Tag: real estate investing

1031 Exchange Rental Property into Land?

Reading Time: 4 minutes

Real estate prices are booming right now. Supply is tight and competition for investment properties tend to also overlap with first time home buyers. To me, the math doesn’t add up as much as it used to, even with low rates to finance the properties.

The funny thing about super low interest rates is at a certain point, you start to not discriminate between a low rate and a no rate. I know it sounds crazy, but for example, a treasury bond with a 0.5% yield starts to be pretty close to just a zero coupon bond.


It’s happened to me psychologically – I can tell.

I’ve looked at some rental properties recently, I have a long time horizon, and so I think “well, as long as the income covers my mortgage at the minimum, that’s all I need – I’ll generate a levered return to real estate prices.”

This is dangerous because unexpected capital expenditures, occupancies, etc. can knock off your cash flow assumptions.

I own several rental properties today. While I can sell them and generate profits, I’ll either be taxed (and greatly reduce those profits) or I’ll 1031 like-kind exchange into rental properties that are also expensive. Not really a “win.” It’s one expensive home for another expensive home.

So back to low rate vs. no rate: if I’m comparing rental property where competition is very high due to tight supply… I started to think to myself:

Why not just buy land where I think housing developments are moving?

“Skate to where the puck is going.”

Can you 1031 rental property for land?

Yes!

Actually the rules are pretty broad. You can exchange commercial for residential. Single-family residential for apartments. Farmland for other real estate. What matters is each is real estate used for investment purposes on either side.

How does is work?

I decided to walk through a hypothetical situation where you bought $650k of rental properties 10 years ago, which are now worth $1.06MM. As shown below, if you sell you’ll either take $387k after taxes or $580k that you can reinvest in real estate.


Is a 1031 Worth It?

Clearly, it seems like if you can sensibly reinvest in real estate, it might be worth it to avoid the taxes and continue to compound capital. Alternatively, if you’re comfortable with your cash flow covering your debt, you could do a cash out refi which I previously discussed.  Or, you just keep the property.

But I’m exploring hypotheticals here.

Look at the tables again and you can see one labeled “acres purchased.” I did a quick check for land for sale on outskirts of areas I currently invest in, but places where I am reasonably confident growth is moving and the land would be reasonable to develop.

You may know of cheaper land and I definitely saw some expensive land and as of right now, that was a reasonable median. So I could buy nearly 80 acres for around $12,500 an acre and use all that cash.

A note on these assumptions: I’m not being scientific. I think some of this hypothetical lot could trade for 25k an acre in 10 years, or double the price. That’s mainly because (i) some of the lots that are currently butting up against the “next” housing area are selling for that, so in 10 years if you picked the right spot, I’m OK with that assumption (ii) home price appreciation will make it easier for a developer to capture that price, and (iii) we have a shortage right now. I think it will take a reasonable amount of time to rectify that shortage (although affordability may hit demand as well).

Mortgage Boot Kills the Fun

In a 1031 like-kind exchange, there’s the concept of “mortgage boot” which basically means you need to reinvest the cash flow from the gain + take an equal sized mortgage. Or cough up more equity of equal size to the mortgage. You may have noticed in the table I included a mortgage. Ideally, you could just take the gain with no mortgage for the next property and no additional cash, but that’s not the way it works.

The IRRs without mortgage boot are shown below. Not too bad – all you owe are the taxes along the way!

IRR with mortgage boot shows the drag on cash flow may be too much for people. This also doesn’t include the principal payment on the mortgage (I assumed a 10-year mortgage, which would be $52.5k in total payments – not fun).

I like my cash flows to go the other way…

Timber Upside

There is one other upside, and I’ve heard a few stories of this, is you buy the land and are able to sell the timber immediately which basically covers your cost. This is treated like a farmland, so there are some specific taxes you have to work through, but that would be an ideal scenario.

Then you own the land and have most of your basis out. Unfortunately right now, with lumber prices through the roof, you probably won’t recognize that value or the person selling the land would have already cleared it for themselves.


Bottom Line: I don’t think switching from a low-cash flow property to negative cash flow property makes much sense.

