So, simple definitions before we dive into this blog post.
1031 Exchange: is essentially a code in the IRS rules that allow you to postpone paying taxes on any gains (in our case, from a real estate transaction) if you reinvest those gains into a similar or qualifying like-minded property. There are other rules, like the 45 & 180 day rules regarding a successful 1031 exchange and I even heard of a Reverse 1031 Exchange during this process, but best rely on your 1031 Exchange Intermediary to guide you through these rules and stay on the required timelines.
1031 Exchange Intermediary: person you hire to legally handle your 1031 exchange. By this I mean, you’ll never touch the money from the sell and purchase of the like-minded exchange…and for legal tax reasons you should hire a 1031 Exchange Intermediary.
Now legally we can’t 1031 Exchange into a swimming pool for our primary residence…BUT WE DID! Here’s what I mean.
Setting the scene: We personally just moved (growing family need more space, wanted a better school district) and living in Florida, we certainly wanted a pool in our new home (which the house we moved into did not have). We recently sold the little yellow house, our first Pensacola rental property for $50k cash. For ease of calculations we’ll use that # going forward for calculations but truly it’s $50k minus all the closing costs, 1031 exchange fees, etc (a few grand total). The little yellow house was not on the market and when we were approached by a potential buyer, the cash proceeds after that sale, after capital gains tax, would allow us to pay cash for the gunite pool we wanted to have installed. Paying cash certainly would have been the Dave Ramsey school of thought…no debt! But here’s why we didn’t go that route.
For clarity, if we didn’t utilize a 1031 Exchange, we would have had to pay 15% capital gains tax on the $50k sale price on the little yellow house, the “house we’ll never sell”. This would have equaled $7,500, which would have immediately been taken out of our pockets IF we didn’t use the 1031 Exchange rule, meaning we would have walked away with $42,500 (minus closing costs).
Compare that to the Pool cost of $40,190.
By 1031 exchanging into a like-minded property, we were able to keep that $7,500 and roll the total $50k into our next rental property, which just happens to be an off-market four-plex, fully occupied, turn-key property.
Here are the #s on the four plex (for a complete copy of this report, download here):
The main focus of the #s on the 4-plex is also our main focus when acquiring properties…cash flow. With this conservative analysis our monthly cash flow is anticipated to be $538. Remember this #, $538. It’s also important that the Cash-on-Cash ROI (CoCR) is above 12% as well. My minimum target for CoCR is 12%. I go more into Cash on Cash Return in the post located here.
Now, let’s switch gears and look at the #s on the pool. Since we didn’t pay cash for it, we obviously financed and we did this through a home improvement loan. Our monthly payment for the pool construction is $359 and we’re going to add-in the additional costs of increased electrical expense for the pump/filter (which has been approx. $65/month) and chemical costs (approx. $20/month).
Monthly Pool Costs: $359 + $65 + $20 = $444
Now recall the anticipated cash flow # from our 4-plex, $538.
$538 – $444 = $94/month
So after paying the mortgage, insurance, property management expense, putting money back for repairs/maintenance, putting money back for capital expenses, putting money back anticipating vacancy costs on the 4 plex, AND paying for our pool, we still cash flow $94/month.
We can buy a lot of pool toys at $94/month!!!
Just kidding. We’ll take that extra $94/month, put into our sacred account to be used for a down payment on our next property.
And while the above paragraph is exciting, we’re still earning 14.86% on our money and have the option to keep the cash flowing asset after the pool is paid off. Acquiring the cash flowing asset is a much better use of money versus paying cash for the pool.
The Lickety Split: Get involved in your local real estate investing association (REIA) – it’s where I found this 4-plex deal.