Problem Solving 1031 Style

I get excited presenting out of the box ideas to my clients

Recently an investor called saying they wanted to rent out their property in Vienna VA.   This is a property they bought for $225,000 and is now worth $325,000.   They now own it free and clear.

This client has called a few times over the past two years and  inquired about buying another investment property.  Even though they were able to pay off the existing rental,  there is not much cash available now to purchase a new investment and for various reasons (mainly being that they recently purchased a principal residence with me) the numbers never seemed to work for a 2nd rental  So when I heard that their long term tenant had left and they wanted to rent it again, I proposed they sell it instead and here is why.

By using a 1031 exchange, they could finally get that 2nd investment and at the same time defer any capital gains on the sale of the current rental.   They would sacrifice some cash flow in short term but generate more wealth in the long term.  Let’s look at the numbers.

Currently they are getting $1850 a month in rent.  After taxes, insurance and HOA fees, they clear $1500 per month.

Let’s say they they sell the current home and replace it with two homes of equal value.  They put down 50% on each new home and take out a mortgage for the remainder.

Now they have two homes generating $1850 in rent.  Let’s assume the same costs for taxes, insurance and HOA.  Thus, each home will net $1500 before the mortgage payments.  The mortgage payment on each new investment will be about $1000 per month.   So with 2 homes, they will clear $1000 per month vs clearing $1500 per month with 1 home.  ($3000 profit before mortgage expense – $2000 in mortgages = $1000 profit per month. )  This doesn’t make sense – trade $1500 per month profit for $1000?

BUT the missing factor is appreciation.

The current property is being replaced with 2 similar properties so all will appreciate at the same rate.  One can not forecast future appreciation but using 3%  as the yearly average  appears rather conservative based on the average sale price history in our market over since 1975.   ( Click here for the stats)

Using 3% means that by keeping the current property,  in 10 years, they will have a free and clear property worth $425,000. By  trading the current property for 2, they will have properties worth $850,000 and mortgages totaling $280,000 (each will have been paid down to about $140,000)  This would mean the net worth of their real estate investment is $570,000 (850,000-280,000)

Okay but over those 10 years, they lost $500 per month in income which totals $60,000.  Subtract that from the $570,000 and the return from two properties is $510,000 vs the $425,000 they would have by keeping one property.

I know this is a very simple analysis.  There are tax implications and other factors that come into play.  One might say that the extra $500 per month invested properly could close that gap.  Nonetheless, I see owning 2 properties being about $85,000 better than owning 1 and even if you massage my calculations this way or that, the difference will still be significant.

Many deals and situations are rather straightforward but when I can offer buyers and sellers options and suggest ideas that work to their benefit,  I get excited and it makes this business even more rewarding.

P.S.  Their long term tenant above was a section 8 tenant.  Learn more about the pros and cons of renting to  Section 8 folks here.  In this case, it was a positive experience for my clients and they are open to doing it again.

Photo credit:  jscreationzs

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