1031 Exchange - Buy Cash or Finance?
Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes
1031 Exchange - Buy Cash or Finance?
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Bill ExeterBusiness Member
1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votesOriginally posted by @Joshua McGinnis:
For a 1031 exchange, you must be buying (exchanging) one property for a "like-kind" property (single to single, duplex to duplex, etc). That said, I don't think that you would be able to 1031 exchange your investment for one or more out-of-state properties.
In general, if you leverage, you can buy more properties and therefore, increase your cash flow.
For example, let's say you have $100K to spend. You could buy one house for $100K all-cash and get somewhere between a 8-15% return in some Texas markets. Alternatively, you might be able to finance 2 or 3 properties with 20-30% down and end up with more cash flow (8-15% * 3 houses).
There are nuances to this scenario, but that's the general idea.
Hi Josh,
The description above regarding like-kind is NOT correct. The Qualified Use requirement means that the properties sold and subsequently bought must be held for rental, investment or business use. The Like-Kind requirement simply means that the investor must sell real estate and then buy real estate. So, to be clear, any kind of real estate qualifies for 1031 Exchange treatment as long as all of the properties satisfy the Qualified Use requirement. The proposed structure above of selling in California and then buying in Texas (or any other state) is perfectly O.K. from a 1031 Exchange perspective. California does have the California Claw-Back reporting requirements, but that's it.
Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews
24 Replies
- Rental Property Investor · Beverly Hills, CA · Member since 2014 · 472 posts · 272 votes11y
For a 1031 exchange, you must be buying (exchanging) one property for a "like-kind" property (single to single, duplex to duplex, etc). That said, I don't think that you would be able to 1031 exchange your investment for one or more out-of-state properties.
In general, if you leverage, you can buy more properties and therefore, increase your cash flow.
For example, let's say you have $100K to spend. You could buy one house for $100K all-cash and get somewhere between a 8-15% return in some Texas markets. Alternatively, you might be able to finance 2 or 3 properties with 20-30% down and end up with more cash flow (8-15% * 3 houses).
There are nuances to this scenario, but that's the general idea.
- Rental Property Investor · Beverly Hills, CA · Member since 2014 · 472 posts · 272 votes11y
Correction - you absolutely CAN do 1031 across state lines.
Per: http://www.1031exchange.com/faq/
You'll just want to check with an accountant to be doubly sure you're in the clear.
- 11yBill ExeterBusiness Member1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
Originally posted by @Joshua McGinnis:
For a 1031 exchange, you must be buying (exchanging) one property for a "like-kind" property (single to single, duplex to duplex, etc). That said, I don't think that you would be able to 1031 exchange your investment for one or more out-of-state properties.
In general, if you leverage, you can buy more properties and therefore, increase your cash flow.
For example, let's say you have $100K to spend. You could buy one house for $100K all-cash and get somewhere between a 8-15% return in some Texas markets. Alternatively, you might be able to finance 2 or 3 properties with 20-30% down and end up with more cash flow (8-15% * 3 houses).
There are nuances to this scenario, but that's the general idea.
Hi Josh,
The description above regarding like-kind is NOT correct. The Qualified Use requirement means that the properties sold and subsequently bought must be held for rental, investment or business use. The Like-Kind requirement simply means that the investor must sell real estate and then buy real estate. So, to be clear, any kind of real estate qualifies for 1031 Exchange treatment as long as all of the properties satisfy the Qualified Use requirement. The proposed structure above of selling in California and then buying in Texas (or any other state) is perfectly O.K. from a 1031 Exchange perspective. California does have the California Claw-Back reporting requirements, but that's it.
Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews - Rental Property Investor · Beverly Hills, CA · Member since 2014 · 472 posts · 272 votes11y
Thanks @Bill Exeter - This is not my area of expertise so I appreciate you setting the record straight.
I had a lender recently tell me that "like-kind" also meant, single fam to single fam, duplex to duplex. Based on what you said, is that not accurate? As long as the other criteria are met for Qualified Use, the "type" of property doesn't matter?
