of years, then move into it for 2 years, sell it and avoid the capital gains tax. 1031 is a delay, not exclusion. There is also a time limit on identifying the intended property for the 1031 exchange (90 days?) and actually closing on it (180 days?) This is one way CPAs definitely earn their money. He needs one that specializes in real estate.
Jimj - if I'm reading your posts correctly, a 1031 exchange is not going to help your friend. A 1031 exchange enables an investor to defer the tax on the sale of an investment property if he purchases another investment property with a basis at least as much as the one he's selliing. If he purchases one with a lower basis, then he'll have to pay tax on the difference anyway.
So, with that in mind, a couple of questions would seem to be in order:
Does he still own a property that qualifies as his personal residence (other than this new build)?
Is he planning on buying or building another investment property after he sells this new-build?
There's very strict replacement time frames that must be met in a 1031 exchange.
Just from what I've read in the posts so far, it would sound like paying capital gains tax on the $400k is almost inevitable . . . but that may not be so bad. As long as he's held the property for at least a year, it would be long-term capital gains tax. And the current rate on capital gains is extremely favorable right now due to one of those incentive laws passed by the current administration. However, that law is due to sunset in the next year or so (I don't remember the exact details).
Have your friend check with his CPA or tax advisor. It's critical that he gets really sound tax advice before he decides when to sell.
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