Buying your Replacement Property (1031 exchage series - Part 4)

If you’ve been a regular follower, you know that one of my major 2020 undertakings was the completion of a massive 1031 exchange. I sold three properties, then bought three new properties. This process allowed me to defer all capital gains from my sales, plus improve my cash flow by around $1,800 per month.

I completed this process in late October 2020, and now I’m ready to share some details about my experience. Because this is such a massive topic, I’ve decided to break up the talking points into separate articles and group them together as a blog series. Hopefully this will make things easier to digest for you, dear reader, and also make it easier for me to put together.

In Part 1 of the series, I outlined some basics about 1031 exchanges. If you missed it and aren’t knowledgeable about 1031 exchanges, check it out before continuing on.

In Part 2, I outlined the following:

• - The market conditions of the middle of 2020 and why it was the perfect time to sell
• - A definition and discussion about the Return on Equity % metric
• - How and why I decided which properties to sell

In Part 3, I explained what it was like to sell 3 properties as part of a 1031 exchange.

In Part 4, I'll outline the timeline for selling my 3 properties and how it affected my buying timeline.  I'll detail out the experience of buying properties as part of a 1031 exchange, and finally I'll provide a before/after impact that the exchange made on my cash flow returns.

Buying Properties as part of a 1031 Exchange

Buying properties as part of a 1031 Exchange ended up being a much more enjoyable experience than I thought.  It feels exciting to be shopping for properties knowing that you have over $100k of available equity that MUST be deployed.  All of a sudden I didn't mind looking at slightly overpriced properties - as long as the cash flow was an improvement compared to my sold properties, it seemed worth it.

Furthermore, I was able to use my situation as a 1031 Exchange buyer as a negotiating tool.  Sellers were taking my offers more seriously, even if my offer was not the highest.

The Timeline

As I discussed in Part 1, the sale of relinquished properties must take place before the purchase of replacement properties.

After getting one sale completed, and 2 more under contract, I misjudged how easy it would be to find good replacement properties.  With expanded buying criteria, a massive pool of capital, and a major sense of urgency, I identified and got under contract on 3 replacement properties easily and quickly (almost too quickly).

I barely completed my sales in time to begin purchasing.  I literally completed the last sale at 3 PM on 9/15/20 and drove to buy the first replacement at 4 PM on the same day.

Replacement #1: Slow and Steady

When I first began searching for replacement properties, I figured I'd need to make tons of offers on any decent multifamily building that hit the market.  

This was one of the first candidates that I offered on.  It's an old building (most multifamily in Central PA is old) in a great B class town.  3 units plus a detached garage that can be rented out.  All units were rented at close to market rents, to good tenants.  The property was listed at $190k which I thought was pretty decent.  With new windows and splitting the heat, I felt it could be worth $220k in the future and rents could be raised slightly.  Not huge value-add returns, but good enough for a 1031 exchange property.

I offered $180k and waived inspections, and I planned to use a commercial lender to finance 80% of the purchase.  I also stated in my offer that this was a 1031 replacement property.  The list agent replied that they had multiple offers and one for $200k cash, but they liked that I was waiving inspections and that I needed to buy for the 1031.  They said if I offered them $195k they would accept my offer.  I offered them $190k and waived the appraisal contingency (in addition to waived inspections), and I was fully prepared to walk away after that.

The sellers came back and said they were accepting my $190k over the $200k cash offer.  I found out later that one of the other bidders was a friend of mine that I met through BP - and he had offered $195k with an inspection & appraisal contingency. (sorry dude)

Our loan was for $152k and this deal used up about $45k of our 1031 funds.  The property appraised at $194k and it cash flows around $275/month after paying all expenses, including property management.

Replacement #2: Going Postal

After locking up my first replacement property, I decided to start looking for better deals on my next one.  I began looking for stale multifamily listings...anything that had sat on the market for more than 30-45 days.  I looked at 4 multifamily listings one day, and offered on all of them.

Going Postal (a side-by-side 2 unit adjacent to a post office) was one of the properties and I immediately saw multiple opportunities.  The unit size is huge, almost 1500 sq. ft each.  Rents were low, around $1000 each, with opportunity to increase up to $1300-$1500 after cosmetic updates.  Tenants pay nearly all utilities.  There's 2 garages in the back that could be rented separately for $75-$100 each.

