1031 Exchanges – Recent Learnings
Having recently completed a 1031 exchange, I want to share some experiences. I owned a 15 unit property for six years, sold it, and bought a 40 unit property with the proceeds. I’m excited that I was able to leverage up, and more relieved to have saved on the capital gains tax. For now.
The property I sold had a lot of equity built up over that time period. It was not a super high growth market, just steady and strong. After awhile the growth in income drives significant growth in value but the leverage is so diluted that your income potential is not being realized. That’s what happened with me.
First, why did I sell it and not consider refinancing? Two main reasons. First, most of the value I add to a property is added in the first 2-3 years. That’s what produces growth in rents and therefore value. Second, I wanted the largest property I could get for the equity in my current property so I wanted to pull all of the equity out, hence a sale.
A commonly overlooked metric in real estate is return on equity. Say you have a property you bought for $1M and put down $250K. It is producing $150K in income, has $75K in expenses, $75K in Net Operating Income ($150K – $75K), a 7.5% cap rate ($75K/$1M) and $25K in cash flow after debt service, a 10% cash-on-cash return ($25K/$250K) which is good in today’s market. You work on it over the next few years and rents have gone up 20%. Expenses have gone up too but we’ll assume your net income has gone up by 10% to $82K and your cash flow went up to $32K.
Now assuming the cap rate stayed the same at 7.5%, your property might be worth almost $1.1M ($82K/.075), nearly $100K growth in value.
However, let’s also say cap rates didn’t stay the same, they declined like most cap rates across the U.S. They declined to 6.5%. Your property is worth $1.26M, a gain of $260K.
So now you have your original $250K plus $260K more in equity. Sell it and you put $510K to work for you. Actually a little less because you have transaction costs, which you can’t ignore, but don’t materially change the point. If you buy a property where cash-on-cash return is also 10%, you’ll get $51K in income, an increase of $19K over what you were getting. And that’s for just a 20% increase in rent.
Back to 1031’s. The rules are that you have to identify three potential replacement properties within 45 days of closing and close on the purchase of one of those within 6 months of closing on the sale of your last property. (DISCLAIMER: I’m not an attorney, confirm all rules with your legal authority).
I first wanted to get a better idea of how long it will take to sell my current property. I contacted real estate brokers in the area, mentioned I was planning to list it soon, and interviewed a few. I confirmed what I thought, that properties will sell quickly. I then went to work finding a suitable replacement property. It’s honestly like Goldilocks and the Three Bears – soup can’t be too hot, too cold. If the replacement property is too cheap I will be putting too much equity in and my returns will be low. If it’s too expensive I have to pull in too much cash out of pocket. It’s not an easy task to ask your broker(s) to help you with. But this really is the hard part in today’s market.
You have to be specific about what you’re looking for, you have to spread your net, talk to multiple brokers, and be aggressive. Talk to them frequently. Don’t let your relationships languish.
For me, I wanted a stable, cash flowing property, not one that required a lot of capital improvements. Normally I do like the value-add opportunities of a property that’s a little more in need of TLC but not this one.
Then the plan would be to identify at least one potential replacement property and once I found this just-right property, I would list my current property for sale and hope the timing worked out. But that’s not what happened. I got unsolicited offers when word got out that I was selling, and they were for my most-optimistic price point. I took one of the offers and insisted upon a 90 day close period. Normally buyers ask for longer closes but in this I, the seller, asked for it. I needed the time to be sure I got the new property under contract.
The replacement property magically appeared in my inbox so my pursuit began. It is commonly believed that a 1031 buyer is at a disadvantage because the seller knows the buyer has to do the deal. There is some truth to that but the seller doesn’t know if you are also pursuing other options.
They have to believe you are. You can hide the fact that this is a 1031 purchase early but eventually you’ll have to disclose it.
Rule of thumb for all real estate investing: don’t be desperate.
Being in contract for both a sale and a purchase is a dance you need to be ready to take all the way. Get help. It’s just yourself in both transactions, probably no real partners. Retain a closing attorney and get a broker to represent you if you think you need one. Or find a mentor whom you can call with issues.
The issues I had were relatively minor. Trouble getting insurance as they were busy. Lender couldn’t get the appraisal done and reviewed, again staff shortages. Buyer of my property had to switch lenders. But everyone was dealing honestly and information flowed smoothly, which is clearly not always the case in real estate transactions.
Would I do it again? Above all, I don’t want to have the capital gains tax, but there may be other ways to avoid or delay that. Cost segregation and bonus depreciation help a lot, and other more creative tools may be available. Who knows, Congress might take this option away some day. Glad to get this one done, though, knowing there were 100 ways it could have fallen apart. And yes, I will try to do it again.