TSI001: Deferring Capital Gains Tax
THE SOPHISTICATED INVESTOR EPISODE 001
TAX DEFERRED STRATEGY USING 1031 EXCHANGES
EE: Hello, everyone. This is Edwin Epperson, your host of The Sophisticated Investor. The Sophisticated Investor is an incredible community, which is focused on education, training and collaboration to help each of our members, and that includes you, to build, protect and preserve your families’ generational wealth. Now, I believe that we truly have a unique and one-of-a-kind educational community. For one, I believe that there are four primary markets, not just one. I believe that those four primary markets include your personal finance and mindset market. I believe the second market is your hard, tangible asset market. I believe that the third market is your stock and paper market. I believe the fourth market is your business investing market. Now those four markets are imperative to be able to understand and then call yourself a sophisticated investor. Today, we have an incredible guest, who is going to educate us on their preferred market of investing, as well as the assets that they like to invest in. Please join me as we welcome today's guest.
EE: Hello, everyone. This is Edwin Epperson, your host for The Sophisticated Investor. Thank you for joining us today. As the name indicates, The Sophisticated Investor, we are a community, a group of investors who are looking to build, protect and preserve our generational wealth for education, training and collaboration. This is our purpose and mission. Our purpose is to build a community dedicated to increasing their financial and business acumen through education, training and collaboration, so as to become considered a sophisticated investor. Now our mission statement; we empower each of our members through education, training and collaboration to build, protect and preserve their families’ generational wealth and to make a lasting impact for good. Today, we have with us Dave Foster from the 1031 Exchange Group. He is going to be talking to us about a strategy that sophisticated investors utilize when it comes to selling their hard, tangible assets. Now remember, we are still in Q2 of 2019. In second quarter, we always talk about our tangible assets. This regard, the 1031 exchange is in relation to selling your real estate. Dave, thank you very much for coming on the show. Welcome.
DF: Thank you, Edwin. It is absolutely great to be here today. It's interesting that sometimes, the most important thing isn't how much you make, it's how much you save after you make it, right?
DF: That's where the 1031 Exchange lives. It is the opportunity that investors have to sell real estate that they've made a profit in, or that they've taken substantial depreciation tax benefits from over the years; sell that real estate and purchase new real estate, in part using those tax dollars. By doing that in a proper way, they're able to defer the payment of that tax that would normally be due on that sale. Now, think about the power of that. When we start talking about it's not how much you make, it's how much you save at the end, this is the opportunity to add anywhere from 20% to 35% of the profit from your real estate transactions to be used for your benefit moving forward. Now, to give an illustration how powerful that can be, let's start with two investors, just a little example. Two investors are going to start with the same property and they’re going to have the exact same appreciation, they’re going to purchase the exact same replacement property. The only difference is going to be that investor A is going to do a 1031 exchange, investor B is going to pay the tax. Let’s assume that it's going to be between federal and state, a 20% tax here. Look at after five years with a $100,000 gain, investor B is going to pay his tax, he now is left with $400,000 from back, or $80,000 from that sale, I'm sorry, to purchase a $400,000 property using $80,000 as a down payment. Look at investor A, they didn't pay the tax. Now they've got a larger down payment to work with. They can actually purchase a $500,000 property. If you look at that far right column, they still owe $20,000 don’t they? Because of the tax deferral. Look at here five, they're ready to sell that property. They're going to do the same thing. Now, all right, calm investor A is starting to quite a bit of tax. Look at how much property they are able to control for their benefit by using that deferred tax as additional down payment? Investor B is in pretty good shape, right? They don’t owe anybody anything, but they're starting to be able to purchase less and less property compared to the investor who's using the 1031 exchange. Year 10, we go out we just start to see this trend decreasing, now investor A is able to control almost a million dollars more in real estate. This is only after 10 years. Now we never ignore that own a huge tax bill, but in the meantime, they're making the money off of that 2.8 million in real estate. Fast-forward to the end of what many would consider a normal real estate investing career, well though I got to tell you, you and I are both discovering this, it's one of those things where you almost can't get out, right? You're in for life. Let's say at the end of year 20, these two investors want to start to slow down, exit the rat-race. Investor A has a portfolio of a million dollars in real estate. They owe almost half a million in taxes. If they were to liquidate, look at how much more they would generate after tax dollars, versus investor B, who doesn't know anything in tax, but is only controlling a portfolio of four and a half million. Now this is just an illustration, a simple example of what Albert Einstein called what, the eighth wonder of the world; compound interest.
