1031 exchanging to a more prime property?

Question

Newbie to this forum and hoping to get some insight from all of you experts!

I  have a rental property in Dublin/Pleasanton area and am wondering if I  should sell and 1031 exchange it to a property in a more prime area  closer to jobs - eg Oakland/Berkeley/Redwood city/San Jose/Milpitas. I  roughly have 400K in equity. Some numbers below

original price - 350K

remodel cost - 150K

so cost basis around 500K (not including depreciation)

mortgage remaining - 350K (24 years remaining on 30yr @3.75%)

current  rent - $3200 /month and cash flow around $1000, I'm not including  vacancy or repairs as we have never had it vacant and with our remodel  everything is brand new

I'm guessing home value should be around 750K, so I would have 400K in equity.

Its  cashflowing right now which is great but I can't help but wonder if in  the long term a property in prime Bay Area would make more sense than a  bedroom community. However, selling would also mean giving up my current  prop tax which is based on the original price.

So I'm going back and forth, any opinions?

** Also cross posted in Oakland Real Estate Forum **

Sam Shueh · Answer

The contingency to allow one sell or to buy is possible in most parts of the US. In SFBA almost all accepted sales have no contingency clause for several years now. We submitted several offers on a local 1031 exchange in SFBA to purchase where all were rejected wanting no part of waiting for buy or selling waiting time. The seller went to Texas, Missouri bought a number of low priced homes scattered through out the continent. Now the issue is how to manage these homes. Not my problem.

$800 is a good investment even if you are not successful after 45 days. Most older people I know are tired of these investment properties want to sell it and pay tax.

$800 is a good investment even if you are not successful after 45 days.  Most older people I know are tired of these investment properties want to sell it and pay tax.

Dave Foster · Answer

@Sven Sante, There are some things you can do to mitigate the perceived and real risk from the time restrictions of the 1031.

However I need to correct a couple of things that @Sam Shueh said.

1. You do not have to be in contract for your new properties within 45 days after your closing.  You have 45 days to identify your list of potential acquisitions.  You have 180 days to complete the process.  Identification is just that.  The sticky wicket Sam accurately refers to is that after day 45 your list cannot be changed and only properties on that list may be used to satisfy your exchange.  So if is best if you can get them under contract as soon as possible.

As a matter of fact that is one of the opportunities - you can go into contract at any time you want including before your old property has sold.  The best of all scenarios is if you can either

a. find a property where the seller will give you a contract contingent on the closing of your sale.

b. Sell your property contingent on finding a suitable replacement.  That frees up your search as well.

2. You are not limited to identifying only three properties.  However there are some limitations on the numbers of properties you can name in relation to their value.  If you name three or fewer then it does not matter how much they are worth.  However if you want to name more than three properties then the total value of your list can be no more than 200% of the value of what you sold.  So if your sale is $750K you could name three $2 mil properties.  But if you wanted to name 4 or more potentials then your aggregate list couldn't be more than $1.5 mil.

From the scenario you're describing that's going to practically limit your identifications to 3.  But if your strategy changes this is an important distinction to grasp.

3. You do not have to always pay tax even upon death.  Thousands of 1031 investors defer payment of tax on sales using the tool throughout their career and using the tax to create more NOI for them throughout their life.  Upon death real property is given a step up basis to the heirs so the deferred tax is eliminated.

You do have to be focused and on task because of the procedural limitations in a 1031.  But my experience has been that while the 45 days seems horrible restrictive it is more perceptual than actual given the work arounds.  And remember that your worst case is that you pay the tax regardless.  There is no penalty for attempting and failing to complete a 1031.  So $750 buys  you and additional 45 days to see if you can protect $60 - $80K in tax.

Sven Sante · Answer

Well, the new property in San Jose area will definitely be negative cash flow in the beginning, that's a guarantee!

It seems irrational for me even to consider giving up cash flow in dublin/pleasanton area and thinking of buying something in san jose.

However, Im thinking long term. A lot of jobs are based in the san jose area - Apple, Intel, NVIDIA and now Google is building a big facility in downtown san jose. With the awful traffic in the bay area I'm betting people would pay premium to rent closer to their jobs and therefore appreciation would be higher.

I know my thinking is called speculation from a lot of forums here, but I still think of it as investing for the long term where jobs and talent are based..

Sven Sante · Answer

@Sam Shueh and Account Closed thanks for your input! I don't need to stick to 750K that is the minimum because of the 1031 exchange but I have a downpayment of 250K-400K to work with so I can definitely stretch further.

