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A global pandemic shaped the real estate market in 2020, causing more foreclosures, evictions, and government relief in order to keep landlords, renters, and homeowners afloat. Now investors are looking to 2021 to see if they should keep expanding their portfolio or wait it out.
Knowing that interest rates are low, but rent collection rates are also much lower than this time last year, many are asking: What’s the best course of action? We reached out to several real estate investors around the country to find out what’s driving their investing strategies for next year.
Investment Strategy for 2021
“To purchase 1 to 2 investment properties — single-family homes with lots large enough to add 2 Accessory Dwelling Units and rent out all 3 units in a residential coastal neighborhood in San Diego,” Olsen said of her investment strategy for the coming year.
“In 2020, the California governor passed multiple bills that make it easier to build an ADU. An investor does not have to live on the property which was a significant shift from previous laws.”
For Olsen, this means that her and her husband are able to invest in more real estate without having to relocate themselves.
Thoughts on the 2021 Real Estate Market
“I feel positive and think that people will continually move to more residential single-family properties,” Olsen said. Because of COVID-19, the U.S. saw renters moving from apartments and properties in cities to more residential homes, equipped with the necessary space to work from home.
“The real estate boom in San Diego specifically was due to families moving out of bigger cities like Los Angeles and San Francisco looking for more space, especially outdoor space. I believe this will continue as companies recognize that employees are capable of working remotely,” Olsen said.
She believes that this trend will continue even after a vaccine is widely distributed, saying that, “even as life progresses and goes back to a “new” normal eventually, I believe the shift to multigenerational housing will stay due to both the California housing crisis and people’s values focused more on family and what is truly important to them.”
Portfolio: Adding To, Holding Steady, or Cashing Out
“We plan to add 1-2 properties to our portfolio. We only have 2 units on one property and have been waiting for the right opportunity,” Olsen explained, mentioning the competitive nature of investing even during a pandemic. Many investors are noticing the opportunities that lie with ADUs, which is showing with the amount of bids placed on a single property. “It’s still a sellers’ market,” she said.
Investment Strategy for 2021
“Our strategy for investing in 2021 is to buy off-market single-family investment properties in markets where we can get a 12% gross rental yield (1% rule) — meaning a $100,000 home rents for $1,000 a month — with a growing population and a median home price below $200,000,” Frank and Katy said. Their strategy? “We purchase them for 70% below market value, fix them up, and lease them as long-term holds.”
Thoughts on the 2021 Real Estate Market
“We’re very confident in single-family housing since that’s what everyone wants with COVID, and with all the government money printing/spending you’re going to see a devaluation of the dollar and a rise in asset prices,” Frank and Katy said of their expectations for next year. “Interest rates are also at rock bottom prices with the Federal Reserve intervention into the markets,” which means investors will have less of a financial strain when purchasing more properties for their portfolios.
Portfolio: Adding To, Holding Steady, or Cashing Out
Frank and Katy also plan to continue adding to their portfolio as they see the investing possibilities created by the COVID-19 pandemic. “We will be adding steadily to pick up as many properties as possible, likely from homeowners who are struggling given the COVID economic situation and expiring unemployment benefits.”
Investment Strategy for 2021
“Assuming the real estate market continues on its current trajectory of low inventory, low-interest rates, and a trend towards suburban migration, we will continue to look for opportunities in newly developing and newly growing suburbs and opportunities in overlooked commercial properties near or in those developing suburbs,” Samuel said of his investment strategy for the upcoming year.
Thoughts on the 2021 Real Estate Market
Like other investors, Samuel noticed the high competition in investing during a pandemic. “It certainly does not feel like a buyer’s market.” Despite the eagerness of property investors, Samuel mentioned that taking on more rentals during a period of time when tenants might not be able to pay their rent could be more of a financial burden than they bargained for.
“The government’s response to COVID-19, including eviction moratoriums, requires additional caution when evaluating buy-and-hold rentals, particularly when buying properties with tenants in place,” Samuel said. “In the new year, we will be approaching the residential real estate market cautiously.”
