1031 Exchange Questions – Why Consider A 1031?

David Moore, a 1031 exchange facilitator with Equity Advantage Incorporated speaks on why you should consider a 1031 exchange, and your different exchange options whether you are a broker or investor!

Why Consider A 1031?

Watch, Listen or Read:

Transcript

So why consider an exchange? Who in the room has a retirement account? All the time I have people ask, “I’m going to have to pay tax at some point anyway why not pay it today?” And I say, “Well, do you have a retirement account?”… “Well, yeah, yeah.”, So why? Because you’re going to have to pay the tax at some point, so why not pay it today? The idea is it’s pretax. It snowballs much quicker. You keep that equity intact, you keep it moving and growing and then at the end of the day, you’re going to have some tax exposure. With 1031 you have the ability to swap until you drop.

What about taxable consequences?

Anytime you give up something, you relinquish something, or you sell something, you have to understand that there’s a tax consequence. Even if I gave something to somebody, I have to be careful with what I give them. If I have a kid and I want to gift them cash, I can give them what? $14,000 per person per year, right? My wife and I could give that person $28,000 a year. But if I gave them $50,000, what happens? I have to pay the tax.

One more comment on gifting on things. Think about this, so if I gave you $14,000 in cash and you truly got $14,000, I have no tax consequence, and you the recipient have no tax consequences. But when we go to $20,000 or $30,000 or whatever, I’m going to have the tax exposure, the person granting the gift. The recipient does not. However, if I’m giving a piece of a property I can actually accelerate those transfers while minimizing tax exposure. Because maybe a $20,000 interest in real estate is only worth $14,000 because that person’s received the minority interest. They don’t have control.

When we look at a retirement account, you’re always in a situation where you’ve got all this money in and you need to get it out at some point. Right? It has to come out. At 59 and 1/2 you can start taking out. At 70 and 1/2 you have to start taking it out.

Retirement Accounts and the Checkbook IRA Advantage

We’ve got the greatest tool in that world because most of our retirement accounts are something called a checkbook IRA. In a checkbook IRA, what happens is the custodian makes a single investment that’s in the membership interest in a limited liability company, that makes all investments. So instead of taking a cash distribution, you can take a membership interest in that LLC as a distribution. What happens next? Now you’ve got a piece of it, so we can discount that distribution. You can accelerate distributions while minimizing tax exposure by using that gifting strategy or that discounting strategy.

Why do you need a good tax person?

So back to the comment earlier on guidance on the LLC. We’re just one member of a good team of professionals. I think good tax people are really the most critical. You’ve got to have good tax people. You would be surprised at how many people have piles of real estate and no tax guidance. I mean Turbo Tax might have an income tax component or property component, but get a tax person. Somebody that’s good. It’s going to cost some money but they’re going to take care of you if you’re ever audited… Mine just tell me to sit down in the other room and I’m happy to do it. They’re going to take care of the stuff.

One example of a value that they might be able to offer you is rental housing. So, you go out and buy a rental house. Who makes the allocation between dirt and improvements? What does that allocation do to your return? If you bump up the value of the improvements, you’ve got more to depreciate. So you’re cashflow changes and it increases dramatically. If you minimize it, then it’s the opposite. So who makes that allocation? Who does that today? If you ever look at your property tax statement, when was the last time that was accurate? Has anybody heard of the cost segregation study? Well cost segregation will take this building and break it up into carpet and tile and counters and lighting and plumbing… All you’re doing is taking the same depreciation but accelerating it. So you don’t get additional appreciation, you’re just getting additional in a given year. If you go out the whole investment life, you’re not going to have any additional, you’re just accelerating that which totally changes the return on investment.

Boil it down to simple cost savings. A house to improve and the dirt to improvements. I mean that’s 2, and you can take it to 10 or 20 even. So the thing is good tax people are going to support what’s going on and they’re going to help you justify what’s going on. They might not be cheap but they’re going to save you. And hopefully they’re saving you a lot more than they’re costing you. Legal people, finance people, property managers, you’ve got a team of people. So take advantage of that team. If it comes to looking at the retirement accounts, 1031 stuff, like I said we don’t give investment advice or sell investments. We just give that conduit out of what you don’t want into what you do want.

Why would you think about an exchange?

The answer is why pay tax that you don’t have to? I joke because one of the guys I hired when we first put the company together says, “Yeah once in a while, somebody in a seminar will be all mad because they say, ‘Well gee you’re American. It’s the right thing to do to pay the tax. It’s a patriotic thing to do to pay the tax.'” So he always used to say, “Well gee, the most patriotic thing to do is to make as much money as you possibly can and have more tax to pay.” Right? The more you make the more you get exposure to it. But that’s how you swap until you drop.

