Sell 1 SFH and buy 2 more, or hold?

Question

Hi BP community. I have a question about selling and buying.

I owned 1 duplex and 2 SFHs in Miami, Fl, but recently sold 1 SFH and looking to sell another SFH due to Section 121 rules (to avoid capital gains). Not thrilled with selling this SFH since it has a 3.25% mortgage. The property has a 45% LTV.

So my question is, given today’s R.E. environment, should I sell the property and buy 2 additional properties, or should I just I just hold on to the property although I would have to pay capital gains on the property (a $40k capital gain tax).

I would appreciate advice from the experienced BP community.

Clay Edmonds · Answer

I think the first question I'd ask is:

What do you ultimately want to do with the equity from this property?

That answer may make the decision much clearer.

If you're planning to sell because you want to take some of your wealth out of real estate and use the money for other purposes, then I'd absolutely have your CPA look closely at whether selling now allows you to take advantage of the Section 121 exclusion while you're still eligible.

If you're going to sell anyway, capturing an available tax benefit can certainly make sense.

But if the primary reason you're considering selling is simply to get the equity out so you can buy more investment property, I'm not sure I'd be so quick to give up this particular asset.

You have two things working in your favor:

A 3.25% first mortgage and only about a 45% LTV.

That means you have roughly 55% equity in the property while carrying exceptionally inexpensive first-mortgage debt.

If the property is cash-flowing properly, I'd investigate accessing some of that equity through an investment-property HELOC or fixed second mortgage while leaving that 3.25% first mortgage completely untouched.

And here's something many investors don't realize: there are second-position investment-property programs that can use DSCR underwriting.

DSCR—Debt Service Coverage Ratio—essentially looks at the property's rental income relative to its housing/debt obligation. Depending on the particular program, that can allow an investor to access equity based primarily on the property's cash flow rather than qualifying in the traditional manner using personal employment income.

That could create an entirely different strategy:

Keep the existing property and its 3.25% first mortgage.
Access a portion of the 55% equity in second position.
Use that capital toward another acquisition.
Finance the new investment separately, potentially with another DSCR loan.

Now instead of selling one property to buy another, you may be able to keep the existing property and add another property to the portfolio.

Obviously, leverage isn't free money.

I'd want to know what the existing property cash-flows today, what the new second-position payment does to that cash flow, how much equity you're actually pulling out, and what return that capital can generate in the next acquisition.

I'd calculate:

1. What return am I currently earning on the equity in this property?

2. How much equity can I safely access without destroying its cash flow?

3. What's the cost of that second-position capital?

4. What return can I reasonably generate by deploying it into another property?

5. What reserves will I have after doing it?

There's also an important distinction regarding the $40K tax number.

You don't owe capital-gains tax today simply because the property has appreciated. Generally, selling is what realizes the gain and creates the taxable event. Your Section 121 concern is really whether you have an opportunity today to exclude qualifying gain that could be reduced or lost if you wait too long to sell.

That's a CPA conversation, particularly because depreciation taken during the rental period can affect the tax calculation.

So I'd bring the decision back to your objective:

If you want to take capital out of real estate, selling and taking advantage of Section 121 may make sense.

If your objective is to grow the portfolio, I'd first investigate whether you can use DSCR-based second-position financing to put some of that 55% equity to work without selling a good cash-flowing property carrying 3.25% debt.

You may not have to sell one investment to buy the next one.

Robert C. · Answer

Hi Clay.  Thanks for the detailed response.

1. This SFH is valued at apprx $750k and I have $420k in equity and it will qualify for the Section 121 Rule as per my CPA. Cap Rate is 4% and net cashflow after all expenses is $30k per year. ROE is apprx 7.8%.

2. Taking a $150k 2nd mortgage would bring my cashflow to $0

3. Assuming assuming 7% interest rate on the 2nd

4. Market in S. Florida is tough and it's difficult to get cashflow unless you put a large down payment.  I think the Cap Rate would be in the 3s as far as %

5. The reserve will not be an issue  as fortunately I have some cash available.

My Retirement Planner (I just retired in November) suggested I sell all my rental properties (1 duplex and 2 SFHs) since real estate rich but cash poor and thinks I should put more into the stock market as it provides a higher cash flow than the properties (although there's an argument that the properties perform better as a total return).  I sold one SFH already which did not have a mortgage and paid off my primary residence.  I am looking to sell the other SFH, however keeping the duplex for a few more years, or maybe much longer (bought it in 1995) because it is in an area being gentrified and property values should move higher once we see real estate have a good appreciation period.

Thanks,

Robert

Ashish Acharya · Answer

Robert, with a 3.25% mortgage and only about 45% LTV, I would not look at this as simply “sell one property to buy two more.” I’d compare the after-tax return on the equity you already have against what that same equity could realistically earn in the next two deals.

I’m from Florida as well, so I’m well aware of the insurance, property tax, and real estate challenges investors here face. In Miami especially, that can materially change the hold-versus-sell math even when the existing debt is attractive.

On the tax side, selling a rental can trigger capital gain and depreciation recapture, so I’d model that before giving up a low-rate loan. If the goal is to stay invested in real estate, a 1031 exchange may be worth evaluating because it could let you defer some or all of the current gain and recapture while moving the equity into replacement properties, assuming the exchange is structured correctly and the replacement properties qualify.

I’d also look at whether the property still has any suspended passive losses attached to it, because a fully taxable disposition can sometimes free those up, depending on the facts.

The real question for me would be: after taxes, transaction costs, and the loss of that 3.25% debt, do the two replacement properties produce a meaningfully better return on equity than the one you already own?

Happy to connect and share some of our resources that might be helpful!