Portfolio: Adding To, Holding Steady, or Cashing Out
“We are always looking for opportunities to add to the portfolio, and with our buy-and-hold philosophy, we rarely consider cashing out,” Samuel said. That being said, he expects expanding his portfolio to be difficult due to the competitive nature of investing at this moment. “It will become more and more difficult to find opportunities to add to our portfolio.”
Investment Strategy for 2021
“My strategy will continue to involve finding distressed deals in nice high-income and middle-income neighborhoods at a deep discount,” McCorkel said, noting that the pandemic and 2020 will not have a large impact on his overall strategy. “Our primary focus is buy-and-hold for small/medium size multi-unit properties, but we will also take on single-family homes that we can fix up and flip.”
McCorkel also plans to expand the kinds of properties he will be investing in, such as those that are bank-owned, pre-foreclosure, or sheriff sales that are increasingly more available due to the impacts of COVID-19. There are other opportunities that interest McCorkel as well, such as wholesaling single-family homes to investors or developers when the time is right.
“There will be many motivated buyers looking for properties who are willing to pay much higher prices than I’d be willing to risk, which makes wholesaling a viable option to raise extra cash,” McCorkel said.
Thoughts on the 2021 Real Estate Market
“Real estate is hyper-local, and Central Pennsylvania continues to be very undersupplied, like many areas of the country,” McCorkel said. “With a low cost of living and low supply of housing, there are a lot of motivated buyers competing over a limited number of houses. Coupled with federal stimulus and low-interest rates, these market forces will continue to force prices up and keep us in a sellers’ market.”
McCorkel believes this will continue into 2021. “I do believe we will see a wave of foreclosure properties as mortgage forbearance expires, which could be a good source of deals, but I don’t think this will be enough to cause prices to fall.”
Portfolio: Adding To, Holding Steady, or Cashing Out
“I’m always adding to my portfolio, but the deals need to make sense from a cash flow and fundamental standpoint,” McCorkel explained. “I completed a big 1031 exchange in 2020 (sold 3 single-family houses and bought a 2 unit, 3 unit, and 5 unit) and I could possibly do another one in 2021. Bottom line, I’ll be always searching for the right deal and ready to close quickly when it comes along.”
Investment Strategy for 2021
“My strategy for 2021 is going to be extreme caution,” Mandel said. Though some investors are encouraged by the current real estate market, Mandel is still aware of the possibility of a recession come 2021 and the continuation of the global pandemic. “Too many economists have been predicting a recession. Why it hasn’t started yet is anyone’s guess, but I am going to stick with conservative.”
Thoughts on the 2021 Real Estate Market
Mandel will continue to think conservatively about investing in real estate during 2021, citing trends and predictions for the market in his area as a reason to not get too eager. “Though the market in my area (Portland) keeps skyrocketing up, it is going to top out at some point. It will probably correct to some degree, and nobody knows how much. Again, conservative will be the key for me this coming year.”
Portfolio: Adding To, Holding Steady, or Cashing Out
Even when thinking cautiously, Mandel says that he will still invest in a property if the right opportunity arrives. “I will jump into a fixer property if the numbers work and I can turn it around quickly. With lower values looming as stated above, I do not want to get into something I cannot unload,” Mandel said. “While I used to buy and hold, I have in recent years focused solely on flipping.”
Investment Strategy for 2021
Tomaro doesn’t see an increase in renters who can’t pay rent due to COVID-19 as a reason to stop investing — in fact, she thinks it’s an opportunity to expand her portfolio and save the profits. “We were very fortunate with our awesome tenants that we only had a couple move out due to the pandemic,” Tomaro said. “But the uncertainty of how long things will last has made us want to increase our cushion and sock money away in case tenants can’t pay rent, and we can’t evict them due to moratoriums. It also just makes good sense to take advantage of historic low-interest rates.”
