Hey, guys. Toby Mathis here and today We're going to talk about 1031 exchanges. I'm going to dove right in and just kind of diagram do the 10,000 foot view and then break it down and then give you some examples of how it works.
First thing to know is as we are sitting right now and this is 2022, the 1031 exchanges work on real estate that used to be you could do some business property and some other things that went away for a little bit. We'll see tax cut and jobs act might I believe that we're we're coming back in 2026 to possibly have those other uses but for right now we're only going to concentrate on real estate so for my purposes 1031 exchange right now is only for real estate. And here's how it works let's say that I purchase property and real estate any type of real estate it could be apartments it could be single families, duplexes, perplexes, even land.
And I have real estate. And the reason I say real estate because it doesn't matter whether it's one or ten or 100, it's just we're using real estate as the example. And as long as we trade real estate for more real estate, of equal or greater value, what the tax code says is 26 U.
S. C. 1031, which is why they call it a 1031 exchange.
As long as you are trading real estate for real estate and following their rules, you do not recognize the gain or depreciation. This is really important to understand. I could literally start buying properties in over a 20 year stretch.
Let's say that that property is tripled in value I could trade whatever that property is, whatever the value is, and I could buy more real estate. So let's say I bought one house and I'd made it has to be investment property. So I put a big caveat on this.
When we're exchanging, it has to be investment property it can't be your house, vacation house, things like that. It has to be an investment property when you sell, and then you need to acquire investment property on the other side. So some of you guys are already saying, wait a second, that means that I could take a home, turn it into investment property 1031 to exchange it acquire other investment property.
And could I move into that at some point in the future? The answer's yes, but we're not going to get into that just yet. You can buy or I can sell the real estate.
So I'll say again, I bought a piece of real estate. 100,000 and it's worth, let's just say it's worth 500,000, 20 some years later it's gone up 500% or whatever that is. So there's $500,000 and I want to buy more real estate.
So I sell that property for $500,000. Know I acquire, let's say that I acquire a piece of land for 100,000, a single family resident for 100,000 maybe I get a small duplex for 100,000. I know you're not going to get a duplex 400 times but you get maybe, maybe I do the duplex for 300,000.
So all that adds up to 500,000 The answer is I pay no tax. My basis from that original purchase goes into those new properties and proportionality among them. So at the end of the day I could very in this happens, I should anticipate that I will not be paying tax on the sale of my real estate throughout my life.
And then if I do this correctly and I pass away with a bunch of investment properties even if they're in an LLC, if I pass away with a bunch of investment properties on the basis of those properties, steps up to the fair market value. When I die in English, I never pay tax during my lifetime. And then when I die, my estate or my heirs will never pay tax either.
That's why real estate investors use this. So it's called a 1031 exchange. And what I'm really doing is I'm taking value and I'm buying equal or greater value if I buy less value.
So let's say that I sell a $500,000 piece of property and I exchange it for a $400,000 piece of property. I have $100,000 of value that I'm going to be taxed on. Sometimes they call that, but it's just the amount of or some benefit or here's another one that that'll throw you off.
You have to add in equity and debt. So if I have a $500,000 piece of property and I've got $400,000 of debt on it, and I buy a $400,000 piece of property, with $300,000 of debt, I also I still have 100,000. Even though my equity didn't change, I have $100,000 of equity.
Doesn't matter you still have to add in the debt value. You can pay off the debt like there's a misnomer. Like if you if you look online, you're going to see people saying, oh, you have to replace the debt.
Otherwise it's put No, you look at the equity and the debt and so long as whatever you're acquiring equals, you're going to be fine. You can bring cash, you could, you could private note, you could do whatever and pay off that that note. As long as it adds up to the full value, you're going to be fine.
But that's not what I want to talk about today. What I want to focus in like a laser beam today is what you have to do to take advantage of a 1031 exchange. And here's the big one.
You have to use what's called a Q II qualified intermediary. Number one, you can't touch the money if you are selling a property, you're selling it with a qualified intermediary. The qualified intermediary takes those funds and then you're on a clock.
You have to complete the exchange within 180 days. In other words, using my example I sold a $500,000 property from the day of closing. I need to acquire replacement property within 180 days.
Otherwise, no exchange. It's going to be taxed. I'm going to have depreciation recapture in long term capital gains.