Crystal Smith · Answer

Can you clarify for me how a section 121 applies to investment properties. I thought it only applied to your primary residence.

Henry Lazerow · Answer

Will you be able to find single families that cash flow with today’s rates? Unlikely as most do not. Maybe sell it to buy a larger 4 unit, etc. I would not sell with a 3 rate.

Jimmy Lieu · Answer

Great question and welcome! Personally, I’d have a hard time giving up a 3.25% mortgage without first looking closely at the numbers. With 45% LTV, you have a lot of equity tied up in the property, so I’d compare the return on that equity today versus what that same equity could produce if you sold and bought two properties. If the current SFH still cash flows well and has solid long-term fundamentals, paying $40K in taxes later may be less painful than giving up cheap debt and taking on two new loans at much higher rates. On the other hand, if the equity isn’t producing much of a return and two new properties would meaningfully improve your total cash flow and growth potential even after transaction costs and financing, selling could make sense. I’d also run the tax situation by a CPA before making the decision because Section 121 has specific ownership/use requirements, and rental use and depreciation can affect how much gain is actually excluded. I’d make this an ROI decision rather than a tax-only decision.

Clay Edmonds · Answer

Congratulations on your retirement. I am  in Delray Beach.

Thanks. Those numbers help considerably, and they actually change my thinking somewhat.

The number that jumps out at me is this:

If you borrow $150K against the property in second position, your current $30K annual cash flow essentially goes to zero.

That makes me much less enthusiastic about leveraging this particular property simply for the sake of keeping it.

Right now you have approximately $420K of equity producing $30K per year in net cash flow, plus you're sitting on an exceptionally attractive 3.25% first mortgage.

The question isn't whether you can access the equity.

You probably can.

The question is whether accessing it actually improves your financial position.

If taking $150K out at approximately 7% eliminates the property's cash flow, you're effectively converting a property producing $30K annually into a break-even investment so you can redeploy $150K into another South Florida property where you're telling me cap rates may only be in the 3% range.

I'm not sure that's a good trade.

This is where I think your Section 121 opportunity becomes much more relevant.

Your CPA has already confirmed that the property qualifies. So now I'd have the CPA calculate exactly what your after-tax proceeds would be if you sold today and used the Section 121 exclusion.

Then compare two strategies:

KEEP AND LEVERAGE

Keep the 3.25% first mortgage.Borrow $150K in second position.Existing property's cash flow falls from approximately $30K to $0.Deploy $150K into another investment.Determine what the combined portfolio actually earns.

Versus:

SELL AND REDEPLOY

Sell the $750K property.Pay off the existing mortgage.Use the Section 121 exclusion while you're eligible.Walk away with a substantially larger pool of equity to redeploy.Use that equity to acquire one or potentially multiple properties with lower leverage.

The second strategy may actually put you in a stronger position, particularly if South Florida properties require substantial equity today to produce meaningful cash flow.

There's also a third option I'd keep on the table:

Do nothing.

Sometimes that's the option investors forget.

You have a property producing approximately $30K annually with very inexpensive 3.25% debt.

There's nothing wrong with continuing to collect the cash flow while waiting for either property values, rents, interest rates or acquisition opportunities to create a better reinvestment environment.

So with the additional information you've given me, I wouldn't automatically recommend taking the second mortgage.

I'd compare:

1. Keep it exactly as it is and collect the $30K.

2. Leverage it and determine the return on the entire combined portfolio after the additional debt.

3. Sell while the Section 121 opportunity is available and determine what your after-tax equity could earn if redeployed elsewhere.

And I wouldn't limit the third calculation to South Florida.

If your objective is building an investment portfolio and South Florida is producing 3%-range cap rates, there's another question worth asking:

Does the next dollar of my investment capital have to stay in South Florida?

That's really the decision you're making.

Your 3.25% mortgage is valuable, but cheap debt by itself isn't a reason to keep an asset.

The asset still has to compete with what that $420K of equity could potentially earn somewhere else.

With the numbers you've given me, I'd spend some serious time modeling the sell-and-redeploy scenario before the Section 121 window closes.

Robert C. · Answer

Shiloh, thanks for tour thoughts on the different approach. At this point in my life (recently retired in November), I am looking to simplify things as much as possible so don’t think investing out of state would be a good fit for me. I already have a Realtor and PM (does both) that manages my current rentals in Miami and she has done a good job over many years so things are “simple” as far as the management.

I guess I am looking for cashflow, but am young enough (errr 63, so not SO young) that I am also thinking about creating more equity over the next 10-12 years.  Maybe I need to define this first, but after reading all the advice, it may make more sense to try to 1031 the duplex into a larger property (3 or 4-plex) and that it provides the same or more cashflow and I get to participate in the appreciation of a larger asset over the years.

Thanks for your feedback

Robert C. · Answer

Thank you all for your responses and advice. Seems everyone is in favor not selling the SFH with a 3.5% interest even if it means having to pay the $40k in capital gains by not selling in the next 6 months (I’d still have to pay the 25% of the depreciation taken so far), plus closing costs, RE commissions, etc.

Maybe I look at trying to 1031 the duplex into a triplex or quadruplex and leave the SFH alone. However it may be tough to find something that cashflows the same or better, even with a large down payment (40%-50%).

I will run the numbers on selling the duplex and see what the numbers show and at the same time look at what’s available in the market in small multi-family in the Miami or Naples market.

Thank you all again, I appreciate the advice.

Robert

Robert C. · Answer

Thanks Clay! I will do some modeling and see which scenario works best, even the “do nothing” option.

Sell 1 SFH and buy 2 more, or hold?

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