Epic Real Estate Investing - Creative Financing: 1031 Exchange | 1031

Episode Date: May 27, 2020

If you own an investment property and you are planning on selling it and buying another property, you should definitely know about 1031 tax-deferred exchange! Therefore, in today’s 1031st episode, Matt goes through CWS Capital’s article, titled, 1031 Exchanges Explained: The Ultimate Guide, that comprehensively explains this form of creative financing. Tune in and find out more! Learn more about your ad choices. Visit megaphone.fm/adchoices

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Here's Matt. Hey there, Epic Investor. It's Matt Terrio from Epic Real Estate, where we show people how to invest in real estate with an emphasis on retiring early. This is the Epic Real Estate Investing Show. If it's your first time here, really glad that you found us. If you like what you hear, make sure you hit the subscribe button before you go. And if this is not your first time here, welcome back. And thank you for sharing this with your friends and family and associates. I love that about you. So thank you. All right. So today, it is episode 1,031, episode 1031 here at the epic show.

And so it just seemed fitting that we talk about the 1031 exchange. See how I did that? See what I did that? Uh-huh. So if you own investment property and are thinking about selling it and buying another property, you should know about the 1031 tax deferred exchange. It's a procedure that allows the owner of an investment property to sell the property and buy another property while deferring capital gains tax. So over here at Cashflow Savvy, we help our clients do this quite a bit. And I should actually say Mercedes helps our clients with 1031 exchanges quite a bit because I'm not involved in that part. but I don't think I've ever personally,

either Mercedes or myself, done one for ourselves. I don't think I've ever personally executed a 1031 exchange because I or we have never sold a property to where we're going to experience any sort of significant financial gains where it was worth the trouble. Because there's some steps to follow to be able to execute this. What I mean by that is we still own all of my good properties, all of our good properties that that we bought right and or have experienced significant appreciation.

We still own them. We don't sell, right? That's the, as if Warren Buffett says, his favorite holding period is forever. So we kind of adopt that. We never have the intention of selling. And the only ones that we do sell are kind of the ones that are losers or they're the headaches or, you know, whatever may be, just they haven't performed the way that we wanted them to. So we sell them and there's not a whole lot of gains there.

So there's not a whole lot of taxes to pay. pay if there's any. Now, there could be some situations on the horizon, however, where we're going to have to start considering it. I'm certainly going to have to start considering it as I've got a big focus right now in upgrading the ROI or the cash flow, I should say, on my portfolio, as well as the quality of my properties. Because what we've kind of found over the years, the better the quality. and this ain't this is not a steadfast always rule, but kind of a rule of thumb that we've discovered is the higher the quality of the property,

the easier it is to manage. But we've had some stinker tenants and some of our nice properties too. So that's why I say there are exceptions. But for the most part, that's the rule. And, you know, for example, as far as upgrading the cash flow, I had two condos in Oregon

that have pretty much been just flat. with regard to values since I purchased them. And together, collectively, they cash flowed about $1,600, which is not a great cash flow for that area. Or no, it's actually decent for the area. It's not a great cash flow for the country. Like, I can do a lot better in other places. But they're just kind of an easy acquisition.

And I was like, yeah, why not? Let's take them. So I owned them free and clear. And that was, I guess it was about six months ago. I was able to sell them and purchase four properties outright in St. Louis. So I sold the two properties in Oregon with $600 a month of cash flow and purchased four properties with the proceeds from those, purchased those outright in St. Louis. I own those free and clear with $3,500 in cash flow.

So I essentially doubled my cash flow with the same amount of money being deployed. and there wasn't a whole lot of capital gains there, so I didn't go through the 1031 exchange. Yeah, the rents that they're not great in Oregon, at least in the southern part. The job market isn't that great, and the jobs that are there don't pay too much. So it's really tough to push the rents here.

