Leverage: Are we doing it right?

Question

My wife and I own a couple of properties in Los Angeles (1 single family, 1 4-plex). After many, many discussions, we've decided to use our resources and move forward in expanding our long term portfolio and purchase another multi-unit property. Our plan is as follows:

Property 1, single family home: Where we live now. Currently sitting on about 350K in equity. Just signed docs for a $170k line of credit at 4%.

Property 2, 4-plex: This building was purchased 12 years ago and has provided us with a very healthy stream of monthly cash flow. Sitting on about $400k in equity. Rate is now at 6%. We're currently trying to do a cash-out refinance at 5.125% (non-owner occupied). Hoping to get somewhere between $170-200k cash out. This would shave around $3-500 a month off our cash flow from this building.

We'll then use the cash out and part of the HELOC to purchase a new building. We've discussed more expensive buildings with less units in more desirable, rent-controlled areas.... and 5+ unit buildings in non-rent controlled, less desirable areas. Our agent, who is my wife's father is exploring several options for us. I personally like the idea of finding a multi-unit fixer and perhaps starting fresh with new tenants (our single family home was a major fixer and it worked out very well for us).

We will also use a portion of the HELOC for flipping to bring in extra cash flow.

We in the ballpark here?

Bill Exeter · Answer

The Reverse 1031 Exchange is definitely the safer way to go.  They are more complex, and not all investors will be able to utilize the Reverse 1031 Exchange.  However, when suitable, the Reverse 1031 Exchange takes the majority of the risk in a 1031 Exchange out of the picture.

Forward (regular) 1031 Exchanges mean that you sell (and trigger) your capital gain.  The question is whether you can identify and acquire (close) on one or more replacement properties within the required deadlines.

The Reverse 1031 Exchange has no upfront deadline, so that the investor can take all the time they want to locate and acquire their replacement properties, and then they have 180 calendar days to sell (and close) on their relinquished properties.

Account Closed · Answer

Account Closed  - Guessing a 1031 wouldn't be an option for us. The rules around that seem so strict.... I don't see how it's possible to find a place and close the deal in such a short time span. How would I calculate the 12yrs of depreciation? Thx again!

Account Closed · Answer

@Brandon Turner  - Account Closed - Thank you so much! Another investor proposed this to me: Sell the 4-plex, which would leave us with around 400k. + the 170k HELOC = 550K-ish downpayment on a building around 2mil - My investor friend said this could get us much better returns than the current plan.

What do you think?

Account Closed · Answer

Ben,

That's why reverse 1031X is the way to go. You buy first then sell and exchange later. However, most people don't have the down payment to buy first before they sell.

With respect to depreciation, take a look at line 18 of your Schedule E tax returns. You have been off-setting your rental income with depreciation. Now you have to recapture it. Say you have been depreciating your 4plex at $10k/year, that's $120k that you have to recapture. So your projected gain will be $520k, not $400k like you stated of above. Your tax liability is $520k. If you haven't been depreciated over the last 12 years, OUCH, you will still be required to recapture.

Account Closed · Answer

It's true that the higher the price, the less competition you get, which means higher returns. However, it looks like you are betting the farm on it. Too high risk for me. Also, if you failed to 1031X in time, there's a huge tax liability that you would have to pay because you will have to recaptured 12 years worth of depreciation. For this reason, I'd rather pay a little more money and go with  Reverse 1031 Exchange. Of course, not everyone is in a position to do this.

It's a no go for me.

Account Closed · Answer

Hi Ben,

Sounds like you got it figured all out. I'd say that the HELOC should be considered as your emergency funds. Tap into it when need to, but it should be used on a short-term basis only. There must always be an exit strategy on your HELOC money.

Value-add is always a good strategy. If you could find a value-add building in a good neighborhood, you've got it made. Personally, I'd take a building in a good neighborhood with a lower cap rate over a building in a less desirable area with a higher cap rate. However, the building must be able to service its own debt at the lower cap rate, say 5% vs. 7% cap rate in a less desirable neighborhood, etc. If L.A. is like here, the city will allow you one time rent adjustment to bring your rentals to FMV. So you might be able to start fresh if some of the tenants don't like the rent adjustment and move.

Good luck.

Account Closed · Answer

@Ryan Thomas - My head is spinning :) - Thank you!

Ryan Thomas · Answer

Capital Gain Tax Calculation

1. Figure out your net adjusted basis

Original Purchase Price (PLUS) Capital Improvements (MINUS) Depreciation (EQUALS) Net Adjusted Basis

2. Calculate the capital gain on the sales price of the property

Sales Price (MINUS) Adjusted Basis (MINUS) Closing Costs (EQUALS) Capital Gain

3. Caluculate capital gain taxes due

Recaptured Depreciation (25%) (PLUS) Federal Capital Gain (depending on your tax bracket) (PLUS) State Capital Gain (Depending on your state) (PLUS) S1411 Medicare Surtax 3.8% (if applicable) (EQUALS) CAPITAL GAIN TAX DUE.

You should consult your legal/tax advisors.

If you want to sell investment property and buy investment property, 1031 exchange may be the way to go.

Brandon Turner · Answer

Hey @Ben Kahle congrats on your progress so far. You are rocking it! I think you are doing the leverage thing perfectly. Just be sure that the numbers work on the new properties, and you stick with fixed-rate loans when possible (I know the HELOC probably won't be, which is always a concern, but just be sure there are caps on how high it could go.)
	
	Good luck!

Leverage: Are we doing it right?

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