...well not exactly tax free, but tax deferred at least.  Earlier in the year I mentioned a resolution that I'd declared for myself - to sell a high-end property that had built some equity via appreciation and re-invest in a multi-family via a 1031 tax deferred exchange. 

Here's a quick overview of how a 1031 works. 

A 1031 is an IRS code that allows investors to build wealth by exchanging properties while deferring taxes.  Any property may be exchanged for a "like kind" property.  Most real estate transactions fit this definition.  A rental property, for example, could be exchanged for a commercial or farm property. 

You'll need a "qualified intermediary" in order to execute a 1031 exchange.  In lay terms:  when you sell the property you're not allowed to touch the cash, otherwise the tax man is going to come knocking. 

When you sell the property, title is transferred to the buyer via the intermediary, and the proceeds of the sale are delivered to the intermediary.  At this point you have 45 days to identify replacement properties.  Within 180 days of the original closing you'll have to close on the purchase that you're making to complete the exchange.  

Here's the key: 45 days will go by like a flash.  If you haven't started the process of identifying the replacement property or properties before you close the sale of the property that you're relinquishing then you might find yourself in a squeeze. 

I'll talk a bit more about this in the near future....and discuss a project that I now find myself in the middle of.

I’ve stated in previous posts and articles that running the numbers and making sound assumptions about your potential investments is one of the keys to avoiding real estate investor burnout.  Real estate is a long term game and you can’t build a stable portfolio overnight.  This means you need some staying power, so if you end up packing it in after your first investment or two you’ll never get there.  

So in my view looking before you leap is the best way to keep your momentum as an investor, and that means having an idea about what to expect from an investment in terms of rate of return, cashflow and net present value.  

But analysis is like aspirin, or fine wine, or just about anything, for that matter.  A bit of it can make a big difference – but that doesn’t mean that a massive dose is a good idea.  More isn’t necessarily better.  

How do you strike the right balance?  Well that depends on the investor.  Personally, I’m an engineer by training and I love numbers; that’s why I ended up building this site.  I see the value in using a tool to catch all of those assumptions wrapping them into a cashflow projection.  Plus, I love to tinker.  But therein lies two danger – 1) becoming infatuated with the analysis and forgetting about the underlying uncertainties (no analysis is perfect) and 2) becoming infatuated with perfecting the analysis to the extent that you never get a deal done.  In other words: don't get paralyzed.

Both of these problems happen...probably more than you’d think.  

So...how to avoid these issues?  Again, it depends on the investor and your personality type, but I’d suggest the following rules of thumb: 

• Remember: your analysis is based on your assumptions.  Unless you have a working crystal ball you’re never going to get it all right.  Your analysis will give you your base case.  When you get your results ask yourself “is this target a good result?  Does the potential reward justify the risks?”  if the answer is “yes” then drive on and figure out how to make the deal work – don’t spend time fine tuning.  
• Analysis is a process:  I worked for a while in strategic planning with a major corporation.  We spit out huge, detailed plans.  And we never followed them.  Is this a bad result?  Well, not necessarily – the planning process itself is hugely valuable.  It forces executives to examine their assumptions, communicate their goals, and crystallize their thinking.  The planning process helps organizations to articulate their vision and set their course, even if they don’t follow the resulting plans to the letter.  Real estate analysis is similar: running the numbers will force you to consider the big questions around vacancies, rental rates, repairs, and other risks that you might not consider before jumping into the investment.  
• Evaluate the sensitivities:  Don’t just look at the final “answer” – look at the sensitivities to understand how much risk you’re taking.  Ok, you’re forecasting a 5% appreciation rate...but what if it’s 3%?  Or 8%?  The EquityScout tornado diagrams will help you do this, but if you’re running spreadsheets you can do the same thing manually.  
• Be honest with yourself:  There are two camps that you want to stay out of – the overly conservative camp that kills every deal that comes along by handicapping them with excess costs, and the rose-colored-glasses camp that tweaks all the variables up until they get the result they want.  Nervous Nellies do no deals, and the Pollyannas do bad ones.  
• Remember: once you’ve made your bed you’re going to have to lie in it.  A single fortuitous event (a upgrade in the neighborhood) or misfortune (a mold infestation or a disastrous tenant) will radically impact the performance of your investment.  You’re still going to have a lot of uncertainty to manage once you make your investment; the purpose of the analysis is simply to ensure you’re pointed in the right direction before you pull the trigger.  

…how's your market?

From time to time I contribute pieces to publications on investing in real estate.  Recently I wrote an article that appeared in the Houston Business Journal on investing opportunities in the Houston market .  Markets are starting to turn south in some areas of the country, but there are three key points that prudent investors can follow that will help turn up opportunities in some sectors:

• Buy cashflow:  positive cashflow is your best hedge against the risk of falling property prices. 
• Understand the risks:  keep it simple, avoid complex mortgage products that you don’t understand. 
• Run the numbers:  don’t get paralyzed by the analysis, but check your assumptions and know what sort of return you can reasonably expect from your investment.

These can feel like truisms, but the key is considering what they mean to you and your particular market.  See the article for more…
 

It’s January 20th and I’m just now rolling out with my New Year’s resolution.  Seems like procrastination, but to me it’s a strategy.  See if I hit the gates with the rest of the masses and proclaim my goals on the first of January then inevitably right about now I end up realizing that my vows to hit the gym more frequently and to get my life more organized are unlikely to pay dividends.  Resolutions (promises) made in the heady first days of the New Year are usually doomed by an excess of optimism – and sometimes by the remorse of a champagne headache. 

So I get around to ticking off some to-do’s for the year towards the end of January, which ends up prompting me to set some boring but do-able goals that take me a few steps closer to where I’d like to be at the end of the year. 

And this year’s goal is to start practicing what I preach in two areas:

• First: Don’t hoard equity in an investment, and
• Second: Don’t  fall in love with a property.

These are good rules to live by, and ones I’ve talked about in the past in my writings.  And they’re also two rules that I’ve violated in one particular investment.  I own a townhouse loft in the Montrose district of Houston.  Towering floor to ceiling windows.  Acres of hardwood floors.  Street lined with majestic live oaks.  And, I happened to live there…and I happened to be living there when I met the woman who would later become my wife.  Fond memories.  So when we moved out I held on to it. 

It hasn’t done badly, all things considered.  Montrose is hopping, builders are building, and prices have started to tick up.  So it’s time to get rid of it, fond though I might be of the property.  Cashflow-wise the property does ok, but that’s because I bought it before the price ran up.  Now it’s time to put that equity to work. 

The graphic shows my plan: take the $130k in equity that’s sitting uselessly in this property and turn it into six multifamily units that will pay me $5,000 per month in rental income (vs. the $2,100 that the loft is generating).  And do it through a 1031 deferred tax exchange that will allow me to avoid paying capital gains tax on the profit. 

So now that I’ve publicly declared my resolution perhaps I’ll feel more compelled to stick to it.  I know a lot of investors have equity squirreled away in properties that have run up in value.  I’d love to have other investors join me in resolving to put that equity by pulling it out and investing it in bigger properties. 

…and , I trust someone will call me out in December and see if I’ve stuck to my goal.  We’ll see…

I'll write a post soon on the ins and outs of the 1031 exchange - the key to making this work.