#22: Real Estate Investing 101 - How to use a 1031 exchange to prevent paying capital gains taxes (w/ Jordan Downey, CPA of Frankel Zacharia)

The one topic that a lot of investors will come into, like, I'll go to meetups and stuff like that. And a lot of them will say, you know, hey, I sold a property, so I want to do a 1031 on it, you know, and, you know.

It'S like the buzzword, right? I don't know what it means, but If I say 1031, yeah, it was.

Like, you know, so they're real competent about, yeah, I want to do this. And then he's like, oh, by the way, what is it? And so, yeah, how do you facilitate?

And they sold it. They sold it probably three months ago, so.

Or even three years ago.

Yeah, you know, that's. That's pretty common, you know. So, like, I think there's a lot of misunderstanding of what, what a 1031 is and what you need to do to meet those. Those regulations. But I think, you know, the first off, big thing to know about 1031, it is. It's a very black and white test that you have to meet. There's not a lot of gray area in it. You either check the boxes or you don't. So you can really put yourself out there into maybe some not so great situations by taking positions on your return thinking you did a 1031, when in reality, you didn't check some of the boxes along the way. And it's a pass or fail thing for the most part.

On today's episode of Heading west, we talk about 1031 exchanges and how to use them to prevent paying capital gains taxes with our guest, Jordan Downey. Boy, talk about a powerful tool with regards to tax savings and just general wealth building. You know, capital gains can be a killer. Whether you're selling a business, you're selling stocks, whether it's selling real estate, it can really kill your pocketbook. But if it's done right, these 1031 exchanges is a real tool that can help you save money, defer taxes. This episode with Jordan was incredible. Just to learn how to not pay so much to the government and taxes.

And another great way to continue that generational wealth to the next generation. 10:31 Exchange is a great way to do it, but there are steps and very critical steps that you need to go through and. And having someone like Jordan help you in that.

Yeah.

Is awesome.

Yeah. And just to wet your whistle, if you're thinking 1031s, why would I listen to this episode? We're talking about? How do you defer your capital gains taxes until the end of your life, ideally. So that way Nobody, not you, not your family, has to pay the gap for gains taxes to the government. So it's a great tool for wealth building. It's a great tool for tax savings and keeping money in your pocket throughout the entirety of your life. So trust me, you're going to want to listen to this one. So we're going to head west. Stay tuned as we discuss 1031 exchanges with our guests, Jordan Downey. This episode is brought to you by Skyline Point Capital. If you're anything like me, you're always considering where to invest your money. Stocks, bonds, crypto and rental home. The list is literally endless. As we've all seen over the past year, the stock market is unstable, the housing market is just weird and inflation is on the rise. In times like these, the clear place to invest my money is in multifamily real estate, AKA apartment complexes. Here's why. Returns on real estate investments have little to no correlation with the stock market. There's lower volatility, stable income streams, and the tax benefits are insane. And let's not forget that the apartments will typically appreciate in value over time, which means you can walk away with a pretty nice return when the complex is sold in three to five years. Best of all, multifamily investing is passive, so you get all the benefits without the hassle and headache of your typical rental home investment. Getting started has never been easier. Head to skylinepointcapital.com to learn how you can start investing today. Well, thanks for joining us today, Jordan. We're excited to have have you a tax expert in the house. Thank God, because Steve and I are anything but experts in taxes. So, so happy to have you here. And especially tackling a topic today that, you know, you hear it from time to time when you're sitting with your financial advisor or you talk about real estate, but you don't really know what it is. So I'm excited that you're here to break it down for us. We're talking about 1031 exchanges. So again, thanks for joining us, Jordan, and I'll just jump right in. I'll start asking questions because there's gonna be a lot of data on this one. Can you, well, first, can you give us a little bit of your background of what you do for profession, how you serve real estate clients and then talk us through what is a 1031 exchange.

Sure, sure. Yeah. So I years ago decided to get fully committed to tax and I got a master's of taxation to boot. And so, you know, that's when you know you're really having fun and pot committed, I suppose is what I told my wife. But no, like, so over the years, not only, you know, professionally, but, you know, personally just had a passion for real estate and kind of working with developers, with contractors, with investors and so forth. The one topic that a lot of investors will come into, like, I'll go to meetups and stuff like that. And a lot of them will say, you know, hey, I sold a property, so I want to do a 1031 on it, you know, and, you know.

