Summary: For this article I spoke with RealWealth Investment Counselor, Joe Torre, who frequently helps our members find 1031 exchange replacement properties. Many of the members he helps have a goal to increase cash flow by doing a 1031 exchange, so I thought this would make a quality article. I hope it helps you understand how to find quality replacement properties that can help you boost cash flow. Enjoy!
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Introduction: How Doing a 1031 Exchange Can Help You Increase Cash Flow
There are so many reasons why people choose to do 1031 exchanges. For some, it’s an opportunity to build greater wealth by finding replacement properties in up and coming markets with a high chance for appreciation. For others, it’s a chance to create financial freedom by boosting their monthly cash flow… so they can retire, travel the world, spend more time with children or grandchildren… so they can live life on their own terms.
In this article, we’re going to focus on the goal of passive income. Read on to learn how you can identify 1031 exchange replacement properties to boost cash flow.
12 Rules for Identifying Replacement Properties That’ll Cash Flow
There are three general rules you have to follow when identifying replacement properties. These rules include:
1 - The Three Property Rule
The Three Property Rule states that when doing a delayed exchange, the exchangor has 45 calendar days from the date the relinquished property closes to identify a replacement property. Under this rule you may identify up to three properties of any value, as long as you purchase one of these properties within the 180-day exchange window.
2 - The 200% Rule
The 200% rule allows you to identify more than three properties, but the combined value of these properties cannot exceed 200% of the relinquished property’s value. If you use this rule we recommend creating a little padding (180-190%) so you don’t go over the 200%.
3 - The 95% Exception Rule
If you choose the 95% rule you can identify any number of properties and you don’t need to take the sale price of the relinquished property into account… if you actually acquire AND close on 95% of the value of the properties you identify. Be careful with this one. If you acquire less than 95% your entire exchange will be invalid.
When looking for replacement properties that will cash flow, there are a few more rules we generally follow. Note that these “cash flow rules” are not specific to doing a 1031 exchange, but are important for anyone looking to purchase cash flowing property. That said, if you are looking to find replacement properties that will cash flow, you should consider following these rules as well.
These replacement property cash flow rules include:
4 - The Population Growth Rule
When identifying replacement properties that will offer strong cash flow we look for markets with population growth. Population growth is a good sign for potential cash flow, because typically about 40% of a market’s population will be made up of renters. As the population grows, the demand for rental properties grows correspondingly.
5 - The Job Growth Rule
We also look for markets that are experiencing job growth. This follows the same logic as above, because typically, as more jobs are created more people move to an area. In other words, job growth causes population growth.
Note: Markets like Southern Florida, which are retirement destinations, may not show huge amounts of job growth but they do show population growth. These areas would still be considered strong cash flow markets.
6 - The Affordability Rule
When looking to generate cash flow, you don’t want to overspend on your investment property. Choose a market that offers affordable housing prices and about a 1% price to rent ratio.
7 - The Inventory Rule
When doing a 1031 you need to be able to identify replacement properties quickly and close within 180 days. Because of this it’s important to choose a market that has a good amount of inventory, so you’re not losing out during bidding wars.
8 - The Low Property Tax Rule
9 - The Landlord Friendly Rule
When looking for cash flow it’s also important to look for landlord-friendly markets. An ideal market would be one where there are no rent control initiatives and where it isn’t insanely difficult to evict problem tenants. IE: California may not be the best option, especially if you’re a newer investor. (My family owns apartment buildings in the LA area, so I can speak about the difficulties first hand. Dealing with California tenants, especially in pricier zip codes, can be an absolute nightmare sometimes)
10 - The “Right Kind” of Property Rule
When identifying cash flowing replacement properties it’s also essential to choose the right kind of property.
For example, a duplex will generate more cash flow than a single-family rental. Even if one side is vacant you still have income coming in from the other unit.
This is a little off topic, but another benefit of investing in duplexes over single-family homes is that you can have up to 10 loans through Fannie and Freddie. If you only invest in SFRs these 10 loans will amount to 10 doors. If you invest in duplexes you’ll get 20 doors with 10 loans. A 4 plex is an even better opportunity for cash flow, but they cost significantly more. Around $500,000+ in many markets compared to $200,000 or so.
Another important consideration: you may want to stay away from choosing new construction replacement properties. There are ALWAYS delays when it comes to building new homes, and it would be awful for your 180-day window to come to a close when the property you’d like to buy isn’t ready to go. If you are set on new construction, speak with your investment counselor or qualified intermediary about how to avoid risks!
11 - The “Right Timing” Rule
There are certain times of year that are better for cash flow than others. Ideally, you want these prime time cash flow periods to line up with the close of escrow on your replacement property.
Here are a couple of tips:
- Avoid closing during November and December. It can be hard to find tenants looking to move during the holidays.
- It can also be harder to find tenants during football season in some markets. People don’t want to spend their weekends looking at rentals when their favorite college team is playing on Saturdays and NFL games are their priority on Sundays. This is especially true in markets like Pittsburgh and Dallas.
- If you want to maximize your cash flow, time your close for February or later, because there’s no football and no holidays during this period.
- Also, in February people start to get their refunds from the IRS, so many prospective tenants have money for security deposits.
- You may also want to consider staggering the purchase of duplexes by a month or so, so you can avoid having vacancies at the same time.
12 - The Don't Discount Section 8 Rule
If you’re really looking to maximize cash flow with replacement properties, consider investing in Section 8. This article explains the pros and cons in detail: Is Section 8 Good For Landlords or Not?
Additional Cash Flow Replacement Property FAQ
Can You Exchange Your Property for Multiple Properties in Several Markets. Should These Markets Be in Different States? If So, Why?
Yes, you can purchase replacement properties in more than one state. This is a good idea, especially if the property you plan to relinquish is on the pricier side.
A good rule of thumb: If you’re buying 10 or more properties, you should diversify into 2 or 3 markets. If you’re buying 3 or fewer properties it’s okay for all of them to be in the same area. Ideally they would be within driving distance of one another so you can visit them during the same trip. Travel time eats up cash flow.
What Type of Replacement Property Do You Recommend for Cash Flow
We covered this a bit above already, but we’d typically recommend duplexes for replacement property if your goal is cash flow. Duplexes are still affordable, but they offer a larger income opportunity on one loan.
What if You’re Already in the 45-Day Window? Is It Too Late To Find Cash Flowing Replacement Properties?
No, it’s not too late! Ideally, you’d want to have at least an idea of what replacement properties you’d like to purchase before you close. But it’s still possible to find cash flowing replacement properties with little notice, especially if you work with an expert who knows the ins and outs of finding replacement properties.
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