Defer Taxes Till You Die! 1031 Exchanges

[00:00:00] Mike: Welcome to this episode of the Hidden Money Podcast where Kevin and I are excited to have the one, the only Dave Foster, a man who literally wrote the book on 1031 like-kind exchanges. Dave, we are grateful to have you here. We want to unpeel some of the hidden money that exists in IRC 1031, and what we most commonly know as like-kind exchanges.

Welcome Dave.

Dave Foster: Hey, thank you so much. It's great to be here. And I really do appreciate that introduction because the one and only Dave Foster, if you ask my children is one too many. So, I appreciate the sentiment.

Mike: Well, I can't help you with your children, but I can tell you, and anyone else listening, Dave has helped some of our clients save incredible amounts of money, utilizing 1031s.

Not all 1031 Qualified Intermediaries are the same, and we'll learn what that term means here in a minute, but there's a lot of cool things you can do if you get more complicated with the 1031 rules, and not a lot of people know how to navigate that.

Kevin and I only know the basics. We need an expert in 1031s to help our clients navigate these things, and Dave has been a great partner with us.

Dave Foster: Appreciate that. A mentor of mine, a long time ago, challenged me to stop thinking about the tax code as a way that the government uses to get your money, which we all agree it is, but he said, "Think of the tax code as a behavior incentivizer. And if you perform the behaviors the way the IRS wants you to, then they reward you with less taxes."

And that goes right into what we were talking about at the beginning, that hidden money that exists in the tax code. If you're just willing to dig it out and 1031 exchanges are right there.

Kevin: Yeah, and this is a very niche part of the tax code because there's a lot of pitfalls, and I've had clients fall into these pitfalls because they didn't have a good QI, or an intermediary networking this deal with them. Instead, they might buy a property that's lower in value, and all these kinds of nuances in the tax code, which we can kind of get into a little bit of those details, Dave.

But for, I guess, our broad audience here, can you just explain the benefits of a 1031? When do we use one, and why should I?

Dave Foster: Yeah, absolutely. As a matter of fact, that really feeds into this whole pitfall thing, because the history of 1031 exchanges, it exists in the code to allow investors to sell investment real estate, and then buy new investment real estate.

And if you follow the process appropriately, you get to, [00:03:00] indefinitely, defer paying all of the tax on the gain and on any depreciation that you might have had to recapture.

Instead of paying that to the government as tax, you get to use it for your own benefit, and make the money off of it. So, it's a way to let you take tax, and instead of paying it, you get to compound the earnings for yourself. So, I mean, it's a hugely powerful thing for anybody who's selling real estate that has a profit.

Now, it started out when our nation was in the transition, becoming a national industrial center, and we were coming out of World War I, going into World War II. Our country was hungry, and the family farm was the staple of that.

Well, the problem was that, with the tax code the way it was, farmers could not sell their farms and go buy bigger farms to feed our country because of the tax they had to pay on the profit. They couldn't afford it.

Which also meant that a whole generation of young farmers couldn't get into farming because the older farmers weren't selling their farms. So, our nation's agribusiness was stymied, and that's when they put Section 1031 into the code specifically to try and do that.

 So, that's what it is put in a nutshell, Kevin. That's all it is, is you get to take the tax and use it for your benefit when you're selling and buying investment real estate,

Mike: I'm just going to point out that what you mentioned right there, the deferral of tax, and then you, kind of, got into the time value of money and the power of compounding, that's the entire point of our podcast and hidden money. Like Dave says, the tax code is a code filled with incentives that our society has agreed, help our economy, and help our nation out, and if you follow these incentives, it will pay you. It will pay well to do.

Any time you can save taxes today and invest those savings so that they grow in the future, that grows your financial freedom faster. It can have a snowball effect, and 1031s are just an awesome opportunity for those that can utilize it to defer those taxes and grow their financial freedom.

Hidden money.

Dave Foster: Here's a real painful example. My very first real estate transaction, 1996, I bought a piece of property because we wanted to become real estate investors. We bought a piece of property, fixed it up, put a renter in it, sold it.

I thought it did great until my accountant told me that I had a $30,000 tax bill. Now, that's almost 30 years ago. If I would have been allowed to keep that $10,000, and making 10%, which is pretty easy [00:06:00] for the estate investor to do, I would have been able to have doubled that five times over. So, take $30,000, double it, double it, double it, double it, double it.

