Do you want to know how to grow your wealth and grow it faster? If so, then this very special episode is for you. Host, Marco Santarelli, and his guest, Dave Foster, share with you an incredible tool out there: the 1031 Exchange. Unknown by many, the IRS allows you to defer your taxes and grow your wealth faster through it. Having been using 1031 Exchanges as the cornerstone of his own personal real estate portfolio, Dave takes you into a deeper look at using a tax-deferred exchange that you can use to invest your money forward in more properties. Through this, you’ll discover your equity snowballing your wealth and cash flow. Take advantage of this information now. Know more details from this conversation with Marco and Dave.
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How To Use Equity To Snowball Your Wealth And Cash Flow
We’ve got a special episode. Why? If you’re interested in growing your wealth and growing it faster, the question is how do you do it? There is an incredible tool out there that many people don’t even know about, but the IRS allows you to defer your taxes and grow your wealth faster. It’s called a 1031 Exchange. The whole point of a 1031 Exchange is to move your investment money forward to invest in more property. Why wouldn’t you want to be able to grow your portfolio faster? With me is a special guest. His name is Dave Foster. Dave has been using 1031 Exchanges as the cornerstone of his own personal real estate portfolio. He decided to get into real estate investing right after his first son was born. He specializes in helping others take advantage of using a tax-deferred exchange to grow their wealth faster. Dave, welcome to the show.
Thanks, Marco. It’s great to be here.
I’m glad to have you on because this is something that a lot of people don’t understand because they see the label 1031 Exchange and they’re wondering, “What is that?” A lot of people are clueless to even what that means. It’s totally boring. It’s an IRS Tax Code, it’s Section 1031 of the Tax Code. Rather than talk about the dry stuff, let’s talk about what is it and how we can use it to help benefit me and you and all our audience when it comes to growing their wealth and growing it faster.
The funny thing about boring is not fun until it stings you. That’s how I got into the whole industry of 1031. It was years ago, back to even before we called them fix and flips. I bought a duplex in Denver, did a renovation and sold it. I was all fat and sassy going to my accountant. He presented me with a not so lovely tax bill. I hit the roof, I was like, “How in the world could I have worked this hard to make this little?” It was crazy. Right at that moment in time, this was 1996, there had been a major change in the IRS statutes that made this thing called 1031 user-friendly. I call my accountants and the two said, “I’m sorry, you’ve got to pay all the tax.” I had some friends who said, “Dave, we’re starting a business and that business is going to help people use this tool so that you won’t have to pay tax on that gain next time.” I said, “Count me in. I’m to count it and I get it. Let’s do it.”
Many years ago, we started working with those four clients as well as for myself. It has been awesome. You can read the story about what I’ve done but all that though, the 1031 Exchange does exactly what you said. It lets you take those tax dollars that you’d normally would have paid and you get to use them for yourself to buy a new investment property. In one sense, it’s like a big exercise in compound interest. Instead of paying the taxes, take the taxes and buy real estate. Profit from that real estate and take the taxes plus the deferred taxes and buy new real estate. Keep that thing rolling forward as long as you left. That’s an awesome strategy.
In its most basic form, the 1031 Exchange is what? It’s a tax section. How would you define a 1031 Exchange?
The Section 1031 Exchange comes from the code name 1031. It is when you sell a property that either has a lot of appreciation or that has been depreciated heavily. Either way, it gained a big taxing. When you sell that property, you follow a specific process and simply go and buy a new investment property. By doing the process in the middle, you don’t have to pay tax on that gain. It all gets rolled over. As long as you never sell that property, you will never pay the tax. As long as anytime you sell that property, you do another 1031 Exchange. You will never pay the tax. I don’t recommend it, but it’s 100% certain. If it happens and you die owning that real estate, your heirs get that at what is called a Step-up in Basis. The tax all the way through the years goes away and they inherited tax-free. That’s how powerful it is. It’s sell and buy.