It'S like the buzzword, right? I don't know what it means, but if I say 1031. Yeah.

So they're real confident about, yeah, I want to do this. And then he's like, oh, by the way, what, what is it? Yeah, how do you facilitate?

And. And they sold it. They sold it probably three months ago, so.

Or even three years ago.

Yeah, you know, that's, that's pretty common, you know. So, like, I think there's a lot of misunderstanding of what, what a 1031 is and what you need to do to meet those, those regulations. But I think, you know, the first off, they thing to know about 1031, it is. It's a very black and white test that you have to meet. You know, there's not a lot of gray area in it. You either check the boxes or you don't. And you know, so you can really put yourself out there into, you know, maybe some not so great situations by taking positions on your return, thinking you did a 1031, when in reality you didn't check some of the boxes along the way. And it's a pass or fail thing for the most part. So. Yep.

So can you just, can you tell us what a 1031 exchange is, to be specific, just in case someone's coming in, they've never heard of 1031 Exchange. Can you talk about what it is and why it exists?

Yeah. So, I mean, it's been around for a long time. I couldn't tell you the exact date, but for the most part, you know, at 10:31 is giving you the ability to take property A, that you own and exchange it for property B, and move your basis from one property to the other to basically, I want to say, like avoid tax, but to delay the recognition of the gain on that property that you sold. And so it's simplistic way, like if you have zero basis in a property because you depreciated it out, it's been a legacy property or something along those lines. And you Have a million dollar sale if you can. If you find another property to replace it that's a million dollars or more, then you can basically defer that gain and put, you know, put it into the next property in essence. And so you won't actually, you know, realize the gain when it comes time for your taxes. You're just going to report that you change the basis, you shifted the basis from property A to property B. So that in the grand scheme of things like that's what we're doing, we're taking gain that is recognized on one property and pushing it to another. So we're not realizing it on our tax return. And so we get that delay gain, we're not paying tax on it and we're just deferring it down, down the line for the most part.

And that's post sale. Right. So if I've got a million dollar property and I want to do a 1031 exchange, I've got to sell the property and then take the proceeds and roll it into another million dollar property roughly. Is that.

Yes.

That accurate?

Yes. So whatever replacement property, is there any replacement property that you're going to exchange for, like it has to have a value that's equal to or greater than the property that you're selling. There's some nuances that come into play here. But if you have a million dollar property and you exchange it for a million dollar property, taking all fees and stuff outside of this, you'd have no cash in hand and you would just have moved and have a property B instead of property A now. So there was no real change in your economic benefit or detriment. You just have a new property that's worth the exact same amount. But if you, you know, if you're exchanging a property along the lines and you receive cash in exchange for on the sale, you receive cash. And the next property, well that, that cash is something that's called boot. And so you'll recognize you'll have gain on that that you'll be taxed on because you received cash and not just a replacement property. And so some of the things that people will get caught up in is like, well, I exchanged a property and I took out a larger loan. I received a bunch of cash in return. Well, there is, because you receive cash, there's some sort of change in your economic benefit there. And that's going to create a taxable event in that sort of situation.

Jordan, when people go and they do their first 1031 exchange, do they have to keep doing 1031s on the next sale or the next sale or can, what do you see out there of investors or syndicators or people that want to buy a property just themselves? How can they really take advantage of 1031s and not feel like they're so constrained that they can't be flexible in their investment?

