Selling your single-family home rental and trading up into a large commercial property without paying taxes is one of the greatest wealth building tools that ever existed, and still exist today. Let me explain. This is what I did. I took my single-family home rental, and a little bit of cash flow, and I sold it. I took 100% of my profits, or 100% of my equity, and I purchased a 44-unit apartment building without paying taxes again. Not only did I increase my net worth with a 1031 Exchange, it also increased my cash flow enough where I can leave my job as in as an engineer.
Let's say that this is you. Let's say that you have multiple single-family homes. You bought them with the intent of using them to assist you with your retirement, or at least set you up for the retirement, but it quite didn't work out that way because of the low cash flow, the number of repairs, and maybe the management issues. What do you do? How do you get on track towards retirement?
What is a 1031 Exchange?
How about bundling your multiple single-family home properties and selling them without paying taxes again and trade up into a Starbucks, into a Triple Net Lease investment where you have no landlord responsibilities and perhaps you have a 15-year lease. Not only does this increase your net worth, but also stabilizes your cash flow for the next 15 years. How do you do that? Well, that's what we call the 1031 Exchange, it's also known as a 1031 Tax-Deferred Exchange. I'm going to illustrate how to take your rental property and trade it up into a larger commercial property, increasing your net worth, and increasing your cash flow without paying taxes.
I can't stress enough that if done the right way, the 1031 Exchange is one of the most powerful tools out there to build wealth in real estate by paying no taxes or by deferring taxes. I'm going to start this case study off by giving you the problem and then the solution, and then moving on from there so you can really get it.
The problem is you have a single-family home with equity. That's a good problem. Secondly, you have a little bit of cash flow, which is also pretty good. But here's the issue, your intent when you started purchasing single-family homes, were to buy multiple single-family homes so that you can increase your cash flow. Your hope was that this would set you up to retire or leave your job, or perhaps if you were to get downsized at your job, you could still pay the bills with the cash flow from the multiple single-family homes. Many of you, that's your goal. Or maybe it's to pay the kid's college tuition when the time comes.
Here's the problem. Your plan isn't working out the way you intended. The main reason why is because it's taking too long. Buying single-family homes is the long way of achieving the goals. That's the problem.
The solution is based upon the 1031 Exchange. The solution is to sell your single-family home rentals, all of them or the ones with the equity, and performing a 1031 Exchange or 1031 Tax-Deferred Exchange where you pay no taxes and purchase either a:
- triple net lease investment
- a large apartment building
- a shopping center
- industrial building
- office building warehouse
- mobile home park
If you do it correctly, you can multiply your cash flow and net worth. The next thing I want share with you is the three main things you need to know when considering or doing a 1031 Exchange.
3 Things to Consider Before Your Do a 1031 Exchange:
- You need to know the 1031 Exchange basics. The numbers 1031 is code word for an IRS, Internal Revenue Service, tax code. 1031 Exchange is a law and stipulates that you can sell your investment property and trade up into a larger property and defer your capital gains taxes if you follow certain rules. I call those the 1031 Exchange basics.
- Know what your profits are. It doesn't make sense to know this when you sell your property. You need to know what the profits are so you know exactly what you can trade up into.
- What are you exchanging into? What is your replacement property? Are you selling your single-family home rental and trading up into an apartment building, self-storage, office building, retail or raw land? We'll go over what you can exchange into and what you cannot exchange into.
4 Basic Rules of 1031 Exchanges
- Your property that you exchange into must be equal to or greater than the property that you're selling. The property you are selling is called your relinquished property, and the property you are exchanging into is your replacement property. If you are trading up from a $500, 000 to a $1 000,000 property, your replacement property is greater than your relinquished property.
- The amount of equity that you move forward must be equal to or greater than the next property or properties you buy. You must take all your profits from your relinquished property and put them into your replacement property. If you do not, if you make $250,000 in your sale and you only move forward $200,000, that means your 1031 Exchange has failed, and you're going to pay taxes on that $50,000. It defeats the purpose of what you're trying to do, which is build wealth and buy more assets. You must bring your total profits 0f $250,000 into the new deal. Then you have your corresponding mortgage which is the leverage part. Again, the value and the equity must be equal to or greater than the property that you relinquish.
- Once you sell your property, you have 45 days to identify your new property. Then you have a total of 180 days to close your deal. Once you sell your property, you have a 45-day period to identify your new property, and then from the day you sold up to 180 days, meaning an additional 135 days, to close your deal. You have six months to do everything. If you go beyond those six months, it's considered a failed 1031 Exchange, and you have to pay the taxes. We call that boot.
- You must use a qualified intermediary, or a qualified 1031 Exchange Company. You can find one on the internet or ask your escrow company for who they use or who they approve to do your deal. Not anyone can complete your 1031 Exchange, they must be a qualified Company. It's called a Qualified Intermediary or a QI.
3 Rules of the Identification Period
- The first rule when identifying your next property is called the three-property rule. You can identify up to three properties, and then you can close on one of them, just so long as the value is greater than or equal to your property that you sold. That's the three-property rule.
- Next, we have the 200% rule where you can identify an unlimited number of properties, but it can't exceed 200% of the value of the property that you relinquished.
- Then we have the 95% rule where you can identify more than three properties, but you must purchase at least 95% of all the properties that you identified.
The most popular out of the three is the three-property rule because it's the simplest. That means that once you sell your property, you can identify three properties and just purchase one, so long as it's greater than or equal to the value of your relinquished property and you move all your equity forward.
Which Properties Qualify?
