Capital Gains or High Interest Rates

[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.

[Dave Foster]

@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.