Thoughts on the 2021 Real Estate Market
“As a realtor, I feel optimistic about the market for the most part,” Tomaro said. “I worry about the first-time buyers who have decent jobs but debt. I worry that they are going to get squeezed out of the market and not be able to buy due to rising prices.”
Portfolio: Adding To, Holding Steady, or Cashing Out
“We are planning on adding one or two units, but we may cash out on a few to take advantage of the seller’s market and then reposition, meaning sell some of our units that are one-offs in further-out locations and buy units that are closer to ones we have,” Tomaro explained, noting that despite rising property prices there are still opportunities to acquire more real estate. “Long-term, we would like to have our units in a closer cluster, and we have our eye on some areas that surprised us with how well we did with them, so we’d like to grow in those areas. We’ve been at it for about 15 years, so we are really looking to capitalize on what we’ve learned.”
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Under Internal Revenue Service code section 1031, investors who exchange ownership of real property for a like or similar property can preserve wealth by deferring capital gains taxes and depreciation recapture. Since there are four different ways investors can rollover the proceeds from relinquished assets into new properties, it’s important to have an exchange strategy in place prior to selling any existing assets.
The Main 4 Types of 1031 Exchanges
Investors can use one of these four common 1031 exchange methods when relinquishing real property for new assets:
1. Two-Party Simultaneous Exchange
Simultaneous exchanges are the oldest of these four 1031 exchange methods. Two property owners agree to swap deeds and ownership interest of their properties. While this method eliminates the need to find buyers, it’s usually very difficult for exchangers to find fair-market-value properties with matching debt and equity structures. Delays in ownership transfer can also negatively impact the integrity of the swap and expose exchangers to serious liability.
2. Delayed Exchange
Delayed exchanges are the most common form of 1031 exchanges. Exchangers have 45 days to identify a like-kind replacement property and must close on the property within 180 days. These two timelines are usually non-negotiable with the Internal Revenue Service; however, the IRS issued Notice 2020-23, which extended these deadlines in certain instances due to the COVID-19 pandemic.
3. Reverse Exchange
This type of exchange occurs when exchangers acquire a like-kind replacement property prior to fully relinquishing ownership of current assets. Since exchangers cannot simultaneously have ownership of their relinquished property and the target asset, they must have an Exchange Accommodation Titleholder (EAT) temporarily take possession of the relinquished or target property via a special purpose entity such as a single-member LLC. The EAT then takes possession of either the relinquished property or target property under a Qualified Exchange Accommodation Agreement.
4. Construction/Improvement Exchange
Under this method, exchangers can make improvements on a target asset using their equity generated from the exchange. Exchangers can either refurbish or make capital improvements to existing real property, or build new from the ground up. Improvement exchanges can significantly enhance the value of the acquired property.
However, the improved or new replacement property must have the same value as the relinquished property. And the 45- and 180-day deadlines still apply, which can complicate this type of exchange transaction since exchangers have just under six months to complete all capital improvements.
Other 1031 Exchange Strategies
A fifth method, personal property exchanges, used to be more common, but the IRS limited like-kind exchanges to real property with the passing of the Tax Cuts and Jobs Act effective January 1, 2018. Previously, exchangers could include assets such as aircraft, boats, machinery, or equipment in personal property exchanges.
At their core, each one of these exchange methods is executed to defer capital gains taxes while also potentially generating passive income from target assets. Each exchange method has its own intricacies and opportunities, and real estate investors should carefully weigh the pros and cons of each option before initiating the 1031 exchange process.
Realized is the end-to-end partner for investment property wealth management. The company aims to make it easy to transform individual property assets into investment property wealth solutions.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
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Ben Mizes is the co-founder and CEO of national startup Clever Real Estate. He’s used the 1031 exchange to scale up his real estate portfolio from a single unit to 26 units in less than two years.
Before I was the CEO of Clever Real Estate, I was a real estate investor in my hometown of St. Louis, Missouri. I initially built up my portfolio by purchasing and rehabbing small multifamily units, a process that taught me a lot of different skills, from how to install new flooring to how to get an accurate contractor estimate to how to manage tenants. But it wasn’t until I really scaled up my investments that I learned about one of the most powerful tools in the investor’s toolbox: the 1031 exchange.
