Increasing Cash-Flow, Deferring Taxes and Reducing Risk using a 1031 Exchange | PREI 048
Would you like to defer (or eliminate) your capital gains taxes? How about increasing the cash-flow of your real estate portfolio?
The taxable gain in real estate is due to a combination of the appreciation in value and the amount of depreciation taken over the period of time that it was owned by the investor. The tax savings using a 1031 exchange can be enormous. And using a 1031 exchange can help you re-position your real estate holdings into more, and better income real estate to increase your cash-flow and lower your risk.
This is a content-rich episode, so get ready to expand your knowledge.
If you missed last week’s episode, be sure to listen to The Difference Between Rich and Wealthy (and Which is Better).
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Increasing Cash-Flow, Deferring Taxes and Reducing Risk using a 1031 Exchange
Today’s show is pretty special. There’s a reason why real estate is one of the most tax favored assets in the entire country. There are a lot of great benefits to owning income producing real estate. We’ve talked about depreciation in past episodes, how you can amortize or depreciate the improvements of your property over 27 and a half years. You don’t need to spend a single penny to get that depreciation. It is absolutely incredible.
At some point, that will run out. After 27 and a half years, that clock will run out. Now, you don’t have that ability. There is a way around it. There is a way too reset the clock. There’s also a way to take equity that you have in your existing properties and move that equity into other better, larger properties. That doesn’t necessarily mean that you’re going from single family homes to fourplexes or apartments. What it does mean is that you can take the existing equity you have across one or more of your properties and leverage that into more property, better property that increases your cash flow.
In the process of doing that, because there are sales involved, you can defer your capital gains taxes. In fact, done right, you can defer them forever, indefinitely or at least until you pass away. Then there are some nifty things that happened like a step-up in the basis of that property so those that you will or heir the property to can start the clock over for themselves without any tax impact. It’s really a powerful thing. That’s what you’re going to learn about today.
I have a really special guest who’s going to go into a lot of detail. I went through a lot of information before bringing him on the show. I structured my questions in a logical format where we can just start with the most basics and go through some complicated scenarios. First, I want to take one of my listener questions here, which I don’t think I’ve covered in the past, but it ties in somewhat nicely to what our topic is today.
This person writes and says, “Hi, Marco and Michael, a quick question about depreciation on tax returns. I know you guys are not CPAs but I’m sure you must have done it so many times. If a property is older than 27 and a half years when I bought it and if I bought it rehabbed, can I still claim the depreciation on the building, not the land? Does the counter get reset somewhere during the process or is this something that is applicable to properties newer than 27 years old or just one string of life of the building? Thanks, guys.”
I know what you’re asking but you’re asking the wrong question. It’s really not a matter of the age of the property. You’re getting the depreciation cycle of 27.5 years confused with the age of the property. The age is completely irrelevant. A property could have ten different owners and each owner gets to start that 27.5 year depreciation cycle over every time there’s a new owner that takes possession of that property. There can be an indefinite number of 27.5 year depreciation cycles. The 27 and a half year depreciation starts the day you take possession of that property. It has nothing to do with the age. It could be a new construction. It could be a 150 year old property. It really doesn’t matter. That’s really the short answer to your question, but what you’ll see in this episode here is that you can reset that 27 and a half year depreciation clock by using this tool, this 1031 Exchange tool. It’s just a part of the IRS code, but you got to think of this as a tool because it allows you to take that equity out of your property or properties, move it to other markets and increase your cash flow and leverage up your properties and reset that clock. It’s a really wonderful thing.
It’s my pleasure to welcome, Ron Ricard. Ron is the Vice President and Regional Account Manager for IPX1031. He’s also a designated certified exchange specialist, one in a few than a 130 people in the country who has earned that certification with the Federation of Exchange Accommodators. In over the last fourteen years, Ron has taught 1031 Exchange accredited courses to over 30,000 investors and real estate professionals. It is my great pleasure to have him on the show today. Ron, welcome to the show.
Thanks for having me, Marco.
