How To Build Wealth Through 1031 Exchange With Adam Nishikawa

And I specialize in the 1031 exchange. I've done a little over 2,000 exchanges all over the country. I'm based here in Southern California, and I find that a lot of my out-of-state investors live here in Southern California, but they're investing out of state. So I'm curious, what is a 1031 exchange? Most of my investment properties are not in Southern California, so this is where I'm home-based. Today's presentation is really just kind of some of the basics of the 1031 exchange, but also just hopefully you learn something about some of the advantages of using the 1031 exchange. I know some of you are flippers and developers and people that maybe those particular properties don't qualify for the 1031 exchange, but any of your long-term buy-and-holds, Airbnbs, midterm rentals, long-term rentals would qualify. This is part of the very fun and exciting tax Code, Section 1031, and it's basically a transaction that allows you to buy and sell your investment properties without paying capital gain taxes. I'm just going to skip ahead real quick to go over— I don't even have a slide on it. The 1031 exchange is deferring long-term federal and state capital gain taxes. So to give you an idea of what that is, and I work with mom-and-pop investors all the time that never actually sold an investment property until they talked to me, and then they realize, oh my gosh, I owe an enormous amount of taxes. So there's long-term federal capital gain tax, which is between 0% and 20% based on your income. If you have a job, it's between 15% and 20%. There's a state capital gain tax, or it's taxed as ordinary income, but if you sell investment property, you pay a state tax rate between 9% and 14.4%. Because California is the highest in the country. And then there's the Medicare surcharge tax, which is 3.8%, or otherwise known as the Obamacare tax. And then there's depreciation recapture tax. So if any of you are taking accelerated depreciation on your properties, you would owe 25% of all the depreciation you've taken upon selling that property. So depreciation you've taken on a property, that's a very significant portion that you're going to be paying in recapture tax. And so all these taxes typically put my investors between 28% and 34%. So that's a ton of money. So whenever investors call me, it's usually after they've talked to their CPA, or they're about to panic when I send them to their CPA to find out what they owe in taxes. So in order to avoid paying all those capital gain taxes, you have to do something called a 1031 exchange. And the way that's done is it's basically an investment exchange. A transaction which allows you to defer the payment of capital gains tax by buying like-kind investment property of equal or greater value. Like-kind is very misleading, that word. It's not like-kind. Like, all like-kind means is that it's used for investment or business purposes. That means that if you currently own a single-family home rental, you can exchange that into a condo, a duplex, commercial real estate, land, a farm. You're not limited as long as it's a real property held for productive use in a trade or business. There's also syndicated investments you can 1031 exchange into that qualify as real property, such as a tenants in common deal or a Delaware statutory trust. So these are all potential investment vehicles that are qualified for the 1031 exchange. What are some examples of real property that you've seen that would qualify for a 1031 exchange? My clients really vary from maybe a condo that someone— it was someone's first home that they bought. It was a condo, they moved out of it, it's been a rental, they want to sell it and exchange it into something else. It could be somebody that operates an Airbnb or hotel business. It could also be somebody that was like a dentist and they owned the office building that they were operating their business out of. So they're gonna— they sold their dental practice and now they're going to sell the real estate that they were operating in. So my clients are typical— typically any long-term investment property that would qualify for 1031 exchange. That also includes 30-plus-year leases. So if you have any clients in like New York or places that use co-ops, those qualify as long as they're 30-plus years. Typically, if your title insurance will underwrite it, then we will exchange it. Oil and gas rights— that was one that I had some investors just absolutely kill it during COVID on oil and gas rights. Delaware statutory trusts— super popular alternative investment vehicle. You typically buy it through a financial advisor. It's a FINRA-regulated product, and it's just one of those investments that— one of the reps for one of the larger companies based in Orange County, he was doing like $10, $20, $30 million a year. 5 years later, he was doing $200 million a year in placement because it's just one of those things that boomers are retiring and they don't want to manage their investments anymore. And a lot of them are choosing to go to something that's very passive, such as a Delaware Statutory Trust. So 2 or 3 of my deals every month are invested in these. So they're very common. They're a great solution for an older investor that's ready to tap out and they don't want to pay the taxes. So they're going to do a 1031 into a DST. But these are all examples of water rights. If any of you are from Fresno—

no?