Honestly, like some of the topics that you had listed here on, like the do's and don'ts and different things to think about for 1031. So we'll talk about in a little bit. You know, and jumping ahead now, like, we, you got to take a look at what your 1031 is doing for you and what the other side of the equation is. So I'll just give you a simple example of a situation I ran into not only once but twice last year. The individual came to me with, with this 1031 that they were, that they had already done and facilitated. And after I looked at the whole deal, I was like, well, you know, you did the 1031, so we're kind of like stuck with, with that. However, you know, if you would have sold the property outright and just recognized the gain, we would have been able to depreciate and, you know, take accelerated depreciation and different, different things to reduce your overall income. And because of how the tax rates flow between capital gains on the sale of a property and ordinary losses coming over from, you know, operating property rentals, you actually would have had a lower tax liability at the end of the day, even though your income might have been a little bit higher just because of the flux of the rates and how ordinary versus capital was going to be treated. So to answer your question, Celie, you got to understand what the benefit is on the other side as well as what you're deferring. And so if you have a property that, you know, is, has a lot of personal, tangible property built into it, think like large rental property, large apartment complexes or warehouses, office space. When you 1031 into that, you're basically, you're keeping your basis down really low, which also affects how much depreciation you're going to get on that next property. And so you can run into situations where, yeah, it'd be like, it'd be nice to defer this gain, but if I can create a, I'll have a $400,000 gain, but I can create a $350,000 ordinary loss on the other side and reset my basis at the same time, well, it will work out to where you end up paying less tax in that situation. So everybody's situation is different. So you have to look at it from both sides and, you know, have your professional run that calculation for you in order to determine if it is really worth it to go through the process, which is obviously, you know, there's boxes you got to check, which means there's fees you got to pay, there's things you got to do. It creates a little more work so forth. So, like, understand what you're signing up for and making sure you're not, you know, actually going to end up in a worse situation than if you would have just recognized the gain and took a cost seg on the next property.

Jordan, you said what you're signing up for with the 1031 exchange. Can you kind of go through the steps of what an investor or property owner has to do to get a 1031? I think it's probably. It's not just going down to the post office and getting a form and filling it out.

Right, right. So we get into those steps. Let's just talk about some of the things that will preclude you from actually doing it. So let's just make sure you actually qualify for the 1031 first. So when you have a property and you're going to exchange, you cannot sell that property before having an intermediary involved. I mean, so you have to have somebody signed up to help you with the transaction because you can't possess title of both of the properties at the same time, or else it won't be an exchange, it'll just be a sell and a buy. So you have to have that exchange factor in there. That's what is referred to as a qualified intermediary. So you have to go and have somebody sign up for that. So, you know, step one, don't sell the property on your own and then expect to do it 10:31 because you have skipped the step of having the actual exchange occur by having somebody in the middle of the two transactions. Another thing that you have to make sure you want to qualify for, that the property itself can actually be exchanged. So there's. There's kind of two key things on this. Like, I know that this is. This is a lot of real estate discussion, but back in 2017, under the TCJA, the tax cuts and Job act, they made it so you can only do a 1031 on real property, which means, you know, you can't, you can't 1031 your. Your vehicle anymore. But it also brings some issues into the equation. When you do cost segs, you have all this tangible personal property sitting in there that no longer really qualifies for a 1031 anymore. So you got to understand the risks and the things that are built into the transaction when the 1031 happens. And so that's kind of the first piece. And the second, you can only 1031 real property, which means you can't 1031 a LLC interest that's not real property. So if you want to get out of a syndication you're in and you want to defer the gain, you're not eligible to do that. The only entity that's eligible to do that in that situation is the LLC syndication that you're a partner. And they'd have to 1031 the property. So there's no way for you to defer your gain from an LLC interest on it for 1031. So that's just something to keep in mind that those two things don't, they don't work. And they're common questions that I get. So going into, like what you need to do to run through the 1031, like, what are the boxes you need to check, what are the steps that you need to take? First off, you need to get a qualified intermediary involved. You can find them. A lot of the times, title companies will do this as part of the service because they want to do the title work. And so they'll provide this 1031 service in addition to that. But basically, you go out and you enlist them, you sign your 1031 contract with them, and they will be the individual, the company that is signing as part of the transaction. So they're going to be involved in the contracts, they're going to be involved in that sort of thing, and they're going to, you know, help you go through that process and making sure that you don't take possession of the cash when your property sells and then when you take the next step. So step one, get that intermediary contract and everything. They're going to walk through the contracts with you, and when your property sells, they're going to take the cash. So, I mean, you do not have access to the cash. So you really need to be comfortable with whoever that intermediary is because, you know, there could be some bad players. I hope that there's not in, you know, our area, but, you know, it has happened, so just be aware of that. But you're going to take that, you're going to have that, that cash sitting there in a trust account that they're going to have, you know, control over, and you're going to direct them on what to do with it next. So once the, Once your property sells and they have cash in hand, you have 45 days to put in writing what properties you're going to go after. Okay. And you can identify. Yeah.

