First Time Poster- Cash Out Refi or Sell

16 Replies

Hello, I would like some advice on a property that my family owns.

It is two SFR's on one lot (detached) in LA County that was bought in the early 80's and is now owned free and clear.

It has an NOI of ~30,000 and I think it would appraise between ~800k - 1M (it appraised for 700k in 2008 when my father died), but it's really hard to find comps like this because of the multiple properties on 1 lot.

So with the market in Socal getting really hot again, I thought now would be a good time to either sell the property (into a 1031 exchange) or do a cash out refi and use the proceeds of either option as the down payment on a commercial property (which would obviously have a higher cap rate).  

The math and analysis I have done suggests selling it would be the better option, but anyone with a contradictory opinion would also be greatly appreciated.

Can't answer your question without knowing all the math you know that tells you it would be better to sell.

You need to talk to a Real Estate Lawyer and probably a CPA.  

Was the property owned by just your father?  Are you the only heir?

If you inherited the property from your father, you would be eligible for a stepped up basis based on the value at the time of his death.  This means you would only pay tax on the capital gains for the appreciation since then.  Assuming 900K selling price, 700K value in 2008, a 6% commission and 15% capital gains - it would only be about a 20K tax bill.  You also could add any improvements since 2008 to the basis.

A 1031 would benefit from the stepped up basis, but seems like an unnecessary complication for relatively small tax deferral(you have to pay it at some point).

Hi @John Pearson  ,

First of all welcome to the site! 

Depending on the location of the property the SoCal market hasn't necessarily heated up.  Much of the sales growth has been in the luxury market.  Above $1 million.  I think you should start by contacting a realtor to help with sales value.  Also make sure you do a proper analysis and take out only enough money so you would have positive cash flow each month.  

I personally am a fan of getting out of debt so if it were me I would probably sell it.  As @Jesse T.  has stated much of this will depend on title.  

Good luck either way!

Brett Synicky, Real Estate Agent in CA (#01956059)
949-329-3617
Originally posted by @John Pearson :

Hello, I would like some advice on a property that my family owns.

It is two SFR's on one lot (detached) in LA County that was bought in the early 80's and is now owned free and clear.

It has an NOI of ~30,000 and I think it would appraise between ~800k - 1M (it appraised for 700k in 2008 when my father died), but it's really hard to find comps like this because of the multiple properties on 1 lot.

So with the market in Socal getting really hot again, I thought now would be a good time to either sell the property (into a 1031 exchange) or do a cash out refi and use the proceeds of either option as the down payment on a commercial property (which would obviously have a higher cap rate).  

The math and analysis I have done suggests selling it would be the better option, but anyone with a contradictory opinion would also be greatly appreciated.

Welcome to BP!

What you have is a duplex. It's hardly rare as two on a lot (single parcel) is fairly common in certain areas, especially LA county.

LA county is big AND diverse, since you don't even hint at the community or zip code or if this is a big house with a granny flat, pretty hard to guide you. 

Not following all your logic, as I've had (and currently do have) duplex rental with better (I.(ie higher) cap rate than most commercial /industrial properties offer today.

Want to elaborate in your info and append your original post?

Lots of questions remain for analysis of course.  Let me add one more to that - what are your goals and what is the ownership structure?  You mention that your family owns it.  is this several extended members or only your immediate family on your tax return? 

The reason I ask is that in considering the 1031 exchange multiple owners of TIC interest have the opportunity to either go forward as one group in an exchange. Or they can each decide what to do with their tennant in common %. So if 5 cousins own it as equal Tennants in common and it's worth a million then each of those cousins owns 200K of real estate. They could each choose the path best for them - whether to sell and take their portion as cash taxable, do an exchange on their own for that 200K portion, or band together with one or more and do the exchange on that portion. There are a lot of possibilities depending on the direction you want to go.

Originally posted by @Jesse T. :
A 1031 would benefit from the stepped up basis, but seems like an unnecessary complication for relatively small tax deferral(you have to pay it at some point).

 Hi Jesse, I thought I would respond to the comment that you have to pay it as some point.  This is not necessarily true.  Many of our clients strive for the "swap til you drop" tax planning strategy.  If you continue to 1031 Exchange throughout your lifetime and then pass on and leave the property to your heirs, they will also receive a step up in cost basis and the taxes completely go away.  So, if done properly, as part of an ongoing 1031 Exchange strategy, you will never pay the taxes.