I don’t want that to go past people too quickly. We could end the show because what you said is powerful, it is literally everything. What you essentially said, in other words, is that done right, you can defer capital gains taxes on your real estate portfolio indefinitely. Never pay tax on it and then pass your real estate holdings, your portfolio, onto your kids or your heirs and so on, done right forever or as long as they don’t change the Tax Code, you can defer taxes indefinitely.
One of the nice things is that this has been part of the code since 1920. We’re not too worried it’s going to go away. It’s been around for a while. The two different levels that you can think about this, I get the calls every week that say, “Dave, why should I do a 1031 Exchange? It only defers the tax. I’m going to have to pay it someday.” I simply ask them when the last time was that anybody gave them that argument for not investing in an IRA or a 401(k)? It’s all tax-deferred. You’re going to have to pay the tax anyway, so why worry about it? The answer is because, for that period of years, you get the interest. Even if you have to pay the tax back, you’re still going to make all the money of all the interest from that deferred tax while you’re at it. Secondly, it goes even deeper to what you said and that is that done correctly. You can die and pass the wealth to your heirs tax-free. I have my first third-generation client that we’re working with. Granddad died and passed his estate tax-free to his son who then started re-continuing to invest. Dad passed away, his children got it tax-free and they’re doing 1031s with us to continue that deferred on. That can go generation upon generation. What a great legacy.
We’re talking about two major benefits. One is the deferral of taxes on the capital gains from the properties under a sale. The other thing too is I don’t want it to be glossed over is the fact that you can take that equity, take those gains in your properties and leverage it. Put it to work and build your portfolio larger. You increase your cashflow and you increase the wealth creation that you have because you are building a portfolio and adding an additional property to it. That’s huge because that is compounding on steroids. If you pencil it out and step back and think about it, you can take the equity from one property and leverage that into 2 or 3. In 3 to 5 years from now or maybe a little longer, a little less depending on where you are, you can take that equity yet again and leverage it up into a larger portfolio. It’s almost a mushroom effect.
That’s exactly right. That little snowball starts rolling downhill and it became a big snowball by the end. What’s also powerful with this is that one of the great concerns that investors have is what happens at the end of my active period of investing. I’m going to slow down sooner or later. That’s when 1031 can be used to start to position your portfolio. You may be an active investor and you love having your 4 or 5 properties that you manage but maybe time to take your cruise to Alaska or start to slow down. When that happens, you could do exactly what you said, Marco. Start to diversify and sell those properties, but use it to buy properties that are not going to be management-intensive that will be managed for you that are in better areas for cashflow if that’s what you’re looking for. Better positioned in areas that would be candidates for appreciation, in those little hidden areas where nobody knows about yet. When you put your real estate in there and it is out of sight, out of mind, out of your hair except for that monthly check that comes by electronic transfer. That’s when you can then sit back and wait to die because of its cashflow until you’re gone. The tax is gone as well.
I appreciate you saying that because that starts to get into the ‘why’ and the ‘when’ question. My next question may be different for everybody that I ask but in your opinion, when do you think is the right time to be doing 1031? I’m going to ask you your opinion, then I’m going to put some color on it because I have my own perspective.
You’re right, it’s different for every person because it’s depending on where they are either investing career, juxtaposed with where we are in the market. We can never time the market but we have to recognize that all markets look exactly the same. It’s whether the circle is small or big. Given those two parameters, I see investors starting in a market early investing for appreciation because that’s generally the biggest bang for your buck. The market is low. Remember 2009, 2010 after the dark days, you could pick up properties for a song and two years later, they were worth 2 or 3 times with what you paid for. Appreciation was the quickest way to make that. You’re from California, you know what’s happened. Amazing appreciation but an appreciation that has started to stagnate. When I ask my California investors, “What are your returns like as NOI on your rentals?” They start gagging because they’re not making any money.
That’s then the perfect time because you’ve harnessed all of the appreciation equity build to sell those properties that are highly appreciated but poorly performing and transfer those into a market where the appreciation potential isn’t great but the cashflow is. It’s some place that is not coming on people’s radar screen. I was on a forum and somewhat out of the blue I mentioned Oklahoma. Within hours, it was blowing up with people saying, “I hadn’t even thought of Oklahoma.” Most people don’t but you’ll never know where these places are going to be. That’s where you can position them in. Anybody who is active, you are in a ton of markets across the country. You see these things in real-time. You can help those investors get out of appreciation heavy and into cashflow. That’s the single best time to do a 1031 or to do it in reverse.
