Questions about BRRRR with a 1031 exchange

[Daniel Soovajian]

Hello,

Curious for BP's advice on my situation here...

I live in WA and have a condo in CT that's worth about $125,000. There's $32,000 left on that mortgage and I want to put the equity there to better use. I am exiting the CT market and plan to continue investing in TN for my next few properties. I haven't lived in that CT condo for 2 of the past 5 years so my plan was to sell the condo and purchase an investment property in TN via a 1031 exchange to defer the taxes and depreciation recapture expenses. 

I want to pursue the BRRRR strategy for my next investment property but am not sure how that would work with a 1031 exchange. Can I only use the funds from selling my CT condo on the down payment of the new investment property? Or is there a way to use the money from the 1031 exchange to cover my rehab expenses too? I don't think a 203k loan is an option since I won't be living at the new TN property, so what path forward allows me to make best use of the funds in the 1031?

Or could I put a big down payment (like 75%+) on the new TN investment property, complete the BRRRR with my own funds from outside the 1031, and then refinance to pull the $ out for the next BRRRR?

Last question: going forward, would these type of questions be best suited for a CPA with real estate experience or are they too technical on the 1031 side and I should consult with a 1031 facilitator for advice? 

Thank you!

[Michael Noto]

@Daniel Soovajian A real estate savvy CPA will be able to advise on a 1031 exchange. If you need contact info for one here in Connecticut let me know. I know of a good one. You seem confident in the value of your condo, but if you need any comparable sales data on that front let me know as well. 

[Stanley Bronstein]

@Daniel Soovajian.  I'd like to get @Dave Foster or @Bill Exeter to chime in as they are 1031 experts.

I think one thing you need to watch out for is whether or not it is your intent to hold the BRRRR property as an investment.

1031 Exchanges have an intent requirement wherein you basically have to have the intent to hold the property as an investment.

Here's a .

 

[Dave Foster]

@Daniel Soovajian,  You're on to something.  There's a process we're working with a couple of investors right now called an "improvement exchange" that accomplishes exactly what you want.  Caveats - they're a little complex and expensive.  But they let you use your 1031 proceeds for not only the purchase but the stabilization of a value add property you intend to hold for investment.

In an improvement exchange you sell your current property and start a 1031 exchange.  Using the exchange proceeds in your account your Intermediary purchases your new property (in theory less expensive than what you sold) and holds it in an entity called the Exchange Accommodating Title Holder (EAT) apart from you.  The the remainder of the proceeds in the account are used to repair the property.  The value of the property after repairs are complete is the cost of acquisition plus the amount of the repairs.  So you then complete your exchange by taking title to the new property now at a value that completely absorbs your 1031.  And you did it with exchange proceeds only.

Example - Sell a property owned for cash for $200K.  Use the Improvement exchange and the QI purchases a property for $150K that needs $50K of improvement.  The your contractor uses the other $50K of exchange proceeds to improve the property.  Now it's worth $200K so you take title and that completes your 1031 exchange into a newly improved property fully tax deferred.

Pretty slick isn't it?!

Another option if the dollar amounts to justify it is to do a partial exchange - Say the replacement property was $190K and only needed $10K of improvements.  You would sell for $200K and buy for $190K to complete your exchange.  The other $10K comes to you taxable and you use it to improve your property.

And yet another option which you hinted at is to make sure the property acquisition is more than your sale and then use your own resources for the improvements.

In all of the above scenarios you can do a refi afterward to get the dollars to obtain your next acquisition - A true BRRR process.

[Daniel Soovajian]

Thanks so much @Michael Noto @Stanley Bronstein and @Dave Foster - very helpful feedback!

I think at this point I need to educate myself a bit more on some of the ins and outs of what's possible with a 1031 (to make the most of everyone's time) but once I'm ready to have a more informed conversation with an CPA and/or 1031 intermediary, does it matter what state either of those professionals are located in when coming up with a solution for my situation? 

I'm not sure if there's any particular advantages or licensing requirements that would steer my decision towards working with a CPA or 1031 facilitator in WA vs. CT vs. TN vs. any other state.

[Stanley Bronstein]

@Daniel Soovajian Most 1031 issues pertain to federal taxation, so it's not necessarily state specific.  HOWEVER, some states handle 1031 exchanges different, so I recommend you talk with a CPA who's familiar with the taxation of 1031 exchanges in your state.

[Dave Foster]

@Daniel Soovajian, I'd echo @Stanley Bronstein's counsel.  Most 1031 QIs who have a national footprint are well versed in the few quirks of individual states like CA and PA.  And since 1031 is a federal statute that is in general followed by the states any QI with demonstrated experience and a national footprint should be able to help you out.  Bunches of 1031s start in one state and end in another anyway

Regarding your CPA - the best CPA will not be located in your state necessarily but will be the best at unravelling the fed code while understanding filing in your state.  So again look for competence not geography.  My poor long suffering accountant of 30+ years has followed me through 6 states without a hiccup.  He swears he's going to fire me every year but I fear his retirement will come first!!

[Adam Dobbins]

Thanks y'all!

This hit the mark of a similar question I had about flipping one off my properties into a newer investment.

I have intentions of doing a BRRRR strategy with the 1031 exchange as well.

I'll need to talk to my CPA and see what the rules are in VA as stated.

Thanks again!

[Dave Foster]

@Adam Dobbins, VA is an easy state to work with. A normal exchange process and documentation that satisfies federal also satisfies VA. You do have to pay the transfer tax. However, if you are simply conducting a regular deferred exchange and a reverse exchange you will only pay on one sale.

[Adam Dobbins]

Dave, Thanks again for your insight and time!

