Is Today the Right Day to Sell and Buy?

I received the following letter recently:

Dear Mark,

I own a rental house in LA and my tenant just gave notice. I bought the house about 15 years ago and am thinking of buying a duplex in Santa Barbara and doing a 1031 exchange to avoid paying taxes. My current wife and I thought we could rent out half and move in to the other half of the duplex. Is now a good time to sell and buy? My place was worth more last year and the values are more expensive in Santa Barbara.

KJ

Dear KJ,

I’m glad you ended up with the house. After all this time, assuming that you haven’t refinanced numerous times, you might have accumulated a substantial amount of equity that would allows you to afford Santa Barbara real estate. Remember, if you buy a house anywhere but Santa Barbara, you haven’t paid enough.

Now is a good time to buy. Interest rates have dropped backed down and even though you said that your property is worth a little less than it was last year, so might be the replacement property you purchase.

If you are thinking that you can immediately move in to one part of the duplex because you are renting out the other half, it will not work unless specific circumstances exist. One scenario would be if you sold your house for $700,000 and bought an evenly distributed duplex, say 3 bedrooms and 2 bathrooms on each side, for $1.4 million. In this case, one half of the duplex would satisfy having to spend a dollar amount on your replacement property that is equal to or greater than the sales price of your relinquished property (exchange funds). Having met that requirement, the other half of the duplex becomes available for you to occupy. The duplex doesn’t have to be evenly distributed; I just did that for easy math. The prudent approach would be to follow the traditional course of first renting out the property before occupying it.

It is not a requirement to spend a dollar amount equal to or greater than the value of your relinquished property. If you spend less, just have your advisors calculate the tax owed. It might be worth it to buy something for less money and in the long run pay less in mortgage payments and taxes. On the other hand, you could buy something that is more expensive by adding money to the down payment from a source other than the relinquished property, or increasing the loan. There are rules concerning the amount of the old and new debt (loan) so get good advice up front.

The terminology is “like-for-like,” meaning the replacement property for your rental cannot be occupied by you. Plus, you mentioned buying a duplex (what people would consider “rental property”), but you are not limited to buying a duplex.

If you eventually want to move in, you can buy a duplex, a single family home or a condo. I suppose you could buy vacant land but that creates other issues that you don’t appear ready to tackle. Do not close escrow on your relinquished property without first establishing a 1031 exchange with a qualified accommodator. You could end up owing tax on the entire gain.

Before you can occupy your replacement property you must first rent it for the appropriate amount of time so it satisfies the requirements of the 1031 exchange. Confer with your tax advisor to make a decision on the time period. Some have said that the new rental should appear on at least two tax returns (which could be less than two years) while others could be more aggressive and suggest less time. I would err on the side of caution. You do not want the IRS knocking on your door.