Ep #510 – 1031 Exchange for Tax Deferment
Dave Foster is a 1031 Exchange Qualified Intermediary and has seen it all. Dave helps people leverage the 1031 Exchange to their long term advantage.
Here’s some of what we covered:
- 1031 Exchange Basics
- Why you need a Qualified Intermediary
- How to keep your funds safe
- Understanding Bonus Depreciation
- The Four D’s
- Understanding Step Up in Basis
- Common 1031 mistakes
- Tenants in Common structures
To find out more about our guest:
Full Transcript Below
Ep #510 – 1031 Exchange for Tax Deferment – Dave Foster
Rod: Welcome to another edition of “How to Build Lifetime Cashflow through Real Estate Investing”. I’m Rod Khleif and I’m thrilled that you’re here. And I know you’ll get a lot of valuable information from the gentleman that we’re interviewing today. His name is Dave Foster. He’s been around a long time in the real estate space specifically in the 1031 exchange space. And so, excited to give you guys an education. If you don’t, what kind of drill down a little bit. We’ll start with some basics, but we’ll kind of dig into how to best utilize 1031. Welcome to the show, Dave.
Dave: Hey Rod, thanks. It’s great to be here. And in one sense, you just made me feel really old. I’d be … in a long time.
Rod: And you’ve definitely got a voice for radio brodie. You’re like that gravelly Wolfman Jack voice. Anyway–
Dave: I think I’ve got a face for radio too but that’s okay.
Rod: Yeah. Well, me too. Yeah. Funny. So, you know, give us a little bit of your story. You know, I know you’re a 1031 intermediary. Your website’s “the1031investor.com”. So, talk about a little bit about how you got into this business and–.
Dave: Yeah. You know, I need, I think a part of that, we take a little time trip back to when I was just starting my real estate investing career and probably the same issue and the same as most people around. You end up getting this niggling idea that, “Hey, maybe real estate investing is a good idea.” And so, what we did, we were my wife and I were both on fairly high profile corporate careers and we said, we want to get out of here because we had our first child. And I swear to– gosh, when that baby comes, you want to throw your TV out the window because you just want to sit there and look at that little kid. And we said, “Why do we want to waste time working in careers when we could be spending time with our children as they come?”. So we started to look for avenues for developing the cash flow that was going to allow us to slow down and take that exit to the ramp. Same stories a whole lot of people today.
Well, we hit on real estate. So like everybody, I just don’t write him. I bought a duplex at Denver, fixed it up, sold it, was feeling fat and sassy, baby and–
Rod:. All right. Just because that Denver is my stomping ground, what street was it on? Where was it? Tell me.
Dave: It was right across the street from Sloanes, like–
Rod: Oh, no kidding, sorry. Sheraton, Sheridan and 26th.
Dave: That’s exactly right.
Rod: Yeah. That’s so funny. I can still name every street between Kipling and Havana because I had houses on most of them anyway. Please continue. So–
Dave: Yeah, well you know, it’s really sad on it for and what it’s worth now.
Rod: Oh I know.
Dave: I should have had to.
Rod: Oh don’t get me started. Don’t get me started on that. Good morning to five hundred.
I had five hundred houses there and if I still had them they’d be free and clear and I’d be netting I don’t know, somewhere between $500,000 – 600,000 a month right now.
But anyway, what it could have should it
Dave: Be here to be a boat.
Dave: Well, so I was feeling great about that, right. And then I went to my accountant, Turbo Andy, at the end of the year and like every accountant and because I am one, I can poke fun at us. But like every account, they’re great at telling you about the pothole you stepped in last week. Man, if you would have done that different — and I didn’t. It was at that moment that I realized that I had a silent partner whose name was Uncle Sam, and he was actually going to make more money off this deal than I did, so that all of a sudden stopped looking like such a great deal.