So I had to make some moves, right? Had to move the portfolio round. And so I was able to do that and more than double the cash flow. Anyway, the point being, I'm anticipating some opportunities to do that again, but by selling some properties that have appreciated, where there would be some capital gains if I didn't use a 1031 exchange.

So my antenna right now is up for the 1031 exchange, and I'm walking back and forth from my office into Mercedes. So how does this work again? How does that work again? And who do we need to do this? And so yesterday I conducted a Google search to give Mercedes ear a break and freshen up myself because I know the tax code, it changes frequently.

And I know things with IRS is self-directed and 1031s and your income tax, your state tax, your federal tax, the deductions you're allowed to take with real estate and business, that stuff is changing all the time. So I just wanted to see what's the current scoop, what's going on right now. And I came across an article on the website or on the internet on the website of CWS, K.W.S. Capital.com. CW.S.capital.com. And the article was titled, 1031 exchanges explained, the ultimate guide. Boy, was it ultimate. And by the way, I'm not affiliated with them in any way, but it's a pretty comprehensive explanation. If you want to look it up for yourself, 1031 exchanges explained. The ultimate guide is the name of the article. CWS capital.com is the website. And I'm just going to read from it loosely for you to share what I found in case you find yourself in a similar situation. And there's some other situations that you might be in that I'm not in, but it still might make sense for you. So what is a 1031 exchange?

Well, kind of answered already. But the answer to that question, it can be really complicated one. So it's kind of important just to start with the basics. So a 1031 exchange gets his name from section 1031 of the U.S. Internal Revenue Code, which allows you to avoid paying capital gains taxes when you sell an investment property and reinvest the proceeds from that sale within a certain time frame in a property or properties of like, kind, and equal or greater value. Okay, so that's the definition.

That's what it is. Now, to do this, it's highly recommended that you get an intermediary to execute this for you because there's a lot of things that you got to do. and you want to make sure you do it right because you can go through all this trouble and still have to pay the taxes at the end of the year if you did it wrong. So under Section 1031, any proceeds received from the sale of a property remain taxable. For that reason, proceeds from the sale must be transferred to a qualified intermediary rather than the seller of the property and the qualified intermediary transfers them to the seller of the replacement

property or properties. So a qualified intermediary, it's a person or company that agrees to facilitate. facilitate the 1031 exchange by holding the funds involved in the transaction until they can be transferred to the seller of the replacement property. The qualified intermediary can have no other formal relationship with the parties exchanging property. So there has to be somebody in the middle. That's what we call a qualified intermediary. So when would you want to do a 1031 exchange? So I kind of shared my reason for doing it, right?

And that's actually bullet point number one for them here. As an investor, there are a number of reasons why you would consider utilizing a 1031 exchange. And some of those reasons include, ding, ding, ding, I'm number one right here. You may be seeking a property that has better return prospects or may wish to diversify assets. So that's a really good reason. And it's probably one of the most popular reasons because that's number one. But there's some other good ones here. second one is if you are the owner of investment real estate, you might be looking for a managed

property rather than managing one yourself. Third is you might want to consolidate several properties into one for purposes of estate planning, for example, or you might want to divide a single property into several assets. So it all depends on your goals there for estate planning purposes. And then this one here, which I really like this one. I just haven't owned a property I guess I'm getting to that point where it will make sense very soon, and that's probably why I'm interested in it. But to reset the depreciation clock, which is a very creative idea that I hadn't thought about until recently.

And so this one I really, really like to reset the depreciation clock, and I'll talk about that in a second. The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange, it allows you to defer capital gains tax, thus freeing more capital for investment, in the replacement property.