It’s great to have you here. This is a topic that I think is long overdue. I think a lot of real estate investors have heard of 1031 Exchanges. Many of them know what a 1031 Exchange is. Far fewer have probably used a 1031 Exchange. Maybe they didn’t know that they needed it or maybe it just hasn’t come up to a point in their investment career where they need a 1031 Exchange. Today, what I’d like to talk about is what a 1031 is? How to use it? What the benefits are? From there, I think we can maybe answer some miscellaneous questions that I have that hopefully will educate our listeners and help them to build their portfolio or defer taxes using these 1031 Exchanges. How’s that sound?
Sounds great. It sounds like it’s going to be a full day.
No kidding. Why don’t we start off with you? Tell us a little bit about yourself and about IPX1031.
As you’ve mentioned, I’ve been doing this about fourteen years. It’s a great job, if you have the opportunity, because I love helping people. The best part about this job is helping people save taxes. IPX is the nation’s largest qualified intermediary. We’re really the only one with the national presence, and we could handle exchanges anywhere within the United States. We are a sister company to Fidelity, Chicago, Lawyers Title and a bunch of other title companies across the country and owned by Fidelity National Financial. We work with everybody in terms of title and escrow and closing attorneys, but it’s nice to know we’re part of a big corporation because as you’ll find out, one of the things that we do as an intermediary is we have to hold your money between when you sell property and when you buy the replacement property. It’s nice to know that your money is being held by a nice, big, safe company with lots of insurance, bonding and that kind of protection.
That’s exactly true. Let’s start off with the most basic of questions here. We’re talking about 1031 Exchanges. What exactly is a 1031 Exchange?
1031 refers to the section of the tax code that allows you to sell an asset that you use in your business or investment and reinvest the funds or reinvest the proceeds from that sale into, which you refer to as like-kind asset. By doing so, you get to defer taxes. For many of your clients, they will own, let’s say, a single family rental house, is going to invest in property for the last few years. They want to sell that property to buy a duplex. By doing the 1031 Exchange, they sell their property at the close of escrow. The money comes to a neutral third party referred to as intermediary, they then go by that replacement property and the money is sent to the title company or closing attorney there. That effectively is what the 1031 Exchange is. You sold a piece of investment real estate, you bought a piece of investment real estate. Because you never touch the money, you get to defer paying taxes on the profit that you made.
Let’s be clear on what like-kind means because I think that’s confusing for some people. In this particular case, at least with real estate investors, that would refer to income producing property, investment property, not your principal residence, right?
Correct. It could be any kind of property used for business or investment. If you are running your doctor’s office inside of a building that you’re practicing in, that’s considered an investment real estate. For most of that, it’s going to be income producing property. If you have bare land that’s been in the family for a long time and it’s appreciated in value, that’s considered investment real estate also. Any kind of investment real estate can be exchanged with any other kind. You can sell residential to buy commercial. You can sell bare land and buy a fourplex. You can sell a farm and buy a rental condo. It could be any kind of investment real estate for any other kind of investment real estate.
Like you said though, this is not for primary residences, this is not for second homes, this is not for flips. Those are not considered to be investment real estate. As a general rule, investment real estate is a real estate where you either run your business from, you’re getting rental income from or in the case of bare land, is considered to be investment because it’s held for appreciation purposes.
What about a qualified intermediary, also known as a QI? If I understand correctly, the way the laws were written as far as QIs go, virtually anyone can be a qualified intermediary as long as they’re not defined as not being able to be a QI. I don’t know if you’re familiar with this but maybe you can just touch upon that so people understand what a qualified intermediary really is.
Let me take one step back from that. It’s possible to sell a piece of real estate without a realtor. Technically, it’s possible to transfer a title to a buyer without having to go through a title company. However, whenever you do an exchange, you must use a qualified intermediary. What we do by definition is we are a neutral third party. We are not the realtor. We are not the title company. We are not the lender. We are not your mother. We’re not your CPA. We are just a neutral third party. Our entire job is just to hold the money between what you sell and what you buy. As you mentioned, what we do is not regulated, so there are a lot of entities out there who will act as an intermediary who have very little bonding or insurance or basically security on the client’s funds, but it is a required part of any exchange.
