11 Not So Obvious 1031 Exchange Strategies
My promise to my readers: No click bait here on SimplePassiveCashflow.com – all the tips will be provided on the SAME page, so relax! For real estate investors at some point, you are going to need to do a 1031 exchange. Having just done two of them, I wanted to share my experience before I forget it (since its sort of a pain in the butt and people forget painful things). Hopefully, it will help you create a game plan going in.
So no investor is left behind, a 1031 exchange is a way to defer your capital gains from a sale of real property. This is one of the advantages of real estate as compared to stocks or other assets. I am no lawyer or CPA, but basically, you have 180 days from the sale of your first/subject property to exchange into “like kind” investments using the proceeds (sale price minus existing mortgage and sales costs). This transaction needs to be done via an intermediary/custodian who sets up an escrow to create the paper trail for your upcoming taxes. This process is something you don’t want to DIY because if you screw up, you are going have to pay taxes on the proceeds, plus all that depreciation (recapture) you benefited from. Oh and one more kicker… once you sell the subject property you have 45 days to create a list that identifies all potential replacement properties, but more on that in a bit.
So now that the newbies have caught up there are the tips:
1) Have properties ready to go: This means having a purchase and sale agreement signed and having completed the negotiation before the subject property (the home you are exchanging/selling) closes. As the close date for the sale of your subject property gets closer (~2 weeks) and especially if it’s a slam-dunk transaction (i.e., the buyer is bringing cash to close/no financing), you might want to take the risk and execute those purchase and sale contracts sooner. Note that this is a bit shady to your agent because if complications do arise then you will have to cancel your contract and no one will like you L
2) Don’t screw around. Get your inspections done as a soon as possible. Knowing if you are going to move forward or abort the purchase of a property is super important. Remember other than the 180 day time limit the other properties on you 45-day list could be bought by other investors.
3) Work with a real estate attorney who has experience with a 1031 Exchange: Policies regarding 1031s will vary from year to year with changes in the Tax Code. Once you sell your property, you will also need someone to hold your funds in escrow, because you are not able to take possession of the funds. If you do take possession of the funds from the sale of your property, the 1031 exchange won’t work anymore. But good thing you found that lawyer that will do this all full service for you.
Rumor has it that the silly escrow rule was created when some guy took the proceeds from the sale of his property to Las Vegas and blew all his money on rocks and hookers. After that, the Government was like, “These people are idiots, we can’t let this happen.” So that guy ruined it for everyone, and now we have to all follow this arduous process.
Pick that lawyer and have all of the contractual details worked out before the subject property goes under contract to sell. Expect to pay $500-$1200 plus additional fees for each property you acquire. Talk to your lawyer and get educated about all the rules, such as the 200% rule, 45-day list, 180-day rule, what is eligible to write off, and get them to sign off on your plan. Remember these guys know how to do 1031s, and it’s ultimately your job to get the big picture right. That’s why you’re the boss.
4) The All-Important 45-Day Rule: As mentioned earlier you need to create a list of potential properties that you can acquire before the 45th day after the sale of your subject property. The rules change on these 1031s all the time (see disclaimer below) but I was only able to identify up to 200% of the subject property’s value which for me was eight properties for $800k, since the subject property sold for about $400k. (I don’t know where this rule came from, but it was probably conceived by Vegas, hookers, and rocks) What I would do about 10 days prior to the deadline of your 45-day list, send out an email blast to all your agents, turnkey providers, long lost wholesalers (you know the folks you exchange info and you never hear from again like an ex-college classmate) and basically do a roll call for all properties. This is a time to call (not email/text) to explain your situation. Set broad constraints, and specify that you need X properties from each provider that you will buy X of them. This will let the sellers know that you are serious, and they may move mountains for you and bump you up in the priority line. This may also eliminate the silly negotiation process and get you the best pricing. The beauty of doing this is that you are creating a competitive bid format and will ultimately fill up your 45-day-list with the best candidates.
