In this episode of The Agent of Wealth Podcast, host Marc Bautis is joined by Dave Foster, Founder and CEO of The 1031 Investor. He is a degreed accountant and serial real estate investor who is a qualified intermediary and consultant for tax saving strategies such as the 1031 Exchange and the Section 121 Homestead Exemption. Today, Dave breaks down how to use the 1031 Exchange in layman’s terms.
In this episode, you will learn:
- What a 1031 Exchange is.
- When and why to use a 1031 Exchange.
- The six requirements of any Exchange.
- How to recognize and avoid common 1031 Exchange issues.
- How to transition from active real estate investing to passive real estate investing using a 1031 Exchange.
- And more!
Disclosure: The transcript below has been lightly edited for clarity and content. It is not a direct transcription of the full conversation, which can be listened to above.
Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. On today’s show, I’m joined by a special guest, Dave Foster.
Dave is the Founder and CEO of The 1031 Investor. He is a degreed accountant and serial real estate investor who is a qualified intermediary and consultant for tax saving strategies such as the 1031 Exchange and the Section 121 Homestead Exemption.
Dave started fix and flipping in the 90’s and realized that about 40% of his profits were going directly to the IRS. Today, Dave will break down how to use the 1031 Exchange in layman’s terms.
Dave, welcome to the show.
Thanks, Marc. It’s great to be here with you. As I was listening to your introduction, I realized something – I’m not just a serial real estate investor, I’m pretty sure there’s a touch of ADD in there. I’ve really enjoyed my ride through real estate. It’s been a lot of fun.
They often go hand in hand… I’m looking forward to today’s topic. We have a lot of listeners that are real estate investors, and while they’ve probably heard of a 1031 Exchange, they might not really understand the mechanics. Can you start off by giving a quick definition?
What is a 1031 Exchange?
Under section 1031 of the United States Internal Revenue Code, a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property, a process known as a 1031 exchange.
The 1031 Exchange is part of the United States tax code that deals with real estate transactions. There’s actually another one called the Section 121 Homestead Exemption. Both of these have to do with the sale of real estate.
For anybody out there wanting to maximize return on their work – whatever it is, if you make cookies, build computers, run a tax business or buy stocks – those things all have something in common: When you sell them, you pay tax. Real estate has been the foundation of American growth for over a hundred years, and in 1920, the IRS formalized these parts of the code that allow real estate investors to keep the real estate velocity moving by buying and selling new real estate without having to pay tax in the middle.
It was originally designed for farmers. At the time, many young farmers could not sell their farms and buy new, bigger farms because they couldn’t afford to pay the tax. This was bad for any upcoming farmer wanting to break into the business, as well as experienced farmers looking to sell and grow. That’s why the IRS instituted this, it’s really the greatest gift in the tax code.
When and Why to Use a 1031 Exchange
My introduction to the 1031 Exchange came from a mistake that I made 30 years ago. I bought a duplex in Denver, fixed it up, sold it, and had a $30,000 tax bill on it. Ouch. As I started doing math, I said, “Holy cow, if I would’ve had the use of that $30,000 making 10% a year for 30 years, I’d have $100,000 just from that transaction.” That’s the power of the 1031 Exchange.
Yeah. So, like you mentioned, by utilizing a 1031 Exchange, a real estate investor can avoid paying capital gains tax on the property they sell by rolling over the entire amount into the new property.
Exactly. That capital gains tax stays with you, so you can invest it and make more money. So it’s kind of a form of compounding interest, right?
Now, the other big shoe that drops on real estate investors is depreciation. Depreciation is a game of pretend, where the IRS lets you pretend that your real estate loses value every year. You own it so that after 27 years they will let you using tax write-offs act as if your real estate is worth zero. So you get that tax write off every year. Well, the problem is that when you sell that real estate, does it really go down? No. Real estate goes up in value. So, guess what? The IRS will make you pay back all of that tax write off that you took of depreciation as well. The 1031 Exchange also lets you defer that, so you get to defer the capital gains the depreciation recapture.
