A Real World 1031 Exchange - Part 1: Prologue

A Real World 1031 Exchange                    6/1/2014

Part 1: Prologue:

In 2010, my wife went back to work giving us a nice boost in income. After failing to find an appreciably bigger home in our price range, I thought 'How about if we buy a rental property?'.

I thought that the more wealthy of my fellow Baby Boomers would like to retire near the beach due to the mild climate so I started looking near my work close to the Los Angeles Airport (LAX). Not having one iota of real estate knowledge, I was looking for a place where the rent would cover the mortgage, taxes, and insurance. (I could not imagine that anyone with a cash-flowing property would ever want to sell it.) In the back of my mind, I wanted to do vacation rentals or a backpacker's hostel.

I eventually found a triplex in a short sale for $885k. The rents just covered PITI (Principal,Interest, Taxes, Insurance). (Who would have thought that they had an acronym for my goal?) The one good thing about waiting until you are sixty to start investing is that you can accumulate a pretty good credit score. Also our home mortgage was almost paid off so a refi gave us the down-payment for the rental property. Thus we became the proud owners of a 2-br house in front of an over/under duplex, both painted bright aqua, one block from the Venice Boardwalk and one block the other way from Google's future L.A. office. The fact that there was no parking on-site or on the adjoining street didn't bother me. Neither did the fact that our street was the four-lane main thoroughfare along the coast from Venice to Santa Monica.

I became a gentleman landlord to a bunch of 20-something surfers. After a couple of months, I decided to take over management from the P.M. company. Two weeks later, an SUV ran into the apartment displacing all of its tenants for four months. Luckily Farmers' Insurance paid for everything including loss of rent. Unluckily one of the tenants got a lawyer and suggested that if I didn't give her $10k, she would sue me for illegally forcing her out of her home. (Even though she had verbally given notice before the accident.) Luckily I had met a lawyer at a landlord association. Unluckily he charged me $6000 to write three letters to the other lawyer.

Things then settled down to the normal operations of a 100-year-old building. After three years, RE agents started asking if I wanted to sell. I had enjoyed going to the beach on weekends and puttering around the property, but rents would have to skyrocket for me to get decent cash-flow. After a long escrow that fell through, we eventually had a long precarious escrow that completed. We had had the keen foresight (dumb luck) to buy in what became the trendiest neighborhood in the U.S.

We had made about $315k in appreciation, (Selling price $1.29M minus Closing costs $90k minus the price we paid for the property: the 'basis' $885k). However, the profit is subject to (currently) 20% capital gains tax by Uncle Sam plus 13% income tax by California. Giving up 33% ($105k) would leave a not very big nest egg for our retirement. Except we had set up a 1031 exchange during escrow.