1031s have these rules wrapped around it. There are quite a few rules, but there are some very basic rules like the 45-day rule and the 180-day rule. This is the first thing we normally hear from clients when they give us a call about 1031s or maybe they’re looking to do one or maybe they’re already in the process of doing one. Let’s explain the 45-day and 180-day rule for our listeners so we understand how this process works.
90% of the questions that we get when it comes to 1031 Exchange is, “What can I buy? How long do I have? How much money do I need to spend?” We’ve talked about what we need to buy, again, any kind of investment real estate. The second question, the one you’re bringing up now is really, the crux of it is, “How long do I have to reinvest the new property?” From the day you close escrow on what you’re selling, you have 45 days to identify, to tell us what you’re going to buy and a 180 days to actually buy it. 45 days to tell us in writing, “I’m going to buy one of these properties,” and 180 days to close escrow.
What does identify mean? Identify means you give us a piece of paper where you’ve written down addresses. We’ll talk about how many you can identify in just a minute. During the 45 days you can change your mind on what you’ve identified as much as you want. When midnight strikes on that 45th day, even if it’s a weekend or a holiday, it doesn’t matter. Whenever midnight strikes on the 45 days, whatever you’ve identified is locked in stone. You have to buy from that list. You cannot buy a different property on day 46 or 50 or 65. You have to buy from that list. That’s what the 45 days really is, that critical a factor.
Now, you have 180 days to close escrow. Unless you’re buying new construction or commercial real estate, that hardly ever comes into play, but that 45 days is to tell us exactly the property you’re going to buy.
It’s also very important for our listeners to know that you or the qualified intermediary, they have to be engaged before you relinquish the property. In other words, before it’s sold, they need to be involved. If you don’t, you’re going to completely botch your 1031 Exchange.
Exactly. As a matter of fact, I literally got a phone call this morning from somebody who had closed escrow last Thursday and said, “Hey, is it too late to send the exchange?” The answer is yes, because the title company or closing entity has to know to send the money to the intermediary and not to the seller of the property. We have to be engaged prior to the close of escrow.
If they’re in the process of closing escrow but funds haven’t been disbursed, is it possible to request the title company to hold those proceeds until you get your paperwork involved?
It depends where exactly you’re referring to. If the escrow is actually closed but the funds haven’t been disbursed, the answer is still no because technically, the client has rights on the money. They have the ability to get the money even if they haven’t picked up the check yet. It has to be done before the close so that at the disbursement, the escrow has the direction that the money has to come to us.
It’s very important to impress upon everybody that this 45-day rule might be one of the most important rules because it is hard and fast. There is no exception, unless there is some sort of major federal emergency and the President of the United States declares some sort of state of emergency, I think that is the one and only exception to this rule. Is that true?
That is true. That’s also only if it is a federal declared disaster during your 45 days. For example, there were some hurricanes or some major storms in South Texas last week. A couple of the counties were declared disaster areas. Because of that, if you happen to be in the middle of your 45 days or your 180 days, then you are given extra time. Essentially, short of there being a tornado or a flood or earthquake or some major havoc affecting you, then no, you will not get an exchange. My hope is you’re not going to look at this as praying for a tornado. You don’t want it to come because it’s obviously very unexpected when it does happen.
You think we’d be done with rules but there are more rules. From this 45-day rule, we can segue onto a couple other rules here. There’s the three-property rule and then the 200% rule. Let’s talk about those.
The question that always comes up is, “How many properties can I identify? Can I just give you the Thomas Brothers’ guide so I’ll pick something here?” The answer is no. One thing I should mention also, in an exchange, you’re not limited to one for one. You can sell one property, buy two or three. I did an exchange once for a woman who bought eighteen properties. Similarly, you can sell multiple properties to buy one. If your goal is to only buy one or two properties, most people identify under a rule that limits you to no more than three properties. If you identify three properties, those properties could be of any value anywhere in the United States.