Stepped Up Basis
You used the word defer a couple of times… An important thing to note is yes, if you wind up at the end selling your real estate and you are not able to 1031, you will have to pay taxes. But one of the benefits is something called a step up in basis when someone passes away. If you do own this real estate when you pass away, the individual who inherits the real estate will actually get a step up in basis. Again, the taxes can ultimately be avoided.
Yeah, absolutely. As a matter of fact, we talk about that as being the fourth strategy of the 1031 Investor. When you die, your heirs get the property and the step up basis – the tax is not paid by you or your estate, it literally goes away. That’s such an incredible opportunity to start a legacy. But you have to be patient and play the game.
How about if I give you a quiz? There’s four D’s of 1031 investing, the last one being die. I’ll give you the first one and we’ll see if you can figure out the other two. The first one is defer. The reason why it’s deferred is because that’s what starts the whole process.
People will say they’ll just go ahead and pay the tax, because they think they’re going to have to pay it someday. But any day that you keep the tax deferred by doing a 1031 Exchange is a day that you get the money. So whether it’s two days or 35 years, a 1031 Exchange is beneficial. So why not start out by deferring, even if you don’t end up following this strategy until you die.
Now, what do you think the second “D” is?
I’ll go defer, again.
Yeah, t’s defer. As long as the 1031 Exchange is available to you, you can react to and adjust to whatever stage the real estate market cycle is in because the 1031 Exchange allows you to 1031 from anywhere in the country to anywhere in the country. You can exchange any type of investment real estate for any other type of investment real estate. You can exchange any number of real estate into any other numbers of real estate. As long as you’re purchasing at least as much as you sell and using all the proceeds, then you’ll continue to defer all tax. So think about those bunch of folks up in Palo Alto that sold all their Bay Area properties, massively appreciated property prices, right? And they followed this guy named Elon down to Austin where land and real estate was dirt cheap. They sold at the peak and they went to a different market where they could buy cheap real estate cycles and develop at different times and in different places, and you can use that 1031 Exchange to go into any place you want.
We do an awful lot. Right next door to you there are those brownstones, all of those properties that were in families for 20, 30, 40, 50 years. And what’s unique about them all is they’ve had such a swing. They go up huge in value, they come back down, families hang on. At some point in time it’s time to get rid of it, to invest in maybe multifamily or something where you can make more money. Whatever the real estate cycle is telling you to, you can use the 1031 and keep that tax working for you. Okay, you’ve probably seen a trend mark, but what do you think the third D is?
Is it defer again?
Yes, you got it. Here’s why. In the same manner that the 1031 Exchange can be used to accommodate wherever you’re at in the real estate cycle, it can be used to accommodate wherever you’re at in your life cycle as a real estate investor. Now, I don’t know about you, but when I started out my real estate investing career, I had way more energy than I had money. So how did I use that to my advantage? I tore down a lot of walls, and I fixed a lot of plumbing. I am painted a lot because that’s what I could do. I didn’t have the money to do it. So we did add value to projects over time. There’s just a natural transition isn’t there to where we have more money than energy maybe, and now it’s time to go buy bigger projects where we don’t have to manage them.
And that’s where the move into multifamily can be huge or into triple net commercial properties where you go from active to passive and the 1031 Exchange lets you do that. You and I were talking about Delaware statutory trusts, which you’re part of your toolkit that you offer to investors. Those Delaware statutory trusts can be handled with a 1031 Exchange and they do the exact same thing. They move you from an active position into a passive position. Now, as people start to get closer to retirement, someone may be an investor in Brooklyn and they want to retire in Florida, or maybe ahead of time they will sell their northern New Jersey or New York portfolio and invest in Sarasota When they retire, guess what? Their entire portfolio awaits them and they did it without having to pay tax on the transition.
And I think you mentioned, I mean three of the four Ds were deferred. And I think people do ask that question of like, well, if I’m going to have to pay it at some point, why does it even matter? And I’ve seen different analyses on the power of deferral, and it doesn’t matter if it’s real estate or any other type of asset. If you’re able to defer paying tax on it, there is a numerical mathematical benefit. You’ll simply have more money at the end of it, even if you’re paying tax at the end of it, just from that ability to defer. So there is definitely a definitive benefit to being able to defer.