It sounds like it's really important to get an intermediary. Do you get that before you sell? I mean, do you have somebody lined up ahead of time or after you sell?

That is step one, you have to have an intermediary sitting there ready to go a lot of the times if you can have the contract kind of put together. But they're going to be involved in kind of finalizing the contract and taking possession of the cash. So they need to be price. Step one is like you're deciding to sell your property. Step two is getting an intermediary and then step three is selling the property. Yeah.

So you were saying you're just starting to say 45 days. It sounds like from the transaction to then indicate where you're going to spend the money. So it almost even sounds like you have to have some idea of how you, where you're going to exchange the money for in another property before you even sell the first one. Is that, would you say it's accurate?

No. Once the property is sold, you, you have a clock. So the clock is 45 days to identify the property that you're going to acquire. So in that 45 days you can identify three properties to replace it with. To have an unlimited value on the properties. There's kind of a. We'll just get into a little nuance, but you can actually identify more properties, but they can't be more than like the total value of what you're identifying can't be more than 200% of the property sold. Something along those lines. Don't quote me on that number, but I'm pretty sure that that's about what it is.

Sure.

So it's either three properties, unlimited value that you're going to identify within the 45 days of sell. After that's identified, you have 180 days from the time of sale to actually close on the properties that were identified. And so you're on a clock to get it done in order to get that treatment. Like I said, it's a pretty black and white test on the amount of days when you need to identify them, the amount of days that you need to close in that process. So once you've identified the properties and you go and you get a contract with them, you use your intermediary to go through that process, because they have the money, they'll be doing, you know, that title work, they'll be doing the closing on behalf of you. And then once all that's done and they have purchased the properties, that's when it will then be transferred to you in title and that's how it becomes an exchange at the end of the day. Does that make sense? Any questions on that?

No, that makes sense.

I have a question. What happens if you've identified three properties and you end up. Those three properties are not what I want to do. And I found another one, but that's my fourth property. Can I. If the first three don't pan out, can I find another one?

Is it within the 45 days or not?

Yes.

If it's within the 45 days, then you should be able to remove the previous and add this one in or restrict the value of what the properties are in order to go beyond the 3.

What happens if it's past the 45 days?

Gets a little tricky. I'd say it's kind of a facts and circumstance thing, but likely it's not gonna. It's not gonna be included.

So it sounds like you need to. You need to have your act in gear. If you're gonna do a 1031 exchange and find three properties, you're looking way before the sale of the property to make this happen. This is. This sounds like it's not just a last minute, oh, by the way, I want to do a 1031.

Yeah. No, normally you have done the planning and already identified before you sell. The identifying additional properties kind of is just a, I want to say, like a precaution so you can identify other properties just in case one doesn't sell or, you know, it falls through, which happens at the 11th hour sometimes. But for all intents and purposes, you really need to plan ahead and have it ready to go for the most part. So when you get into a situation where you haven't planned ahead and you're really desperate, which I've seen, you tend to way overpay for a property to get the deal done. You know the seller's gonna. Gonna have the upper hand on you if they know that that's what's going on.

So, like investors of, like, Skyline Point Capital, we compete with some of these people that have a 1031. They're waiting the last minute and they have to get it in and they end up paying way more for the property than they should. So we see that all the time. We specially see that at the end of the year right before tax season. They've got to, they've got to buy or. And get something done. It's. It's crazy.

Sounds like a good time to sell your property or if you own a property, a good time to sell the.

End of your thing is, is not likely related to 1031. It's. It's likely related to the fact that they are looking for deductions because they know they have income. So because the 1031, like the 180 days or you know, whatever that, that's a little, you know, it'll go over the years. But depreciation, when you're doing those, that's a calendar year thing. So you either are in the calendar year or you're not.