So you can buy more property before you have to pay Uncle Sam, right? So that's a good thing about it. So the depreciation, let's talk about that and why that is important. Depreciation is one of the big benefits of owning real estate. It's an essential concept for understanding the true benefits of a 1031 exchange. So depreciation is the percentage of the cost of an investment property that is written off every year, recognizing the effects of wear and tear. So when a property is sold,

capital gains taxes are calculated based on the property's net adjusted basis, which reflects the property's original purchase price, plus capital improvements minus depreciation. So if a property sells for more than its depreciated value, you may have to recapture that depreciation. It all depends. Talk to your CPA. But that means the amount of depreciation

will be included in your taxable income from the sale of the property. So what they're saying here is if you buy a property and you hold on to it and you get all the tax benefits from it, particularly the depreciation, when you sell that property, you may have to claim all that depreciation you took as income and then be taxed on it. So that's where they say Uncle Sam will come along and recapture the depreciation. Now, since the size of the depreciation recaptured increases with time, you may be motivated to engage in a 1031 exchange to avoid the large increases in taxable income

that depreciation recapture would cause later on. So depreciation recapture will be a factor to account for when calculating the value of any 1031 exchange transaction. When they're saying they're calculating, because there's some costs involved, not big costs, but there's some time, there's some energy involved, some effort, you're going to have to burn some calories to make this happen.

Not a lot, right? But this is why I haven't done it in the past because it just didn't seem like it was worth it. Like there wasn't that many much gains for me to, for it to come into play. But with maximizing your depreciation, then when you sell that, if you have to claim that as income, that could be a huge tax burden, right? Now that I'm thinking about this, I have to check with my CPA. Because you don't have to take that depreciation. I don't believe.

You don't have to take that in, they give it to you for 27 and a half years. I don't know where the half came from. I'm sure there's a reason for it. But 27 and a half years, you can take that annual depreciation on your taxes. And I think there's a way to accelerate that and take a bunch of it.

I'm not sure. You have to check your CPA, like I said. But this has got me thinking. You can accelerate that depreciation to where you can do it in, less years in fewer years. I don't even know if you could do it all in one or not, I'm not sure. But then if you did a 1031 exchange into another property,

you might be able to do it all over again. That would be creative, right? That would be really creative. So check with your CPA, see if you can do that. All right. So choosing a replacement property, the timing and the rules. So like kind property is what's involved with the 1031. And that is defined according to its nature or characteristics,

not its quality or grade. It's a big question people have. Can I exchange for this? Can I exchange for that? Does it count this? Does it count? What this means is there's a broad range of exchangeable properties. And it just has to be real estate.

It doesn't have to be anything specific about the real estate. For example, vacant land can be exchanged for a commercial building or industrial property can be exchanged for residential. But you can't exchange real estate. say for collectibles like artwork, since that does not meet the definition of like kind. So like kind really just means real estate for real estate. And the property must be held for an investment, however. It can't be your primary residence.

And it can't be for person. You can't have this property for personal use. So it has to be an investment property. And then the time frame is it usually implies you have to hold on to this or have owned the property for a minimum of two years. Usually. I don't know what they mean by usually. But I've heard the number always two years,

but it sounds like there's even a loophole there to some degree. So consult your CPA. All right. So to receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value. You must identify a replacement property for the assets sold within 45 days and then conclude the exchange within 180 days. Now, this is what we hear around the office all the time.

People are ready to sell a property and they come to us, I need a property. I need to identify a property. really quickly in the next 45 days because they're doing the 1031 exchange. So they have to, they have a limited time, a small little window

where to find that next property. And a turnkey provider can be a great resource for that because they've got properties ready and available. And then you have to complete the sale. Once you've identified it, and you just have to complete the sale within 180 days within the six months.

So there are three rules that can be applied to define identification. You need to meet one of the following. Okay, there's the three property rules. which allows you to identify up to three properties as potential purchases, regardless of their market value. Then there's the 200% rule, which allows you to identify unlimited replacement properties

as long as their cumulative value doesn't exceed 200% of the value of the property sold. And there's the 95% rule, which allows you to identify as many properties as you like, as long as you acquire properties value at 95% of their total or more. All right. So those are the three Identify Rules. And you have to do that within 45 days once you decided you're going to do a 1031 exchange. I think it's 45, yeah, it's 45 days from the sale of your property.