Yeah, this is where I love real estate and why I chose it was because any other industry, any other business I could start, there was no off ramp that kept the tax at bay for that long to get the real benefit of compounding it. So that’s why we chose real estate.
I know that there are a lot of moving parts to a 1031 Exchange. Can you walk us through the full process of how it works?
How a 1031 Exchange Works
Yeah, you’ve got to remember that this is a process where the IRS lost a massive court case in 1996. So now everyday investors can do these. So they were not happy, so they had to let us do it. They did not have to make it easy. So there are some very specific regulations and some of them seem kind of punitive. So the first key to remember is that your 1031 Exchange is going to start with the sale of your old property. You cannot touch the proceeds, you cannot do it yourself. You have to use the services of an unrelated party called the qualified intermediary whose only job is to process the 1031 Exchange for you. So they obviously have to be involved prior to the closing of your sale. So it starts with the sale. Now, from that date of closing, you have 45 more days simply to identify your potential replacements.
They don’t have to be under contract, but at the end of day 45, you are stuck with what’s on that list and can’t change it. So I usually tell people, you know what? Think of that 45 days as the, oh my gosh, I got to get it under contract period. And as a matter of fact, you can’t even go into contract on your new property before your old property closes. You simply have to close the sale before closing the purchase. So that 45 days is really critical. You have a total of 180 days to complete your purchase. That usually doesn’t feel so bad, but it’s the 45 that’ll get you.
Another key to the tip is that whoever is the taxpayer or the deeded holder for the old property has to be the taxpayer or the deeded holder for the new property. You can’t sell from an S corporation that may own a piece of real estate and then go buy new real estate in your name.
So that can take some advanced planning, particularly when you’re wanting to maximize your liability protections using LLCs and that kind of thing.
The final requirement is the reinvestment requirements. The IRS says that if you want to defer all tax, you have to do two things. First, you have to purchase at least as much as your net sale. Now that’s your contract price minus closing costs and commissions. So say you sold a property for $320,000 and there were $20,000 in closing costs and commissions. In order to defer tax, you have to purchase at least $300,000 in real estate. Now let’s say there was a $100,000 mortgage on that. So you have $200,000 in cash that goes into your intermediary’s account. You have to use all $200,000 of that to purchase $300,000 in real estate. Now, everybody wants to say, but wait a minute, I put $20,000 down on that property, or I spent $50,000 fixing it up. That’s not taxable, is it? It’s not. But when you’re doing the 1031 Exchange, here’s the nasty cram that the IRS sent you. They say that if you take $20,000 out from that sale, you are not taking your original capital. Now wait a minute, how can that be? I started with $20,000. They simply say no, if you’re going to take money out in a 1031, you’re always taking profit first.
So, in general – and this is perhaps the big drawback to a 1031 Exchange – people say, but I’ve always got to keep growing bigger or staying the same. When do I get some money? When do I get to enjoy it? And the answer’s really easy. It’s the additional cash flow. But even more important, if you want a big chunk of money, go ahead and purchase new property and then do a cash out refinance. The cash out refinance is not a taxable event, and our investors will use that quite a lot If the equity market is speaking to them, well, they could sell a piece of real estate, but then they got to pay the tax or they could do the 1031 Exchange and then do a refinance of it and take that cash and go put it into equities. They kept their tax for only 1031, but they also got to invest in what they wanted. Those requirements all have to be met.
And is there a either pass or fail on the 1031 or is it possible that part of the transaction will be taxed everyone eligible and part you may owe taxes on?
So for the first five requirements, the requirement that it be investment real estate, the 45 180 days, the taxpayer or title holder requirement and the requirement to use the qualified intermediary, those are pass fail. The only one where it is possible to do a partial exchange is on the reinvestment. If you wanted to take $20,000 out, you can do that. You would only pay tax on the $20,000 and then whatever other profit would still be sheltered. I know
You mentioned selling Brooklyn brownstones to buy something in Sarasota… So there’s flexibility in the location. What about the type of property? What’s eligible for a 1031 Exchange and what’s not?