So. So in the 1031 tax code it says that when you're exchanging has to be a like for like exchange. You know, I can't, I can't and correct me if I'm wrong, but how I understand is I can't sell an apartment complex and then buy a residential home as an exchange. It has to be similar. It has to again, like for like is that can I can does that to be exactly like for like apartment for apartment, retail strip for retail strip or as long as does it. Is it more residential and residential or commercial and commercial. Like can you kind of describe or explain what like for like that.

That sort of provision was for the other ancillary things that were going on previous to 2017. So like when you're doing a 1031, it was. You could do a 1031 at pretty much anything, you know, so you could exchange a boat for a different boat or a car for another car. So the like kind like provision sitting in there is really built towards, you know, those other things. When you have real estate, I mean it's real property for real property. And so from my understanding if it's real property, it's real property and it is like kind and it would qualify. It doesn't necessarily matter if it was commercial use or residential use per se.

Gotcha. Yeah, that's helpful. It keeps it at least removes restrictions like if I'm trying to sell an apartment today or you know, get out of one, but it's hard to find apartments that builds a lot of constrictions in there where you can't maybe find a good exchange within 45 days. But if I have the opportunity to put it in industrial or retail strip or this, that or the other at least gives you some options.

Yeah. And that's. I Mean, I'll kind of caveat a little bit. The fact that normally we don't see things like, you know, somebody buying who has like, vacant land and they're going and buying a high rise. You know, like, normally that's not how it works really, but for the most part, you know, real property for real property and it'll, it will qualify.

So, so, Jordan, I, we're talking about a 1031 exchange because we're, we're talking about the deference of capital gains. You know, I'm just, I'm exchanging and pushing off the, the tax payment on the capital gains on these properties long term. So what's the advantage of this capital gains? If, if I, you know, I keep doing this for 10, 20, 30 years and now I've just got a bigger, you know, I'm assuming my, my real estate's going to continue to grow. And so therefore my capital gains tax that I'm, I'm owing is growing as well. If I get to 30 years down the road, do I just have a bigger tax payment coming to me? What's the real advantage of deferring all these capital gains taxes?

Yeah, I mean, I think everybody knows the time value of money, right? So having money in your hand is better than giving it to the government, not having it. So there's always that kind of premise. Right. But a lot of the strategies come into. When you're holding these legacy assets, when you transfer them to your next generation, you're holding those assets at debt. Well, you get a step up in basis at debt to where your heirs, they're not going to pay those capital gains, they're going to get a full new basis in those properties. And so nobody pays at that point. And so we have a lot of families, like, that's the plan of like farmland. You know, they have like 50 million in farmland, but, you know, there's, it's still being held by the first generation, waiting to pass to the second generation and so on that passing the second generation who's not farming or anything and has no desire to hold the land, well, that's when they'll sell it. Once, once that step up is achieved at the end of the day. And so there's not a, there is a possibility where you get all these deductions and you deferred all the gain and then nobody pays any capital gains at the end of the day because of the way inheritance works, Jordan, with.

Your clients that you have that have this mindset of they're going to play the long game with this, can you give us an idea of out of all your clients, how many are thinking in the long game with 1031s and how many are just. I'm going to jump into it now, but I can't think about 30 years out from now. Should we all be thinking about 30 years out with a 1031 exchange to transfer real estate?

I mean, I think it is a long play for the most part, but the important thing is knowing if you have the cash to pay it and knowing what you're gonna do with it. So if you're gonna continue to buy real estate and you don't want to forego, you know, 15 to 20% to the government on that gain, then, then it makes sense to continue to do the 1031 as you continue to, you know, go from a 10 unit apartment complex to a 30 unit apartment complex to 100 unit, you know, and as you slowly step up to those, you know, I think it, it totally makes sense. As long as, you know, like we talked about before, you have a big enough gain there that the depreciation or what you could get on the other side is not going to be enough to offset it. And so I would say, like, it's a total, it doesn't really matter the age. It's really just what your strategy is on what you're going to do after you sell and what the ramifications are tax wise on whether it makes sense or not. Most people aren't sitting there thinking about, okay, I'm going to hold this for 45 years until I pass away and then my heirs are going to get it. That's, that's normally not the mindset, but like some people who have had, you know, farmland or, you know, apartment complexes and they've owned it for 35 years, they fully depreciated. There's no basis sitting there. Well, those are the situations that, you know, they're in their mid to upper 60s and the conversation really is on estate planning. It's just like, hey, I would not sell this, you know, and here's why. And normally when you outline it like that, they're like, well, that makes sense. So I'll just hold onto it until I pass and then my heirs can sell it as they will and the government won't receive any funds in that transaction.