If your goal though is to buy three, four or five or, in this case, eighteen properties, there is a second rule that allows you to identify more than three properties. That is what we refer to as the 200% rule. The 200% rule allows you to identify 200% or two times the value of what you sell. If you’re selling, let’s say a $500,000 property, you could identify two times that or a million dollars’ worth of replacement property. Again, make sure we focus on this. If you’re identifying three or fewer, there’s no dollar limit. If you’ve identified three or fewer, you can be identifying 10, 20, or 30 times what you sold. If you identified more than three, now the cumulative market value of all those properties cannot be more than two times the value of what you sold.
Is it worth talking about the 95% rule?
It really isn’t because nobody ever uses it. In my fourteen years, I think I’ve seen it used four times and all four times are by accident. You can identify whatever you want, but you got to buy everything. That’s rarely, rarely used.
It would seem that the purpose of these rules is to prevent people from listing out every single property for sale in a particular market or city just so they have anything and everything under the sun to pick from and they don’t have to worry about identifying specific properties.
That’s a great way to look at it. The question I always get is, “Do I have to be in contract by the 45 days?” In the way the rules are written, the answer is no, technically not. Technically all that you’ve done is given us a list of three properties or a list of X number of dollars’ worth of real estate. The reality is, if on day 46, those get all sold to somebody else or you find out they’re being held up by termites or something and you don’t want them anymore then you lose. You’re going to get your money back in six months and pay your taxes. By the 45 days, you really should be in contract. Ideally, your loans approved, your inspections are done. You want to be pretty comfortable with what you’re going to buy by that 45 days. The reality is most of my clients are either done with their exchange or almost done with their exchange by the time we get to the 45 days.
That brings up a very good point and a caution. If someone is looking at a particular set of properties and they’ve identified some of those or all of them within that 45 day period, you need to make sure that you have a certain number of those properties under contract or at least have an option on them. In other words, you need to have some sort of control on those properties so you don’t lose them and end up having the situation you just described where you lose all those properties on the 46th day. Now, you’re completely out of luck. You’re going to have to buy something but you’re going to pay taxes.
Exactly. That’s why really by the 45 days, you want to be pretty locked down on what you want to buy.
To be clear on the tax piece, I don’t know if we glossed over this before, but it’s the capital gains taxes on the equity or gains that you’re pulling out of the property you’re selling. What you’re trying to do here is avoid paying capital gains taxes and deferring those taxes. In some cases, almost indefinitely, you could set up your affair so those taxes are deferred indefinitely. You’re deferring those capital gains taxes onto your next properties and your next set of properties and so on and so forth.
The way to look at it is this, the 1031 only defers the taxes. When you sold a house to buy a duplex, you sold a duplex to buy a fourplex and you keep doing all that, the goal is eventually that basically you die before you sell anything, now your heir’s got to step up and get the tax paid and all the taxes are wiped away. That’s why the motto of our industry is, “Swap until you drop.” You just keep exchanging and then hopefully you never have to pay the tax map.
There you go. Swap until you drop. I like that. I’ll have to borrow that phrase. It’s good.
You’re more than welcome to. Like I said, the motto of our industry. One thing I should point out also is that you referred to capital gain. You said something earlier that a lot of your clients are going to probably get confused. Don’t confuse the equity in your property with the profit of the property. I know you wouldn’t do that, Marco. The equity in the property is just the amount of cash that you get after everybody, including the bank, has been paid off, whereas the profit in the property or the gain is the difference between your basis and what you sell the property for. That will include both capital gain as well as state taxes, as well as what’s referred to as depreciation recapture tax. 1031 defers all of those even if you’re selling in one state and buy in another, you’re still deferring state tax in virtually every state as well as the capital gain and depreciation recapture on the federal tax side.
There’s a reason why real estate is referred to as the most tax favored asset in the country. It’s because you can do these 1031 Exchanges and defer your capital gains, your net proceeds from that sale. What’s really cool about it is when you do an exchange into a new property or a new set of properties. What you’re doing is you’re resetting the clock all over again on the depreciation schedule.
As many of our listeners know, you have 27 and a half years, with commercial property it’s about 39. It’s a longer cycle than with residential real estate. With residential real estate, you have 27 and a half years to depreciate the property, which is a phantom expense that the IRS allows you to depreciate this property without having to spend a single dime to get it. Then you can get yourself a new set of properties and restart that depreciation cycle, that clock, all over again. That’s an amazing one-two punch that comes with the 1031 Exchange and the depreciation expense.