But this was 1996. Rod, you remember what happened? Well, you won’t because you’re so much younger. But what happened right at that moment–
Rod: That’s really funny. In 1996 when I had 500 houses in Denver. But anyway, I’m 60. I may look young but I’m not. I’m holding … anyway.
Dave: Yeah. So 1996, there was a huge court case that was settled over 1031 exchanges and they went from being this hoodoo-voodoo kind of process to being something that normal average American investors could use. And I had some really good friends in Denver at that time. And you know, you could– you know, what is, the marker of a really good friend is what? Those are the people that feel like they can mock you mercilessly. So they laughed at me and said, “By the way, Dave, how do we start a business, to do these things for people? So that they won’t have to pay tax on profit like you’re afraid to do”.
I said, ”Count me in”. And that began the 20+ year journey of not only doing 1031 exchanges for myself to get us to our goals, but also to help others do their own exchanges. So that they don’t have to pay tax on the profits from their real estate sales.
Rod: You know, what’s interesting buddy, but, you know, we were talking about how we are arguing who had the worst memory, but I swear I’ve heard you speak before and I’ll bet you it was in Denver in order to meet up or something, because is your name now is starting to ding with me a little bit. Anyway, I digress.
Dave: But as long as it was not at a post office, I’m okay.
Rod: Right. So let’s do a real quick high level basics of a 1031 with the timelines and the requirements and what you can and can’t do. You know, I spend a lot of time on it. But just for those that haven’t really got a clue what’s involved. So let’s do that.
Dave: Right.So the whole goal of the 1031 is to sell a piece of investment real estate that you either have highly appreciated or you have depreciated highly and you’re going to sell that and purchase new investment, real estate. That’s really the simplicity of the process. But inside of that or those components that have to be there and they all have to be their president every time. Someone like myself, a qualified intermediary, has to be a third party in addition to the process, and they monitor the process, document the process and help you stay straight of all the statutes.
So you use a qualified intermediary from the date of your sale. You get another 45 days to identify your potential replacements. You’ve got a total of one hundred eighty days to close. So right there you see the IRS is they were ticked off that they lost the lawsuit. So they tried not to make it easy, simple as that. But you’ve got the time frames. What you’re looking to do is purchase at least as much real estate as you sold using all of your proceeds to do that.
Now, the nice thing about that is that, it does not have to be one for one. The number of pieces of real estate doesn’t matter. And that’s where a lot of our clients can get very strategic as they go through their careers, because we’ve all seen our careers periods where we want to expand, periods where we want to contract, periods where we want to change the class or sector or demographics of where we’re investing. The 1031 doesn’t care about that at all.
So you can go anywhere, you can buy anything as long as it’s investment, you can buy any number. The key is that it’s investment property, for investment property. And then there’s some issues that the taxpayer has to be the same on either side. But in a nutshell, that’s it. But it all starts with that first criteria, which is get the QI involved. They have to be involved prior to the sale. And your QI should be your guide through the minds of Morea and to finishing the 1031.
Rod: So, you know, I know I don’t know if it’s not the recent past, but I know there have been horror stories about, you know, because the money goes into a bank account and the people who ran off with the money, I mean, is that where QI’s have been fraudulent? I’m sorry. Hasn’t happened in a long time, but I don’t know–
Dave: Yeah, because every 6 to 10 years, somebody goes off the reservation and takes the money. The reason for that is that the IRS is much, sadly, is much more concerned that the investor is going to do something to various, that they are concerned that the QI is going to so they don’t let the investor have constructive or actual receipt. So what happens is these QI’s get massive amounts of money sitting in their escrow accounts and–
Rod: Occasionally, they occasionally drugs, whatever, they lose it. Okay.
Dave: Whatever is–
Rod: We won’t waste any more time there. But I just think this is triggering some memory for me.
Dave: Well, there’s a really easy fix that’ll take 3 seconds to talk about.
Dave: You want to make sure that your QI is keeping segregated, FDIC insured accounts that simply are in your name and in the name of the QI. And as long as those are two signatory, money’s never going to move from that account.
