1031 Exchange and Subject To - Posted by JG

Posted by Dave T on February 08, 2002 at 02:24:07:

My argument is not with your strategy, but rather with your use of the terms “return” and “maximizing returns”. In my experience, the term “return” is often a synonym for “yield” and is usually understood as “return on investment”.

I applaud your strategy when an investor, such as yourself, is in a position to take advantage of equity to produce income. In fact, I have used this strategy myself.

Let’s say that you purchase a rental property for $100K cash. You rent that property for $1200 per month, with $1000 monthly cash flow. Since your investment in the property is $100K and your annual cash flow is $12K, your annual return is 12%. Assume that your income and expenses stay constant, but, with a modest 5% appreciation, your equity doubles in about 15 years. Your return (return on investment) is still 12% even though your equity has grown to $200K through appreciation.

Now to implement your strategy, let’s say that shortly after you purchase your $100K property (all cash), you find a $50K property you can purchase and realize a $500 monthly cash flow. Because you used all your cash to purchase the first property, you decide to convert some of your equity to cash with a refinance. Let’s refinance your property for $50K to get the cash to purchase the new property. Since this is a hypothetical discussion, let’s ignore closing costs and financing costs.

You take the $50K from your refinance and purchase the new property (free an clear) for $50K. At 8%, your $50K mortgage will cost you about $367 per month, but your new investment will generate $500 cash flow per month for a net cash flow increase of $133 per month.

Now instead of one property generating $1000 per month in cash flow, you have two properties that generate a combined cash flow of $1133 per month. Since you still have only $100K of your money invested in the properties, your return on investment has now improved to about 13.6%

But wait, you want to do better. Instead of buying just one property for $50K cash, you decide to buy four properties with 75% financing. You make $12500 downpayments on each of four $50K properties and finance $37,500 on each new property purchase. The mortgage payment on a $37500 loan (at 8%) is $275 a month for each new property. Now you have five properties generating $1533 cash flow per month (net operating income of $3000 minus debt service of $1467). Because you have not added any money out of your pocket, your investment in all five of these properties is still only $100K but your return on your $100K investment is now about 18.4%. By leveraging your equity, your return in this instance has increased from 12% to 18.4%. By the way, you still start with $100K equity in these five properties, and with 5% appreciation, your equity will increase to around $400K after 15 years (actually a little more because you are paying down debt as well). For our $100K investment, the FMV of these five properties will be about $600K in 15 years versus only $200K in our single property example.

I think we both agree on the validity of the approach. When the benefit derived from the leveraged equity is greater than the cost of doing so, it makes sense to take advantage of the opportunity.

I can’t comment on whether to use a 1031 or a leveraged equity approach to achieve your goals. You have to work up the cash flow numbers for each approach to determine which is best for you in light of the costs inherent in each approach.

I do note for your consideration, that in a 1031, the cost basis in your relinquished property plus any cash (and/or debt) you add to the replacement property purchase, becomes your new basis for the replacement property. To me, you would not get as great a depreciation expense in a 1031 exchange as you would by using leveraged equity to purchase an additional investment property.

1031 Exchange and Subject To - Posted by JG

Posted by JG on February 05, 2002 at 08:51:34:

I purchased a rental property for 92k 10 years ago and put 30k down. I now have a buyer for 200K. The capital gain is roughly 20% of 108K. I refinanced last year and pulled out 75K. I still have 70k equity in this property. This property has been a “cash cow” over the years.

Here are my questions:

  1. How can I maximize the rate of return and minimize the tax consequence for the above property?

  2. I would like to do a 1031 Exchange and move the money into 2 properties. Can I take possession of the 2 properties via “Subject To”.

  3. What are my options? Or what should I be considering?

Thanks in advance for any input.

Consider - Posted by Bud Branstetter

Posted by Bud Branstetter on February 05, 2002 at 10:16:30:

You have about 23K in depreciation that you would have to recapture in the year of sale besides the tax on the appreciation. The money that you pulled out has to be taken into account much like boot in a 1031. You would have to look for property in which there are 130K in mortgages and 70K in equity. Many of the subject to deals would not have that much equity. As you stated you are considering two deals. I would first find the subject to deal that requires lesser cash. Option it then find your buyer for your property. After that it should be easier to find an exchange for the remaining cash. In effect the total value has to be greater and the mortgages have to be greater.

It is an interesting thought to exchange subject to where you have pulled cash out via refi. If that subject property that you have little or no cash into gets foreclosed, do you care. You have all the cash as equity in the other property. I’ll have to explore that more.

Re: 1031 Exchange and Subject To - Posted by jim

Posted by jim on February 05, 2002 at 09:47:38:

You have stated the capital gain is the difference between the purchase price and the sale price. Have you been depreciating the property according to IRS guidelines over the years? Offhand, it does not sound like you have been. Have you included any repairs you have made recently for the sale in your figures? Be sure to take advantage of these and all of the legal deductions that you can. For a 1031 exchange, I would go to a company that specializes in these.

Re: 1031 Exchange and Subject To - Posted by Jg

Posted by Jg on February 05, 2002 at 10:23:59:

I have been depreciating the property over the last 10 years.

There have been no major repairs over the last 10 years. The tenant agreed to take care of minor fixes. I don’t understand why the tenant has never wanted to purchase the property. His mortgage payment would be less than monthly payments??? I simply get a check in the mail each month and never hear from him.