That’s why a lot of people, after they’ve owned a property for a period of time, ten, fifteen, twenty years or up to 27 years. They’ve built up a lot of equity in the property, the idea of re-leveraging that equity into more property into incremental investment. If you sold something for 200 and you buy something for 300, that’s going to give you, in round numbers $100,000 new depreciation to write off. That’s one of the benefits of real estate like you mentioned are these phantom tax write offs, as you call them for depreciation. Every time you leverage up, every time that incremental investment becomes a new depreciation schedule.
It’s incredibly powerful. Here’s another tip I just want to share and throw out there before I forget. Sometimes we have clients that call us and they are in the middle of a 1031 Exchange. They haven’t identified their property so we’re scrambling against the clock to get properties identified. I think it’s very important to start looking for those replacement properties well before you close. If you can’t do that then there’s an argument to be made that you should extend the closing on the property that you’re selling just to buy you some extra time in order to find and identify those properties. Would you agree with that?
Absolutely. A lot of it depends on the market you’re in. Right now, in much of the United States, there’s very little inventory. Finding a replacement property is not as easy. I always say they’re the fastest 45 days of your life. Most of my clients are actually in contract on the replacement before they close, but you can literally close escrow the very next day. In some cases, even the same day as you sold your property. One thing that’s important to realize here, you do need to sell your property before you buy the replacement. There is something called a reverse exchange where you buy it first, but that’s a much more expensive, much more involved transaction and probably something we’ll talk in another podcast, but not today. Being in contract on the replacement property even before you sell yours is perfectly fine, but as long as you sell first, then buy.
We have really good relationships with our teams and providers all around the country. If an investor is in a situation like that, we’ve been able to help them lock down a certain number of properties subject to or conditioned upon their closing of their 1031 property. We can usually dry out that cycle or that schedule so they can close and not worry about losing the properties that they want to purchase in whatever market they’re looking at. We can help you with that if that’s the situation. Tell us about the reinvestment of the net proceeds. First of all, just explain what the net proceeds mean on that 1031 sale and then how do you go about reinvesting that? Because that’s really what the QI is supposed to do in this situation.
This goes back to the third question of, “How much do I need to reinvest?” The simple answer is all of it. It doesn’t matter what you bought the property for. It doesn’t matter how much you depreciated. It doesn’t matter how much money you put as a down payment or to fix up the property or improvements during the life. All that matters is how much you are selling the property for. If you sell a property for $500,000, you need to buy at least $500,000 worth of replacement property to defer all your taxes. If you want to buy something a little bit less and pay taxes on the delta, you’re welcome to do so. If you want to defer all of your taxes, you want to buy equal or greater to the net sales price. By net, I just mean you are deducting the cost of the realtor and escrow and titles, essentially the closing cost. Do not subtract the loan or whatever that net sales price is. You want to buy equal or greater to that amount.
When you do close escrow, obviously, any existing loan that you have on the property also gets paid off. What’s remaining are the net proceeds, that’s what, as you say, comes to the intermediary. Part two is all of that equity, all of the cash that comes from the sale, all needs to go as a down payment or towards the purchase of the replacement property. Any cash left over is considered to be what’s referred to as boot or taxable. Equal or greater in value and use all the cash proceeds.
If you’re short $20,000, $10,000 to close the escrow on your new property, you just come out of pocket with that.
You can either come out of either your own pocket or you can just get a bigger loan. You can make up a difference however you want. As a matter of fact, let’s say you have a property that you’re selling for $500,000 and you have 450 of equity and you don’t want to get another loan on a new property. As long as you put out that $50,000 from your own pocket, that’s okay also. You don’t need necessarily to replace the loan, you just need to replace the value of the loan. However you make up that difference whether it’s with your own cash or with a loan, perfectly fine.
At what point should an investor bring their tax professional or their accountant into this process, because obviously there’s tax implications or lack of tax implications. At what point should they bring their accountants in?