I've been in multiple local real estate meetup, luncheons and dinners and whenever there's somebody up there talking about 1031s, one of the, one of the first questions they asked because now, Jordan, you're talking about estate planning, long game, the family. It's a much bigger thing than just getting an intermediate intermediary. And one of the questions that comes up is who's the. If I want to do this, who is the first person I should call to help me think through that? And Jordan's got a smile on his face. Are you the first phone call people usually make?

Yeah, that's who they should call. I mean, we'll be able to tell you whether it's worth it or not, depending on your strategy. Because, I mean, your CPA advisor has all the information to help you through that process and can do those calculations at the end of the day. So thank you, Steve, for the, you know, for the softball and the, the.

Unforgiving plug for myself. Yeah, Jordan, his team are incredibly good at what they do, so we'll. The plug is well earned. Jordan. What? Who else should be involved in this? Obviously you as a cpa. Obviously the intermediary you're going to involve. Are you involving your financial advisor? Who else ends up part of this mix throughout the process?

I mean, in an attorney, sometimes the attorney gets involved. It depends on how big and complex the transaction is. I mean, a lot of the times, you know, the title company will be able to facilitate most real estate transfers, including the 1031, you know, so they'll, they'll be able to help you through that process. So depending on what asset you're selling, how many people are involved in it? Are you in an LLC and there's 200 investors and you're doing a 1031, you probably should have a little more due diligence on that. So I would suggest having the attorney involved. But if it's a small group of investors, maybe just closely held family members and such, then going through a normal real estate transaction doesn't have to be too complex. Just get the qualified intermediary involved. Make sure with your advisor that it makes sense, your CPA advisor to make sure that the numbers make sense on what you're trying to do and then kind of go from there. Just follow those steps that we had already outlined previously. Something came to mind real quick when we were talking about the things that you have to do in order to qualify for a 1031. The capital gains, like you stated, is what you're deferring, but you're only eligible to defer long term capital gains in this provision. So basically that means that you have to have purchased that property and held it for a year and a day before you can sell it. And do the 1031. And so that's a misconception that I run into often, but you need to have held that for a year and a day. Now the next property, the dates tack on meaning like the long term rates tack on to the next property. And so it's really that first property that matters.

Well, I want to, I want to leave listeners with kind of a recap. So I'm going to, I'm going to try to recap as somebody who's not done 1031 exchange myself personally with my own real estate, but you let me know if I missed it. But first off, if I've held a piece of property for a year and a day and I want to exit that, I want to sell it and I want to consider a 1031 exchange. My first call is to Jordan Downey at Franklin Zachariah to talk about my tax situation to make sure it makes sense for me. From there we'll get an intermediary involved to, to be that again, intermediary between the two pieces of property. And I've got 45 days essentially from the time I sell my property to, to at least identify up to three properties that I'm going to roll that cash over into the next property. And, and the reason I'm doing this, because I don't want to pay capital gains right now. I'd rather defer it long term so that eventually, hopefully when I die, none of my family pays capital gains on the real estate empire I've built over the next 30 years. Is that a, is that a good recap and synopsis of what we think?

So honestly, yeah, I mean, we're talking about deferring it into the future. We're talking about checking all the boxes and obviously making sure it makes sense for whatever, you know, plan you have, whether it's a short term plan or a long term plan, just understanding what that is and then it's a matter of just, you know, running the numbers and making sure it fits into that plan.

That's wonderful. Jordan, thank you so much for breaking this down for us. One of these topics that most of us, most of us don't really quite understand. I think that was a really good overview of the power of a 1031 exchange. So thanks for joining us today. And if, again, if you're listening and you're thinking more about 1031 exchange, Jordan, his team are incredible what they do. And if you just want to learn more about private real estate investing, go to skylinepointcapital. Com. Again, Jordan, thank you so much for joining us today and excited for the next.

Absolutely. Thanks, guys. Appreciate it.