REtipster does not provide tax, investment, or financial advice. Always seek the help of a licensed financial professional before taking action.
If you’ve been around the real estate investing world for any length of time, you’ve probably heard of the 1031 Exchange before… but just in case you haven’t, we’re going to give you a quick primer on what this is and more importantly, how you can use it to save yourself a TON of money on taxes as you’re growing your real estate portfolio.
The 1031 Exchange is one of those fantastic tax advantages real estate investors get to take advantage of, and you NEED to know about this if you’re planning to make it big in real estate.
In this lesson, I'm talking with Scott Saunders, the Senior Vice President of Asset Preservation Incorporated. Scott has an extensive background and a huge wealth of knowledge and experience in this realm. He will help us develop a new understanding and appreciation for how you can use this mechanism to get further, faster when you’re upsizing your portfolio, whether you're selling off a piece of land or some other type of real estate.
As land flippers, we are often considered “dealers” who cannot take advantage of this helpful tool, but much of your classification depends on your intent and how well you document it along the way, so be sure to learn how to do it right!
In this episode, we will:
- Delve into the nuances of the 1031 Exchange process and how it can revolutionize your investment game.
- Understand and adhere to the importance of timelines and deadlines for a successful 1031 Exchange.
- How to identify suitable replacement properties in a 1031 Exchange.
- Find a reputable, qualified Intermediary who can facilitate your 1031 Exchange.
- Avoid the potential pitfalls and constraints of 1031 Exchanges.
Scott Saunders is an undisputed master in the 1031 exchange realm. He's been working his magic in real estate since 1988, and with more than three decades of work experience under his belt, he's seen it all when it comes to real estate taxation.
Scott has worn many hats throughout his career, but his current role as the Senior Vice President of Asset Preservation, Incorporated suits him perfectly. He takes pride in aiding real estate investors as they expand their portfolios and maximize their profits without losing their shirts to the IRS, thanks to the 1031 exchange. Brace yourself for insights from this financial maestro!
Links and Resources
- APIexchange.com (Scott's Website)
- Scott's Phone Number: 888-531-1031
- Scott's Email: firstname.lastname@example.org
- Scott's YouTube Channel
- Straight-Line Depreciation Explained
- How to Calculate Land Value for Taxes and Depreciation
- What Is a Qualified Intermediary?
- What Is a Reverse 1031 Exchange?
- Real Estate Investor vs. Dealer: What's the Difference?
- Tenants In Common (TIC) Explained
- Tax Hacks: Doing a 1031 Exchange (the Easy Way) with RealtyMogul
- RealtyMogul (REtipster Affiliate Link)
- Delaware Statutory Trust
Editor's note: This transcript has been lightly edited for clarity.
Seth: Hey, everybody, how's it going? This is Seth Williams and you're listening to the REtipster podcast. This is episode 167, and today we're finally dedicating a full episode to the 1031 exchange.
So if you've been around the real estate investing world for any length of time, you've probably heard of the 1031 exchange before. But just in case you haven't, we're gonna give you a quick primer on what this is and more importantly, how you can use it to save yourself a ton of money on taxes as you're growing your real estate portfolio. This is one of those amazing tax advantages that real estate investors get to take advantage of. And as a real estate investor, you need to know about this. This is a big deal if you plan on making real estate a big thing in your life.
And today we're talking with Scott Saunders, the senior vice president of Asset Preservation, Incorporated. And Scott has an extensive background and a huge wealth of knowledge and experience in this realm. I met him over a year ago at a speaker dinner for a conference we were both speaking at. And in just about five minutes of talking with the guy, I learned a ton about 1031 exchanges. It kind of blew my mind.
And I thought, you know, I wonder if I could recreate this conversation for the REtipster audience? And even go beyond that, learn even more things that I'm sure Scott can talk about that most of us don't know about, specifically as it relates to land investors. Which is kind of a niche that doesn't get served a whole lot when it comes to this kind of thing. So we're going to understand how land investors can use this, and even just real estate investors in general, some of the things that you need to know and some of the things that you probably don't know about it that you're about to learn.
So, Scott, welcome. How are you doing?
Scott: Hey, Seth. I'm doing great. Great to be here with you today with your audience. And I actually think it's a fun topic. Most people don't think taxes are all that exciting, but when you're looking to build wealth and scale and grow in real estate, this is just a tremendous tax-saving strategy that really helps propel people faster forward they can really use to their advantage.
And a little known fact, I don't know if you know this or not, but it's been in the Tax Code now for 102 years. So we're not talking about something that just came about, we're talking about something that investors have been using for decades and decades and decades.
So I'm looking forward to unpacking it, adding some value for your listeners, and hopefully talking about the rules, the process, and maybe some things they haven't heard about before.
Seth: Amazing. Over 100 years. I had no idea. That's pretty cool.
So maybe we just start at the very most elementary level. What is a 1031 exchange? And why might this be advantageous for land investors specifically?
Scott: Yeah, let's say you buy a property if you were to do a taxable sale. And it's just the most simple level. I take some land, I sell it, and I receive back cash. That's a taxable sale.
In a 1031 exchange, I have a property that I sell. The consideration for that instead of being cash is what we call a “like-kind” property. So at the most basic level, taxable sale property for cash, 1031 exchange, I give up property, I receive back like-kind property.
Now, you hear this word, 1031. And so let me kind of share where that comes from. It's not that complicated. It's a section of the Tax Code, which happens to be Section 1031, that talks about how you do this. Now, why people do this is that a 1031 exchange allows you to defer all of the capital gain taxes that you otherwise would have had to pay if you did a taxable sale.
Now, with land, there's one aspect you don't really face most of the time, which would be depreciation recapture, because there are no buildings that you're depreciating. But in a taxable sale, you have up to four different taxes that you pay. So first, if you have an approved property, you pay depreciation recapture at a rate of 25%. The remaining federal capital gain is taxed at either 20% or 15%, depending upon your taxable income. Some investors face what we call this net investment income tax. So this is a 3.8% surtax on any income over certain thresholds. So a single filer over $200,000, married filing jointly over $250,000. So, on a larger land deal, you're going to face that net investment income tax.
And then the fourth component, which I think is important, is state taxes. So you could be in a state like Florida or Texas or Tennessee with zero, but the highest state tax rate in the country right now is in California, it's 13.3%. The point being you've got to add up all four levels of taxes to see what you'll be paying in taxes. So you might make a nice profit, but at the end of the day, you might not put as much in your pocket. After you pay the federal government, you pay the state government.
So where an exchange comes in is I take all of that gross equity, I pay zero in capital gain taxes, so I defer paying that and then I use that equity to go out and redeploy and buy more real estate. So it's going to give you much more purchasing power, which allows you to grow and scale faster than someone who's selling and paying the taxes every time they do a deal.
That's the big benefit. It's a purchasing power that gets redeployed into other property because you have all of that gross equity you can put that into something else and you can do bigger deals faster.
Seth: So maybe I can just illustrate this with an example. And if I'm saying this wrong, feel free to jump in and tell me.
Let's say I have a $100,000 house, for easy numbers, and I sell this thing for $100,000 cash and I just put in my bank account. So if I were to do that on an investment property, I might pay, I don't know, 20%, 30%, maybe more in taxes.
But if I were to take that money and instead very quickly go out and buy a second property worth 200,000 or whatever, just a like-kind exchange, something that's bigger, kind of upsizing my portfolio, instead of paying that $30,000 in taxes, I wouldn't pay any of it. I would just take all of it and put it into that new, more expensive property.
Am I saying that right or am I missing anything?
Scott: That's a great illustration. You're correct. When you do an exchange, you don't pay taxes today. You reinvest in another property.
And so one of the things that comes up, and here's a common misconception that I'll kind of address, which is, “Well, I'm going to have to pay the taxes someday, so why not just pay them at today's rates? They're relatively low. Bite the bullet.” And the beauty of an exchange is this: you can exchange over, and over, and over again and never pay capital gain taxes during your lifetime. Build a huge real estate portfolio, and then you pass on that highly appreciated property to your heirs. They get what's called a step-up in basis to the fair market value at the time you pass.
So let's just say you start with $100,000 piece of dirt. You go up to 200, 400, 500, a million. At the end of your life, you've got a $10 million portfolio. And so it's all capital gain, but you never paid taxes. You deferred it. And the tax code says your heirs now get the value at $10 million. So you essentially deferred paying taxes in your lifetime. And now your heirs don't have to pay the taxes either, because they get the value at the time they inherit it.