- Member since 2015 · 6 posts · 1 vote11y
Josh and Bill did a great job of answering your question. In case there's any more confusion, check out these videos. They should clear a few things up. @Gustave Stroes
http://www.investopedia.com/terms/l/leverage.asp
http://www.investopedia.com/video/play/gearing/ - Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes11y
Originally posted by @Joshua McGinnis:
In general, if you leverage, you can buy more properties and therefore, increase your cash flow.
That makes sense Josh, but in the long term right? In the short term I'm trying to figure out if the mortgage payments would wipe out the cash flows. So that you have to wait until the loans are paid off before realizing the benefits. If I was 25 then that would be the way to go I think.
I love developing spreadsheets and that's what I should be doing here. I was just curious what others thought. If maybe there were any "rules of thumb" about this type of thing.
- Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes11y
Originally posted by @Bill Exeter:
The description above regarding like-kind is NOT correct. The Qualified Use requirement means that the properties sold and subsequently bought must be held for rental, investment or business use. The Like-Kind requirement simply means that the investor must sell real estate and then buy real estate. So, to be clear, any kind of real estate qualifies for 1031 Exchange treatment as long as all of the properties satisfy the Qualified Use requirement. The proposed structure above of selling in California and then buying in Texas (or any other state) is perfectly O.K. from a 1031 Exchange perspective. California does have the California Claw-Back reporting requirements, but that's it.
Thanks for that clarification Bill. That was the impression I got from our tax advisor also.
- 11yBill ExeterBusiness Member1031 Exchange Qualified Intermediary · San Diego, CA · Member since 2008 · 1k+ posts · 1k+ votes
Originally posted by @Joshua McGinnis:
Thanks @Bill Exeter - This is not my area of expertise so I appreciate you setting the record straight.
I had a lender recently tell me that "like-kind" also meant, single fam to single fam, duplex to duplex. Based on what you said, is that not accurate? As long as the other criteria are met for Qualified Use, the "type" of property doesn't matter?
Hi Josh,
No problem. We have lenders crossing the line all the time. They are arrogant enough to think they can practice tax and provide the wrong advice all the time. It just amazes me! We had a client that had to sue BofA last week to force them to fund their loan. BofA said exactly what you were stating and said that it did not qualify and they refused to fund. this was the clients only identified replacement property and they were right up against the 180th day. BofA finally backed down as soon as they saw the initial complaint filed against them. It drives me crazy.
Exeter 1031 Exchange Services, LLC and Exeter Trust Company4.726 Reviews - 11yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
@Gustave Stroes In the midst of the good counsel being given to you one issue may have gotten lost - Your reinvestment goals. You mentioned the question of buying few for cash or using some debt and purchasing more properties. The issue of like kind and number of properties has been adequately processed but I'm not quite sure what you mean by "netting cash of 1.1 - 1.5 mil". Is the property owned in cash or is there some debt and your 1.1 - 1.5 includes the mortgage payoff?
It makes a huge difference on your 1031 exchange and could leave you with a taxable event. In order to complete an exchange with no immediate tax liability you must do two things - first purchase at least as much as you sell. This means your net sale which is the gross selling price less costs of closing and commissions and before mortgage pay off.
If your net is including a payoff of mortgage and you only invest that cash then the IRS will say that by not replacing the mortgage you in essence took profit "boot" and the difference would be taxable.
Second you must also use all of your net cash in the next purchase or purchases. This criteria doesn't seem to be much of an issue to you since you're talking about using the cash to leverage more properties.
Critical to you is identifying exactly what your net sales price before mortgage pay off is and using that or more as your reinvestment target. The IRS is expecting you to replace the debt with new debt or additional cash from your own resources.
The 1031 Investor5137 Reviews - Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes11y
Originally posted by @Dave Foster:
@Gustave Stroes In the midst of the good counsel being given to you one issue may have gotten lost - Your reinvestment goals. You mentioned the question of buying few for cash or using some debt and purchasing more properties. The issue of like kind and number of properties has been adequately processed but I'm not quite sure what you mean by "netting cash of 1.1 - 1.5 mil". Is the property owned in cash or is there some debt and your 1.1 - 1.5 includes the mortgage payoff?
