1031 or refi to fix cashflow?

7 Replies

I've got 2 rentals and a primary residence and what feels like no way forward. Rental 1 is worth roughly $350k with $100k in equity and $30k depreciation recapture. Rental 1 rent is $1800 and mortgage $1600. Rental 2 is worth $400k with $20k in equity, no depreciation yet. Rental 2 rent is $2000 and mortgage is $1800. New tax law limiting write off on interest ($10k a year which we hit with primary residence alone) means my rentals are costing us close to $900 a month in taxes making our properties cashflow negative. I've considered refinancing Rental 1 but my ROI is only 6% so I'd like to move all that equity if possible. Rental 2 was purchased as a primary residence with a VA loan so I'm mostly just stuck with it to avoid losing money on selling costs. I just learned a 1031 has to be upwards. Doing a 1031 upwards on Rental 1 makes me nervous because it would be a huge deal and I've never done a 1031 before. Is a 1031 my only option to fix my cashflow issue? Should I incur the costs of refinancing? Should we just try to stick it out?

@Account Closed

Sounds like you just bought non-cash flowing units. I reckon a refi would help you out, depending on how low you can get that monthly payment. A 1031 may lead you into another non-cash flowing unit.

I don't think the taxes are the primary issue right now. You've got a $200/m margin between your rent and mortgage. I reckon when you pay for lawn care and new doorknobs (or whatever basic expense), you'll be negative cash-flowing. Or, imagine the repairs during turnover time or capital expenditures.

I'm a little hazy on your mortgage interest deduction limit. The $10k figure jives more with SALT deductions.

Personally, I wouldn't spend $350k to make $2,400/year margins that just get eaten up by regular expenses anyway.

Account Closed  Yeah, no cap on Investment property interest/property taxes.

I wouldn’t let a depreciation recapture bill stop me from selling if I wanted to, without a 1031.

@James Galla no argument from me that it's not the best situation and trust me, plenty of lessons learned! They were both purchased as a primary residence and I decided to rent them instead of selling focusing on the equity build since my job's income was more than enough back before I had a wife and child!

I was talking about Federal so sounds like you're saying I understand the tax situation wrong. Will do some more digging today.

Thanks for the shout out @Bob Norton , I think you're absolutely right about the interest deduction on rentals.  So Account Closed you'll want to do some refiguring there.

Buuuuutttt... Those suckers are negative anyway. You're starting your month on each of them with NOI of $200 before any allowances for vacancy, cap ex, bad tenant etc like @James Galla said, You don't say for sure that your mortgage is PITI. If it's not then thats even worse. You're bleeding and no refi in the world is gonna help that.

One significant piece of data I'd need to truly understand your situation is what you mean by "equity".  Equity is not the same thing as profit.  You could have a bunch of equity because your tenant paid off the mortgage or you put a lot of money down.  But that's not profit and you won't get taxed on it.

But for sake of this example I'm going to assume that your equity is all profit and taxable.  That's going to be your worst case I think.

Start with rental 2.  It's negative, there's no profit, and it's expensive.  Sell it yesterday and get out from under it.

Rental 1 - OK there's some profit and tax here.  $70K or gain at 15% fed and something for state depending on where you live.  And 25% on the depreciation recap.  So figure a tax bill of around $20 - $25K.   Your options are to sell and pay that tax now.  Hold on to the property and at your rate of burn on it you'd probably lose the same amount of money over the next 6-7 years.  Or you could 1031 into better cash flow.

Here's the caveat - I'd actually consider holding one or both of those if they were vastly under priced for near term value and had incredibly strong near term appreciation potential - think something like a city wants to buy one, or there's a light rail needing the back yard, or they're zoned for high density MF.  That would make some near term burn worth it.

If those aren't in place then these are not a good appreciation play in this market. And they're not a cash flow opportunity. So that takes us to the 1031 option. Your greatest fear is moving up in a 1031 and I get that. But what if you did a 1031 with rental 1 and bought 2 or three smaller properties with much better ROI. True cash flow properties.

Another option like Bob mentioned would be to do the 1031 and purchase a small or mid sized MF property. Heck, if you got rid of rental 2 and 1031'd rental one you could use the proceeds and debt space of both to purchase almost a million of MF property. I know you could better ROI from something like that.

And if you're feeling burnt out and overwhelmed you can always 1031 into a fractional passive commercial property and get a 6-7% return with non recourse debt so it doesn't haunt you and your only job is to go to the mailbox every day.

There's around 500,000 1031 exchanges each year.  They're really not all that scary.  You just have to pay attention to the details.

@Dave Foster confirming PITI and the $100k "equity" is $50k my down payment and $50k appreciation. Rental 2 is next door to a major new town center that just broke ground so I am expecting appreciation there soonish.

All around it sounds like confirmation I just need to do the 1031 on rental 1.

Happy to take any advice on reading or finding qualified intermediary, etc.

Account Closed, Since 1031 is a federal statute any qualified intermediary nationwide can handle your exchange.  Demonstrated verifiable experience is your most important criteria not distance.  Here's an article we wrote for BP on pricing - https://www.biggerpockets.com/blog/how-much-does-a-1031-exchange-cost.   We're one of the QIs here on BP.  And I did send a colleague request to you :)