EE: There you go.
DF: The idea is that those dollars in my hands can benefit me and then the benefit of those, start to benefit me and the interest on the interest on the interest, as long as I'm able to hang on to the money. It's really nothing different than exactly what everybody has been doing for decades using tax deferred IRAs and 401Ks, because when the interest is in your hands, you get to make the interest on that interest and use that for your benefit. That's the motivation when using the 1031 exchange. Yeah. The devils are the details of course. There's some very rigid requirements that all have to be met for the 1031 to be valid. We’re going to just have a chance to touch on each one of these this morning, but we can flush them out at a later date. The first requirement is it's got to be held for investment. The second and third are that there's some very stringent timing requirements that must be met. There's this animal called the qualified intermediary that has to process the 1031 exchange for you. As you can imagine, when the IRAs is going to let you keep your tax dollars, it's not something that they really are comfortable doing, so they want to add a level of protection from abuse. That's called the qualified intermediary. Think of that as one of those, “I'm from the government. I'm here to help kind of moments. Believe us. That's who we are.” There's some requirements on a title must be held. Then of course, the question that's on everybody's mind, “Well, how is it that I have to reinvest my cash? What is it that's going to allow me to defer all my tax?” If you can meet all six of these requirements, maybe you have completed a successful 1031 exchange, you will get to defer payment on the tax, have a substantial depreciation redemption. As long as you own that replacement real estate, you will never have to pay that tax. That's the teaser that I want in everybody's mind right now as we get ready to go forward. As long as you own that property, you'll never pay the tax. As long as any time you sell that property and do a 1031 exchange, you'll never pay the tax. Pretty awesome concept, isn’t it?
EE: That is pretty incredible.
DF: Let's dive right in the first requirement, properties can be held for investment. The use of the property is going to be the key. It's any property, real estate that is held for trade, like in your trade as a shoe cobbler, or your trade as a manufacturer of some sorts, any property itself for business use. I have a strip center and I put businesses in that and I rent those shops out. Or today's hero, the small, singular multifamily real estate investor, it's my business that I own properties for rental, or holding properties for investment. I buy a property today, because in the future, that property will appreciate over time. Any real estate that is held with that intent qualifies for 1031 exchange. You can sell that real estate, yet purchase any other type of real estate, as long it is all for those same purposes.
EE: Now Dave, real quick, ask a question. The exchange, the holding of property and then exchanging it for property of like kind, it sounds like it's more – its intent is exchanging property for the same intent. Can you exchange a let's say somebody buys a little single-family home and exchange that into a six-unit multifamily?
DF: Well, that's exactly right. You can exchange single families for multi-families, residential for commercial, industrial for agricultural. The type of real estate doesn't matter. You're absolutely right, it's the intent. Do you hold that real estate with an investment intent? I can see the cogs turning right now, right? Transitioning my real estate throughout the years from a sector where the appreciation is maxed, to a sector where the appreciation is still growing for one where cash flow is lighter, to where cash flow is heavier, or one where management is more active, to where management is more passive. All those kinds of things get factored into why you would want to sell and purchase other real estate. When you do the 1031 exchange, you're not having to pay the tax on that process. Now in honor of hard and tangible asset week, which is what we're in, by the way, we've got to maybe look at doing that for Discovery Channel as well, right? They should put it right next to Shark Week. Hard tangible assets, there's some interesting things about from real estate that you would not think of as being real estate. For instance, we're in a very interesting cycle right now Edwin, where oil and gas have just started to rise again after a very long sustained trough. Whereas, hard real estate is actually at a point where we think it's peaking. We're starting to see some price retrenches, we're starting to see days on the market in certain areas. Well, the opportunity is because oil and gas interests are considered to be the same thing as real estate –
DF: - you can sell real estate and purchase both working interests and royalty interest programs in oil and gas.