Thanks Dave. For what is is worth, I did some learning out 1031's a while back so the concept of like kind exchange and boot is familiar.
Said property is worth from $1.5M on the low end to $2.0M on the high end. The mortgage is $400k so since we plan to pay that off, that portion of the sales process will be taxable. I am assuming that as long as we invest every last cent of what remains in like kind investment property than that portion will not be taxable. As I have thought about it today during this thread I have concluded that until we can achieve $120k annually in passive investment cash flow, our goals will be to maximize near term results.
- Investor/Developer · Los Angeles, CA · Member since 2010 · 107 posts · 92 votes11y
Another thought to consider...
Why wouldn't you refi your current asset in the 90210 and use the cash out proceeds (or credit line) to reinvest into another property. That money would not create a taxable event and you wouldn't be under the gun to replace a good asset in a strong market.
One of the big mistakes I see investors make is selling one good asset to chase cash flow. Another of the more commonly heard regrets, "I should have never sold...."
Best of luck and keep us posted on your progress.
A
- Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes11y
Originally posted by @Allan Glass:
Another thought to consider...
Why wouldn't you refi your current asset in the 90210 and use the cash out proceeds (or credit line) to reinvest into another property. That money would not create a taxable event and you wouldn't be under the gun to replace a good asset in a strong market.
One of the big mistakes I see investors make is selling one good asset to chase cash flow. Another of the more commonly heard regrets, "I should have never sold...."
Best of luck and keep us posted on your progress.
A
Thanks Allan. Here are my thoughts on that. Right now there is a lot of equity sitting up their on the hill, yielding very little cash flow. Appreciation in that market is pretty good, but let's say it takes 5 years for it to gain $200k in value. Can I make $200k in 5 years with say $1M at my disposal? I'd say yes, so that makes an argument to sell. What if the market dips and it takes 7 years to come back up and gain the $200k? Then for sure it makes sense to sell.
I would love to use the money to fund buy/build/sell deals here in West LA. But my wife is not comfortable with that. To her, this is a 401k, her retirement so to speak (she bought it in her 20's). And converting to cash flowing passive income is something that appeals to her.
And frankly we need cash flow right now. To keep us going so we can focus on rebuilds.
Another way to think of it... if someone handed me $2M in cash right now, would I be eager to buy a house in Beverly Hills that cash flows less than $1000/month? Or would I do something else with the money?
Of course there is another possibility. To rebuild the BH house and sell it. Things being what they are on the hill you could build a home on our lot that would sell for $5M I beleive, possibly up to $7M. Our little chicken coop is surrounded by some very expensive homes. Builders are buying lots that look like nothing more than a cliff on the side of the road and building 7000 sq ft homes that sell for over $10M. But this path would require some gumption. It's a hillside home, and LA has some pretty convoluted ordinances on hillside building.
I hope all this makes sense...
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes11y
Hello Gustave,
120k annually in passive cash flow off of 1,500,000 should not be that hard to accomplish.
Off of commercial properties putting 25% down and having debt fixed in the 4's for rate and cap rates in the 7's to 8's cash flows range from 14 to 20% going in. If you just had 10% pre-tax off of 1,500,000 that is 150,000.
I have clients in Texas. Multifamily is frothy in the recovery cycle but retail strip centers are poised for strong growth.
Whoever you are talking to make sure they work in the deal size you want to transact. Example listening to someone buying 100k properties when you are trying to buy larger stuff with 1,500,000 doesn't make sense. Not unless you want houses all over creation but that will not be passive.
What you really need to do is talk a few people on the phone to get an idea of positives and negatives with various investments. I talk to people all the time for 30 minutes or so. Goals vary by the age in your life, leaving a legacy to the kids, tax goals, passive versus active, how long you want to hold for etc. The lender will not just look at your down payment but various other factors when giving a loan. I think with the low interest rates paying all cash doesn't make sense right now.
