Please help!

36 Replies

Dear All,

My family is trying to make the best out of a situation that we are currently in.  We live in Southern California and have a rental property which rents about 2k per month, after paying the mortgage (about 1028 dollars/per month, with 196K left at 4.65% rate for 30 years), we are able to keep 800 dollars.  The renter is in our house for about 1.5 years.  A couple week ago, my tax man advised us to sell the rental property before 5 years period, so our profit won't get taxed (ours is 15% bracket).  So we plan to sell the house in about 2 or 3 years, take those money and pay off our primary residence which owes about 260K at a 3.5% rate.

We were thinking about refi the rental property to a 5 year ARM, I called around and got the best rate at 3.625 with about 5000 dollars cost of closing cost with us bank and a payment of 868 dollars a month. If we go with this route, we are able to keep extra money in our pockets, but it is not a good way either (extra money is used to pay for the closing cost). Others gave me 4% with a cost of 3000 dollars.

We had lived in our rental property for 15 years and don't want to pay extra tax.  

What do you suggest us to do?  Should we keep the rental?  

Any suggestions are welcome.  Thanks you all for reading and suggesting.

What do you think you could sell it for?  If it's cash flowing $800/month in your pocket I would keep it.  Your primary residence rate is very low so as long at that's a fixed loan I would keep it, money is cheap.

My mindset is focused on long term wealth creation so I like the cashflow.  If you don't want to be involved in rentals you may want to look at selling......but that's up to you and your goals, comfort level, etc.

Hello Eddie,

Thanks for the reply.  I like the cash flow to but I don't want to deal with the tax that I have to pay later, in case I have to sell the house after 5 years or more.  It is my first rental so I still have lots to learn.  

Have a great day.

Did you live in your rental or did you purchase it as a rental?

How much has it appreciated since you bought it?

It looks like it will take you 2.5 years to come out ahead on the re-financing you mention and you lose a fixed rate, so I would definitely decide on holding/selling in the near term first.

Even in the holding situation, I am not sure the refinancing is a "slam dunk".  You pay 5K to get 5K over 5 years, but you may quickly give that back if interest rates increase significantly.  At an increase to only 5.65%(still low historically) you will be even at 7.5 years and worse after that.

I agree, if you are making $800/mo in cash flow why would you sell it? I don't know California laws but you are probably depreciating the rental property to off set your taxes, correct? When you sell the property you would still pay capital gains taxes. And why would you pay off a 3.5% fixed rate mortgage? Surely you can earn more than 3.5% with the money you would use to pay off the mortgage. As for converting the 4.65% fixed rate mortgage on the rental to 3.65% 5 yr ARM to save $200/mo does not make any sense in my opinion. Find another tax man who is familiar with real estate investing.

Good luck

@Jesse T.  Thanks for your advice.  I lived in that currently rental house for 15 years before I made it a rental.  The house was purchased at 250000 dollars and had appreciated to about 380K.  Based on what you said, it is wiser to hold on to it for later sell.  Do you think I should refinance for a better rate than what I currently have which is 4.65 for 30 years fixed (rental rate is different than primary residence)?

@Nuhan Demirkan  Good afternoon, 

Thanks for your advice.  This year would be my second year to depreciate the house to off set my taxes.  What is your opinion on refinance that house with a lower rate than I currently hold right now (4.65% at 30 years fixed).  U.S. Bank is offering me a rate of 4.125 with about 2000 dollars cost for 30 years fixed.  Is that better in the long run?  

Originally posted by @Cuong Thai :

@Jesse T. Thanks for your advice.  I lived in that currently rental house for 15 years before I made it a rental.  The house was purchased at 250000 dollars and had appreciated to about 380K.  Based on what you said, it is wiser to hold on to it for later sell.  Do you think I should refinance for a better rate than what I currently have which is 4.65 for 30 years fixed (rental rate is different than primary residence)?

 You are looking at a 130K in capital gains.  If you sell within 3 years of when you converted to a rental you can use the exclusion on those capital gains(this saves you 19.5K in federal taxes).  There will be a tax bill(at your income rate) from the recapture of your depreciation - about 9K/year at your income tax rate. 