Rod: You’re allowed to be a signatory on the account.
Dave: So you’ve got an element of control, but not so much that the IRS.
Rod: That’s a protection for sure. Okay, so talk about what– you just went through the requirements? Yes? I think you just went through the requirements. Yeah, talk about, you know, we talked about this before we started recording how people will start. Well, actually, let’s go here first. Let’s talk about bonus depreciation first, because you know, there’s been some talk that in some cases it may not be around much longer, but like this year and I don’t even know if it’s still in play next year, but it might even be better than 1031 as a temporary solution. What’s your comment on that?
Dave: Well, I think there’s probably some truth in that. You keep the word temporary–
Dave: In the sentence, because depreciation is this horrible, awful gift from the IRS, that really isn’t a gift, because whenever you sell, you have to pay it back. So you get the tax break when you take it. And bonus depreciation is simply an acceleration for certain components of real estate. That lets you take more than the normal amount of depreciation at the beginning.
So at its end game, it simply means you’re going to have to pay more back at the end. So you get a temporary benefit? Absolutely.
Dave: And that’s why people are saying, well, it’s better than the 1031. Here’s where the 1031 though outshines it and that is that with the 1031 you’re indefinitely deferring all depreciation. And if you play your cards right to the end, you’re never paying it.
Dave: So do you need a temporary benefit for a huge windfall profit this year? Sure. Bonus depreciation might be your friend.
Dave: Are you interested in maximizing the amount of deferred tax that you’re getting to invest for yourself throughout your life then the 1031 is the way to go.
Rod: Yeah. And of course, if you never plan to sell, ultimately sell that, and that last property, what do you call it the 40s?
Rod: Could you tell the audience what that means?
Dave: Yeah. We live by a mantra of the 40s. Defer, defer, defer, die. Because as long as you– when you do a 1031 exchange, as long as you own that replacement property, you’ll never pay the tax.As long as any time you sell that property and do another 1031 exchange, you’ll never pay the tax.
Rod: Right. So you can kick the can down the curb, just like our politicians are doing with our national debt, just can down the curb. But with this, there’s not a horrible ending.
Dave: Well, the horrible part of it is you die–
Rod: Well there.
Dave: But here’s what happens when you die, your heirs inherit that property at what is called a step up in basis, which means the tax and depreciation go away and it really becomes a tax free event.
Rod: Yeah. Now, that’s a beautiful thing. Yeah. In that regard. And but you mentioned that, people will start off with this 1031 and I guess I’m guilty of it myself. I did some 1031s and I ultimately sold those properties which kind of defeats the purpose. Well it kicked the can down the curb a little bit. But you know, if you keep going into another 1031 property, you’ll never pay that tax ultimately. And you know, how is there any death related nuances as it relates to inheritance and things like that with the 1031 property?
Dave: Well, you know, it’s got to come in the interplay, of course, with inheritance tax. But the first thing that happens is, there’s that step up in basis.
Dave: So that’s going to reduce the amount of estate anyway. I would say, you know Rod, the biggest nuance is for you investors out there, be very careful about telling your children about this part of it.
Rod: Funny. That’s funny. Okay, so are there any instances where you wouldn’t want to do a 1031?
Dave: If you are looking to– well, you know what, you’re kind of talking to the band leader here, although my brother, I like you, I’m guilty also of having properties that I 1031. And they ended up selling, and I didn’t because I wanted to go into something that was a little more adrenaline filled. So for me it was a land development and 1031 exchanges are only for real estate that you have the intent of holding for productive use. So if your heart is really in the fix and flips, if your heart is in the land development or construction where you’re creating inventory, the temporary ones are going to be right for you. But if you’ve got a longer term horizon, the beautiful thing that I’ve discovered now is that I can keep my creative energies going and still use the 1031. It just has slowed it down a little bit.
