1031 exchange in an overinflated market?

Question

I need some insight on a 1031 exchange. I have a closing coming up with a relinquished property netting me just over $140,000. This equates to $700,000 in spending power at 20% down. The only problem I am seeing is that it is extremely hard to find a deal, let alone cash-flowing rentals in my market. In my particular market, the active listings have gone from 504 at the lowest point in the summer to around 1400 now so it's getting closer to a balanced market but still about 2500 listings short. Would you:

1. Pocket the $140k and pay roughly 30k in taxes netting $110,000. Use that cash to buy off-market deals (only able to be bought in cash NOT 1031 funds to be competitive) and make up the $30k you lost in taxes. Then continue to use those funds to BRRRR

OR

2. 1031 Exchange the funds and pay market value (which I think is actually overinflated because of the supply shortage) essentially overpaying 50-60K on $700k worth of assets.

In my mind, I'm thinking it's better to be cash heavy right now for when defaults come and continue to BRRRR and get the lost taxes back through wholesales/flips bought with the cash rather than overpay and lose the same amount on overinflated prices.

Any insight?

Ryan Kelly · Answer

@Michael Thomas why not jump into a syndication that allows 1031 exchange money? You could scale into a larger deal, get a preferred return with a lower risk profile, and possibly get bonus depreciation the first year as well.

Dave Foster · Answer

@Michael Thomas, Totally get it.  And your desire to stay conservative with free cash anticipating a market down turn isn't wrong.  That is the poison pill of 1031 investing - the best time to sell and start a 1031 is the worst time to buy and complete a 1031.  But I'm horrible at predicting anything accurately.

And here's the dilema - Not doing the 1031 creates the exact market conditions you want to avoid.  $27K Tax on a sale of 140 is a reduction of available cash of 20%.  In order to equal to buying power that $700K property would have to drop to $560K in order for you to buy it with your cash net of taxes.  The 20% in tax doesn't equal a dollar reduction.  It's a % reduction in what you can buy.  And outside of something like the credit crisis a reduction of $700K properties to $560K is a much more difficult market condition to replicate.

So we recommend to our clients a two fold course of action

1. Don't look at the numbers only in your sale.  Look at the other reasons for your sale.  Is this an opportunity to move from potential cap ex to less potential cap ex.  Is this a chance to move geographically to buy more cash flow.  Are you wanting to change sectors.  Or use the sale to take advantage of advantageous financing that will boost your return?  All of these things can move the needle toward doing a 1031 even if all you do is sell high and buy high.

2. Be ready to abandon the 1031 at day 45.  There is no penalty for starting and not completing a 1031.  The opportunity have 45 days to keep your options open is worth something.  If you can't find something then let it die and pay the tax.  But you might surprise yourself.  It's just anecdotal to our firm, but even in this market well over 90% of our clients are completing their exchanges with properties that satisfy them.

So I guess that equates to me selling you a lottery ticket for $850 that has a 90% chance of paying you $27K.   How many of those tickets would you buy?

Caleb Brown · Answer

Stick to your numbers and find something around market value. Worst case eat the tax. To open up options you can look in more areas but you'd need to establish a team

Michael Thomas · Answer

@Caroline Gerardo AHHH this is great feedback, thank you so much. I agree with everything you said. I have spoken with my CPA and he said roughly $27k in taxes so I rounded up of course since the hand we all must feed seems to always want more. That's another problem you mentioned, with supply so short in my market, additional time restriction rules of 1031 don't do any favors. I agree with the all-time top as well, it's so hard to gauge since that is subjective to the short-term performance of the market 5-10 years but long-term real estate is why we are all here. But you said it best, it's about what risk is worth taking and I will need to figure out if I want to stress a little more or relax and ride the wave.

Caroline Gerardo · Answer

Get your CPA and quick books person to really run the numbers- how much is the tax due? Don't guess. The exchange does have handcuffs of time that limit your choices AND you pay upfront costs. Third option is to move ahead with 1031 exchange, find out how much $$$ you have to hand over subtract that from tax consequence if you can't find a deal. Markets have softened a little. You will be buying in the all time top of the market if you exchange. I sold a long term hold this year and paid the piper because worry is not my friend. It depends on your attitude towards risk.

1031 exchange in an overinflated market?

Most Popular Reply