Ep 119 How to Defer Your Capital Gains Taxes When You Sell Your Short Term Rental” with Bill Exeter

Dear hosts, I know that a lot of you are just starting out on your journey of Airbnb hosting; and the last thing you’re thinking is of selling or expanding your empire. It's 2020 and life happens, at the beginning of the year, I didn’t think I'd be selling, but here I am which is one of the reasons for today's episode. In today’s episode, we’re going to discuss “How to Defer Your Capital Gains Taxes When You Sell Your Short Term Rental.”

Are you scratching your head yet? Let’s start at the beginning, you bought your home or vacation rental, you started renting on Airbnb or VRBO. Now you want to sell because your property has appreciated in value. Yay.

It means you have to pay taxes on that capital gain. Boo.

Depending on your market, those taxes can be as high as 35% of your gain. Double boo.

If you want to buy another investment property and turn it into a vacation rental or diversify your portfolio into long-term tenants, you can defer that capital gain with a 1031 exchange. Mind you I say defer—not completely forget.

Who is Bill Exeter?

There are tons of rules and regulations, which is the reason I brought in Bill Exeter, Chief Executive Officer of Exeter 1031 Exchange. Bill has been doing exchanges for 0ver 36 years and has administered over 100,000 of them throughout his career. His company is one of the few qualified intermediaries that have any kind of government oversight.

In How to Defer Your Capital Gains Taxes When You Sell Your short term rental, you’ll learn the importance of this and much more. We’ll answer questions like:

  • What is a 1031 exchange?
  • Which rules and regulations do I need to follow when doing a 1031 exchange?
  • The dates that I have to hit (Trust me – that one is important — you miss them and you have to pay those capital gain taxes.)
  • Can I do a 1031 exchange if I also live in my home? (Yes, we answer that question.)
  • And finally, how do I protect myself and my funds?

Whether you’re thinking about selling now or in the near future, How to Defer Your Capital Gains Taxes When You Sell Your short term rental is the episode that will answer all your big questions — even the ones you didn’t know you had.

Evelyn: Bill Exeter. Thank you so much for being part of the hosting journey podcast. And for joining us in this one big episode, all about the 10:31 exchange.
Bill:  Thank you. Glad to be here.

Evelyn:  I know my people are talking about it and we're going to start. And before this, I'm going to do the introduction about how much you have done on 10:31 exchanges. So you and I don't have to talk about it. So let's talk about what is a 10:31 exchange and you know, how can someone that is selling an Airbnb? Like, let's start the story with the beginning.

 

Bill: Sure! What probably a perfect example is you have someone who buys one property and they get into the Airbnb business and they really like it. And they get to the point where they think, “Okay, it's time to sell this one and maybe buy two or three” and increase the number of units that they have and increase their cash flow. And then they often meet with their CPA, or at least hopefully they meet with their CPA. And that's when the CPA tells them how much taxes they're going to pay. And that's usually a shock. And then once they get past that, they realize, hopefully the CPA so it tells them, “You can do a 10:31 exchange to defer all the taxes”. So going back to the one property, they bought it and it's gone up in value. Now we have this capital gain and they've depreciated. So we have depreciation taken on the unit and they're going to sell it. The capital gain and the depreciation is deferred into the future by doing a 10:31 exchange. And that means that they're going to reinvest in other in rental or investment or business-use property. So in this case more Airbnbs and probably two or three or four units instead of one. So they're diversifying into multiple units and maybe even the different geographic areas, etc, all on a tax-deferred basis. So it's really designed to allow them to sell, do a 10:31 exchange, keep all of the money in their pockets. So instead of paying federal and state taxes, everything is in maintains their investment in their pockets so they can buy more units, etc, and not lose half or a third of their profit to the government.

 

Evelyn: Yeah! Because the reality is to house depending on the state where you live and all of this. And, and I want to be very clear. We're not giving you any advice right now. This is not this show. You need to talk to your CPA. All right, this is informational. This is very informational. And a lot of this, one of the reasons why I've decided to do this episode is because I am going through a 10:31 exchange. That's how what I'm doing when I'm selling my house in New York. And what I want my people to know is this —- if you're selling your primary residence, if it's your home, you cannot a 10:31 exchange because you're doing it, it your primary residence. But, if are doing, (which is something that I'm doing) my primary residence also has an Airbnb. It also has an investment part in it. I can do that investment part can be deferred as a 10:31 but my primary residence does not have to be, it cannot be deferred. So I have to pay capital gains taxes on that other part. So I want to be clear about that because you know, people might think like, “Oh, but I can do that with”, because a lot of people do their primary residence as Airbnb.

