Newbie investor recent purchase AND Question about 1031 exchange

9 Replies

Hey! Just wanted to introduce myself to BP and ask a quick question. Although I've been a member for some months now, this is my first post. 

I'm a newbie investor from St. Paul, MN and I partnered with my brother to purchase our first investment. We've owned for about 6 months and everything has gone smooth. Investment details- FHA, Owner Occupy, Multifamily (duplex), House hack. Since our purchase the market has started to level out but noticeable increase in the value of our property nevertheless. 1 month of sweat equity and a fresh paint job, the place looks pristine. We are living for cheap considering the area and if or when we move out and rent out the entire place there will be a nice cash flow.

My question is about 1031 exchange.

Since we purchased as FHA owner occupy, we must reside in this residence for 2 of the next 5 years to fulfill our lender requirements. However, is it possible to sell before we fulfill the 2 year residence requirement and use a 1031 exchange toward our next purchase, which would be a bigger owner occupy multifamily?

Does it make sense to leverage our duplex to scale into a bigger multifamily? Or do we hold our duplex and take out a second loan to purchase the bigger multifamily?

Thx, 

Michael 

612-382-3912

@Tim Swierczek can probably help you regarding the lender requirements.  

From the tax perspective - you can exchange business property but you cannot exchange personal property.  An owner occupied duplex would likely be considered a mixed use property.  The side that is business use you could exchange, the personal use would not be eligible for exchange however if you live their 2 years that side may qualify for the Section 121 gain exclusion.

There are costs to completing a 1031 and timing requirements - with just paint and a little sweat equity how much value do you think you created?  It may not be worth the hassles of structuring a 1031 if there is not a lot of gain to shelter.

If you decide to keep it and try to purchase another property you will likely have to do some explaining to your lender as to why you are moving. Seems they are trying to police this a bit more than in the past, they don't want people getting FHA loans without the intent to live in the property. Changing your mind after 6 months would surely question your intent.

If I were in your shoes I would talk to Tim about your options for purchasing a second property outright.  This will likely require a higher down payment but if  you are making money and can get approved it will allow you to continue investing.

Thanks @John Woodrich  

@Michael Dorr   

"Since we purchased as FHA owner occupy, we must reside in this residence for 2 of the next 5 years to fulfill our lender requirements. However, is it possible to sell before we fulfill the 2 year residence requirement and use a 1031 exchange toward our next purchase, which would be a bigger owner occupy multifamily?"

Your comment here is a misunderstanding.  Your lender requirement is only one year in the property.  The 2 out of 5 years is an IRS requirement.  Yes, it does affect taxes but I just want you to know the lender requirement is only 1 year.  Yes, you can sell at any time.  Did you both go on the loan for this home?  If not you have more flexibility.

"Does it make sense to leverage our duplex to scale into a bigger multifamily? Or do we hold our duplex and take out a second loan to purchase the bigger multifamily?"

This cannot be decided without a total picture of both the duplex finances and your finances as individuals.  If I were to guess I would speculate that purchasing a second duplex would be more likely but that is a very gross generalization.

Tim Swierczek, Lender in WI (#103522) and MN (#103522)
(651) 772-9000

@Michael Dorr , congratulations you're on a path to the holy grail of REI - A combination of tax free - tax deferred income and growth.

I agree with @Tim Swierczek I don't think the lender requirements are that you live in the house for 2 out the 5 years prior to sale.  That is the requirement if you want to sell and take the first $250K ($500K if married) of profit tax free.  Of course that only applies to the portion of the duplex you actually live in. 

However, if you live in that side long enough to qualify for that then you can sell and not only get the tax free portion on the residence side you can 1031 exchange the other side for another investment property and defer all tax on gain and depreciation recapture.  

So I think everyone's idea of slowing down the transition of this property and simply buying another investment property while you season long enough to take advantage of sec 1031 and sec 121 is spot on.

@John Woodrich Thanks for the info about the exchange. From the little sweat equity, paint and increase in market since our purchase, the house is now worth 30k more than when we purchased. You are right that it probably isnt worth the hassles of structuring a 1031 but something to think about anyway. 

@Tim Swierczek Thanks for clearing up my misunderstanding about Lender and IRS requirements. Only one of us is on the loan so we do have some flexibility here. We did not purposefully do this but I am beginning to understand that this is in our favor. Now we can go get another owner occupy low rate loan for our second investment. Knowing this, it makes sense to hold our duplex and purchase another investment.

 @Dave Foster Great input! A follow up question on the 1031 exchange. Lets say I do season long enough to take advantage of the full exchange, are there guidelines on the value of the new dwelling I am purchasing with that exchange? Min max price? 