@Cuong Thai  

I would hold on to the property and if you're going to sell in 2 or 3 years an arm sounds great. But since you're cash flowing well I would look into a 30 year fixed. Rates have been going down for the past couple of weeks so you could still lower your rate to 4.25% if you're credit is good and your DTI works out.

My only reason for saying this is because after 2007 you just never know.  I'm personally a bit more conservative so arms aren't really my thing unless it's something like a 10 year fixed or maybe a 7 year fixed. 

Good luck and keep on moving forward.

I completely understand your aversion to paying tax on the profit.  Your accountant was wise to steer you to the sec 121 exclusion which allows you to sell a residence that you own and have lived in for 2 out of the previous 5 year period and take 250 of the profit (500 if married) tax free.

Your problem is that your coming up on that 5 year window and don't want to pay tax on profit but the property is also cash flowing nicely so there's reason to keep it also.  There are at least 2 other solutions that can still accomplish both goals of limiting tax and enjoying cash flow.

1. At some point in time move back into the property and live in it 2 more years and then sell.  The clock starts again when you move back in so you could once again take advantage of sec 121.

2. Keep the cash flowing property as long as you would like but when you sell simply do a 1031 tax deferred exchange and purchase other investment real estate.  You can do this in perpetuity and never pay tax on the profit.

1. At some point in time move back into the property and live in it 2 more years and then sell.  The clock starts again when you move back in so you could once again take advantage of sec 121.

I wanted to add an important point to the above comment by Dave.  You can certainly move into the property at any time in the future, and once you have lived in the property for another two (2) years you would "qualify" for the 121 Exclusion again, however, since the property was held for rental or investment purposes before you qualify for the 121 Exclusion again, the gain would be prorated between the number of years that you held the property as rental or investment vs. the number of years that you lived in the property as your primary residence.  You would not qualify for 100% of the tax free exclusion in the future.  And, you would also have more built up depreciation recapture at that point in time.  The 121 Exclusion does not exclude any depreciation recapture. 

This is not an easy decision to make. 

On the one hand, you can sell today and exclude all of the gain today (but not depreciation recapture) so that it will always be tax free. 

On the other hand you could continue to hold the property and then structure 1031 Exchanges as you go and as long as you never sell and cash out (you always 1031 Exchange) you can defer the taxes indefinitely.  When you eventually pass on your heirs will receive a step-up in cost basis and the capital gain and depreciation recapture taxes will completely go away.  It is a difficult call, especially when you have a nicely performing property.

@Jesse T.  

 Good evening Jesse,

Thanks for your great reply.  I will have to consult my tax man again.  Good luck to you.

Cuong

@Shaun Weekes  

Good evening Shaun,

How are you neighbor?  I know where Alta Loma is.  My kids swim at the RAA-Cove.   I have been thinking about refi to a 30 years fixed as well.  I called around and the best rate I got is 4% with about 5K closing cost.  My monthly mortgage payment will be reduced about 100 dollars which probably takes me about 50 rental months to make up this amount.  I just don't know what to do at this time.

The builders are building big houses in your area.  Soon 15 freeway will be filled with new houses.

Take care and thank YOU,

Cuong T.

@Dave Foster  

Good evening,

Thanks for giving me great advice.  I need to learn more about the 1031 Exchange.  I don't even know what that is.  

A question for you is that once I do the 1031 Exchange, can  I use that money (profit after paying mortgage) to buy my a primary residence?  I am living in a two story home right now and would love to down grade it to a single story home.  After a recent move, my right leg gives up on me.  Any advises here are greatly appreciated.

Have a great day,

Cuong T.

I am in the same exact situation and have been for years on a property. Was holding for my mom and now she isn't going to live in it. So do I hold or sell?
I have done lots of research and doing as stated, 1031, but waiting for right time and ready to buy a like kind property to follow the rules
I recommend hold and 1031 when its time

@Bill Exeter  

Good evening Bill,

Thanks for clarifying it for me.  It is great to talk to knowledgeable men that commented here.  I have a few question I wanted to ask of you:  When can I structure 1031 Exchange?  After 5 years or right now?  I know the couple that is renting our house is very nice.  They really take great care of our property.  It is managed by a local rental property manager as well and she is on top of everything.  I would hate to sell this house, like you said, it has been giving us a nice cash flow.  I was thinking of refinance this house to a lower rate (4% from U.S. Bank with a 5K closing cost), but I just don't want to spend that much money to refi.  