So this, to be honest, is one of these secret strategies that real estate investors use to grow massive portfolios, right? The big people do it in commercial real estate, they certainly do it. The REITs do it, the Donald Trumps of the world do exchanges. But where I think it's great is it allows your average investor to get into the game. So let's just say you buy a piece of dirt for 100 grand. It's worth 300,000. You do an exchange, out of that 300,000, you scale up to a 600,000 to 1.2 million to 2 million. This is really the tool that allows the average investor to get into the game and keep redeploying their equity.
And what's really great about this, Seth, is you've got the ability to do this with real estate, any type of real property, and we'll unpack that in a few moments of what will qualify. And some things you maybe even thought about as being qualifying like-kind property. You can't do this with stock. You can't buy Apple low and try and sell it high and defer paying the taxes. So we have a built-in advantage owning investment property that they don't have in the stock market or with other types of investments. It really gives a real estate investor a huge leg up on other asset classes.
Seth: When I hear the word “defer,” what I think of is just “delay.” Meaning, like, you don't pay the taxes now, you pay them someday. But from what I'm hearing you saying, you would never pay the taxes as long as you just keep going and you never get to the point where you just sell out and take the cash and run with it. Is that accurate?
Scott: You're 100% accurate. As long as you don't pocket the money and take the cash out on a sale, you can defer it.
So sometimes you'll hear it called a tax-free exchange. It's not tax-free. You're merely kicking the can into the future. But there are a couple of options. So people might go, I want to sell it. Well, you could. Another one you could do is something called a partially deferred exchange. You sell a million-dollar property, and let's say you buy one for 800,000 and you take a little cash out. That's called taxable boot. You just pay taxes on the money you take out. The rest of it's deferred.
But I'll tell you, I've been doing this since 1988, so this has been my sole focus, really ever since I got out of college. That's all I've done. The vast majority of investors exchange over and over again. And you've got in your audience a good percentage that do dirt deals. But let's say later on you come out of a piece of dirt. Let's say you go into an approved property. Let's just say it's a twelve-plex, an eight-plex, something like that. Because it's an improved property, you can refinance it. So you do an exchange out of land into an approved property the very next day, and you got to make sure it's done as a separate event. You can refinance and pull all your money out tax-free or most of your equity out tax-free. So there's actually a way, because it's not really fun, Seth, if you keep reinvesting, reinvesting, and you don't ever get to enjoy the benefits. We're all buying real estate to build portfolios that will fund our lifestyle, right?
Doing an exchange into an improved property and doing a refi is a completely non-taxable event. And that's how you get access to your equity without triggering a tax hit. So that's a strategy many investors do. They call it equity harvesting, different names. But that's a way to get access to the capital that you're accumulating over time without triggering taxes. And that's what savvy investors have been doing for decades and decades and decades.
Seth: But if you do that refi, then that's now debt you have to pay on, right? With interest.
Scott: It is. But think of it this way. Let's say I got a twelve-plex, I've got tenants paying my debt. I'm not paying my debt. So you're right, there's debt on it. But as long as the numbers work and you can still have a positive cash flow, you, as the investor, aren't paying the interest. You've outsourced that to your tenants. They're really paying your debt.
Seth: Gotcha. So I know one of the things that kind of trips some people up with 1031 exchanges is the timeline. So can you give us a quick rundown on what do you need to adhere to, what needs to happen within 45 days, what needs to happen within six months, and what happens if you don't meet those deadlines?
Scott: Sure. What I'll do is let me go through the time deadlines and then also let me kind of insert what I call some practical tips that I find help people out.
So in the most common exchange, it's called a delayed exchange. Sometimes you'll hear it called a starker exchange, but it's delayed over time. So let me walk you through the sequence of steps. What do you do to set up an exchange? Number one, you list your property, and once it's under contract, this will be what we call your relinquished property, or the property you're selling.
Once you're under contract, you contact what is called a qualified intermediary. Sometimes you'll hear others call it a QI, an intermediary, a facilitator. We are going to be assigned into your transaction. We'll step in and we're actually going to sell the property to the buyer.
So when you close on the property, that is day zero, the closing of the property being sold, you have 45 calendar days, and they end at midnight of that 45th day to identify the property. And then you have another 135 days after that to close on it. So it's 180 days maximum.
The first 45 is what we call the identification period. The 180 days is called the exchange period. So you've got some very specific time deadlines that you have to adhere to.
And the question we get asked all the time, particularly in markets where inventory is tight, is there any flexibility in those? And 99.9% of the time, there isn't. And a very narrow exception is if you've got property in what is called a presidentially declared disaster area, say a hurricane, a wildfire, typically these are natural disasters. If the IRS declares your county a natural disaster area where you've got a presidential disaster declaration, you can get an extension of 120 days. But let's say that doesn't apply to the vast majority. And frankly, if you have a hurricane or fire go through, you've got all sorts of challenges. This isn't something you really want.
You've got to identify in that 45-day period. Now you've got flexibility there, Seth. You can start on day five and identify three properties and you can revoke them and you substitute with better properties. But by midnight of the 45th day, you have to buy something in that exchange period that was identified in the first 45 days.
And you probably hear this all the time. People look at that as a little bit of a challenge or certainly a concern. Right, what if I don't find anything? So let me give you my tip that I think makes it a little bit easier. As soon as you're listing the property that you're going to sell, you just get in a listing and you think you're going to list it at a reasonable price. You're going to get some good offers on it at a reasonable time period. Start working with your real estate professional, the broker you're working with, on what you want to purchase at the moment you list.
Where people get into trouble is they don't start until they close. I say start that process early on. Start looking at what you're looking for. You can start making offers, you can make contingent offers, but start identifying what you want to buy. I personally did an exchange two years ago. I sold a property in Phoenix, Arizona, and I exchanged into five replacement properties. So, four of them in St. Louis, one in Memphis, Tennessee. I didn't even list the property I was selling until I had locked up my purchases. So I literally had all five purchases with a verbal confirmation that I'd be buying and felt very good that I had all my purchases locked up.
So the way to kind of get around that obstacle is work on the negotiating the purchase. As soon as you list the property, get a bit of a jump on it. That's a big pro tip there. So that's called a delayed exchange. Yeah, the process is pretty simple. A good qualified intermediary, by the way, is going to walk you through this. They'll let you know, hey, here's your 45-day period. They'll provide a form to identify properties on. They'll explain those rules and we can go through those because you've got three different rules to choose from, to identify.
Seth: So, yeah, a bunch of questions coming up here. So how many properties can you identify within the 45-day period? I often hear the number three thrown around, but could I do 10, 20, 50, as long as it happens to be those that I end up buying on?
Scott: Yes. You've got three different rules. So what you've heard, Seth, is what's called the “three-property rule.” So if you sell, let's say for 200,000, you could identify three properties of any value. So one at 200, one at half a million, one at a million. But you're limited to three properties under the three-property rule. But that's just one of three rules.
The second rule is you could do something called the “200% rule.” So that allows you to identify an unlimited number of properties, but no more in value than twice what you sold. So if you sell for 200,000, you can identify up to 400,000 of a bunch of small one-acre parcels. So three property rule, you're limited to three, but the value is unlimited. On the 200% rule, you've got an unlimited number, but the values are capped at twice of what you sell.
One more rule here and it's rarely used. Believe it or not, I did this personally a few years ago. It's called the “95% rule.” And what this states is if you identify more than three and they're over twice the value of what you sold, you can buy those. So in your example, can you identify 50? Absolutely. But there's a little caveat you must close on, meaning acquire 95% of the value of the properties identified.
So to kind of make it really simplistic, if I identify ten hundred thousand dollars properties and I only buy nine of them, in a real estate deal, we'd say, hey, that's pretty good, you bought nine out of ten, but you're not over 95%. So you would have to pay all your taxes. So if you're going to use this 95% rule, my input would be you want to be 100% sure you can close on every single asset that you've identified.
So in summary, three-property rule limited on number, unlimited value. 200% rule is many properties but no more than twice what you sell. Or 95% rule. You violate the three property rule and 200%, but you basically have to close on everything. That's what it is.
