Our Rental Tripled in Value—Here’s How We’re Using a 1031 Exchange To Avoid a Massive Tax Bill

Key Takeaways:

– The author and their husband bought a condo in a rough neighborhood in Brooklyn when they got married.
– They rented out the condo after they moved to the suburbs and had children.
– The condo appreciated in value significantly.
– The author learned about the benefits of a 1031 exchange, which allows them to defer capital gains tax by trading their property for a like-kind property.
– They need to find a new property of equal or greater value within a specific timeframe.
– The author is building a team to help with the exchange, including a real estate agent, lawyer, and third-party to manage the transaction proceeds.
– They are starting to research potential investment locations for their new property.
– The author will document their journey in a monthly series throughout 2024.

BiggerPockets:

When my husband and I got married, we bought our first place—a brand-new, 1.5-bedroom condo—in Bedford–Stuyvesant, Brooklyn. At the time, the Bed–Stuy neighborhood was rough—for example, a biker gang that loved to throw huge all-night parties was headquartered at the end of our block, and there were abandoned buildings every few feet, often rustling with the sound of homeless inhabitants. Back in the early aughts, this ZIP code was not for the faint of heart.

But at $375,000, a solid C-/D neighborhood was what we could afford in NYC, and our place was new and huge (for Brooklyn) at 1,200 square feet. Plus, I had a hunch. When we first toured the apartment, I went up on the roof and looked out over the neighborhood. From that vantage point, I could see three luxury buildings going up within a few blocks of us. I knew this neighborhood was about to change.

We loved our place and lived happily there for many years. Then, two kids, one black Lab, and an inevitable migration to the Jersey ‘burbs later, our Brooklyn place transitioned into a rental unit. We had good luck as landlords and very low vacancy rates, renting to excellent tenants who always seemed to be at the same life stage as we were when we lived there: just married and about to have babies—since the .5 bedroom in our apartment made the sweetest nursery.

Our Brooklyn rental, however, never drove significant cash flow. With sizeable monthly maintenance (typical for apartments in NYC) on top of our (fixed, 30-year) mortgage, we pretty much broke even every month. But man, did it appreciate.

Over the last few years, we started to realize that based on this equity growth, we could make much more money with our money. With the 2024 resale value of our condo now hovering around $950,000 and a lot of downward pressure on it going much higher anytime soon (due to a hefty New York millionaire tax that kicks in when the sale price tops $1 million), our $800,000 in equity is not working nearly hard enough. 

We realized that, in this case, we were perfect candidates for a 1031 exchange.

What Is a 1031 Exchange?

A 1031 exchange is a tax-advantaged strategy that allows you to trade like for like and essentially kick the hefty capital gains tax can down the road. In our situation, this would save us a whopping $80,000-plus. 

The gist of the exchange is that you hire a third party to manage the transaction proceeds (if you touch the money yourself, you instantly forfeit the tax deferral benefit and have to pay capital gains taxes), and you are bound by very strict timelines. 

Here are the basic rules:

  • New property needs to be of equal or greater value than what you’re selling.
  • Need to identify the new property within 45 days of closing on the old (you can ID up to three properties).
  • Need to close on the new property within 180 days of selling the old.

The timing is tight, and any misstep means you forfeit the tax advantage and are on the hook for capital gains tax. 

Our 1031 timer starts in May—five months from now, when our current tenant’s lease ends. Between now and then, we’ll be learning and networking and putting in place as much as we possibly can, so when it’s crunch time, we’ll be ready to go.

Building Out Our “Sell” Team

Every month, we’ll give ourselves new tasks and things to research to optimize our position and options. Here’s what’s on tap for January:

  • Interviewing agents to list our Brooklyn property, agreeing on a fee
  • Deciding: Do we need to do anything to the condo before we list it?
  • Interviewing and finding a lawyer 
  • Interviewing and finding a third party to help us with the eventual money exchange
  • Start thinking about where we might want to buy

Next month, we’ll share how we’ll pick our location and narrow down cities for potential investment (all out of state), and we’ll start to think about our buy box. Stay tuned! 

This 1031 diary will be a monthly series throughout 2024, chronicling our journey to a (hopefully) successful and profitable 1031 exchange, which will kick off in May. We’ll share everything—all the numbers, analysis, the good decisions, what we wish we’d done differently, the big mistakes (hopefully not many), and everything in between. 

Got questions? Got advice? What are we missing? Share in the comments below!

Dreading tax season?

Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.

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Property Chomp’s Take:

When my husband and I first got married, we took the plunge and bought our first home—a brand-new, 1.5-bedroom condo in the Bedford-Stuyvesant neighborhood of Brooklyn. At the time, the neighborhood was not the safest, with a biker gang throwing parties at the end of our block and abandoned buildings scattered throughout. However, with limited options in New York City, we settled for a solid C-/D neighborhood that we could afford at $375,000.

Despite the rough surroundings, we had a good feeling about the area. During our initial tour of the apartment, I went up to the roof and saw three luxury buildings being constructed nearby. I knew that change was on the horizon for this neighborhood. We loved our spacious condo and enjoyed living there for many years. But as our family grew with two kids and a black Lab, we eventually decided to move to the suburbs of New Jersey. Our Brooklyn condo then became a rental unit.

As landlords, we had decent luck with finding tenants and had low vacancy rates. Our renters always seemed to be in the same stage of life as we were when we lived there—newly married and preparing to have babies. The extra half-bedroom in our apartment made for the perfect nursery. However, our rental property did not generate significant cash flow. With high monthly maintenance fees on top of our mortgage, we barely broke even each month. Nevertheless, the property appreciated significantly over the years.

Recently, we realized that we could make more money by leveraging the equity growth of our condo. With its current resale value reaching around $950,000 and the potential for it to exceed $1 million triggering a hefty New York millionaire tax, our $800,000 in equity was not working hard enough for us. We determined that a 1031 exchange would be a suitable option for us.

A 1031 exchange is a tax-advantaged strategy that allows you to defer capital gains tax by trading one investment property for another of equal or greater value. By hiring a third party to manage the transaction proceeds and adhering to strict timelines, you can avoid immediate tax liabilities. In our case, this exchange could save us over $80,000 in taxes.

To execute a successful 1031 exchange, there are several rules to follow. The new property must be of equal or greater value than the one being sold. You must identify the new property within 45 days of closing the sale of the old property (up to three properties can be identified). Finally, the new property must be closed on within 180 days of selling the old property. Any misstep in timing or failure to adhere to these rules will result in the loss of the tax advantage.

Our 1031 exchange timeline begins in May, which is when our current tenant’s lease ends. In the months leading up to that, we plan to learn, network, and prepare as much as possible to ensure a smooth transition. In January, our tasks include interviewing real estate agents to list our Brooklyn property, deciding if any renovations are necessary before listing, finding a lawyer and a third party to assist with the transaction, and considering potential investment locations.

This article is the first in a monthly series chronicling our journey through the 1031 exchange process. We will share all the details, including numbers, analysis, decisions, mistakes, and everything in between. We welcome questions and advice from readers as we navigate this complex process.

If you’re dreading tax season or unsure how to maximize deductions for your real estate business, check out “The Book on Tax Strategies for the Savvy Real Estate Investor” by CPAs Amanda Han and Matthew MacFarland. It provides practical information to help you with your taxes and develop an ongoing tax strategy.

Please note that the opinions expressed in this article are those of the author and do not necessarily reflect the views of BiggerPockets.

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