And that tells you how much money I left on the table because of that compounding effect. What's that dollar worth in my pocket right now? 30 years from now? And that's when I became a 1031 fan.

Kevin: That's a good point. And you've got to have your eye on the bigger prize, and that you eventually pay your tax at some point, unless you die, which we can get into as well. It's a little morbid tax plan, but there are ways to eliminate taxes.

Mike: It works really well.

Kevin: It works very well.

Dave Foster: It's 100% guaranteed.

Kevin: It's 100% guaranteed.

Yeah, it's just a little sadness involved. But yeah, deferring taxes in the future, you are going to pay the tax on it, and we can kind of get into how that happens, but to your point, if you can 5x your $10,000, yeah, you're going to pay that $10,000 at some point, but I'm going to pay it in tomorrow's dollars with inflation.

I've already grown my money 5x. I don't care if I pay the government $10,000. I've already won.

Dave Foster: Well, you're exactly right. And I actually call that the 'First D' of 1031 investing. Now, I'm going to challenge you though, Kevin, because I think I can show you several different ways where you don't ever have to pay that tax.

But you're right. That first pillar is to start deferring, because whether it's two years or whether it's 30 years, every day, every year that that tax is in your pocket, you're making the money off of it. So, why not?

Now, that would take me into the second pillar, which is the 'Second D' of 1031 investing, and that is for your listeners out there. They need to understand that 1031 exchanges will work no matter what part of the real estate cycle the market is in, because you can exchange any type of real estate for any other type of real estate. And you can exchange real estate anywhere in the country that you want.

So, are we in the early parts of a real estate cycle where a single family investing is huge? You start to let the profits build up on those, and then, you sell one, buy two.

Are we in a time of the real estate market where San Francisco is appreciated like crazy, but Austin, Texas, is dirt cheap? So, we do what a lot of my clients did. We sell in San Francisco, and use the 1031 exchange to go invest in Austin. Those folks haven't done so badly, have they? Because they recognized where the market was and what it was doing.

There's a time to go from fewer to greater numbers of properties. There's a time of the [00:09:00] cycle to go from appreciation to cashflow, or to go to commercial. Whatever it is, wherever you're at in that real estate cycle, the 1031 exchange can be used to accommodate that and keep your tax deferred.

So, the 'Third D' is also, you can guess, defer, because just like the 1031 exchange can accommodate where the real estate market is, the 1031 exchange can accommodate wherever you're at in your personal journey.

We'd like to end up moving from active into passive investing because we can do passive investing for a much longer period of time. Well, the 1031 exchange allows you to do that. So, instead of paying the tax at some point in time, you just keep it going against that final eventuality. But there's some other ways that it could be used as well.

When we started having children, we began to buy vacation rentals, and moved from long-term rentals into short-term rentals because we could also go and stay in those. So, right away, we were starting to save money because we were paying zero for our vacations, but we also still had the tax deferred in the 1031 exchanges. So, we're still making our money on the deferred tax. We're making memories as a family. We're saving money on vacations. Kind of a big win, win, win.

And here's where we get to the really, the biggest, what I think, is bonus in the 1031 exchange, short of dying. And that is, that the 1031 exchange is investment property for investment property, but it does not have to stay investment property forever.

So, what if instead of retiring and buying a beach house somewhere, I simply moved into one of my vacation rentals and converted it into my primary residence?

Again, as long as I live in it, I'm never going to pay the tax. But if I have owned it for 5 years, if I have lived in it for at least 2 out of the previous 5 years, then I can sell that property at any time, and I get to take a proration of that gain, tax-free, between the number of years it was rented, and the number of years that I lived in it.

So, part of your answer, Kevin, is there's a 'forever' situation right there. I've got a client that did that with three condos at St. Pete Beach. Three identical condos, same floor.

He bought one on his 1031 exchange. He rented it for 2 years. Then he moved [00:12:00] into it and lived in it for 3. So, he owned it for 5 years. He'd lived in it for 3 out of the 5. So, when he sold it, 60% of that deferred gain went from tax-deferred to tax-free.

That's how you eliminate the gain while you're still alive. And where do you think he moved?

Kevin: To the next condo?

Dave Foster: The same thing over and over again.

Mike: Every three years.