To the person saying their lender said a 1031 has to be duplex to duplex FIND ANOTHER LENDER. If they will make up stuff like that then what else will they fabricate?? A person should simply say if they do not know something 100% then they shouldn't make it up. Your mortgage broker should have said they are not sure and then called a 1031 person to clarify.
- 11yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
You're spot on with your analysis of taxable boot on that mortgage and yes if you invested everything else there should be no additional tax on the gain.
The 1031 Investor5137 Reviews - Investor · San Jose, CA · Member since 2014 · 167 posts · 146 votes11y
Any reason why you can't do a cash out refi so you can take some of the equity and invest in other properties. Say you take out 500K out of the equity would the rent not cover the mortgage on the extra 500K loan? Are your rents too low ? I know your goal is cash flow but I would try to get that with retaining this property if possible since it seems to be in a good area.
Just my two cents.
- Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes11y
Thank you Dave Foster for confirming my thoughts on the 1031 and boot. But perhaps a related question for you and Bill Exeter:
I'll use simpler numbers. Assume I sell a rental property for $1.5M, on which I owe $500k. And exchange it via a 1031 for like kind property to the tune of $1.5M. But I finance $500k of the new acquisitions. Does that yield a non-taxable event?
To Joel Owens, thank you for you input. I like your point that buying a handful of rentals from say Memphis Invest might not be the best choice. I plan to start talking more seriously with lenders once we get our corporate entities set up (we're using NCH for that). And I am always ready to listen to anyone's advice.
To Radhika, thank you. Your point was brought up earlier in the thread also. And my wife and I have struggled with this. Does it make sense to give up a piece of the rock when that rock is Beverly Hills? It seems on the surface to be maybe not a good idea. Counterpoint, yes BH is a nice area, but what does that really mean in terms of RE investing? Does it mean the chance for high appreciation? Maybe, I've not studied it that carefully, but I would guess there are other neighborhoods in West LA South Bay that have appreciated more rapidly of late. Venice and Manhattan Beach are two cases that come to mind. And in any case, is appreciation not just risk with no control (i.e. gambling)? Some would say that.
As a rental, our house in BH is not a great investment. The property is simply worth too much vs. the rental income it can generate. Now for a rebuild it does make sense, since it is admittedly a "distressed property" in a very exclusive area. Don't get me wrong, it's a cute house and anyone who visits it falls in love with it. But relative to what is around it, well the difference is in orders of magnitude.
- 11yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
That's exactly the way it was designed to yield a no-tax event. Simply ask yourself two questions about the transaction.
1. Will I purchase at least as much as I sold? In this case you sold for 1.5 and bought for 1.5 so the answer is yes.
2. Did I use all of the cash generated in the next transaction or transactions? In this case you generated 1 mil in cash (you sold for 1.5 and paid off a 500K mortgage) and you put all 1 million down on a new 1.5m property.
At the end of the day your situation would be exactly the same - no taxable event.
The way tax creeps in is if you bought less than what you sold or if you took some cash out of the deal.
The 1031 Investor5137 Reviews - Investor · San Jose, CA · Member since 2014 · 167 posts · 146 votes11y
Thanks for providing more info. Based on what yousa said about rent being low and may not be feasible to increase and you goal of having passive income I can understand why you want to sell it..
Good luck with what ever way you decide to go. Just make sure that when you invest in a property long distance they will be challenges if you do not do enough research.
- Investor/Developer · Los Angeles, CA · Member since 2010 · 107 posts · 92 votes11y
@Gustave Stroes I understand your answer but still question your strategy. You're chasing upside without concern for mitigating your downside.
A single family home in an upscale and strong demand neighborhood like Beverly Hills is like a blue chip stock in your retirement portfolio.
