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How Pros Choose A Fix-And-Flip Property

How To Flip homes For Profit

  • Shoot for 70 percent of the after-repair value (ARV) minus cost of repairs.
  • Look for homes with good bones (i.e., a solid structure)
  • Choose newer homes for faster, less thorough flips
  • Get all proper permits for repairs or additions
  • When starting out, get a mentor to teach you the ropes

If you’re looking to invest in real estate, one way is with a rehab project, also known as a fix and flip. The process entails buying a fixer-upper, remodeling and/or renovating it and then selling it at a profit. With home prices rising across the country, however, flipping homes can be tricky. It’s important to know what you’re doing when taking on a fix-and-flip project. If you make a mistake, your profitable investment could turn into a costly money pit.

How do you separate the winning properties from the losers? Fix-and-flip investors look at a number of factors to help determine whether a property is a good investment.

After-repair value
One of the most important things that investors searching for properties to flip must consider is the property’s after-repair value, or ARV, according to Nancy Wallace-Laabs, of KBN Homes, LLC.

“Typically, if you’re investing, you want to buy a house that’s 70 percent of the ARV minus the cost of the repairs,” she said.

For example, if you determine a house’s value after you make repairs will be $200,000, and you estimate the repair costs to be $20,000, you shouldn’t pay more than 70 percent of $180,000 (the ARV minus cost of repairs), or $126,000 for the property.

Wallace-Laabs said she evaluates each property she comes across and asks herself whether it’s better suited as a rehab project or a buy-and-hold (that is, a rental property). “On flipping, you really need to analyze and know your formula to know how much money are you going to make on that property?” she said.

Lucas Machado, president of house-flipping company House Heroes LLC in Sunny Isles Beach, Florida, near Miami, agrees that the flipping game is all about the numbers.

“What do you think the thing is going to be worth once you’re done fixing it up?” he asked. “What are you paying for it right now? What are you paying to buy it, and how much is it going to cost to get it to being worth that? It’s really about nailing those numbers.”

It’s important to analyze comparable sales in the area to get a good idea how much the property could sell for, he said. You need to make sure you’re comparing “apples to apples,” he added: If a property in the area sold for $300,000, but it had a pool and your property doesn’t, for example, the two properties aren’t comparable and you can’t expect to sell yours for that much money.

“Good bones”

Doug DeShields, president of the National Real Estate Investors Association, and an active rehabber himself, said he typically looks for homes that were built between 1950 and 1975.

“They have good bones, good structure,” he said. “They’re typically brick and we can tend to do well in those houses.”

Part of knowing whether a house has “good bones” or not is having some familiarity with what it takes to make necessary repairs, according to DeShields.

“You do not have to be the world’s best carpenter,” he said. “You don’t have to swing the hammer one time. But what you need to do is have a good feel for the various aspects. You need to know a little bit about construction, whether you can physically do it or not. You need to know what makes a good property.”

Thorough inspections
On the other hand, if you’re looking to do a less extensive flip, you should look beyond a property’s “good bones,” according to Travis Moore, owner of Fargo Home Solutions.

Moore said he sometimes prefers less extensive flips — the carpet-and-paint-fix-ups, as he called them — that require less expensive remodeling. According to Moore, for that style of flip, the age of the house can make a huge difference.

“If I’m doing a project like that, I really like to stick to homes that are built in 2000 and after, because you’re not going to find as many surprises,” he said. “When you get into older homes, you may think it looks OK — it’s got good bones, it’s got good structure — so this is probably a good candidate for just kind of cleaning it up. (But) on older homes, expect to have a few surprises.”

To get it right on older homes, according to Moore, it’s important to do a thorough inspection.

“Before you purchase it, really do a deep dive inspection on it … really beyond just looking at what’s visible,” he said. “Any home that old that I’m considering a lighter renovation, I really dig deep into its condition for everything, (such as) plumbing and electrical.”

Proper permits
When you buy a property, know that not every addition or feature may be permitted — and if that’s the case, it could cost you. Flippers should be cognizant of the permitting requirements for their specific location, according to Wallace-Laabs.

“If you end up doing work on a property and then (are) trying to sell it on the retail market … you have to provide proof that you pulled permits on that work,” she said.

