A Kinda Sorta Case Study In The Making — Turning Lemons Into Mojitos

What’s better than a case study in real time? Especially one for which we’re only pretty sure we know the ending? This is a superb example of gettin’ things done on Purpose, with a Plan, while taking full advantage of all the tools available. The lemons you ask?

Try three rental houses in San Diego — two of which were, regretfully, not performing as planned. Not only that, but the timing of their acquisition was not the best. They’re both upside down now. Between them $8-10,000 a year in negative cash flow is generated.

The third house spit out positive cash flow, and had appreciated nicely, even accounting for the recent backslide in prices. At first glance we guesstimated this property’s net equity at somewhere between $150,000 and $200,000.

I was contacted by the owner, who asked me my opinion of his situation, and whether he should use the cash he had on hand to separately acquire any additional income property.

Here’s a summary of Bill’s status quo at the time, which was around the end of last year.

Enough cash on hand to acquire a couple more income properties.

An existing Sominex Account easily big enough for my scaredy-cat tastes.

1 property in need of selling — about 4 years ago.

2 properties in need of flushing, one way or another.

A little over $200,000 in unused depreciation, accumulated over the last 8 years.

First thing outa the box we had Bill double check with his accountant on the amount of unused depreciation available to him. Turns out he was more or less in the ballpark. Then we looked at all three San Diego properties to figure out what best to do. It was decided that although the two losers were a giant pain in the butt for sure, they were now so upside down, Bill decided to bite the bullet and tough it out a few years.

This left the high equity rental, which we had Bill prepare for market, following our in-house interior designer’s instructions. It sold in about a day or so, and closed this month. His net proceeds landed in the range predicted, which will allow him to do the following.

He’ll acquire three brand spankin’ new duplexes in different parts of one of our favorite growth regions in Texas. He’s holding back $20-25,000 to replenish his Sominex Account (cash reserves, for the uninitiated), spent on upgrading the rental just sold. We love that attitude on his part, as regular readers will attest. Never make your Sominex Account a 2nd class citizen of your Purposeful Plan.

The three duplexes will be bought using 20% down payments. All title policies and an additional 2% of his closing costs will be credited to Bill in escrow. Total capital required to close all three will be roughly $155,000 — or close enough for horseshoes. Cash flow from the three will land somewhere around $10,000 annually, probably a tad more. What a pleasant co-inky-dink. That just happens to offset the negative cash flow from the lemons back in San Diego. And no, it’s not really a coincidence.

The capital gain Bill incurred via the sale of the San Diego rental will be more than offset by all his unused depreciation. This is cool on more than one level. Besides avoiding either a handsome (ugly?) capital gains tax bill or a tax deferred (1031) exchange, he becomes what I call, (and please excuse the phrase) a reconstituted virgin as it relates to his cost basis. No exchange means no artificially low adjusted basis. This in turn means that not only will the capital gain on his new properties be significantly reduced in the future, but that his future annual depreciation will also rise big time.

His new annual depreciation will be roughly quadruple what he left in San Diego. He’ll be increasing his leverage while simultaneously going from a break even cash flow to a five figure annual cash flow. Let’s summarize all this.

Sold much appreciated property without paying capital gain.

Immediately goes from no cash flow to 5-figure cash flow — after tax.

Immediately quadruples his tax shelter when new duplexes close escrow.

Offsets negative cash flow in San Diego with positive flow in Texas.

Avoidance of 1031 reduces future capital gains monumentally.

One of the bonus perks, at least as far as Bill’s concerned, is he now has one less property sucking up his time managing. Don’t know about you, but managing property is without a doubt my least favorite thing to do in real estate — and there is no runner-up.

Also, he’ll be rackin’ up huge amounts of unused depreciation for the next round of moves — always a good thing. Oh, lest we forget, this move’s most profitable result will be the epic increase in his capital growth rate. We’ll not know how much the increase will be ’till we have a year or two behind us, but it’ll be impressive. Not only did he increase his leverage just short of a factor of three, but by controlling more property — located in a region far more likely to increase in value, his chances for appreciation are now far more likely. (And sooner, rather than later.)

BawldGuy Axiom: Expertise, knowledge, and experience can often turn what seems a difficult set of circumstances into something very workable. But don’t expect something as cool as turning lemons into mojitos. That’s a bit much, don’t ya think?

This is an ongoing saga, for which the ending is still to be played out. We’re just now putting the duplexes under contract. I’ll let you know when it all finally shakes out. You get the idea though, right?

You own property in San Diego? Maybe some place much like it? Give me a call so we can explore the possible together. Try 619 889-7100. Have a good one.

Related posts:

1. Real Estate Investors: A Case Study In Turbo Charging Your Journey To Retirement
2. There’s The Best Way To Go — And Real Life — A Case Study
3. How A Purposeful Plan Makes Use Of A Partial 1031 Tax Deferred Exchange — A Case Study
4. The Art of the Possible — Turning Dead Equity Into Growing Capital
5. Road To Recovery — How To Begin Making Up Lost Ground