$25K property to a $400K Lake House using 1031 exchanges

[Jake Thomas]

About 2 years ago I drove by this horribly ugly blue house that I could barely see from the road. I had been reading BP posts about driving for dollars and finding the seller to buy it. After an hour of google searching, I found the owners phone number and the rest is history. Finished the remodel and placed a great tenant on a 2-year lease. After 11 months into a 24-month lease, the tenant advised me they needed to break the lease. My wife and I decided to sell the property to buy something else and utilized our first 1031 Exchange. Using simple math we purchased the property for $25K put about $45K into it and sold it for $155K netting roughly $82K after closing costs. So rather than paying around $32K in taxes we did a 1031 exchange on this property.

$25K before

After

We did have three properties picked out for the 1031 exchange since you are supposed to name the addresses with 30 days and close within 180 days but 2 of the 3 fell apart two weeks in. We did close on one of them. It was a $50K rental utilizing the 1031 exchange that we still own and it rents for $900/month. This property was purchased through a craigslist transaction. It only needed a roof but the interior was good to go. I agreed to purchase the home and the seller used me as his Realtor to buy their next home netting me around $6,500 in commission which covered the entire roof. After purchasing the rental that left us with $102K in the exchange to buy something else with. We ended up finding a property on the MLS that we closed on for $125K. I had to supplement the extra $23K but it was worth it to avoid taxes on the first property.

$50,000 rental

This property we purchased for $125K with the remainder of the 1031 Exchange turned into a bigger project than expected. We closed on it in Nov of 17’ and decided in January to turn it into a flip versus a rental. Our original intention was to make it a rental as we don’t typically flip properties. I confirmed with several 1031 experts that we could sell it and do another 1031 and they all confirmed this would be ok assuming we don’t continue to do this and we do not plan on ever doing it again. We purchased this one for $125K had about $40K into renovations and holding costs and sold it for $225,000.

$125K purchase before

After 

While I was finishing up the rehab on the $125k house my attorney gave me a lead on a couple going through a divorce. They owned a house on a very popular lake not far from where I lived and we have always wanted a lake cottage. I made them an offer and they accepted at $270K. We closed on the $125K house that sold for $225K netting around $220K after closing costs and $55k profit after remodel and expenses. We did another 1031 exchange (saving around $21,450 in taxes) and purchased the lake house for $270K using the 1031 funds and supplementing another $50K cash. We intend to turn the lake house into a weekly rental for around $2K per week on the weeks we don’t use personally during the summer.

Lake house 

Now you would think it ends there but never with Real Estate investing. I found a local bank that will give me a line of credit on the two paid for properties I have acquired through the 1031 exchanges (Lakehouse and rental for $50K) at 75% of appraised price so around a $350,000 LOC I can use to buy more properties. I already have a 5 unit under contract using this LOC and plan on using this for years to come.

A quick summary of the numbers

Total cash out of pocket invested:

$25K house A purchase price

$45K house A renovations

$23K house B extra cash need for house B purchase

$40K house B renovations

$50K Lake house extra cash needed for purchase

$183,000 total cash invested

$53,450 saved in income taxes using 1031 exchanges.

Values of what I own now from this:

Rental house market value of $90,000 and rented for $900/month

Lake House market value of $400,000

Line of credit $350,000

We are very happy with how everything turned out and we have that 25K rehab to thank for it.

[ADAM STEWART]

Congrats @JakeThomas! Very inspiring and just goes to show that we need to be flexible and willing to adapt as the situation warrants.

[Jacob Morgan]

I went through the process of examining the 1031 process and rules last year and found that they were generally too inflexible for my needs at the time. First off - they are very particular and tricky regarding personal vs business property. It's supposed to be like for like - if you sell a rental, it should be converted into another rental. Depending on how much business you actually get in renting that house out on AirBNB, it may be an issue to sell that to a tax auditor should you ever need to.

The second issue that I had was that there are rules about equity positions between former and exchanged properties. I believe there should always be an equal or greater equity position in the new property to the gain that is being deferred. (I'm not a tax guy, just trying to present an issue that came up and was explained by a 1031 specialist). This in my case severely limited by ability to leverage the new property to fund further purchases. Your $350k line of credit sounds like it could be in that questionable territory.

[Dave Foster]

@Jacob Morgan, That's too bad  you let that opportunity slip by.  The 1031 rules are rigid but you were fed bad information.  i don't know what QI told you the above but nothing could be further from the truth.

1. Like kind is determined by qualified use of the property.  Yes you may not exchange personal business property for investment real estate and vice versa.  But the statute specifies that any real estate purchased with the intent of holding for productive use in trade, business, or for investment may be sold and exchanged for any other type of real estate which you intend to hold for productive use.....  Any type for any type as long as it is investment.  Type, source of income, and amount of income are not statutorily prescribed.

No competent QI would every tell you that a short term rental is not like kind to a long term rental.  The person that told you that does not know the statute.

2. Equity has no bearing at all on the 1031 exchange.  In order to defer all tax you simply need do two things - First you must purchase at least as much as your net sale (the contract price minus closing costs/commissions but before mortgage pay off).  Second you must use all of the net proceeds (net sales price minus mortgage pay off) in the next purchase or purchases.  You can add funds to the purchase to replace the mortgage (thus increasing your equity position).  And you may add cash or debt to a purchase of more than your sale which would affect your equity.  Equity itself does not matter.

You can also purchase less than what you sold (thus decreasing equity or increasing equity depending on whether you add cash or not) and you may take cash from the sale (also decreasing equity) but in those events you are doing a partial exchange and you pay tax on the difference without jeopardizing the remainder of your exchange.