And another thing to kind of share, when you identify, there's some very specific wording. You have to identify specific properties. So if you've got several parcels of land, you can't say, “I'm going to buy one of these five-acre pieces of land.” You've got to identify the assessor's parcel number or if it's a street address, you've got to identify a specific property. So the wording in the Tax Code is it has to be unambiguously described. So sometimes we'll have somebody, they'll go into, let's say, a condo complex in Hawaii, two-bedroom, two-bath. You have to identify unit 32 or unit 77, a specific property, not just a “two-bedroom, two-bath condo.”
Seth: Now this qualified intermediary that you're talking about, is that what you are or how do you go about finding one of these?
Scott: Yeah, a qualified intermediary is a middleman. That's all we really are. So we're going to hold the funds and we're going to prepare all the paperwork.
Now here's something a lot of people don't know, Seth. We are in a completely unregulated industry at the federal level. There's no federal oversight, so we're not under the SEC banking or anything like that. There are a handful of states that have state-level consumer protection laws. I'll rattle off the states: Colorado, Nevada, California, Oregon, Washington, Idaho, Virginia. And you know, a handful of states have that, but we're not in a regulated industry and so we're physically holding your money.
One of the most important things you want to do is find out how does that qualified intermediary secure those funds? Right. What security do they provide? Some things that you want to look at and I'll kind of share that with you and your audience. First off, probably one of the most important things, you want a separate segregated account. You don't want to be in a big pooled commingled account, but you want your money to go into your own account, require your signature to set up that account, and then your signature to move funds at any time. So that's an important aspect.
Another one that's probably a reasonable safeguard is work with a company that's a subsidiary of a big parent company. So most of the major title insurance companies have subsidiaries, like Stewart's, our parent company. There are a lot of banks that have qualified intermediaries. So now you're part of a bigger financial institution. So you're going to get those institutional controls, right? Checks and balances. Our parent company is publicly traded, so we're going to have all of those institutional controls built into it and a decent resource, a place to start.
It's kind of a mouthful, but the industry trade organization, I've been on their board and past president of it, is called the Federation of Exchange Accommodators. But I'll make it really easy to remember. Their website is super easy. 1031.org is their website. So it's just 1031.org and you can find qualified intermediaries in your local area that subscribe to the code of ethics and agree to hold funds in certain matters.
So that's a place to start, but for sure do your due diligence. There are a lot of excellent companies out there that do this, but you want to look at how are those funds being held, particularly in today's world. Look at what happened with the banks a few months ago. You probably don't want to be a big depositor in a little local community bank, but you want somebody to work with a lot of the bigger national banks, some of the ones that are too big to fail. That would probably be another good practice to make sure you're working with the big banking institution.
So does that give you kind of a little background on what a QI or qualified intermediary is?
Seth: Yeah. So I guess to clarify, first of all, that's what you are, correct?
Scott: Correct. I'm a qualified intermediary. Our company is Asset Preservation. What we do is we hold the money and we prepare all the paperwork. Yes.
Seth: Okay, so do you replace a title company or do you work in addition to a title company and how do you guys make your money from this process?
Scott: Yeah, we work in addition to, so we're another principal. So we would work with the real estate agent, the title company, we'll even work in conjunction with somebody's tax and legal advisor. So we're another principal in the transaction, qualified intermediaries.
Since they're not regulated, the fees vary. I would say you're looking on average somewhere to $1,000 to $1,500 is a fairly typical fee that's charged. We charge $1,250, which covers one sale, and then you could buy up to three replacement properties. So it's kind of a flat fee that allows people to sell one and buy up to three other properties. Might start at $1,000 and then charge you $500 for the purchase. But somewhere in that range is a typical fee.
I do want to point out that's on a delayed exchange, there are some really creative exchange variations out there that a little bit more sophisticated investor might want to use. Let's say you found just an unbelievable land deal, right? You found something that's $300,000 under market, but the seller needs a quick close. And you know, this deal has a lot of built in profit into it.
You can do something called a reverse exchange where you buy the new property first, then you've got six months to exchange out of your current property. You can do something called an improvement exchange, buy a piece of dirt, put a rental cabin on that beautiful lake property and rent it out airbnb. You can do a reverse improvement, buy the new property, start building a building, and then sell your existing property within six months. Those are all called what we call a parking arrangement because the QO is actually going to be parked on title. We're going to form an LLC, be parked on title. Those fees are going to be a lot more expensive, somewhere between $6,000 to maybe 12 to 15.
So that's another tool for maybe a little bit more sophisticated investor that could benefit from those strategies. So those are other options that are out there.
Seth: Going back about five or eight minutes. We're talking about identifying these three properties or however many. So what does it mean exactly to identify? Is this a paper you're filling out? Is this a person you're telling about it? Is this going on record somewhere? How does that work to identify?
Scott: You just have to write down so you take any piece of paper and you write down, identify these three properties, you have to sign and date it and then you send it typically to the qualified intermediary. So most of the time you're going to identify with the qualified intermediary.
Now these rules are pretty specific. You have to sign and date it, you have to unambiguously describe the properties. And once you do that, at the end of the 45th day, you've got to purchase one of those properties you've identified. You can't try and shoehorn something in after day 45. So the rules are specific and it can't be oral. It's got to be done in writing.
So it's interesting when you go back to the code. The rules from this came out from the IRS back in 1990, so we're talking quite a while back. They use a weird word, they use the word “telecopied.” So you can send it on over and done a number of different ways today. We've all got smart devices, right? Email wasn't happening back in 1990, except maybe the military. So the tip would be put it on a piece of paper, scan it in, and then send it to your qualified intermediary as an image. Don't just identify it in Microsoft Outlook. That way you've got your signature on it.
And a pro tip would be, I always have people have the qualified intermediary verify that they received it and send a copy of that back to you if you get audited a few years down the road. Now the qualified intermediary has it, but you can pull up your file and you could show the IRS. “Not only did I send it over, but I have proof my qualified intermediary received that.”
So I think that's an important thing. We all know there's a whole bunch more IRS audits that are going to be coming in the future because there's significant staffing for auditing. So anything you can do today to sleep well at night, and if you do get that letter in the mail that you're being audited, at least you're prepared for it proactively.
Seth: You mentioned earlier that qualified intermediaries are not regulated. Does that mean that you guys don't get audited?
Scott: You're 100% correct. We're not regulated at the federal level. So the states that I mentioned have some local consumer protection laws. They're really to protect the proceeds. But no, we're not audited.
I want to share with you, it's super important to do your due diligence selecting a good qualified intermediary. Some have better security than others, and those are the types of questions you want to ask and get good answers to.
Seth: So on that whole thing. So if you guys are never audited, what if you're my friend and I want you to do me a favor and just forget about those first three properties I chose and just put these other ones in there instead? You're never going to get audited. So as long as I've got my records from my IRS audit, I'm good. What's to keep a qualified intermediary from doing that?
Seth: Yeah. No can do, Seth. So we get asked that all the time. People want us to get creative about substituting. Here's why.
We're a principal in the transaction. We're a subsidiary of a huge parent company. We're not going to have somebody go through an audit. If we do that, we're committing tax fraud. We're not going to commit tax fraud because you didn't get your act together on exchange. So, believe me, over the years, I've had every trick in the book. Everybody, every request, as you can possibly imagine, from a revert request to, hey, pull my file out and can you run out and give me a cup of coffee and come back in a few minutes? Wink, wink. A reputable, qualified intermediary will never do that.
And the reason is let me tell you why. When you're an intermediary, what we're doing is we're holding money on your behalf so you don't have access to it. We're a principal, right? We act like a buyer or seller. We're a principal. We don't act as an agent of the investor, right? A real estate agent acts in the best interest of their client; a CPA and a lawyer is an agent of their client, we're not. We're a principal. So we're going to follow the rules of our agreement. If you don't choose to identify or you don't have your act together, that's on you, not on us. So we're just going to follow the strict wording of our exchange agreement. If you follow those rules correctly, you can do an exchange, and I will tell you set.
There are people that try to monkey around with this. There's somebody got audited in California a few years ago. It's called Dobrik v. Commissioner. They tried to backdate, they got audited. They got hit with a $2.2 million capital gain tax, hit a 75% fraud penalty. They had to pay another $1.6 million in fraud, plus they had to pay interest on it. So the penalty box for committing tax fraud is relatively severe, as it should be.