This is not a requirement that investors should try to skirt, because it could end up costing a lot of money, she said. Wallace-Laabs mentioned that she knows an investor who bought a house and didn’t do proper due diligence before finalizing the purchase. It turned out that a previous addition to the property had never been properly permitted.

“So now my investor friends have to tear out all the sheetrock so the city can inspect the plumbing, behind the walls, the electrical, and even (check) that they put in the right size of window to call it a bedroom,” she said. “So instead of them thinking it was going to cost them $30,000 to fix this house, now it’s going to cost them $60,000.”

Get a mentor
Then, there are the big things you should look for when evaluating a fix-and-flip property — avoid foundation issues or termites for example, but there’s only so much a newbie can know. That’s why every fix-and-flip expert we spoke to recommended turning to an experienced mentor for help.

The investment advisers at Position Realty can help you with finding the perfect investment property (we have a list of wholesale properties), help you analysis the property to make sure it’s a profitable investment and help you inspect the property for issue you may over look. Give us a call today!

Position Realty
Office: 480-213-5251

Hard Money Basics: What Everyone Should Know About These Loans

When it comes to real estate lending options, there is no shortage of different types of loan products available in the market today. However, one of the most common, and often most misunderstood, are hard money loans. If you aren’t familiar with these loans they are a unique type of lending opportunity that can help both buyers and investors get the financing they need.

These transactions are most commonly used in fix-and-flips, rent-stabilize-refinancing deals, cash-out refinancing, land scenarios, construction deals, bankruptcy or foreclosure payoffs or transactions when the deal is particularly time-sensitive. In fact, one of the biggest perks of using hard money loans is how quick they are when compared to traditional banks.

So, What Exactly Are Hard Money Loans?
Hard money loans are fast—but there is more than that to these lending options. Simply put, hard money loans are an alternative to a mortgage and are designed for borrowers who need money quickly and who only wish to hold on to a property for a short period of time. Hard money loans can be used in a variety of settings, but are perhaps most common for those taking on fix and flip projects and who want to invest in real estate in an effort to make some quick cash.

Typically, these loans are meant for short-term only (most commonly 12 months), but that doesn’t always have to be the case.

These loans are also becoming a popular option for borrowers who are unable to get a conventional real estate loan. Lenders do not use a traditional underwriting process, and instead look at every situation individually. For borrowers who have had foreclosures or issues in the past, this can be great news as many hard money lenders won’t even look at the borrower’s credit history—they only concentrate on the property that is being invested in.

Hard money loans are financed by private hard money lenders. Typically, they are private individuals or small groups that lend money to those who need it. Since these loans aren’t funded by a bank, they are typically much more flexible.

The Loan-to-Value Ratio
When you apply for a hard money loan, chances are you will hear a great deal about the loan-to-value ratio. Hard money lenders will lend money based on the property you are buying, instead of your credit score and background. Instead of looking at assets or equity alone, the primary thing the lender will look at is the property being purchased. This is the main collateral that the lenders will use. This does make it riskier for lenders so they will typically look for a loan-to-value ratio of around 50-75%.

The term “value” in the loan-to-value amount is actually based on what the lender could expect to get for the property in a one to four month selling time. This is why these loans are so popular for fix and flip properties.

Important Facts About Getting a Hard Money Loan
If you think that a hard money loan may be the right option or you, there are a few things you should know about the application process and what goes into securing one of these loans.

The first is that the applications are simpler. Everyone who has ever gotten a mortgage before knows how complex a mortgage application can be. The good news is, hard money loan applications are much simpler. This also means they can be approved much faster. In fact, many of them are approved in just 24 hours. Closing can typically happen within 10 days.

However, while hard money loans are significantly easier to get than mortgages, lenders are still going to need some basic information. This includes:

– The location of the property
– Recent appraisals
– Inspection data
– Purchase price of the property
– Planned resale price of the property
– Estimated remodeling costs—if applicable
– Borrower’s credit score
– Total assets and income of the borrower
– Level of real estate experience from the borrower

Once you are fully aware of what goes into a hard money loan and how it may be able to help you secure the finances you need—it is time to find a hard money lender. The good news is, there are many hard money lenders out there that are available to provide those who need it with the financing they are looking for.

Hard money loans aren’t for every situation, but they are a very popular and very reliable form of financial backing for those who need to quickly and easily get a large sum of cash.