No. I always tell my wife I ask. at least one time. Personal property does not qualify for the 1031 exchange. So artworks, boats, vehicles, stocks— so like a real estate investment trust does not qualify, unfortunately. That is shares that you own in a company that owns the underlying real estate. And then your primary residence— you get the primary residence exclusion, so you can't use the 1031 exchange unless you have a duplex and maybe you live in half the property and you You rent out the other half. When you sell a duplex that's half rental, half primary, you actually get to take the primary residence exclusion on the side that you own your primary residence. So $250,000 if you're single, $500,000 if you're married, and then you would 1031 exchange the other 50%. So for some investors that are house hacking, or they're buying, renovating, living for a couple years, trading to another asset, they could potentially benefit from Also, if you have a highly appreciated primary residence that obviously far outweighs the 121 exclusion, you can actually move out of the property for 2 years. And then what happens is when you sell that property, the 121 exclusion is 2 of the last 5 years to qualify for that. So you could still get your $250,000 or $500,000 tax-free, and then you would 1031 exchange the balance. So it's kind of a way to combine the two. You can combine both, but it has to have been your rent— a rental property for the 2 years before you sell it. So that's the requirements for that, but you can combine it. I help a lot of investors do that. So the most common question I get is, well, I'm selling my investment property, what do I need to buy for full tax deferral, right? You don't want to pay any taxes. So if you take a $500,000 gross sale price, obviously not in Southern California, and there's a loan payoff of $100,000, And closing costs of $30,000, you would have to buy a replacement property for $470,000 for full tax deferral. Anything under that, you pay prorated capital gains tax. So if you found the perfect property but it was $450,000, it's not the end of the world. You just pay taxes on the difference. Unfortunately, escrow, title, brokerage commission, my fee, all the normal selling costs can be deducted. But you'll notice the loan part. So a lot of investors come to me, they sell the property, they don't want to get a new loan. So you do have to get a new loan of equal or greater value for full tax deferral, or you have to bring in the cash equivalent. So if you have like an older investor, they've all— it's almost paid off, it's like $80,000 left, they can just bring in $80,000 cash instead of getting a new loan. Or if the property that they're purchasing allows for seller financing, they can sell seller carryback for the loan amount that they need for the 1031 exchange. So any kind of debt would qualify. Could be hard money, could be a normal mortgage. It doesn't really matter as long as it's there on the property. So we have clients that do 1031 exchanges, 6 months later they do a cash-out refi, pull the cash out for another deal. That's totally okay. Do not do the refi right before the exchange or in the middle of the exchange because that's changing the debt-to-equity ratios. Any questions on this so far? I know this is really exciting stuff. So the debt, we already kind of went over the debt. So holding title in a 1031 exchange, this is super important, especially because many of you are investors. And I find that a lot of investors, they just want the most protection. So they end up putting their properties in different sorts of protection vehicles, whether that's a trust, an LLC, a multi-member LLC, Many different irrevocable trusts if they're super, super high net worth, and you end up with all these investors with different types of ownership. The important thing in a 1031 exchange is that the tax ID number is the same from the sale to the purchase. So that means if you sell the property in your individual name, you need to buy with the same tax ID number. Now fortunately, several of these entities are considered disregarded entities. So like Single-member LLC, that's still filed on your personal tax returns, right? There's no K-1 filed, so that's still your tax ID number. Revocable living trust, that's also your tax ID number. Now, if you go over to like a multi-member LLC, well, that's going to have its own tax ID number because there's multiple shareholders in the corporation. Also, if you go into an irrevocable trust, that trust is essentially never dying. It goes on forever and it just gets passed down through the generations, but the tax ID number is completely independent from who the beneficiaries are of the trust. So all of these things are important if you, if you're as an investor planning on doing a 1031 exchange and you have a multi-member LLC with a bunch of partners right now and your partners want to go different ways, that's going to be hard because that tax ID number is tied to the property. You've been filing Tax returns with it for the last several years. If you change that from multi-member LLC to your individual names as tenants in common with the other investors, the IRS could see that as a change of ownership completely, and you may have to wait a period of time before you'd be eligible to even do the exchange, or you just have really good tax attorneys. But basically, it can basically create a little bit of risk for you. So it's really important how you hold title.

Yes, Joe.

Seller mom-and-pop have to transfer it into their name when they buy mom-and-pop, okay?

Okay.

The next day they can transfer it into an LLC, correct, without a problem? Correct. Single-member LLC, especially if the mom-and-pop are filing taxes jointly. One thing that comes up a lot in 1031 exchange too is Step-up in basis. Are you guys familiar with the step-up in basis upon death? So when you pass away, your heirs receive what's called a stepped-up basis. So that means that if you did all these 1031 exchanges throughout your life and you had a huge tax bill, when you pass away, your heirs actually don't owe those taxes. I might have explained this, but can you 1031 to multiple properties? Like you can sell a $1 million and buy a $100,000? Yeah, absolutely. So the 1031 exchange is excellent for investors that are diversifying their portfolios. You can take $1 million into 3 properties and put $330,000— We have wire fraud insurance as well, and then we use a text to confirm for each of our investors so that they know when any money is about to leave the bank. Because what happens is when they're in the middle of a 1031 exchange, People get stressed, people are looking at their emails, and there's lots of wire fraud things out there now. So what we do is make sure that if they need an earnest money deposit sent in for one of their new purchases, which we will do if we're holding the funds, we'll send them a text confirmation letting them know, hey, do we have your express permission to send this money to your new purchase escrow? If so, click yes. And that way we can ensure that we're not sending money anywhere that we're not supposed to be sending money. So nothing is invested. You know, we use a very large bank, billions and billions in assets, with very conservative balance sheets to make sure that we're not putting our clients' money at risk. I'm gonna get a good workout here.

You mentioned the 3rd DST that is kind of a placeholder. Is that just you leave it open to put an address in within 180 days?

Okay.

And also, what qualifies as a property to 1031? Like, how long do you have to hold it? You know, what, like, if it was a rental, could you just rent it for a few months out of the year or something?

Okay, perfect. So I'll address the what qualifies for a 1031 So the 1031 exchange is only for long-term investment property. That's typically a hold period over a year. I would say 2 years to be safe. Most of my investors and CPAs consider 2 years as the safe harbor period, but the tax code actually doesn't specifically say a time frame. We just follow case law. But to make sure that it— what doesn't qualify are flips, right? So if you flip properties, that's short-term capital gain tax.

Okay.

So that's not going to qualify. If you are a developer, you are building that property to be sold. It's considered inventory, so that's not going to qualify as well. So it has to be something that's a buy-and-hold asset.

I do like short-term leasebacks for sellers. Let's say it's 3 months, but I can show rent rolls for that. And let's say I sell it after a year period, would that qualify?

Ask your CPA or tax attorney. But back to your other question for the DST.