Will my plan work?

General Real Estate Investing
1

I recently inherited and am about to sell a piece of property. I’d like to use the proceeds from that sale to buy 2 condos in the same building. The condos are currently vacation rentals and I will keep them that way. I’m planning to use a 1031 exchange between the sold property and the condos to defer capital gains tax. I’d like to then immediately mortgage both condos and use the cash to buy a personal residence.

The previous property will sell for $800k. The condos are $400k each. The daily rental rate for the condos is about $185. If a bank will loan me 80% of my equity (is that typical?) in the condos at 4.5% interest over 30 years, I will be able to spend $640k on a personal residence and my mortgage payment would be $4050/month. Adding in the condo association dues of about $1000/month, I would need to keep both condos rented a little less than half of each month to pay the mortgage.

Should this work? I’ve never bought real estate before and there are a lot of moving parts here so I’m wary. My income is only about $3k/month so I would not be able to carry the mortgages without the vacation rental income. I figure in the worst case scenario the condos are foreclosed and I lose the 20% equity but at least I have my personal residence and I avoided capital gains tax. The best case scenario is the condos pay themselves off and I even net a fair amount of money some months, plus I deferred capital gains tax. I think that scenario is quite likely unless there is an economic collapse and people stop going on vacation.

2

Those are big dollar amounts for condos. If you sold that $400k condo … you could take that and buy you a lot of low income or middle income single family homes in Texas ($20k-$50k cash for each one), or a nice commercial property or two. Heck, $400k would be a handsome 20% downpayment on a $2,000,000 / 150 unit apartment complex here!

150 apartments x $500 /avg month rent per unit equals $75,000 per month or $900,000 per year in gross rent!!!

Can you imagine turning that $400k into $900k per year in gross rent (probably $150k-200k per year in NET profit, realistically, factoring in maintenance on an older property, insurance, property taxes, management, vacancy, etc).

Personally I wouldn’t think about spending that kind of money on a condo…especially as a real estate newbie. You can cash out & make a lot more money elsewhere. But it’s your call. =)

3

The 1031 exchange is not necessary in what you describe.
Your basis on the inherited property should be close or possibly even more than what you sell it for. So you should have almost no capital gain on the sale.

Financing on Condos is difficult in this market. Check with your lenders before you puchase these.

I would also recommend looking at Multifamily properties vs these condos.

If you make 3k a month, how will you pay property tax and insurance on your 640k home?

You need to rethink the size/cost of the house you want so it’s more in line with your income.

4

Thanks motivatedceo and pete_houston.

After more consideration, I realized that sooner or later there is bound to be some sort of problem that causes a significant vacancy throughout my rentals. If that happens in the scenario I described, I wouldn’t be able to pay the mortgage and I would lose them. I would be on the hook for a $3,240/month mortgage plus maintenance charges. My $3k/month income wouldn’t be able to take it. In the apartment complex scenario, I would be on the hook for a $8,100/month mortgage.

Can you imagine turning that $400k into $900k per year in gross rent (probably $150k-200k per year in NET profit

After paying a $100k/year mortgage I would net $50k-$100k/year if those numbers are right, but covering the mortgage and other expenses during a vacant period would be a serious problem.

Personally I wouldn't think about spending that kind of money on a condo...especially as a real estate newbie. You can cash out & make a lot more money elsewhere.

Is buying as many cheap properties as possible the key to generating income above the mortgage expense? It sounds like it is. I didn’t realize that.

Back on the expensive condo thing for a second, I figure I could finance a $325k condo, put 20% down ($65k), and have a mortgage payment of $1,320/month plus $500 maintenance fees. I could probably do a $2,100/month long term rental on the condo to cover the mortgage, maintenance fees, and property taxes, or I could set it up as a vacation rental and probably make $2,300-$4,500/month before expenses depending on 50%-100% occupancy. The nice thing is I wouldn’t be over-leveraged and since I’ll own my home I could conceivably cover the expenses if there’s a vacancy problem.

What would you do with $65k in my situation? There are a lot of foreclosure condos a little ways from here going for $25k-$30k each. If high volume and low price is the way to go, would you buy 12 of them instead of the $325k condo?

The 1031 exchange is not necessary in what you describe. Your basis on the inherited property should be close or possibly even more than what you sell it for. So you should have almost no capital gain on the sale.

I wish. The property I inherited was originally put into a trust and the basis was determined a while back. I’ve talked to two different CPAs about getting a stepped up basis to the sale price and they both say it can’t be done. One of those CPAs actually handles the trust. I’m completely open to ideas on reducing, eliminating, or deferring the tax though. At this point it looks like I’m going to have to pay up ($75k) because I don’t want to be on the hook for a $640k mortgage.

Financing on Condos is difficult in this market. Check with your lenders before you puchase these.

I spoke to a lender for quite a while yesterday. She said they do finance condos as long as they aren’t “mixed usage” meaning some vacation rentals and some timeshare in the same complex. She also said they only loan 70% on investment properties, the interest rate would be 5.75%, and closing costs would be 3.25%. Should I be able to do better than this?

I would also recommend looking at Multifamily properties vs these condos.

Is a duplex a multi-family property? Any other examples? When looking to generate income, is the goal to house as many people as possible?

If you make 3k a month, how will you pay property tax and insurance on your 640k home?

I don’t understand. I’m not sure of the exact property tax rate but I think it’s less than 1%. 1% would be $533/month and insurance can’t be too bad.

5

What kind of trust does not allow basis step up when inheriting?

