How would you capitalize on appreciation?

Question

Looking for some insight and recommendations based off of what worked well for others. Here's the background info:

My wife and I bought a small house, 2 bed 1 bath, in 2018 and rehabbed it while living in it. We moved out in 2021 and started renting it out. We've had great tenants, a good property management company, and few expenses over the past few years. We're considering our options for moving forward.

Numbers:

Purchased for ~ $230,000 (2.5% interest)

Remaining balance ~ $220,000

Appreciated to ~ $400,000

Cash flow is ~ $500 a month after setting aside for all reserves

Options we're considering:

1- Cash out refinance- at current market rates, rough estimate is that we could access close to $100,000 in equity, but our cash flow would go to $0 or possibly negative for a period.

2- Sell now - if we sell before the end of the summer, we could still qualify for living in the property for 2 out of the last 5 years for the additional tax benefits. We could maximize our capital (~$150,000), but lose any future cash flow with the property.

3- look into a 1031 exchange for a multifamily or small apartment complex. I've explored this option the least and don't fully understand the benefits of a 1031 exchange compared to our other options.

4- do nothing, continue to let the property cash flow. I personally don't believe that the property will continue to appreciate or see the rent growth that it has seen over the past few years.

Based off of the surface level information, what options would you go with and why? Are there other options that you would consider that aren't listed?

Eric Fernwood · Answer

Hello @Maxwell Emerson,

Your next step depends on your financial goal. If your goal is financial freedom, you'll need a rental income that can replace your current income and must increase fast enough to outpace inflation.

Inflation increases the cost of goods and services over time, effectively reducing the value of your money. For instance, if your rent is $1000/Mo and the annual inflation rate is 5%, the buying power of $1000 will decrease to $950 next year. You will need approximately $1630 in ten years to buy what $1000 can buy today. Therefore, if your rental income doesn't keep up with inflation, you must consistently reduce your monthly expenses or return to work to compensate for decreased purchasing power to maintain your living standard.

No matter how many properties you eventually own, unless rents outpace inflation, you can not achieve true financial freedom.

Back to Your Situation

You stated, “I don't believe that the property will continue to appreciate or see the rent growth it has seen over the past few years.” Thus, you may need to take action. To simplify the decision process, I created the following decision tree. (click to enlarge)

Bottom Line

Evaluate the property based on whether it will enable you to achieve financial freedom. If rent increases have not outpaced inflation, you know what to do.

Greg Scott · Answer

What is your Equity earning you?

Your cash flow is $6K per year on $180K in equity.  Your RoE is therefore 3.3%.  So, yes, your cash flow dollar amount looks big, but from a percentage standpoint, it is terrible.  (You can do better in a savings account!)

I would sell while you can avoid the capital gains.  Use that cash to look for other real estate investments that will appreciate and give you cashflow.

Greg Scott · Answer

How would a 1031 exchange benefit him if he can sell today using the owner/occupant exemption?  In this particular case 1031 seems like a bad idea.  It increases cost and creates time pressure that he would not have from a straight sale.

Dave Foster · Answer

@Maxwell Emerson, the great advantage in a 1031 is that it lets you capture all of the equity for your next purchase.  And it lets you sell the current asset.  If you like the asset you've got then a refinance is a better option.  But if you think appreciation has stalled or capital expense might be lurking then a 1031 is better than just a sale because you get the compounding effect of the deferred tax working for you not the government.

Dave Foster · Answer

@Greg Scott  and @Marc Greger, Totally agree with you.  But if they converted to investment anytime prior to today they are outside the 5 year look back and would have to 1031 if they want to sell and not pay tax.

I just saw the end of summer comment buried in the commentary.

Bill B. · Answer

You can take $22k in tax savings (plus any state income tax savings) and walk  away with $150k on which the bank will pay you a GUARANTEED $600/mo in interest. Or you can make $500/mo and if everything goes perfect in 4 years you will have earned back the extra taxes you paid. (Again assuming you didn’t owe another $15k to your state.)

I don’t see how this is even a choice.

Ps. You are cutting this really close. The 2 out of 5 years is a hard deadline, you must sell before you’ve been out of the house 3 years. After that you’ve lost the 100% deduction forever, even if you move back in.

Marc Greger · Answer

I don´t get the 1031, this is done on investment properties where you didn´t live in, if you had it as your residence I´d sell it. It´s tax free, take the money.

Then look for an investment with better returns. I´m currently investing in notes, if you want we chat about that and how it works. If I´m not mistaking if you sell you´d get more money out than you would with a cash out refi.

So if you want cashflow, notes pay monthly. Just an rough example:  Let´s say you get 160k of your sale, you go out and get a note with 6-8% (which is more than doable) you look at a 800-1000 monthly cashflow, no tenants, toilets, property taxes, insurance etc.  but of course also no tax benefits no appreciation *This is not investment advice it is my opinion and only what I would do

How would you capitalize on appreciation?

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