Low Return on Equity (ROE) Rentals: When It's Time to Redeploy via 1031

Measure ROE on the equity you could take out today, not on the cash you put in years ago

Cash-on-cash return looks backward at your original down payment; return on equity looks at what the equity is worth now. Take the property's market value, subtract the loan balance and the cost of selling, and divide the last twelve months of net cash flow by that figure.

Hypothetical: a house worth $950,000 with a $200,000 loan and $50,000 of selling costs has $700,000 of equity. Net operating income after taxes, insurance, repairs and a 5% vacancy allowance is $35,000; debt service is $15,000; net cash flow is $20,000, so ROE is 2.9%. Add the year's principal paydown, say $5,000, as a separate line and total return on equity is 3.6% before any appreciation.

• Use your actual three-year average vacancy and a capital-expenditure reserve, not the pro forma you bought on.
• Count a management fee even if you self-manage; your hours have a price.
• Keep appreciation out of ROE and show it separately, because it is unrealized and taxed on exit unless exchanged.

The benchmark is the after-fee yield of whatever you would buy with the same equity, not a rule-of-thumb percentage

No statute or IRS publication sets an ROE threshold; the decision is a comparison between 2.9% and what the same $700,000 earns elsewhere after fees, debt and tax. Passive replacements such as DST interests and net-lease property publish projected distributions in their offering documents, and those projections are the number to test, net of the sponsor's fees and any leverage inside the trust.

A 5% hypothetical yield on $700,000 is $35,000, or $15,000 a year more than the house pays now, with no tenant calls. Whether that gap is worth the illiquidity and sponsor risk of a DST, or the single-tenant risk of a net-lease building, is the real question, and DST vs direct ownership lays out the trade.

Selling and paying the tax turns $700,000 of equity into about $553,000 of investable cash

Assume the house was bought for $350,000 and $150,000 of depreciation has been taken, so adjusted basis is $200,000 (hypothetical). Amount realized after $50,000 of costs is $900,000, giving a $700,000 gain: $150,000 is unrecaptured §1250 gain taxed at up to 25% ($37,500), and $550,000 is long-term capital gain at 15% for a married couple whose taxable income stays under the 2026 20% breakpoint of $613,700 ($82,500). The 3.8% net investment income tax under §1411 adds $26,600 on the full $700,000, for about $146,600 of federal tax before state tax.

After paying off the $200,000 loan and the tax, roughly $553,000 remains to reinvest. At the same 5% hypothetical yield that is about $27,650 a year, against $35,000 when the full $700,000 goes into replacement property through an exchange; the deferred tax is the difference, and it keeps compounding for as long as you hold or keep exchanging.

The gap shrinks when the gain is small relative to equity, when your income sits in the 0% bracket (taxable income up to $98,900 married filing jointly for 2026 under Rev. Proc. 2025-32), or when a taxable sale releases suspended passive losses under §469(g) that an exchange would keep frozen.

A cash-out refinance raises ROE only if the new loan costs less than the property yields on its value

Borrowing against the house is not a taxable event, so a cash-out refinance can pull equity without a sale. But it raises ROE only when the property's yield on value exceeds the loan's rate: the example house yields 3.7% on its $950,000 value ($35,000 ÷ $950,000), so a new loan priced above that lowers your cash flow while the equity you pulled still has to be reinvested somewhere.

Refinancing shortly before an exchange raises a separate problem, because cash pulled out in anticipation of the sale can be treated as boot, which is a reason to decide between borrowing and exchanging before you talk to a lender.

Deleveraging or refinancing beats an exchange when you still like the property and the yield is the only complaint

If the location, tenant quality and condition are fine, the cheaper fix is often financial rather than a sale: pay the loan down to lift cash flow if the rate is high, or refinance and redeploy if the rate is low. An exchange makes sense when the asset itself is the problem: the wrong market, capital expenditures ahead, or a management load you no longer want.

• Refinance: keep the asset, add leverage, no tax; needs a rate below the property's yield on value.
• Deleverage: pay down debt, raise cash flow, lower risk; no tax; ROE on the enlarged equity may still be low.
• 1031 exchange: change the asset and the workload; no tax now; 45/180-day deadlines and replacement rules apply.
• Sell: full liquidity; about 21% of the example's equity leaves as federal tax.

Management hours and single-asset risk belong in the spreadsheet next to the yield

A 2.9% return that costs 150 hours a year is worse than the number shows, and a single house carries one roof, one tenant and one local market. Give the hours a dollar value and treat concentration as a cost, then compare against a replacement spread across several properties or tenants; the common mistakes page lists what goes wrong when the decision is made on yield alone.

Age matters too: if the plan is to hold until death, heirs take the property at its date-of-death value under §1014 and the deferred gain vanishes, which favors exchanging over selling for anyone who does not need the cash. Confirm the recapture and bracket math with your CPA or attorney before you list.