Any other suggestions for me from here.  I have 4 beautiful children, and we want to help them with their education in the future.

Once again, thank you very much,

Cuong T.

@Mick Harvey  

Good evening Mick,

Thanks for dropping me your advise.   Based on what you said, when I am ready to buy another property, I should sell this house and use the money to pay for another property (of course with 1031 exchange ready).  Can I use this future property as my primary residence and convert my currently residence into a rental property?  Since I really want to down grade to a single story home.

Again, thank YOU!

Cuong T.

I am in the same exact situation and have been for years on a property. Was holding for my mom and now she isn't going to live in it. So do I hold or sell?
I have done lots of research and doing as stated, 1031, but waiting for right time and ready to buy a like kind property to follow the rules
I recommend hold and 1031 when its time

That's where I am not 100%. Says like kind. It's residential real estate, I say yes, but I have a lot more reading to do when it comes time as you should do to protect yourself. I have to wait for market in VA beach to come back first. So I have lots of time
Good luck

Originally posted by @Cuong Thai:

A question for you is that once I do the 1031 Exchange, can  I use that money (profit after paying mortgage) to buy my a primary residence?  I am living in a two story home right now and would love to down grade it to a single story home.  

Hi Cuong,

No, the 1031 Exchange only applies to rental, investment or business use property.  You can sell rental property and exchange into other property that you hold for rental or investment purposes.  You can not acquire property to be used as your primary residence, second home or vacation home. 

Originally posted by @Cuong Thai :
I have a few question I wanted to ask of you:  When can I structure 1031 Exchange?  After 5 years or right now?  I know the couple that is renting our house is very nice.  They really take great care of our property.  It is managed by a local rental property manager as well and she is on top of everything.

I'm going to try to answer a number of the questions above in one reply, so here goes:

Holding Period

One of the most important issues involved in 1031 Exchange transactions is your INTENT to hold for rental, investment or business use.  The key is to be able to demonstrate that you did in fact have the intent to hold the relinquished and replacement properties for rental, investment or business use.  The amount of time actually held as a rental can be a huge part of this "proof."  Most advisors recommend holding the property for rental for at least 12 months; some recommend 18 or  24 months.  So, once you feel that you have held the property long enough to demonstrate that you did in fact hold for rental or investment, you can certainly sell and structure a 1031 Exchange.  It is also important to note that less than 12 months may still qualify if you feel that you can demonstrate that you did in fact have the intent to hold but some business or economic reason triggered an earlier sale. 

Qualified Use and Like-Kind Property Requirement

There is lots of incorrect information floating around the internet regarding Qualified Use Properties and Like-Kind Properties.  1031 Exchanges apply to both real estate and non-real estate, referred to as personal property. 

In the real estate context, ANY kind of real estate is like-kind to ANY other kind of real estate.  So, the like-kind test is easy for real estate.  You must sell real estate and you must buy real estate.  As long as what you are selling and buying qualifies as real estate under state law, then you are in good shape.  This includes fractional ownership interests (tenant-in-common interests), Delaware Statutory Trusts (DSTs), water rights, air rights, mineral rights, certain types of oil and gas investments, etc.  If you are told that you must buy a condo if you sold a condo, etc., that is completely incorrect, and never has been correct.

The Qualified Use test is the more critical test.  Qualified Use means that the real estate that you sell and buy as part of your 1031 Exchange must be held for rental, investment or business use.  Property held for sale such as developers buying to build and sell, rehabbers buying to fix an then sell (flip), etc., are held for sale and not investment and do not qualify.  Property used for personal use will not qualify, such as a primary residence, second home, or vacation home. 

The 1031 Exchange gives you a lot of flexibility in terms of repositioning your resources/portfolio. You can sell a SFR and buy office, retail, industrial or go back into SFRs.