You mention family, so I'm assuming that there are multiple family members that own the property as tenants-in-common.  They could each make their own decision as suggested above, but with an approximate $20,000 tax bill, assuming the computations above are correct, it would likely not make sense for multiple separate exchanges with the costs and additional headaches involved.  For example, if there are five family members that each own 20% of the property, and assuming the $20,000 tax amount is correct, each family member would only owe $4,000.  It would probably be better to sell and pay the tax and not worry about the complexities of structuring a 1031 Exchange.  Having said that, we do have clients that would still proceed in order to defer the $4,000, so it is certainly a personal preference.

Hello everyone.  Thank you for all of the replies.  I will try and answer as many questions as I can and hopefully clear some things up. 

I guess the main question I have is in a more general sense.  What would be the pros and cons of a cash out refi vs. sale of the property?

From what I can think of:

1) Possible capital gains tax on sale 

2) 6% broker commission

3) Loss of rental income during the transition between properties

4) Higher ROI on new property.

What else am I missing?

@Joe Villeneuve  

I understand completely. I am just now taking the first steps into the feasibility of the sale of this property so I am still gathering all the details at this point.  As I get a more concrete idea I will probably add additional information to this thread. 

@Rick H.  

One of the main reasons for the previous appraisal was in order to receive the step up in basis when my father passed away.  The "swap til you drop" is definitely something I have thought about so depending on the amount of taxes owed, a 1031 exchange is definitely a possibility.

Hey john I live in Altadena and a local realtor as well. Let me know if I can help you with getting you comps in the area

John, the trust you mention certainly simplifies some of the issues surrounding how to structure a potential 1031 exchange.  Of course as you know, the trust can do an exchange as a tax paying entity.  In fact I applaud you - your family has had the foresight to put into motion one of the most powerful intergenerational wealth transfer tools using the combination of 1031-trust- and probate step up basis.  I would strongly recommend that you speak with your accountant to get the accurate picture of potential tax liability in a sale without a 1031 before deciding whether it is worth it or not.

Another calculation I would recommend you do after that is a simple opportunity cost analysis over having the deferred tax to continue to invest vs. paying that tax and losing the leverage. Depending your parameters it might really surprise you how much money that deferred tax is making for you right now. For instance, if the tax approaches $300K and in your parameters you can make 10% return on your investments then the opportunity cost of paying that tax is $30K/year - or almost equal to what your net NOI is on that property. That could be a significant loss of revenue.

Lastly you made a statement that intrigued me - You mentioned the potential loss of NOI during the time while searching for a replacement property if using a 1031. That can be a problem and another equally troublesome problem can be finding just the right property with the right ROI to 1031 into. Both of these issues could be solved very handily by a reverse 1031 exchange.

In a 1031 exchange you must always by statute close the sale of your property before you accept title to the new property.  But the mechanism of a reverse exchange preserves that statutory order but allows you to control the new property before you sell the old property. Your QI does this by creating a corporate entity referred to as the exchange accommodating title holder that takes title to the new property and then holds it until you sell your old property.  You then take title to the new property from the EAT and you have completed your exchange.  There's obviously a lot of ins and outs of such a process that will be unique to your situation but the two most significant factors I can see that may benefit you are

1. A reverse exchange gives you time to locate and lock up the perfect replacement property.  Especially if you're looking at a commercial property a lot of due diligence is needed and the pressure of the 45 and 180 day limitations of straight exchange can make such a process daunting.

2. Even better is the fact that while the EAT holds the property you are still getting NOI from your old property AND the revenue from the new property so other than whatever additional costs of financing there may be you are actually able to generate a double NOI for a period of time.

Congratulations on the foresight and planning your doing.  I think your analysis will steer you the right direction for your family.

Hard to say with limited info, but I know if I could sell a property of mine that made *only* $30k/yr for $1m+ I'd do it in a heartbeat. To me the return just isn't worth it unless long-term appreciation is significant.