Dave Foster: So, it really is possible to not have to pay that tax as long as you live, to end up getting some of it tax-free, and leave it a great legacy to your heirs.

Mike: I want to talk about an example that I experienced with one of my clients, that goes into that. I remember in college, we talked about this concept of 1031s, 'Defer, defer, defer, then die.’ and it was a cool theory, but I had never actually seen it.

One of my first clients, like the first 5 or 6 clients I had when I started my own firm 15 years ago, came in, and it was the son who had just inherited a bunch of properties. We looked at it. His dad had bought properties, and done half a dozen 1031s on each and every property as it continued to cycle through, and never paid tax, and his dad was not a rich man, or at least you wouldn't consider him rich.

He was a postal worker, but he had bought a dozen or 11 properties over his life using 1031, using the tax deferral to never pay tax as he grew, and he died with these, I think, 11 properties. When he died, those properties that had all that deferred gain got a step-up in basis.

And I remember, when this client, the son, had come into my office, he's like, "I think I have a big tax problem. I don't know anything about this. Help me figure this out." and we started unwinding it, and a few hours later, I realized his dad is under the estate tax threshold, so there was no estate tax. He got a step-up in basis, and the son didn't want to keep the properties.

He wanted to sell them. He got to sell all of them, get all that profit, and not pay a dollar in tax. So, it is true. This does happen. Granted, you have to die, and like we mentioned, that's morbid. We don't want to think about it, but if you do die in this situation, you have permanently deferred taxes, and this guy got something like four and a half million dollars tax-free from his father, who just barely scraped by as a postal worker and utilized the power and the leverage of 1031 exchanges, to leave his son a heck of a nest egg.

Dave Foster: Absolutely.

Kevin: I love that example you gave, Dave, because you're, kind of, marrying two different tax laws. You’re marrying the 1031, you're marrying Section 121 with the Homeowner Exclusion. It takes intentionality. It takes patience. 

The 1031 exchange requires planning and [00:15:00] being intentional, and being able to let that tax saving breathe a little bit so you can defer it, and then, like you mentioned, eliminate it with the 121 Homeowner Exclusion, or keep 1031-ing it until you die and it goes to your heirs. So, this is a very good strategy.

And to peel back what 121 is, and Dave kind of hinted at it, if you live there 2 of 5 years, any primary residence, your main household, if you live there for 2 of 5 years, and you sell that property, if you're single or married, filing separate, you're going to get a $250,000 gain relief. You can eliminate up to $250,000 a gain. If you're married, it's double, it's $500,000.

So, that's what we're talking about with the Homeowner Exclusion. And we're, kind of, marrying those two ideas. It just takes a little bit of creativeness and patience and just being intentional. You won't fall into a 1031 exchange;

there's too many hurdles. So Dave, can you speak to the qualifications and hurdles that you run into when you're trying to do a 1031?

Dave Foster: Yeah, absolutely. It's all in the details of how you perform them because the IRS is going to require absolute conformity to every part of the 1031 process. You don't get to say, "Whoopsie! We forgot this date." It's all or nothing.

And it starts with the fact that the IRS is very paranoid, as you can imagine, and so, they do not let you touch the money from your sale, because they think there's too much opportunity for you to go off and do whatever you want with it.

So, the money has to be held by an unrelated third party called the Qualified Intermediary. Now, because you can't touch the money, that means that the Qualified Intermediary has to be in place prior to the closing of the sale of your real estate, because if you close, even if you leave the money at the title company, it's still under your control, and so, you can't do a 1031.

So, right there, that just shuts the door on a whole lot of people, because I get the calls every month of, "Dave, I just sold my property last week. I want to do a 1031 exchange." Sorry, that ship has sailed. You can't.

Now, because the 1031 exchange starts with the closing of your sale, you've got to think of it almost in reverse. So, I always tell people, think of the 1031 starting with the sale of your real estate. From that date, there's two very, very rigid timing requirements.

The first is you only have 45 more days to identify your replacement properties. They have to go on a written list. So, you've got to use a cue how to hold the money. You only have 45 days.

Well, now the IRS says you got to keep that list [00:18:00] to three or fewer, unless you meet some very rigid parameters if you need to identify four or more. So, that 45 day period, that's really the killer for most 1031 exchanges, and I tell people the best way to get around that is to take care of the hard thing first.