5) Have a Backup Plan: When soliciting for your 45-day-list, you may also want to ask for properties that aren’t ready to be sold yet but “are in the pipeline.” For example, these are the properties that have just been picked up by the seller from an auction or those where a wholesaler is in discussion with the first seller, and the rehab has not begun. Fast forward a couple months, and suppose a few properties on your 45-day-list fall through due to a bad inspection, you are going to need to go back to your list and if you had properties that were ready to be sold at that time of the 45-day-list creation, a lot of them will be sold by then. In summary, this is where adding in the sleeper picks or prospects makes building your list complicated. You need to really meditate with a “Simple Passive Cashflow Latte” and think of every angle.
6) Your 1031 facilitator, gets paid when you do a 1031 exchange. Your lender gets paid when you refinance. Your Bank gets paid when you set up a HELOC. Each are a tool and every situation is unique. Is a 1031 really your best option? Sorry if this point is a bit late in the conversation, but I am assuming you are reading this article before showing up to the Toga Party with your loin cloth.
7) Do your own research on a “Reverse 1031 exchange”. It’s a bit more expensive but might be the right tool for the job, however, it is not for the situation where you are trading one property for many. Personally, I think it’s a tool for a really unique situation and it’s not worth discussing, but I’m sure a Lawyer will want to tell you all about it at their $300/per hour billable rate.
8) Get Everyone on the Same Page: Have a good old-fashioned, conference call to get your lender and 1031 facilitator on the same page. Isn’t it great to be the leader of a conference call for something meaningful this time? Funny Video. But what is not funny is getting that call from the lender who uses the underwriter as an excuse for why you can’t get a loan a couple weeks before the close. That phone call is totally avoidable with proper communication upfront to ensure you can qualify for the loans with the proper debt to income (DTI) requirements and Cash Reserves. As of June 2016, you need six months of PITI for your first four loans, but loans #4-10 need six months for ALL properties. When I was trying to close loan #10, I needed about $33,000 dollars of cash reserves just sitting there ($550x6x10). This makes an optimizer like myself really irritated. Luckily you can use ~100% of 401k or Roth accounts. Just a last month they allowed you to only count 70% so you can see how that rules change. Also in terms of cash reserves, make sure you have consulted with your lender about the required amount of time you need to season the funds in your bank account.
Also depending on your 1031 facilitator, you might be able to talk them into paying the appraisal fees out of the 1031 funds instead of out of pocket. I got my lender to reverse the charges and bill the appraisal fee at closing. Unfortunately, the home inspector will likely want to be paid via cold hard cash because he (Let’s be honest…it’s always a guy) is running a good old-fashioned cash business. Just kidding, he takes credit card too. Did I mention that you should relax through this 1031 ordeal? Now, is the time for yourself to enjoy an Old-Fashion or other alcoholic beverage, you are almost done.
9) Use It Or Lose It: As you are getting to the end of your 1031 timeline and utilizing most of the 1031 funds, you are going to have to decide to use it all or leave some money unutilized. Typically you will have to pay taxes on the remaining (this remaining is called “the boot”). You are going to be faced with decisions to pick up properties that are less than desirable or walk from the deal (and pay the taxes on the unutilized funds). Case in point, say the last property needs $30K to close the deal but the seller is dragging their feet with final punch list repairs that came from the inspection. The seller is refusing to replace the roof because the roof is 15 years old and has a few good years left. Therefore, the seller does not want to pay $10K to fix it per your request. Let’s do the math, if you walk from the deal you pay ~25% of the $30k due to tax implications of not utilizing the funds and pay the government almost $8k. Armed with this information, it would be logical to suggest that the seller pays half of the roof costs ($5k) as it is a good business decision for you to make this concession and not pay the taxes on the boot (5K<8K). This is a simple example, but this is how the decision needs to be analyzed. Also, keep in mind, information is power. If the seller knew that you were in the late stages of your 1031 and you did not have any other potential 1031 properties to go after on your 45-day-list or nearing the 180-day deadline you would be at their mercy. But that’s negotiation, which can be a fancy 52-card game of BS.
10) Just take it day by day: It is not easy, but it’s simple…LOL. This is where you are glad you picked an investor focused lender who has done these things before instead of the neighborhood big bank. Again make sure you keep the line of communication open with your lender (every few days) to avoid large surprises.
11) A 1031 Exchange is Not for Beginners: If you have not purchased a rental property before I would try to buy one outside of a 1031 to test the agent, lender, market, and especially yourself. The 1031 is going to require you to have many plates spinning at once. It is best to first figure out the nuances with a simple one-off transaction.