Position Realty
Office: 480-213-5251

10 Rehab Tips That Increase The Value Of Your Property

You need to keep your investment property repairs to a minimum to stay profitable. You also need to keep your properties in good shape to attract tenants or buyers. There are the basic improvements, such as carpet and paint, but these can still costs thousands of dollars. The following are some inexpensive ways to improve your investment properties with very little cash.

10 Budget Rehab Tips That Boost The Value Of Your Investment Property

1. New Electrical Switch Plates

This is such a minor, yet overlooked improvement. Most rental owners and rehabbers paint a unit and leave the old, ugly switch plates. Even worse, some even paint over them.

New switch plates cost about 50 cents each. You can replace the entire house with new switch plates for about $20. For the foyer, living room and other obvious areas, spring for nice brass plates. They run about $5 each – not much for added class.

2. New or Improved Doors

Another overlooked, yet cheap replacement item is doors. If you have ugly brown doors, replace them with nice white doors (you can paint them, but unless you have a spray gun it will take you three coats by hand).

The basic hollow-core door is about $20. It comes pre-primed and pre-hung. For about $10 more, you can buy stylish six-panel doors. If you are doing a rehab, the extra $10 per door is well worth-it. For rentals, consider at least changing the downstairs doors.

3. New Door Handles

In addition to changing doors, consider changing the handles. An old door handle (especially with crusted paint on it) looks drab. For about $10, you can replace them with new brass finished handles. Replace the guest bathroom and bedroom door handles with the fancy “S” handles (about $20 each).

4. Paint/Replace Trim

If the entire interior of the house does not need a paint job, consider painting the trim. New, modern custom homes typically come with beige or off-white walls and bright-white trim. Use a semi-gloss bright white on all the trim in your houses.

If the floor trim is worn, cracked or just plain ugly, replace it! Home Depot carries a new foam trim that is pre-painted in several finishes and costs less than 50 cents per linear foot. Create a great first impression by adding crown molding in the entry way and living room.

5. Replace Front Door

You only get one chance to make a first impression. A cheap front door makes a house look cheap. An old front door makes a house look old. If you have nice heavy door, paint it a bold color using a high-gloss paint. If your front door is old, consider replacing it with a new, stylish door. For about $125, you can buy a very nice door.

6. Tile Foyer Entry

After the front door, your next first impression is the foyer area. Most rental property foyers are graced with linoleum floors. Many homes in Tampa, FL also have an outdoor porch that would benefit from new tile. Consider a nice 12″ Mexican tile. An 8ft x 8ft area should cost about $100 in materials.

7. New Shower Curtains

It amazes me that many landlords and sellers show properties with either no shower curtain or any ugly old shower curtain in the bathroom. Don’t be cheap – drop $40 and buy a nice new rod and fancy curtain.

8. Paint Kitchen Cabinets

Replacing kitchen cabinets is expensive, but painting them is cheap. If you have old 1970’s style wooden cabinets in a lovely dark brown shade, paint them. Use a semi-gloss white and finish them with colorful plastic knobs. No need to paint the inside of them (unless you own a spray gun), since you are only trying to make an impression.

Americans spend 99% of their time in the kitchen (when they are not watching TV). A fancy modern faucet looks great in the kitchen. They can run as much as $150, but not to worry – most retailers (Home Depot, Lowes, Home Base, etc) often run clearance sales on overstocked and discontinued models. I have found nice Delta and Price Pfister faucets for about $60 on sale. And don’t forget to check eBay!

9. Add Window Shutters

If you have ugly aluminum framed windows, consider adding wooden shutters outside. They come pre-primed at most hardware retailers and are easy to install. Paint them an offset color from the outside of the house – (e.g., if the house is dark, paint the shutters white. If the house is light, paint them green, blue, etc.).

10. Add a Nice Mailbox

Everyone on the block has the same black mailbox. Stand out. Be bold. For about $35 you can buy a nice mailbox. For about $60 more, you can buy a nice wooden post for it.

People notice these things and buyers love them! As a real estate investor in Tampa, FL or anywhere else in the world, staying mindful of these easy and cheap fixes can help your profitability soar.

