1031 Exchange worth it?

Question

Hi BiggerPockets! I'm pretty new to the forums but I've been using BiggerPockets as a resource on and off for a few years. I'm getting more serious about real estate investing- I was a full time architecture graduate student and that took up 100% of my time.

I ran the numbers on a condo I own and I realize it is underperforming financially compared to a home I recently bought. The condo can get about $900/month in rent and the home $850/month yet the SFH sees $2200 less per year in expenses. The SFH is outside the city limits and taxes are much cheaper and the condo regime fee is a killer.

The condo is vacant right now and in good shape to sell. In my area, many condos and apartment buildings are being built that offer similar rents but with more amenities and newer construction. I feel like competing with them is hard and the response to my listing it for rent is proving that. I have decided to sell the condo and would like to reinvest the proceeds of the sale or pay off a loan (HELOC) that I recently took out to buy a new property. The HELOC amount is approx. $85k. I know that the 1031 exchange would only apply to a new property, not the payoff of this loan.

My primary question for more experienced investors is: is a 1031 exchange worth the trouble?

The stats on the property: the tax basis is $52,978 and the potential sale will bring in approximately $130,000. I have improved the condo with capital expenses around $20,000 (actually more but I don't have the receipts and documentation for everything unfortunately). Without the improvements, my accountant estimated that my taxes after commissions will be $12,500- $9,500 Federal and $3000 state. With the improvements, she estimates I will save about $2500-3000 in taxes. Is the 1031 exchange to offset $10k in taxes worth it?

I'm very new to real estate investing as a profitable business versus a hobby and have a lot to learn so I'm anxious to hear any insights from you guys.

Thanks,

Virginia

Dave Foster · Answer

@Virginia Hunt, You'll get a dozen different opinions on this from a dozen different people.  I think you've got a great handle on the pivotal questions.

The cost and hassle of a 1031 vs $10K in tax.  Take $10K and lay it out on your kitchen table (or in your mind if you don't want to have that much fun).  And ask "what am I willing to do for this money?"

The 1031 will cost you around $750 - Would you pay $750 to get $10K.  Probably!

The 1031 has some hoops to jump through in the form of a 45 day identification period and a total time frame of 180 days.  Would you be willing to subject yourself to this calendar for $10K?

You may not find a property that works and you will have wasted $750.  Are you willing to spend $750 for the chance to get $10K?

If you're able to write off your heloc interest then that as an option shouldn't enter your thinking.  Since paying it off benefits you a little but not much.

There you have it - a 1031 is extra steps.  It's not guaranteed.  But it's cheap.  And not paying taxes is better than paying taxes.

Only you know you!

Dave Foster · Answer

Well said @Michael Bishop.  I think it was Albert Einstein supposedly called compound interest the "...most powerful force in the world.  Those who understand it earn it.  Those who don't pay it."  The 1031 does let you use it.

But there's an additional component that is also at the core of a 1031 investor's strategy - leverage.  That $10K of tax doesn't represent $10K it represents a $50K rental with leverage.  And the favorite patron saint of Bigger Pockets Robert Kyosaki calls financial leverage, "...the advantage the rich have over the poor and middle class".

Moderation in all things of course but the 1031 does allow you to capitalize on both of the above financial principles to your advantage.

Clayton Mobley · Answer

@Virginia Hunt I'm a huge fan of the 1031, and many many of our clients have used it (multiple times) to great effect.

I agree with Dave, if you'd spend $750 to get $10k, I'd go for it! I know it sounds very complicated and a little intimidating, but that's what your qualified intermediary is for! Yes there are timelines and rules, but since you're only looking to exchange one prop worth about $130k, you're probably aren't going to be dealing with the more complicated rules that apply to exchanges for multiple props, you'll probably just go 1 for 1.

As has been said, yes there is the risk that you don't find a prop that works and you lose the $750, though I don't hear stories about that very often (or at all). Also, nothing is stopping you from doing the market research before you get into the 1031 process! Figure out where you'd want your new prop and start scouring MLS - get some possible options locked and loaded early so you know you can hit that 45 day identification deadline (that's usually the hardest one). You're not actually losing money right now, just not making as much as you could be, so you're in a good spot to figure out where your capital will work harder.

Given the numbers you've presented, I'd say the 1031 is worth it for sure. If you value your time/energy/stress level for a 6 month process (max 180 days) at more than $10k, then maybe it isn't worth it to you. But once you have a solid QI on your team, a lot of the pressure will be off you - someone is there to tell you what each step is and make sure everything is documented appropriately, which is totally worth $750 to me, personally.

If you're interested in staying invested in RE, a 1031 is a powerful tool to get accustomed to. If you're not super interested in the REI game anymore and would prefer to invest elsewhere, then it's just unnecessary hoops - you have to decide what your long-term goals are and go from there.

Best of luck!

Clayton

Matt K. · Answer

The amount of money I saved on my 1031 was significantly greater than what I'd make in the same period of time through my actual job. It was difficult, but wasn't impossible and this is coming from someone who found out about a 1031 by accident on google. Not to sound like the old grandpa or anything... but I did one working full time and fishing (read that as doing a thesis) for my masters. Probably the worst possible timing.... but even now it wasn't that bad.But in all honesty, that's because I wanted a investment property. This was my one big chance to jump in... it sounds like you're already in. I'd at least try assuming I wanted another property, even if you didn't get it you only paid small amount to try.

Michael Bishop · Answer

A lot of people mentioning the $10K you'd save by doing a 1031, but I'd go one step further and say that it's even more about future value. This example from "The Perfect Investment" by Paul Moore absolutely blew my mind:

If you take $1 and double it daily, tax-free, for 20 days, it's worth $1,048,576 after day 20. Take that same $1 and double it daily, but this time it's taxed at 30%, and it'll be worth $40,640 at the end of day 20. A $1M dollar difference!!!

While this is an extreme example, it can still be applied to the 1031 exchange. Earnings accumulated on compounding of principal money and tax-free earnings will greatly (and mind-blowingly) outperform earnings on compounding of principal alone.

Matt K. · Answer

those smarter than I will chime in... but you can do a reverse 1031... where you find the property first then sell yours.

Dave Foster · Answer

@Matt K., you're absolutely right.  I was reading into the scenario that the gain wasn't really great enough to absorb the extra cost of a reverse.

Virginia Hunt · Answer

Thank you for the responses- @Dave Foster, @Matt K. and @Clayton Mobley. It does sound like the 1031 exchange would be worth my time- especially since it's a $750 risk for potentially $10k reward. My concern is that the timing would need to be correct for me personally- I would need to be prepared to take on another rental and have the time to find the property, etc.

A 1031 sounds intimidating- but I would be working with someone else who would hopefully know what they are doing.

Thanks again for the responses. I think it's the right move.

1031 Exchange worth it?

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