Hello Cuong,

To come back around to your re-fi question.  I wouldn't spend $5,000 to save $100 a month.  As you said, this will take you 50 months to make up the expense, but what I don't think are taking into account is that you would be resetting your amortization schedule.  You would have a full 30 years of payments in front of you which means you will likely be paying more in the long run and not actually saving any money with the refinance.  I'd look at how many months into your existing payment schedule you have already achieved and remember to calculate those extra payment on the back side.

With regard to selling I'd say you have to decide if you are comfortable investing in real estate.  If you think it is a good fit for you then I'd say hold on to that property.  $800 a month in positive cash flow is great and it should only get better with time.  The 1031 exchange is a great tool if you want to sell and defer the gains in the future.  

If you decide you are not comfortable with real estate investing and holding rental property then you have a golden opportunity in the tax exclusion by selling soon.  

Before selling I would look at where you can re-invest those dollars and do any better than you are right now.  Right now, based on the equity numbers I saw earlier in the post you are earning over a 7% return on your EQUITY.  (130k equity and $9,600 per year)  This doesn't take into account any appreciation that you may get out of the market, any of the debt pay down that you are getting the benefit of through your renters covering your mortgage, or any of the depreciation benefits you get each year.  When you add these other factors to your rate of return you will start to see the power of real estate investing.  

Best Wishes,

Craig Jones

p.s. If you'd like clarification on any of my comments I'd be happy to talk with you about it.  I can be reached at 541-241-0700

@Bill Exeter  

Good morning Bill,

Thanks for taking your busy time to answer my questions.  There are so much to learn.  I am new to this type of business when my neighbor offered me her home.  Since she had a bigger home than mine, I moved my family to what is our primary residence and converted mine into a rental property.  I didn't know what else involved with this type of business until I asked questions and you kindly explained them to me.

Are there any books or trusted websites that I can read to further broaden my knowledge in this business?

May I follow you here in this website?  

Have a great day and Thank YOU,

Cuong T.

@Craig Jones  

Good morning Craig,

It is your first post, and you used it to answer my question.  Thank YOU, Sir!  Just like others who answered my questions here, your answer further explained and helped me understand the logical aspect of real estate investing.  I don't have any background knowledge on real estate investing at all.  I just got into this business because my neighbor sold her house to me.  Wow, there are so much to learn here.  I will certainly give you a call to chat with you.

When do I need to fill out the 1031 Exchange?

Are there any books or websites that I could use to further my knowledge on this type of business?  I read as much as I can in this website whenever I have my free time.

I have two cousins living in Oregon as well.  They said it is really beautiful up there.  They live in Portland, OR.  We drove by it when we went to Vancouver, Canada for our vacation 6 years ago.

Again, Thank YOU!   

Cuong T.

Keep in mind that in CA, due to Prop 13, your property taxes go up very little.  As a result if you did a 1031 exchange your property taxes would likely go up a lot (probably @50% increase).

Also, If you have kids, you can sell them the house and they can keep the low tax basis.  If you sell then they have to buy a house and the taxes are determined by the sale price.  I had one friend in CA that bought his dads rental house, taxes on similar homes were running @ 12k a year but he was paying less then 3k.

You mentioned that you would like to move into a single story home, is the property in questions a single story home?  You could move back into that.  Or just sell your current home and move into a single story, does not force you to change your plans with your rental.

If you move from your current home can you rent it out and still cover the mortgage and cash flow?  It might be a chance to cashflow another property.  

You can also use the extra $800 a month to pay down your current mortgage, that is almost 10k a year in extra payments and will greatly reduce the term of the mortgage.

Lots of options here, just depends on your wants and needs.

Good Morning Cuong,

A 1031 Exchange isn't a form to fill out, but rather a process to follow at the time you decide to sell a property.  I'm sure there are some good articles on this site somewhere that will detail the process.  You will work with your real estate agent, your accountant and a 1031 accommodator when the time comes.  It is pretty painless, but there are some strict time lines to follow.

There are definitely tons of books and information out there to help you learn about real estate investing.  I think Bigger Pockets is one of the best resources.  Tons of excellent free information and lots of knowledgeable people willing to help.  If you listen the weekly pod casts you will get a steady stream of recommended reading along with an hour or so of great content.

We used to live in Portland, but moved to Bend (Central Oregon) a few years ago.  More sunshine and less rain here.  

Have a great day! - Craig

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