Erica tells her story of how she was eating lunch and walked from the job to eventually build a thriving coaching business.
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.
The turnkey world was explained in this previous post. If you are going down this passive investing path, here are some questions to ask. This is not an interview, but simply a conversation starter. Use the salesman to educate yourself and exercise your BS-Detector. A lot of people ask me who the people to work with are. I am afraid for those who think like that because they will not go through this important education phase.
- Can you break down the structure of your company for me? (Let them explain)
- Tell me how your process works from start to finish? (Let them explain)
- What does “turnkey” mean with your company? (Let them explain)
- Do you own properties close to the one you’re selling to me? (Determine if you are working directly with the TKP or middleman)
- Will there be a tenant in place before I close on the property? (There are pros & cons)
- Can I use financing to purchase the property? What happens if my financing falls through? (Determine if you are potentially overpaying)
- Is the home required to pass inspection and appraisal before I close? (Determine if you are potentially overpaying)
- Can I hire my own appraiser before closing on the property? (Determine if you are potentially overpaying)
- Do you use other companies to help you provide turnkey properties? (Understand where their deal flow comes from)
- What is your role in the sale of the turnkey properties? (Get a sense of the size of their operation, are they the sales guy, rehab guy, or everything?)
- Who are the “boots on the ground” in these areas? (Are you talking to the actual guy who manages the crews or just their sales person who never leaves the office)
- Who owns the homes? (Understand where their deal flow comes from)
- Who rehabs the homes? (Clarification on the buying process)
- Am I expected to pay for the rehab? (Clarification on what you are buying)
- Who manages the properties after the sale?
- How long have you been in business for?
- Is there a warranty on the property after the sale? (Beware if they provide vacancy assurance or warranties on work. They sound good but the provider could just be covering their work with a 3rd party insurance company)
- Can I see a scope of work with expenses for one of your rehabs? (Check out markups and what is fixed)
- How many properties are generally in your inventory month by month? (The more properties means better economies of scale but can also mean more bloat and more competition from other buyers)
- What sets you apart from other turnkey companies?
- What are some mistakes you make when you started out, and how are you doing those things differently now?
- Do you invest? If so what?
SPC Git Er’ Done Action Plan:
- Make a list of Turnkey providers, markers, agents to have a conversation with.
- Send out emails to providers and schedule discussions.
- Get on the phone, learn, and exercise your BS-Detector.
- Email (Lane@simplepassivecashflow.com) me a screenshot of your iTunes review and I will send you the spreadsheet with some of the most popular Turnkey Providers to start your call list.
Why the heck are we talking about, a board game?
When people in the very final stages of their life were asked, “what they regretted,” the response that often came up was that they wished they ‘played’ more. (Also in the top responses was a regret of spending so much time at work) The point is, although we are making investments and working hard, we should not forget to ‘play’ or have fun. I had a friend that played hours of video game baseball. Other than the fact that nobody plays baseball on video games, I always gave him crap. Now a little wiser, I realize that he was right… it made him happy and that was important (Side note: I do not condone mindless World of Warcraft addictions). Read on for the second lesson from this board game.
For the past decade, one award-winning board game called “Settlers of Catan”, has built up a huge, cult-like following, garnering hundreds of 5-Star reviews on Amazon and played by normal people unlike the Magic Gathering Card game or Dungeons and Dragons. In other words, females play this game and guys, who could probably save their lives by throwing a football play it too. If you have not heard of this game then you probably have never heard of BiggerPockets.com and you live under a rock. The strategy-intensive game, is intended to last less than 45 minutes. During that time, players collect resources and use them to build roads, settlements, and cities on their way to victory.
Check out this well made 4 minute documentary on the game.
The board game presents players with many decisions that parallel those facing many experienced real estate investors. In Settlers of Catan, there are 5 resources which include sheep, lumber, ore, brick, and grain. In the beginning of the game, sheep and wood are sought after, whereas in the dramatic ending of the game, ore is needed to lock in a win. Side note – I actually have a t-shirt that says “Nobody wants your F-ing Sheep” because as a typical occurrence in every game there is always one unfortunate player who is lagging behind and still trying to peddle their surplus of sheep.