EE: Wow. Now that's incredible.
DF: Those are the little dummies that are inside the 1031 exchange, that can be so powerful for you. It essence, what do you have the opportunity to do now? Sell real estate high, buy oil and gas low. Same thing is true of little resources. Same thing is true of things that you don't necessarily think of, like mobile home parks, those types of things, as long as what you are buying is considered to be real estate, that's where you just have to look at the state interpretations of what that real estate is. The second requirement, remember we talked about the timing requirements, they are so rigid. From the day that you've closed the sale of your old property, you have 45 days to identify your potential replacements. That's 45 calendar days. Day one starts with the day of closing. The reason why this is so important is that during that 45-day period, you have to identify your potential replacements. Once day 45 passes, you cannot change that list. You’ve got support time to close, but you've got to be very focused on finding the replacements you're going to purchase in the end. Turned out 45 days, you can do one of two things; you can either purchase and actually accept ownership. If you can find the property, you can sell and close within two days. That's fine, but you either have to purchase and accept ownership, or you've got to provide that written list of replacement properties. That list goes hard on day 46. It's got to be in writing, that's how serious they are. It's got to be a specific identification. You have the early days back in the 90s, when we started this thing, we used to have exchangers come in with the LA County phonebook and say, “Here's my replacement list.” The IRS decided to put the kibosh on that was some specific requirements. You've got to identify something to the point where you could walk up and ring the doorbell. Now here’s how the IRS is starting to put a restrictive funnel on you, if you will. If you need three or fewer properties on your list, it doesn't matter how much they're worth. Sell a property for $100,000, name three 10 million dollar properties. That's perfectly fine. The only thing is of course, you're going to have to be able to purchase one of them. You've got to be thinking strategically that way. A lot of folks today have become enamored with the idea of selling a large asset and purchasing multiple smaller assets. To do that, their list is going to have to be greater maybe than three properties. You can do that, but if you do, then the value of the list, the total can't be more than 200% of the value of what you sold. Back to our example, if you sold if the property for a $100,000, you can name three 10 million dollar properties, you could name four $50,000 properties, because that's 200% of what you sold. You could not name three $50,000 properties and $175,000 property, because that goes over the 200%. Unless, you actually purchase 95% of the value of the list. In our example, that would mean you would have to have purchased all four properties. That's a pretty dicey gamble, given that anything can happen at any time, right? It only takes one property to fall out of escrow. The idea is shop fast, shop decisively, try to keep your list under 200%. If you're going to name more four more properties, and try as much as you can to complete those purchases within the 45 days, because this is the key. There are no exceptions. There are no extensions.
EE: Now that's very interesting, Dave, when you say no extensions, because I was on – this is my earlier understanding of the 1031 exchange, is that you could identify within that 45-day window, identify properties. Then if you needed to trade out one of those properties, because it fell out of escrow like you said, or it was taken off the market, so there is no extension, there are no exceptions to that rule?
DF: Yeah. If you lose a contract on something and you're still within your 45 days, you just pick another property. If you're after day 45 and that's the only property on your list, you’re being highs with the IRS, then that property is the property that is still available for you. You may be purchasing it from another person. I actually have had that happen to me once, where my client negotiated a little too hard and lost the property. That actually had to go to the buyer of the property and offering a substantial amount of money for that buyer to assign his contract to our client. You don't think that's dumb a little bit?
EE: That is it.
DF: Exactly. After day 45, there is not going to be the opportunity for an extension, unless congress declares some disaster that would extend all the filings.
EE: I see.
DF: Like they did with the California fires. In filing that was due, say between January 1st and March 15th, was allowed to be extended to June 15th.
EE: What you're saying Dave, is that since we live in Florida, probably the best chance to get a filing extension is to try to get properties located on the beach during hurricane season?