I'm working at learning as much as I can & looking to get something identified, but have been traveling a bunch; with limited internet.

I appreciate yours and everyones help, time, and patience!

[Suzanne DiIorio]

@Dave Foster isn’t there a fee involved if you want to use part of your exchange money for renovations? I was told $5,000 by our 1031 company.

[Suzanne DiIorio]

@Dave Foster we have a house through a 1031 that I would like to sell. It’s worth about $350k and it’s free and clear. I’d like to sell under an exchange and buy 2 houses that need work with the money. I’ll need a mortgage on one or both bc $350k won’t quite cover 2 houses that need work. If the fee is roughly $5k to use 1031 money for Reno, can I pay that once for both houses? What is the best strategy here?

[Natalie Kolodij]

Originally posted by @Dave Foster:

@Daniel Soovajian,  You're on to something.  There's a process we're working with a couple of investors right now called an "improvement exchange" that accomplishes exactly what you want.  Caveats - they're a little complex and expensive.  But they let you use your 1031 proceeds for not only the purchase but the stabilization of a value add property you intend to hold for investment.

In an improvement exchange you sell your current property and start a 1031 exchange.  Using the exchange proceeds in your account your Intermediary purchases your new property (in theory less expensive than what you sold) and holds it in an entity called the Exchange Accommodating Title Holder (EAT) apart from you.  The the remainder of the proceeds in the account are used to repair the property.  The value of the property after repairs are complete is the cost of acquisition plus the amount of the repairs.  So you then complete your exchange by taking title to the new property now at a value that completely absorbs your 1031.  And you did it with exchange proceeds only.

Example - Sell a property owned for cash for $200K.  Use the Improvement exchange and the QI purchases a property for $150K that needs $50K of improvement.  The your contractor uses the other $50K of exchange proceeds to improve the property.  Now it's worth $200K so you take title and that completes your 1031 exchange into a newly improved property fully tax deferred.

Pretty slick isn't it?!

Another option if the dollar amounts to justify it is to do a partial exchange - Say the replacement property was $190K and only needed $10K of improvements.  You would sell for $200K and buy for $190K to complete your exchange.  The other $10K comes to you taxable and you use it to improve your property.

And yet another option which you hinted at is to make sure the property acquisition is more than your sale and then use your own resources for the improvements.

In all of the above scenarios you can do a refi afterward to get the dollars to obtain your next acquisition - A true BRRR process.

Ummmmm

I'm obsessed with this. 

Haha

Dave how does the timeline need to play out for the improvement exchange? 

This reminds me of a BRRRR technique brought up with regard to refinancing where - 100% of HUD being able to be pulled sooner than 6 months (delayed financing).

Basically he has his Renovation funds put into escrow so they appear on HUD toward basis as well. (SMART) (@Alexander Felice I think this was your Podcast) 

I'm imagining we're using a similar setup here to make this 1031 happen- do we need to stick to normal 1031 timelines? 

[Dave Foster]

@Natalie Kolodij, and @Suzanne DiIorio, I know right?!  The improvement exchange can be huge powerful depending on how well your QI can help you take advantage of it.

the timeline usually runs something like this in a true improvement exchange where the sale by itself is enough to fund the purchase and improvements.

Day 1 - Sell the old property and proceeds go into the exchange account.  The 180 day exchange period starts.

Day 2 - 180 

1. The new property is identified, contracted, closed (or all three) using exchange proceeds.  Title is held by the QI as the Exchange Accommodating Title holder.  Since proceeds are all coming from the exchange account the client doesn't come out of pocket at all for either the purchase price or the improvement exchange fee @Suzanne DiIorio (this is the way we do it.  If you use a different QI there's no guarantee they'll do it this way).

2. (the second the new property is purchased by the EAT) exchange proceeds are used at the clients request to pay contractors for the improvements on the property.  

3. (prior to day 180 of the initial sale) all improvements must be complete and the title then goes to the client to finish their 1031 exchange. And actually we go further and transfer the membership interest of the EAT rather than transfer deed because it saves a new tax assessment, doc stamps and closing costs (again, not every QI will know to do this).

So the key to an improvement exchange like this Natalie is that it must be complete within the 180 days from when their old property sells.  And yes, the improvements are added to the depreciable basis - Woo Hoo!!

Yep Suzanne, these are pricey unfortunately.  But there's a whole heap of moving parts that have to be there for 1031 compliance as well as your protection.  $5000 seems a little high for a free and clear property and there may be some ways to shave more off by structuring it a little differently.  I'd have to talk to you some more to see what could be done.  What's nice is that we're able to structure the exchange fee from proceeds as well so it doesn't come out of your pocket.  So there's minimal impact to you.

[Suzanne DiIorio]

Wow what a great informative answer thank you! What if I split the proceeds into 2 houses on the new purchase? 2 fees? 

[Dave Foster]

@Suzanne DiIorio, not necessarily.  There's some options to consolidate fees and structure.  Would depend on your personal situation.

[David Glascock]

@Dave Foster so you can brrrr out of the 1031? I just want to be clear. We just purchased a property with 1031 funds. I like the idea of pulling some of the equity out.

[Michael Szypulinski]

@Dave Foster....mind blown

[Dave Foster]

@David Glascock, You're not exactly Brrring out of the 1031.  You are simply taking a property that you own and placing debt on it.  The gain and depreciation taken (your adjusted cost basis) all stay with the property.  It feels wonkey but the IRS has made a pretty clear distinction between refinances after and before a 1031.  Understand that if they really don't like you they could certainly question a cash out after a 1031 is complete.  But the general practices that is the time to do it.  And when you do it after you are not taking profit and violating your 1031.  You are simply accessing equty through debt (debt which has to be repaid and that is the key distinction).