3 Reasons to Do a Cash Out Refinance of an Investment Property

Reading Time: 4 minutes

One benefit of real estate investing is being able to take your initial capital out of the deal and still own the property. My wife and I just did this through a cash out refinance on investment property we’ve owned. It is fairly straightforward, but let me try to explain the mechanics and benefits we saw.

Simple Explanation

The simplest example would go like this: Let’s say you bought a $100k property and put 20% down, so you have $20k of equity and $80k of debt. you bought extremely well and it turns out your property just so happened to be the next hot area. You appraise the house and its new market value is $175k. Because total assets = liabilities + equity, if your mortgage was still $80k (in real life, it would probably be paid down some), your implied equity would now be $95k!

You could sell the property and take the proceeds or you could do a cash out refinance of your investment property.

How much could you take out?

Since this is an investment property, a lender will typically only lend up to 75% LTV against the property for it to qualify for Fannie / Freddie backing (which gives you access to low interest rate, 30 year loans).

The way the lender looks at it is, if you were to buy the property today we’d feel comfortable giving a 75% LTV loan, so we shouldn’t care where the money is going per se. You could still sell the property and take the money so in this case, they are agnostic.

The mechanics are pretty simple. A new mortgage is done on the new property value, they pay off the original mortgage and cut you a check for the difference. In this scenario, you could take out $51,250! That’s 2.6x your initial investment and you still own the property!

Now, obviously you may decide that taking all the equity out is better for you, but for us, we didn’t want to sell the property and wanted some liquidity so it added up for us.

Cash out refinance example

To be clear, this is real estate we are talking about here, so don’t expect to be able to take out your equity immediately. We did ours after owning the property for 10 years. We could’ve done it earlier, but the timing lined up and rates moving lower made it an attractive time. There are closing costs that can be a few thousand dollars, so you want to make it worth it.


So some of the benefits of a cash-out refinance are obvious, but let me lay out my favorite: 

  • Able to Take out Initial Equity with Limited Tax Consequences

As shown in the example, we were able to take out our initial equity, which we can now use for other investments. But the even better part is that the cash doesn’t count as taxable income or a gain on sale, because we are technically taking out a loan.

That is a sweet benefit. You will also be able to claim the interest as a expense on your tax statements going forward to reduce taxable income. I view it as a win-win-win.

  • Can Redeploy in Another Investments, including Real Estate

Many people use cash out refinance proceeds to invest in other real estate properties, but my wife & I decided that we should (i) put some money back into the investment property (ii) use some of the proceeds for some projects around our personal home and (iii) fund tuition savings account.

I personally like the idea of building a real estate empire on cash out refinances. Personally, our proceeds that we received could easily go to buy two new properties. In about 8 years, we probably could take our equity out of all three again and go buy two more properties. You can do a cash out refinance many times, as long as you have enough equity built where it makes sense to cover closing costs. Its a “Get Rich Slowly” scheme.

At the end of the day, you could use it for whatever you’d like!

  • More attractive rates than a Home Equity Line of Credit (HELOC)

I often see people debating a HELOC vs. a cash out refinance. We went with a cash out refinance because we had built up significant equity and even though we were refinancing a primary residence loan with an investment property loan, since interest rates have gone down our total monthly payment didn’t move much.

The interest rate on a cash out refinance can typically run 50-100bps wider than what the primary residence market is (we got ours at 4.25% when market rates for primary residences were around 3.60%) and will obviously depend on credit score.

HELOC’s are akin to getting a second mortgage on a home, because you are tapping the equity behind the existing mortgage. Therefore, if first lien mortgages are already higher than primary, you should expect second lien mortgages to have an additional risk premium built in (i.e. come at a higher rate).

In our situation, a HELOC was going to be high-4%-5% range and has faster payback terms (5-25 years). We preferred to lock in a new 30 year mortgage at an attractive rate. HELOC interest also isn’t tax deductible anymore.

HELOCs do have lower closing costs, though, given in a cash out refinance a lender will want the typical closing items: appraise the property (fee), you’ll need a real estate attorney in many cases (another fee), a title search for the lender (fee) and other closing costs.