What I usually tell clients is, before you even get started, before you even sell the property, it’s nice to have a chat with the intermediary. Because if nothing else, let’s go over what you’re planning to do and then let’s see if there are any potential hiccups or potential issues, whether it comes to investing or how much you want to reinvest or getting a loan or whatever the case might be. If it’s a simple transaction, you don’t need a lot of money on this duplex and you want to go buy a fourplex. For the most part, you know what you’re doing. You probably may not need to bring the accountant in right away.
If there’s any question about what you’re doing, any complication in those cases, we typically will recommend that you bring your accountant in and ask them some questions. Sometimes the question may be as simple as, “How big is the check I have to write to the government?” If you can do an exchange and not have any taxes today, you probably don’t need to do an exchange. That would be something that’s worth finding out from the very beginning. My suggestion is always call the intermediary first, you talk to them about the situation. That way, if nothing else, you know what questions to ask your accountant. Frequently, when you ask your accountant questions, you’re not sure what you’re asking them.
What about when their situation is a little more complicated and you are selling a group of single family residential properties because now you are trading up into multi-unit properties? Obviously, your single family residential properties don’t sell all at the same time. You might have one sell today and another one won’t close for another 30 days and that gets a little bit messy. Is there a way to handle a situation like that?
There’s a couple of things you can handle it. The first thing to realize is the 45-day and 180-day clocks both start when the first property close at escrow. If your goal is to sell, let’s say, three properties to buy one larger replacement property, the first one that closes. The thing I will tell them first is, it’s probably worth you working with one agent who is coordinating everything. What I’ll suggest is the first one that goes into contract ask for a longer escrow, maybe a 60-day escrow on that first one. With the expectation that maybe the second one, you go into contract, you can time it so that they’re relatively close together.
If you think there’s going to be one property that’s going to be much more difficult to close because it’s in an area that’s maybe the real estate doesn’t move very fast, or there’s a certain price point or certain kind of property. You might want to put that one on the market first. Once you find a buyer for that property, once you’re getting closer to finding a buyer for that property, then you could put the other ones on the market. Ideally, you want to close everything within a reasonable amount of time so that maximizes your ability to know what you’re going to buy by that 45 days for the identification etc.
That said, this is also the time where sometimes the reverse exchange plays into it. Where maybe you’re selling one right now, where the client wants to sell five properties. The way it’s going to work out, they’ll be able to sell three of them before they close on the apartment building that they want to buy, but the other two they probably won’t be able to soon. In this case, we are going to do a combination of a regular exchange and a reverse exchange where they’ll sell the two others afterwards. Again, more expensive, more money out of pocket upfront, but in a situation like this where you’re selling multiple property but you have something specifically in mind, then it’s something worth exploring also.
The net result is that you still can defer all your capital gains access in doing it. It’s just a little bit more complicated. You’re juggling closing dates. Hopefully you’re working with some sellers that can be a little bit flexible with you in extending those closing dates for you. You just have to closely manage all these properties on the closing date on them.
Here’s a scenario, what if you sold a property and now you want to purchase something larger but you want to bring a partner in with you. It’s kind of a loaded question. I know how this is going to work. How does this play out if you want to bring in a partner on your new property in a 1031?
There’s a term that you just use there that scares the heck out of me. That term is partner. You don’t want to bring a partner with you. You may want to bring a co-owner in with you, but not a partner. Let me explain why. What’s important in a 1031 Exchange when it comes to vesting is that it has to be the same taxpayers selling as buying. Marco, if you’re selling a property in your name or your trust, and you need to buy a replacement property either in your name or your trust because you’re the same taxpayer buying the new property. If you want me to go in and buy that property with you, what we need to do is we need to be tenants in common on that property so that your share of whatever you buy is equal or greater to what you sold. If I’m doing the selling, my share is equal or greater to what I’ve sold.
We don’t want to form an LLC or partnership or corporation or any kind of entity that is his own taxpayer. We would need to buy the property as tenants in common. One thing I do recommend here, if you’re doing that is please this is one area where you definitely want to bring in your tax professional. Because you want to make sure the structure of the co-ownership of the property does look like a true tenant in common relationship and not a kind of partnership.