DF: What a strategy. I'm not sure that I couldn’t get behind them when actually. Yeah, exactly. That's exactly right. You take this timing very, very serious. Now let's try this over the [inaudible 0:19:28.6]. Sold the property $400,000. They won't identify two or three for 10 million each, can they do that? Yes, of course as you got to speak, because they're all identifying three or four of your properties. If they wanted to take four $75,000 condos, could they do that? Now quick math, $75,000 condos times four, $300,000. $300,000 in your list is more than 200% of the $100,000. Could they do that? Wouldn’t that person be a star?
EE: No, they could not.
DF: Maybe they could and but if they purchased 95%.
EE: That’s right.
DF: Everybody every time was out to go through. Yeah, but you're absolutely right though, we do not want to rely on that, if at all possible. The only time I've ever seen that done successfully was when they actually closed on 20 properties during the 45-day period, and they had 25 on their list. When day 45 actually came, they took those five properties off their list. At the end of their exchange, the only properties on their list were the properties they had already closed on.
EE: Interesting, interesting.
DF: That's the way they stopped. Yeah, the 45 days is the single rule that I see more exchanges fail on than any other. The second half at the time it grows much, much easier. You have a 180 days from the day that you close the sale of your old property to purchase your new property. 45 to identify, an additional 135 to close. Of course, the property has to be one that's on the replacement list. If you closed during the 45 days, that becomes the list. If you closed after the 45 days, it's got to be a property that was left on the list.
EE: If the property is on the list, you've got to close it in 45 days. If you closed on a property off the list, you have an additional 135 days?
DF: Yeah. I said that confusing. Not quite. If you close on the property during the 45 days, it's simply automatically is on your list.
EE: I see. Okay, okay, okay.
DF: Because you can change that list all you want during the 45-day period.
EE: Okay. Then after the 45-day period, those properties on the list are locked in, but you have an additional 135 days to close on those properties?
DF: Correct. That's exactly right. Yeah. Of course, guess what?
EE: No exceptions and no extensions.
DF: Yeah. Day 179 comes and you're sweating that closing, you better make it happen. Day 181, you're done.
EE: What happens, Dave, if somebody is not able to follow through with their agreements, or with their requirements to be able to take full advantage of the 1031 exchange? Are they then penalized the entire amount due in taxes, or is it seen as a pro-rated amount?
DF: Yeah, that's a great question. Actually, it's the entire tax. You will either complete your exchange, but if you do not do an exchange fully, then you will pay all the tax. Now we're going to talk about a thing a little bit, called the partial exchange. In essence, what you're asking is if I can't do an exchange, what happens? You pay the tax. Now, there's no penalty for not completing an exchange, but you will end up having to pay the tax. If you can't find good replacement properties, you don't turn in a 45-day list, your proceeds come back to you and you pay the tax. If you’ve identified one property and at 170 it burns down, so you don't want to close on it, you don't purchase it. Your exchange dies on 181, you get your proceeds, you pay the tax on it, but you don't pay penalties. You don’t have to pay extra interest at that point in time. Those are your time reason. Those are the things that trip people up far more often than anything else. The qualified intermediate requirement is the great mediator for this, because the IRS requires that you use an unrelated third-party, whose sole purpose is going to be documenting the 1031 exchange, consulting with the client to make sure that they're doing it the proper way and processing the transfer of the proceeds. The QIs got to be involved at, or prior to the closure to the sale, because the client cannot touch the money. They can't touch it actively by getting a check. They can't have what is called constructive receipt, by leaving it up in title company, where it's under their control. The QI is the key to the 1031, because they have to be involved, they have to document it appropriately and they've got to be the one that helps you wade through the fog and smog and bog of the 1031 exchange process. That's the QI. They're your guide, if you will. To have title requirements, when we talk about that, this is the actual statute the way that it reads. If you notice it says, the taxpayer transfers property. However the taxpayer for that property. What that means is the tax return who's reporting the activity of that property, wherever they hold that property, that you need told the new property.
EE: Now you can transfer title during ownership of the property, right?