 

Bill: Absolutely, NO! The primary residence portion falls under section 121 of the tax code or what we call the 121 exclusion. So f they're single, they get 250,000 in capital gain tax free. Or if they're married 500,000 in gain tax free, as long as they've lived in it for two out of the last five years. So that would apply just to the primary residence portion of the property.

 

Evelyn: Yes. And are there any criteria for the investment portfolio part?

 

Bill: Yeah, that's a good question! That we get a lot of that. It's what we call split use property because parts that part of your primary residence part is of investment property. And a lot of people get really hung up on how long has it been used as a rental investment or business use in this case, Airbnb. And you know, the code and the regs have no holding period required. And that's where people get so confused because one person says “you have to hold it for at least a year”. And another person says “a year and a day” and somebody else say “two years”. And then people call us and say, “I don't get it. What is it?” And then the real issue is you have to prove that you had the intent to hold for rental purposes. So if you get audited, can you show that, you know, X percent of your property was used as an Airbnb, and that was truly your intent? Well, usually if you've used it as an Airbnb, you've got plenty of records and documentation and rental income, etc. So you can prove that that was your intent. So there's really no holding period required. It's all about what was your intent? What did you actually do with the property? And obviously the longer you hold it as an Airbnb, the easier it is to prove that was your intent. So that's where the timing comes in, but the timing is not a requirement. It just helps prove the facts.

 

Evelyn: Yeah. And so, and in my case, I've been doing 10 years of Airbnb and it's reported in my taxes as well. And so our old expenses and everything else.

 

Bill: Yeah and 10 years is fantastic. I mean, we're usually say if we've got a year and it's a plain vanilla transaction, you're okay. If you're pushing the envelope a little bit, or if it's a split use property two years might be good, but 10 years is you're in great shape.

 

Evelyn: Yeah. I mean, And dear host think about like, let's say for example, you might have a two family home, or you might have a casita in the back that you're using as your Airbnb and you have the primary residence. If you sell your home, you could take that primary… that gain for yourself — that $250,000 if you're single and the $500,000, if you're married. But then if you're going to buy another property for investment now for primary residence for investment only, then you could use part of that and defer the capital gains taxes. And what I do want you guys to think about is not that those capital gains taxes will ever go away, right? Bill?

 

Bill: Correct! They're just deferred as a tax deferred exchange, not tax-free.

 

Evelyn: Okay. Will that ever change? Can that get deferment ever changed to be tax-free like, if you hold onto that property, let's say for two years, and then moved into it. If it was a, let's say a vacation rental for two years, and then you decided to retire there and moving, can it become your primary residence?

 

Bill: Good point! Yes! It can be a yet be carefully. The initial intent has to be to hold for rental purposes, but intent can always change. So if you rent it and hold it as an Airbnb for say two years, which will straddle three tax returns, that's really strong proof. That was your intent. So after that, you could certainly change your intent and move into it as a primary. The other thing to keep in mind is — if you let's say you don't convert it to a primary residence, you just exchange it. You hold it as an Airbnb and you keep exchanging and maybe keep expanding the number of Airbnb units you've got, etc. When you pass on and you leave the, all of your real estate holdings to let's say your kids or your grandkids, or whoever you choose to leave the property to, at that point, they generally will get a step up in cost basis. That means that the capital gain tax goes away, the depreciation recapture tax goes away. So it's tax deferred throughout your lifetime. But if you hold it until you pass your errors, we'll get that step up in cost basis. And that's when it becomes tax-free.

 

Evelyn: Really? So it will be tax free too. But then don't, they have to pay taxes for your, Oh my God, what is it called? Do death taxes?

 

Bill: I believe it's a state tax? Yeah, death taxes. So, the reason you get that step up is let's say you bought a one Airbnb for a hundred thousand, and then, over the years it went up in value now it's worth 500,000. And you pass on the, the heirs that inherit that property, their cost basis is stepped up or increased to the fair market value at the date of death. So if it's worth 500,000 at death, their cost basis is increased to 500,000 and reason for that is what you just pointed out. And that is the value of that property. — the 500,000 is included inside their estate for estate tax or death tax purposes. So they can't double tax you, they can't tax you on a state tax and capital gain tax. And most of us will never pay a state tax unless you're, well, at least under current tax law, you know, you've got like $24 million in value. And unless your estate exceeds that, you'll be fine as a couple. You won't pay any estate tax and then you also get the step up in cost basis. so becomes tax-free.

 

Evelyn: Okay. Alright! And I'm going to say one more time, guys. You have to find some good CPAs, some good accountants, because this is so important for your planning, your estate planning.