My input is to do a straight-up exchange plan in advance, work with somebody in advance, line up your purchases, and you can defer taxes and build a huge portfolio really quickly. But don't try and monkey around around the edges. It's just not worth it.
Seth: Yeah. The reason I'm asking these questions is it's not because I'm going to do it. I find it really fascinating that you guys don't get audited and that there's no regulation because, like you saying, you'd be committing tax fraud, but how would anybody ever catch you if you're it not audited? I mean, I know how I would get caught. Obviously, you have your own moral conscience and all this stuff, but if somebody doesn't have that and they just want to monkey around and they're never going to get caught, what's to keep them from doing that?
Scott: At the end of the day, let's say you were audited and we monkeyed around for you. Then they would know that we did that, and here's the big risk.
Seth: Is that because I would point to you? Is that how they would know that?
Scott: Well, they would know because you would point to us, or it would come out that we backdated it.
Okay, here's the big problem. Let's say your exchange is blown. Now. It's a taxable sale. You got to pay the taxes in our particular company, we've done over 250,000 exchanges, right? A quarter million of these. Seth, if I did this for you and I've violated my exchange agreement for you, and let's say the IRS finds one other time when we did it, you know what the IRS could do? They could come back and say, every exchange that we've ever done is unwound. Because we didn't follow our written agreement as a principle, we acted like an agent, which means now you have control over your exchanges.
So take your one deal out. Now all of the other people we've worked with ever could have their exchanges invalidated because we monkeyed around with one. And I can tell you, I won't mention names, but we've worked with all sorts of well-known people and players on deals. So big Fortune 500 companies, names of people you know. So there's no way we want to risk jeopardizing all of those legitimate exchanges because one person wants to come in, become a shyster, right?
Seth: What a disaster. That would be terrible.
Scott: Yeah, that's on you. So again, you want to work with a reputable company. And there are lots of reputable companies that are going to 100% do that that are ethical players.
Seth: So I've heard you mentioned a couple of times doing your due diligence on a qualified intermediary. And the things I've heard you mention are making sure your funds aren't commingled with other funds and making sure they have good security. I'm just curious, what does good security even mean? Or what would be red flags to the questions I would ask that would say, oh, I shouldn't use this one. What exactly am I looking for?
Scott: Yeah, why don't I do this? I'll share what we do in that regard. And there are other companies that will do something similar. We provide from our parent company, which is Stewart Title, a letter of assurance. So it's signed by the CEO of Stewart Title that says if anything happens to the money while in our possession, Stewart Title, who's been in business for 127 years and publicly traded, stands behind the money.
And there are other companies that can do that. Through maybe a letter of assurance. You could set up a standby letter of credit at a bank that you pay a fee for. There are some other mechanisms, but when you're working with a subsidiary of a big parent company, you're going to get those institutional-type security arrangements that are out there, and not everybody has those and can offer them.
But I personally think you aren't entrusting your money to somebody else for six months. And the most important thing is to make sure that they're going to have it to purchase the property that you want. There have been some examples in the past where people have absconded with funds. There was $100 million in Las Vegas. There was $132,000,000 bankruptcy that involved six different companies. The largest was $420 million because they invested in auction rate securities, a market that went illiquid back in 2007.
So there are a lot of great companies, but this is what you want to look at, are these types of things. And then look at the parent company. If they're publicly traded, look at their balance sheet. What do they have in equity, how long they've been around? What are their financial ratings? So you can find a very reputable qualified intermediary. It's pretty easy to find them.
Seth: So there's really like, people who just set up shop overnight, like, hey, I'm a qualified intermediary, give me your money. And then they'll just take off with money. Is that something that's happened?
Scott: Unfortunately, yeah, that's happened. And sometimes there are people that are trusted in the community. I'm here in Colorado. There was somebody by the name of Scoop Daniels, I believe is his name, about ten years ago, a trusted guy, church-going guy, worked on all these deals and one day just left. He went to South America for ten years. They found him and brought him back.
One individual, Ed Oaken, who was one of the larger bankruptcies. He served a 150-year prison sentence. So his situation, believe it or not, if you pull up an American Greed, you can find Ed Oakin on there. He did the typical crook thing, took other people's money and spent it. Bought cars, jets, yachts, all of that stuff. And he's a rare exception. But unfortunately, from time to time it does happen.
So do your due diligence. I think starting with the 1031.org, people that are willing to join a trade organization is subscribed to that. Dakota Ethics is a good start. And then just look at what bank do they put the money in, who can control that account? Having your signature to open it up and then to move money out is a really important aspect of it, I think.
Seth: Just kind of some random questions here. Is there a minimum dollar amount you need to be working with? Or a maximum dollar amount, like the deal needs to be 25 grand or higher, or it can't be higher than 100 million or anything like that, or like a limit to how much you can save in taxes or anything.
Scott: You can do it on any size deal. We get that question all the time. We've done billion-dollar deals, a billion. We've done deals with ten different apartment complexes. Smallest deal I've done is $12,000. And the way I kind of frame that, it's always a lot of money to you, right? If I'm selling my lot for 50,000 that I picked up for eight grand, that's a lot of money to me and to another investor, whatever their amount is, it's a lot.
So, no, you can do it on any size transaction. Really what it comes down to is where I say maybe you want to look at it, you want to weigh the taxes, you owe. And you came up with a good idea. Let's just figure somewhere between 20% to 35% is taxable on a typical sale. Then you got the fee, let's call it around $1,000 to $1,500. You got a really simple decision. Do I want to write checks to the federal government, my state, or would I rather pay a modest fee? And so if you've got only a little bit in capital gain, it may not make a sense to do it the other time. It may not make sense to do an exchange is if you don't want to be in real estate, you made money on a deal and you made a whole bunch on it. But you want to go back and you want to buy stocks, bonds, alternative investments. You don't want to be in real estate, well then an exchange isn't for you.
Now, I find most people in real estate love real estate, and all they want to do is buy more. They want more units, more dirt, more value, more cash flow. But there are times when people do want to get out for whatever reason, maybe partnership, they're going their separate ways and they're just willing to liquidate. So they might make a decision to just eat the taxes on that.
Hey, Seth, one thing I want to kind of jump into a little bit. Can we unpack? I want to unpack a little bit of like-kind property.
Seth: Yeah, let's do that.
Scott: So like-kind is super broad when you're dealing with real estate. It's any real property held for productive use for investment or in your business, exchanged for any other real property held for investment or used in a business. So land can be exchanged for improved property.
Probably an easier way to look at it, actually, Seth, would be let's talk about what you can't exchange. Number one, you can't exchange your primary residence. So the house you live in, that doesn't qualify because it's your residence. It's not held for investment. So you can't do that.
Number two, and we can maybe expand upon this a little bit, property that is held primarily for sale. So dealer property, fix-and-flips. Those types of properties where you hold for sale, not long-term investment, are excluded. As long as it's not your house and it's not property you're holding for sale, you can exchange it.
So let me share some things you can do. Land, improve property. You can exchange a vacation home that is held for investment and meet certain requirements. Certainly apartments, multi-family retail, industrial. There are even things called Delaware Statutory Trust or tenant-in-common ownership. So I can go in and buy a slice of a large building with a bunch of other co-owners and that qualifies.
When you want to look at creative things, have a little fun, here. You can exchange in New York City air. Literally, it's called a transferable development right? I've got a 20-story building, and I've got the right to add five stories, even though I don't add it. In New York law, that's considered real property, and I can exchange it.
Seth: So this is like air rights, right?
Scott: Air right, Yeah. So it's called an air right. The technical term is a transferable development, right? But it's an air right. We do exchanges on certain states on water rights. So in Colorado, water is precious. Same thing in Nevada, Arizona, new Mexico. A few states water rights, if they're considered real property under state law, can be exchanged.
Another one, easements of every type can be exchanged. So I can have an agricultural easement, I can have a conservation easement, and exchange that. And you can even exchange what is called a perpetual communication easement, which, if I say that in English, it's a cell tower. So if you've got a piece of dirt with a cell tower on that high point, I can create a new perpetual communication easement, sell just the cell tower, keep the rest of the dirt.
Another one that you probably never think of would be oil, gas, mineral rights. So as long as it's a royalty interest, the right to extract it, you can actually keep the land and exchange the mineral rights or the oil rights on it.