Your answer was heavily focused on the idea of increasing your net operating income, your rate of return and the cashflow. I agree with everything you said, 100%. The other thing I would add to that it’s not and/or, it’s just and is this. A lot of people are sitting on a bunch of equity. I jokingly say that Californians, people from New York, New Jersey, certain markets like Denver, Colorado, some people in Austin, Texas, but definitely the coastal markets. People who own one or more properties are what I call equity rich, cashflow poor. If this is you and you are sending on a whole bunch of equity, what I like to say is that equity is either dead, dormant or idle. You pick. If you have dead, dormant, or idle equity, your return on that equity is zero. Until you take that equity and put it to work in an asset or another larger portfolio or something that’s generating cashflow, you’re not getting a return on the equity. You’re getting a return on the property if the equity is trapped in.
If you can take that equity out, move it, not lose it and turn it into income-producing assets. All of a sudden, you’ve increased your cashflow, probably increased your cash-on-cash return or your rate of return based on the equity that you’ve liquidated. You can increase the size of your portfolio. While doing all of this, you can also minimize your downside risk. If you’re in a highly appreciated market, call it an overpriced market may be a bubble market. You can get out of harm’s way and you can position yourself in a better market that’s either stable where you can sleep well at night, or it’s closer to the bottom of a market cycle where you can ride another wave of appreciation. It’s always appreciation potential, but appreciation in a new market and get out of a market that has had a very strong long run. I know that was a long way in addition to what you said, Dave, but I also look at it from the people who are equity rich and cashflow poor.
I love that too. It’s a great segue because equity also represents one other thing in people’s minds and in reality, equities represent a market risk. The more equity I have in a property, the less risk I have. That’s not a bad thing or a good thing in and of itself. If I’m 75, I’d probably want a little more equity than less. If I’m starting out, if I’m aggressively trying to grow my portfolio, equity is the last thing I want because I can make up for that risk in a number of different ways. The quicker that I move to increase my portfolio, then what happens? The quicker equity starts to build on those properties and that starts to take me out of harm’s way. You’ve got a time that position to move from equity into cashflow, do it quickly and swiftly and get those new properties working for you. Here’s a twist that’s going to add to a long answer. I call it defensive investing. It is where you’ve got all of that equity and you’re going to turn that into a number of smaller assets. The reason for that is that typically the smaller the asset, the greater the return on investment. It’s easy to rent $100,000 house for $1,000, but you’re not going to rent a $200,000 house for $2,000. You’re only going to get $1,400 for it or whatever. You’re trying to go over my larger asset that’s giving you a poor return into numbers of smaller assets that will give you a greater return.
When you use the 1031 Exchange, there’s this incredible flexibility that it gives you because you can take your proceeds and allocate them towards your purchases in any way that you want. If you want to defer all tax, you’ve got to do two things. First, you have to purchase at least as much as you sell. You can purchase more that means more leverage. Secondly, you have to use all the proceeds from the sale, but you don’t have to allocate them in any particular order. Let’s say, someone was selling a California house for $500,000. They have no debt on it. That’s not that uncommon. They could go and make it buy a couple of houses for cash. What they did was they took $200,000 of risk off the table. Those assets are theirs. Nobody’s going to take them or touch them. All they need to do in a downturn, ratchet down the rent if needed and take the remaining proceeds and use those as down payments on a large number of other properties. You get both the safety of cash-owned assets but the arbitrage and the pop that comes from higher leverage. That’s another twist that can happen that locked that equity we’re talking about.
That’s what I want to see more people do take advantage of because it’s such a great opportunity. You are further ahead in many different ways and I don’t see any downside to it. I don’t see negative. I don’t know if you do.
