What is the best route for this 1031 Exchange Scenario?

Question

I have a condo in Los Angeles that I plan to do a 1031 Exchange within the next year. The property is worth approx. $450k and I will have $300k in cash once it is sold to purchase other investment properties. My ultimate goal is cash flow to be able to quit my job (self-employed) and focus on real estate full-time. Do I purchase a multi-family unit in Southern California for maximum appreciation?  Or, should I purchase multiple units in other areas around the country and convert them to MTRs/STRs for maximum cash flow? Keep in mind, taxes and insurance costs in California are higher than a lot of areas. All ideas/ suggestions are welcome!

Jake Andronico · Answer

@Laura Yazdi

I would get super familiar with the 1031 exchange process. @Dave Foster is super knowledgable.

MTR's/STR's in other states can be much more headache than they're worth, but it depends on how active you want to be.

Have you looked at Las Vegas? Much more landlord friendly, affordable, but still close by to where you are.

Whatever you decide, best of luck to you!

Gino Barbaro · Answer

@Laura Yazdi

I think you're asking all the right questions. Dave Foster is the 1031 specialist we use at Jake & Gino, so I would get clarity on that piece first. Next, decide where to roll the money into.

It sounds as if you don't want to stay in California. I would learn how to invest outside your backyard. There are plenty of multifamily groups in your area that have investors investing in other parts of the country. We have a ton of members from California partnering up in different markets.

You've got a good problem on your hands. Good luck

Gino

Sean Ross · Answer

Hello @Laura Yazdi,

This is anecdotal, but we're seeing our 1031 clients flee from the higher-tax and higher-regulation parts of the country to places like TX, NC, GA, FL, AZ, etc.  Lots of West Coast capital going elsewhere.  We hear lots of complaints about landlord laws, delinquent tenants, and homeless encampments causing trouble/damage.

Maybe there is wisdom in the crowd. Again, just anecdotal.

Here are some things to consider about 1031 exchanging in and out of California specifically:

1. California Clawback Provision - California Franchise Tax Board has rules about investors who sell and 1031 out of state.  In short, they're going to require you to file a new form each year to update them on the investment.  If you ever recognize capital gains down the road in another state, they want their cut.  Failure to file the form (#3840) will result in retroactive tax recognition in California.

2. California tax burden - Due to the clawback provision, you don't get a full break from the higher income taxes in California if you sell in another state later after a 1031 exchange.  You'll still likely get some lower taxes, since some of the gain will be accrued in another state, but you still need a good tax accountant here.

3. CFTB review of 1031 exchanges - California Franchise Tax Board is even more diligent than the IRS when it comes to scrutinizing 1031 exchanges.  No matter how you 1031 in CA (inside or out), you really need to dot your "i"s and cross your "t"s.

We do tons of work in CA. If you don't already have a preferred 1031 intermediary to work with, we'd be happy to give you a free consult whenever you're closer to making a decision.  If you do already have one, I'm happy to be a second opinion.

Laura Yazdi · Answer

Hello Andrew, thank you for your input. I am looking for a tax strategist that knows the California real estate laws and landscape. Do you offer real estate tax strategies? Particularly with someone who is self-employed and trying to buy more property and take my legal deductions?

Dave Foster · Answer

@Laura Yazdi. An excel spreadsheet is going to be your best friend (well that and a crystal ball).

Appreciation and cash flow make up part of the calculation of the Internal Rate of Return (also including depreciation benefit and amortization of the loan).

Running this calculation comparing properties of different types. in different locations is going to give you an idea of where your best benefit is going to come from.

A couple more caveats

1. You still have to use some educated guessing to get to certain assumptions - like appreciation rate and NOI cash flow etc

2. Your own predisposition toward active or passive management.  Where do you want to live?  If you want investments close to you then that's going to be a big factor.

3. Your tax situation.  the taxation and benefits of STR vs LTR are incredibly different.  But running an STR is very different from managing an LTR.  Again your personal strengths and desires will play a huge role.

Laura Yazdi · Answer

Hello Sean, This is very helpful. Thank you. Saving your contact information down for when I start the process. - Laura

Jay Thomas · Answer

When it comes to cash flow versus appreciation, there's a bit of a trade-off. In Southern California, multi-family properties offer potential for appreciation along with some cash flow, given the steady population and desirable market, but higher property costs, taxes, and insurance can eat into your profits, and finding a suitable unit in your budget might be competitive. On the flip side, multiple MTR/STRs in other areas could yield higher cash flow, especially in tourist-heavy or affordable markets, but managing dispersed properties can be challenging, with considerations like vacancy periods and potential property management costs if you opt out of self-management. Don't forget to research local regulations surrounding MTRs and STRs, factor in management fees if you plan on outsourcing, and assess your risk tolerance between a larger, single multi-family property or multiple, potentially distant, MTR/STRs.

Laura Yazdi · Answer

I lived in the unit 2015-2020. It has only been rented for 4 years of the 8 years I have owned it. It was my primary for the first 4 years.

Brad S. · Answer

I assume you haven't occupied the unit in the past 5 years and don't qualify for any of the tax exclusion?

Alex Olson · Answer

Depends on asset class and age of property. Aar is about 20-30% depending on your expected exit cap. 7-10% cash on cash return.

What is the best route for this 1031 Exchange Scenario?

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