Should I sell or not, and what about the gain taxes

Question

Hi Guys,

I Purchased a 1925 4 unit in 2013 for $140k as a bank owned property and house hacked with it as my primary resisdence. I now live in a singe family home with my family as of 2017. The rents were $500 in each of the identical 1/1 units when I purchased the quad. I have made improvements to and raised rents over time with a fast growing market and now my rents are up to $1200-$1350 in each unit.

I obtained a private 2nd mortgage of $150k interest only at 8% a few years back.

I have had the 4 unit on the market for $550k since mid 2018. Rents were a bit lower and we were in the process of making more improvements and waiting for leases to expire. We went under contract twice and fell through for appraisal coming in too low and second for a cash buyer looking to retrade a significant amount.

We took it off the market for a month and a half while renovating one of the units thats now getting $1350. We are now stabilized at the higher rents mentioned above and put it back on the market. We are looking for a cash buyer or someone with a strong down payment to avoid any future appraisal issues.

We have a buyer who is putting 50% down and is coming up on a 1031 exchange deadline to identify a property. It is a sophisticated investor who we are confident will close the deal.

Now my dilemma is the taxes I will face upon sale. If I try and 1031 exchange at this point, that gives me a very limited time to identify and close a qualified deal ( 45days after my close to identify 3 properties and 180days after my close to then close on one of those identified properties). Also, if I do happen to find and close a deal within the timeframe, will I be able to pay the second mortgage? ( original purchase price is $140k and debt is $290k)

I have a good buyer now but risk having to pay the capital gain taxes plus depreciation I have taken in previous years taxes.

I would love to hear your imput and any ideas and advice in moving forward. Thank you all so much!

Jason

Basit Siddiqi · Answer

@Jason MaestasIf you want to take advantage of doing a 1031, you must engage a 1031 intermediary before the sale of the property. The reason for this is that you can't touch the cash. It has to sit in an escrow account held by an intermediary.I would personally go with the 1031 exchange route if you continue planning to be in real estate. As Dave pointed out, you will be eligible to exclude 1/4 of the gain(assuming all units are the same). The rest will be eligible for 1031 exchange.Do you know how much the appraisals came in at?Did the previous buyers ask you to lower the price to match the appraised price? if yes - how did you respond?

Kyle Kadish · Answer

@Jason Maestas - Plenty of great comments so far.  If 1031 is the route you are taking, always start looking for properties to purchase before you even list what you are selling.  The 45-day identification period does come quickly.

Worst case scenario is you pay ~$1,000 to a QI  and do not complete an exchange.

Backstops exist to use all of the proceeds as well.  Some clients explore Delaware Statutory Trusts as replacement property for some or all of the proceeds from the sale (or even a Plan B in the identification process).

Good luck with the process.

Dave Foster · Answer

@Jason Maestas, Some great feedback for you here.  I'm going to assume you're selling.  How can you make the 1031 work for you?

1 First of all I think you'll qualify for 1/4th of the profit to be tax free.  If you bought it in 2013 and lived in one unit until 2017 then you would be entitled to the primary residence exemption of sec 121. So that's big bonus #1.  If you sell for $500K then $125K of the profit (and whatever basis is allocated to that) comes out tax free.

2. That changes your reinvestment requirements for the 1031.  Instead of having to buy replacement property for at least $500K you would only have to purchase $357K of replacement real estate using whatever cash goes into your 1031 account after the tax free portion comes to you.  Bonus #2

3. You actually have 45 days from the closing of your sale to simply identify your potential replacements. You have 180 days from the day you close your sale to take title to the new property.  Time constrained - yes but not as badly as you fear.  You can go into contract at any time so if you find the right new property before you close the sale of your old property get it under contract.  That is fine.  Bonus #3.

4. If that private note used to purchase the property is secured by the property then it will be paid off as part of the closing.   You'll still have to purchase at least as much as you sell but you can either take out new debt.  Use the tax free money to supplement and reduce initial debt, or take out a new private note.    Bonus #4.

The investment basis in your property is probably less than $50K.  The gain attributed to the investment side could be north of $300K.  That's would represent a tax of around $45K.

Thats pretty significant!  I think you'd find a 1031 to be worth it.

Jason Maestas · Answer

After speaking with my CPA, It looks like the property has been fully depreciated and will be subject to the full gain of the sale minus the 1/4 I lived in, which $38,600 will be tax free  of that 1/4th.

Basically say I sell for a net of $500k. $500k/4 units is $125k each. 3 of the 4 units will be taxed on the $125k and the 4th unit I used will be taxed on $125k-$38,600= $84,400. So $125k*3=$375k+$84,400=$459,400. Taxed at 15% is $69k.

So I would definitely want to 1031. I just get worried about finding a good deal and having deadlines to do it within.

