Here is the tale of how an incomplete 1031 Exchange can haunt real estate investors. Mr. Jones had bought a lot at a great price from his friend and built an apartment building on it. His cost basis was roughly 1.9 million. His circumstances a few years later demanded that he come up with liquid cash for other obligations he had, and he sold the building for 3.8 million. After sales costs and other accounting adjustments, his net capital gain was a bit over 1.4 million. He had enough knowledge to open a 1031 Exchange with the title company's accommodation department. This IRS tax code would allow him to roll the proceeds over into a new investment property without paying tax on the approximately 1.4 capital gain. He had his eye on a parcel of land in the country he would develop. There were ongoing problems with the purchase and even though he was warned that he MUST complete the purchase on the new property within 180 days or get soaked with taxes, he did not, believing erroneously that he could get an extension because "somebody had told him so". Imagine his surprise the following year when he filed his tax return and was presented with a federal tax liability of almost 215,000 and a comparable amount to the State of California. By then he had already spent a good amount of the liquid cash he received from the sale. The year after his failed 1031 Exchange Mr. Jones sold two rental homes at a significant loss but he could not apply the loss retroactively to his huge gain the previous year.
Moral of the story:
Sellers should plan their exit strategy carefully if they want to sell real estate investment property
Consult with a tax professional before any purchase or sale
Evaluate the entire portfolio if there are more than one property and sell them in the right sequence
Obtain and listen to the advice of professionals who know the rules (real estate brokers, 1031 Exchange accommodators, CPAs), not "somebody at the title company"
Capital gain is not related to how much the loan is on a property; it is calculated from the cost basis not the equity
Occasionally sellers choose to pay capital gains taxes because they have plans that do not allow for an exchange. This decision should be made consciously and should never be a surprise tax bill