@Dave Foster  

Hi Dave, I was wondering if you could tell some more about the reverse exchange you mentioned and how it is financed.  If one were to use the proceeds of the sale of property "A" as the down payment on  property "B"  would that be possible with a reverse exchange and an EAT?  

@John Pearson  So you don't have any standing in this matter, correct?

If your Mother is in charge of a trust, she is either Trustee or Successor Trustee, NOT executor (unless she has dual-capacity involving testamentary trust as created within a will).

Unless your Mother follows your direction, which would not be sufficient giving your limited familiarity with legal aspects and lack of access to market data, you don't have the ability to either borrow or sell yourself. So, this is largely an academic exercise. 

Borrowing while vested in a trust is limited to about half the equity on a free-and-clear property. Banks do not make loans to trusts do conventional financing is not a choice for your Mother. 

I own other loans in Alta Dena and surrounding communities, to trustees and both executors and administrators of probate estates. 

Sure Jay,  I can flesh out the general framework a little more.  We can connect off line if you want to get more specific about your situation.

First though, to address your specific question about using the proceeds of the sale as a 'down payment' on something else - absolutely.  And this could actually be done in a regular exchange without having to do a reverse as long as you complete your purchase within the 180 day window from the date of sale.  So if you wanted to, you could simply sell your property for $1m, identify a replacement property for $5m within the 45 day identification period, close on that property within the 180 day limit using $1m of cash from the sale and new financing of $4m.  No problem at all.

But what if you find the perfect property before you sell the old one?  Or what if the new property needs significant improvements?  Or what if the new property isn't constructed yet?  Or as you said, what if you didn't want to lose income during the process? This is where the reverse exchange can be a real asset to you.

Because the statutory order of a 1031 exchange always has to be sale followed purchase, the Reverse exchange exists specifically to address the situation in which you find the perfect next property but you haven't sold your old property yet.  In it's purest form, it runs something like this (of course there are dozens of different twists and applications).

1. You locate and contract the perfect "next" property (lets call this property B).  Your intermediary forms the EAT which is what will take title to property B.  You provide the financing for the purchase (this can come from anywhere - The loan is actually made to the EAT non-recourse but secured by the property, you and the assets so it is not a conventional product but there are many banks and lending institutions that do this type of lending - especially with an already free and clear property to add as additional security if needed).  

2.  The EAT takes title to the property.  You are not an owner or member of the EAT but you are secured and protected so that you have total control over the property and the EAT.  Your rights include the management of the property and rights to all revenue of that property while the EAT owns it.  You now have control over the new property B and are generating the revenue from it.

4. Now you set about selling your old property (property A).   While this is going on you also continue to generate the revenue and incur the management of property A. 

5. When Property A is sold you do a 1031 exchange on it to purchase property B from the EAT for what the EAT paid for it.  Any mortgage on Property B is paid off (or paid down if you are purchasing up).  The EAT ceases to exist and you now own your new property.

So the EAT, on your behalf, buys prop B for $1m with a loan secured by the old and new property or with cash or whatever.  You control, manage, and benefit from this property while the EAT owns it.  When you sell  Prop A for $1m that cash goes into a 1031 exchange and is used to buy prop B from the EAT.  The EAT sells it to you by paying off the mortgage it used to buy property B.  And as the dust settles you own property B free and clear and have done so tax deferred.  

Although we've done reverse exchanges successfully for decades, the IRS finally officially acknowledged their existence and gave some guidance to them in Rev Proc 2000 - 37.This ruling has some specific format and timeline benchmarks in order to take advantage of the IRS offered "safe harbor" for reverse exchanges.  But it does not restrict or limit other applications that follow appropriate procedures and practices that adhere to and follow the rules of Sec. 1031.  Obviously this is just a rough snapshot of one type of reverse exchange and there are tons of applications possible. But reverse exchanges can be a very powerful friend to have when the need is there.

@Rick H.  

Yes she is the trustee as well as executor. 

I am quite aware that I cannot buy or sell on behalf of the trust. If it helps you to think of it as academic that's fine. 

If lending institutions will only do 50% LTV, then that sounds like another compelling reason to sell it vs refinance.

@Dave Foster  

Thanks for the information that was very helpful. I will def I reach out to you again if it sounds like something I would like to pursue. 

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