The IRS defines the 1031 exchange as “when you exchange real property used for business or held as an investment solely for other business or investment property that is the same type or ‘like-kind.’” To put it in simpler terms, the 1031 exchange allows you to “trade” one investment for another more valuable investment, while deferring capital gains.
In a very short time, the 1031 exchange can help you massively scale up your holdings — my portfolio increased exponentially in only 13 months — without having to hand over a huge chunk of your profits to the IRS. Here’s how it worked for me.
Starting My Investment Portfolio
My first investment was a modest multifamily building that I bought using the “house hacking” strategy, meaning that I lived in one of the units, essentially rent-free, while the cash flow from the other tenants paid the mortgage. This property was in good shape, and didn’t require serious rehabbing. It gave me my first taste of being a landlord and, more importantly, my first taste of successfully investing.
Within a month I’d partnered with a friend to look for a more ambitious project: a multifamily unit for a gut rehab. We pretty quickly found a huge fourplex that needed extensive renovations, and we bought it off-market. Looking back, I’m almost surprised that it worked out as well as it did. We were 23, there was a lot we didn’t know, and we had no real idea what we were getting ourselves into.
In a very short time, the 1031 exchange can help you massively scale up your holdings— my portfolio increased exponentially in only 13 months — without having to hand over a huge chunk of your profits to the IRS.
We started off by calling 20 contractors to the property at the same time, to give competing estimates on the rehab (to say they were unhappy about this is an understatement).
From their estimates, we put together a rough budget of what we thought the renovation would cost, though it was really just a guess. Things were awry almost immediately; after one of our first contractors badly damaged the property, we ended up doing most of the renovations ourselves, learning as we went.
It was a baptism by fire, but I learned the business from the ground up. A few months later, I started Clever Real Estate, a referral network that connects home buyers and sellers with agents at a discount rate.
Scaling up With a 1031 Exchange
Now the 1031 exchange enters the picture. After the fourplex was done, my investment partner and I started looking for a more ambitious acquisition. Through a combination of luck and networking, we learned that an 18-unit complex was about to hit the market. It was a great opportunity, and we weren’t the only ones interested; a group of more experienced (and more capitalized) investors was also circling. To add more pressure to the situation, we’d been planning on buying eight units, so we didn’t have quite enough cash on hand to put a down payment on 18 units.
What we did have, luckily, was the power of the 1031 exchange. If we could sell the units we already owned, we’d be able to use a 1031 exchange to flip all that money into the 18 units. Of course, the 1031 exchange comes with a lot of restrictions. You have 45 days to identify up to three like-kind properties that you could potentially acquire, and then you must close on at least one of them within 180 days of selling the initial property. That’s a tight timeline.
Identifying the replacement property wasn’t an issue, since we already had our eye on the 18 units. But could we sell the initial property in that small window of time, before other investors swooped in?
Luckily, we pulled it off. And it really was close — if we hadn’t been able to defer capital gains taxes on that sale, we wouldn’t have had enough money to close on the 18 units. I’ve since learned that investors in similar situations who aren’t able to meet the strict time limits have other options (which I’ll detail below).
When to Use a Reverse 1031 Exchange
A reverse 1031 exchange is a variation on the classic 1031 exchange that gives investors a little wiggle room on the time restrictions. Let’s say you run into some trouble selling your initial property, and you can see that you aren’t going to be able to wrap up the sale within the 180-day limit.
The reverse 1031 allows the third-party intermediary that handles the actual “exchange” logistics to take ownership of the replacement property, and hold the title until the investor is able to sell the initial property. It can also work the other way, with the exchange company purchasing the initial property, and holding it until a third-party buyer can be found.
A reverse 1031 exchange is a variation on the classic 1031 exchange that gives investors a little wiggle room on the time restrictions.
