1031 TO BUILD MY PORTFOLIO & KEEP CASH IN EQUITY

General Real Estate Investing
1

I had a quick thought yesterday and wanted to see if I could get a little input from the more experienced people here on the forum.

I’m entering the second phase of my business plan and would like to focus on building an extensive portfolio of rental properties using a 1031 in about 2 years. What I would like to do is obtain about 4 multifamily (2-4 units) properties with a minimum ARV of 50k (purchased at 35k or less). After the holding period required for the 1031, I would like to “trade-up” to a possible “commercial” apartment building. This is where the questions start…

  1. How strict is the “like-kind” rule? Would 4 two-family properties equate to say, and 8unit single apartment building?

  2. If I purchase my properties with an attached HELOC to pull out some of the remaining equity for cash BEFORE the 1031 is that allowed?

  3. Is a 1031 allowed on larger Commercial sized properties (ie: apartment complex’s)

I apologize if I seem misinformed about the techniques needed for the exchange, but the IRS sure doesn’t make their material “reader-friendly”. Thanks in advance.

2

“like-kind” means real property for real property. not trading a house for stocks. Non-like-kind property included in the transaction is considered to be “boot” and is taxable. thus, your scenario of trading a multi-family into bigger properties is OK. you can do 1031 exchanges on just about anything. my tax advisor said she had a professional musician who did a 1031 on a very high-end violin.

I’m not sure what your question means related to a HELOC and pulling out equity. A 1031 exchange enables you to defer payment of cpaital gains taxes. That taxable amount is your “profit” (net proceeds minus cost basis) and not really related to how much you leverage the property. With that said, the 1031 exchange does involve how much debt you take on since if the replacement property has a smaller mortgage, that reduction in mortgage debt is viewed as a realized gain. It get a bit tricky if you buy a replacement property and take on a smaller mortgage.

yes, your stragety is a solid one, but it takes time to build equity. However, I have one case where I started small single family home that rented for $850/mn, now 6 years later and two exchanges it has turned into an 8 unit aprtment building, a building lot for a multi-family and another much larger and nicer SFR rental property.

3

Thanks for the comments, your SFH scenario is more or less exactly what I would like to do. I guess my “big idea” is that I would like to be able to obtain a solid cash-flow for a year pull out some cash to stick in the bank and then 1031 up to a bigger property to hopefully increase the cash-flow & basically consolidate multiple properties into one big project.

My worry with the HELOC came from a post I came across stating that if cash is pulled out of the properties close to the time of the 1031 is can create some sort of problem with the IRS or some sort of violation. They’re the last people I want to have an issue with so I want to try and have a pretty good idea of the process.

If you don’t mind me asking, how did the process for your SFH go? Any problems arise that weren’t initially forseen?

4

aak,

Mortgage boot does not apply to the delayed exchange (sometimes called a Starker exchange) that is the norm for real estate exchanges these days. It is perfectly acceptable to acquire a replacement property with less debt than you had on your relinquished property.

Since the replacement property needs to have an equal or higher value than the relinquished property to make the exhange fully tax-defered, it is not that common to bring additional cash rather than additional debt to the settlement table to complete the replacement property acquisition.

Nevertheless, it can be done without compromising the delayed exchange.

5

Thanks for the correction Dave T; my previosu post was a bit mis-worded. The key point is that are are some scenarios where the amt of mortgage debt can come into play as to whether the exchange is fully tax deferred. I’m a bit less familar with those since all of my exchange have been fully deferred whereby I was trading up in value by taking on additional debt as well as bringin cash to the table in some cases.

As for the processing with the SFH, it was straight forward and was exchanged becuase values here in Calif shot thru the roof (plus I had bought it a deep discount and rehabbed it). So I was sitting on $75K in equity, but was cash negative as a rental. This was a nice example of how to use a 1031 as it allowed me to take advantage of the equity I had from the rehab/purchase at a discount.