If the hard thing is finding your new property, then do that first. Get it under your contract before you sell your old property. All that matters is you have to close your sale before you take title to the purchase, but you can be under contract for it. Use contingencies, use additional earnest money, use a lease option, whatever it is, if that's the hard thing to do, get that new property wrapped up first, but don't take title to it. That's how you get around the 45 days.

Now, the second time requirement is you only have 180 days from the date of the sale to take title to your new property. Now, that's not so bad, unless you're using one of the greatest applications of 1031, in my mind, which is to move from properties that are older with more capital expense exposure for repairs and stuff, into new construction, because you might go into contract for a new construction, but it's not going to be ready for six months.

Well, you've got to take title to it within 180 days of when you close your sale. So, if you're working with a builder like that, you got to really make sure that you can guarantee they're going to have it done.

Those are really the biggest pitfalls, if you will, that are out there, and how you can solve them. One of the things that causes some people difficulty is that the taxpayer for the old property has to be the taxpayer for the new property.

And Mike, we've dealt with that several times, haven't we, where there's entering LLCs, and partnerships, and that kind of thing? You just have to unravel it.

Mike: I want to just review from our experience where we've seen clients fail in their 1031s, or we've seen clients have ugly surprises in their 1031s. Kevin and I have seen a lot of it. 9 times out of 10, it's generally because either they did not find a Qualified Intermediary before they sold, or they found a really cheap one that was not helpful and did not explain the rules.

You've got to have the QI before you do the sale. Talk to them. Make sure they know what they're doing and can walk you through what you're trying to accomplish.

No: 2, where we see people get in trouble a lot of times, is when they got debt paid down, and then, their new property, they had less debt. So, there's something called 'boot' in 1031. [00:21:00] Generally, that's after you've done your exchange and bought your replacement property, if you have cash leftover, you're going to pay tax on that cash, if you don't use it in the 1031.

But the IRS also says if you compare the debt that you had before you did the 1031, to the debt that you had after the 1031, if it's smaller, you've basically paid down debt and whatever that decrease is, is considered boot, and that's also taxable. Even if you didn't get any cash out of it, if you got a reduction in liabilities, you're going to pay tax on that.

And Kevin, we did have a client, a great client, that had a great idea to defer a bunch of taxes a year or so ago. You blessed their plans, but they changed those plans just a little bit before they came in.

Can you kind of walk us through what happened there?

Kevin: Yeah. They sent me some analysis, and this is very smart for anybody who's going through a 1031, to check with the CPA first. Get with someone like Dave to help mediate and walk you through everything, but at CPA, we know your tax basis. We know your accounting.

When this specific client came to us, they said, "We're selling this property." And I knew which property it was. It was on their tax return. I had their tax basis at the depreciation schedule and everything I needed. They said, "Here's our budget for the new property," and I was like, "Cool.

All right. Yep. Everything shakes out. You're moving up in property. It's like-kind property. Everything's good here." Get to tax time, those facts didn't end up that way, and we're talking millions of dollars, and they ended up going down in property.

They took some cash home with them. It was a mix of everything, and so, they thought they were getting away with taking some cash, and doing all that, and I walked them through the rules of this, but they also did not have a QI who was walking them, alongside with them, and so, no one caught it.

The QI, I think they were just transactional-based. They're like, "Yep, this is the property you're selling. Here's the property you're getting. Let's just get this thing closed. I'm going to collect my $1,500 fee, and we're going to move on."

Not even taking a step back and advising them saying, "Hey, you're going down in property. You're paying off some debt. That's taxable benefit to you. You're moving down. You can't do that."

And it was heartbreaking for them on the end when I had to be the bad guy, and it wasn't necessarily my fault. It puts me in this awkward position, and yeah, I have to deliver the news when I had nothing to do with the transaction, wasn't even involved in the process after my initial consultation with them.

So, if your plans change, get with the CPA first. Walk through your depreciation schedule, walk through your target property budget. How much debt are you getting? And what's the time look like?

Then if the plans change, please circle back with your account, and go, "Hey, from our original plan, this is now happening. Am I still good?"

And then, maybe if you want to, and just be extra cautious, you can check again before close, but your QI should be able to walk you through all that, and [00:24:00] that's where Dave can help.