 

Bill: Very true!

 

Evelyn: Yeah… You have to know.

 

Bill:  It's amazing that there's a lot of CPAs, you know, they specialize so you need to find a CPA that really specializes in real estate and that real estate tax related items. Cause a lot of them, don't focus on real estate and real estate is a very specialized industry.

 

Evelyn: Yeah, yeah. Believe me. I'm in the moment right now researching finding me a new CPA because, my last one had passed away a couple of years back and whatever. And it's a task, and not a fun one. Okay! Let's continue… because there are very specific rules, let's say. So you have your vacation rental that you're selling that you have decided, “You know, I just want to sell this is it… I am moving to another state and I like managing my properties close to the chest. So I want to move those properties there, nd I'm going to do a 10:31 exchange”. Let's talk about all the rules and regulations because they are many of them.

Bill: True! The real key ones are really kind of three or four. One is you have to have the 10:31 exchange in place before you close on your transaction. So as long as you've got the 10:31 in place and the qualified intermediary lined up and all of the documentation has been completed and ready to go before closing, then you're in great shape. If the closing occurs without the 10:31 exchange in place, unfortunately it's taxable and there's no way to go back and fix that. So always make sure that the 10:31 is in place before closing. And then you've got some timeframes as you pointed out to worry about. So when the closing occurs and the closing is what triggers the timeframes, so if you close today, let's say tomorrow's day number one. And you've got exactly 45 calendar days to identify what you're going to acquire. That's the most stressful part of the 10:31 exchange. Because 45 days is about six weekends. It moves very quickly…

 

Evelyn: Yeah, Especially…

 

Bill: After that 45 day window. Oh, I am sorry, go ahead.

 

Evelyn:  Oh, I'm sorry. Especially in a market, like right now, the properties are on the market and they're selling in a day. It's like, “You don't have time to be like dilly dallying, like….

 

Bill:  Yeah, that is very, very, very quick. And a couple of facts there too. You know, a folks will call us and ask, “Well, can I buy first? If I find the right property, then buy first?” And you certainly can! It's a reverse 10:31 exchange. Those are a lot more complicated and more costly. And if there's a lender involved, they don't really like reverse exchanges. But there's a couple of ways to approach it when you're selling your current property. If you can find a buyer who's willing to give you a long-term close, maybe 90 days, 120 days or more, or if they'll give you, you know, a number of 30 day options to extend, as long as you haven't closed your deadlines don't start running…

 

Evelyn:  So…

 

Bill:   Sorry, go ahead…

 

Evelyn: No. Well, okay. And I'm sorry, Bill to interrupt, because right now I'm in the middle of my closing.Bbut I feel like, look, I don't have the money to put a down payment on anything else. Right?

 

Bill:  Right!

 

Evelyn:  And the reality is that for me, it's like properties that are available will not be available when I close. They will be gone.

 

Bill: That's true. That's very true! And that's one of the risks cause you identify, most people use the three property rules, so they identified three properties. And historically, the reason for that is you identify three, probably with the intent to buy one. And then the second and third are backup. And as you pointed out in today's market, the second, third property are properly long gone. So the backup strategy doesn't work anymore.

 

Evelyn: And what happens if you have to buy more than one, because you have a big capital gain.

 

Bill:  Good question! So there's a couple of ways to do it. Some people will sell one property and buy one property. That's a larger property. So maybe they sell one unit and buy a fourplex. So it's a one for one, others may sell one property and want to buy a whole bunch smaller assets. You know, like a client I talked to me yesterday was selling here in California, buying in Tennessee. And on a tennessee, he was buying a whole bunch of single families at 20, 30, $40,000 a pop. So in that case, you're going to use the 200% roll. So you can identify as many properties as you want up to two times or 200% of what you sold. So if you sold for million? 200%, it would be 2 million. You could identify $2 million worth of property. And he identified all a lot of single families. So that makes it more challenging. But that's one way to do it. If you want to diversify your portfolio is to use the 200% rule and buy a lot of smaller assets.

 

Evelyn:  Yeah, exactly! So it's not…. Oh, and then another thing is this, please let them know that if you're selling your short term rental, it's not like you have to buy another short-term rental. It could be that you could buy a multi-family. Right?

 

Bill:  True! Absolutely!

 

Evelyn:  Like it doesn't have to be a just short-term rental or you could buy a single family that you're going to rent out to a long-term tenant. You just have to be incline, right?