For listeners that are wondering what the heck is a tenant in common, it’s also known as a TIC. All it is, is really just an arrangement where you have two or more people that co-own a piece of real estate, but there’s no right of survivorship. That’s all it really is. It’s not technically speaking a partnership. It may look and smell like a partnership, but at the end of the day you have no right of ownership or survivorship if you were to pass away. That’s really all it is.
The nice thing about tenant in common ownership also is that it does not need to be 50-50. You could own 90%, me 10% or you 73% and me 27%. It gives you the ability to own a fractional share of the property not necessarily equal shares of the property.
I had a question actually from a client of mine. What are some guidelines of how much equity you should keep in a home, I assume he meant an investment property, before deciding to either refinance to reinvest or do a 1031 Exchange to “upgrade” it? I have some comments on this and maybe you do too. Do you want to go first on this one? I could be very long winded on this one.
I’ll start if only because I think my answer is very short. The answer is that truly is a question about your investment strategy, whether your investment strategy is to leverage yourself to be able to buy multiple properties, whether you can be cash or negative whatever. That truly is a question having to do with your strategy from an exchange point of view, when is the right time to exchange is something that you have to decide for yourself whether the amount of equity you have, whether it’s the right property for you. There’s much more that you can answer more than I can.
You’re spot on, that’s exactly what I was thinking. Your strategy on what you’re planning to do, how large you want to build your portfolio, what you want to have in your portfolio, the stage in your life, are you in accumulation mode right now or are you just maintaining a portfolio where you want to rapidly accelerate the pay down of the loans so you have greater net worth and maybe increased cash flow. Strategy comes into this very heavily. Then you got to look at market conditions. If the current and what you feel the future market conditions are such that you’re not going to see a lot of future growth or equity growth in that property because there is a lack of appreciation, then you may want to consider doing a 1031 Exchange out of that market. Unless you got a real jewel of a property and it’s a cash cow, then it may be worth to keep it.
The amount of equity, the return on equity is always a big fat zero. If you can leverage that equity and take it out of properties where you were equity rich and turn that into multiple properties in other markets that make sense where you can increase your overall cash flow by leveraging out of that property, taking that equity and increasing the size of your portfolio, that is a wonderful strategy. That’s what you see on a lot of investors in expensive markets, like the coastal markets, be it New York or California, where you’re just pulling equity out of these very pricey over-inflated markets and reducing your risk out of that market, putting it into a more linear markets like the Midwest down south and through the south east, increasing your cash flow, having properties with less downside potential because the land costs aren’t as much as they are in these coastal markets. I could go on and on, but that’s a long winded answer or commentary to that question.
I think those are the things you need to keep in mind and consider. If you’re not sure what to do, talk to your professionals, give our investment councilors a call. They could talk to you and walk you through it. Maybe you can give Ron Ricard call and he can talk to you about it as well. That’s what I’ve to say.
Now, we’re getting close here, Marco. I want to attack on one thing, a lot of times I get asked the question, “Why do people do 1031 Exchanges?” The answer that you would expect is that you do it to defer taxes. That is not at all why you do 1031 Exchange. You do a 1031 Exchange because you want to buy a property that’s better. What does better means? Better means whatever it means to you. Whether better means that you want to go from the highly inflated coast, as you put it to the cash flow south and south east. Whether it’s, “I want to go from my single family house to an apartment building or my apartment building to a single family house.” Whether it’s, “I’m older now and I want more cash flow than appreciation,” whether, “I’m looking for extra strategy.”
The key here is that you do an exchange because you have a piece of real estate today, but it no longer meets the criteria that you have as part of your investment strategy. If you have this in the stock market, you don’t like your stock anymore and you want to sell it to buy another stock, you can do that but every time you do that, you’re going to pay the tax band, whereas in real estate we don’t have to. The beauty of the 1031 Exchange is it allows you to reposition your real estate assets into something that makes more sense for you today, than the property you bought five, ten, fifteen years ago.
