The Back End of a 1031 Tax Deferred Exchange: Big Blue

The back end of a 1031 Tax Deferred Exchange…

I call it Big Blue. She’s a 2000 square foot   Pre-1920’s two story Victorian that was converted      into an upstairs/downstairs duplex some 30-50 years ago.  10 foot ceilings and 5 coal fireplaces with original mantels.  It would be easy to convert back into a single family house too. It’s in the heart of a Historic Neighborhood that I identified as a rapidly changing neighborhood. This fit my ideal target as a real estate investment in a rental property for charlotte, north carolina.

I had a buyer for a vacant lot that literally sat 5 doors down from Big Blue and I was looking for an opportunity to buy a replacement property. I believe in being tax efficient via the use of 1031 exchanges; however, I do not believe in buying just anything in order to defer taxes. Heck, you could end up losing more money with a unwise purchase than the savings!  I was not into building and was into cash flowing so the goal was to replace the non-cash flowing land into a rental.

I put the word out that I was out looking, rummaged through my files as I had contacted every multifamily property owner in the plaza midwood neighborhood over the years, and perused the mls….  Where did the deal come from?  Actually my property manager knew I liked this specific neighborhood (let alone the street) and said I’ve got the place for you.  Big Blue was Pepto Pink at the time and somewhat a scourge to the neighborhood due to the owners philosophy with rentals -but that’s another story.

We scheduled our walk-through and I knew immediately it was a buy.   Deferred maintenance?  Yes.  Some that I would address immediately and others I’d handle over time.   I have learned over the years that over improvement is a waste of time and money for those in the game of rental properties. My first question to all investors when looking at a property is????    “What is your goal with this property?” The response’s are varied but more than less have something to do with making improvements, adding on, and how its going to be the most beautiful rehab, throwing off lots of money when its sold.  Others talk about top end upfits for top rents -I know that is a niche that works; however, it doesn’t fit in my plan when dealing with volume (lots of rentals) and the capital available to a rental portfolio with scale.  In theory this is great; unfortunately, most are not equipped with the Knowledge, Experience, nor Cash to execute victoriously.  Did you hear that?  Yup -most don’t necessarily fail but lets just say make a meager sum of money from the sweat, tears, time, and tied up capital.

Do you know what my goal is?

My goal is to make a minimum of a 15% cash on cash return with a rental and to have the ability to sell it for twice my cost/investment within 3-5 years in an AS-IS condition. I state an as-is condition because it puts the basis of the investment on a level field.   Talking about rehabbing to sell retail (for instance) is a whole other venture in which additional capital, time, and/or expertise is required -let alone the ability to turn an actual profit.  You see I just view a rental as an asset -one that can be swapped like a chess piece.  One that I intend to continuously double in amount (both value and more rentals) and one in which I’ll take a profit from time to time to diversify.

Now let’s look at the deal to see what you think. The agreed upon purchase price was $84k.  My 1031 money was $35k.   Like those numbers? I bought the place empty and put 15K into both units.  Downstairs needed a new gas pack (heat/air system), installed stack washer/dryers, fridges, ovens, new kitchen cabinets, paint, redid hardwoods, etc.   Turnkey rent ready.  I rented the top unit out at $575/mo and the bottom unit at $600/mo for a total of $1,175/mo or $14,100 annualized (not accounting for any vacancies).  On the surface it sure looks good huh?  YUP.

So another question might be – financing?

I initially borrowed the remainder ($84k purchase – $35k 1031 money + 15k rehab = $64K) being $64K from a family member on an interest only payment of $373.33 based on 7% interest rate.   One and half years after purchase,  I refinanced this property on a 30 year fixed rate mortgage at 7.625% on a loan of $110k and ended up refinancing it (for the same amount) one year later for a 30 year fixed at 6.25%.   The excess balance was reinvested (note: I did not say I lived off it, took a vacation, or bought a new car).   The Principal and Interest Payment is $677.29 with taxes adding $180 and insurance @$40 per month.  Total payment is $897.29/month or $10,767.48 annualized.    Today’s rent is $1,250/mo or $15,000 annualized leaving a monthly positive cash flow of $352.71 not including vacancies, maintenance, management, etc.   Believe me I don’t plan to live on that cash flow.  In my opinion, a good 25% of rental income can be eaten by these additional expenses alone -therefore, leaving no income after an averaging out of expenses over time.

Still -Not bad huh? Normally I would advocate that you not pull equity out (or as I call it: “Eat your equity”).   Had I done that my refinanced loan would of been for $64k with a monthly payment of $394.06 which equates into a monthly positive cash flow after PITI (principal, interest, taxes, & insurance) of $635.94.   Like that?  You Should -staying disciplined, a few rentals set up like this will accelerate your wealth. At the time, I choose to extract that equity and reinvest into another rental.   You see one of my strengths is buying right so I choose to extract the money (at a cost of 6.25%) to reinvest.   What is that?  That is buying a property at a discount to its true value and/or creating forced appreciation through proper renovation.  A favorite statement of mine heard from a fellow investor:  “If I have to pull out a calculator to see if it’s a deal -its not a deal”.

I got to tell you that this property has turned out to be a low hassle investment.  It is 1 1/2 blocks from a hip business district and correspondingly attracts the creative loafer on a budget.   Typically it takes less than 30 days to fill a vacancy and tenants tend to stay at least 2 years.   ‘Slowing the Turn’ in rentals is the key to creating wealth: one wants to provide a nice product at a good price to attract and retain good residents.   The value in today’s (2009) depressed market is a conservative $180-210k with @$160/mo in principal pay down (forced savings) and a current loan balance of @$100K.

Some may say why not refinance and pull out more equity?   I say “no way” as the asset (rental) by itself cannot support more debt based on the income it generates. A more sophisticated method used in creative financing is to pledge the remainder equity (in the form of a 2nd loan) as additional collateral for a commercial loan.   I have done this a time or two to help minimize the cash needed to fund another business venture and/or rental property acquisition.  This is the beauty of acquiring (and retaining) assets that are appreciating over time -the ability to leverage them based on income generated to acquire additional assets and/or live the life of ones dreams.

Now if I were to follow the coarse set and make the monthly minimum payment of $677.29/mo this property will be free & clear in 23 years.   What if I added an extra $100/mo till the loan is payed off!  What would happen?   This loan would be paid off in June, 2027.   Not bad -that shaves off 6 years.

Did you see what I did with this 1031? I took $35k from a non income producing vacant lot and deferred the gain on that sale with the purchase of a replacement property: Big Blue.   I improved the property, stabilized it, and refinanced pulling out all the funds (including the money from the vacant lot) and thus walked my funds right down the line into another rental.   Rinse and Repeat.

Talk about Wealth Creation!

P.S. Some may say you can’t do that in todays market.   That’s not true! Sure standard non-conventional 1-4 housing non-owner occupied mortgage money is not easily available.   However, this same stradegy can be used with owner financing, private mortgage money, and even commercial loans.   A tool is missing in todays envirorment; however, the method is not dead. Check out the Front End of a 1031 tax deferred exchange.