I understand that it does not appreciate as rapidly as a growth stock and I also understand it does not yield dividends equal to a more speculative growth investment, but, when the markets turn, which they always do, It's more likely to retain it's value and provide you a hedge against the risk of more speculative investments.
I'm suggesting that by abandoning a solid and less risky investment in order to put all your eggs in a more speculative basket you're giving yourself a better chance of a larger income stream and perhaps better short term appreciation, but you are also risking all of your equity in a more speculative market by buying in less solid markets.
To me a smarter, safer move would be to retain a solid blue chip asset that pays for itself and perhaps also pays for the additional equity you could borrow against the asset (new loan or credit line), and then re-invest that borrowed equity in more speculative investments if you wish to generate additional cashflow.
If you've outspent yourself and need to generate cashflow quickly for another reason we haven't discussed here I understand that sometimes decisions must be made on a shorter time horizon. However you mentioned your wife views this purchase as her/your retirement nest egg. I would be less willing to cash in the blue chip investments in my retirement portfolio to speculate for short term cash flow. I would however be willing to use them as collateral, borrow my seed money (especially if it was non recourse debt) and take leveraged risks for additional cash flow.
- Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes11y
Originally posted by @Allan Glass:
@Gustave Stroes I understand your answer but still question your strategy. You're chasing upside without concern for mitigating your downside.
A single family home in an upscale and strong demand neighborhood like Beverly Hills is like a blue chip stock in your retirement portfolio.
I understand that it does not appreciate as rapidly as a growth stock and I also understand it does not yield dividends equal to a more speculative growth investment, but, when the markets turn, which they always do, It's more likely to retain it's value and provide you a hedge against the risk of more speculative investments.
I'm suggesting that by abandoning a solid and less risky investment in order to put all your eggs in a more speculative basket you're giving yourself a better chance of a larger income stream and perhaps better short term appreciation, but you are also risking all of your equity in a more speculative market by buying in less solid markets.
To me a smarter, safer move would be to retain a solid blue chip asset that pays for itself and perhaps also pays for the additional equity you could borrow against the asset (new loan or credit line), and then re-invest that borrowed equity in more speculative investments if you wish to generate additional cashflow.
If you've outspent yourself and need to generate cashflow quickly for another reason we haven't discussed here I understand that sometimes decisions must be made on a shorter time horizon. However you mentioned your wife views this purchase as her/your retirement nest egg. I would be less willing to cash in the blue chip investments in my retirement portfolio to speculate for short term cash flow. I would however be willing to use them as collateral, borrow my seed money (especially if it was non recourse debt) and take leveraged risks for additional cash flow.
Hi Allan - wow, that is an interesting post. It contradicts many of the views I've developed in my limited time following real estate investment.
I guess the first thing I am curious about is labeling rental property as a speculative investment. I've come away with the impression that it is the least speculative RE investment, as long as you do not count on appreciation. After all, when the economy is good, many people rent. When the economy is bad, more people rent. Where do you see the downside? High vacancy rates?
Also, although BH is pretty blue chip, the housing prices there go up and down with everything else. Maybe they don't go as low, and come back stronger afterwards, but they still swing. Here is a not so scientific chart I made for myself to investigate this:
This if for all of Beverly Hills. What I determined from this chart is that if I had taken the value of the house in 2006, and put it into some type of stock or mutual fund where interest is compounded, then over a ten year period I'd only have averaged a 1.3% annualized gain. That's not even keeping ahead of inflation. OK, so this includes one of the worst downturns we've had, but who's to say that won't happen again? No one really knows. I've been taught that banking on appreciation is just speculation, which is risk with no control (i.e. gambling).
As for my situation, I'll explain. I am 53. Until 2013 I had a job that paid over $300k/yr, but that is gone. Of course Uncle Sam took a huge bite out of my salary so it was not quite as rosy as it seems. I hated the job and was miserable, and have never regretted being self-employed. I've been flat broke several times in my life and it never bothered me that much. So I am not too terribly risk adverse. But my wife has never been in such a situation is and is much more risk adverse. We have no income right now, save restricted stock units from my old job. We have two homes with about $1.5M in equity each, one we live in and one we rent. We prefer the home we live in now, so I would like to convert the BH home into something other than measly cash flow with the possibility of appreciation. If we convert it to rental income with a cash flow that we can live on, then we can take on risk in other areas of RE investing.
