Yes, the 1031 route requires buying new like properties. However, the current real estate market here is on fire and especially with income properties. The capitalization rates are through the roof so the return on rentals very low if I buy into this inflated market.
For example, I have four nearly identical homes built in 2002 and purchased for between $125,000 to 145,000 from 2006-2011. They each rent for $1,300 monthly but there is HOA and some other costs. That return is great when you look at their purchased cost. If I were to buy a new one today (through a 1031 exchange) it would cost me $220,000 but the rent is still $1,300. It would be like throwing away my equity. Nonetheless, each home has around $100,000 equity after real estate and transaction fees etc...
Here are some numbers- 4 properties are on 15 year notes (two of those mentioned above) while 3 are on 30 year loans which yield better cash flow. The cash flows are $427, $128, $373, $172, $368, $547 and $292.
Scenario #1
Sell the three properties with low cash flow to pay-off another two houses. Why only two? Becuase of taxes (remember active not passive income) plus realtor fees and of course closing and other associated costs means the three properties with approximately $100,000 equity will yield only $240,000 at best assuming 20% tax and other cost burdens.
Paying off another two provides an additional $1,900 income monthly but that means losing $938 of the current monthly $2,000 (138+373+427). The three chosen are the oldest properties to sell plus other factors.
This results in a monthly income of only $2,962 after selling three properties and having some cash on hand. Liquidating real estate that contributes towards the monthly $2,000 means I am canibalizing the base of income thus not simply adding income.
Scenario #2
Pay-off existing mortgages with IRA funds. This I already looked at previously so fortunately had the numbers calculated. Paying-off the largest mortgage payments first with the least balance (thus 15 year notes) gives most bang for the buck. Starting with the simplest calculation, it will take $485,000 to pay-off 5 mortgages (they are 125,86,86 & 139 thousand rounded) when factoring in the 10% early withdrawl penalty. The income than rises to $5,924 monthly or $71,088 annually.
The problem is income tax on the withdrawl from the IRA. Depending on how much is taken each year (plus other income) my tax bracket could easily destroy the amount available after the first $200,000 getting into a 28% bracket and 5% state income tax thus 33% loss on top of the 10% for a whopping 44% loss meaning you can nearly cut the monthly and annual in half to be more realistic.
Another big con to this approach is not having large funds available in the event of a major problem with the properties. A series of sewer line connections or other large expense could quickly outstrip my capital needed to maintain them and keep them rented.
Scenario #3
Skim off the stash enough to get by and don't worry about the 10% penalty because I will enjoy a 15% tax bracket. This may be my default position because each year the property loans are decreasing quickly (mature 15 year loans) thus my total net worth maintains status quo or even grows depending on the market returns and how much I need to live.
Scenario #4
A hybrid of sorts. Pay-off one property per year to avoid the tax penalties while skimming off the top for living expenses of the IRA Of course, send the wife back to work if possible and look for other income.