In doing the QI work since 1999, the only investors of mine that lost any money in the worst real estate crash in American history. He lost it because they were overleveraged. Every one of those investors that had the leverage to keep the cashflow coming looked at their paper net worth and said, “I’m poor right now.” They did not care because cash was still coming in. Few years later, they’re all smirking again because that’s all recovered. It’s the idea of being able to hold on for the long-term.
That’s why I put much importance on the positive cashflow. It’s the glue that holds your deal together. Regardless of what the market is doing, you can weather through it because you’ve got the sustainability of keeping and maintaining that portfolio in good times and bad. Over the long-term, your equity, net worth and your wealth will grow. Meanwhile, your cashflow will also grow because you’ve got a large portfolio with equity, the cashflow to go along with it and you can take that equity and grow your portfolio even larger. This is why cashflow is important. You’ll make more money through the equity growth, through appreciation over time, but you’d need the cashflow to get you from where you are to that end goal that destination that you’re getting to with your real estate portfolio.
I like to say the cashflow is the sustainability factor. That’s what’s going to let you move in the long-term.
What does not qualify for a 1031 Exchange? Everything we’ve talked about, even though we’re not using the word 1031 Exchange all that much. At the end of the day, certain things do qualify and don’t. Give us a quick breakdown of what does and doesn’t qualify.
I’m going to give us a segue into our next episode. There are two sections of the Tax Code that deal with real estate. The first one is Section 121 and that deals with your primary residence. That lets you sell a property you live in tax-free. There is a connection between 1031 and 121. We’ll leave that as the cliffhanger teaser. I’ll be back, we’ll talk about the primary residence and how you can make 1031 work with that. The other part of the Tax Code is 1031 and in essence, at its broadest, it deals with every other kind of real estate, not your primary residence but that you have owned for productive use in investment. It could be a restaurant that you run your pizza place out of. It could be a multifamily complex, a commercial building. Interestingly enough, oil and mineral gas rights are real estates. Put that in the offer and think about that. Any kind of real estate that you own for investment, you can do a 1031 Exchange with and buy any other kind of real estate that you’re also going to use for investment. One of the things I was going to ask you, Marco, is what are you seeing out there that are the hottest sectors of real estate?
Single-family homes because demand is strong and inventory is thin. There has been for many years and continues to be strong demand for single-family rentals.
I would say definitely. There’s a move back into that because, for a while, you heard the song and dance of multifamily. Everybody wanted multifamily. When everybody wants something, what happens to the price? All of a sudden, the returns that you and I are looking for start to look more attractive with single-family homes. That’s what the 1031 Exchange lets you do. Sell multifamily because everybody wants it, go into and purchase single-family rentals. Sell commercial, if that’s a problem because of the Amazon effect that you’re scared of, and buy industrial or agricultural land. You can mix and match, but as long as its real estate that you used for investment, it qualifies for 1031. If you happen to be sitting on some mineral and gas rights in Ohio or Texas, you can sell those and buy yourself a bunch of single-family rentals and not pay tax.
What are the requirements for an exchange? I believe there are six?
There are six requirements. It’s got to be an investment property. There’s a couple of critical timing because this is a very rigid statute. You have to remember that back in the day, the IRS has lost a lawsuit that did not make them happy. They have to let you do a 1031 but they don’t have to make it easy. From the day that you close your sale, you’re on some tight timelines. You’ve got to be shopping quickly because you’ve got 45 days to identify your potential replacements and only 180 days to complete the entire process. It’s critical that you be focused right from the beginning. If not on a particular area with good professionals who are going to help you focus in on an area really quick. Thirdly, you’ve got to use what’s called a Qualified Intermediary. These people are going to be an independent, unrelated third-party whose only job is to document the exchange and process the transfer of the funds from the sale to the purchase. If you sell your property without authentic QI in place before the closing, you cannot do 1031. That’s the critical factor and a good guy is going to coach you through the rest of these requirements. Whoever owns the property, the old property has to be the owner of the new property.
