Failed Exchanges Can Save Taxes Too!

Ralph just retired and needs to sell his rental as soon as possible, but it’s barely breaking even. Ralph’s situation is unique, and while he didn’t complete an exchange – it actually ended up benefiting him.

Meet Ralph

He has just retired and needs to sell his rental property as soon as possible. Because he refinanced and took cash out a few years ago, the property is barely breaking even. Ralph worries that, if there are vacancies on the property, he won’t have enough cash flow to stay above water. His precarious situation means a small downturn in the economy could wipe him out.

Why This Is Important

Ralph is not our typical 1031 candidate. However, a 1031 is a good option for him. While we hope Ralph’s situation is not yours, we’re sharing his case to illustrate the flexibility and versatility of these exchanges, which can achieve many different clients’ economic and tax-saving goals. 

A Complicated Situation

Real estate is the best investment one can make in this country. Because of this, we don’t generally encourage my clients to sell their properties and cash out. Ralph’s case looked like it might be the exception.

Because of his high LTV, it will be difficult to find a replacement property that will put him in a better position. He can’t qualify for a mortgage. He might get debt using DSTs, but they also have qualifications he can’t meet. The most important consideration of all was that Ralph needs some cash in the bank.

After working through several partial exchange options, there didn’t seem to be a way to make it work. It seemed as though cashing out was a necessary evil for Ralph.

Ralph’s Tax Problem

If Ralph sells without exchanging, he will realize about $400,000 of cash from the transaction. He previously took $200,000 in tax-free cash from refinance proceeds. With this sale, he could end up paying tax both on that cash and on the new gain.

As is the case with many investors who refinance and take cash out, Ralph’s basis is less than his loan. His gain will be about $650,000. This could mean $194,000 in taxes, almost 50% of his gain! Ralph was not happy to hear about that.

Failed Exchange May Provide Some Relief

Ralph’s property is due to close escrow in mid-December. After much consideration, we advised him to send the money to an accommodator and to look for a property to buy in a 1031 exchange. If he is unable to find a property, the accommodator will return his money in January. 

If this happens, it will actually save him a significant amount of tax. When you sell in one year and collect proceeds in a second year, the IRS calls it an “installment sale.” With an installment sale, you report the gain as you receive the cash. Ralph will receive cash in 2019 that will be used to pay the debt and selling expenses. In 2020, he will receive the cash that the accommodator has. This will result in the gain being taxed over two years. 

Capital gains for qualifying investors with low incomes have a zero percent tax rate. By spreading out his taxes, Ralph will qualify for this rate in both years instead of just one. There is also a 20% rate on capital gains when your income is high.  Splitting the gain up means that Ralph will pay this 20% on a lot less of his money. Altogether, if Ralph follows our advice but is unable to find a replacement property, he will save $30,000 or more in taxes.

There is one important caveat that should be shared here. The IRS requires you to actually try to find a replacement property when using this exchange method. We advised Ralph to keep records of his efforts. If he simply sends money to an accommodator and never make attempts to find replacement properties, he won’t be allowed to use an installment sale to reduce his taxes. 

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