 

Bill:  Exactly! That's a good point because a lot of people interpret like kind property as condo for condo or Airbnb for Airbnb. And that is not true. You're exactly right! Like kind literally means you're selling real estate. You have to buy real estate. You just have to re-invest in other real estate. And as long as it's some type of rental investment or business use, it will qualify for qualified use and light kind treatment. So it's wide open, including things like water rights and air rights and mineral rights, oil and gas interests. Those are also considered to be real estate and you can exchange into, or out of those as well. So there's, it's a very broad definition.

 

Evelyn:  Yeah. I think, and the law just changed not that long ago, right? Because there were other, they made it a little tighter.

 

Bill: They did. Yeah. The tax reform act of 2017, eliminated non real estate. So before that you can do 10:31 exchanges on real property, but you could also do it on anything else. Like, chipping trucking, machinery, equipment, livestock, etc. The tax reform Act eliminated anything that was not real estate. So now you can only 10 31 exchange real estate to real estate.

 

Evelyn: Really? So, let's say if you… I thought that it was just like, it could be… like could they do 10:31 exchanges for incline? Like, let's say if I'm selling, you know, cows, can I buy another kind of animal?

 

Bill:  Yeah. Typically you could, we did a lot of exchanges on different herds so cattle and what have you. Typically it would be something like, it would be cows, maybe Jersey made as the breed and they would go to a Holstein or something like that. So it'd be a herd for a herd. It does have to be very specific when it terms of non real estate. So light kind was very specific. We would do a lot of aircraft exchanges, things like that. We did a lot of the large trucks, a lot of shipping boats and vessels, things like that, but that was all eliminated. So now it's just real estate for real estate.

 

Evelyn:  So all of that was eliminated. Oh, they must be so pissed!

Bill: Yeah, it was, it was kind of a frustrating process. There was three or four exchange companies that did nothing but personal property. They didn't do real estate. So they obviously had a very difficult transition because they, everything they just did were just wiped out. We were 99 point, but a basically 99.9% real estate. So it didn't really affect us.

Evelyn: Okay…All right. So I'm sorry. Let's go back to the rules of time because that's really important. So we have the first 45 days. So we have 45 days.

Bill:  Exactly! Then after the 45 day window, you've got an additional 135 days to actually complete the 10:31 exchange. So that means you have to purchase and close on the new purchase. And that's a total of 180 days. So a lot of people think it's 45 plus 180 and it's NOT! It's 45 plus an additional 135 days for a total of 180 days, which includes your 45 day identification period.

Evelyn: Yes! Now, and what happens because I imagine it must have been happened if those properties that you identified go “bye-bye”, and you cannot buy any of them.

 

 
 
 
 
 
Bill: Good questio! It does happen. Absolutely. In fact, we track it. Historically, meaning historically don't count recessions and COVID-19 and things like that. But historically in a normal market, we've had about 8% of the exchanges for some reason don't go through. So it could be that you've identified three properties and then you're doing your due diligence and you decide they're not right for you. So if you're still in your 45 days, you can change your mind and identify other property. But once you pass that 45 day window, you can't change your mind. You can't identify other property. You have to acquire something on your identification list. And if you can't, then unfortunately exchange fails, it becomes a taxable event. So you just report it as a taxable state sale instead of a, a tax deferred exchange.
Evelyn: Okay. So then that means you are paying taxes.
Bill:  You just pay taxes. No we're coming up on year end. So it does give investors an interesting prospect, which is, let's say your, your sale closes today and we're in November. And, for some reason you can't complete the exchange, you identify property, but you just can't buy them for some reason. That means under the treasury regulations, you can't have access to your funds until the 180th day period passes, which lands next year. So it actually pushes the capital gain tax into the following tax year, under certain circumstances. So even if your exchange failed before you just grabbed the cash and say, “Okay, I have to pay tax on it. Talk to your qualified intermediary and find out when you have the right to the funds. And that's the year in which you're going to actually pay taxes. And if you, if it's structured properly, you can actually defer the tax at least for one more year.
Evelyn: Really? Oh, well, well, well, okay… Now! Something that I just heard from one of the CPAs that I'm interviewing was that she said that “If you do not buy property the intermediary, (which of course I'm poaching the word, thank you very much people) and buy the 10:31. It's just going to cost you more money”. I mean, like I have no idea what that means, correct me please.
Bill: I'm not sure what they meant. So they said they can buy the 10:31?

Evelyn:  Yeah. Like, like it could be held. Like, it doesn't mean that you… I don't know. Tell me, tell me, talk to me, bill. I'm concerned.

