This was written for a 1031 exchange intermediary company. It goes back about 4 years or so. What’s interesting is how we had another black swan event (COVID) that changed predictions wildly. Keep that in mind as you read on…
Is It Time to Cash In?
Real estate investors try to look ahead. As we near the end of 2018, many are asking, “Is it time to cash in?” Several markets saw a healthy increase in prices over the last several years. If you were fortunate to buy property in the few years after the Great Recession, you may have a lot of equity that could be used to move up to the next level.
According to CoreLogic, single-family properties across the U.S. with a mortgage had an increase in equity from 2017 to 2018 of one trillion dollars. That is nearly 25% of the total increase of equity for these properties in the 5 years between 2013 and 2018. That’s a lot of cash available for small investors thinking of expanding their investment portfolios.
Prices in some markets are starting to soften. And, interest rates are still quite low. Though some have lamented the rise in interest rates, they are still historically low. You may be able to cash out, for example, a single-family rental in California and buy a duplex or fourplex in a market with declining prices.
The Top 5 Markets*
The markets with the biggest increases in residential property values include Nevada, Idaho, Washington, Utah, and – not surprisingly – California. Some are predicting that prices will continue to rise in 2019. Others predict a housing market crash.
Las Vegas is presently the hottest major city in America. Housing prices rose nearly 14% between mid-2017 and mid-2018. Nevada prices are supposed to rise another 9% into 2019.
Utah is another highly desirable place to live. However, prices in some areas, including Salt Lake City, are considered overvalued.
Top 5 Over-Valued Markets*
San Jose, CA, Seattle, WA, Oakland, CA, Portland, OR, and – third on the list – Las Vegas, NV. You may be thinking, “Say, what? You just told me that Las Vegas home prices are expected to go up in 2019!” Indeed, I did. Rather, CoreLogic did. Zillow thinks so, too. They are predicting an 8% increase in 2019.
CoreLogic defines an over-valued market as, “…one in which home prices are at least 10 percent higher than the long-term, sustainable level…” It doesn’t mean that prices won’t continue to go up. At least for the time being.
This is reminiscent of the Southern California market between 2000 and 2006. Yes, prices were still going up between mid-2005 and mid-2006. But, if you bought in 2006, you were buying at the height of the market. In fact, one investor bought a property at what she thought was a good deal in June of 2006. She saw prices starting to soften and decided to snap up a 2-story condo in a highly desirable neighborhood in Chula Vista, CA. After the housing bubble burst, it was valued at $150K less. Didn’t matter; she was not likely to find a buyer anyway. It would take 12 years for the property to get back to its pre-crash price. But, if your property is making money, its value doesn’t matter. You can ride out any storm.
*Stats and predictions from CoreLogic.
All Real Estate Is Local
You may have heard the saying, “All real estate is local.” Google “housing market predictions for 2019” and the results are articles that give national statistics. The median price of homes has increased across the US. New construction is expected to go up, too. Interesting, but not really helpful to the individual investor. National trends can give you an overall sense of what’s happening in real estate. But, what’s happening in Boise, Idaho may be different from what’s happening in San Diego, California.
Hurricane Harvey hit Houston and surrounding areas hard. The homes that were flooded gave investors who “flip” homes a great opportunity. (In case you don’t watch HGTV, investors buy homes that most others don’t want because they need a lot of repairs. They buy them cash, fix them up, and sell them, hopefully, at a profit.)
It was also positive for sellers. Inventory shrank and displaced buyers needed homes. Prices went up in some areas and so did rents. Home prices were cooling before Harvey. Which shows you that predictions are helpful, but a big event can change everything.
It’s All in The Timing
Fact is, it’s nearly impossible to perfectly time a sell and a buy. A more helpful way to make a plan is to determine if it’s the right time in your situation. What’s happening in the neighborhood where you own your properties? What would be your reasons to sell? It’s not just about getting the most cash.
One investor sold a single-family home in a hot area of Southern California in the first half of 2017. If she had waited a year, she could have gotten at least $50K more. In her situation, she needed to buy a personal home. The cash she did walk away with was enough to build a brand-new home and buy a rental in the Houston area. Mortgage free.
Another investor sold a 10-unit building in California a few years ago. It has sold two more times since then; most recently for double what he sold it for. Sounds like bad timing, right? Except he turned 10 units into 31 units by doing a 1031 exchange into the Houston market. Recently, he was offered double what he paid for his 18-unit residential income property. For him, it’s not the right time to sell. Another investor in his situation might decide to cash in and upsize to a 40-60 unit building.