612-382-3912
Originally posted by @Michael Dorr :

@John Woodrich Thanks for the info about the exchange. From the little sweat equity, paint and increase in market since our purchase, the house is now worth 30k more than when we purchased. You are right that it probably isnt worth the hassles of structuring a 1031 but something to think about anyway. 

@Tim Swierczek Thanks for clearing up my misunderstanding about Lender and IRS requirements. Only one of us is on the loan so we do have some flexibility here. We did not purposefully do this but I am beginning to understand that this is in our favor. Now we can go get another owner occupy low rate loan for our second investment. Knowing this, it makes sense to hold our duplex and purchase another investment.

 @Dave Foster Great input! A follow up question on the 1031 exchange. Lets say I do season long enough to take advantage of the full exchange, are there guidelines on the value of the new dwelling I am purchasing with that exchange? Min max price? 

Regarding a 1031, remember that personal use property can't be exchanged so in the example provided you would only be able to defer $15k.  

Regarding the value of the new property, that will depend on the value of your current property and your loan amount.  If your property was worth $250k, you have would generally have to spend $250k or part of the exchange will be taxable.  Any money you receive will likely be taxable and any reduction in debt will also be taxable.  Exchanges work well for moving up to a bigger unit but they do not work if your goal is to reduce debt or take cash out.

@Michael Dorr If only one of you was on the loan then you are in great shape. Accident or not it was fortuitous. Most people in your situation would go out and buy another duplex using FHA with the 2nd person. Do not do that! You have a better option. Have the other person use the 5% down conventional multifamily loan, this will preserve the FHA loan for the 2nd purchase and will save 10% down on the second purchase by borrower #2.

This is because the 5% down conventional duplex-fourplex loan is only available if it is the person's only loan at the time of closing.  By using my strategy this person's 2nd multi-unit purchase would be 3.5% instead of 15%.  Here's how it looks:

99% of investors strategy (if house hacking muti-units)

Purchase #1- 3.5% FHA

Purchase #2- 15% Conventional

Total % down 18.5%

The savvy well informed investor's strategy

Purchase #1- 5% Conventional

Purchase #2- 3.5 FHA

Total % down 8.5%

I'm sure you were not given this advice because 99% of LO's are not investor friendly and they simply do not know this option exists.  It's a bummer because this one mistake will set the beginning investor back a few years.

~Tim

Tim Swierczek, Lender in WI (#103522) and MN (#103522)
(651) 772-9000

@Michael Dorr , Again, you've stumbled onto a brilliant application that actually will allow you to take advantage of tax free and tax deferred income and reduce debt at the same time if you wish - or to continue to leverage.

If you hold long enough that you qualify for the 121 exemption (having lived in it for 2 out of the previous 5 years) then you would most certainly qualify for a 1031 exchange on the other portion.

What you exchange and what is tax free is simply following the allocation your accountant sets up when putting the rental half into service.  If the units are identical then 50% of the sales price would be allocated to primary residence and 50% to investment.  So if the sales price is $300K then $150K would be primary residence (all the profit associated with that would be tax free).  And $150K would go into your 1031 exchange.  

Under sec 1031 then if you want to defer all tax you need to purchase at least as much as you sell.  So your reinvestment target would be to purchase at least $150K.  This could be one or more properties.  So in your first purchase you will have the ability to actually reduce debt for your next investment purchase.

Big CAVEAT - Should the new tax reform bill go into effect you will need to live in that property for 5 out of the previous 8 years.  So Congress in their infinite desire to never let a good thing go unpunished is putting the brakes on tax free primary residence sales and by extension house hacking in multi family structures.  So my counsel in this case might be that you actually move out of that property as soon as you can and turn it all into investment so that after some time goes buy you sell and 1031 the entire thing.  So you won't get tax free dollars out (but you could refi and do so) but you'll keep everything tax deferred.

Say it with me together like a 4 letter word - "Congress"!

@Tim Swierczek My brother and I looked into the 5% down conventional multifamily loan. After some research we decided this is the route we wanted to take. My brothers lender informed us that a 5% down conventional multifamily loan no longer exists in MN. We were told there was a recent change and that 15% was the lowest down payment for a convention multfamily loan. Any insight to this?  

@Dave Foster I really appreciate you info. Love the feedback. Definitely have to see what happens with the new tax reform. Something that could greatly effect all Real Estate Investors.

612-382-3912

@Michael Dorr your brother's lender is 100% wrong.  Most LO's do not own rental property and just do not understand the guidelines properly.  It's not uncommon.  I can tell you that our company has closed them this year and I have one client who is currently approved by underwriting to buy one in Minneapolis.  Please PM me I would be happy to help you.  

Tim Swierczek, Lender in WI (#103522) and MN (#103522)
(651) 772-9000

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