Explain to me how "Trading Up" a house after a few years works?

Question

I've heard of this strategy where, instead of holding and renting a property for the length of the 30 year mortgage, you only keep it for a few years and then "trade up" to 2 properties or a better property. And you build wealth and your portfolio this way.

Can you explain how this works, preferably with some examples with numbers?

Russell Brazil · Answer

I can give you 2 recent examples from my own portfolio. 2010 purchase price of $292k. Down payment and closing costs roughly $60k. 2016 sales price $405. Walked away with about $185k.

2012 purchase price $305k. Down payment and closing costs were about 70k. 2016 sales price $515k. Walk away with about $250k

So now I have a lot more money to either trade up or buy multiple properties.

It should be noted these properties were both in hot markets. DC and Boston, and in a time of even higher growth than usual being purchased after the housing collapse.

David Faulkner · Answer

Trading up is a wonderful thing, but just to play devil's advocate, here is the major downside I see: When you "trade up" via 1031 exchange, you usually need to buy into the same market you sold into and do it under a time constraint. For example, you sell into a hot market, great, you got a great price and made a killing on appreciation. Then, however, you'll need to turn around and buy right back into that same hot market on a larger more expensive property. It  works in the opposite way in a cold market. OK, so you could try to find a below market deal on distressed property or buy somewhere else in a less hot market or something like that, but these have risks of their own. Also, for both selling and buying you incur significant transaction costs (selling especially more so than buying).

For these reasons, I prefer to "add up" rather than "trade up" by saving or cash out refinancing the down payment and purchase additional investments without selling the old ones (if they are performing well). Cash out refinance is tax free money, and better yet the interest you pay back is also deductible. Refinancing is much less expensive than selling. Your mortgage payment and leverage goes up, and that has some risk but this risk can be intelligently managed in most cases. With this method, you can better pick and choose what and when to buy and when to sell (if you ever sell at all). Food for thought ...

Russell Brazil · Answer

Appreciation and equity build up are how the largest amounts are made in real estate. Though both cash flowed just fine for me. The strategy though was mostly buying during a time of panic, and buying in major metro areas that experience high growth. Boston, DC, NYC, Seattle, San Francisco, Dallas, Denver are the type of markets I like.

Dave Foster · Answer

@Jeff L., The 1031 exchange that @Clayton Plank refers to is a part of the federal tax code.  It allows you to sell property that you have used for investment and use the proceeds to buy new property also for investment.  By following a few steps of a process you're able to defer payment on any gain.  And you can change location or type or number of properties to fit whatever your investing goal is.  Best of all, when done correctly, there is no difference between your normal sell - buy activity.

It has been an incredible intergenerational wealth builder in our country as it acts just like an IRA in that the IRS allows you to use the tax dollars to build your own portfolio.

Leslie Pappas · Answer

Hi @Jeff L., if you’re considering a 1031 exchange and an accredited investor you might consider learning more about Delaware Statutory Trusts (DST). They could give you the option to "trade up" to owning interest in multimillion dollar properties that offer long-term income - and don't require you to be a landlord! Whether your exchange is $100,000 or $1 million, these investments can be sized to fit your exchange.

Jeff L. · Answer

Oh yea, duh.

So would you say this strategy heavily depends on appreciation?

Russell Brazil · Answer

You are missing my initial down payment and the amount I payed down the mortgage while owning the property. 405 - 8% or so, minus my mortgage balance left me with 185.

Jeff L. · Answer

Thanks Russell, I don't understand how you arrived at the "walk away" total though.

First example: 405-292 = 113k (you said 185)

Second example: 515-305 = 210k (you said 250)

And that's not including the closing costs when buying or the agent commissions when selling.

Jeff L. · Answer

I understand that using a 1031 exchange is ideal, but I'm wondering more about how the math works out after owning a house for 5 years or so.

Is the equity you've built in that time really substantial enough to trade up to two houses, or a more expensive house?

Clayton Plank · Answer

@Jeff L., are you referring to a 10-31 exchange? It does allow you to sell your current rentals and defer the taxes on profits into your new larger asset. The exchange has to be like minded. Also you have time limits on once you sell you have to find and purchase your next. The newer unit also has to be more financially. You cant sell 1 under mortgage to purchase one small free and clear.

Explain to me how "Trading Up" a house after a few years works?

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