Lastly, if you want to defer all tax, you’ve got to purchase at least as much as you sell and you’ve got to use all the proceeds in the purchase. You could take money out, but if you do, the IRS is always going to say that you’re taking a profit. They’re going to make you pay tax. That does segue into another nice strategy for your audience. That is if you need cash out or if you’re selling a property, you can only find 2 or 3 and you wanted a couple more then complete your 1031 Exchange, use that defensive investing idea. Buy one or two of those properties for cash. As soon as your 1031 is complete when you find your next attractive purchase, simply do a refinance of one of the cash owned properties. You’ll have equity that’s trapped, but it’s equity that’s available to you. By doing it after the exchange, you don’t have to pay tax on what you pull out.
We’ve had a number of people come to us at the 11th hour on 1031 for whatever reason, things have fallen apart or they drag their feet and they have to identify properties. They’ve got literally in some cases, there were days left. They’re coming to us scrambling saying, “I’ve got three days to identify and put under contract properties for my 1031. I’m losing my tax benefits. I’ll have to pay tax on all the proceeds.” In every single case, this happened more than once. We’ve been able to help them, in other words, bail them out of a tax situation. There was only one case where it was a partial tax payment. For the most part, the rest of it went through fine. My point and my suggestion are that people should get on top of this early. Before they close on the property that they’re selling to move the proceeds into some other property or other sets of properties, it doesn’t hurt to talk to us 30 days early. Because we can start having conversations about the markets to be in and start looking at properties and evaluating what’s available and out there because maybe we can even put it on the side and put ear market for you and reserve it. The point is don’t wait until the last minutes, start early.
At the worst case by doing that, that client is going to become educated. They’re going to know once their property closes, a good deal when they see it. They’re going to eliminate a lot of that. It is fine to go under contract for your new property before your old property closes. You have to close the sale of your old property before you close the purchase of your new property. Working early and you want to get that done. There’s another benefit that a guy like you, people don’t think about this as much. The idea of being able to evaluate multiple markets simultaneously to see what’s going to be the best fit for them. That could take you months or years doing it by yourself. If someone who’s in multiple markets already can’t give them that low down instantly. What I’ve seen is this investment real estate tends to be a commodity. It’s like pork bellies, orange juice and apples, they all look the same, they just have different addresses. You may be shopping and you may find a property you want but you’re not ready. If it’s in the market you want and it’s the property type you want, you can probably find that exact property for them. Sixty days later, it’s going to have a different address but it’s going to have the same performance, the same characteristics, and it’s going to be right where they need it.
Dave, I know there are different rules in place for a 1031 Exchange. You have to identify within 45 days, and you have to close within 180 days and not one hour more. There are these three timeline rules, but how often are there issues with these timelines?
Much less than you would think because people are starting to get the idea that they can get out there and be proactive and aggressive. We get that question all the time and we still see it. I did an anecdotal study of our exchanges. What I found was that less than 10% of our exchanges that fell apart is because of a timeline issue. Less than 10% blew up because of any timeline issue. That means that 90% of the time, you’re generally able to find the properties that you need.
What’s the most common or the biggest 1031 issue?
It’s still the timing because of that 45-day list. The 45 days are critical and it’s fixed and finite. We have to tell people that our corporate servers are on Mountain Standard Time. If they’re emailing in a doc list, they need to understand if you’re in Cali, it’s an hour later, don’t send me a time-stamped email at [spp-timestamp time=”12:00″] California because it’s too late in. You’ve got to be careful with that. What I counsel people is that if you cannot find good properties, don’t make a bad deal to satisfy the exchange. The exchange is a nice way to give you a boost. If you can’t, at the end of day 45, simply don’t turn in a 45-day list and your exchange will die. You get your proceeds back. They’re taxable, but there are no penalties for doing it that way. That’s better than feeling pressured to go into a bad deal. If you can go into it relaxed knowing that you’ve got a backdoor, you’re not going to give them arthritis, you can be as aggressive as you can. Over 90% of the time they made it work. That still is the biggest pitfall for the 1031. The other one is that people won’t cash out. They’ve got cash needs for something, somewhere. That’s where we go back and we talk about the idea of do the 1031 either fully and they’d refinance or do a partial 1031 take a little bit of money out, pay a little bit of tax, but leave the bulk of the profit in there so that you’re still getting some good leverage.