Any type of real estate, regardless of what it is, can be exchanged for any other type. So you can go from residential to commercial, single family to multifamily, raw land to industrial, doesn’t matter a bit as long as it is real estate that you purchased with the intent of holding for productive use. Now that implies without giving a specific holding period, that implies that your intent has been to hold the property. So most people feel comfortable at any hold period more than a year. But because there’s not a statutory holding period, there might be situations where it’s possible for you to sell a property that you’ve owned less than a year, as long as you can demonstrate that your intent when you bought it was to hold it.
And then I guess the reverse is probably true too. So let’s say I’m doing a flip where I don’t intend to hold, but the project lasts over a year. That’s something that wouldn’t be eligible. I didn’t intend to.
That is correct, because your intent was not to hold it. That’s exactly right. So really what kind of property doesn’t qualify? Fix it flips if you’re a builder. New construction, one of my favorite clients of all time sold a property in the Smoky Mountains after 90 days. And I challenged ’em on it because I was like, to make sure people are thinking right, they’re not just trying to get away with something because they can’t. And he said, Dave, I had to honor this contract for the renter in my purchase agreement in my closing, and it was a long-term contract. I said, well, okay, that’s great, Nate, but you’re still selling it, so how are you going to demonstrate that your intent was to hold it? He said, oh, no problem. We got the ring photographs of the bear. There was a bear that had taken up residence at the trash can in the house and the tenant no longer felt comfortable living there and taking the trash out. So they vacated the lease and he didn’t want to mess with a bear. So he said, I’m going to sell it to a 1031. And literally his accountant put those photographs in his file if he’s ever questioned.
What about mixed use property? Is there a hard exclusion if you use the property for personal use as well?
No, it’s not like a 401k or IRA where a personal benefit prohibits it. There is actually a safe harbor given in the IRS statutes – as long as you have rented the property for two weeks out of two consecutive years, and kept your usage to either the lesser of 14 days a year or 10% of the number of days it’s rented (but not counting any days you stay there while you’re working on it), the IRS guarantees that your intent is fine.
I always tell people to limit their use, but do use it. And secondly, when you do go to the property, take a paintbrush in a can of paint and spruce it up.
There’s another type of property that’s very similar to this called a house hack. We’re doing this with my sons and our younger relatives… We work with them to buy their first property, which is always a duplex. They live on one side, they rent the other side. The side that they’re renting is investment real estate. So when they sell the property down the road, they can do a 1031 Exchange for that part of the property and defer the tax.
But you know what the other half of that duplex is? They’re primary residence. So if they’ve lifted it for two out of the five years prior to selling it, then they get section 1 21 and they get the first, if they’re married, $500,000 in profit tax free. So by being willing to start with a duplex, they learn how to be a landlord. They set themselves up to get a chunk of money tax free and to defer all the rest of the profit in a 1031.
Now, let’s say they sold that duplex for $200,000. That’s a hundred thousand per side. The primary residence side’s all tax free on the other side. How much did they sell? A hundred thousand. So what do they need to buy a hundred thousand in investment real estate? Well, what if they bought another duplex for $200,000? The one F of the duplex satisfies the reinvestment requirements, doesn’t it? And they could use the other half in any way they want, and so they can take advantage of all kinds of things. So there’s a lot of ways in which mixed-use properties can boost your returns,
Makes sense. Alright, we’re just about out of time. Dave, I’d like to thank you for being on The Agent of Wealth. You gave some great information on 1031 exchanges and how they can be utilized. How best can someone reach out to you and find out more information?
I know that the 1031 Exchange can be confusing, so we created 1031 Investor to help educate people on them before they use them. You can find all of our resources at 1031investor.com.
Perfect, we’ll link to that in the show notes. Dave, thanks again and thank you to everyone who tuned in today. Don’t forget to follow The Agent of Wealth on the platform you listen from and leave us a review of the show. We are currently accepting new clients, if you’d like to schedule a 1-on-1 consultation with our advisors, please do so below.