 

Bill:  I'm not sure what you're referring to because you can, you can't extend the deadlines or anything like that. So I'd have to know more details as to what the CPA was talking about. It doesn't make any sense for me.
Evelyn: Okay. So, okay. Can you for by any chance you cannot find properties is the only option going to be, to pay taxes, to buy the capital gain taxes. Is that it? There has to be something.
Bill:  No, it really failes at that point beause you can't complete the 10:31 exchange. You know, there are folks out there who have, various strategies they think or say “It will save your 10:31 exchange”. We've looked at most of them. We don't think they qualify. You know, I think the fact that once you've gone through the 10:31 and you have the right to the funds because you can't acquire the properties, it's a failed exchange and it's taxable. Anybody who says, otherwise you just have to have your tax advisor, look at the, whatever they're looking at and, dig in and just to protect yourself, it's kind of buyer beware.
Evelyn:  Yeah. And guys, buyer beware. Alright. Now you have your 45 days, you have 180 days all the time you guys are holding onto the money. The money is somewhere somehow. What can a person expect? Me, the seller.
Bill:  Yeah! And the first thing, when you, when you asked that question, the first thing that came to mind is, most people don't talk about this, but it's important. So you, as the seller, you know, as you're choosing a qualified intermediary, those are the questions you want to ask. Number one is a qualified intermediaries are holding a lot of money for a lot of clients. So how do you protect yourself? How do you protect your funds? How do you know they're, they're safe and they're insured, etc. So those are questions you want to ask. Very few qualified intermediaries have any kind of government oversight or regulatory oversight. It's in fact, it's less than 1% of the qualified intermediaries out there. The 10:31 industry doesn't have any agency that looks over them. There's no ability to get licensed unless you go down a different path. So that I think that's key is to make sure that you have an entity you're working with that is somehow governed or regulated by an agency. So we went down that path…
Evelyn: And how can you check that?
Bill:  Yeah, you can, I would ask them, “how are you licensed, regulated, etc” if they are, most of them are not. In our case, you know, we recognized that a long time ago, we went down a number of years, took about two years of going through regulatory review and approval, to get a trust company charter. So all of our client funds now fall into our trust company. And that means that they're licensed by the division of banking. They're regulated by the division of banking. And we get an annual audit by the division of banking. And most of the failures I've seen out there over the years would have been avoided. Had there been some kind of government oversight. So it's, I think the government oversight is number one, the most critical part to make sure somebody's watching over the qualified intermediary shoulders. And then you certainly want to check, you know, fidelity bond and errors and omissions insurance to make sure you're covered there. I think another really important issue is to make sure your funds are held in a qualified trust account or a qualified escrow account. That way their funds are clearly designated as client or trust funds. A lot of exchange companies hold them in their corporate name and it's okay at qualifies to do that. But if there's a bankruptcy filing, for any reason, the judge will rule their corporate funds, not client funds. So that qualified trust account is critical.
Evelyn: Oh my God, that's so scary.

Bill:  It is. It's very very scary!

 

Evelyn: Okay, you are just like scaring me. Alright! So what else? So we need to make sure that whoever we're dealing with… I mean, and how do we find them? Because my person was recommendation from my lawyer.

 
Bill: Get a recommendation from your attorney or your CPA, or you know, somebody you trust. So that's a good start because that way, you know, they've worked with them before and they've got a track record in terms of the regulatory, background, you know, find out who their regulated licensed or over who, who has the oversight over them. And then you can check with the government agencies. So in our case, it's the Wyoming division of bank and you can actually go to their website and you can look up the fact that we're licensed by the Wyoming division of banking. So you can check on things like that. I would ask, absolutely ask for a copy of their fidelity bond and their errors and omissions insurance and call the insurance agent to make sure it's still in full force and effect. You know, people can document, a fidelity bond or an insurance policy, but it may not exist. So call the agent to make sure it exists that's also critical. And then find out, you know, under the qualified trust account, get a copy of the trust agreement, find out who the trustee of the escrow agent is and make sure that they're truly licensed and bonded, etc.

Evelyn: Wow. You see, I would have never thought about that. Isn't that amazing?

 