Based on what you said, it’s possible to terminate it in an exchange if you wanted to or needed to. I don’t know why you would need to, but I assume that it’s possible.
The way that your exchange is structured will always be complete before you have to file your next tax file. If it falls apart, you can’t do anything about it, it doesn’t get reported on your tax return. It’s like it never happened. That’s the only issue.
Someone who is in a position or needs to or wants to do a 1031 Exchange, what would be the expense of doing it? How does that work in terms of the cost of doing 1031?
They are surprisingly inexpensive compared to the amount of gain. It’s not like a realtor commission thing or started to hugely. Nationwide, you’re going to find a range of four full-service accommodators, not the internet fill-out a form thing of around $750 to $1,200 for a complete exchange. They’re a little higher on each coast if you choose someone there. They’re going to be a little bit higher if you use an attorney or an accountant who’s doing a few a year. Your lowest cost providers are typically going to be the Hartland QIs that that’s all they do. They’re doing thousands a year and they’ve got some economies of scale. If it’s $750 to $800, that’s a bargain for a tax.
In the grand scheme of things, that’s nothing because you’re not only deferring your taxes and if done indefinitely, but at the same time, it allows you to take that equity and compound it. Reinvest it, grow your wealth, grow your portfolio, increase your cashflow, increase your rates of return, get out of harm’s way inexpensive, overpriced or inflated markets. All the benefits and upside potential of putting your portfolio’s growth on steroids for a minimal cost. Basically, it’s what you would pay for property insurance.
In one fell swoop, the world now knows who to blame for me raising prices.
Dave, the biggest takeaway here as I’m thinking about this and our conversation is to put your equity to work. If you’ve got equity, take advantage of the 1031 Exchange. It’s been there for decades. Put it to work and use it and grow your portfolio faster than you could otherwise. Is there anything that I didn’t ask you? I think you have another comment that you want to make on that. Do you not?
I was going to say people get scared because they’ve got this lovely gain, this equity. I’m not going to be able to find something to do with it but they’re scared to sell. The true investor mentality is I can always find deals or I’m going to work with professionals who know how to help me find the deals. If you can get into that kind of mindset, you’ll give up your equity to grow your portfolio in a heartbeat. Get rid of the fear. Trust yourself as a professional. Trust the professionals you work with because it’s always going to be there for you, no matter the market. There were people buying properties in 2008. They were buying it cheap and then knew what to do.
The whole point of doing the 1031 Exchange is to take that equity and move that equity or call it investment money forward to invest in more property. That’s why it’s there. With that, anything else that you’d to share that I haven’t asked you that you think our audience should know?
If there are questions, they can always reach me at The1031Investor.com.
Dave, I appreciate you coming on the show. It’s great information. People are not aware of what we talked about. They’ve heard of a 1031 Exchange but they don’t realize that it’s a powerful tool to leverage up, grow and expand what they already have. I wish that more people would know about it because we would be three times as busy as we are if people were coming forward knowing that they could do this.
Albert Einstein called compound interest the eighth wonder of the world. The 1031 Exchange gives you access to compound interest for your real estate.
Dave, I appreciate you coming on the show. Thank you for your time. For the audience, download our free report, The Ultimate Guide to Passive Real Estate Investing. It’s a free download on both our websites, the PassiveRealEstateInvesting.com website where it’s the home of our show and also, at NoradaRealEstate.com. Get your free strategy session to talk about the options you have with the 1031 Exchange and how you can put it to work for you. We work with Dave. He’s a great guy. He’s done a lot of exchanges for clients of ours. Let’s help build your portfolio. If you have a question about real estate investing, go to the website and click on the Ask Marco! button and I will cover your question on the show. I try to get to all of them, but I get more than I can possibly cover. If you haven’t subscribed, remember to subscribe. Help us spread the word, go to iTunes, leave us a rating and review. As you know, I read every single review. Thanks for reading. We will see you in our next episode.
Important Links:
- Dave Foster
- The1031Investor.com
- The Ultimate Guide to Passive Real Estate Investing
- NoradaRealEstate.com
- iTunes – Passive Real Estate Investing
- Ask Marco!
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