Which option creates the better ROI? And is a cash-out an option?

Question

Friends, I'm contemplating a 1031 on a sale, but I am weighing a few options on maximizing the best ROI over the long haul. I'll share it with round numbers for a hypothetical analysis. Say the relinquished property nets a profit of 50k and I have two properties under contract, each for 100k, which I'll keep as rentals. I could designate one or both properties, but I want to maximize my ROI.

Would I be better served spreading the 50k between the two properties, effectively putting 25% down on each (Option 1) or putting the 50k on one property, tying the gains to just the one property for the long haul (Option 2)? (I can use other funds to buy the second property.)

A secondary question is this, could I utilize Option 2, throwing the 1031's 50k down at the one property, then do a cash-out refi (or get a line of credit) to pull 25k-30k cash out of the property? (I would then use that cash to acquire the second rental under contract anyway.)

Dave Foster · Answer

@Eric Yow, in order to defer all tax you need to purchase at least $173K if that is your net sale price. That means that if you do the 1031 with those two properties you would complete a 1031 and owe tax on the difference between the aggregate net purchase price of $166K and your sale of $173K. My guess is there's at least a couple more net expenses in there that you're not thinking about yet like your exchange fee at least that would make your net's almost equal - worst case is you sell for $173 and buy for $166 so you pay tax on the $7K but shelter the tax on the remaining.

You can purchase those two properties using any combination of cash loan and proceeds that you choose. You can even find a 3rd and then you'd have no taxable boot and you could split your $50K on three.

You could use all your proceeds on one and then immediately refinance to purchase a second one with the refi proceeds and complete your exchange that way. You'd be buying one for cash and in essence buying the second using your cash and loan. It would all just have to happen in the 180 day exchange window.

Eric Yow · Answer

As it appears, we won't be doing a 1031 on this transaction. We will have held the home only 5 months by the date of disposition. The holding period just wouldn't be met, plus I don't have any way of documenting my intent was to do anything other than to sell for a profit. (*We bought it intending to acquire a portfolio of rental properties, but the flip was just too good to pass on, so we decided to sell.) Next time, I'll consider buying with the intent to hold, rent it for a few years, then 1031 exchange it into a bigger deal.

Thank you all for your help.

Eric Yow · Answer

Thank you both for your help!!!

Bill Exeter · Answer

Hi @Eric Yow,

I thought that I should clarify the definition of Net Sale Price. The Net Sale Price is not the amount that you net from your sale transaction. The Net Sale Price is computed by taking your Gross Sale Price (I assume that is your $173,000) and subtracting your routine selling expenses such as real estate agents commission, title insurance charges, escrow or attorney closing fees, documentary transfer taxes, exchange fees, recording fees, etc.

In your example, your Net Sale Price would likely be about $165,000. You would then add your routine purchase expenses such as real estate agents commission, title insurance charges, escrow or attorney closing fees, documentary transfer taxes, recording fees, etc., in order to compute your total purchase cost.

You will have deferred all of your taxable gain as long as your total purchase cost is equal to or greater than your Net Sale Price and you have reinvested all of your net equity (cash). The ROI does not really come into play here because you must trade equal or up in value and reinvest all of your cash in order to defer all of your capital gain and depreciation recapture taxes.

Eric Yow · Answer

@Dave Foster @Bill Exeter

Let me run this by you with a little more specificity, then. The house sale will be about $173k. The homes I intend to acquire are $90k and $76k contract price. Does that mean my numbers don't work? Or can I use some of the 1031 proceeds towards the 90k and 76k replacement properties, but not all of it? Ideally I use at least 18k on the 90k house and 15k on the 76k house, to put 20% down on each. I am hoping to continue acquiring homes, so it is likely that I'll find a third to designate. Just trying to learn what options I have.

The underlying question was about ROI and which route would be the best in the long run. However, if the replacement property has to cost what the first sale nets, I couldn't use the sale proceeds on just the one property.

Bill Exeter · Answer

Hi @Eric Yow,

There is no requirement as to how you decide to allocate your equity between one or more possible Replacement Properties. You can allocate the equity put down and the debt take out anyway you wish as long as the Replacement Properties that you acquire have a total combined purchase cost that is equal to or greater than the Net Sale Price of your Relinquished Property (not net equity or net profit, but Net Sale Price) and you reinvest all of the net equity (cash) into the Replacement Properties.

Dave Foster · Answer

@Eric Yow, you can allocate the cash in your 1031 in any manner you choose. So you're wise to be comparing scenarios of different down payments to receive your maximum ROI.

However what isn't clear from your post as to what your actual reinvestment requirement is. In order to defer all tax you need todo two things - Purchase at least as much as you sell (net purchase) and use all of your net proceeds in the purchase (net cash).

It doesn't matter how you total that up between replacement properties and it doesn't matter how you allocate the cash. You can do a partial exchange and take some cash out or buy less than what you sell but you will pay tax on that difference.

Simply reinvesting the profit will not save you any tax in a 1031.

Matt Vogt · Answer

The point of the 1031 exchange is to protect the profits from the investment you're relinquishing. It's not going to matter how you allocate that 50K, either way it should be protected from taxes which is the entire point of the 1031. Someone please correct me if I'm wrong.

Which option creates the better ROI? And is a cash-out an option?

Which option creates the better ROI? And is a cash-out an option?

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