Dave: For instance, we went from single family rentals to vacation rentals. We went for vacation rentals and a commercial property. I ended up buying a property that I ended up turning into a major motion picture movie set. You know, those kinds of things all can be done within the 1031. And ultimately, now, as we start to look at the next phase of our investment, we’re 1031 wanting to do more passive investments, things like Delaware, statutory trusts, triple that, commercial properties, the things that take less activity.
So there can always be reasons why you need cash, it happens, but as much as you can, like you said, kicking the can down the road. Every day you defer that tax is a day less that the government gets the money a day where you get it to spend for yourself, and that’s kind of the balance of the court.
Rod: I mean, you can kick the can down the curb and refinance as well. So, you know, you can pull money out. There are ways to get money out that you.
Rod: Right. You can just pull the money out. Tax deferred. I won’t say tax free, but at that moment it’s tax free. So what are some of the common mistakes you see people make or issues that pop up as it relates to 1031 exchanges?
Dave: Single biggest mistake is I still feel maybe two or three calls a month where someone says, “Dave, I sold a property. I want to do a 1031 exchange”.
Dave: Yikes. I always have to ask because if you’re in the northeast part of the country, you typically say, “I sold a property when you go into contract”.
Rod: Right. You’re going to escrow.
Dave: Right. That’s Okay. You still got some chances. But if you have actually closed escrow–
Rod: You’re done.
Dave: You cannot do that through an exchange because the QI wasn’t involved. Those are breaking calls because they’re so excited.
Dave: And what they’re going to be able to do.
Dave: That’s probably the biggest pitfall. The second biggest pitfall, I think. Well, it’s not so much, is it, is confusion around reinvestment targets because people think I only have to reinvest my profit. And so they’re thinking in that terms and what we have to tell them is that, “Remember your partner, Uncle Sam, they’re leaving their tax in the game. They’re expecting you to leave your money in the game. So any amount of cash you take out, you can do. But any amount of cash you take out or any amount of property you purchase less than what you sold, they’re going to call profit”. Now, people save the day I put twenty thousand dollars down on this, that’s not taxable.
And you’re right. If you weren’t doing it through an exchange, you would pay tax on that. But because you’re doing the 1031 exchange, you’re taking that, the IRS is saying, “No, that’s not your original capital, it’s profit”.
And we always remember who’s got nuclear weapons to deal with those arguments.
Rod: Yes, they do have a pretty, pretty unlimited budget. So talk– you mentioned that you transitioned from a much more active stuff to more passive investments.There’s a lot of people do as they age. What are the nuances of that as it relates to 1031 exchanges, if any?
Dave: You’ve got to be careful of a certain class of investments that you go into because they do have to qualify as real estate and investment real estate. So for commercial properties, that’s obviously fairly obvious. When it comes to the fractional passive world, there are a lot of people out there talking about this thing called the syndication. Now, syndications are there’s nothing wrong with them. But when you purchase an interest in ossification, it’s important to understand that in most cases you’re purchasing an interest in an entity, a partnership or an LLC that owns real estate. You’re not actually purchasing the real estate itself. And so that doesn’t qualify for.
Rod: Oh, so we have done 1031s inside of our syndications and we have to do what’s called a ticket tenants in common, right?
Rod: Okay, can you speak to the nuances of that?
Dave: Yeah, that’s exactly right. Tenants in common means just that, that I am becoming an owner of the property along with you.
Dave: So I own a percentage of that property. You own a percentage of that property.
Dave: And that’s what qualifies it for 1031.
Rod: So you can’t do it, guys. Those of you listening, I mean, you can do it, but it’s going to cost you a lot more money for sure, because there is a little more structuring involved. It’s a little bit of a hassle, but it’s–what we’ve done it. It’s not the end of the world. If you’ve got somebody putting a big chunk of your equity into the deal from a 1031, you know, it can really help.So–
Dave: You went the further, you went the extra mile, Rod, to create the financing structure with yours.
Dave: That will qualify for that. That’s a huge deal. Yes. So many syndicators don’t have that ability.
