Getting mixed advice: Cash Out Refi or Sell?

Question

After talking to several professionals (real estate, banking, CPA, etc) I am getting conflicting advice about what course of action we should take. I am not sure which move makes the most sense for us.

We have over 10 years experience in long distance property management, but no experience purchasing investment properties (these were inherited). Our goals are to gain more experience in RE investing, scale up our portfolio, & increase cash flow.

Current Properties (in OC/SoCal):

Prop A - $350k equity

Prob B - $400k equity

Prop C - $530k equity

Cash flow averages $650/mo each after all expenses, vacancy, repairs, & capex reserves. All properties are slightly under market rent and are in the process of being brought up to market in the next 8-12 months. Newest tenant has been there for 6 years.

Advice given:

1. Sell Prop A in a 1031 exchange & invest in a small apartment complex with a max price of  $1.0-1.2M.

2. Sell Prop A in a 1031, invest in a new property, & put remainder of cash in a TIC. This would be an option if I was unable to find a good property in time to satisfy the 1031 deadlines.

3. Cash out refi any of the properties at 75% LTV & buy new property.

4. Get LOC on any of the properties to pay cash for a new property then get a conventional mortgage to pay back the LOC.

If we sell, we would sell Prop A. It has the highest market value and lowest cash flow. I would prefer not to sell any of the properties since the CA appreciation has been so great and continues to rise. But I also want to build up our RE portfolio.

Why would you choose one option over another or would you choose a completely different option? I want to understand the reasoning behind a decision so we can figure out which option makes the most sense to us and works best to help us achieve our goals. Thanks!

Michele G. · Answer

Mark - I have been looking for properties, but the ones that have good cash flow have offers within hours. Once I determine my strategy I will need to step up my game and be able to put offers in very quickly!

Brent - our exit strategy is to pass on our portfolio to our kids. Our 5yr goal is to have $10,000/mo in passive income. We have a well paying business so we don’t “need” the passive income right now - it would be nice though!

Katie - Good points! I “inherited” the properties before death under prop 13 so my taxes are very low and my basis transferred so that is low as well. There is only 4-6 years left of depreciation on the properties. I put a call into my CPA to figure out how that changes my future tax bill.

Dylan - I believe if I were to move & live in the property to satisfy the rule I believe I could offset some of the gains. That’s not an option for us since we are settled and have kids in school that don’t want to move.

Dylan Vargas · Answer

@Michele G. @Katie Lepore Great points Katie! Michelle, would it be worth living in a property for a couple of years? Would this qualify home a s a primary residence and save enough on taxes to make it worth the move? I do not know the answer but am hoping someone can chime in with the answer. If you believe in the California appreciation then keep the homes and refi in a manner thats best for you. We will get a dip in the market again, I would think, therefore presenting another opportunity to get back in the California market if you decide to sell now. This is a great time to sell. Good luck and keep us posted.

Katie L. · Answer

@Michele G.

Just some additional food for thought - did you inherit from a parent or grandparent such that exclusions were filed to save the property from reassessment from property taxes when you inherited it? If you sell and instead buy another property, you’ll start with fair market value assessment for prop taxes (which if you’re staying in So Cal can have huge effects). I’m sure you’ve heard of Prop 13 rules here in California which usually cause property taxes to increase at a slower pace than fair market value making a lot of homes purchased in CA have a very low property tax basis, which can represent significant savings each year.

Secondly, if you sell, also think of the annual effect on income taxes depending on where you buy next. You’re likely paying CA income taxes each year on the rental income via nonresident return since CA property yields CA source income and I’m sure you’re aware that CA has some of the highest income tax rates in the country. By selling in CA and buying elsewhere, what kind of income taxes do you save year after year?

Just 2 additional factors to throw into the analysis since I’m sure you’ve already considered the large capitals gains taxes you would pay upon sale depending on how long ago you inherited the property and if you received it at a stepped up basis (very likely unless they died in 2010).

If you end up deciding to 1031 the properties and need legal or cpa referrals in Southern California or San Diego, let me know.

*this post does not create an attorney-client or CPA-client relationship. Readers are advised to seek professional advice.

Brent Coombs · Answer

@Michele G., first, you should work out your your long term goals. If it's just to maximize your children's inheritance, probably don't sell in favor of better cash flow for you in the here and now. But if you do like/need the idea of significantly improved passive income to meet your goals, then of course, your current 1.8% return on equity is abysmal, and would easily be bettered if you were sell to start again in different markets!

Which refinancing method you should use may well depend on what best terms and rates you can get out of Lenders. I'm not sure that either method is a no-brainer winner. But congrats on being in the position to have such great options. All the best...