All right. So there are a number of possibilities for making the 1031 exchanges that vary in their timing and other details, each creating a set of requirements and procedures that have to be followed. 1031 exchanges carried out within 180 days or commonly referred to as delayed exchanges, since at one time exchanges had to be performed simultaneously. All right. So those guidelines have loosened up over the years. So the 1031 exchange timeline.

It looks like this. Step one. Sale date. Complete the sale of property one. Okay. Next, get a qualified intermediary involved to accept the proceeds of the sale. So you can't take possession of those proceeds. They have to go to the intermediary.

Step two, within 45 days of that sale date, you have to identify, your replacement property. Then the qualified intermediary transfers proceed funds from sale to seller of replacement. So the intermediary is going to be handling your funds that you made and then the funds that you're going to reinvest in the next property. Then step three, within 180 days of the sale, you have to complete the purchase of replacement property.

All right. So there's a few different types of exchanges. actually there's several. I'm not going to go through them all. But this is why you need that third party intermediary. Let's see. Built to suit exchanges allow the replacement property in 1031 exchange to be renovated or newly constructed.

However, these types of exchanges are still subject to the 180-day time rule, meaning all improvements and construction must be finished by the time the transaction is complete. Any improvements made afterward are considered personal property and won't qualify as part of the exchange. All right, so even if you're going to fix it up, before you close on it,

then that still is subject to the 180-day rule. Okay. And then this is the one here. If you acquire the replacement property, this is a good one. You may have heard of this before, and this is pretty creative. It's called a reverse exchange,

another creative financing strategy. So if you acquire the replacement property before selling the property to be exchanged, that's a reverse exchange. So in this case, the property must be transferred to an exchange accommodation title holder which can be the qualified intermediary,

and a qualified exchange accommodation agreement must be signed. Within 45 days of the transfer of the property, a property for exchange must be identified, and a transaction must be carried out within 180 days. So the time frame is the same, 45 days to identify, 180 days to complete, but it doesn't matter which one is sold first, or which one is purchased,

which transaction is completed first. So you could sell your property, and then go identify the next property, or you could buy the next property and then go back and sell your original property. Okay? Let's see. Timeline of Reverse 1031 Exchange.

Looks like it's the same. Step one, purchase replacement property. Step two within 45 days. Identify the next property to sell. Yeah, I kind of said that already. Step three, within 108 days, complete the sale. But in both scenarios, you have to have that third party

intermediary involved. Okay? Now, don't get the boot while you're replacing your property is the headline in this next section. So like kind properties and exchange must be of similar value. So the difference in value between a property and the one being exchanged is called boot. So if a replacement property is of lesser value than the property sold, the difference cash boot is taxable. Right? So you can't exchange, take your property and buy one of lesser value and escape the taxes.

no, you're going to have to pay taxes on that difference of the lesser value, and that difference is called boot. All right. The presence of a mortgage is permissible on either side of the exchange. If the mortgage on the replacement is less than the mortgage on the property being sold, the difference is treated like a boot. And then the fact needs to be considered when calculating the parameters of the exchange. All right, so here's some good news.

Because if you're just exchanging one property for another and you're kind of really close, you can actually take some of the... the expenses and fees that impact the value of the transaction, therefore the potential boot as well. So some expenses can be paid with your exchange funds like the broker's commission, the qualified intermediary fees, the filing fees, related attorney's fees, title insurance premiums, related tax advisor fees, finders fees, escrow fees. You see that finder's fees.

How could you get creative with the finder's fees? Just something to think about. Escrow fees. Expenses that cannot be paid with exchanging funds include financing fees, property taxes, repair or maintenance costs or insurance premiums. But interesting that finder's fees can be paid. It doesn't say what the limit is. I guess that's why you have to call and discuss the third party intermediary. But you could get created with that.