Position Realty
Office: 480-213-5251

Seven Secrets To Successful Single-Family Rental Real Estate Investing

Real estate investing in general, and single-family real estate investing in particular, is very different from buying stocks, commodities or most other investments. Real estate is a leveraged investment that has the potential for delivering excellent returns because the cash down payment is a fraction of the retail value, yet it is also a hands-on venture where you make more decisions that affect your returns.

On the other hand, stocks and other investments increase or decrease in value solely based on market conditions, and the only decision you make that affects your returns is when to buy or sell. While tax law treats real estate as a passive investment, it is really more of a business venture. Both short and long-term returns on your real estate assets are directly affected by your knowledge and the choices you make.

Consequently, it is critical that you approach single-family real estate investments with a clear understanding of what it takes to be successful. You must evaluate your purchase options and make a selection based on criteria that have proven through the years to increase the odds of success.

Key Considerations As You Plan Your Purchase

When considering your first (or next) single-family real estate investment, keep these seven pointers in mind:

1. Don’t let emotion cloud your decision making.

If most or all of your real estate experience to date has been buying and selling your personal residences, keep in mind that you were purchasing for a different purpose with a different set of criteria in those instances. Buying a home for yourself and your family is an inherently emotional endeavor. You “love” the large kitchen, your spouse is “wild about” the main floor master bedroom, the kids are “so excited” about the pool.

With investment real estate, it’s all about the numbers. If the combination of the purchase price, estimated renovation costs, expected rental income and market conditions support a purchase decision, you can feel comfortable moving forward.

2. Buy based on current returns, not future appreciation.

Will the property have a positive cash flow the day the renters move in? That’s the evaluation criteria you must use. Trusting that area rents and home values will increase over time and that that is where you’ll get your return is a recipe for disappointment, if not disaster. Optimism is an excellent personality trait, but in single-family real estate investment, it can lead to big losses. The best deals make money from day one, and long-term appreciation is a bonus.

3. Budget realistically.

As a property owner and landlord, there are expenses you will incur in order to maintain the value of your asset, so you must plan accordingly. The most obvious of these expenses is the upkeep on the property. However, there are other costs you should budget for. One that is often overlooked is vacancy expense.

In a perfect world, your property would be rented continuously with no gaps. However, the reality is that you may lose a tenant on short notice and have to pay the mortgage for a month or two before a new tenant has moved in. If you have not budgeted for vacancy expense, this interruption in your cash flow can come as an unwelcome surprise and a hit to your financial planning.

4. Know your sub-markets/neighborhoods.

Choosing to make a single-family rental investment in a particular metropolitan area simply because a national article states the market, in general, is positive can backfire if you don’t get the details on the specific sub-market or neighborhood where you intend to buy. While the key financial indicators for a city such as job growth, population growth and others may be on the rise overall, that doesn’t guarantee that the specific community you are interested in is enjoying the same kind of upswing. In fact, one sub-market may be growing because businesses are moving there from the area you have in mind. Be sure you have an in-depth understanding of all the forces at work. The key to success in real estate has always been location, location, location.

5. Learn about local regulations and federal laws.

All forms of investing are governed by regulations. However, with stocks and commodities, understanding those regulations is your broker’s job. In real estate investing, the responsibility for understanding everything from local annual registration and inspection requirements to federal fair housing laws falls to you. The time to learn about these legal issues is before you make your purchase. Failing to understand your obligations until after you’ve missed a deadline or violated an ordinance can be very costly.

6. Build a relationship with a local handyman or contractor.

Every rental property will need repairs and maintenance — if not immediately, then certainly over time. Before you complete your purchase, you should invest some effort in researching and connecting with experts in the area that you can call on as needed. Waiting until a pipe bursts to find a plumber can increase both your stress level and your repair costs.

7. Set aside funds for capital expenses.

As a property owner, you will have a variety of smaller, ongoing operating expenses, everything from fixing dripping faucets to making minor repairs. But items such as rooves, HVAC units and driveways eventually wear out. These things have longer lives and higher price tags and are known as capital expenditures or “capex.” These kinds of expenses can run from thousands to tens of thousands of dollars, so it is important to budget and set money aside on a regular basis to cover them.

Preparation: The Key To Investing With Confidence

Investing in single-family rental properties can be intimidating, especially if you are new to the process. The key to forging ahead confidently as you identify, vet, purchase, update and operate a rental is having done all your homework in advance. The considerations above are a great start.