Bill: There are lot of people would just assume that our industry is licensed and regulated. They said, think we're just like a bank or trust company or an app company or something like that. And we are not.
Evelyn: Basically, so what you really say is that you can put on a little single and say I'm a 10:31.
Bill: Yep! Absolutely. In fact, I was talking to competitor about a month ago and there was, two individuals they hired a young guys. And they worked for them for five months and then left and started their own qualified intermediary. And that's the scary part because people can just walk away five months later, start their own company. They really have no idea what they're doing. They have no experience. They haven't made mistakes yet. And unfortunately, clients the one that'll pay for them.
Evelyn: Okay, wait, wait, what are the mistakes now? I want it.
Bill: Well, most of them is going to be somewhere in the documentation and you may not even see it until under audit. And then under an audit. That's when you're going to find out if there's any errors, did they really know what the transaction was all about? Did they assign the right document to the qualified intermediary? Does their exchange agreement qualify under all the different IRS requirements and the state requirements? There's just a lot of stuff that if you look at it, you wouldn't even know that it's a problem until audit.
Evelyn: Okay. All right! So you did the 10:31 basically do your due diligence, my people. So let's say you're about to sell your home and you decide, “Oh my God, yes. I'm going to do my 10:31” and you're not closing yet. You're about to, but not yet. And you're going to go ahead and do it. What steps can they do beforehand? Like they find out all of this, “Yes, my person is good they are good people”. What else do they need? What does the person like? Because one of the biggest things that I was asking you, and thank you so much for, for coming and telling me, we were talking about the basis. Like, what is the basis that they decide what's the capital gain? Can we talk a little bit about that?
Bill: Good question. Yeah. In fact, a lot of people kind of group, a lot of different formulas together and they get the formula for the taxable gain, confused with the formula for equity. And so really from a 10:31 exchange perspective, the equity is one of the formulas we care about an equity is if you close on the sale, how much cash are you going to end up with in your pocket? That's your equity or your proceeds or your cash. And all of your equity has to be reinvested in new property that you acquire to qualify for a 100% tax deferred exchange. The basis doesn't really come into play from a 10:31 exchange perspective, but it does have to be calculated and accounted for. So your basis is, you know, years ago, let's say you buy your first Airbnb and you pay 500,000 for it that's your original cost basis. And then over the years, you start to depreciate that you write off a little bit on your tax return as a depreciation deduction every year. So that 500,000 starts to shrink every year. So your basis is going down. Then let's say you make some improvements to the Airbnb. In that case, you're going to take whatever your adjusted cost basis is and add whatever the improvements are. So maybe you add a hundred thousand to that, and that's going to be your adjusted cost basis. And then when you sell, let's say you sell it for a million dollars. You take a million dollar sale price, you subtract your closing costs, and then you subtract whatever your adjusted cost basis is. And that's your taxable gain. That's how much you would pay tax on if you just sold and cashed out and paid tax, or it's also the amount of gain that will be deferred if you do a 10:31 exchange,
Evelyn:  My God. Okay. Okay. Okay. Okay. Wait, wait, wait, wait, wait, wait, wait, wait, wait.

Bill: That was a lot of information fast.

 

Evelyn: I know and my brain. And my brain is like “Did I complete that” Okay. And in my brain did I complete this and believe me dear host. I have been working on my 10:31 for months. I like looked at numbers, talking to people and I still get all confused about this. And I'm a smart, I am not dumb, I'm a smart girl. I bought for $500,000. I spent a hundred grand. I sold for million if I don't. And let's say, my closing costs are $50,000. Right? So realistic. My closing costs are $130,000 really. So now I have $650,000. Right? But I have been, depreciating through the year still. Right?
Bill: Exactly. So part of that 600,000 has been written off over the years.
Evelyn: Okay. So that has to come back into the formula, the depreciation.
Bill: Yeah! If you just sell the property and decide, “I'm not going to exchange, I'm going to pay tax”. And that acts absolutely comes back into the formula. So the government's really telling you that, every year we allow you to write off part of the cost to shelter your income. But if you sell and cash out all that depreciatio that you've taken as deductions over the years and all gets added back to your income or what they call depreciation recapture. And it's all taxable again. So if you don't exchange all that depreciation comes back and gets taxed on top of the capital gain tax. So you really have different categories. For example, you use — you sell for a million, you subtract the $50,000 closing costs. You're really your net sale price is 950. And if you've got, adjusted cost basis of 600 ignoring depreciation, you've got a $350,000 capital gain sitting there. So that's taxes, capital gains. And then whatever portion of that, 600,000 was written off as depreciation that gets added back as depreciation recapture. So it can be a big number if you've had the property for a long time.
Evelyn: Yes. Like in my case 16 years.

Bill: Yep. You've probably written off, more than half of it. So it's a, it'll be a big bite.

 

Evelyn:  I know, I know. I'm so scared about my, but it's okay. We're going to come out on the other side. That's why we're doing this smartly the smart way. Okay. So, so I know my people are going to be confused. What do you think they might, we can clarify for them that will make this easier besides calling you?
Bill: Well, the tough part is the depreciation taken over the years and your adjusted cost basis. Now a lot of people just don't track that. And so hopefully their CPA is. And so the easiest way to do that is just call, your tax advisor and say, okay, as of today, what is my adjusted cost basis? And that's going to be your net cost basis for tax purposes as of right now. So that means all of the, whatever you paid for it originally in any improvements you've put into it minus any depreciation that you've written off, that's going to be your adjusted cost basis. So hopefully they've got a whole spreadsheet and they can just kind of say, okay, your adjusted cost basis is X.

