How to purchase REI using 1031 exchange

Question

Hello community,

I am new to real estate investing and have an interesting question which I hope someone can help me out with or at least point me in the correct direction.  This might be more of a what would you do in this situation?

I have a friend that sold a rental property and now has a 1031 exchange for 240k that he would like to get invested before taxes are due.  The property was sold on the 8th
of August for a point of reference on the timing.  He does not have the best credit but the cash, I do have good credit.  I am from Nashville TN, and my friend is from Green Bay WI.  He is not interested in purchasing any property in Wisconsin because of the high property taxes compared to other states.  We are looking in the area of Bowling Green KY as the prices in Nashville are quite high currently.  We are planning on doing a partnership on this property.   We are looking for properties that do not need much/any cosmetic work and is ready to rent.

What we would like to do is use his 240k for a down payment on 3 or 4 unit property (maybe if it worked out two of them), then use a hard money lender to get the remaining money needed to purchase the property.  Then within three months or a year do a refinance on the property and use the money we get out to pay off the HML and then he can get a portion/most of his original investment out of the property.

We did not create an LLC yet and when I spoke with some of the hard money lenders that is a requirement.  But then a normal bank would not do a conventional mortgage for an LLC property.  At least that is what I was told when I contacted two of them.

I guess my main question is – does this sound like a correct way of doing this?  Our thinking is if we went to get a mortgage on the property right away his money would be tied up for years (thinking 6k for closing costs, it would not pay to pay that again in a year or two to get the money out).  Should we go the LLC way or is there a better way out there for this situation?  Any help or ideas would be great!!

Dan Beaulieu · Answer

We see about 75% of new partnerships go south if you have never done a deal together. Definitely tread carefully, and clearly lay out all expectations and profit splits in writing. It would be in either a Joint Venture Agreement or Operating agreement for your LLC.

In a JV, one person buys the property with a loan, or cash, and leaves the other person out of it entirely. The Joint Venture Agreement would give you an equitable interest in the property.

If creating an LLC, your operating agreement clearly outlines responsibilities and profit splits.

It is true most HML need an LLC especially for a partnership. Some can do your personal name if you search hard enough.

Seems like 240K on a 1-4 unit in Bowling Green may take you pretty far and you may not even need a loan? You're definitely on the right track though.

You'll want to go with a commercial lender on this type of transaction so that they can be a little more flexible with the LLC stuff, no debt to income considered, basically just the cash flow of the property considered. There are a few companies offering fixed 30 yr mortgages, stated income, in an LLC, with rates around 6% right now. These products let you cash flow really well and generally are less headaches than a conforming loan.

Bill B. · Answer

So your friend already set up the 1031 before he sold it right and never received any of the money from the sale. (If he did it’s already over, no 1031).

If he didn’t, you’ll need some @Dave Foster advice because the selling tax payer has to be the buying tax payer and any amount of debt he had he has to get again.  You might be able to work some kind of TIC (tenants in common) but I would be careful here. You are comingling a boatload of money to most “friends”.

Imagine you guys go in on this deal with his cash and your loan and then you decide to never make a payment? Or lose your job, or the place is vacant and you don’t want to make the payment. Etc etc.

Justin R. · Answer

A 1031 exchange gets its name from Section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.

The Role of Qualified Intermediaries

Under section 1031, any proceeds received from the sale of a property remain taxable. For that reason, proceeds from the sale must be transferred to a qualified intermediary, rather than the seller of the property, and the qualified intermediary transfers them to the seller of the replacement property or properties. A qualified intermediary is a person or company that agrees to facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property.

- cited from CWS Capital Partners

https://www.cwscapital.com/wha...

Dan Beaulieu · Answer

Yes. New LLCs are created all the time to purchase property. Most loans will be personally guaranteed regardless, so they would look at personal credit and personal cash. That is completely normal, even though the note will be in the name of the LLC and title will be held in the LLC.

John Baeten · Answer

@Luka Milicevic the reasons we thought about the HML for this situation was 1) as far as I could find online it looked like the closing costs would be cheaper than a normal mortgage (this might not be correct but it is what I was going with).  2) I did not feel the odds of finding anyone that would like to be another partner in this deal would be good.  All we have is a idea - not much else to prove anything right now.  2a) If we did find a partner then I really wouldn't be needed in this equation.  Which could be good or bad.  Maybe I just try to go on my own and look for a single family property.

John Baeten · Answer

@Daniel Beaulieu A follow up question with the LLC and a commercial lender.  Can you even get a loan for an LLC if it is just created and does not have any value – or proof of income coming in?  All we would have would be the figures on the property to show that it is currently making money and we plan on keeping it doing that after we purchase it.

Dave Foster · Answer

@John Baeten, As far as the 1031 goes your friend has to take title to at least $240K of real estate (assuming that's the net sale and not just the cash proceeds).  So you'll have to structure as tenants in common immediately in order for him to do that.  You can take title to the remaining amount.  And you can later contribute both your interests into an LLC but then that LLC becomes the taxpayer for the property and when it sells it will have to do the exchange and the two of you are stuck together raising the issues that @Daniel Beaulieu is speaking of.

But the above requirement is set in stone.  So you'll have to make your financing work within that framework.

John Baeten · Answer

Thank everyone for their response.  I will try to put all the answers that I have for everyone here.  Please let me know if you have any other questions – as I am new and just trying to do this right – or at least more right than wrong.

For the partnership I trust my friend we have known each other for almost 30 some years.  He is even married to my cousin.  So, I think we have a very good foundation on that – but I do agree we need to get it all in writing to make sure we are all on the same page at all times.

For searching for properties, we are just looking at the basic sites (Zillow.com, realtor.com & crexi.com).  I know there are others, and probably better but this is what I had to work with for now.  From these sites I have not found many duplex or larger for the 200k range.  I am just looking now on Zillow and only see 4 in the while city of Bowling Green.

Luka Milicevic · Answer

@John Baeten

Disclaimer: Not tax advice and check with your attorney before doing anything. This is just my opinion.

The 1031 has to be done in the same name as the property that was sold. IE: If your friend owned it in his personal name, the new property would have to close in his personal name.

In terms of the LLC, I hadn't heard a HML requiring an LLC. I've only find banks have issues with it if they aren't doing a commercial loan.

You said you don't want to tie up his money with buying on a conventional loan and then doing a refinance. Have you considered that HML loans also have fees and double digit interest rates? You also need to consider that most, if not all HML will not take 2nd position liens. I've never met one that would. The other thing is the length of the loan. HML are fast but short term. 6 months and less. Does that fit into your timeline?

The way I would structure it is to bring on an additional partner for more cash or scale down what youre looking for and eliminate the HML entirely.

What you are trying to do is by all means possible, just need to find the right lenders. I personally don't like complex financing structures with multiple layers of debt. That is just ME.

How to purchase REI using 1031 exchange

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