Re: 1031 Exchange and Subject To - Posted by jim

Posted by jim on February 05, 2002 at 11:37:31:

Do you still have the same tenant living there? If so, why do you want to sell the property? From what you have stated, having that tenant in that property sounds like a dream situation. He pays the rent, fixes minor repairs himself, has stayed a long time you never hear from him, and he doesn’t want to buy the property. Some people would rather pay rent than buy.

Is the property in an area that will keep appreciating, even at a low rate? If so, I would not sell the property, particularly since you seem to be facing a large bite in taxes. Those who have done very well in real estate and stocks have been “buy and hold” investors.

Have you considered just buying the other properties that you are interested in without selling this one? There are many ways. I see them every day as I am in the mortgage business.

Re: 1031 Exchange and Subject To - Posted by JG

Posted by JG on February 05, 2002 at 12:38:27:

Thank you for your response. Let me answer your questions.

House Info:
1992 FMV 92k
1992-2000 5k/yr profit
2001 refi pulled out 75k
2002 FMV 200k
2002 projected profit 3.5k with 75k equity

Q1. Is the property in an area that will keep appreciating, even at a low rate?
The property has appreciated on average above 8% over a 10 year period. Over the years we pulled out 5k/yr profit. Then we refinanced and pulled out 75k.
The property is surrounded by 750k custom homes. I believe the property will continue to appreciate at an above average rate. But, tell me who has the “crystal ball” and can project future appreciation. The rate of return goes down as the equity goes up in the property. I am interested in maximizing the rate of return over the next 10 years. Does it make sense to move the money into 2 properties, instead of just having one?

Q2. Have you considered just buying the other properties that you are interested in without selling this one?

Yes and No - I have not done much real estate investing over the years, just kind of fell into this deal. The farm is producing more crops than I can store in the barn. I need to figure out where to store the produce.

Any advice would be helpful.

Re: 1031 Exchange and Subject To - Posted by jim

Posted by jim on February 06, 2002 at 24:04:00:

My three cents:

When investing in real estate or stocks for the long term, one should have a good reason to sell, because selling only incurs expenses (brokers fees and capital gains taxes). From all of the information you have given me, I can see no reason for you to sell or exchange this property. It sounds like you have had a good investment since you purchased it and will have a good investment for many years to come. 1031 exchanges are nice, but the government never gives you something for nothing. You have to jump through the hoops, dot your i’s and cross your t’s. If you don’t do it properly, it doesn’t count in which case the taxes and penalties can be very high.

I would continue to invest in quality properties for the long term using the BUY AND HOLD method which has worked so well for you. Do not invest because you do not know where to put the money. Put the money into the bank until you find a lucrative deal that you have analyzed and determined that it is the proper investment for you and that you will be happy with for years to come.

I wish you the best of luck.

Re: 1031 Exchange and Subject To - Posted by JG

Posted by JG on February 06, 2002 at 24:16:04:

In order to maximize the rate of return I would need to consider refinancing every 3 years as long as the rates are favorable.

I could use this money for real estate investment.

Re: 1031 Exchange and Subject To - Posted by Dave T

Posted by Dave T on February 07, 2002 at 16:09:14:

You lost me here. How does refinancing every 3 years maximize the rate of return? Perhaps you could give me a hypothetical example?

If your intent is to refinance to get money for investment use, do you still have the $75K available that you got from your first refinance?

Re: 1031 Exchange and Subject To - Posted by JG

Posted by JG on February 07, 2002 at 16:43:41:

Let me answer your questions:
Q1. How does refinancing every 3 years maximize the rate of return?
If the property is appreciating at a steady rate the return will drop over the years because the equity in the house is increasing.

Assume you buy a house for 100k and put 10k down

Looking at the return due to appreciation only (10% app):
Let’s look at (appreciation in yr)/(equity in house)
1st yr - 10K/10K = 100%; FMV end of yr ->110k
2nd yr - 11K/21K = 52%; FMV end of yr ->121k
3rd yr - 12K/33K = 36%; FMV end of yr ->133k

The rate of return drops as the equity goes up! Shouldn’t you want to reduce the money tied up in the house to get the returns up?

Q2: do you still have the $75K available that you got from your first refinance?
Yes - but it’s invested in more property

Does this make sense to you?

Re: 1031 Exchange and Subject To - Posted by Dave T

Posted by Dave T on February 07, 2002 at 23:08:00:

Does not compute for me. Your equity from appreciation may go up, but your cash investment in the property stays the same.

In your example, you still have only $10K invested in the property at the end of three years. Since you have not added any of your money to the property in either capital expenses or principle reduction, your yield (return on investment) would still be computed based on your $10K cash contribution to the deal.

In my way of thinking, equity is not the same as cash “tied up” in the property unless it is cash out of my pocket. Appreciation in the property just increases my net worth (wealth).

Re: 1031 Exchange and Subject To - Posted by JG

Posted by JG on February 08, 2002 at 24:10:00:

Years ago, my thinking was similiar to yours, until I realized I had 150K equity in a 200K house.

Then I refinanced and pulled out 75K and bought another house and began to understand…

Now I have instead of 1 house (200k) appreciating,
I now have 2 houses 200K + 275K = 475K appreciating.

I am considering 1031 exchange or refi and picking up two more houses this year.

I believe my thinking is sound. What do you think?