The combination of house hacking and the 1031 exchange is an incredibly potent strategy for beginning and intermediate investors
Experts agree that real estate is, by far, the best way to build wealth. But it’s not easy. If it was, everyone would have a real estate investment empire.
Successfully building a lucrative real estate portfolio requires guts, savvy, insight and, yes, a little capital. But most of all, it requires a plan. No one stumbles into an early retirement, or an eight figure net worth. It takes careful planning, long-term discipline, and battle-tested strategies.
Luckily, there are proven ways to optimize that crucial first investment, and then leverage it into an exponential upgrade, essentially steepening the curve of your wealth-building, and shaving years or decades off your timeline.
How? Through the most potent one-two punch in real estate investment: house hacking and the 1031 exchange.
What is House Hacking?
Everyone knows real estate is a great investment, but buying a house, living in it while you pay it off over 10 or 20 years, and then selling it, isn’t exactly an awe-inspiring pace of wealth creation.
House Hacking is a strategy to help you dramatically accelerate that initial investment, while still providing you with a place to live, and generating positive cash flow in the meantime.
It’s actually quite simple: you buy a small, multi-family rental property, live in one of the units, and rent out the others. The cash flow from renting out the other units should cover your mortgage and expenses, and then some, while you’re essentially living rent free. Small, multi-family buildings can be renovated fairly quickly and easily, so you can make them more appealing to renters, and get that cash flowing.
The benefits of house hacking compound each other nicely; according to the U.S. Bureau of Labor Statistics, the average U.S. household spends 20% of its expenses on rent or a mortgage; but you, while you’re house hacking, will be spending 0% of your income on rent. In the meantime, you’ll be able to sock away the large majority of that 20% income boost for your next investment move.
There are other benefits, too. If this is your first investment, your financing terms and down payment are largely going to dictate the quality of your investment, and you’ll get far better terms as an owner occupant than you would as an investor. Keep in mind that even if you do eventually move out of the property, that loan you got as an owner occupant stays in place.
Buying as an owner occupant also gets you access to loans that require smaller down payments. If you opt for FHA or VA loans from the government, you could put down as little as 5% or even 0%. Compare that to the average investment loan, where you’ll be required to put up to 25% down.
Upgrading Your Investments with the 1031 Exchange
So you got a great rate on a loan, with very little money down, closed on a multi-unit building, renovated and refreshed the property, and rented out the vacant units. You now have multiple rent checks coming in, you’re living rent free, and you’ve acquired valuable hands-on experience as both a landlord and an investor. Now what?
If you’re an ambitious investor, you’re probably already thinking about selling your property and flipping that money into a larger, more lucrative investment. There’s just one obstacle: capital gains taxes, which can eat up as much as 40% of your profit.
Fortunately, there’s a semi-obscure provision in the tax code that can help you completely defer your capital gains taxes. It’s called the 1031 exchange, and it’s one of the most powerful tools available to investors who are trying to upgrade their investments.
It works like this: the 1031 exchange allows you to sell off one property, take the proceeds from that sale, and reinvest them in a property of equal or greater value without paying 40% of your profits as capital gains taxes. It’s important to note that you’re only deferring your capital gains taxes, not avoiding them entirely. When you finally sell your investments, all your past tax bills will come due.
Of course, something like the 1031 exchange comes with plenty of rules attached. There are strict timelines involved; you have 180 days from the sale of your initial property to close on the purchase of your replacement property. Go even one day over that time limit, and you could lose all your tax benefits.
You also have to identify up to three potential replacement properties within 45 days of selling your initial property; you don’t have to buy all three, but you do have to buy at least one, and even if you buy multiple properties, their total value has to be equal to or greater than the value of the initial property.
There are also limits on what kind of property you’re allowed to upgrade to. Investors using the 1031 exchange are limited to "like kind" properties, meaning that the replacement property has to be similar in type to the initial property. So if you’re selling a single-family rental property, you can flip that money into another, more valuable single-family property, or even upgrade to a multi-family property. What you can’t do is flip that single-family property into an office building, or a strip mall.
Your Path to a Real Estate Empire
Combining house hacking with the 1031 exchange gets you into the game fast, and then lets you level up your investments without having to pay a big chunk of your profits to Uncle Sam.
And here’s the thing: the 1031 exchange can be used repeatedly. That means you can continually upgrade a chain of properties over the course of years, going from a modest two or three unit building, all the way up to a full apartment building, or something even more ambitious, all without paying a cent of capital gains taxes. Sure, those bills will eventually come due, but when you’re selling a $20 million office building, a decade or two into your investment career, the tax bill for that little two-unit building that got your foot in the door will seem almost quaint. And there’s no better mark of success than when paying your taxes becomes a source of amusement.