Sell Investment on an 1031 exchange?

Question

Hello BiggerPockets community! I need some wisdom from those of you with a bit more experience than me in Real Estate investing.

My wife and I have a rental property in North Carolina that is locked in at 3.75% interest rate, cash flows about $400/month. We have about $85000-$100000 worth of equity.

We are considering a few options, and would value any input you have in the best move.

1) keep the rental property

2) sell it utilizing a 1031 exchange and take the equity to purchase 2 smaller homes as rentals, but likely with higher interest rates.

What would you do?

We would greatly appreciate the wisdom!

Pat Lulewicz · Answer

@Gabriel Pais this entire situation really is a math decision with the caveat of finding replacement property as @Dave Foster mentioned. On the HELOC point, still same math equation exists. Even if you get floating rate at 6-8%, and it has a ceiling that you can stomach because the deal is good if the rate adjusts, the new deal just has to cash flow. My HELOC has adjusted from 3% to 7% over the last 3 years, but my rental still makes more than that AND its still lower than what I'll find on the open market, PLUS I controlled the closing process. Just find one that has a good cap or pay for a cap. If the open market is still giving you DSCR loans at 8%-10% without buydowns, then the HELOC makes as much sense as DSCR loans. Plus, if you have a W2 job or know that your self-employment efforts will bring steady cash flow, you just pay yourself (the HELOC) over time. And if the rate gets out of control, refinance the whole damn thing at purchase or when your seasoning hits if there's trapped equity in the new home.

Gabriel Pais · Answer

Dave, Thank you for sharing for sharing the wisdom, this is really helpful and considering the options the 2 properties that I'm planning to buy are on a smaller market, but have a lot of potential with appreciation within the next 5-10 years and I think putting 20% to 25% on them would help me have more leverage to fight off the interest rates. The only constrains I see with a 1031 exchange is the timeline that it takes to close, so I'm already starting to search the area of where I want to buy the properties, before I even consider doing a 1031. I will keep you in mind when I'm ready to perform a 1031 as I can see you are intermediary for 1031 transactions! :-)

Pat Lulewicz · Answer

Where in NC? What kind of price point is the current home? Do you already have replacement property/ideas in mind? Selling the home can mean that its going to sit vacant for a while forgoing opportunity cost. Then there's also the buy side...you have to meet the timelines of the 1031 exchange at a time where lending is tough AND if you're buying smaller (i.e. less expensive) homes, there would be a higher demand and competition for those with in state and out of state investors alike battling it out for rental grade inventory. Unless you all-cash 1031s, if you're against the clock and NEED to buy a property, remember that overbidding still leaves it up to the appraisal to make sure you can qualify for the financing. Don't want to see y'all get caught by the clock, lose an amazing interest rate and steady cash flow, AND pay the recapture and gain taxes for selling.Any opportunity to go to the lender on the primary OR the bank that you use for your personal banking, and see about getting a HELOC? If you don't have another primary and are renting or something of the like, they may still view it as your primary. If they can do a HELOC without even getting a formal appraisal done, just a desktop, then you might be able to pull equity that way.

Gabriel Pais · Answer

Paul thank you sir for sharing your input that it's true a 1031 is risky business with the closing on time and that's technically the main concern for us. The location I know it's a great trade off for long term equity building, so even though our current rental is low on interests, I think selling it and pulling all the equity will help for big down payments on smaller properties. As for the HELOC, I have a hard time considering that option because interest rates are volatile, and I think that type of loan would probably be better for a fix & flip.

Dave Foster · Answer

@Gabriel Pais, This will be a math and effort calc for you. Three questions 1. What's your effort level now and what would it be if you 1031 into two properties?2. What's your actual rate of return (including allowances and things that reduce monthly cash flow) now? And what would it be if you 1031'd into the two new properties?3. What is your appreciation currently and potential for the current property? What would the potential be if you 1031d. Typically two smaller properties will rent for more than one larger property. And the operating cost isn't usually that much different. There's two of every system in two smaller houses. But larger properties have larger more expensive systems. Typically two smaller starter home properties will appreciate faster than one larger. But location has a lot to do with this. Typically two smaller properties will take more effort. The one thing that a good 1031 exchange can do is to let you concentrate and free up your equity for later. If you want to purchase two smaller properties. Then purchase one of them with the greatest amount of leverage possible. And purchase the other in cash , or with as little leverage as possible. This way you have lots of equity in one of them so less risk of loss in a market down turn. And if you later find a property you really like you can refi that property at any time and pull the money out for your next acquisition.