The 45-day limit for 1031 exchange does intimidate me, in this hot market how can one be sure to get something within that time range!

Another question is since the rentals will be cash flow for the first few years how do you investors do it, do you cough up money from your pocket or other rentals till they become cash flow neutral?

Account Closed · Answer

IMO, for long term appreciation, your idea and thought process is spot on. But for 750K it's unlikely to buy a decent (no major structural problems and not in a bad neighborhoods) SFH in San Jose.

Maybe you can do some research in Newark, which is booming because of its proximity to Facebook headwaters. Also Tesla just rented two big buildings in nearby Ardenwood area (in Fremont, but out of your range) that will eventually host thousand of Tesla employees.

Dave Foster · Answer

@Sven Sante,

I forgot one thing that you said that also triggered a bell.  While the net sales price is your reinvestment target to avoid all tax it is possible to purchase less than that and simply pay tax on the difference.  In your case absent firm numbers - if your contract price is $750K and you have $50K in closing costs your net sale would be $700K.  That is your reinvestment target to avoid all tax.  But if you only wanted to purchase for $650K you could do so.  You would pay tax on the $50K but shelter the remaining tax in your 1031.

Sam Shueh · Answer

You get 3 shots at it.  You need to be in contract within the 45 days time frame. You still have 180 days to close it.  Even 1031 is not a 100% sure thing as many law makers consider it as tax loop hole wants to change it. I spoke to 1031ipx local VP, his position 2 weeks ago after coming back from DC is it is never a sure thing.

Once you identify 3 like properties if the outcome is get rejected by all 3, you are ineligible. No second chance. But you have 250-400K for the next venture for the down payment.  You can still own two rentals. One can also buy a condo say 650K so you pay just 750-650K=100K tax which is managible at your tax rate.  You have to pay tax later no matter what even after death. As for source of rest that is your problem.

Sam Shueh · Answer

In Milpitas it is similar if not more bad news on prices. Neighborhood facing traffic noise from freeways, train and now Bart is generating a lot interest. When the wind blows eastward from downtown SJ one can smell treated sewerage. That does not deter home buyers in 95035. Only east foothill there are a few isolated neighborhoods that are decent. I image the asking price there will discourage most investors these days.

Sam Shueh · Answer

Finding $750K in my turf (SFBA South Bay) is a real challenge. Median SFH in SJ is $975K  today and I think 12-15% appreciation can happen in 2018.  At $750K it will be in 96122, 95116, 95111, 95127 neighborhoods, if you can find any.  Went thru a 1031 tax deferred exchange in SJC very recently. While it took 3 days to sell and 10 days to close in SJ(2 cash offers), finding a replacement SFH w/o paying 1.1M+ in SJ is close to impossible. Every home has a dozen bids on the table. The people feel their jobs are secure and will offer top prices. Went to Monterey County not even in prime coaster towns I found anything that is not junk is at $900-950K. The rent in Monterey County is lower may be $2.4K instead of $3.5K in SJC.

Near downtown SJ where Googl announced to build a campus in the future, the land is not all allocated, the $ speculation has started for months. 1000s of cluster condos, apts are under construction. A decent th (1400-1500 sf 3/2) has jumped to $1.1M from 0.82M from 2 years ago, and it was mid 500K ~5 years ago. A sfh 1500 sf not all permitted is going for 1-1.2M in Burbank rating 5 schools. The rental income will be higher when 15K employees and Adobe expansion is completed. The appreciation of any properties will be higher but the cash flow is less positive. If you got only 750K it is a condo in 95126, 95128 3/2 or 2/2.5 with $350 hoa. Wanting a SFH you need to cough up more.  Milpitas is unique because Bart is going through. Many older homes seller want arm and leg for it. Some neighborhood one can smell odor from sewage and face trains they sellers do not hesitate to charge maximum-95035.

Andrew Kerr · Answer

@Sven Sante - I always like to start with data and numbers before I make decisions. Re-run your current property in the BP rental calculator. Pretend that you are buying it all cash. Figure out a return. Or simply calculate what you are getting for a cash on cash return and a cash on total equity return.

Then run some scenarios of potential replacement properties. Can you get a similar or better return?

Once you know your current returns and potential returns, then it might be easier to decide to move to a more stable area. Or you might decide that you are getting solid returns now, and if you were to change the funds over to a new area, the returns you would get are not worth the extra security or peace of mind.

1031 exchanging to a more prime property?

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