Do Your Research
Whether you plan to buy and sell in the same market or are considering investing in a new area, research is critical. For example, you may want to buy a small multi-unit in Houston, but there are not many available at this time. (Which is why the investor with the 18-unit is approached by realtors regularly.) Other areas may have more multi-unit properties available, but high vacancy rates. A good real estate agent in each market is critical. They can provide you with the current and historical data you need to make good decisions.
You want to make sure that you compare prices within a market, not between markets. When you live in California, the homes in Texas look mighty cheap. But, the worst thing you can do is overpay for real estate. A house you can buy for $200K is a bargain to a Californian (“I’ll take two!”) But, the market value for that house might be $180K.
The rental market is another critical area to analyze. The financials you receive from a seller will sometimes have “pro-forma” rents. This is where the seller provides “rosy” numbers based on where they believe rents will go in the future. Be careful; the cap rate they claim is sometimes based on pro-forma rents. It’s certainly nice if rents go up in the future, but you need to know if the investment makes money now.
When you’re moving from one market to another, who you rent to may change. Are you moving from the city to the suburbs? How does this change the demographics? Real estate websites, such as Trulia, provide demographic data. One investor bought a multi-unit residential property in an area where Spanish is the primary language for most of his tenants. He does not speak Spanish. Fortunately, the manager onsite does speak Spanish. It doesn’t mean that you can’t invest in an area where you don’t speak the prominent language, but you need to not be surprised by that fact.
You also need to be real about who you are and what you can handle. The financials may be compelling, but the property may not the right investment for you. Perhaps you can afford a 24-unit building, but are you prepared to manage it? If you currently invest in a few single-family homes, expanding to that many units may be more than you can handle. (And if that sounds crazy, remember our investor who turned 10 units in California into 31 units in Houston.)
Deferring Taxes
If the property you want to sell was your primary residence in two of the last 5 years, you may not have any taxes to pay on the gain. An unmarried seller will get a $250K deduction; a married couple a $500K deduction. So, if you net $200K on the sale, you likely won’t pay any taxes. Obviously, you’ll want to consult with your accountant before you sell.
If you do not qualify for a deduction against the net profit, then you should consider a 1031 exchange to defer taxes.
1031 Exchanges
A 1031 exchange is an IRS-defined event. Reading the IRS’s explanation of a 1031 will give most people a headache. They make it sound much more complicated than it actually is. In essence, you are going to sell your property and buy a “like” property. As long as you spend as much or more on the new property, you will not pay taxes on the net gain from the sale.
There are rules that must be followed. However, working with an experienced and reputable “intermediary” will make the process far less confusing. In fact, you must use an intermediary because you cannot touch any of the money from the sale. When you close on your property, the proceeds from the sale go to the intermediary – not to you.
The Rules
A “like” property does not mean that if you sell a single-family residential income property that you must buy another single-family property. Selling pretty much any kind of real estate allows you to buy any kind of real property.
For example, you could sell a duplex and buy a small strip mall. Or, sell an office condo and buy two single-family properties.
You have 45 days to identify up to three replacement properties and 180 days to buy one or more of them. They should be of equal or greater in value. (You can buy a property of a lower value, but you’ll pay taxes on the difference.) The 180 days begins when you close on the sale of the property you are exchanging.
Depreciation will be capped at the amount of the original property. Our investor with the 18-unit building was surprised to learn this. The investor who sold the Southern California condo has no idea because her accountant handles those details. But, it’s something you should discuss with your accountant.
Conclusion
Prices in many markets have gone up. They are expected to continue to rise in some markets. Whether it’s time to cash in depends on your personal situation. Analyze your current investment portfolio. Determine whether it makes sense to buy an investment in your home town or another state. Or to just stay put. National trends and predictions are helpful, but may not apply to your situation.
Consult with your accountant and a good realtor to get the information you need to make a good decision. If a 1031 exchange is right for you, be sure to find a reputable intermediary to make sure you follow the IRS rules and complete the transaction in 180 days.
Remember, cashing in is not always about getting cash. There are many reasons to sell and buy investment properties. Worry less about trends and more about what is best for you.
Helpful calculators
https://www.1031x.com/Capital-Gains — a calculator to estimate savings if you defer your capital gains tax with a 1031 exchange. https://www.1031x.com/45-reminder a 45 day calculator. https://www.1031x.com/Tax-Reform-2018-Calculator a tax reform calculator.
Sources:
https://www.foxbusiness.com/personal-finance/home-prices-rising-fastest-in-these-states
https://gordcollins.com/housing/us-housing-market-update/