So, like-kind is very, very broad. It just has to be real property. After 2017, you can only exchange real estate. Prior to that, you could have exchanged exchanges on art, gold, coin collections, businesses, the tax reform, the tax cuts and JOBS acts, eliminated personal property exchanges. Today you can only exchange something that's considered real property, but you want to look to your local state law, because real property varies from state to state a little bit. A water right in Colorado is real property, in Washington it's not because water is plentiful. So every state's going to have a little bit different rules on that.
But I think that opens up a lot of potential. You can start scaling with land, and then you could go into multifamily and you could go into a Delaware Statutory Trust. So a lot of options out there.
Seth: Does all of this real estate or light kind of real estate have to be in the U.S. Like, say, if I own land in Belize or something, that doesn't count.
Scott: For this. You can't exchange U. S. property for Belize. So it has to be within the United States.
And now there are a few little caveats. You can exchange Guam, Mariana Islands, and the U.S. Virgin Islands qualify. The other one you can do to take your example of Belize is you can do a foreign for foreign. I can exchange Belize for another Belize property or Belize for Mexico.
So in the United States, it's got to be a U.S. property for another U.S. property. You can also do foreign exchanges, foreign property for foreign. But I can't go domestic to foreign and I can't go foreign to domestic. They modified the Code back in 1989 to restrict that.
Seth: So when we're talking about foreign to foreign properties, are we like completely leaving the IRS at this point? And now we're talking about that country's thing? Or does the U.S. somehow still stay involved if you're a US citizen?
Scott: If you're a U.S. citizen, it still is a tax liability, but it's a foreign for foreign. It gets just to let you know, it gets complicated the way you transfer property in other areas.
I just wanted a contract in a property in Tuscany, Italy, and it's different. Real estate laws are different. The process is different. When you put in earnest money in Italy, it goes hard at the time you make your earnest money. It's not like in the U.S. where you've got an escrow that's neutral. You put your money in. If you walk from the deal, your earnest money goes over to the seller.
So all these different international laws, it's fascinating learning how to transfer real estate in other countries because there are different terms and different mechanisms. But the vast majority, U.S. for U.S. And I gave you those little caveats so people cannot come out of the U.S. and go buy that rental condo down at Cabo. That's not going to work. Or the ski place up in Banff, that's not going to work either.
Seth: So from what I'm hearing from all that, is that if I've got a piece of vacant land and I wanted to do 1031 exchange with it, it can go to literally any of those things we talked about, which is very diverse. But you mentioned that this doesn't work with properties that you hold for the intent of selling it. It sounds like that whole investor versus dealer argument about what am I and what am I doing with this property. So how does one prove whether they're an investor or a dealer? Like, do they have to own it for a year or more? Or is there something else that has to substantiate that claim?
Scott: Yeah, this is probably one of the more not confusing, but there's a lot of discussion on this topic. So the question that we get asked all the time in regards to this is how long do I have to hold it before it's held for investment? What's the time period? Is it a year? Is it a year and a day? Is it 18 months? Is it two years?
Here's where I think you've got our unique planning opportunity. The IRS says it's just your intent. What you intend to do now, what they're going to look at are your objective facts and circumstances. What provable facts do you have that support investment intent or contradict it?
A lot of investors want to know the time period, and certainly the period of time is important. But I want to be really clear, there's no time period in the Code that says one year is long enough, or two years or 18 months, or a year and a day. Those might be reasonable time frames to aim for, but it's not required. We've got a tax court decision from just a few years ago. Somebody held it for only eight months, but it was considered held for investment.
So what do you guys want to do to do this right? You want to document your investment intent. If your intent is to hold for long-term investment, what I would do is have some correspondence with the other players in the transaction. Have an email to your real estate broker, “I'm gonna buy property in Missoula, Montana, which I intend to hold for long-term investment.” Keep that email if you need it. After you buy a property, email your CPA, or maybe your tax or real estate attorney, “Hey, I just bought such and such property in Yuma, Arizona, which I intend to hold for long-term investment.”
Where people get tripped up is they don't take the time to document their intent. So if you've got two, three, four, or five data points that substantiate your investment intent, if you get audited, you're going to be on much, much more solid ground. Here's where people get hurt. They have no documentation. They tell the IRS, well, of course I intended to hold it for long term investment. And the IRS is going to come back, and they're gonna come back with two simple words, and you probably know what they are. “Prove it.” Give me proof that shows your intent was to hold for investment. Who did you tell that to? When did you communicate it? What can you prove to me that happened at the time you're doing the transaction that supports the intent.
So a lot of taxpayers don't do this, and I think everybody in your audience take the time to document that intent. I think an email to your CPA would be great. An email to your real estate or tax attorney, have correspondence with your real estate broker. If you're married, you even have a discussion with your significant other, right? “Hey, we're looking at properties we intend to hold for long-term investment. Here are some of the parcels we're looking at.” Rip off that piece of paper, slip it in a file folder.
So the more you have support that documents the intent to hold for investment, the stronger you'll be in an audit. To the extent that you have goose egg, the weaker you're going to be in an audit. So those are just a couple of planning tips.
And we were talking right before we kind of kicked off this show, Seth, about people that maybe flip properties or hold really short-term. One thing you can do, you can buy some assets in whatever entity you're buying in where you flip them. You flip it, make the money and pay your ordinary income.
But let's say you find a property that you want to hold long-term, buy that in a separate entity and kind of separate it. So you have one entity over here that's flipping, and then you have another entity here that holds for long-term investment. That way you can show the IRS, “Look, I bought these properties to flip. I paid my taxes as ordinary income. But I had a couple properties over here which were I really intended to hold for long-term investment.” The purpose of that LLC was to hold long term, and I treated them separately.
So try to bifurcate your assets. Here are my flipping assets. I'm paying my taxes. I'll deal with it. Here are my assets that I'm going to hold for long term investment. So that might be a strategy that people can do when they're really kind of doing a little bit of both that would help them out. That's a way that I'd recommend structuring it.
And the other thing is, pull in your CPA. You want to get your tax advisor involved who knows all of your unique facts and circumstances as a qualified intermediary. Seth, I have no idea what you're doing with your investments. I have no idea of your intent, what you do, but your tax advisor will know what you're doing. So bring them in early on, get their advice.
And as a qualified intermediary, we're happy to talk. We're really good in this niche called 1031. I know all the tax court cases. Everything about 1031, probably better than most CPAs ever know. But I can't give tax or legal advice. But I could talk to your CPA and we could talk about, here's an aggressive approach and here's a conservative approach and here's what's in the middle. And then you and your tax advisor can decide to do what's right for you. Some investors are aggressive and some are conservative. Some tax advisors are fairly aggressive. Some tax advisors are ultra conservative. So I don't know where somebody lies on that continuum and what's right for them. Somebody that has one property and that's all their wealth is a very different scenario than somebody that owns 60 properties and they're very wealthy. They can probably stomach a little more risk because of their financial situation.
So that's why you got to pull in your tax advisor, bring them into the thought process, the decision making process, and get their input and guidance. I think that's critical.
Seth: That's interesting. I've had these similar discussions with my CPA before about how do I prove whether I'm an investor or a dealer? And a lot of the examples you just shared, even seemingly trivial stuff like having a separate LLC that's called like Williams Long-Term Investments, LLC to imply that, hey, this is a long-term investment, and buy it with that one instead of Williams Land Flipping LLC or whatever your normal land flipping entity might be.
So it feels kind of grayish, kind of loosey goosey, but maybe that's just the nature of the beast sometimes.
Scott: Well, you know what? I like the gray area because it gives you opportunity, right? If you're somebody that likes to be a little bit more willing to take just a touch more risk or you want to be pushing the envelope in a gray area, you can. So sometimes people want it to be all black and white. I actually like that it's about your intent and documenting that which you mentioned, right? Having different names for LLCs that reflect the intent and treat them that way, those are really easy things to do. But if you get audited, it makes it pretty easy in front of the IRS to clarify that.
So take the time to document that investment intent. I think that really would help all the listeners. If they ever face an audit, they can do it a lot more confidently. There's nothing worse than getting audited and the IRS says, hey, show me how it's held for investment and you can't come back with anything. You're going to lose in that situation nine times out of ten because you have nothing in your court to support that. So be smart, learn from podcasts and things like this and bring that into your real estate investing. And if you haven't been doing the past, start doing it right on a go-forward. Everybody can change and do it better.
