Sell a fully owned house to start investing? HELOC?

Question

My grandma lives with me (and my younger brother) in Gainesville, FL. I am a full-time college student and working sometimes 40+ hours a week. We are currently renting a 3/2 home for ~$1300/mo.

She fully owns a home (3br/1ba) in the panhandle area (Niceville, FL) that Zillow estimates being worth around $180k. I have no idea if Zillow is accurate or not but more modern homes in the neighborhood are selling for $200-$300k so it may be a good rough estimate as I haven't had it properly appraised yet. The home was built in the 50s, and since then an additional portion (den) was added. It has a fairly recently redone roof as well. The problem is that it has an old septic tank, no central heat and air, and only has one bathroom.

We are currently renting it out for $1000/mo using a property manager since we live 300 miles away and can't manage it ourselves. We could probably get a little more out of it, but a lot of families understandably don't like only having one bathroom and no central heat/air. My grandma thinks adding central heat and air would be expensive since the attic has hardly any crawl space. The rent we are collecting helps us comfortably live here in the house we are renting.

I have started doing some research around BiggerPockets, looking into tax laws related to selling her house (121, 1031 exchange, etc.). She has not lived in the home for 2 out of the past 5 years, so capital gains would be an issue if we wanted to sell it without a 1031 exchange. I would like to take advantage of the fact that she has all of the equity in her home to start investing and/or buy a home for us to live in here as opposed to paying to rent.

My main reason for posting here would be to probe the community for ideas that I may not have considered yet (since I have only been researching for a week or so). Her home is in a VERY good location next to the best elementary school in the area, next to (but not too close to) a major highway that goes straight into Destin (major tourist/shopping beach town), and on a half-acre lot. The only downside is the features the home is lacking. These reasons make me think it's a good idea to keep it and continue the cash flow it provides.

The problem is that we do not have much savings available for investing/buying in town (less than $10k). We have a nice emergency fund that I am comfortable with, but not enough savings on top of it for a 20% down payment on an investment property. We could probably have enough for a 3.5% FHA loan within the next year, but on the other hand we could pull a HELOC on her home to potentially (not sure how feasible this is) buy a home for us to live in in Gainesville, and maybe a down payment on another investment property. Gainesville is a college town so there are a lot of rental possibilities due to the large influx of students and young professionals.

Some miscellaneous information that may be nice to know:

Our combined yearly income (my 40+ hours a week part time jobs, and her retirement) is somewhere in the $60k ball park. My credit is rather good (high 700s, a lot of credit cards that I pay off every month, but no large auto/home loan history), and hers is low 700s (long term, but no recent loans/credit cards). We have no debt (been able to pay for school using grants/working).

There are a lot of resources here that I haven't been able to fully navigate yet, so please feel free to just direct me to similar threads/blogs! I can provide more details if necessary. Thanks!

Dave Foster · Answer

@Wesley Piard, There's folks here who were buying stuff 3-4 years ago and getting a 4% rule on rentals. 1%, 2%, .5% is nothing more than a ratio between monthly rent and asset value. It's a way to stick your finger in the air and guestimate whether the property is a good rental or not.A property free and clear or a property heavily leveraged will not impact that % rule thing. In your case you're getting $1000 rent and it's worth $180,000 so you're about at the 0.5% rule. Is that good? In CA and some other places that's reality. In Cleveland it's a horrible return. But what does it really mean? It's as much a function of opportunity cost as it is simply looking at an individual asset's performance.$1000 rent is $12000 annual with $4k - $6K in Taxes and insurance. $1000 in repairs and $1000 in vacancy (all just estimates). So what you're really making is a $4000 return on an investment of $180 ,000. That is an annual return of 2.2%. There are people who will be content with such a return if their asset is showing great appreciation. I mean after 2.2% is exactly what Walmart is paying in dividends right now. So if you're getting a Walmart size annual NOI and you're getting $12K - 18K in appreciation every year that's not so bad. Those are the questions you've got to answer.There's no statutory holding period for converting a 1031 property into a primary residence. There is a safe harbor at 2 years. A lot of folks feel good at anything more than a year. Each individual set of facts are what you use to build your documentation of intent.

Dave Foster · Answer

@Wesley Piard, Although it's a fairly simple rental right now it's not performing well enough to make it a "keeper" in most cases. The deferred maintenance and comparative fewer amenities also cause concern. You're going to have difficulty getting enough money out of a LOC to do two things with. You may not even be able to get one since it's a rental. Given the age, location, and current stage of the market, it's telling me its time to sell before a negative happens. Question is going to be what direction do you go with the money. Great list of options by @Michael Glaspie but I'd take #5 off the table. No reason to pay cap gains if you're going to buy another property. Simply 1031 it. The other big factor he alludes to is also what @Richard Sherman pointed out. If your grandma keeps ownership you can inherit it with the taxes completely gone.