Another thing to highlight is the properties that won't qualify for a 1031 Exchange. Your personal residence does not qualify, you may not use that for a 1031 Exchange. You can't trade into stocks, into developed lots, or into foreign property. Those are the four main no-nos when doing a 1031 Exchange.
Now let's dive a little deeper into the case study, so you can see how it really works. If you have a property or properties that you are considering selling to trade up, you can just follow this guideline. The first one was the 1031 Exchange basics, so now that you completely understand those basic rules let's move on to the second and third main things you need to successfully perform a 1031 Exchange.
Determine Your Profit
The second thing is determining your profit that you're going to have to move forward into your exchange. I'll give a quick example of how you're going to calculate what your profit is. You have your sell price, let's say you're selling your property for $500,000. You're going to pay off any loans that you have, pay the commission, and you're going to pay closing costs. Whatever is left over, that is your equity that you are moving forward. Remember, in an exchange, all of it needs to move forward into your replacement property.
The profits to move forward to buy a new property, that is your down payment. Your down payment will then help you to determine what your replacement property will be. For example, let's say after you sell your property, pay off your loan and closing costs, you have $250,000 left over. You're going to put that into your 1031 Exchange account, and then you can purchase a property of up to a million dollars, that's a 25% down payment. You can do that if you want to leverage that much.
3 Considerations in Choosing Replacement Property
1. What Are Your Goals?
When considering your replacement property, the first question that comes to mind is; what are your goals? Are you going to sell your single-family home and go into a larger apartment building to increase your cash flow? Are you going to buy a self-storage, a retail, an office building? It's important to think about your goals.
There are two goals I can think of right away. One would be to increase your cash flow. The second goal would be to restart depreciation. Maybe you've had your rental property for many years, and you can no longer depreciate it, so now you want to do a 1031 Exchange, buy a bigger building, and restart the depreciation. You can do that. Again, the beauty of commercial real estate.
2. What Can You Afford?
Just because you have $250,000 and you want to leverage it into a million dollar property, doesn't mean you can afford it. You need to determine whether you are able to do that financially and if you will qualify for that loan.
3. Get Started Early
The third thing, probably the most important these days, is to get started early. Back in the day when I first started doing 1031 Exchanges, there were plenty of properties to choose from all around the country. That's no longer the case. Now it takes time and execution, so give us a call, get some advisors in your team so you can be successful in this endeavor.
1031 Exchange Case Study
Here is the case study. I kept it simple because, if you plan well, it can be simple.
I'm going to sell my single-family home. Right now the cash flow's about $300 a month. My goal here is to increase the cash flow, because buying a single-family home was a good idea when that first started, but it is just not enough cash flow. My goal is increase the cash flow and get my retirement track going once again.
I'm going to sell my single-family home for $500,000. After I pay off my loan, pay the realtor, pay the commissions, and pay closing costs, I have about $250,000 in profits. That goes into my 1031 Exchange account. Remember, it has to be a 1031 Exchange company, a qualified intermediary that will hold the money for you to make this legal.
Then I have 45 days to identify my next property. This is key, you must identify in 45 days. I'm looking at an apartment building, at a Dollar General store, and I looked at an office building nearby. I decide to go with the apartment building. It is an apartment building called the Village Creek Apartments, it has 16 units and I'm going to buy it for $750,000. Remember the rule that when you sell the property, with a 1031 Exchange, your replacement property has to be of equal or greater value. With this example I go from $500,000 to $750,000.
Why Buy This Property?
The goal is to increase the cash flow, so let's go over the numbers so you can see why I selected this property.
- It brings in $112,000 a year in gross rental income.
- I pay all of my expenses, taxes, insurance, repairs, and property management, which is $43,000.
- I'm left over with $69,000. That's my NOI. Income minus expenses equals NOI. This $69,000 is what I have left over to pay the mortgage.
Let's do a quick calculation on the mortgage.
- I'm buying this for $750,000.
- I'm putting a down payment of $250,000 and have $500,000 leftover, so I will have a $500,000 mortgage. If you do the quick calculations at 5% interest, amortize over 25 years, the payments are about $2,900 a month. Multiply that by 12, and it comes out to be $35,076 per year.
I have my NOI, minus my mortgage for the year, which equals my cash flow for the year of $33,924. That's why I'm buying this property. I'm going from $300 a month to $33,924 per year which is a significant jump. That's what you can do, and the best part, it's tax-free.
So, I identified this property. I like it and I'm going to buy it. I then have additional 135 days to close. This is really important. I have 45 days identify. Once I identify the property, let's say on the 45th day, I have an additional 135 days to close, for a total of 180 days. If I go over that 180 days, I have failed my 1031 Exchange, and I have to pay the taxes.
I close on my deal and Village Creek Apartments is mine. Did I accomplish my goals?
First of all, my exchange was successful and I did not pay taxes on the $250,000, so my taxes were deferred successfully. Secondly, I increased my cash flow by nine times. I'm going from $300 a month to $2,900 a month. That's a significant jump. Thirdly, my depreciation restarts. I had this single-family home for a long time. I used all the depreciation and all the tax write-offs. Now I'm buying this 16-unit apartment building, and I can start writing off once again all the profits or the cash flow that I make from the property. Then lastly, the most important thing for me personally, I'm back on my retirement track because if you recall I bought this single-family home, and was dismayed because it was taking too long. Now I'm back on track by exchanging into this 1031 Exchange property.
I have another post called "How to Turn Two Houses Into 34 Apartment Units". You can read that and see an example of what one of my students did. He did a 1031 Exchange, and he took his two single-family homes and bought 34 apartment units. I go over exactly how he did it and all the numbers. It will probably be very helpful for you to read this blogpost as well.