The bottom line? If you’re determined to use a 1031 exchange, you can probably make it work even when the timelines don’t line up perfectly.
The Finer Points of the 1031 Exchange
So is a 1031 exchange right for your situation? It depends. There are a few other restrictions on how they can be used. Primarily, there’s a “like-kind” rule — but this rule probably doesn’t mean what you think it means: You can exchange an apartment building for land, or a ranch, or even a strip mall. The important rules are that the properties are both used for business purposes and are located in the U.S. — surprisingly lenient rules, and quite counter-intuitive.
I should also emphasize that using a 1031 exchange doesn’t eliminate your capital gains taxes; it only defers them. However — and this is where you can see just how powerful the 1031 can be — if you eventually use a 1031 exchange to “trade up” your newly-acquired property, you continue to defer your capital gains taxes. By repeatedly using 1031 exchanges, you can upgrade your portfolio until your tax liability is dwarfed by your net worth, or you can literally continue deferring them until your death.
No one likes the taxman, but the next time you’re tempted to badmouth the IRS, just remember that they’ve given us an incredibly powerful tool to build a real estate empire, tax-free.
Learn more about the different types of 1031 exchanges or join our Avail community forum to see how other landlords have leveraged the 1031 exchange in their investment portfolios.
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Most investment property owners have heard of a 1031 exchange, but many might not know what it is or its significance. That’s understandable, seeing as 1031 exchanges are only relevant when investors are thinking about selling investment property.
If you’re ready to sell an investment property, it’s imperative to understand the ins and outs of a 1031 exchange because using this vehicle can save you a lot of money in taxes.
To help you better understand 1031 exchanges and when you would benefit by using one, we’ve asked Logan Allec, CPA, at Money Done Right. Allec specializes in taxes for real estate investors and works on 1031 exchanges on a near-weekly basis.
What Is a 1031 Exchange?
A 1031 exchange references the Internal Revenue Code 1031. It allows you to sell appreciated investment property and defer the gain on it — meaning you don’t have to pay taxes on any gain that you’ve realized on that property if you reinvest the proceeds into another investment property.
Can You Invest in Anything You Want with a 1031 Exchange?
You have to invest in like-kind property, and the definition of that is pretty broad. For example, if you sell an apartment building, you don’t have to invest only in another apartment building. You can invest in single-family homes, raw land, or even a bowling alley. A big “no-no” is reinvesting the proceeds into a primary residence because that’s not a business use.
Why Would Someone Want to do a 1031 Exchange?
Investors really like a 1031 exchange because they avoid paying taxes. The more taxes investors pay Uncle Sam, the less cash they have to reinvest. Investors want as much ability as they can to keep rolling more proceeds into more and more properties to expand their portfolio, and when there’s a tax drag on that — when a portion of their sale has to go to the government — it impedes their ability to keep expanding their portfolio.
Understanding Common 1031 Exchange Methods: Which 1031 Exchange Method Is Right for You?
Why Wouldn’t You Want to Use a 1031 Exchange?
There are reasons not to do a 1031 exchange. For example, if someone’s in the lowest tax bracket of their life, they might just want to bite the bullet this year and not do a 1031 exchange — rather than down the line when they are presumably going to be in a higher tax bracket. At some point, you will pay taxes when you cash out.
Another reason someone would not want to do a 1031 exchange is if they have a loss, since there will be no capital gains to pay taxes on. Or if someone is in the 10% or 12% ordinary income tax bracket, they would not need to do a 1031 exchange because, in that case, they will be taxed at 0% on capital gains.
Finally, an investor might have another investment opportunity that’s not real estate-related. In that case, that person might prefer to pay the taxes so they can invest in that other opportunity.
Is the Capital Gain Taxed at 15%, or Is There More To It Than That?
The capital gains tax rate depends on your ordinary income tax bracket. Capital gains are taxed at 0%, 15%, or 20%. The majority of mom-and-pop real estate investors, however, will pay 15%. For example, in 2019, if you’re married and filing jointly, and you make between $78,751 and $488,850 a year, you pay a capital gains rate of 15%. Married couples who make $488,851 or more a year are taxed at 20%, and married couples who make $78,750 or less pay 0% on capital gains.
