The last post was all about selling our first intentional rental (above). This post is about the 1031 exchange process and how we structured the deal for the replacement property.
Quick re-cap of what a 1031 exchange is: To defer capital gains taxes and depreciation recapture, you can use what is known as a 1031 tax-deferred exchange. There are rules to look into before you attempt one but essentially the seller has 45 days to identify replacement property and 180 days to close on it. To fully defer taxes, more value in real estate must be purchased than what was relinquished.
I’ve heard of investors making bad investments because they felt rushed to make a decision and I hoped we wouldn’t make the same mistake. We knew we had to make a purchase of 185K (our sale price) which means we would need to buy higher value than our typical single family house value. This meant we’d need multiple singles (allowed within rules of 1031) or a multi-unit. We put the word out for what we were looking for and also started an automated MLS search for small multi-units in our areas of interest. We found a house on MLS with a duplex behind it making it a three unit or triplex. It was in an area we like a lot for rentals. It was a C class area.
We made an offer below their asking price of 195K and asked for some seller financing. We ultimately settled for a purchase price of 180K with the gain from our sale of 56,000 as a down payment and the seller carrying payments for 7 months at 1,000 dollars per month – straight to principal. This would effectively lower the amount we would refinance after seven months (by 7,000 dollars) and allow us to do some other refinances before needing to refinance this one.
But I thought you had to buy more value in real estate than you relinquished? I’m glad you asked. This is where having professionals to call on is important. The company who is our 1031 “custodian” that holds our funds was able to help advise us. It turns out that the 5,000 dollars in realtors fees we paid to sell our relinquished property actually can be subtracted from our sale price, thus reducing our basis to 180K that we needed to purchase to fully defer taxes. That’s about as close as we can cut it and still shelter all of our gain.
This deal is not yet complete but I feel certain it will go through in the next couple of weeks with no issue. Time will tell how good this investment is but we combined some old and new strategies to make this deal come together. One thing we did was utilize a 1031 exchange which we’ve never done before. We combined that with seller financing which we have done before and we found the deal on the MLS which we haven’t done in years. This deal is a reminder for me that deals can be made on the MLS but you may have to get creative. You may be “making” a deal by being creative more than “finding” a deal.
In this case, the seller was an investor and understood owner financing. We were able to offer a slightly higher price if she would entertain our owner-financing request. The seller’s agent was also familiar with this strategy and could present our offer clearly. For the seller, our significant down-payment reduced the risk significantly. For us, the owner financing allowed for some quick pay-down from rents received and we avoided the cost of private money we would have paid if doing this using our old standby – the BRRRR technique. It also was long enough to get us past the six month seasoning period required by most lenders to do a re-finance. Our private money costs would have been about 7,000 dollars for a seven month hold. Instead we’ll pay, or more accurately our tenants, will pay 7,000 dollars towards principal. Remember, principal is our money. It’s the equity we build up over time. So I consider this a 14,000 dollar swing to the positive on this deal by just being creative and seeing an opportunity to create a win/win.
What I might do differently:
I might have asked for the owner financing for a full year or two to see if the seller would be interested. I may have increased the monthly payment to 1500 to principal as the cash flow would support it; thus lowering the re-finance amount significantly and boosting cash flow into the future. However, we’ve made several purchases and structured several deals to sacrifice cash flow today for a bigger gain in the future so this one will be just fine as our cash flow will be healthy from day 1.
What we may do with it in the future:
We could refinance the balance due in seven months into a long-term rate and term loan and have nice cash flow which is plan A right now. We could also have the property appraised and potentially pull equity out of it, reducing cash flow, but have tax-free money back in our hands after we deferred all of those gains through a 1031 exchange. In other words, it is allowable to roll your gains into a property and then pull the gains out in a re-finance if there is substantial equity. This would resemble the BRRRR strategy.
So when someone tells me there are no deals on the MLS (which I, myself have said recently) I will tell them about this deal. They do exist. But you may have to put together some creative strategies.
How a mediocre deal got us here:
The relinquished property was sold due to increasing taxes and minimal cash flow after having pulled equity to invest in other properties. This new property should bring up our total cash flow from pretty much zero on the relinquished property to approximately 600 per month on the new property after expenses. We will pay no capital gains or depreciation recapture at this time. This was all possible because we took action on a mediocre deal about seven years ago. That was when we bought the relinquished property off of the MLS with a conventional loan and paid for minor repairs out of our pocket. We were scared. We since pulled equity which we used for other properties. The property also appreciated over this time. Now we are transferring the equity into this new deal.
If any of this was unclear, don’t worry. We started with the boring old conventional loan structure and now do more creative strategies when we can. This isn’t all that advanced but it combines several strategies in one deal. Re-read this if something wasn’t clear or comment below and I will answer all questions.
As happy as we are about this deal, I don’t want to give the impression that we’re getting every deal we offer on. The same week this deal worked out, two other deals did not. But this one did because we are making offers. You will get zero percent of the deals you don’t offer on.
I hope this helps you to see that there are deals out there even in this seller’s market. Some are even on MLS if we can structure them creatively. Make offers and listen to sellers and ask realtors questions to see the level of motivation of the seller or how you may be able to help them solve their problem. And as always, Keep The Main Thing The Main Thing.