With Low Interest Rates, Should You Skip the 1031 Exchange and Refinance Instead?
With interest rates currently at dramatic lows and home sales riding high, many investors are thinking about how to best capitalize on the market conditions. There are three points you should reflect upon when considering whether or not to refinance or sell your investment property.
First, what does it look like to refinance your existing property? Second, what does it look like to sell and find a new property using a 1031 exchange? And finally, what is your personal situation, and how would either option affect and benefit you? To answer all three of these questions, let’s analyze the comparison on a micro-level.
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Historically, refinancing an investment property would add debt—and there is a cost for accessing that debt. However, with today’s low interest rates, refinancing might allow you to pull out cash and lower your monthly mortgage payment, creating a win-win situation for you. You must also consider the performance of your investment property.
Let’s analyze. What is your actual net operating income? Remember, that number will equal revenue minus expenses. Then, factor in allowances such as vacancy, repair, and mortgage payment (include taxes, principal, and interest).
Consider the appreciation potential of your current property and the path of progress–factors that make this property attractive and could potentially increase its income-producing capabilities or value over the next couple of years. This positive potential is a driver in determining whether you keep it or decide to reinvest in an area with more revenue-generating opportunity or better appreciation.
Another concern to take into account is the physical condition of your current property. For example, if you have an older property that will need a new roof in a year or two, that can erode years of profitable gain. If you sold this property for another investment needing fewer repairs, that should increase your future net operating income (NOI). The questions to ask yourself are:
- What is the current NOI of the property?
- What is the projected NOI if I keep the property and refinance?
- If the property is a marginal producer now, what will happen after the refinance?
Make sure you are comparing all the apples in your basket.
Selling your property using the 1031 exchange
Now let’s take a look at the “sell” side of the question. However, before we drill down into the nitty-gritty of selling your investment property, let’s define a 1031 exchange.
What is a 1031 exchange?
A 1031 exchange is a process that allows investors to defer the capital gains and related federal income tax on the sale of investment real estate by replacing it with other investment real estate. Basically, you indefinitely defer the capital gains tax and depreciation recapture that would normally be owed from that sale. You can continue to do this in future sales/purchases as long as you use another 1031 exchange.
How a 1031 exchange impacts your decision to sell or refinance
The main question is, if you decide to sell (using the 1031 exchange), what can you buy? If all you can purchase is a property similar to what you currently own, refinancing might be a better fit for your situation. If you find a property that will perform better than your current one does, then selling is optimal. You will have 100% access to your equity with the 1031 exchange for a property that’s a better performer than the one you currently own.
Also, take into account the deterioration potential. When a correction happens in the market, people flee from less desirable areas, making it more difficult to rent productively.
Let’s use Denver, Colorado, as an example. As Denver becomes more populated, housing prices are soaring and residents are more willing to commute farther in exchange for cheaper rent. If the market softens in Denver and it becomes cheaper to live closer, a rental in nearby Watkins might not be a great investment as it becomes harder to rent out and the area experiences higher vacancy rates.
Are the properties you own positioned to survive a correction? If so, refinancing might be a good opportunity. If not, selling the investment with the 1031 exchange is a great option to take all the equity and put it toward a better property closer to the city.
Sell and complete a consolidation or diversification exchange
Another option to consider in a 1031 exchange is consolidating your investments with a consolidation exchange.
If you have four residential properties, worth $100,000 each, selling them to purchase a $400,000 property (perhaps in commercial real estate) could result in a higher return on investment (ROI). With the consolidation exchange, you can accomplish this without having to pay tax on the properties you’ve sold. In many cases, the consolidation results in a much less management-intensive portfolio.
Conversely, you can diversify your investment portfolio by selling one large property to invest in several less costly properties using the 1031 exchange. These options all lend themselves to our final topic: the evaluation of your situation.
Evaluate your personal situation
The third and final leg when considering whether to refinance or sell your investment property is your specific situation. Examine the performance, quality, location, and potential of your investment. All of these factors are unique to your situation.
If you anticipate moving to a different region, selling the current property to relocate is the best fit. Or, if you are planning to retire, finding a more passive investment may be a more suitable option. If the property is only three miles from where you live and has solid earning potential, refinancing could make the most sense.
Be sure to discuss your options with your lender and learn what rates you can qualify for in either case. Realistically evaluate your situation and decide what you can do right now from a financial leverage viewpoint.
Remember, a refinance typically doesn’t give you access to 100% of the equity. In a sale with a 1031 exchange, you have access to 100% of the equity for reinvestment purposes. You can always consider selling, then refinancing the new investment to pull out equity without being taxed.
On a high level, examine the performance analysis of the current property. Think performance potential vs. potential in the market. Analyze the deterioration potential, appreciation, and quality of your property, and your position for what benefits you the most. Then, become a Microsoft Excel nerd, break open a spreadsheet, start those comparisons, and let the games begin.