I am not familair with your question about pulling cash out just prior to the exchange, but there are a lot of fine details about 1031 that can make them tricky. This is why a good accomodator is important. Also, I might recommend to get the 1031 book from www.firsttuesdayonline.com. Its a realtor educaton group in Riverside, CA, but they will sell to anyone and the books are super cheap ($10) and of very high quality with lots of examples. I liked them so much I bought their whole series. They also have a very nice newsletter as well.

6

So tell me if this is right.

I buy a house for 10k

I rehab for 35k

I sell for 85k

So I have roughly 40k in proceeds

When do I file for the 1031 exchange?

Then I find a property with in the time line given and this property is selling for 75k. Do my proceeds of 40k go to the down payment of the new property and I get another mortgage for the 35k? How does this work?

Lets say the same senerio but insted of buying a 75k house I buy a 35k house then what?

Thanks

Phil

7

Just to make sure we are on the same page, a 1031 exchange can not be used for property you purchase to rehab and flip. Flip property is dealer realty and not eligible to participate in a 1031 exchange.

Let’s say that you buy a house for 10K, spend 35K on rehab, then rent the property to your tenants. After a couple of years, you decide to use the equity in your property to upgrade your rental portfolio.

A 1031 exchange is perfect for this situation. It is not clear from the situation you outlined whether there was financing used in your purchase and rehab. From the low numbers involved, I will say no. So you have a free and clear property with an adjusted basis of $45K (ignoring depreciation to keep the illustration simple) that you plan to sell to your tenant for $85K, so you have no sales commission or other selling costs. Let’s assume that your price is about 10% below market, so the buyer agrees to pay all of your settlement costs to lock in your below market price.

When do I file for the 1031 exchange?

You don’t “file” for an exchange. You contact a qualified exchange intermediary (QI) and open an exchange escrow account. The QI will help you draft an exchange escrow agreement that you will sign, the QI will sign, and the buyer of your relinquished property will sign. Once you are at settlement, the settlement attorney will follow the instructions in the exchange escrow agreement and deposit the exchange proceeds with the QI.

The time to get the ball rolling with your QI is after you have a purchase and sale agreement on your relinquished property but before you go to settlement.

For the property in our example, you will have net sale proceeds of $85K forwarded to the qualified intermediary. Note that this number is your entire equity, not just your profit. If your property was mortgaged to finance the property purchase and rehab, then your loan will be paid from the settlement proceeds. Whatever is left over (your equity) is forwarded to the QI to be deposited into your exchange escrow account.

Then I find a property with in the time line given and this property is selling for 75k. Do my proceeds of 40k go to the down payment of the new property and I get another mortgage for the 35k? How does this work?

In our example, your net sale proceeds of $85K are applied to the purchase of the replacement property and most settlement costs. Since your exchange funds are sufficient to complete the purchase of the replacement property, no new debt or additional funds are required at settlement.

However, since you are trading down in value, whatever exchange funds that are left over after the replacement property has settled are distributed to you as cash “boot” and taxed, first, as unrecaptured depreciation at 25%, then any remainder taxed as long term capital gain.

The recaptured depreciation is added to the cost basis of your replacement property.

If, instead, your replacement property value had been $150K, then the $85K in your exchange escrow account will have to be supplemented with enough cash or new debt to make up the difference and to cover settlement costs. Note that in a delayed exchange, you are not required to bring new debt to the settlement table, nor is the new debt required to equal or exceed any old debt on the relinquished property.

Lets say the same senerio but insted of buying a 75k house I buy a 35k house then what?

The situation is the same as above. The difference is that now you will have around $50K (less after closing costs) in taxable cash boot instead of only $10K. Since the amount of cash boot received exceeds your total capital gain, only so much of the $50K that represents your taxable capital gain will be taxed. Because you are paying all the taxes due in a taxable sale in this situation, you have nullified the exchange. In other words, by trading down so much, you could have saved yourself the exchange fees you incurred because you got no tax benefit from the exchange in the first place.