The life cycle of an investor starts with typical equity building with rentals that utilize leverage (sheep/wood) and progress to larger deals (brick/grain). As the investor reaches the second half of their progression and surpassed the “critical point” where they have amassed enough equity build-up to live off their “dividends,” the investor will look to convert their portfolio to a more cash flowing portfolio via de-leveraged rentals, private lending, or notes (ore in Settlers of Catan). This stage is often called the end-game strategy. So often I see newbie investors with low cashflow/low assets with shiny object syndrome and want to get into notes or land contracts because that happened to be what Guru seminar they attended.
So if you don’t care about this fricking game and skipped ahead to the conclusion here it is. Whatever path you take in investing keep the end in mind… the end game… the goal. Have a series of if/then exit strategies in mind with everything you invest in. A few examples:
- A lot of people talk to me and say that they are tired of investing for appreciation and want to go for 100% cashflow to hold on to indefinitely. Having a few years of experience I realize that nothing is forever and things happen. Those investments that you bought, might have gone up in value 20% and it makes sense to cash out or you find another investment that is so much sweeter. But at the time of purchase, you did not think of these potential decisions when you bought the low 40k homes or a duplex/triplex/quad that are inherently harder to sell to a retail buyer as your exit strategy. Perhaps buying a higher price single family home would have been a better way to go (forgoing optimum cashflow).
- You have that meeting with a lawyer who sells you on this elaborate corporate structure but it might be a bit overkill since your dreams of building a 50 home portfolio transitions to other investments.
- You waste your time and money creating a small network of contractors to serve as part-time staff to service your 3 duplexes in the area. However, now it looks like you should sell and you wasted all that sweat equity in creating that system.
- You heard about the wonders of the Self-Directed IRA from a local Real Estate meeting and rush out to make the conversion and deploy your cash into a Real Estate notes. Now you realize that you have lost your leveraging ability but more importantly you are unable to use your IRA as cash reserves to get Fannie Mae loans.
SPC Git Er’ Done Action Plan:
- Don’t let this article give you an excuse for analysis paralysis, but inspire you to find that mentor who can help. You will never know all there needs to know by yourself.
- If you have implemented your Real Estate plan and looking for something fun to do, go out and enjoy life and buy this game! (Help support the site buy via Amazon affiliate link)
Do not buy properties all cash. I don’t care even if you are in the endgame part of your strategy. The real risk in having so much equity in your properties. The real security is having cashflow.
Warning – Paradigm shift ahead! In the old Caste System people were split up in ranks to keep lower class people from rising up and keep those in power where they are whereas today, money/mindset is the real separator of the masses.
When I first got started in Real Estate investing I was lucky to have a good job and was able to skip right over the wholeselling/birddogging roles and go right into a buy and hold rentals with the conventional 20% down payment. Little did I know that I had just vaulted over about 80% of my local REIA members who had little money and not making any deals. To be in that 80% group was a terrible place not because of the endless books, seminars, training for the wholeselling/birddogging strategy but competition was fierce – imagine the start of a triathlon as the athletes jump into the first stage of competition -the swim, even the best athletes struggle to distance themselves from the pack as the pack pulls and sabotages those who try to distance themselves.
“Mindset of the best Performers”Continue reading
I’m going to take you back to high school math class for a moment. Remember the 4 Quadrants, they are labeled Quadrant 1 in the North East quadrant and Quadrant 2 in the North West…etc. The above graph only shows Quadrant I. To put it simply these markets in Quadrant 1, have median home Rent to Value ratios above 1% (a 100k property rents for more than 1000 per month – 1000/100,000=1%). These are the markets that investors like as cashflow investments because the income typically covers the mortgage and then some.
“The Real Cashflow Quadrant – Turn Key Rentals Heat Chart 4/2016”Continue reading
Download the worksheet to calculate the return on your deployable equity.
Wait I thought Seattle/San Francisco was a hot market with double-digit appreciation and an up and coming tech market?!? Return on Equity = Profit (Cashflow) / Total Deployable Equity if your sold (Don’t forget to include selling commissions)
“every month that goes by you are losing $300/month per $25k you have of deployable equity”
“Why I sold my High Appreciation Seattle Rentals: Return on Equity”Continue reading