Evelyn: In 16 years. I've had like a zillion accountants.

Bill: That's always one of the challenges.

Evelyn:  Okay. So do I have to just go back to my taxes? Will it be in there?

 

Bill: Well, it should, each tax return should pick up where you left off, should pull in the old stuff and then should add the current year. So your current tax return, if it's done properly, should have all that information that you need and should have the adjusted cost basis in your current tax return.
Evelyn:  Okay. I think I have that. basically be current with your paperwork. Okay. Alright. All right. And now what, because you going to be buying properties, maybe one maybe more, and you could include some of those expenses as well, right? Not just the purchase price.
Bill: Exactly. So when you go out to buy property, we call it the routine purchase expenses. So your broker's commission, if you pay any title insurance, if it's an owner policy, escrow or closing attorney fees, a documentary transfer tax, things like that, or that are routine purchase costs would be added to the purchase price of the property,
Evelyn:  But not the intermediary cost. That's not…
Bill: The 10:31 exchange fee would also count that usually comes off on the sales side. So normally when you sell your current property, you can deduct your routine selling expenses. And one of those is the 10:31 exchange intermediary fee.
Evelyn: Okay. Okay. Alright! Well and dear host, I get it! This has been that there's a lot of information about 10 31. And I want you guys to just really think about it, right? Oh, and let's talk about boot. Let's talk about that because, because let's say for example, you have $500,000 in capital gains, but you don't want it, you don't want to invest it all and you don't have to, so bill take it away.
Bill: Sure! In fact, that's an excellent point because a lot of the websites and brochures and things you read says, you have to trade equal or up in value and you have to reinvest all your cash. And so people just think, “Oh my God, I have to do that”. Well, if you don't, it doesn't mean your 10:31 exchange fails. It just means maybe you're trading down in value. Maybe you sold for a million and you re-invest 800,000. So you trade down by 200,000 or in a lot of cases in the real estate world, people are real estate rich and cash poor. So maybe they think I need 50,000 in cash or a hundred thousand in cash. So I sell for a million. I buy for a million, but I get a bigger loan. So I ended up with cash leftover. So we pulled cash out. Those are okay. It just means that you, you still have a good 10:31 exchange, but you've traded down in value. So in that first example, that 200,000 would be taxable. It's all applied to your taxable gain or in the second example where you pulled out a hundred thousand cash or 50,000 in cash, the cash would be taxable. Everything else would be tax-deferred. So it doesn't hurt the exchange. And a lot of people do it on purpose all the time because they needed some liquidity or they just want to trade down and get rid of some of their debts.
Evelyn:  Yeah! So what you have to remember is this, let's say you need $200,000, right? But, you're going to have to pay taxes on that $200,000. So if you need $200,000, take out more to include the tax that you're going to pay, you're going to have to pay taxes. And it's normally what, like 30% or more depends on where you live.
Bill: Federal and State depends on where you live, but it could be like I'm in California. So it's probably more like 35%. It's ridiculous. But it just depends. So yeah. Take, take state into consideration. A lot of people forget to take the state into consideration. There's probably a state tax too that is living a tax-free state.
Evelyn: And what about city?
Bill: The city sometimes like in New York, they do have some New York taxes you have to worry about. So certainly looked at that.
Evelyn: Yeah, me.. And so, and now dear host, if you're thinking about reinvesting your money, you might want to re-invest in a state that does not have taxes. That all you paying are income taxes and not, you know, that you're paying federal taxes and not state taxes. So think about where do you want invest next and consider that because for me in New York, for me to pay capital gain taxes is 35%. If not more, it's a lot of money. Look and I'm not into, I'm not one with SSL. I should not pay taxes. I'm very okay with paying taxes. But we do pay taxes also. It's not like we don't and everything else. It's just like, okay, come on.

Bill: True! You just don't want to pay too much in taxes. It's a painful experience.

 

Evelyn: It's okay or joyful. It depends… It depends… You know, and especially like, look, in my case, I'm not selling because it was my choice. It was more because the city, um, decided to, to do certain things with Airbnb and they just banned us all of this the regular rules and regulations just were against us. So Michelle, that for me was like between that and COVID and everything else, it just wasn't worth it. It wasn't worth it to continue doing it. And there's a lot of equity in the house. Anything else that a person should know or should ask?