Most people who own a property ten years or more, that’s probably not the right property for them today. They probably would like something better, whether it’s for more depreciation, more cash flow, less maintenance, whatever the case might be. Don’t think of 1031 as a tool to defer taxes. Think of 1031 as a tool that you use to reposition your real estate asset into something that makes more sense for you today.
That’s very well said. I think a lot of that comes down to a common denominator of increasing your cash flow. I think secondly would be to position yourself to take advantage of potential market appreciation in other markets that may be more right for that growth. I don’t like to talk about appreciation too much because you will get that equity over time, but you’re right, you’re basically improving your portfolio through a 1031 Exchange.
Ron in winding up here, I want to leave our listeners with some thoughts and questions that they should have in the back of their mind when they’re talking to a QI, a qualified intermediary. What are the most important things they should look for, the questions that they should be asking a QI before they hand over the money from the sale of their property?
The first thing to ask is who are you in the sense of what kind of protection do you have on the money that you’re holding for me? What kind of bond? What kind of corporate backing do you have? Because, again, what we do isn’t at all regulated. There are a couple of states who have a little bit of regulation on them, but the vast majority of states have zero regulation on what we do. If you want to make sure that money is safe, because even if the intermediary themselves are honest people they are also subject to people trying to give them the fragilely wire money to the wrong place and stuff like that. You want to make sure that the money is not just backed up by bonds and stuff like, but it’s all secured by a parent corporation who can step in and make good on those funds. It’s not worth saving $50 to find somebody on the internet who can do this.
The second thing you want to ask the intermediary is how much help are you going to give me? There are a lot of intermediaries who are strictly order takers, whereas there’s a lot of us out there who truly want to help our clients and we will walk you through it. I will say honestly that I probably talked a third of the people I speak to out of doing an exchange because it’s just not right for them to do. You want to make sure you’re dealing with somebody who’s not just holding your money. You want to make sure someone’s going to guide you through this. Hopefully you have attorneys on staff who can guide you if things got very complicated in the transaction.
What about E and O insurance coverage?
E and O insurance is the insurance that the company has, in case they make a mistake. If somehow we make a mistake on the Pay Board that costs our clients a million dollars in taxes, that the insurance company would pick that up. You know insurance is very important as well as fidelity bonding, which is essentially the guarantee that I’m not going to walk away with your funds.
We live in the world of acronyms and I guess I should’ve just spelled it out, E and O refers to Errors and Omissions coverage or insurance. What about guarantees? Is there such a thing as a guarantee in the world of 1031 Exchange?
I will say given qualified, yes. In terms for us, our guarantee in it over and above these errors and omissions insurance or the fidelity bond is that being backed by a publicly traded Fortune 300 company. Each of our client’s exchanges literally has a corporate guarantee for up to $50 million, so that if somehow someway, the funds got sent to the wrong place, the corporate guarantee would step in and make good on those funds. That’s one thing that we do offer that I’m sure the vast majority of other intermediaries aren’t able to do so.
In wrapping up, is there anything else you’d like to share with our listeners? Something I didn’t ask you that maybe I should’ve asked you?
I think we’ve got over the major components. The last thing I will say is don’t be afraid to ask questions on the intermediary. Bring them in as early as possible into the transaction to help and guide you on the transaction. There’s really nothing to do, paperwork wise, until the property that you’re selling is in contract, but feel free to get them addressed. If you’re clients want to give me a call whoever is listening to this podcast. I welcome their phone calls. I have a toll free number, 877-747-7875. I’m always available to answer questions all over the country.
Is there a website or anything that you want to give out as well or just that phone number?
Perfect. Ron, I’m sure you’re going to get a number of calls from this episode so I appreciate your time. The information was fabulous. I look will look forward to working with you on my 1031 Exchanges.
Sounds great, Marco. Looking forward to the next podcast and let’s start to do some business.
Sounds good, talk to you soon. Thank you. Bye.
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There you have it. I hope that has helped you better understand a 1031 Exchange, its benefits and how you go about doing it. If you have any questions, be sure to give Ron a call. He will help you in better understanding it if we didn’t cover something that is unique to your particular situation.
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That’s about it. Thanks for listening. We’ll see you next week on our next episode.