Seth: On that whole thing of holding it for a year or more, does that mean anything? I know you mentioned the one about somebody who owned it for eight months and that was fine. But I mean, just generally speaking, does it help if you can prove it's been 365 days since you bought it? Or is that just a meaningless metric? Like, don't even think about it?
Scott: I'll give you my opinion. In my opinion, it's a meaningless metric. It's beneficial to demonstrate that maybe you've held it in two tax years, but there's nothing magic about day 366. It's a day.
So if I were to give you some broad input, the longer you hold it for investment, the more conservative becomes. If I hold it for 18 months or 24 months or three years, I can more easily make the argument that I'm holding it for long term investment. If I turn around and sell it in two weeks, I'm going to have a really hard time saying, and I held it for investment, particularly the other thing they're going to look at, Seth, they're going to look at things, did I list it with the real estate professional? I say I'm holding it for investment, then I list it with the broker. Well, obviously then I'm holding it for sale.
So they're going to look at a whole wide range of factors to determine what really was your intent. So you've got to make sure that if you have that investment intent, the facts support your investment intent and they don't contradict it. That's, to me, the most important thing, having a lot of good supporting facts.
Seth: Yeah. Again, maybe this is something about me, but I keep thinking about this through the lens of somebody who's trying to game the system and cheat the Code and all this stuff.
Say if I bought a piece of land, that in my heart, I know I intended to flip that thing. But all of a sudden, I change my tune and I decide I want to make it look like I'm holding it for an investment. I mean, couldn't I just shoot a quick email to my CPA saying something to that effect and then maybe put it on some marketplace to lease it out for rent, and then document that and then just sort of check some of these boxes just to kind of I mean, is that something people do? And does that work if they try to do that?
Scott: Well, if you're a savvy investor, I think anytime you create good facts to substantiate what your intent is—I understand what you're saying there—if you have a lot of favorable facts that support that, I think that makes a much stronger case.
I understand where you're going with that. You know, you've got a deal. It's got a lot of built in equity. But if you want to do an exchange, taking the time to do the sort of documentation, creating that paper trail and those facts and circumstances that will help you. If you're audited, most people don't do anything at all, and so they get audited. And he said, she said. And in that situation, a lot of times, the IRS will win, because your job as a taxpayer is to be able to support your position.
So let's use something not really just for real estate. It's morning right now. Let's say I woke up this morning and I intended to eat well today and exercise. And let's say I just started the morning I went out, I got three Egg McMuffins at McDonald's, and I didn't get a walk or workout in. My intent might have been to exercise, but if you look at what I actually did, I didn't work out. I blew off my workout, and I had three Egg McMuffins for breakfast, putting crap in my body. Well, the reality was, the facts show that I didn't really intend to work out this morning because I did something different.
It's the same way with the IRS. They're going to look at what you actually did, and that's going to show what your intent was, because your intent is right here in your brain. They're going to look at what you actually did or did not do to determine what your intent was.
Seth: So, in my limited experience with 1031 exchanges, I dealt with them as a banker when we were trying to close some various SBA 504 loan deals, which are inherently slow. They do not happen, quickly. Sometimes they take more than six months, believe it or not, to get those things approved and done. And in other situations, when I had other investors trying to invest their money with me through a 1031 exchange.
Just in those kinds of experiences, they seem a little difficult to do just in adhering to this rigid time frame. And it makes me wonder, why do they make these rules so hard? It's almost as if they're trying to make this difficult. Is there some benefit to the government to make it this way? Or are they just intentionally trying to make it cumbersome? Like, if they don't want us to do a 1031 exchange, then they just outlawed. Why make it such a hassle to do these things?
Scott: Yeah, the whole 1031 exchange came about back in 1921. So the rules came about for 1031 back in 1921, but they were primarily swaps of property.
An individual named TJ. Starker in 1979 went through a tax court case which created our first delayed exchange. So you could do a delayed exchange in 1979 for five years only in the West Coast, the eleven western states under the 9th Circuit Court. 1984, they codified in Congress the 180 days and 45 days.
So let me get to your point on this one, because you're looking at, from your perspective, saying the timeline is kind of difficult. The IRS could also just say you have no 1031 exchange. They put in some mandatory guidelines because they want people to have an intent to do the transaction. From the IRS's perspective, they would rather the IRS is the enforcement mechanism, right? They would rather get all the tax revenue. The IRS wants as much tax revenue as they can get. That's their job, to get the maximum amount of taxes that they possibly can.
So the IRS thinks that it's very generous. They provided a provision with that six-month window and 45 days to take advantage of tax deferral. You don't have that with other asset classes. So, again, I think the real estate investor has a tremendous tool available that you just don't find in other parts.
I get what you're saying from the frustration of it. It is what it is. But to me, why not use this tool to build a massive real estate portfolio? Follow the rules, take the time. Yeah, there's a little bit of stress. You've got to find rules, you've got to do some due diligence. But if I don't have to pay taxes and I can defer that indefinitely, I'm coming out way ahead. So I have no problem doing that.
I do cost segregation on some of my assets that I own. Does that take time to do a cost sake study? I got to pay money, but now I get a massive accelerated depreciation that I can use to my benefit. So sometimes you got to jump through a few hoops to get a massive benefit. To me, it's worth it. I'd rather get the massive benefit than not have that benefit available at all.
If you took 1031 out. So today I'll be on with somebody in Congress. I spent probably met with 60 people in the last year in Congress educating them on why 1031 is good for the economy. It helps create transactional activity. Real estate brokers get paid on it, title companies, lenders. It's something like $98 billion annually impact on the GDP of the country. There was a study done on that.
So it really affects, it creates thousands and thousands of jobs. So we educate people in Congress of why having this thing called 1031 is good for the economy. It helps real estate investors. And real estate, as we all know, really is a big aspect of our overall economy. So if you had people not taking advantage of exchange, let's say it was eliminated, people would not sell their properties because they'd have to write a big check to the government. And we'd have a lot less real estate transactions, a lot less turnover.
Think of what we see going on in the marketplace now. We see people leaving states like California, the western states, and they're going to Texas and Florida, Tennessee. Up in New York and New Jersey, they're going down south to Florida, the Carolinas. This allows businesses and people to relocate, bringing their investment with them. And so companies are relocating and they're doing exchanges on their companies and creating jobs at a new marketplace.
So it really allows people to kind of redeploy their capital into places where they think they're going to get a better return on their investment. And frankly, investors do a lot better job of creating return than the government does. And the government knows that. That's why they have this incentive in the Code is it helps create communities. I can tell you there are areas where people took an old blighted area, did a 1031 in, and created a whole new shopping center and redeveloped it, which now becomes a little economic hub for that community.
We're going to need 1031. Now think of office buildings, class A office building, the vacancies in some cities there's about 50%. We're going to need to repurpose downtown office buildings into something, could be storage, could be housing. 1031 is a way to come in and do that and improve it during that exchange time, the six months, and repurpose commercial buildings. So shopping malls that are kind of dying off that maybe Amazon wants to have take over that old Kmart store that was there, right? And they'll make it a distribution center.
1031 allows that to happen. So we do this for individuals, we do it for corporations, for partnerships and REITs who do major economic redevelopment. So as you can tell, I get a little excited about it. It's not just tax law. It's about creating jobs and economic growth and allowing capital to flow to where it can best be deployed and get the best return on investment.
Seth: Well, I guess one counterargument to what I heard you saying earlier about the whole thing about why does it have to be so hard and just be thankful that this is here at all, that kind of thing. I guess the way that I look at this is (and maybe I'm just thinking about it wrong), but with that whole 45-day timeline to identify a property and then six months to close on or 180 days to close. So the problem that I've had in trying to find self-storage deals over the past couple of years, like existing facilities to buy, is that the easiest deals to identify within 45 days are the worst deals, the ones that will not make much money or even lose money. I've seen people asking twice what their facilities are worth and I can go buy those all day long, but it's not good for me. And if I just do it to do it just to not pay taxes, it may actually long-term be a really dumb decision. And at that point, I think it's on me to understand that and not do it.