@Basit Siddiqi the previous appraisal came in at $350k which was before a renovation in the $1350 rate unit. All the other units are the same as the time of the appraisal but rents have increased. The $1350 rent was $725(worst unit in the building) for a long time tenant(13 years). Another unit is increasing from $900 to $1250 next month after his initial 2 year lease. Market has definitely accelerated in the immediate areas.

John Warren · Answer

@Jason Maestas I noted that you mentioned the appraiser is "Maybe they were looking at comps instead of income approach". They are definitely looking at comps since this is a 4 unit. I have never seen an appraisal based on the NOI of a four unit before, and I am sure that could be a big part of the reason you are having trouble selling it. I noticed you are an agent in the area there. What are the comps?

Jaysen Medhurst · Answer

@Jason Maestas,  a couple more thoughts:

• What would the numbers be like if you refinanced into a 75% LTV loan, paying off your original and 2nd mortgage? Even with a $500k appraisal, I have to think that you'll walk with ~$100k and still be cash flowing ~$600+/month. You're ROE would stink, but you'll have pulled out all of your money and then some.
• Conversely, maybe this isn't such a great rental after all and you've just been saved by outsized appreciation and skyrocketing rents. If the property is actually worth $550k and the rents will max out at $5400/month, you're not even hitting the 1% rule.

Bill B. · Answer

You have to spend at least $550k on your new property to defer all taxes.

The depreciation will be almost nothing. 25% tax on 4% of the building value times 5 years. So 25% of 20% of the building’s share of the $140k original value. So less than $7k.

But the $400k capital gains is probably $80k in taxes? Plus any state taxes plus the 3.5% Obamacare tax may kick in. Could be another $40-$50k between them.

So sell for $550k $20k in sales expenses? pay $140k in taxes and pay off $150k second. If that’s all you owe walk with about $240k to invest.  or 1031 with $530k-$150k or $380k to invest.

Depends on what you can buy for $240k or $380k I guess.

Jason Maestas · Answer

Thank you @John Warren and @Jaysen Medhurst for your the input.

The property is fairly easy to manage and I could possibly have some expenses coming up like AC units, water heaters, and the roof is getting a bit on the older side.

My cashflow with existing mortgage is $36k minus the $150k second private loan at 8% interest only ($12k a year) leaves $24k actual cashflow.

The returns are good but I do want to scale up. The building has been on the market for about half a year and had trouble with the appraisal coming in way low. Maybe they were looking at comps instead of income approach.

I am worried about finding a good deal within 90 days (45 days to close and another 45 after close) if I go under contract and choose the 1031. Not under contract at the moment.

The value that has come out of this building has been amazing and I know it will be difficult to replicate because market timing and appreciation had a lot to do with it. However, a bigger deal with a little less % in returns is still more valuable to me because it is a scale up and in the direction of my investing goals.

Do I wait until I find another good deal to 1031 into and risk having to sell for less because I wouldn't have to time to let the 4 unit sit on the market waiting for a cash or strong buyer who will not have an appraisal stipulation, or do I sell it now and risk not finding a great deal or no deal at all and paying the capital gain taxes?

And @Jaysen Medhurst, my question is about the difference between my purchase price of $140k vs the total Debt amount of $280. In the 1031, how much exchanges over? The difference between the sale price of $550k and the $140k original purchase price? or The difference between the $550k sale price minus the $280k debt amount?

Jaysen Medhurst · Answer

@Jason Maestas, I agree with @John Warren, that selling may not be the best idea here. We don't the whole picture, but you could probably tap into the equity in another way and not have to worry about the 1031 rules, etc.

That being said, if you're under contract, you're under contract.

Can you find a property similar to yours (price, rents, etc) and 1031 into that? Maybe something with good tenants on "auto pilot." Then top into the equity of the new place through a HELOC. Pen Fed Credit Union does 80% LTV on an investment property. That would give you ~$150k to put towards your next deal.

The other option would be to upgrade to a larger property (8-15 unit). With ~$260k from your sale, you can get into a $1MM property. There are more value-add opportunities because you'll be able to force appreciation.

Lastly, I'm not sure what you're asking, "if I do happen to find and close a deal within the timeframe, will I be able to pay the second mortgage?"

John Warren · Answer

@Jason Maestas is the place a headache to manage? Are there mechanical issues coming up you don't want to deal with? I am not sure I would sell unless your return on equity is really low or something. The 45 day window can push you to buy a property you don't even like, which may not be as good a property as the one you are selling! I recently helped a buyer complete a 1031 exchange in Melrose Park, IL, and it was a bit stressful for him during the 45 day window. He did well, but deals are not plentiful pretty much anywhere in the US right now.

Should I sell or not, and what about the gain taxes

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