Source: forbes.com

Position Realty
Office: 480-213-5251

US Housing Flipper Make 50% Gross Returns

Property investors were bullish on the U.S. housing market in 2017, flipping more homes than in any year since 2006, when the real estate bubble that helped upend the global economy was still inflating.

Investors flipped more than 207,000 single-family houses and condos in the U.S. last year, Attom Data Solutions said in a report, which defines flips as sales that occur within 12 months of the last time the property changed hands. More than 138,000 investors flipped a home last year, the most since 2007.

“The long up-cycle that we’re in is giving more and more people confidence to try their hand at home-flipping,” said Daren Blomquist, senior vice president at Attom. Rising home prices are “pulling more people onto the bandwagon.”

Buy, Sell
Investors flipped more than 207,000 homes in the U.S. last year, the most since 2006.


Source: Attom Data Solutions

Today’s home flippers appear to be more conservative than bubble-era investors. The average flip generated gross returns of 50 percent in 2017, compared to 28 percent in 2006. Thirty-five percent of flippers financed their acquisitions last year, the highest share since 2008 but far lower than the 63 percent who used loans in 2006.

Still, red flags show up in local markets. Flippers in Austin, Texas; Santa Barbara, California; and Boulder, Colorado, earned gross returns of less than 25 percent (which don’t include the cost of renovating the homes), suggesting that investors in some markets are depending on slim margins. Flips represented almost 13 percent of home sales in Memphis, Tennessee, in 2017, more than twice the national average, a sign that some flippers are becoming overconfident, Blomquist said.

Source: bloomberg.com

Position Realty
Office: 480-213-5251

How to Avoid the Common Pitfalls of Real Estate Investing

Learning to invest in real estate is just like any other business or career: It takes time to get good at it. Too many people get frustrated very easily and give up, and this is not only the case with real estate.

Study and learn as much as you can about the process, the industry and the areas in which you’re interested in investing. As I’ve watched clients create, as well as lose, rental real estate fortunes, I’ve learned common strategies that have helped more succeed with fewer mistakes. Here are six concepts I encourage you to consider when investing in rental properties:

1. Have a master rental property analysis spreadsheet.
Create an Excel spreadsheet to analyze any and all possible deals. That’s right — you’re not going to buy the first rental property you see this year. Start with the Fair Market Value (FMV), money down, improvements and mortgage/carrying cost — then move it through rental income, expenses and wrap it up with a cash-on-cash ROI figure. Run every property through the gauntlet of your spread­sheet. If, after putting the numbers into all the columns, the ROI isn’t good or it’s not in your favor, move on to the next property. Base your decision on the key factors generated by your spreadsheet. This is why you took fifth-grade math — embrace it.

2. Remember, you are buying “numbers.”
Too many investors get emotional about their purchase and even envision themselves living in the rental property they’re ana­lyzing. This is a terrible mistake. In these situations, the investor often over-improves the property, investing far too much time or capital and blowing their ROI out of the water. Don’t think your rental property needs granite counter­tops; instead, realize you aren’t buying a property, you’re buying numbers. What do your dollars get you in “dollars and cents?” Remember, it’s not about your personal wants and needs; it’s about how much you can make off the property. Pouring a lot more money into the property to get a higher rental rate can backfire.

3. Do your research.
Let me say that again: Do your research, then do it again. I see so many new investorsbuy the first rental they see. Take your time. Also, don’t look at a property as to “Why shouldn’t I get this?” Look at it as to “Why should I get this property?” Make the numbers prove it to you. Don’t assume you’re going to buy it unless you find something wrong with it.

4. Buy local if you can.
The words “if you can” are the key. Don’t get hyperfocused on buying local so you can check on the property. It’s far more important to buy quality rental properties (good bones, reputable location, ease of upkeep, etc.) rather than local. But, if you’re living in an area where there’s a strong rental market with legitimate returns on investment (that aren’t dependent on putting down a fortune), consider yourself lucky.

5. Learn to manage your property manager.
Unless you’re a full-time real estate investor and one tough SOB, get a property manager. If you don’t have the temperament to be tough and start eviction proceedings three days after a tenant is late, have a personal intervention with yourself. You may not be cut out to be a property manager even if the property is local. You may not have the time, skills or system to be your own property manager. Be a realist. Your time could be better spent looking for other rentals, doing the books or running your business. With that said, always — and I mean always — have a budget in your rental property analysis for a property manager (approx­imately 10 percent of gross rents). Even if you have visions of grandeur and start managing, you want the budget to stick in a property manager.

