161 – What You Don’t Know About The 1031 Exchange with Dave Foster

Synopsis

Dave is a real estate investor from St. Petersburg, Florida. About 25 years ago, he discovered the 1031 tax-deferred exchange that allowed him to sell investment real estate and buy investment real estate without paying tax on the profit. In this episode, Dave reveals things about the 1031 Exchange most of us don’t know about including advanced strategies to benefit from it.

Key points

What Is A 1031 Exchange

It is part of the U.S. tax code. Changes in 1996 turned this into something that benefits real estate investors. By using the services of a qualified intermediary, a person can sell a piece of real estate, follow a few steps and the documentation needed, then purchase a new investment real estate to replace what was sold. If the process is followed correctly, you won’t have to pay taxes on the profit.

Without a 1031 Exchange, a California investor making a gain of $100,000 could end up paying 30-40% in taxes. The 1031 Exchange instead lets you take that $40,000 in tax to invest for your own benefit.

It gives investors the ability to keep their money working for them as long as they keep doing a 1031 Exchange every time they sell their property and buy a new one to replace that.

The portfolio can be passed on to the next generation who can keep deferring from paying taxes.

The Timeline For Exchanges

There are six requirements that have to be met. Timing is the most critical.

From the day of the sale of your property, you have 45 days to identify your potential replacement properties.

You should be shopping before you even close the sale on your property to ensure you have a good list.

You have 180 days to complete the process. There are almost no exceptions to this unless there’s a national emergency. If the President declares a national emergency, then the IRS might give an extension to the date of filings.

When The Deal Falls Through

If a property deal you were eyeing falls through, you have to name another property before day 45.

You can only buy the properties on the list you submitted.

Other Requirements

When doing the exchange, the same entity or taxpayer selling the property should be the same one buying the new property.

Anyone can do an exchange whether you’re an individual, trust, or LLC. But the owner has to be consistent.

Whether the deed is in the name of the owner or the LLC, all the IRS wants is for the tax returns to be under the same taxpayer.

In order to defer all taxes, you must purchase property that is as much as your net sale.

For example, if you sold a property for $530,000 and paid off $30,000 in commissions, your net sale is $500,000. Let’s say you have $200,000 in the mortgage. After paying that off, you are left with $300,000 in your exchange account which you must use to purchase at least $500,000 in real estate. It could be one property or a number of properties.

You don’t have to replace the mortgage. You are allowed to come up with backup funds from wherever you want.

The most important is that you purchase a property at least as much as your net sale and use all of your proceeds from that sale.

Buying the New Property Through A Syndication

Syndications are mostly set up as general or limited partnerships. Based on the rules, you cannot sell a piece of real estate and use the proceeds to buy membership into syndication.

But if the syndication is set up in a way that allows you to purchase a tenant and common interest in the real estate itself then you will be allowed to do a 1031 Exchange.

Tenancy in common is much more flexible than buying a property through an LLC because the LLC is the taxpayer and the partners are going to be stuck forever if they want to keep doing exchanges.

Tenants in common always specify the percent of interest each is getting from the real estate.

Documentation By A Qualified Intermediary

An Exchange Accommodator is required as they will walk you through the process to make sure you’re doing it right. They need to be involved prior to the sale of the first property.

While a lot of people call an intermediary at the last minute of the closing, it’s beneficial for you to start talking to one once you start contemplating selling your property.

There are strategic options you can explore if you have the time such as moving to a state with lighter taxes, a shift from commercial to residential, etc.

You could lose out on an exchange because you didn’t know where or what to look for in the next property you will purchase.

However, there is no penalty for starting a 1031 Exchange and not finishing it.

The Costs Of A 1031 Exchange

A full-service qualified intermediary will cost between $750-1,200 for a complete exchange.

How Depreciation Recapture Works

When you sell a property, the IRS is going to make you pay 25% of the value of the depreciation on that property whether you took it or not.

But gain and depreciation recapture are both deferred by the 1031 Exchange.

So it’s best to just roll that depreciation into the new property which could result in the new property not getting any more depreciation or it could be starting a new depreciation schedule.

Who Shouldn’t Do 1031 Exchanges

The rule is that the property has to be real estate that you have the intent to hold for productive use in business trade or investment.

This implies a long-term investor or cash flow investor. There’s no statutory holding period and there’s no requirement to generate income.

So 1031 Exchanges are not for people doing fix and flips.

Offering the property for rent, having a renter, or filing two consecutive tax returns on the property are some ways to prove that you have the intent to hold on to it.

Rather than doing fix and flips, Dave suggests buying a property, doing rehab on it, and renting it out. Now, when you’re itching to buy another one, you could do a refinance on that property and use that to purchase a new one.

The refinance is tax-free and years down the road, you can sell that property and do a 1031 Exchange.

Holding on to that property up to a year and a day turns it from short-term to long-term. Also, the property gets reported on two consecutive tax returns.

But everything boils down to the facts of a case and being able to demonstrate that you meant to hold on to that property.

Advanced 1031 Exchange Strategies

Dave shared how they were able to turn 1031 Exchange dollars into a boat he lived on for 12 years.

First, they did a series of conversions and did 1031 Exchanges to buy investment properties. After a year or two, they moved into the property to convert it into a primary residence.

Prior to 2008, if you move into a converted property, you can get 100% of the primary residence inclusion.

So if you sell a property that you lived in 2 out of the previous 5 years, you can take the first $500,000 of profit, tax-free.

This way they’ll get all of the profit including the 1031 Exchange tax-free and they’ll roll that forward into the next property.

Dave did that until he and his wife were able to get the boat.

While that can no longer be done completely today, you can still gain a portion by pro-rating the tax-free gain between the periods you lived in it and when it was used as a rental.

Last Tips

If you’re passionate about real estate, do it and do it now. Only explore and do what you’re passionate about.

If you’re not doing what you’re passionate about, you will suck at it.

Resources

References

• 1031 Exchange

More from our guest

• You can reach out to Dave and find out more about 1031 Exchanges at www.the1031investor.com.
• Get $50 off your first exchange by going to www.the1031investor.com/podcast