Dave Foster: You're absolutely right. There's more accidental tax paid based on the reinvestment requirements, which are twofold. I try to keep it really simple so I can understand it.

As long as you purchase at least as much as your net sale, and as long as you use all of your proceeds in the purchase, you'll defer all tax.

Now, people get into this thought process of trying to figure out, "But I only have this much gain, so I only have to reinvest that." No, no, no, no. The IRS interprets it differently.

The IRS simply says any amount you buy less than you sell, that's profit. Any amount of cash you take, that's profit. That's profit, and you're going to pay tax on it.

So, it's not even so much about the replacement of the debt, because you can add your own funds to, instead of taking out a bank mortgage. In essence, what that becomes is debt to yourself and the IRS will allow that, but as long as you purchase at least as much as you sell and use all the proceeds, you'll do for all tax.

What those folks could have done very easily was buy additional properties, because it doesn't have to be one for one. They could have bunched together their equity and bought some properties for cash, and bought some others with debt, and then, if they wanted money later, go back after the 1031 and refinance those properties. That's not a taxable event. That would have saved them all of that tax.

And lastly, we're starting to see a lot of investors that still have fairly high debt-leverage, but they're wanting to protect their portfolio from a recessionary environment, using cash to buy replacement properties, and then replacing the debt by buying things like Delaware Statutory Trusts, where it's non-recourse debt, so it absorbs your debt component, and still brings in cash flow.

Meanwhile, you've got no-debt properties outside, and a lot of the risk is gone from those. So, just like you said, Kevin, there's so many different ways to do it that'll work, but they've got to ask.

Mike: There are many ways of skinning this cat. And a point I want to make is if someone tells you, "You can't do a 1031 this way," go find someone else and ask them, well, how can I do it, if I want to? There are, not always, but almost always, different ways to defer tax, to utilize 1031s. So many different ways.

You just got to find someone that knows how to do it. A good Qualified Intermediary is hard to find. Dave Foster, if someone is looking for a good one, or has questions, how do they find you?

Dave Foster: Well, we realized a long time ago that the greatest barrier to people using this tool effectively is learning, [00:27:00] and it's education. So, we created an entire branding called The 1031 Investor, and if you go to www.the1031investor.com, you'll find access to the book I wrote, to a YouTube channel, which you can subscribe to.

We produce new content all the time for that. We've got calculators. 

www.the1031investor.com

We love to help people.

Mike: www.the1031investor.com

Check it out. Read David's book. It is not a hard book to read, like most things I've tried to read on 1031. You make it make sense for us normal people. Thank you, Dave.

Dave Foster: Now, I tell you what, if someone asked me, “What's the most important thing when you're wanting to take advantage of this?” First of all, it's never too soon to start.

You start now, but realize that it is a long game. The longer you can stretch it out, the more planning, the more opportunity there's going to be to take advantage of it, throughout.

And that's what keeps us in that realm of continuing to defer where the benefit is ours. So, it's about patience and action now.

Kevin: Beautiful. Yeah, thank you so much, Dave. We've been looking for you for years. We've encountered so many 1031 exchanges in our practice as real estate has become so popular with bonus depreciation, where it was from 2017 interest rates, where they were back then, as well.

Our clients were scooping up real estate, like they were playing Monopoly, and now, they want to, kind of, transition into different properties, and so, we're glad we found you.

We've always had a gap in service and never a good referral source for our client base. So, thank you so much for being here and glad to have you.

Mike: Thank you.

Dave Foster: Well, you can tell what kind of finance and accounting help someone has by the amount of questions, and the amount of time I have to spend, and your folks are always among the best educated, and they ask the right questions, and that's the key to getting, I think, the right answers.

You got to know the right question to ask. So, love working with you guys.

Mike: Likewise. Again, all 1031 intermediaries are not created equal. Don't just go to the cheapest one. Don't just go to the most expensive one. Most of these services are, kind of, I think they're white-gloved by some other big companies that we never learned the name of. You call these people, they say they're 1031 QI. You ask them one or two questions and they got no answers, or they have to go call someone. That's scary. 

A lot of them don't have in-house counsel or in-house expertise. I'm not saying Dave's the only good one out there. I'm sure there's other good ones out there, but make sure whoever you're working with knows the rules, can walk you through the intricacies, and when you have outlying issues, can help you find a solution.