Monetize California Equity Without Taxes
Conatus Real Estate had the opportunity to present a deal profile on how to “Monetize California Equity Without Taxes” at the Orange County Real Estate Investors Association (OCREIA) meeting last month. We received positive feedback on the content so we wanted to share with our network.
Few key Takeaways:
- Many people that own California investment real estate have a lot of equity, but low cash flow. Further, it could trigger significant tax bills upon sale.
- A 1031 Exchange can help to achieve a multiple on current income and defer all capital gains taxes
- Over 370,000 properties in Los Angeles and Orange Counties alone that could benefit from a 1031. Do you own one?
Good morning, good afternoon, good evening, whatever time of the day it is for you. All of us over here at Conatus Real Estate are ecstatic to have you for one more episode of the Conatus Tricks of the Trade. Now, last month I was invited to give a deal profile presentation for the Orange County Real Estate Investment Association. This is a great group run by Karen Hall. Karen, thanks for the invite. So happy to present, come and present and share some of the experiences that we have every day over here Conatus. Now, I want to kick the presentation off with a few questions. Now, this is just a blog. Don’t worry. Don’t be afraid to put your hands up. Nobody’s watching you know. Well, actually, if you’re at work, somebody is watching yourself. Just put up a mental hand.
Now, for all of you out there, how many of you actually own yourself California real estate or know somebody that owns California real estate? Okay. I can see a bunch of hands going up there. Now, of those people with your hands up, how much of that real estate has a lot of embedded gains? Okay. A lot of those hand staying up. Just what you’d expect. A whole bunch of people that have hit the California real estate lottery. Now, of those people with your hands still up, how many of you like to pay taxes? Oh, all the hands went down. Just what I’d expect. I’m in the right place.
In this presentation, we are going to talk about how to monetize California equity without the taxes. Now, in this scenario, our customer came to us in the spring of 2018 with the property in Manhattan Beach that they had purchased for $17,000 in the 50s. I know it’s mind-boggling to think about Manhattan Beach real estate for $17,000, but they were definitely lottery winners and that’s what they bought this for. They lived in the house until about 2016 at which time they decided to rent it out. And the rents they got were 2,500 bucks. You can make a case that maybe they should have gotten more, but that’s a topic for another discussion.
So now, what is the problem? The problem is that this is a tear-down worth only $3.4 million. How in the world can that be a problem? A teardown worth only $3.4 million? Well, the problem is that of that $3.4 million just about all of its gain. Considering a pretty typical tax rate, everybody’s going to vary by the specific situation, but we’re going to use 30% for this scenario. They’re facing a potential tax bill of over a million dollars. Now, I think that we can all agree that that is a problem. What is the solution?
The solution is a 1031 Exchange. Now, Common Strategy in a 10:31 exchange is to trade all of that embedded equity from that great real estate investment that may not be cash flowing so much. We’re going to trade that for another property or portfolio of properties that have a much better cash flow. Trust me, all the numbers in the spreadsheets say that and we’ll give you a little pop up here to highlight that. We underwrote that in this situation, they were making about $23,000 annually. We applied a pretty light expense ratio, mostly because of the low rent, but they’re likely self-managing and the tenant’s getting such a great deal, so they’re probably not putting their hands out for many repairs.
With the debt service, about $50,000 there we estimated they’re probably coming out of pocket about $25,000 a year after debt service to hang onto this $3.4 million house. Can you imagine that? That’s so tough. I have to come out of pocket $25,000 to hang onto this $3.4 million in equity. What we told them was that, “Hey, I think that we can create, turn that $23,000 in income into $168,000 in annual income.” They looked at us like we’re crazy, but we kept talking. We set out to create this marginal benefit of $145,000 a year.
For those of you that are not familiar, a 1031 Exchange is an IRS approved regulation that allows sellers of properties with high gains to avoid the capital gains taxes if they satisfy certain requirements. There’re a few different types of Exchanges, a deferred, a reverse, and a property-for-property. By far the most common as a deferred Exchange and that’s what we’re going to focus on here. In a differed exchange, what we’re doing is that the home that we own, we’re selling this. This is called the relinquished property. When we sell this, the proceeds from that sale get held with a non-related 1031 exchange Intermediary. We go out and identify houses that we were going to purchase with those funds. Those are called replacement properties, and when we close on those houses, we use the funds held with the intermediary to close those houses.
Now, there’re a couple extremely important dates that come along with a 1031 Exchange. One of the most important things that you need to do first off, actually, it’s the thing that happens earliest in the process is that before we close on the sale of our relinquished property, we need to engage our 1031 Exchange Intermediary. This is so important because even if all of our funds are held in escrow, they never touch our accounts. I never touch them. I have no benefit of that cash. The way that the IRS views it is that we had possessory rights to those funds. They treat it as boot, the exchange busted, and we’re paying taxes. So extremely important. Remember this, if you’re doing an exchange, so important to get your intermediary engaged before you close on the sale of your relinquished property.
Now, the next most important thing is that within 45 days, we need to execute this wacky IRS process called the identification process. What this is is that within 45 days I need to go tell somebody, not even the IRS, I just have to go tell somebody that I might be buying this list of houses. To do this properly, check with your exchange intermediary, just to make sure that everything is working correctly or your tax attorney or CPA might know as well, but we’re providing this written list of properties that we might buy to somebody, and that person would acknowledge it. That’s the identification process. All of the properties that I end up closing needs to be on this list, but I don’t have to buy all of them. So that brings us to our third timeline event and that’s within 180 days I just have to make sure that all of the properties that I’m going to close on for this exchange, I am closing on within 180 days.
