Is 1031 Exchange a cheat code or just a better way to sell bad properties?

[Matthew Vanhorn]

Gut feeling is that 1031 Exchanges are a cheat code to scale a portfolio faster than one could otherwise. But I listen to all of the podcasts, read many of the books, and haven't seen/heard a solid strategy of how to aggressively use 1031s to our advantage. In real life, I only see folks selling bad properties via 1031 Exchange. So to ask it another way, when (if ever) does it make sense to 1031 exchange great properties into greater properties? Any real world examples of your 1031 wins you're willing to share?

[Eric Fernwood]

Hello @Matthew Vanhorn,

1031 does seem like a cheat code. It is used when you want to exit a property (or properties) and redeploy your equity into better performing property (properties), without tax consequences. No other investment vehicle has this tax advantage. Many of our clients exchanged properties in California, Seattle, or Portland for properties in Las Vegas.

Another equally big advantage of real estate is cash-out refinance. Cash-out refinance is how many of our clients have grown their Las Vegas property portfolios with minimal additional capital investment.

Before I continue, here's a brief background: we've delivered over 490 investment properties to more than 180 clients. We've completed about eighty 1031 exchanges and helped numerous clients grow their portfolios through cash-out refinance purchases. This experience gives us a solid understanding of both options.

A frequent question I receive concerns whether they should do a 1031 or a cash-out refinance. Which is the best option depends on whether the property is performing and the amount of equity. Because this is a frequent question, I put together the following decision chart.

1031 or Cash Out Refinance?

The first and most important decision is based on whether rents and prices have outpaced inflation and if the property is in a landlord-friendly environment. If the property has not met both requirements, 1031 or sell the property.  If rents and prices have outpaced inflation and the regulations are favorable, keep the property. The next question is whether the proceeds from a cash-out refinance, plus your savings, are enough to purchase another desirable property. If no, do nothing for now; continue to accumulate equity. If there is enough equity to buy another property, do a cash-out refinance.

Other Considerations - 1031

• You are not allowed to use the proceeds from the relinquished property to pay for renovations. Some of our clients have opted to pay capital gains tax on a portion of the proceeds and use that money for the renovation.
• If you only identify the replacement property during the 45-day identification period and you cannot close on any of the identified properties, you lose the tax exemption. We minimize this risk by coordinating the sale of the relinquished property with the purchasing of the replacement property. Using this approach, we usually close on the replacement property within about four weeks of the exchanged property closing. With this approach, if the replacement property falls out, we have time to get another property and complete due diligence before the end of the 45-day identification period.
• Not all purchase contracts include 1031 exchange verbiage. Have your listing agent obtain the correct verbiage from your exchange agent for your state and include it in the agent-to-agent remarks, specifying that the 1031 text must be included in the offer.
• To fully defer the capital gains tax on all the proceeds, you must reinvest all the proceeds from the sale into the replacement property.
• If there is existing mortgage debt on the relinquished property, it's important to consider how it will be handled during the exchange. Any reduction in debt or cash received may be treated as taxable boot, resulting in potential tax liabilities. Talk to your 1031 exchange agent.
• The relinquished and replacement properties must meet the requirement of being held for investment or used in a trade or business. Personal residences or properties primarily held for personal use do not usually qualify for a 1031 exchange.
• It's important to understand the state-specific regulations regarding like-kind exchanges. Some states may not recognize or fully conform to the federal provisions. Consult with a tax professional familiar with your state's laws.

Other Considerations - Refinance

• When you refinance the property, will it still provide a positive cash flow?

Summary

Cash-out refinances, and 1031 exchanges are powerful tools for investors. Primarily:

• Use 1031 to replace poorly performing properties.
• Use cash-out refinance if the property has performed and you want to reinvest the equity.