Please go ahead and blow holes in anything I've written here. I won't be at all offended and will hope to learn something from it.
Gustave
- Investor/Developer · Los Angeles, CA · Member since 2010 · 107 posts · 92 votes11y
Hi again @Gustave Stroes,
I understand your points and agree selling can be an option. I understand your position more clearly now that I know this is not your only asset and not your whole "nest egg."
I also understand your point about finding more return on the money invested in the BH house by moving that equity into units that generate more cash flow, and agree that would be a smart move on your part, especially since your income driven at this point in your life.
However, the point I'm trying to make is that you don't have to sell your "blue chip" asset to access the equity. If you can qualify for a cash out refi, you can avoid two things - the tax obligation you'd get on sale and/or the pressure of finding a replacement property (1031) in short order in a very tight market.
By speculation in the comment I mention above, I mean chasing return into more speculative markets. I agree residential rental properties are one of the least speculative segments of the RE market, but where I've seen investors go wrong is to sell A area assets towards the top of the market and replace them under pressure in B or C markets in order to chase income.
If you can borrow the equity and have your BH tenants pay for that borrowed equity in the form of rent, you can use that free leveraged equity to find return elsewhere (B and C markets). If a market were to collapse like it did in 2007/2008 you wouldn't be fully exposed to the larger swings of the B and C markets and could use the BH property as a hedge.
I'm not a fan of selling A assets, particularly when your basis is low (which I assume is your case...). If you can achieve the same goal with leverage, especially cheap leverage like we have now, it seems to me the better choice.
Again, best of luck on decision.
A
- Los Angeles, CA · Member since 2013 · 21 posts · 0 votes11y
I'm a multi-family broker in Los Angeles, CA. Glad to see you taking advantage of an aggressive market! Looks like you have a good idea of that the property might be worth... Have you gotten a professional Market Evaluation yet? Would be happy to generate a draft proposal as a third opinion or reference (it's free!). It would give you a good idea of how we market our listings/ the quality of our work.
Depending on the exact area, condition, and if there's upside, etc... I might be able to extract additional value for the property. Obviously not sure if you plan on listing or selling the property off-market --either way, I can bring a bevy of qualified buyers to you property; most likely an all-cash buyer --and a buyer willing to extend escrow to aid your 1031 exchange timeline.
As for your 1031 exchange options, I can certainly help identify healthy and safe investments. I would recommending looking into Triple-Net (NNN) assets as an option. If you plan on taking your funds out-of-state, you can probably expect to double/ maybe even triple your current cash-flow. Corporate backed NNN (20 yr. leases) are what a lot of my apartment clients are exchanging into. these days. They come in the form of everything from 7-Elevens-to-Walgreens, etc. Depending on the scale you're most comfrtable with.
Would love to be a resource for you. Feel free to contact me with any questions or comments or view my firm's website for an idea of how we can help.
Best Regards,
Matt Sillaman// www.irea.com
- Contractor · Paso Robles, CA · Member since 2015 · 18 posts · 3 votes11y
Originally posted by @Allan Glass:
Hi again @Gustave Stroes,
If you can borrow the equity and have your BH tenants pay for that borrowed equity in the form of rent, you can use that free leveraged equity to find return elsewhere (B and C markets). If a market were to collapse like it did in 2007/2008 you wouldn't be fully exposed to the larger swings of the B and C markets and could use the BH property as a hedge.
I'm not a fan of selling A assets, particularly when your basis is low (which I assume is your case...). If you can achieve the same goal with leverage, especially cheap leverage like we have now, it seems to me the better choice.
Again, best of luck on decision.
A
Hi Allan,
Your points are clear. I understand what you're saying, thank you.
I like your logo btw!
Gustave
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