Michael Glaspie · Answer

All the above statements are pretty spot on. You have just walked into the lion's den of possibilities. Here are a few options:1)HELOC for repairs and flip it for profit2)HELOC for more rentals and hold current to pay off HELOC3)Seller finance to reduce tax obligation and receive. a large enough initial downpayment from buyer to use FHA for a primary4) Hold and use cashflow with the specific intent to invest all residual income5) Sell and take "Capital Gains" hit but purchase another property to help offset it6) Transfer deed to an LLC to remove it from Grandma's name (this opens another door of possibilities but may trigger tax increase due to transfer of ownership)I can go on, and others with different approaches can add to this list as well. You are definitely in the right place to be asking questions. My personal opinion is that you first need to decide what it is that you ultimately want. When you begin with the end in mind, options begin to eliminate themselves and it becomes much more clear. Best of luck in the transaction and keep us updated on your decision.

Dave Foster · Answer

@Wesley Piard, I know Gainesville well. We've been looking at MF projects for my two gator sons. Pickings are a little slim right now but if you could find a duplex to 1031 into that would be ideal. There's actually several that are in the low 200s and it would be possible to live in one unit and rent the other to provide positive cash flow and eliminate your own rent. Another option would be a house with an out building. I just saw one that actually had a mother in law suite that would be a very attractive option. Or yet another option - pick up two of those 4 bed 4 bath apts and generate $400/room to students. Those aren't great fits for long distance investors. But for families with college students or for students who are connected in the community those can be great producers for little effort.Bottom line is the 1031 would work. If you bought a multi at the right price or if she rented it to you for fair market (even if she gifted the rent back to you. You just need to decide what you want the living situation to look like in Gainesville and make the 1031 accommodate that.

Frank Geiger · Answer

Zillow is not accurate. Reach out to a realtor and ask for comps. What are your goals? Do you want rentals? You can keep the property and finance into a mortgage to pull some cash out for another deal. You can sell and get the quick cash for a bigger investment or just more properties. The good thing is you have endless options with this rental. A good start is to establish your end goal and then work back from there.Heads up: Replacing the septic is pretty expensive. Also, adding central air is expensive if the ductwork isn't already in place.

Richard Sherman · Answer

@Wesley Piard this comment is not to be morbid, but it should be something to think about as well. When she passes, whoever inherits any property that she owns will get a stepped-up basis. So the value for a tax standpoint will be the value on the day that she passed away. Clearly, we hope she lives a very long time, but all of us will die someday and taking that into account with our plans is important. Remember if she does a 1031, then it could not be rolled into a primary residence. Possibly do a 1031 into a multi-unit and live in one unit? It is possible but does require a bit of planning.

Dave Foster · Answer

@Wesley Piard, I wouldn't. A good realtor can tell you what it's really worth (not pie in the sky - real numbers) for free. An appraiser is going to charge you. Get the best realtor estimate (maybe 2-3) and then market the property and see what the market tells you. For the official appraisal the buyer usually pays for it.

Wesley Piard · Answer

@Dave Foster Okay, makes sense. Seems like the next step for me is to browse the Gainesville market some to get a better feel for the market (costs vs. rents) and then if I find there are options that may generate more profit then I can evaluate my options further. Would you recommend I get the house appraised so I have a better price to go off of? Thanks for all the advice!

Wesley Piard · Answer

@Dave Foster Thank you for all of the insight. This generates a few follow-up questions. What's the easiest way to determine whether a rental property is "performing" well enough to keep it? Does the 2% rule still apply for a property you fully own already?I hadn't really considered the difficulty in getting a HELOC due to the fact it's a rental property. When you say give the "location and current stage of the market", could you elaborate little? Are you saying the location is good and it's a seller's market and therefore a good time to sell? If we did go the 1031 route, is there a time frame after purchase where it is "okay" to turn the new house into a personal residence? If we didn't move right into it, we would have to keep renting, or take out another loan to buy a primary residence for ourselves which I'm less sure about. Glad all this is getting uncovered!

Wesley Piard · Answer

@Dave Foster @Michael Glaspie Thank you for the input! Unfortunately due to the fact that we need a 3br place to live in (there are three of us), I'm not sure that living in part of a multi-plex would be an option. Most would be one or two bedrooms, right? I agree that would definitely be ideal if it were just the two of us! It would be something to consider, however, if we could buy a single-family house here for us to live in, AND 1031 her house to buy a more-profitable rental property in town. What are the chances of that being a possibility?As for my goals, the main goal is to own a house in Gainesville that we can live in to avoid paying rent, and to keep her house there as a rental property and a good chunk of equity. The secondary goal would be to additionally purchase rental property here. So it seems to me if we want to keep her house, a HELOC may be the best option since we don't have a lot of saving lying around. Now what options does that leave us with? If we were to get a HELOC, what are the chances we could buy a house for us AND an investment rental property?