DF: Absolutely. Yeah. If you've got a piece of property, you complete a 1031 exchange. By the way, here's a classic example; someone starts out small, this single family rental. If they want to go into multi-family investing where they're much more fearful of frivolous lawsuits, liability, etc., etc. They want to own that property in an LLC, a separate entity. They're the taxpayer for the old property, so they can simply sell the old property, complete a 1031 exchange taking title to the new property in their name, and so it's still on their tax return. Then after the fact, once the 1031 is complete, they can again transfer that property to whatever entity they want to set up to afford and liability protection. That instance, they can't change the taxpayer.
EE: Now when they go to 1031 exchange the new property that they just purchased, let's say five years later, they have to transfer title back into their original name, or –
DF: They would just sell as that new taxpayer.
EE: Ah, see. Okay.
DF: Now whoever the taxpayer is, the one thing that we've learned about the IRS, they like to look for issues, right? Doing something like transferring title right before a property sale is a recipe for scrutiny.
EE: Yes, that is true.
DF: We like to see the taxpayer stay consistent during the 1031. After the fact, there's a perfectly rational reason to transfer that title and they could do so at that point in time. Absolutely. For the last and perhaps the most important requirement when we're talking about preserving wealth is the reinvestment requirement. What is it that I have to purchase in order to fully defer all of my tax? You want to think of this as a two-part rule. The first part of that rule is that if you want to defer all tax, you have to reinvest all of the proceeds from the sale of the property. If you sold a property for $200,000 and there was a $100,000 load on it and a $100,000 went into your exchange account, you would have to use all $100,000 in the purchase of your new real estate. The second part of that rule is that you must purchase property, or properties and notice I said properties, because you can sell one, buy several, that are at least equal to, or greater in value than what you sold. Yeah gain, if you sold for $200,000, then you need to purchase real estate worth at least $200,000. Another way of looking at this is to simply take the amount of cash that's left at the end of your exchange, or the end of your sale, what's in your exchange account, and add to that the amount of the mortgage that was paid off. Those two will equal your investment target. Another way of looking at that is simply to say you need to purchase at least as much as your net sale and use all of the cash that was there at the end. Either way, that's what you must do to defer all tax. Now, someone will say that, “Dave, I put $20,000 down. That's not taxable.” That's correct. It's not. That’s your initial capital. Because it's the IRS, they choose to say that if you pull $20,000 out, you're taking profit. “Well, no I’m not. I'm taking my original capital out.” I agree with you. You're taking your original capital, but the IRS says you're taking profit. Who has [inaudible 0:29:20.1].
EE: Now that's the actual sell, correct Dave?
DF: That is correct.
EE: Now somebody can get a loan, or obviously they're going to leverage, so they've gotten maybe 20% down, like in your original example, they've got 20% down to purchase a new property. They purchased that new property and if they can find a bank to go in and let's say, give them a up to a 90% HELOC, they can pull out 10% of that 20% down paid, right?
DF: Well, that's exactly right. Or it could even be actually be more powerful than that, because once you've completed your exchange, just like you can change your entity, you can also refinance the property, rather than taking profit out ahead of time, leave it all in the property, purchase the new property, then take out the HELOC, or do a refinance after the fact, then it's tax-free money.
EE: There you go. I love it.
DF: That's how you can get cash to operate, to continue to grow and expand. One of my greatest fear are kids teeth, which is a very pointy of detail for me this week. That's in essence, the six basics. It's got to be held for investment. You've got the two very critical timing dates, the 45 days to identify and a 180 days to close. You've got to use the services of someone like me, called a qualified intermediary titling the taxpayer and the whole property has to be the taxpayer of the new property and then of course, reinvestment if you want to defer all tax, you've got to purchase at least as much as you sell for one. Six acquirements, but oh, my goodness, it's one slide for us and I think it’s about 8,000 pages of IRS case law. One of the things that I promise that you add, that we were always going to leave you with, then we're going to start to flesh out at both your live event coming up this May and hopefully, you'll have me back and we can start to talk about some of these, because these are these strategic applications, ways that you can use instruction, 1031 exchanges, that will give you so much more power, even than simply deferring all the tax. The opportunity to control your new property before your property sells, the opportunity to actually create new construction, or do a heavy-value land proposition on a property using the 1031. The ability to shift the recognition dates of your game, even though you end up paying the tax, you can get up to 18 months additional to pay that tax. How to use your money to invest as I call it defensively, in an environment where risk is starting to rear its head and we're in an increasing inflation rate market. Ways to use this to be defensive and the destruction of yourself to move from an active to a passive management style. How to go for building your portfolio to preserving your portfolio. That's what I love about your mission statement is that's where you're wanting to take people.