I know that at least some of you out there at this point might be thinking, “Wow, 1031 Exchanges are complex,” and you would not be wrong. And so that’s why we will come up and we will add a little piece to our solution here. Our solution is a 1031 Exchange with Conatus Real Estate. What we do in 1031 exchanges is that we provide an end-to-end solution. One of the most valuable things that we can do and as professionals that we can do in almost any industry, we’ve spent so much time building out this knowledge through experience. We study things, we go to school, we go to college, we talked with people, we go to seminars, we listen to people, share their ideas and soaking it up all this time. Just sharing that with our customers we think provides a great value.
We provide a 1031 sizing. This is the spreadsheet that we had on an earlier slide that provides a comparison of what the income is today versus what it could be after the exchange. Myself personally, I bought over 1100 single-family rental properties for high net worth individuals across 20 different markets. In this, I’ve developed a very strong professional network of service providers. And so another thing that we do is we provide introductions of our customers to these service providers. We offer to take a market trip to any of our customers that are willing to spend that much time with us. We think that this is so valuable because there’s no replacement for getting on the ground and seeing the neighborhoods we’re going to buy and we’re going to invest in. Probably one of the most active things that we do is that we drive this identification and acquisitions process and with that, we manage all the transactions through a portal that we have that keeps everything organized and timely.
Another thing that we do that could get overlooked as part of this IRS identification process, there’s a lot of complexities. If you think about going out and buying a portfolio of single-family rental homes, there’s a lot of moving pieces. “How many homes do I have left to buy? How many proceeds do I have, cash proceeds do I have left to buy those houses? And how much debt do I need to bring in to make up that difference?” Well, we track all of that throughout the process. And we provide real-time analysis to our customers to make sure that we are staying on top of this identification process and hitting all the deadlines.
Now, we’ll come back and take another look at our 1031 sizing. Remember, in this strategy what we’re trying to do here is that we’re trying to take all of this embedded gain in equity in this California real estate. It’s probably sitting at something similar to a one or a two cap rate. For those of you that aren’t familiar with what a cap rate is, that’s a one or 2% annual return against the value today. So we’re going to take that one or two cap and we’re going to try to trade that for a portfolio of cash flowing properties at a six cap or higher. So here comes the billion dollar question. Where does Conatus Real Estate find high returns? Where do you find six caps in California? Yup. You guessed it. Conatus Real Estate finances California returns in Texas.
We set out on this market trip. Remember, we’re leaving great weather and appreciation of California in search of cash flow in a great place like Texas. On this market trip, we did a few things. We started off by driving neighborhoods. Our view on residential real estate is that in multifamily, what we’re investing in to sell to our tenants are amenities, but in single-family, what we’re investing in to sell to our tenants, are neighborhoods. So it’s extremely important to really understand your investment is to go out and drive all your neighborhood, set foot out there, see what it sounds like, see what it smells like, see what it looks like so you really understand what you’re investing in.
One of the most crucial things we can do over on the market trip is to meet our property manager in person. Show up, shake hands with them, show them you’re a real person and not just another California real estate investor on the other side of the phone. It’ll add a lot of credibility to you and your interactions with them moving forward. My favorite thing to do while we’re on the market trip is to walk houses. The whole reason I got into real estate, I love to walk through and see what it looks like, try to understand what the structure is like, everything. We may not be able to walk all of the houses that wind up in the portfolio because of timing and other issues, but it’s really great to get some solid examples so you have something to compare to when we’re sifting through all the potential opportunities moving forward.
We got back from this great trip. We all learned a time, got to see our properties, neighborhoods, meet our property managers, and it’s almost go-time. The trigger point that we view as the time to start putting out offers is when the buyer of relinquished property releases their financing contingencies. This happened in this transaction sometime early April in 2018 and it was on … We dove into the Conatus Portal, which you see here, and this is actually an old version of the portal, but this is where we shift through other potential opportunities and we start showering the market with all of our offers. We didn’t have too big of a task here in this portfolio, so we’re able to lock up all over our homes within a couple weeks after the close of the relinquished property and were able to put together this great portfolio of 12 homes.
Actually, in addition to San Antonio, Texas, we bought homes in Kansas City and also Memphis. The result was if you remember that $23,000 in income that we started with, a loss after debt payment. The client decided that they wanted to take about, a little over a million dollars and buy a Hawaii condo. Must be nice. I wish I could have gone on that a market research trip, but what we got to do is go out and spend about $2 million on a portfolio of cash flowing single-family rental properties. In this, we we’re able to put together a portfolio that produces an underwritten $130,000 of annual income. But wait, there’s more. The icing on the cake in this transaction was that if you remember, the owner had lived in the home until about 2016. We sold in 2018, so the owner had lived there for two of the last five years. This qualified them for section 121 Exclusion.
So in addition to the Hawaii Condo, a portfolio producing an underwritten $130,000 in income, they were also able to put $250,000 cash in their pocket. And the best part, all of the taxes were deferred. Now, I know you must be thinking, “Ted, great. Yeah, that’s a great transaction. I’m sure they pop up every day,” sarcastically. Well, they actually do. I will leave you with a parting stat. In Newport Beach alone, there’s over 1700 Candidate homes just like that one. The value of these homes over four and a half billion with associated gains of over 2 billion. If you expand that search to Los Angeles and Orange County, we found that there’re over 370,000 Candidate properties that would fit a similar 1031 Exchange scenario. There is a huge amount of properties in southern California and other places that are sitting on a ton of gains that aren’t producing the cash flow that they could be.
It’s been great to be here with you today. Thank you for your time. Please don’t hesitate to reach out with any further questions you may have and we look forward to seeing you next time.