6. Bundle.
I recently met with a client who had five properties in four states. They were great properties, but look at the inefficiency (and headaches) of registering an LLC in four states, doing four state tax returns, having four different prop­erty managers, four different trips to at least occasionally check on your rentals and four different rental markets to understand and follow. Perhaps when you have 25-plus rentals and can afford to make your full-time job managing your rentals and property managers, then you can tackle four or more markets. For now, purchase rental properties in just one or two markets, or “bundle” as it’s called. Using this type of bun­dling, your property managers can handle a few properties at the same time. You’ll also save travel time and expenses. Plus, you can familiarize yourself with a few good locations rath­er than having properties scattered all over the place. You can also be more efficient with your tax and legal planning and save a lot of time and money by bundling.

Position Realty
Office: 480-213-5251

Diversify Your Portfolio And Invest In Real Estate

The Chartered Financial Analyst (CFA) Institute categorizes real estate as an alternative investment that includes residential and commercial properties as well as mortgage-based securities and real estate investment trusts. For most real estate investors, these investments are characterized as income-generating properties that see revenue from rent earned and capital appreciation from the increase in market value. Since this investment vehicle depends on the net operating income (NOI), maximizing cash flow is key to a successful real estate investment.

Property Valuation

To fully understand the importance of cash flow to real estate investment, it is necessary to know that the value of the property is directly linked to the NOI. Unlike residential homes that get their value from comparable sales, income-generating real estate value is calculated as the annual NOI multiplied by an industry standard rate of return, called the capitalization rate. For instance, if the property has an annual NOI of $100,000 and a 10 percent capitalization rate, then the property would be valued at one million dollars. Since NOI is calculated after expenses and both property value and return on investment are depended on NOI, it is important to maximize income and minimize expense.

The Risk/Return Profile

Commercial real estate increases in value based on two components. The first is capital appreciation from the increase in the surrounding market. As a neighborhood becomes nicer and properties sell at higher prices, the value of the commercial asset increases. There is very little that an investor can do to mitigate the risk of market increase or decrease.

The other component to value is the cash flow from income. Revenue is something the property owner has a large amount of control over and which the risk and return balance can be finely tuned. To lower risk, the operating pro forma should have both estimated market rate returns and lowest logical returns.

REOs and Arbitrage Opportunities

Of course, getting a good deal is the foundation of any real estate investment. A low investment amount and high revenue make for a good return on investment. Bank-owned and government-owned homes often offer properties at amounts under market value. These properties are generally in disrepair, so rehabilitation costs should be factored into the price equations.

The website Equator handles bank-owned properties, and HomePath has extensive databases of distressed properties owned by the government. A knowledgeable real estate agent with expertise in this form of alternative investment makes it easier to identify opportunities for high returns. For active investors, a real estate analysis seminar helps maximize their investment.

Important Correlations

As an alternative investment, real estate is historically poorly correlated to the stock market, making it a good investment to diversify a portfolio. During times of stock market loss, real estate continues to offer returns. Real estate is positively correlated to inflation, meaning that it generally increases in value as inflation increases. This makes real estate a good inflation hedge.

Position Realty
Office: 480-213-5251

Tax Free Exchange: A Valuable Alternative To A Home Sale

Congress is currently talking tax reform. Two very important real estate benefits are on the so-called “chopping block”, either to be completely eliminated or significantly curtailed.

It is doubtful that the home owner exclusion of up to $500,000 (or $250,000 if you file a single tax return) of profit will be impacted; there are too many homeowner voters who will forcefully object. But investors do not have the same strong lobbyist who can make the case for preserving the “like kind” exchange. So if you have an investment property, now might be the time to consider doing an exchange.

Residential homeowners have a number of tax benefits, the most important of which is the exclusion of up to $500,000 (or $250,000 if you file a single tax return) profit made on the sale of your principal residence. But real estate investors — large and small — still have to pay capital gains tax when they sell their investments. And since most investors depreciated their properties over a number of years, the capital gains tax can be quite large.

There is a way of deferring payment of this tax, and it is known as a Like-Kind Exchange under Section 1031 of the Internal Revenue Code. In my opinion, these exchange provisions are still an important tool for any real estate investor.

