Tax Guru – Ker$tetter Letter

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Reinvesting 1031 Proceeds

Posted by taxguru on February 5, 2006

Q:

Subject: Exchange Question
 

My brother and I own a house as investment property together.  We purchased it for $60,000.00 about 5 years ago.  We are now thinking about selling it for $160,000.00 and replacing it with a house or condominium in the $100,000.00 to $140,000.00 price range.  Do we have to pay any capital gain tax in this transaction?  My accountant told me that we would have to pay capital gain tax on the $40,000.00 we use to pay off the mortgage unless we replace the property with property for $160,000.00 or more.  Is this true? Thank you for your advice.

A:

That’s not exactly right.

Basically, to have a completely tax deferred exchange, you need to acquire new property or properties that cost at least as much as the net selling price of your old one.  The net selling price would be the gross price less the selling costs.  I call that the target replacement price.

Whatever you under-reinvest, or miss the target replacement price by, will generally be subject to taxation.  In your example, assuming you have no selling costs, a $100,000 replacement property would put you $60,000 short of your target.  This would mean $60,000 would be taxable; not just $40,000.

Another twist to consider.  The gain that will be subject to tax will be the most expensive portion, which is normally the depreciation recapture.

If you don’t want to pay taxes on the $60,000, you and your brother may want to consider acquiring one or more additional properties as part of this 1031 exchange costing at least $60,000.

This is a relatively simplistic way to look at it.  There are a few more twists in terms of the cash in and out, as well as the amount of debts on both the old and new properties that will affect the exact amount of taxable gain; but the concept is fairly straight forward and I hope clear to you.

As you hopefully know, you must use the services of a neutral third party exchange facilitator to prepare the proper documents and hold the cash proceeds.  You can’t just sell your old property and take the money to reinvest on your own.  You can see all of the rules for properly handling a 1031 exchange at www.tfec.com 

Good luck.

Kerry Kerstetter

 

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