But contrast to that, the best deals usually take more than 45 days to identify and sometimes more than six months to close. So I think that's where the rub is for me. It's like I just need time and 45 days isn't going to cut it. I mean, sometimes just getting the financing approval can take a long time to get done and that can kill the deal. So it's frustrating. It's almost like if they're going to allow this, then make it feasible for more people instead of just making it like, oh, here's the thing, we're going to take it away from you because it's so hard to do. So I don't know, I guess that's where my question was coming from.
Scott: Yeah, well, it's a great point. I think in some markets, people have overpaid for assets because they have the exchange. So I think it's on you as a savvy investor to go into a deal that makes sense because the deal makes sense, not because of tax savings. Sometimes people get that wrapped up and they're looking to just the tax savings. They're not looking at the deal.
I think the way to try to prevent that pressure cooker of that time deadline there is start talking to sellers or assets that you want engage in those conversations early on. So I told you my property in Arizona, I didn't even list it. I knew I could sell it in a matter of days if I priced it right. So I spent all my time negotiating on my purchase and talking to people that I wanted and getting those locked up before I even listed it. So on self-storage, you'd want to do the same thing. You know roughly what you're selling for and you know roughly what you want to redeploy.
And that brings up something we haven't touched upon. In an exchange, you have two simple rules. You've got to reinvest your net equity and have the same or a greater amount of debt for full deferral. So if you do those two things, you have 100% deferral. If you take cash out, that's called cash boot. If you go down in mortgage, that's called mortgage boot. So start that negotiation early on. Just start reaching out to those sellers that you like. Their deals begin the discussions early on. You have a pretty good idea of your asset, what the market is that you're selling. And so that's really your deal to control. I always tell, put all the pressure, put all the energy on the purchase, the sale will take care of itself if you price it right for the market.
Seth: Thinking about this from the standpoint of a land investor. So let's say if I buy a parcel of 40 acres or something like that, and I want to subdivide that land or make improvements in some way or change the zoning or something like that, does that impact a 1031 exchange at all? Like, say, if I subdivide it into ten parcels and I sell off one at a time, are there any additional factors that I would need to be aware of in that kind of scenario?
Scott: Yeah. What I'd recommend there, you buy that 40 acres, sit on it for a period of time, document your intent to hold for long-term investment, and then don't subdivide right away, sit on it for maybe a year-ish or two-ish. Then you're going to move forward with the subdividing and doing everything that involves.
So make it clear, “I bought 40 acres, I'm holding these for long-term investment.” You might very well intend in your head, you see the opportunity to subdivide, break it down into five-acre parcels down the road. But don't start that. If you buy it, and let's say the very next day you start subdividing it, what does it look like? It looks like you're now going to be holding it for sale to sell off those parcels. So if it were me, I'd season it for a period of time, ideally a year or two-ish, then change your mind.
So remember, you can always change your mind with an investment. I could do an exchange under a beautiful golf course property that I rent out for a couple of years, and after two years are up, I decide, you know what, I'd really like to move into that golf course property. I convert a rental and I make it my residence. As long as I'm changing my mind down the road, it can't be my intent to do that from day one. So somebody can always change their intent later on and have a different intent with the property. Just make sure that initially you document the intent was to hold for investment.
Seth: So it sounds like the act of receiving rent on a property, is that significant in terms of determining whether your intent was to sell it or hold it as an investment property?
Scott: Yeah, if it's an approved property, that's one of the big issues. No prudent investor is going to have a property that can produce rent, not bringing in rental income. Now, some people go, “Well, what if I have it rented? At least I have it listed for rent, but I list it for three times market and nobody rents it.” Well, then you're not making a good faith effort to rent your property. So if it's improved property, rental income is a great way to substantiate that. Your intent is to hold for long-term investment. In fact, the IRS will look for rental income. They want to see the rental income. They want to see you taking depreciation, treating it as a legitimate investment property.
Seth: I'm curious, as a land investor who is trying to find deeply discounted deals from landowners who don't want their land anymore, could you almost use this as a selling point to help that motivated seller sell their property to you? Say, for example, if they have other goals for their money, but they're having trouble selling their land, could you somehow help them along in the 1031 process and make it easier for them to go down that path and give them yet another reason to sell their land to you, even at a discount?
Scott: 100%. It's absolutely a great tool. Some sellers, even though 1031 has been around for 100 plus years, some sellers don't know it or they don't know they can sell their land and go into, let's say, a fourplex that provides their retirement income.
So a seller has one piece of land and that's where their equity is. They really want to retire and get some cash flow so they can travel, sell the land, and you're a buyer of the land. You say, look, did you know you can do an exchange out of the land? You can pick up that fourplex for cash. Now you've got $4,000 a month of rental income coming in that allows you to pursue your retirement lifestyle.
So it's a great negotiating strategy, I think, for a buyer to say, hey, by the way, you could do a 1031, go into an approved property and get that retirement income now that you were looking for. So you'd be surprised how many sellers don't know of all the things that are available. So that's a great tool.
And a great way to do that is pulling a qualified intermediary. Just say, hey, I've got an expert here. We'll do a phone call, they'll explain what exchanges are. So a qualified intermediary stays on the line talking about what a 1031 is, what the rules and time requirements are. The buyer then is talking to that seller and saying, here's an exit strategy. This is why maybe I could pick it up at a little better price because you get what you want, which is retirement income. You take this land and you're going to get your retirement income on that improved property.
Seth: Yeah, because I've heard it said when people offer to buy properties with owner financing, where that seller is financing it to them, one of the ways they can sell the person on that idea is the legitimate point of this could help you save money in taxes because you don't have the whole tax bill in that first year. And this is kind of a different way of making a tax strategy offer by bringing in the 1031 exchange, like giving them a tax reason to consider something that they wouldn't otherwise consider unless they realize the potential benefit there. So that's great to know.
Scott: Yeah, no great strategy to do that. At the end of the day, if you can help solve their problem, they're selling a property if you help solve their problem as a buyer, puts you in a better position negotiating to get what you want, which is their real estate. So that's a great tool to use.
Seth: When you think back to all of your experience in 1031s, are there any big mistakes or oversights people make when trying to do this that they could easily avoid? But we've kind of talked a little bit about them just regarding the timeline and all that. But any other just big obvious glaring, don't do this if you want to go down this path.
Scott: Yeah, here's the one mistake and I get it every single week and it's tragic. Here's the mistake. They don't set up a 1031 before they close on the sale of their property. So I'll get a call, I guarantee you multiple calls a week. “Hey, Scott, I need to set up exchange right away. I just closed on my property three days ago and the money's sitting in escrow.” You can't set up an exchange retroactively. You have to set it up before you close. Even if you don't touch the money, if it's sitting in escrow or in a trust account, you have control of the money. It's called constructive receipt. So we probably as a company, get maybe 50 to 100 of these every single month. So these are people that wanted to get tax deferral. They just didn't know they had to have the documents in place prior to closing.
So that to me, hands down, is the number one mistake is not setting up an exchange when they want it. The other kind of thing to be aware of. You don't have to do a fully deferred exchange. So many people think, well, if I sell a property for a million dollars, I've got to go out and buy a million-dollar property. You don't have to do a fully deferred. So you can sell one, turn around and buy a couple of good performing properties. And if there's 20 grand left over, called cash boot, you just pay taxes on that 20,000. So statistically about 30% of all exchanges are partially deferred exchanges. So don't think I'm going to do an exchange and I have to do everything. If you find a really good deal and it's at a lower price point, okay, you pay taxes on the difference and you pay a little bit in tax, but you still did an exchange into one or two replacement properties that make sense.
So don't think you have to do a fully deferred exchange. You got to be all in, do the whole thing or nothing. You can do a partial exchange and buy one or two properties and then that cash that's left over, you pay taxes on that. And then keep in mind, you can use other strategies like cost segregation if you go into an approved property to create some other tax benefits.
So taking advantage of taxes is a critical way to build wealth. If you want to get ahead in real estate, you need to become tax-savvy and entity-savvy. And so this is just one piece, right? There are other things you can do. You need a good tax planner to work on setting up your entities, right? Passive entities over here, you're going to have sub-S entities for your active efforts.
So this is just one tool in your toolkit that could be really critical. And there are some other tools you're going to need as you become an investor. But this tool you can use over and over and over again. So I just think it's phenomenal. Fortunate. It's made a great career for me. And then personally, with my investment portfolio, I use exchanges too. So I'm professionally in the business and then I also personally invest and I never will sell my assets. I will exchange until I die and my kids will get a handoff of hopefully a decent real estate portfolio.