The exchange process is not a “tax free” device, although people refer to it as a “tax-free exchange.” It is also called a “Starker exchange” or a “deferred exchange.” It will not relieve you from the ultimate obligation to pay the capital gains tax. It will, however, allow you to defer paying that tax until you sell your last investment property — or you die.

The rules are complex, but here is a general overview of the process.

Section 1031 permits a delay (non-recognition) of gain only if the following conditions are met:

First, the property transferred (called by the IRS the “relinquished property”) and the exchange property (“replacement property”) must be “property held for productive use in trade, in business or for investment.” Neither property in this exchange can be your principal residence, unless you have abandoned it as your personal house.

Second, there must be an exchange; the IRS wants to ensure that a transaction called an exchange is not really a sale and a subsequent purchase.

Third, the replacement property must be of “like kind.” The courts have given a very broad definition to this concept. As a general rule, all real estate is considered “like kind” with all other real estate. Thus, a condominium unit can be swapped for an office building, a single family home for raw land, or a farm for commercial or industrial property.

Once you meet these tests, it is important that you determine the tax consequences. If you do a like-kind exchange, your profit will be deferred until you sell the replacement property. However, it must be noted that the cost basis of the new property in most cases will be the basis of the old property. Discuss this with your accountant to determine whether the savings by using the like-kind exchange will make up for the lower cost basis on your new property. And discuss also whether you might be better off selling the property, biting the bullet and paying the tax, but not have to be a landlord again.

The traditional, classic exchange (A and B swap properties) rarely works. Not everyone is able to find replacement property before they sell their own property. In a case involving a man named Mr. Starker, the court held that the exchange does not have to be simultaneous.

Congress did not like this open-ended interpretation, and in 1984, two major limitations were imposed on the Starker (non-simultaneous) exchange.

First, the replacement property must be identified before the 45th day after the day on which the original (relinquished) property is transferred.

Second, the replacement property must be purchased no later than 180 days after the taxpayer transfers his original property, or the due date (with any extension) of the taxpayer’s return of the tax imposed for the year in which the transfer is made. These are very important time limitations, which should be noted on your calendar when you first enter into a 1031 exchange.

In 1989, Congress added two additional technical restrictions. First, property in the United States cannot be exchanged for property outside the United States.

Second, if property received in a like-kind exchange between related persons is disposed of within two years after the date of the last transfer, the original exchange will not qualify for non-recognition of gain.

In May of 1991, the Internal Revenue Service adopted final regulations which clarified many of the issues.

This column cannot analyze all of these regulations. The following, however, will highlight some of the major issues:

1. Identification of the replacement property within 45 days. According to the IRS, the taxpayer may identify more than one property as replacement property. However, the maximum number of replacement properties that the taxpayer may identify is either three properties of any fair market value, or any larger number as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all of the relinquished properties.

Furthermore, the replacement property or properties must be unambiguously described in a written document. According to the IRS, real property must be described by a legal description, street address or distinguishable name (e.g., The Camelot Apartment Building).”

2. Who is the neutral party? Conceptually, the relinquished property is sold, and the sales proceeds are held in escrow by a neutral party, until the replacement property is obtained. Generally, an intermediary or escrow agent is involved in the transaction. In order to make absolutely sure the taxpayer does not have control or access to these funds during this interim period, the IRS requires that this agent cannot be the taxpayer or a related party. The holder of the escrow account can be an attorney or a broker engaged primarily to facilitate the exchange.

3. Interest on the exchange proceeds. One of the underlying concepts of a successful 1031 exchange is the absolute requirement that not one penny of the sales proceeds be available to the seller of the relinquished property under any circumstances unless the transactions do not take place.

Generally, the sales proceeds are placed in escrow with a neutral third party. Since these proceeds may not be used for the purchase of the replacement property for up to 180 days, the amount of interest earned can be significant — or at least it used to be until banks starting paying pennies on our savings accounts.

Surprisingly, the Internal Revenue Service permitted the taxpayer to earn interest — referred to as “growth factor” — on these escrowed funds. Any such interest to the taxpayer has to be reported as earned income. Once the replacement property is obtained by the exchanger, the interest can either be used for the purchase of that property, or paid directly to the exchanger.