Are There Other 1031 Tax Issues to Know About?
Yes, there is recapture of depreciation to be considered. One of the great things about investing in rental property is that you get to take a deduction for depreciation, which is a non-cash deduction used against your taxable income. On the flip side, when you sell that rental property, you have to pay depreciation recapture tax at a 25% rate. But that tax, along with capital gains, can be deferred with a 1031 exchange.
Learn how one investor used the 1031 exchange to scale up his portfolio.
What Are the Most Important 1031 Exchange Rules for People to Keep in Mind?
- You can’t sell an investment property, buy another, and then initiate the 1031 exchange. You have to initiate a 1031 exchange before the property sells.
- You can’t do a 1031 exchange on your own. So if you’re thinking of doing one, the first thing to do is to find a qualified intermediary, a company that facilitates 1031 exchanges. This is not something you can DIY.
- There’s the identification period rule. Within 45 days after you sell your property (called the relinquished property) you must identify potential replacement properties.
- You have to purchase and close on the replacement property within 180 days after you sell your relinquished property.
- The property that you exchange into must be of equal or greater value than your relinquished property. If your replacement property is of less value, and you’re getting cash from the deal — called a “cash boot” — you must pay taxes on that cash.
- You can sell your investment property and invest in more than one property. You can buy three different properties, for example, if you want to. There’s no limit. If you identify more than three, there are some extra rules, which your qualified intermediary will go over with you.
- Fees vary on 1031 exchanges depending on the state, but for a standard 1031 exchange expect to pay between $800 and $1,200.
Find a New Property for Your 1031 Exchange
If you’ve decided the 1031 exchange is right for you and you’re on the hunt for a new investment property, browse properties on Realtor.com to get an idea of what’s in your range to qualify for a 1031.
As you build up your investment portfolio, Avail can help you set a competitive rent price, find great tenants, and keep track of your rental property income. Learn more about managing your properties with Avail.
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Once you’ve purchased one rental property, you may feel ready to invest in additional properties. While some of the same steps apply — such as organizing your financing, assembling your team with a reliable lender and a knowledgeable real estate agent, and locating a property — a few differences stand out when you start to accumulate multiple rental properties.
In this article, we’ll look at what you need to know about purchasing multiple rental properties and managing your property portfolio.
Should I Set Up a Limited Liability Company (LLC)?
As you’ve learned by now, owning a rental property (or several rental properties) is a type of business. You’re managing your assets and evaluating your profit and loss for each property. It may be time to consider establishing a Limited Liability Company (LLC) for your investment property.
Before you take that step, it’s smart to consult a financial advisor and a lawyer who can provide advice on current regulations and procedures in your state. You’ll also want to evaluate the tax and other financial implications of setting up an LLC.
3 Reasons to Consider Creating an LLC
- To protect your personal assets from litigation: If your rental properties are held in an LLC, those business assets are separate from your personal assets. If someone sues you, your company is named in the lawsuit rather than you, so your personal residence and other assets are protected.
- To separate your personal and business assets and expenses: Separating your personal and business assets and expenses can make taxes easier to manage and can make it simpler for you to track your investment property income.
- For possible tax advantages: In some cases, an LLC can reduce your tax liability.
3 Disadvantages to Creating an LLC
- A possible additional loan: Before you transfer your property to an LLC, talk to your mortgage broker about the implications for your loan. It’s possible that a new loan agreement with different terms could be required.
- A potential transfer tax: In addition to the cost of establishing an LLC, depending on where the property is located, you could have to pay a transfer tax.
- The cost: The cost to set up an LLC varies by state from about $100 to $500.
Financing Options to Buy Your Fifth To Tenth Rental Property
When you’re ready to buy a second, third, and fourth property, your financing options are the same as they are for your first property. You’ll need to meet the debt-to-income ratio, down payment, and credit score requirements for a mortgage for each new rental property.
