Capital Gains or High Interest Rates

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

2y

@Carolina S., You've got a great rate on your primary. And since that equity will be trapped once your renovations are done, converting investment money into improvements on your primary doesn't feel like the best initial use (especially considering the huge up front cost of paying tax on the profit).

I'd let the primary take care of itself. Grab a heloc, or scale your renovations over time using cash flow from the rentals. Or take a modest amount out and pay tax on it. But keep the rest of the tax-deferred with a partial 1031 exchange.

Another option would be to do the 1031 and purchase two properties. But make one of them a $350K property for cash. and use the other $100K to purchase a property for $500K with 20% down. The free and clear property is out of harm's way. But the equity has been concentrated in it so that you can now do a cash-out refi at any point when you feel like it is to your advantage. And if you want, use that money to improve your primary while the tenants pay the mortgage.

Done that way you can improve your primary, get two cash flowing properties and defer all of the tax from the gain of your sale.

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Jack Seiden

Real Estate Agent · Washington DC · Member since 2016 · 847 posts · 656 votes

2y

Quote from @Carolina S.:

Hello BP community.

I'm in the DC/ VA area and I'm under contract in one of my properties. I'm thinking of doing a 1031 exchange with it. If go that route, I would need to spend about $850k total. If don't do a 1031 exchange and decide to pay capital gains, I would have about $450k free of taxes (this accounts depreciation and other costs). So, I'm trying to decide between the two options below:

Option 1: Buy a couple of properties and split the money from the 1031 exchange for the down payments. I'm looking at a $600k price point each. Which means I will still need to finance about $400k for each property at about 9% rate (the rate is high because we'll using a commercial loan as we'll be purchasing the properties under an LLC). This gives me very little or zero cashflow on the properties. At this time, I'm not looking to invest out of state.

Option 2: Pay capital gain taxes and use it to finance my primary property renovations. I still have a mortgage on the primary of about $450K at a 3.8% rate. If I finance the renovations, I would be able to keep that rate. The renovations will increase the value of my primary from $800k to about $1.6M. However, there will be a lot of equity trapped in my primary. I know I could look to refi to get the equity out but then I would loose the 3.8%. Would it be worth paying capital gains then?

If I decide to go with option 1, I will have to borrow the money for the renovations at my primary and it may make it harder to qualify for a loan given the little or no cashflow.

I appreciate any input.

So there are a few ways to look at this, the 1st question is are you sure your renovation’s will double the property value, most renovations on primary residences, your lucky to get 60-70% of the dollar cost back out upon sale, so really nail down your comps, than you have basically a math problem if your rate on your primary goes up how long if ever before that extra payment is more than 400k in taxes, that’s just a simple calculation to help you decide, but I suspect you actually have a different question here, from a purely financial perspective my guess is the best option is to do anything to avoid that tax hit, but one of the reasons to make money is to spend it on things that you enjoy, based on your overall financial picture and a subjective view of how much enjoyment you will get out of a renovated home, you should decide if you want to roll your profit into another deal or “cash-out” your winnings, I love cars and I’m willing to spend more than is fiscally smart on them because they bring me joy, there is nothing wrong with that, but i don’t think it’s a fiscally smart choice, without knowing your exact property id imagine a renovation would fall into that category, so that’s the terms I would use to decide.

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Sean RossPro Member

1031 Exchange Qualified Intermediary · Denver, CO · Member since 2017 · 174 posts · 97 votes

2y

@Carolina S.

I want to back up what @Jack Seiden wrote. A lot of money put into primary residences isn't recouped $ for $ upon sale. Now there are some improvements (kitchen remodel, bathroom remodel, upgrading windows) where that flips on its head, but it's still something to really plan through.

If you cashed out, didn't 1031, paid the tax, and then did your renovations...the opportunity cost seems very high. You're getting a triple whammy of (1) paying a huge tax premium for not 1031 exchanging, (2) trapping even more equity into a position where it's not actively working for you, and (3) possibly engaging in renovations that aren't cost effective.

Maybe that's worth it! But only from a psychic standpoint. It's very unlikely to be worth it from a pure numbers standpoint.

We have lots of 1031 clients that are struggling with the idea of high interest rates right now. You're not alone. Maybe it's worth finding a cash-flowing asset that you can invest into that doesn't require a new mortgage on your part -- something syndicated or a NNN TIC property where you're just buying into a portion of the property and its existing debt load. That way you can preserve your cash flow and look to reposition when rates are better or prices are lower?

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Capital Gains or High Interest Rates

Capital Gains or High Interest Rates

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