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

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.