However, the qualifications required for financing your fifth-through-tenth property vary slightly and are more strict.
Fannie Mae Guidelines for Fifth-Through-Tenth Investment Properties
Once you own several rental properties, Fannie Mae sets a higher bar to qualify for a new investment property loan. You’ll need:
- Minimum credit score of 720
- Minimum down payment of 25% for a single-unit property
- Minimum down payment of 30% for a 2-to-4-unit property
- Six months of cash reserves for the total mortgage payment (principal, taxes, and insurance) for each financed property you own
For example, if the total mortgage payment for your primary residence, four investment properties, and a new rental property is $2,000 each for a total of $12,000 per month, you would need cash reserves of $72,000 after you have made the down payment on your new property.
Freddie Mac Guidelines For Your Fifth and Sixth Investment Properties
If you don’t have enough cash for the down payment and reserve requirements, Freddie Mac offers a similar program with slightly easier qualification guidelines. However, this loan program is only available for up to six homes. If you’re financing a seventh, eighth, ninth, or tenth property, you’ll need to use the Fannie Mae loan program. For the Freddie Mac program, you’ll need:
- Minimum credit score of 720
- Minimum down payment of 15% for a single-unit property
- Minimum down payment of 25% for a 2-to-4-unit property
- Two months of reserves for the total mortgage payment (principal, insurance, taxes, and insurance) for any 2-to-4-unit properties you own that are being financed
This could significantly reduce the cash you need to have in reserve because you can exclude the amount of the mortgage payment on your personal residence (unless you live in a 2-to-4-unit property) and the mortgage payments on any single-unit investment properties you own. In addition, the down payment requirements are lower for this loan program.
Leveraging a Cash-Out Refinance to Purchase Another Property
Once you’ve experienced success with a rental property, you may want to grow your real estate investment business with additional residences. The biggest obstacle for most landlords to buy additional property is the funds needed to meet down payment requirements. This is particularly true for investors who already own their primary residence as well as four rental properties because, as noted above, they need to meet an even higher threshold for the down payment and also need cash reserves.
As explained earlier, you may be able to use the equity in your primary residence in a cash-out refinance to access funds for an investment home purchase. You can do a cash-out refinance on a rental property to use the equity to buy another investment property, but the guidelines are a bit different.
Some landlords prefer to keep their equity intact because it means their loan balance is low and their cash flow is high. Landlords who aren’t attempting to acquire additional properties are more likely to focus on paying off the loan balance in full to achieve even greater cash flow. Other landlords see untapped equity as a means to purchase more property and grow their rental business.
Cash-out refinancing requirements are a little more strict for rental properties compared to cash-out refinancing for your primary residence. For a single-unit rental property, you can mortgage up to 75% of a home’s value, compared to 80% for a primary residence cash-out refinance. For a 2-to-4-unit property, you can only borrow up to 70% of the property value.
For example, if you bought a single-unit rental property four years ago for $175,000 with 20% down, your starting loan amount was $150,000. After four years of making your mortgage payments, your current loan balance is $130,000. Over the four years, the property value has appreciated to $200,000. Seventy-five percent of $200,000 would make the highest possible loan amount $150,000.
This scenario would allow you to keep about $20,000 in cash that you could use toward a down payment on a new home, pay off other high-interest debt, or use for renovations that will increase your property value and rent price.
Options to Finance More Than 10 Properties
If you already own 10 rental properties and plan to purchase more, you’ll need to look beyond conventional financing methods for a mortgage. Two options to consider are portfolio loans and blanket loans.
Portfolio Loans
Portfolio loans are typically offered by small financial institutions such as private banks and credit unions who will keep the loans on their books and service them in-house. Most mortgages are sold to investors, which means that lenders need to match their investors’ appetite for risk and their loan requirements. Since portfolio loans are not sold to investors after the loan closes, these smaller financial institutions can essentially make their own rules for approving the loans on a case-by-case basis.