The bottom line is that every dollar you save in tax is how much more you have to reinvest in a replacement property. Three or four dollars more makes a big difference. One transaction will put you a lot further down the road.

Why pay the tax if you don’t have to?

The biggest thing you’re going to have to understand when you’re looking to sell something is what’s the tax obligation? Do you have any tax obligation? I’ll be the first to say that there are people who will tell you, “Well 1031’s one of reason the property prices are where they are.” And it’s true because people will pay more… Especially think about coming in from California, those bad Californians like I was. We were used to a different price point than what is here in Oregon. But the bottom line is, if I don’t make this transaction happen then I’m going to have to pay X in tax. If I have a $100,000 tax obligation and we’re sitting there fighting over a $10,000 difference in price, what am I going to do? I’m going to pay the extra $10,000. If I’m outside my 45 day ID period, which we’ll talk about, and that’s the only property I’ve identified, then I’m going to be moving forward with it.

So if you’re a broker, understand who you’re representing. I do a lot of different meetings, and I’ll be sitting in a room someplace listening to people pitch properties, or pitch money looking for properties, and somebody will raise their hand and say, “Hey, I’ve got a 1031 buyer. Their ID date is next Tuesday.”… Now everybody in the room knows that person is highly motivated to make something happen. So if you’re the listing broker, find out where they are in the 45th – 180th and what’s been ID’d.

What’s the old saying on buyers? Buyers are liars, remember that. People didn’t used to like 1031s because if we go back in the late ’80s, there were no ID rules. We’ll talk about the ID rules in a few minutes. But in the late ’80s, you could literally identify Clackamas county if you wanted. That’s why the buyers are liars comment comes up. Because while I ID the county of Clackamas, well you didn’t have any restriction there. In ’91 we had some real tight restrictions come into play and we got three different ID options that we’ll talk about in a little bit. But I would argue today that if you got somebody that walks in off the street to make an offer, they will be less motivated to make something happen than somebody in an exchange that has a ticking time clock going that has to be met in order to get there.

If you’re a listing broker do what you can to find that information out. And if you’re the buyer’s broker do not let that information out. I probably got more people than ever before getting transactions done inside the 45 days than ever before because people don’t want to have that problem.

Class question:

Don’t you have to identify that you’re in an exchange from the acquisition side?

David Moore’s Answer:

Well no. What happens is, contracts in the state are assignable unless they prohibit assignment. The residential and commercial forms, do not prohibit assignment. So at the 11th hour you can always assign the transaction to us. And your forms also include cooperation provisions that give the writer the option to do an exchange. It’s there to cover all possibilities. The downside of those is that it doesn’t put anybody on notice, so if you don’t let us know that it’s going to be an exchange then the deal could get closed without it being structured as an exchange. I am a fan of putting in there somewhere an additional contingency or provision that is, if you’re going to do an exchange put it all in there. There is really no downside to doing that today.

I remember those old MLS books when I moved here… they were big, thick things. We had to go through those and you would look at those things and say, “Gee 1031.” And people who didn’t understand it, they would shy away from that. Going back 25 years ago, people would hesitate because it was scary. I mean I had a little more hair on my head in those days so I came in from out of the area putting a concept together. We actually put the company together because we couldn’t get it done. I’ll never forget my corporate lawyer when we were putting the business together said, “You’re going to do what? People are going to pay you for this?” And I said, “Yeah, yeah. This is the way …” He was just amazed, “Wow.”

1031 exchanges are one of those things where it’s changed a lot and people are much more aware of it today. The purchase sale agreements in most states include some type of built in boiler plate provision allowing the exchange. But I’m still going to say to your point, you ought to put something in there because it puts people on notice. Then you’ve made a contingency so that escrow’s going to get it taken care of. If you don’t have it there, how do they know? Unfortunately we still have transactions that get closed when somebody wanted to do an exchange that doesn’t get done as an exchange.

As a broker, why would you think about it? Maybe you get a listing because you gave somebody the opportunity to go do something. In today’s market it’s hard to find stuff, right? It’s a tight market and people want a lot of money for things. I think where the DST or tenancy in common world, I think that’s a great opportunity for people to get out of things that they no longer want. Or maybe they’re not finding what they want and that gives them the opportunity to get a place to go. So as a broker maybe you get a listing out of it, and if you’ve done your job you’re going to get a seller. You are also going to get a buyer if you’re the broker. So not only do you have a buyer, you know what that person wants. You are working with them and you know when they have to buy it, how much they can spend, and how much they must spend through the exchange. Which is a good thing.

The last point is the most important one. As I said, we still have transactions that close. People want to do an exchange and they don’t get it done. But you have somebody that’s happy. You just potentially saved them a pile of money, and maybe the reason you got the listing is because nobody else mentioned it.