To 1031 exchange and BRRRR or not?

Question

Hi!

Currently about to close on a multi unit at 228K.  Profits will be at around $100K.  Would like some feedback/opinions on what strategy to go with next and pros and cons of 1031 exchange.

PROS:

we won't be paying the capital gain taxes of about $20K

CONS:

Time line of 45 days to identify the next property(s) that needs to total 228K or more.

Once 45 days have passed from the day of closing, identified properties cannot be changed.

We've never done the BRRRR method before and would like to start doing this strategy.  The problem is, if we do 1031 exchange, we cannot use any of the profits towards rehab costs.  It can only be used towards the purchase of properties that need to equal 228K or more.  So, our idea is to use half of the funds to go towards a really well priced property so we can do the BRRRR method (con is we have to fork up the rehab costs), and then the remaining funds to go towards possibly a turn key property so we won't have a lot of up front repair costs and this property should bring us to the 228K mark.  The reason why we would have to buy the 2nd property that is turn key is because we cannot have any all of a sudden cap ex emergencies or repair costs since we already have to use our funds to rehab the first property for Brrr strategy.  We won't make as much money at the onset of the purchase (they always say you make your money when you buy) since it's turn key and usually sold at a fair market value but we also won't have the headaches of having to rehab it ourselves.

OR

We don't do the 1031 exchange, we pay the capital gain but we may have enough funds to do at least 2 BRRRRs with those funds and not have to fork up the rehab costs and also not have the stress of having to find properties that need to equal or pass the 228K mark.

Any thoughts or suggestions?

Would appreciate the feedback!

Thanks BP community! :)

Dave Foster · Answer

@Kat Hughes, It's true that you make your money when you buy the property.  But what you make is not nearly as important as what you keep.  And writing off $20K  immediately isn't helping you keep what you make.

I think you've got the basics covered but may be missing some opportunity to get creative with the BRRR method.  You're right that you must use your 1031 proceeds for the purchase of real estate.  @William Hochstedler there is a way to spend the proceeds in the 180 days but not once you take title to the property.  You're thinking of a reverse improvement exchange where the 1031 intermediary takes title and holds the new property while you improve it.  Although this can be a great process it's expense is generally such that it is only economical if your saving over 30-40K of taxes.  Less than that and you're about as well off to simply not do the 1031 exchange and pay the tax.

Just a couple of thoughts.

1. You're only going to be out . your rehab funds the first time.  Once you've 1031d into the new property and Improved you can now refi and purchase your new property using the refi for purchase and improvement.

2. You could also do the first refi and repay your improvement costs to yourself.  The refi is not a taxable event.

3. With the 1031 you could buy two improvement projects.  Fix one and the refi and use the proceeds to fix the second.  Then refi the second and use that to Brrr to your hearts content.

Kat Hughes · Answer

Hi Dave,

Thanks for the creative solutions.  If we go through with the 1031 exchange, this would be our first and I think my biggest concern is the stress of identifying the properties within that 45 day period and making sure we find a good deal and not just hurry into a deal to meet a deadline.  Also, I would really love to learn the BRRRR process and that is why I'd like to use part of the proceeds to purchase something completely cash, fix it up then rent and refi.  From what I understand, we're not able to use any part of the profits from the sale for the rehab costs (I think that's what I'm understanding from the first point you mentioned).  Ideally I would like divide the profits towards two properties, purchasing them cash, but since we have to meet the 1031 guidelines, we'd have to finance a part of our purchase which I guess is ok, but it's not our first choice.

Kat Hughes · Answer

Thanks William!  Yeah, already talked to my accountant and looked at everything.  We're definitely paying at least 15K in taxes and possibly more but no less than 15K :(

Kat Hughes · Answer

Thank you,  yes you're right.  Definitely need to do my due diligence on those.

William Hochstedler · Answer

Talk to your accountant.

Make sure you understand what your tax liability actually is if you don't do an exchange.

The way I understand it, all the money has to be spent on the replacement property within the 180 days.  This means you can purchase it and pay a contractor to fix it up as long as the whole thing happens within 6 months of the sale and you don't receive any of the money.

I don't know where you are, but I would recommend against a 1031 in markets like ours without more advanced planning.  The short timelines on 1031's are already very stressful and can cause buyers to make poor decisions.  In a tight and already stressful market, it may be worse than paying the taxes and taking your time to find the right project.

Good luck.

Taylor L. · Answer

Just a word of caution about turnkey properties - there's no guarantee that you won't have significant CapEx, unless of course you buy from a provider who makes that specific guarantee. Just make sure to do your due diligence and check major items so you can be reasonably certain about their remaining lifespan.

To 1031 exchange and BRRRR or not?

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