Rod: Yeah, it’s a nuance thing. My partner, Robert’s really good at it, so it’s not a big deal. So I’m not going to confess to be an expert in it. But we’ve, I know we’ve done a couple already just in the last 18 months. So, what happened, I asked you, buddy?
Dave: We were talking about transitioning.
Rod: That’s right. That’s where we were.
Dave: That’s so the syndications. So tick’s indications are certainly one good way to do it. There is a critter called the Delaware Statutory Trust, which was blessed in 2006 for where you’re actually buying a membership in the trust. But because the IRS is its real estate, its real estate, so it qualifies for 1031. So those are types of things that you could do now where what we actually did is kind of an interesting story. We used conversions of investment property into primary residence to actually eliminate our tax burden as we went. So the two parts of the tax code that talk about it, investing in real estate or real estate are 121, which is your primary residence. And if you sell a house you own and if you lived in it for 2 out of the 5 years prior to selling, you get to take the first $250-500,000 if you’re married in profit tax- free.
Now that’s huge, tax-free and you can do it every 2 years. The 1031 is to sell those property by investment property. It’ll definitely defer. Well at the end of that though, there is nothing wrong with you converting after you’ve demonstrated your intent, told for investment, converting that into your primary residence.
Rod: So you rent it for a bit and then you go live in it?
Dave: Precisely. And there’s even a safe harbor from the IRS for this.
Dave: And revenue procedure in 2008. So it’s a perfectly legitimate process. What we do is–
Rod: Oh, hold on. Let me just explain, if that went over anybody’s head. So you’ve got money that you’ve kicked down the can down the curb by doing one or more 1031s and you decide to buy a house with your 1031 proceeds that you intend to use as an investment the day you buy it. So you rent it out. And I would not shirk on that probably. You probably can’t play games with that. So you rent it for a year, let’s say. But then if you decide to move into it then it qualifies for that tax-free sale down the road. How does that impact the 1031 money?
Dave: Right. So since 2008 they the IRS has tightened up a little bit of a loophole.
Dave: So here are the rules; Now if you want to then later sell that property, that’s now your primary residence.
Dave: And get some of the money tax-free. You must have owned it for five years..
Dave: You must have lived in it for 2 out of the previous 5..
Dave: And when you sell it, you’ll have to recapture depreciation and you will get a 23:33 of the game tax-free between the period when it was rented and the period when it was your primary residence. So buy a property rented for a couple for a year. Move it to 4 for. When you sell it, did you order 4, 5? Did you live in it for 2 out of 5? Yeah, you get to take 80 percent or four fifths of that came tax-free.
Dave: We used it to move from Denver to Connecticut by doing 1031 to Connecticut ahead of our move so that when we moved, we simply converted one of our rentals. And then we did the same thing to go from Connecticut to Florida.
Dave: And by doing that, we were able to pull out enough tax-free money that it bought the sailboat we lived on for 10 years with our boys.
Rod:No kidding. Wow.
Dave: The real estate profit tax-free on a sailboat.
Rod: Nice. Love it. So what have I missed because, again, I’m not going to confess to be an expert in this space, is there anything you’d like to add to the conversation? You’ve had a tremendous value already. Is there anything I must ask? Can you?
Dave: You know, I think we’ve covered the nuts and bolts of the tenth or one pretty well.
Rod: Yeah, I agree.
Dave: The key is the guy.
Dave: It’s like everything else.
Dave: Folks come to you because you’re a guide to helping them develop lifetime cash flow. Folks need a few ideas to guide them through that process. And that’s it. You got smooth sailing.
Rod: Yeah.Love it. Well, listen, Dave, thanks for being on the show. And I’m not kidding when I tell you, I’m pretty sure that we have crossed paths before. And I’m going to have to think about it some more. But I appreciate you coming on, my friend. Pleasure to, I think, reconnect. I really believe that. And I’m sure we’ll cross paths again.
Dave: Great being here.
Rod: Yeah. See yah.