Did you inherit in 2010, when the federal estate tax was zero and the basis step up was effectively eliminated? Even if this is the case, there is a special provision in the tax code that allows for up to $1.3 million basis step up for the total estate inherited by non-spousal heirs.

Maybe time to consult another CPA or tax attorney.

6

Cheaper houses rented to low income families generally cash flow a lot better than more expensive houses in nice subdivisions. There is usually an upper limit to the amount of rent you can get out of a house in a nicer area that won’t keep up with the acquisition costs. The better cash flow in the low income areas is balanced by the increased amount of BS you have to put up with.

7

After more consideration, I realized that sooner or later there is bound to be some sort of problem that causes a significant vacancy throughout my rentals. If that happens in the scenario I described, I wouldn’t be able to pay the mortgage and I would lose them. I would be on the hook for a $3,240/month mortgage plus maintenance charges. My $3k/month income wouldn’t be able to take it. In the apartment complex scenario, I would be on the hook for a $8,100/month mortgage.

Yes, but with $75,000 a month in rent (at 100% occupancy, not very realistic though 80-90% is) $8,100 is a drop in a bucket. <<<

After paying a $100k/year mortgage I would net $50k-$100k/year if those numbers are right, but covering the mortgage and other expenses during a vacant period would be a serious problem.

I bet $150k-$200k is more realistic. You have to subtract the $100k a year mortgage and all other expenses from the $900k (potential) gross rent.<<<

Is buying as many cheap properties as possible the key to generating income above the mortgage expense? It sounds like it is. I didn’t realize that.

Basically, yes. You can buy low, middle or upper income properties too … if you buy the property cheap enough. A good basic rule is to buy a house cheap enough so that you can get at minimum 2% back on your total investment, in gross rent, per month. So if you sink $50,000 into a property (including all fixup costs), make sure it will rent for $1,000 per month. Most things on the MLS, and most real estate brokers/agents, only sell properties at “retail price” … those are not real deals and will typically not make you rich very fast. You have to find properties yourself to get the really good deals … people do that through classified ads, bandit signs, billboards, mass mailings, on the internet, you name it, and give low ball offers to the sellers directly. Note the 2% rule does not work in overpriced cities like New York or San Francisco, but it does work in most other places. Also there are plenty of other ways to get rich in real estate … but if you are looking for easy & steady cashflow, then the buy cheap & hold strategy works well<<<

What would you do with $65k in my situation? There are a lot of foreclosure condos a little ways from here going for $25k-$30k each. If high volume and low price is the way to go, would you buy 12 of them instead of the $325k condo?

That’s a dang good idea, if they will rent for a good enough price. Condos are very iffy where I live, in Dallas, as they tend to actually go down in value instead of go up in value in regards to appreciation! But we’re not on the beach or close to the coast. You might focus more on single family homes and townhomes - they tend to be less risky than condos in non coastal towns. Also if you do invest in condos, make sure the HOA fees are reasonable<<<

Is a duplex a multi-family property? Any other examples? When looking to generate income, is the goal to house as many people as possible?

Any structure/house that is designed to hold more than one family, is a multifamily property. That includes duplexes, triplexes, an apartment complex, etc. An individually deeded condo or townhome is still considered a single family home home though - just like a normal house on a street.<<<

8
Did you inherit in 2010, when the federal estate tax was zero and the basis step up was effectively eliminated? Even if this is the case, there is a special provision in the tax code that allows for up to $1.3 million basis step up for the total estate inherited by non-spousal heirs.

The land was inherited into a trust around 2008 and the cost basis of the land was stepped up to the land’s value at that time. Since then the land has appreciated greatly so I have a taxable gain now that I’m receiving it from the trust and selling it. Does it sound like there’s anything I can do?

9
Does it sound like there's anything I can do?

Any idea on this?

10

Where is this?

I would argue that based on the real estate market during the past two years being in decline that your step-up basis in 2008 was incorrect and is actually what it is today…or more.

If that’s not possible, Congratulations, you made good money on a good investment. Pay taxes and move on.

11

Thanks Pete,

Is there a way to verify and/or dispute a stepped up basis from 2008?

12

You can hire an appraiser to verify the value of the property at the time you inherited in 2008. However, remember that 2008 was the beginning of the real estate bubble burst, and the credit industry got derailed by the deluge of sub-prime loan defauls happended around Sept 2008. If the propery valuation was done by appraisal, chances are there is nothing to dispute.

If you are making a profit when you sell, you are well ahead of most homeowners in America today.

A couple hundred $ per month income from a high end condo is really a negative cash flow proposition. One major system replacement, or one month vacancy, wipes out more than an entire year of cash flow.

Purchasing eight $50K properties for rental use is a lot less risk than having one $400K rental. With one property, a vacant month erases all your cash flow for the year. With eight rentals, one or two vacancies duriong the year does not put you into a negative cash flow. If properly managed and maintained, it would take a FEMA size natural disaster to make all eight units vacant at the same time.

13

Lenders are still lending money without income tax verification on income properties? These days they are asking for income tax verification for the last three years as proof that it had low vacancies and could generate that kind of income. What kind of vacancies it had in the past 3 years should be a good indicator of whether this is a good investment or not.

I’ve been looking at those hotel condos myself in different cities where they’re claiming it can make huge returns in a year and that it’s such a great deal. Maintenance free. $8/day service charges to clean it up after the last vacationer moves out so it’s ready for the next vacationer. Write off your trip to this vacation property. Then I asked them for the vacancy rate in the past three years and they didn’t want to give it. Hmmm, I wonder why?