Inheriting a home, have some cash. How to best use home & money?

Question

Love the site, really great stuff.

Anyway, I've been house hacking in Pasadena for a few years and am now living rent free with my family in a home I'm about to inherit from a living relative who owns it under an LLC. Living in this Pasadena home isn't in the cards for us long-term because the home isn’t ergonomically safe for kids and we also need to move into a good school district. Given that the home is unencumbered by a mortgage and worth about $3M, we are truly blessed to have quite a few options as to how to finance both a new home in a good school district as well as other projects in multi-family housing I’ve been dying to get into (not just as a hobby). I have always been interested in and have followed both the markets generally and real estate specifically, and just got my realtor license last year (never sold homes, just wanted to be better informed). I have a full-time job in an unrelated field (computer science) and am looking not just to supplement that income with real estate but to really grow a self-sustaining multi-family real estate business, using this incredible inheritance as a jumping off point.

As a first timer in real estate, my question really just comes down to where to start. How can I maximize my new, greatest asset? My options seem to be the following:

1.Sell the home and use some of the cash for a new home and various RE projects. Main reason I don’t think this is at all viable is because I’d be paying crazy 39.6% fed & 13.3% state taxes on the gain, which by my math is many hundreds of thousands in taxes.

2. Instead of selling, I could rent the Pasadena home out and use my current savings for a down payment on a permanent family home in whatever district we choose. I could then split the positive cashflow from the Pasadena rent to pay for both the new home mortgage and my first multi-family property. I wouldn’t have enough rent cash flow to finance a third property, so I’d probably have to take out a mortgage on the Pasadena home to afford it, which shouldn’t be difficult given our good credit. I am not risk averse if the numbers make sense.

3. I could rent out the Pasadena home and classify it as a commercial property on my tax return, which would allow me to do a 1031 exchange which avoids taxes altogether on a transaction for a new permanent home. Downside might be that it takes 2 years of renting out the home before I can do a 1031 exchange I believe, and I don’t know if we really want to wait that long. I also don’t like the idea of selling CA RE when I can just rent it out, build equity and have the option of mortgaging the asset to leverage myself into other properties.

I’m a numbers guy and so a lot of this is vague only because we haven’t decided on where to live yet, and without harder numbers it’s hard to say a deal is going to work out obviously. But I figured I’d ask people here to see what strategies they’d suggest.

Thanks guys!

Josh Lido P. · Answer

David, yeah I've thought about HELOC's and have determined so far that they'd be great for remodels and great to draw quick cash if I'm tight on money or don't want to draw available dollars from a taxable account. So far, large enough HELOC's don't seem to exist but it's certainly possible I'm wrong. I'd need a several hundred thousand dollar HELOC to be comfortable drawing on it to finance a downpayment on another property (I'm pretty sure a conventional loan would make more sense, but again I'm not an expert). Nice to know there's another engineer working in Pas!

Bill, yes I'm scheduled to talk with an estate attorney this week but based on my research this would qualify as carryover basis because the transferor isn't deceased so it wouldn't be stepped up to FMV.

Bill Exeter · Answer

Hi @Josh Lido P.,

The first thing that I would do is explore the inheritance question. Generally, people that inherit a property from another party when they pass will receive a step-up in cost basis. This means that your cost basis will be stepped up to the fair market value at the date of the person's death. So, in your case, if the property is worth $3 million and the person passes, your cost basis would be stepped up to $3 million. There are of course always exceptions, so I would review this with your tax advisor first. If you receive a step-up in cost basis, you will likely have no capital gain to worry about and therefore no taxes to pay. This may change your strategy considerably, so you should explore this topic first.

David Eiges · Answer

I think a great option in your situation would be to rent it out and either refinance or get a Home Equity Line of Credit (HELOC) against your home.  The latter would set up a revolving credit line that would allow you to quickly access money to purchase other properties.  It would not require you to sell the property or make any additional tax payments.  If it were me, I would use it to make cash offers on properties to purchase, get conventional mortgages after closing, and re-deposit the money back towards your after the conventional financing is complete.  BTW, I'm also an engineer living in Pasadena :)