Sell Or Keep Renting Out Home In San Francisco 2017

[Sam Dogen]

Howdy Folks!

I'm new to the BP community and I'm excited to be here!  I'm a real estate fanatic. But now that I'm middle-aged (40), I'd like to simplify life. San Francisco has had a great rocket ship like run and I'm strongly thinking about de-risking since I have two SFHs and one paid of 2/2 condo in SF.

Situation:

* Single family home bought in the Marina for $1.52M in early 2005.

* Have a written offer for $2.732M. Hasn't released financing contingency yet, but said bank is set to close and fund by June 20. This gives me an OUT to cancel the deal if I find something better b/c I did not give him a financing contingency extension. I accepted their offer which removed their inspection contingency after inspection was given. 

* 4 years left on a 5/1 ARM at only 2.375%. I haggled the crap out of my bank to get this rate in 2016.

* Was renting the home for $9,000 a month. Now, after one month of searching, I haven't found anybody suitable to pay that price. The conclusion: rent has gone down, and I can likely only get $8,000 - $8,500 due to a large surge in new construction luxury condos. 

* The 1% rule or the 100X rule says that I should buy a $9,000/month rental property for $900,000 or less, or sell a $9,000/month property if under 1%. I'm at 303X monthly rent, or 0.33%, which seems absurdly expensive. But that's if I can get $9,000/month, which I can't.

* At $9,000/month, I cash flow after all expenses about $4,500 a month. If the mortgage is paid off, then the property will cash flow about $7,000/month because property taxes are $21,888 / year!

Why I'm Reluctant To Sell:

* Commissions. I got the level down to 4.5%. But that's still $123,000!

* Transfer Tax = ~$25,000

* LTGT = Six figures. Haven't figured it out exactly, but will have the $250K/$500K tax free gains.

* A property for my son to live in in 23 years. Can you imagine how expensive SF will be by then? Holy hell!

* Capital appreciate. I believe San Francisco is one of the cheapest international cities in the world. 

* Uber, Airbnb, Pinterest, Dropbox will all go public in the next 3-5 years, creating a tidal wave of billions of liquidity into the ecosystem looking to buy real estate.

I'd love to get everybody's thoughts!

Thanks,

Sam

[Clayton Mobley]

@Sam Dogen I saw a few mentions of the 1031 and 121 issues and I wanted to offer some clarity here.

Firstly, let me say that I agree that your first move is to determine your priorities. You have an amazingly valuable property here that could continue cashflow easily with minimal contact from you if you hired a good PM (or had your son do it as a learning exercise). Assuming you want the simplest option, keeping it and letting it appreciate while getting, frankly, some amazing monthly income, is the obvious answer. If you're more focused on increasing monthly income or getting a higher ROI in other markets in exchange for a lower rate of appreciation, that is another option, though more complicated. So, the following advice is given under the assumption that you elect to sell in order to expand your cash flow portfolio:

So, as you know, you need to have lived in the property as your primary residence for at least 24 months our of the past five years. They do not need to be concurrent months, in case that makes a difference to you. If you meet this requirement, then you can take the $250k/$500k (if married filing jointly) tax free under Sec 121. So sounds like that option is already on the table for you, great!

However, it looks like you stand to take away MUCH more than that (congrats!). In addition to CG taxes, any amount of depreciation you could have deducted on your taxes (whether you actually took the deduction or not is irrelevant) is recaptured under Sec 1250 at 25%, so your tax bill on this sale would be.... hefty. So let's look at the best way to parlay your gains into something else without giving uncle sam his cut just yet. As @Arianne L. pointed out, you can combine the Sec 121 exclusion AND the 1031 exchange if you meet some criteria. 

You've already met the criteria for the 121, so now we focus on the 1031. In order for a property to eligible for exchange, you have to be holding it with the intention of maintaining a long-term investment. Since this was a home that you converted into a rental, with the possible intention of passing it along to your son, I think you safely meet that criteria. There is no specific time limit for how long you have to hold the property, though the general rule of thumb is one year or more. So, for example, if you purchased a house to flip and sold it six months later, that's not a 1031 eligible property because there was never the intention to hold it long-term. So I'd say as long as the prop has been rented for at least a year, but not MORE than three years (because then you wouldn't have lived in it for 2 years within the past five), then you can qualify for both the Sec 121 exclusion and a 1031 exchange. If you've rented it for more than three years, then you'd still qualify for the 1031, but you couldn't take the $500k tax free under Sec 121 unless you had to move due to employment changes or other IRS-acceptable reasons.

Ok so, to defer all taxation on a 1031 exchange, you have to roll over the total value of your property into a new investment proper, or multiple props. This means that if you sell at $2.75m and take $500k tax free, you must roll the remaining $2.25m into new investment props. Any amount of profit you take  (outside of the Sec 121 excluded amount) is considered boot and is taxable. That means you can't sell the prop, take $750k in cash ($500k under Sec 121 + $250k) and then replace that additional $250k with a bigger mortgage on the replacement prop. You can put in more equity to the new properties and have less debt, but you can't have more debt and less equity, because that would result in you taking cash from the sale, which would be a taxable event. (Let me know if that wasn't very clear, people often get very confused about this rule).

Since you'll have so much value to play with and are looking for cashflow investments, it's most likely you'll reinvest into multiple properties, or into a large MFR. 1031s have a lot of rules about replacement property identification and timing (which I'm happy to go into if you need a primer, but I'll leave for now) so you'll need to be well versed and have a good Qualified Intermediary in place long before you go to market if you elect to go this route.

Given the value of your currently property, you have a million options for reinvestment, so you'll need plenty of research and vetting time before you pull the trigger on selling it. Take your time and be really honest with yourself about your priorities. The property is flowing nicely and will likely continue to appreciate, so if maximizing ROI at any cost isn't your highest priority, all the legwork involved in the 1031 process may not be worth it to you right now. However, if you decide to go that way, know that the 1031 is a powerful tool. Using this process you can expand your portfolio, and continue to use the 1031 exchange if and when you want to sell your new investment props, leap frogging this current property into who knows how many cash flow properties over the next few decades, and eventually leave the whole lot to your son. Upon your passing, the tax basis of any properties left to your heirs gets 'stepped up' to the market value at the time of your death. Basically, if you die and leave a property to your son, and he sells it right away, he'll essentially pay no taxes because his tax basis will be equal to the market value at that time, leaving him zero taxable gain. It's called the '1031 until you die' strategy and it's hugely powerful when done right. Of course, I'm not getting into estate taxes and the use of trusts here, but given the value of this prop those considerations would need to be taken into account if you elected to use this strategy, just fyi.

Ok that's enough of a ramble from me ;) You're in an enviable position and you have several great options, so do your research and take your time.

Best of luck!

Clayton