The property was OVER assessed with a tax assessment of $258,800.

The property was listed for $218k for 76 days.  I offered $180k, waived inspections, and again stated that this was to be a 1031 replacement property.  My agent handled the negotiation perfectly: when the list agent called and said they needed to get $195,000, my agent said "OK well we're offering on 3 other properties.  We know we need to buy one and only one for the 1031 exchange".  10 minutes later, the list agent called and said they were accepting my $180k :)

Our loan was for $144k and this deal used up a little less than $45k of our 1031 funds. The property appraised at $195k and it cash flows around $550/month after paying all expenses, including property management.  We were able to immediately rehab one of the units due to a turnover and rent it for $1300.  Also, I immediately filed and won a tax appeal and reduced annual taxes by around $1500/year.

This is an awesome deal in another solid B class location with great upside! I was particularly proud of the negotiation win and also the tax appeal win.  We intend to appraise and refinance this 2 unit once we can turn over and rehab the other side, and there's a chance we'll be able to pull out some of our purchase money on the refi.

Replacement #3: The Beast

At this point, we had one property sold, we were under contract to sell 2 more, and then we were under contract to buy 2 replacement properties (above).  A lot of moving parts! At this point, I was expecting around $125k of total equity to deploy from my sales, and I had already allocated about $90k.

For weeks, I had been texting and emailing every investor I knew that I was going to buy multiple multifamily properties in the area. One guy responded and said "Hey, I've been trying to sell my 5 unit.  You should buy that one!"

Let me pause and talk about networking.  

This was someone who called me about a direct mail letter that I sent years ago.  I had called him back (determined pretty quickly that his property wasn't distressed enough to be a good BRRRR) and we ended up just talking shop.  This led to us meeting up for lunch, visiting properties together, and he even lent us money on a few deals.  I began this relationship with ZERO EXPECTATIONS - simply wanted to connect with a like-minded person - and we ended up doing a deal together years later.

Back to the deal.  My investor friend had the property listed for $300k for several months and had recently dropped the price to $290k.  I told him to take the listing down to save on commissions, then I got it under contract for $275k.  He ended up pocketing more than he would have after paying commissions, and I got a better price.  Win-win!

The property is an ABSOLUTE BEAST (for me) - 5 units (2 commercial, 3 residential) plus 4 garages in the back.  At the time, all units were rented but by the time I closed one of the commercial units was vacated.  At the time of writing this post, we still do not have the unit filled, so I put a gigantic "WE BUY HOUSES" banner on the front.  Might as well make lemonade out of lemons!

We needed another $63k to close on this deal - so we end up using all the remaining 1031 proceeds, plus we needed to come out of pocket by about $40k.  I was willing to do this because a) we had the cash b) I didn't want to pay any taxes on my sales and c) I was hungry for a big cash flow upgrade.  As I mentioned in the previous post, we ended up selling one of our properties for $10k less since a buyer fell through.  This caused us to need to come out of pocket more than anticipated in this third deal, but it wasn't a deal breaker by any means.

The Beast appraised at $285k and I anticipate around $900/month in cash flow, once the commercial unit finally gets filled.  Just as with the other properties, we financed 80% of the purchase with a commercial loan fixed at 3.75% for 5 years, and amortized for 25 years.

Summary

Overall, I felt that this massive transaction (that took 4 blog posts to describe!) was a success.  The before/after numbers look fantastic.

There were certainly some less than ideal circumstances.  I made $10k less on the sales than expected.  I ended up having to come out of pocket to finish the last deal, which I never like to do.  Plus, I inherited quite a few issues.  I inherited a bad tenant on Going Postal during a COVID-induced eviction ban (still there 6 months later).  I inherited a commercial vacancy on The Beast which I am still dealing with (although taking advantage of free advertising!).  But these issues will come with any real estate transaction - especially newly acquired properties.

I feel very satisfied with the entire experience.  I was able to sell off some dead weight from my portfolio and scale up from 3 to 10 units (plus 7 garages), while deferring capital gains taxes.  I was making a negative return on $114k of equity with my previous properties.  Now I'm making a 13.7% annual return on $154,247 of cash invested.  Much better!

Thanks to all of you who have stuck with me through these 4 blog posts! There was quite a lot of information to share.  If you have any questions, reach out to me through my website, Twitter or through BiggerPockets!