Seth: Do you ever see it happen where a person sells a property because they have this idea of doing a 1031 exchange? Maybe they identify three, then they close, then they try to pursue these things because it looks like a great deal, but then it doesn't work out. Say there's some huge environmental contamination issue or for some unforeseen reason it just doesn't work out. They end up having to pay a huge tax bill. And had they known that, they never would have studied this in the first place.
Because in my mind, that's kind of like my biggest fear about doing this is like I don't want to go into this blindly or somewhat blindly, which is inevitable because you're not going to know everything at the very beginning and then end up in a worse off position than before. Does it happen a lot or how could you avoid that kind of thing?
Scott: So what you're saying does happen not a lot. Let me give you the big planning tip to avoid that.
Where people get into that situation is they find one property they love, they identify the one property, but they don't identify two backups. So the way to avoid this is even if you've got a perfect property and you know you want it and it's great, what I would recommend is put your second and third options on that identification list. So as you're doing your due diligence and you find it's contaminated, now you've got two other backup properties to look at.
So the way people get hurt is they only identify the one that they really want. They're outside of day 45, and there's no way to get any other properties. So I strongly recommend put a couple of backup properties on your identification.
Now, could those also sell or have problems? Of course they could, but I'd rather have my first deal not work out and have two other options to look at that are decent deals than faced with a huge tax hit because I sold my highly appreciated property. So that's a way you can kind of mitigate that or try to proactively avoid getting into that situation.
Seth: At what point do you actually sign a purchase agreement with these new properties and put earnest money down? Do you do that after you've closed on your sale? Because once you do that, you're going down a path. There could be consequences if it doesn't pan out.
Scott: Yeah, you could do it anytime you want. We have a lot of people that will make an offer. They'll put down their own earnest money before the property they're selling even closes, and then we'll later replace their earnest money with exchange funds once they've closed on their sale. So you can start that process, and I'd encourage you to start that process of making the earnest money deposits, negotiate it, you can make a contingency offer, or there are a lot of different ways to do that. But anywhere in the process, you can make the purchase offer and get it locked up under contract. And in fact, I think the earlier you start that, you take some of those time pressures off of yourself, for sure.
Seth: Sounds good. And then last question. Are there any resources like books or websites or courses that you recommend for those who want to better understand 1031 exchanges? Where should they go if they want to really understand this?
Scott: Well, there are books out there. A lot of them tend to date themselves a little bit, and most of the books tend to be a little beefy for an investor. They got a lot of case law. They're written for attorneys and accountants. That's probably not my first choice. Probably your best choice would be in your local area. Find out where a qualified intermediary is putting on a class for CE credit. So most people are going to teach CE classes, two, three hour classes for credit for realtors.
And you as an investor, just jump into one of those. You're not getting the credit, but you're going to get a three hour discussion on the whole process. That's probably a good way to go. We've got a YouTube channel that's linked to our website APIexchange.com, where I've got classes that I do. So I'm an instructor nationally for CCIM. I do a two hour advanced class for them, but I've got introductory classes. That's probably a little better than trying to buy a book.
Now, the one little caveat I'll give you is if you talk to ten different companies about the question of how long I need to hold a property before it's held for investment, you're going to get ten different answers on that. That's just the reality of it. I like the answer that I gave it on this because I think it's accurate about your investment intent. But there are going to be some companies that are going to tell you a time period.
Now, I believe they're wrong. I don't believe that's the most nuanced, accurate answer. So realize when you learn from a qualified intermediary, you might get a little bias of that person teaching. So if I were around, I started giving classes in ‘88. 2023. I know a lot more than I did back in 1988, right? I was just out of college, young and dumb. So maybe pick an instructor that's seasoned, that's been doing this for a while, has been in the business for a while. That would probably be another way to do it. Some people like learning from a CPA or an attorney. I'm neither of those, even though I teach thousands of CPAs every month. But somebody that's got experience, 10 to 20 years of experience doing this, you probably are going to get a little bit more seasoned, maybe a little bit broader in depth answer. So that's what I'd recommend.
If you use Google, you're going to get all sorts of stuff, and you're going to get a lot of people pitching product. They're going to be pitching DSTs that you can exchange into. So sometimes the internet is not your best friend. You're going to get people that have a goal to get you into their particular offering or product rather than you learning about it.
The last thing I'd mention, too, is just call a qualified intermediary. Go to the website I gave you, the 1031.org. Call two or three companies, explain to them your situation. Here are my facts and circumstances, and just listen to their answer. Doing that, sometimes it's better. I think it's faster to speak to three qualified intermediaries, listen to their spiel and how they educate you rather than having to go in. You don't need to spend time on the internet studying this and Googling and reading. It's really not that complicated.
We visited together for a little over an hour. People now know pretty much everything they need to know to put a deal together. So you don't need to be kind of that analysis paralysis, where you think you need to become an expert on 1031, know the basic process and then review your situation with your tax advisor. I think that's super important and maybe with a couple of good qualified intermediaries would be a good way to go.
Seth: I don't know if you're familiar with Realty Mogul, the real estate crowdfunding platform, but I had heard of a thing that they were doing years ago where if you get into a situation where you start going down this 1031 exchange track, you identify the properties, but they all fall through. You're just kind of stuck in a corner. You don't know what to do. You can basically take your money and put it with them and tie it up for five years or however long it takes. And obviously that's not your first choice, but at least you don't have to pay the taxes because the money just goes over there, in a real estate fund.
Is that a viable option or is that a good example of like a plan B or plan C when things don't work out, or any other ideas of what could you do if everything falls apart and you don't want to pay those taxes?
Scott: So for a plan C, probably the best option is what's known as a Delaware Statutory Trust. You go into a property as a co-owner with a bunch of other people.
I'm familiar with Realty Mogul and what they do. There are probably 50 companies out there that offer something. So learn about what's called a DST, a Delaware Statutory Trust. These are kind of a hybrid. They're treated by the SEC as a security, but yet they qualify for 1031 deferral. There are probably 50 or so providers out there, they're called sponsors that have property right now that you could get into within a day or two.
So there are a lot of options. You want to look at them, you want to look at their fee structure. They're going to charge a fee for that. You want to look at their track record. How long have they been doing that? Some companies like Inland have done it for 20 to 30 years. They've gone through economic ups and downs. There are other new players that are in the cycle now. And we all know on the commercial side, commercial is going to face some distress, right? Loans people aren't going to be able to refinance and capital calls, and there's distress in a lot of commercial segments. You don't necessarily want to go into a DST with a brand new player that hasn't weathered a cycle or doesn't have a lot of capital behind them.
So again, do your due diligence with who you're going into, those types of relationships. There's a whole group of financial advisors that specialize in DSTs and Delaware Statutory Trust. And a good one would offer to you several different companies and several different programs. You evaluate them. These are for accredited investors only, so you have to be accredited investor. They're made available through a PPM, a private placement memorandum, and somebody with the appropriate securities license will offer these up.
But yes, there's a whole wide variety of these. Most qualified intermediaries can introduce you to several financial advisors in your market that you could turn to and get a list of options so that's a viable I call it a Plan C. Plan B would be identifying multiple replacements. Plan C, this is kind of a last fallback provision.
Seth: Yep, that makes perfect sense.
Awesome, Scott. Well, thanks again for sharing all of your wisdom and knowledge and experience with us. If people want to connect with you or work with you in some way, or find out more about how your company works, where should they go?
Scott: Yeah, the easiest way a toll free number is 888-531-1031. Website is APIexchange.com. So A as in Apple, P as in Paul, I as in Igloo, exchange.com, and then my personal email is just my name, email@example.com. I spend 90% of my day just talking to people, answering questions. Even if you don't have a transaction, you just want to kick around some ideas, give us a call. That's why we're here, to educate you on your specific transaction. Love talking to people about it, and been great visiting with you and your audience. Had a lot of fun. Hopefully give some new insights, some things to unpack, some things that people haven't thought of before. So thanks so much. I really appreciated this.
Seth: Absolutely. I've learned a bunch here. I'm sure other people have too. Thanks again, Scott. And I'll have links to all the stuff that you mentioned here in the show notes for this episode at retipster.com/167. And I wish everybody out there the best. If you're working on a 1031 exchange, hopefully you found this useful. See ya.
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