Which property class or property value range would be best to put on the buying list?
This is ultimately up to your investing strategy and criteria. For me to tell you what is the best is irresponsible and against what I believe, because you should understand the macro (not micro) concepts for yourself and make your own best individual strategy. With that disclaimer out of the way, I originally went (my personal strategy changes over time) after B/B+ properties that rented for at least $1000 per month and had at least 3 bed and 2 bath. This strategy evolves as my portfolio grows. #1stWorldInvestorProblems. Some things to think of when finding your strategy/criteria include:
- Although I fully intend to hold on to these properties indefinitely for cashflow, I recognize that things change, and perhaps I might want to trade in one “goose that lays the golden egg” for two or three “geese that lay the golden egg” or one “big ass goose that yea you get the point.” To say, “My properties are generating cashflow” is a fallacy. Instead, you have to evaluate what the numbers say on the bottom of the spreadsheet and compare the two situations you are evaluating. You should always be making moves to optimize your return, assuming it warrants the transaction costs.
- I was using Fannie Mae loans, which are those sweet government subsidized 30-year fixed loans. At the time of this writing (5/2016) the most one person can have is 10 to their name (If you are smart also 10 in your married partner’s name too). Your plan might be to only get one or two homes and sail off into the sunset, but your plan might change and you have to change your plan for the “if” in life. To acquire a conventional Fannie/Freddie non-owner occupied property requires 20-25% down payment. There are also lender costs, which I typically estimate at $5000 +/- $1000. Parts of the lender costs are variable, such as an origination loan (basically it’s their fee to have to deal with you and headaches you cause them). Origination fees are typically a certain percentage (~1%) of the final loan, but the rate varies from lender to lender, so this is something you are comparing. Other parts of the lender costs are fixed costs such as inspection costs, credit reports, and appraisal fees. It is these fixed costs that are the same whether you buy a $40K property or a $140K property. This is one reason I personally went after a more expensive property.
- By buying 50K properties that rent for $800 you’re like “Hey that’s awesome that’s a 1.6+% Rent to Value Ratio”. But I suggest reading my article about the nuances of the RV Ratio and property classes. I promise you there is a graph and I’ll show you where I think where the cool kids are investing on the class spectrum. Remember the goal is to maximize the profit, which is the rent minus expenses (and the mortgage if you finance the property). Folks get wrapped around all these metrics, but do not forget the goal.
- This is totally my strategy, but please think for yourself: When I was getting started I went for the higher priced properties (Not the A properties cause there is no cashflow in there). I went for properties that rent for 1100 that I could get for 100K. I would say these were B+ properties (Note: do not take the seller’s definition). My strategy was to find low hassle properties that had better tenants and properties that I could easily liquidate because they were close to the median home. There is a bit contradiction here because yes, they were safer in terms of tenant quality and exit strategy, but the cashflow buffer was less, so I had less ability to lower rents in a market downturn. Now that I have a stronger base in terms of teams, money, and knowledge I try to go for more C properties because I feel I have the experience and risk tolerance for it (although I stated that these could be safer in terms of the buffer in the cashflow).
Goal: I am selling my home for 600k, and I want to invest out of state for cash flow at $200/month per door.
I think that the per door $200 assumption is in line. There is a difference if you are buying $60K properties or $120K properties but either way, I think you will be beating the averages of the stock market, and that is why I do what I do. One day I will make a video showing the math on the hidden benefits of owning rental real estate.
This is how it is going to work if you choose to sell and do a 1031 exchange. First, you sell the home for $600k (~10% will go to commissions, etc.), so you are left with $540K. This is how much you have to acquire, or there are tax penalties. Therefore, if you are looking at $90K properties, you are going to need to pick up 6 of them. Your cash in your 1031 will be $540k minus your remaining mortgage. You can bring cash out of pocket to make up any shortcomings. Check out this article for more info on some 1031 issues and strategies.
SPC Git Er’ Done Action Plan:
- If you’re not doing a 1031… You will need to do one in the future or you are just being silly by hoarding that equity. Today think about the possibility of this exit strategy as you purchase properties. For example, a lot of people talk about buying duplexes, triplexes, and quads, but when it’s time to sell, there is a fraction of possible buyers. And those possible buyers are all investors who are looking to get a deal.