While the terms of portfolio loans vary, typically these loans for investors have adjustable rates and higher interest rates than a conventional loan. The terms are not as favorable to borrowers because these loans are considered riskier and because portfolio lenders often approve loans that don’t fit traditional loan qualification standards. Check with a local private bank or credit union to see how many properties they will allow you to finance with a portfolio loan.
Blanket Loans
A blanket loan is one mortgage that covers the financing for multiple properties. While blanket loans are commonly used for businesses such as construction companies, they can also be used by a rental property investor who owns 10 or more financed properties.
The main advantage of a blanket loan is that you can buy multiple properties at one time and pay only one set of closing costs, rather than paying separate closing costs for each property. However, blanket loans are similar to portfolio loans and are considered riskier since they and tend to have higher interest rates and less favorable terms than a standard mortgage.
When Is It Time to Sell a Rental Property?
As with any other investment, it’s important to review your property portfolio regularly to evaluate whether you should buy additional rental properties, hold on to the ones you have, or sell one or more properties. While determining when it’s time to sell depends on numerous factors and every situation is different, some of the situations that could trigger an evaluation of the potential sale of your rental property include:
- You’re no longer cash-flow positive on a monthly basis. This could happen because of an increase in your property taxes, ongoing maintenance issues, or a declining rental market. If you’re stuck with negative cash flow, the sooner you sell the property, the sooner you stop losing money. You can use the proceeds from the sale to buy a more lucrative rental property someplace else or for other purposes.
- You need cash now or know you will need cash in the near future.
- You’re tired of being a landlord. In this case, you may want to evaluate the option of hiring someone to help you manage your rental properties rather than selling one or more homes.
For more guidance on deciding when to sell a rental property, check out an article by Avail CEO Ryan Coon, When Is It the Right Time to Sell Your Rental Property?
What Is a 1031 Exchange and Should I Use it?
If you decide that you want to sell one rental property and purchase another, you may want to contact an accountant or tax advisor to discuss the option of a 1031 exchange, also known as a “like-kind” exchange. The 1031 exchange is a section of the IRS tax code that allows investors to avoid paying capital gains tax or to limit the amount of capital gains tax they must pay when selling a property, as long as the proceeds of the sale are used to purchase another rental property.
The like-kind exchange is only available for investment properties and not for second homes or primary residences. The capital gains tax exclusion for profits on the sale of a home of up to $250,000 per person, or $500,000 for a married couple filing jointly, is only available on your primary residence and not investment properties.
Depending on your tax bracket, you could owe the IRS 15% to 20% in capital gains taxes on any profit made from the sale price of the home over the original purchase price. In some cases, this can be a hefty amount, so using a 1031 exchange is a popular method of minimizing this tax burden. For example, if you sell the property for a $50,000 profit and are taxed at 20%, you would owe the IRS $10,000, unless you use the 1031 exchange.
While professional assistance from your accountant or tax advisor is essential with a 1031 exchange to make sure you meet all the requirements, the basics of the tax program include:
- When you sell your rental property, any profits are held separately, typically by a title company. This means you do not have access to the funds until they are used toward another home purchase.
- You must identify potential properties you hope to acquire within 45 days of the settlement date when you sell your rental property.
- You must close on one of the designated properties within 180 days from the sale of your rental property in order to receive the capital gains tax benefit.
Learn more about when to open a 1031 exchange (and when not to) and understand the different types of 1031 exchanges so you can determine which method is right for you.
Cost-Effectively Manage Your Rental Properties
As you build up an investment portfolio of rental properties, it’s important to have a strategy for effectively and efficiently managing them — ideally one that helps you retain the majority of the profits. Some investors choose to work with a property manager, and others choose to manage the properties themselves.
If you decide you want to maximize your ROI and manage the properties yourself, Avail makes independent property management simple. From helping you set a competitive rent price and find great tenants to collecting rent online and managing your rental expenses, Avail has free tools for every step of the rental process.
Learn more about managing your properties with Avail.
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