Almost sounds like a wholesale fee, doesn't it? Yeah, it does. Kind of a little bit. All right. So let's see. One of the major benefits, let's see. We've got exchanging partners drop and swap 1031 exchanges. So this is when partners of an LLC want to do a 1031 exchange,

but some of the partners in the LLC don't want to do that. So there's some specific guidelines for that. Then tendency and common property exchanges where there's more than one person involved. There's guidelines for that. I'm not going to go through that because I don't think they're universally applicable. But you can talk to your 1031 intermediary, and I'll explain how that works if that's your situation. Now here's a really good one.

And I'm really kind of like surprised that my mom, I don't know if she figured this out. But she did something pretty cool. Because I'm actually in Oregon right now. It's the one year anniversary passing of my mother. And we had these plans for her this weekend and just another memorial for her, just with a group of friends and family members. But obviously with the coronavirus, I put a halt to those types of gatherings.

So I just drove up to her house and I'm in her house right now. Actually, in her closet. Just like the good old days of when I originally started recording the podcast in the closet. You know why you record in the closet? Because the clothes, they suck up. Suck up or soak up. So, you get a better sound quality in a closet. Just in case you ever wondered.

But what my mom did was this. She 1031 exchanged some properties into a new property. Because one of the major benefits of participating in 1031 exchange is that you can actually take that tax. deferment with you to the grave. So if your heirs inherit property, like I inherited this house, received through a 1031 exchange, its value is stepped up to fair market, which wipes out the tax deferment debt.

So if I ever sell this property, I don't have to pay that tax that she was able to defer through the 1031 exchange. So this means that if you die without having sold the property obtained through a 1031 exchange, the errors, your errors, receive it at the stepped up market rate value and all deferred taxes are erased. And estate planner should be consulted to take maximum advantage of this opportunity. And tenancy in common can be used to structure assets in accordance with your wishes for their distribution after death. All right. So just part of the estate planning practice

a good strategy there. If you want to leave your kids something and you keep on 1031ing all of your property because you're living off the cash flow. And then when you go on to the bigger, better place, and they are left with the property. You get to take your tax deferment with you, and they are left with those properties at the stepped-up market value. Pretty sweet. So 1031 exchange expertise, here we go. The tax deferment provided by a 1031 exchange

is a wonderful opportunity for investors, as we've discussed here. Although it is complex at points, these complexities allow for a great deal of flexibility. This is not a procedure for an investor acting alone. Competent professional assistance is needed at practically, every step. So CWS Capital Partners, they've got experience managing the entire 1031 exchange process and can work with you to provide replacement assets when you need them.

So go to CWScapital.com. If you'd like to contact them, I'll go ahead. I'll give them the free plug here as a thank you in advance for allowing me to share their expertise here with you. I guess your SEO work has its privileges as you ended up on the first page. and the first one that I clicked seemed to be a very nicely laid out comprehensive way

to do the 1031 exchange. And so this is not an endorsement. I don't know them. I have never met them. But they do seem like they've got their acts together. Regardless, you should be smarter and more aware and experienced already about the 1031 exchange. And you can reach out to cWScapital.com

or if you already have one, then take this information to your guy or girl and make sure that they're doing all of this for you too. Ready? So if you found this episode valuable, who else do you know? That might. There's a good chance that you do know somebody else who would. And when their name comes to mind, share it with them and ask them to click the subscribe button when they get here. I'll take great care of them. All righty, so that's it for today. God loves you and so do I. Health, peace, blessings, and success to you. I'm Matt Terrio. Live in the dream. Take care. Yeah, yeah, we got the cash flow. Yeah, yeah, we got the cash flow.

Yeah, yeah, we got the cash flow. You didn't know whom. world we got to dash low. This podcast is a part of the C-suite radio network. For more top business podcasts, visit c-sweetradio.com.