EE: Absolutely, absolutely.
DF: Those are the kinds of things that I'm teasing you with, then we could use 1031 exchanges for. Here's your right way to get hold of me.
EE: There we go. For all those who are listening and are not viewing the slides, Dave has his contact information. You can reach him at e-mail, firstname.lastname@example.org. You can also visit him on the web at www.the1031investor.com. His phone number that you can reach him at is 850-889-1031. Ooh, I like that. You worked in the 1031 on the back of that. Very nice.
DF: It’s a little accident, of course.
EE: Dave, we sincerely appreciate you coming on the show, talking to us about 1031s, helping our listeners and viewers, for those who are watching on YouTube, be able to increase their financial and investing acumen. Thank you so much, sir. I have to tell you, we will absolutely have you back. Would love to dive into some of those more advanced, more sophisticated techniques to utilizing the 1031 exchange.
DF: Absolutely. My pleasure, Edwin.
EE: Thank you very much, sir. It has been a been an incredible – If there's anything else that you wanted to maybe drop, put out there for the listening audience, or for the viewing audience on YouTube, is there anything else that you'd like to offer just, throw out there?
DF: Actually there’s one, if someone is interested taking at a deeper dive on the six requirements that we started in fact about today, if you go to our education website, the 1031investor.com, we've got a 31 part. Yes, it'll put you to sleep at night. 31-part video series that's out there on YouTube, that's broken down into very small snippets on these exact topics. That might be a great way to reinforce
EE: Well, that's fantastic. I will get with you and we'll do a link to your YouTube videos and we'll make sure that we do some cross-linking there, that way our listeners and watchers can go ahead and find you easily on YouTube and get in there and deep dive into this before hopefully coming out to the live event at the end of May. Thank you Dave for coming. I sincerely appreciate it, sir.
EE: Everyone else, this has been Edwin Epperson with the 1031 – You got me, Dave. With The Sophisticated Investor. Here is our future training and education for the hard tangible market, Q2 market. We have in April, I spoke on private lending, the foundational strategy that no one else is talking about. Would love to talk to anyone else who is interested about learning how to become the bank, controlling an asset, instead of owning an asset, the benefits, there are pros and cons to both, but we discussed that in April. In May of course, we've got Dave from the 1031 Exchange. I come in at the end of May. He will actually be presenting live. You can attend our live event. You can find us on meetup, or Facebook. You can sign up, buy the ticket. It's $20. You can come out, meet Dave in person, as well as have a drink and a light dinner on us. Then of course in June, we're going to be going over fixed and flipping in today's market, strategies and lessons learned. This will be presented by Greg Simpson, owner and founder of Out Fast Realty & Investments, as well as the owner of the Tampa Bay Real Estate Investors Association. Thank you everyone for attending, listening to The Sophisticated Investor and Dave Foster from the 1031 Exchange. You can reach him here at LinkedIn. You can find him, Dave Foster 1031, you can also find him on Facebook at Dave Foster 1031. Dave, thank you so much for being on the show. We appreciate it and we wish you the best. Look forward to seeing you at the end of May.
DF: Sounds great.
EE: All right, sir. You take care. Everyone else, this is Edwin Epperson, host of The Sophisticated Investor. We look forward to seeing you on our next episode, as we dive into the other assets in a hard tangible market.
EE: That wraps up our show for The Sophisticated Investor. Thank you so much for joining me and joining our guest today, as we dove into the specific assets and the market that they invest in.
Please join us again when we dive into more investing techniques and strategies in different assets within different markets, so that we can help you, the listener and our community member build, protect and preserve your family's generational wealth. This is Edwin Epperson, your host of The Sophisticated Investor. God bless and have a great rest of your we