The rules are quite complex, and you must seek both legal and tax accounting advice before you enter into any like-kind exchange transaction. The professionals at Position Realty can refer you to an intermediary who can help you facility your 1031 exchange.

Position Realty
Office: 480-213-5251

How To Avoid Paying Capital Gains With A 1031 Exchange

This article is meant to be an introduction on the topic of performing tax-deferred exchanges. There are a number of legal hoops that the IRS makes you jump through to complete a tax-deferred exchange, but they are actually not that complicated once you study up on them a bit.

A tax deferred exchange allows us to sell a piece of investment (i.e. rental), trade or business property, buy a new property with the gain or profit from the sale, and not owe taxes on the sale immediately. If you eventually sell the new piece of property, you would owe taxes at that time. Generally, all gains and losses on sales of real estate are taxable, but an exception lies where the property sold is traded or exchanged for “like-kind” property. The new property is seen as a continuation of the original investment, so taxes are not due at the time of the sale.

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Many people view tax deferred exchanges as being for huge corporations, or only for professional investors. I believe that everyone should take advantage of these where they can. Strategy — purchase a rental home below market value, rent it for a year, sell it, and buy two rental properties with your gain. Note that if you do this too many times, the IRS may take the view that you are not a long term investor, and disallow such exchanges. When you get ready to do a tax-deferred exchange, you will need the services of a qualified CPA or Attorney. This is a basic introduction only, and you should always get professional advice from someone who has all the details on your deal, since so much liability is at stake. In my course I list the company that I use for these real estate exchanges. They are a national company and can help you out wherever you are in the country. I have used them for several deferred exchanges, and they have been an excellent resource and extremely competent.

Let’s look at how one of these deals would work. Assume that you own a rental property that has gone up in value. You’d like to sell this property and then reinvest the proceeds into some other rental real estate. You can avoid the tax bill if you can find suitable property to exchange for. The difficulty of the tax deferred exchange is that the property you are going to purchase must be identified within a certain amount of time, and it must be closed within a certain amount of time after it is identified. Unfortunately, no extensions are possible.

Identifying Property

You must identify property in a written document signed by you, and delivered to the party assisting you with the exchange (cannot be related to you!) on or before 45 days from the date you sold the original rental property. There is a growing body of support for identification of properties, and closing of new properties before the original property is sold. This is somewhat controversial and outside the scope of this discussion.

Technical Note: You can identify more than one property as the replacement property. However, the maximum number of replacement properties that you may identify without regard to fair market value is three properties. You may identify any number of properties provided that the total value of these properties is not more than 200% of the value of the original property you are selling. Note that you don’t have to close on all the properties you identify. You can name several if you’re not sure what will close, or not close, but you have to observe the rules in this technical note in terms of the value of properties you identify. If at the end of the identification period you have identified more properties than you are allowed, you are generally treated as if no property was identified. This means that you pay taxes!

Time Limits For Completing the Exchange

If you have correctly complied with the identification phase of the exchange, you have up to 180 days to complete an exchange, but the period may be shorter. Specifically, property will not be treated as like kind property if it is received more than 180 days after the date you transferred the property you are relinquishing, or after the due date of your return (including extensions) for the year in which you made the transfer.

For multiple property transfers, the 45 day identification period and the 180 day exchange period are determined by the earliest date a property is transferred.

Avoid Boot!

Boot is defined as any money or any type of property of unlike kind (example, a car received as part of down-payment). You will be taxed on this boot regardless of whether or not you carry out the exchange correctly. You will want your exchange company, or attorney to examine your transaction closely to make sure you don’t receive anything that could count as boot. Special rules apply for exchanging property with assumed mortgages.

Summary

The tax-deferred exchange is a great way to maximize your wealth. By keeping your investments growing without immediately paying taxes, you can do wonders for your net-worth. You will need to search out a good intermediary. I am happy to provide the name of mine for our members. This may seem like a dry subject, but it is important to understand when you begin to accumulate some rental properties.

Remember that this article is to provide basic information only. If you are planning on doing a tax deferred exchange, you really need to speak with a professional that handles these transactions on a regular basis. Information here is subject to change by IRS regulations or statute, so be sure to use current information provided by your accountant or other professional when planning a strategy involving tax deferred exchanges.

Position Realty
Office: 480-213-5251

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