@Jake Thomas,s equity heloc is a brilliant move that is not questionable at all.  First of all it did not happen during the exchange anyway so it is out of the purview of 1031.  You may securitize the property any time after the completion of a 1031 as your business model dictates.  Second, He passed the two part test of purchasing at least as much as his net sale and he used all of the proceeds from the sale in the next purchase.

I kind of sense that you were wanting to sell one larger asset and exchange that for several smaller assets using the proceeds of the sale as a down payment.  Again I feel bad you got such bad information because that would have been a perfect use of a 1031 exchange.  We call that a diversification exchange and it lets you maximize leverage (affecting equity) while still deferring tax.

So the whole takeaway from my grumpy Gus diatribe here is that while the 1031 statute is a little complicated and very rigid there is so much room for you to act strategically that you shouldn't write off the tool because of bad advice from a bad QI.

Sorry

[Rudy Estrada]

Love every detail of this story. Congrats!

[Nicole Richards]

Very Inspiring!  I love how the pieces fell into place but took your creativeness to take it to the next level. Thanks for sharing!

[James Miles]

@Dave Foster:  Great explanation and it answers a few questions I have had.  I want to make sure I understand with an example:

If I have a rental property that sells for $320,000 and closing costs/commissions/etc = $20,000 (round number) and I owe $100,000 then according to your formula I would need to purchase (exchange) for a property or properties that cost equal to or greater than $300,000 even though my net proceeds after paying off the mortgage would be $200,000.  

$320,000 - $20,000 = $300,000 (purchase price(s) of exchanged property(s))

$320,000 - $20,000 - $100,000 (mortgage) = $200,000 available cash for down payments.

Did I understand that correctly?

Also, something @Jake Thomas said that I want to confirm:  I understand that you need to identify 3 properties within 45 days (OP said 30) and close on one of them within 180 days of the original sale closing.  It sounded like the property he closed on from the original 3 did not meet the "equal or greater" requirement and found an additional or fourth property after the original time period.  

My question for clarification is, using the example above, if I found 3 houses for $100k each within the initial time period and only closed on one, I would have only used up a 3rd of my required proceeds.  Would I then be able to identify additional properties after the initial timeframe but close within the 180 days and satisfy the 1031 exchange requirements?

Or do I have to identify all properties within the first time period?

Thank you,

[Dave Foster]

@James Miles, Yep You got those numbers nailed.  of course that is if you want to defer all tax.  You can take some cash out.  And you can buy less than what you sold.  You'll pay tax on the difference but shelter the rest of your profit in the 1031.

you do have 45 days from the day you close your sale to identify your potential replacements after day 45 that list is set in stone and cannot be modified.  I think @Jake Thomas got lucky (but don't forget that luck usually only happens to prepared people) and his other properties fell through within the first 45 days so he still had some time to find that other one he closed on during that period.  Once you're past day 45 you're stuck.

The first 45 days of an exchange is the most critical time for sure!

[James Miles]

Thanks,  One of the other interesting tidbits that I have came across in scouring the internet that might be helpful to know is that if you only identify 3 properties in the first 45 days there is no limit on their combined value, however, if you choose to identify more than 3 properties then the combined value of all of them cannot be greater than the total amount of your sale.  

Do I understand that correctly?

Other than that, my biggest take away is this isn't something that you can DIY but you will need to engage a professional that has experience.  

[Jason Carter]

Congrats @Jake Thomas. Great story! 

[Account Closed]

Just like the red paperclip story,congrats on your path!

[Dave Foster]

@James Miles, Now you're getting into the deep weeds of 1031.  It's actually that if you name three or fewer potential replacements it doesn't matter how much their worth.  But if you want to name 4 or more potential replacements then the aggregate value of the list can be no more than 200% of the value of what you sold - unless you close on 95% of the value of the list (usually that means the entire list).

The QI should be monitoring this with you as you go.  And while it shouldn't send you into a panic it does emphasize the importance of the first 45 days.  I highly recommend that you actually get the replacement property/properties under contract during the 45 day period.  And if you can go into contract before you even close the sale of your old property so that you close your purchase/purchases during the 45 day period that takes all the pressure off.

[Trevor Hatchard]

Wow, what a story!

I am still analyzing looking for that first deal, but maybe I need to start small and 1031 my way to financial freedom.

Does anyone know if there any limitations or cons to this method?

[Dave Foster]

@Trevor Hatchard, @Jake Thomas story is a perfect illustration of how to use the power of 1031 exchanges, a lot of leg work, and creative financing.  Don't think of the pace of his efforts as the standard.  Not many have it happen that fast.   But that's the track.

One recommendation - always watch your leverage.  Maximum growth comes from maximum leverage but so does maximum risk.

[Mark Alexander]

Thanks for sharing your inspiring story

[Gina O'Day]

@Jake Thomas

Great success story.

[Charles Bellanfante]

Nice post. With the beat up house you purchased for 25K, Did you know that it was going to increase in value to 155K before investing 45K into the property? If so how did you appraise it beforehand? I like that approach and I am interested in these kind of ventures but would like to get more info on how to know what the concluding value would be after Purchase cost, after renovation cost, etc. 

[Bradley Bissett]

Nice job @jayThomas. Obtaining a lake house through Real Estate investing is one of the reasons I got started. Awesome work.

[Ntiense Inokon]

@Jake Thomas congratulations! This is particularly helpful for me as I'm about to start my first 1031 Exchange and was debating between purchasing multiple properties in mediocre areas vs one property in an area with a strong history of consistent appreciation. Instead, I’ll look into doing a combination of both.

[Frankie Woods]

What an incredible journey!  Thank you for sharing!