 

Bill: I think, probably the one thing we haven't covered would be kind of qualified use and we've kind of touched upon it, which is it has to be rental investment or business use, but you get folks who also intend to buy property, fix it up and then sell it or flip it. And you get folks who are developers, they buy, they build these sell. So if, the investor is really in the business to buy and then build or rehab or convert, and then sell? They're really holding for sale, they're not holding for investment. So it doesn't qualify for 10:31 exchange treatment. So it really needs to be someone who intends to buy and then do anything where they buy and hold, buy, and develop, buy and rehab, etc. But they, whatever they do after they're done doing it, they hold it as rental property or investment or business use. And then I qualify it. So it's all about the intent to hold for investment, as opposed to the intent to hold for sale.

 

Evelyn: Yeah. How long do they have to hold it?
Bill: Yeah, that's the problem is the code and the regulations have never defined how long they say you have to have the intent, but they don't tell you what that is. I think they do that on purpose because it's easy to get around the rules if you just say, Ookay, I got to hold it for a year and a day”. So if you get audited, they're going to look at the intent. They're going to look at documentation. They're going to look at contracts, emails, etc, and look a what was the real intent? And the intent was to buy and rehab in the cell or flip it. They're going to disqualify the exchange. But if you can show the intent was to buy and rehab and hold it, then you'll be in great shape. So, you know, most advisors recommend at least a year, if you're rehabbing or maybe there's going to be some personal use down the road, I do at least two years as a rental with straddles three tax returns. The longer you hold it as rental or investment, the safer.
Evelyn:  Yeah. Yeah. And what you have to also remember dear host that if you go into buy another property that you want to use for your own, as a vacation rental, you could only use it for 14 days out of the year. Nonetheless, if you go into the property and you're going to do maintenance in the property, you could do that. And that does not account for the 14 days. Am I right?
Bill: That's true. Yep. Yeah. You just don't want it to be, I've had people say I moved in and lived there for three months to rehab it. It's like, yeah. I don't think the auditors are going to buy that one. But if you live in it for a couple of years, a couple of weekends or a couple of weeks, or what have you to fix it up, that's probably very, very easily to explain it.
Evelyn: Yeah. I mean, but, but like, Bill, the reality is like, it could happen because I mean, construction happens all the time and I mean, like, it always feels like whatever I go back someplace, it's like, “Oh my God, I'm fixing. All I do is fix”.
Bill: That's true. It's a never ending battle.
Evelyn: I know it is. It is, but it's okay we still love it. Anything that, that we should… Anything else? My dear bill, what can they reach you? Do you want them to call you? Are you like, “Oh my God, I am too busy”
Bill: Sure. Yeah. Oh no, I'd be happy to chat. And you know that what we've found is there's just a lot of confusion out there because a lot of people give their opinions. And then people say, well, I talked to this person, they said one year, and I talked to that person. They said two years, what is it? So there's a lot of that going on. Totally be happy to chat, walk through the transaction, answer any questions they might have, not a problem so they can reach me a couple of ways. They can call me direct. Are I'm in the headquarters office in San Diego. And our number here is area code (619) 239-3091. Again, that's (619) 239-3091. They can email me if they like at [email protected] or go to our [email protected] It's got all of our office locations out there, etc.
Evelyn: And I'm going to have all that information on our show notes. So no worry about that. And bill again, thank you so much for all that information, because I know, when we started the process of starting a short-term rental, we never think that we're going to sell it. Right. We don't think about the answer. Right. We were thinking about the beginning. But the reality is that like, in my group, in the Facebook group, that helps in journey. There's so many people going through this process right now. That is like, it's amazing. And I don't know if everybody's doing 10:31 so now, but a lot of them are, so, thank you so much!
Bill: One of them are doing 10:31's. Absolutely. And you know, when they go into buy one, one of the questions they should ask themselves. And very few people do, but they should is what's my exit strategy. And that way you can kind of plan ahead. Most people, like you said, they go into the beginning, but they don't think about the end till later.
Evelyn: Exactly, exactly. Yeah, exactly. Because, Hey, buy my house thinking I was going to be doing Airbnb. I've got it because it was my house. It happened.

Bill: It's true!

Evelyn: Like, you know, 2020 has happened. Again, thank you so much, bill.
Bill:  Pleasure. Thanks so much. Take care. Okay!
Evelyn: Bill, that was good. Anything that you feel we needed to have it? I'm going to have your info on my show notes.
Bill: Okay, sure! I'd be happy to chat with anybody.

 

I understand that all this new information can be overwhelming and a bit daunting, but we need to be informed so we make the best decisions for our business and life. 

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