So if I want to avoid that, I need to follow these rules. So I have 180 days. I have 45 days to identify replacement properties.
So I actually have to work with my qualified intermediary. And I need to say, here's the properties I think I'm going to buy and if I sell one property, I could choose three or I could do up to I think it's 200% of the value of the property. I could name a whole bunch as long as when you add them all up, they don't exceed 200% of the sale.
So in my case, again, I'm selling a $500,000 property. I could identify properties. I mean, it could be a whole bunch of properties, up to $1,000,000 worth of properties that then I need to acquire within 180 days.
And that's called a deferred exchange. You could do a 1031 exchange where you're literally closing on two properties simultaneously and you're swapping. So for example, hey, I'm selling my $500,000 property and I already know I'm buying these three properties and I coordinate the closings.
So they're on the same day and all we're doing is swapping them. Boom, I don't have to worry about 45 days, 108 days, anything. I'm just swapping them.
Another route you could do is what's called a reverse exchange, and with a reverse exchange generally speaking, I'm buying a replacement property again through a qualified intermediary. I have to make sure that I'm not touching the funds from the sale it needs to. But I mean, I so I'm going to be using this third party and I'm going to be following their advice.
So no matter what I say, you got to be talking to your intermediary in making sure that you're following their advice. There's nuances here. I'm giving you the 10,000 foot view in the rules, but there's always little nuances depending on your scenario.
So let's say that you're you're going to acquire another piece of property. You say, Oh, here I'm going to give money to the intermediary in America. You can go out and acquire it.
And I have 180 days to sell the property that I'm going to be using that I'm that I'm selling to for the replacement. So I am selling a property. I am buying a property.
You could either do them simultaneous, you could sell and buy, or you can buy and then sell, but you still have the 180 day period. The other route you can go as some folks will actually do building and the IRS will even allow you to do land and buildings so long as it's complete within 180 days as well. So again, you have different options available to you.
If I was going to leave you with one word of advice, it's make sure that you're communicating with your qualified intermediary all the time. And so just remember, we have this little timeline. We have the sale on a typical exchange is called a starker exchange.
You'll hear people call it that. That's day one. Identify a replacement.
45 days. So I'll just put replacement and then buy hundred eight days. So that's our time frame to do a 1031 exchange.
You've got to make sure you use the qualified intermediary. But you can do this and I'm just going to give you some scenarios. Now, let's say I have some land, I can't depreciate land, so I never really have to worry about recapture on that situation.
Let's say I've been sitting on some land for ten years. It's gone up in value and I really want income producing properties. I could sell that land, boom, identify my replacement properties, which is either three or 200%, and I identify or 200% of value.
So if I sell the land for a million bucks I identify $2 million worth of properties that I could acquire in buy, and it could be apartments, duplexes, it could be single families it could be condos, it could be other land, it could be a combination. I could buy ten single families, and as long as I close within 108 days, I'm gold. That's assuming cash for cash.
Now let's throw a monkey wrench into it. Let's reverse it. Let's say that I have an apartment building and I sell it, and my replacement part property is land.
Now we have an issue because you really need to move that depreciate over. And if I have land with no improvements, I have no depreciation. So I could be looking at a taxable event there.
So you got to make sure that you're talking to your Q I in crunching your numbers, here's another one. Some of you guys do cost segues, and if you don't know what the costs say is that it's a cost segregation, it's where I break my property instead of doing 27 and a half years and 39 years, I'm doing five, seven, 15 and 27 years or five, seven 15 and 39 years by breaking my property into components. So for example, carpeting in a property is five year property if you buy a single family residence and rent it, you're depreciating that carpeting over 27 half years unless you do a cost sag in which case it'll be depreciated over five years much better from a tax standpoint.
But if you do that, you just have to make sure that your replacement property is using the same the same accounting methodology. So that's all it is, is I'm saying hey, I'm treating it as 1245 and 1250 property. Technically that's what it's called.
But buy my tangible personal property and my structural property and I'm treating it the same and I'm acquiring property that's going to be treated the same. And as long as my depreciable basis moves over equal to are greater than in my replacement, I'm going to be fine. And if I lost any you guys, they're the easiest way to think of it is like if I buy $1,000,000 apartment building and I've depreciated a huge chunk of it and I'm doing replacement property, let's say I accelerated depreciation.
So I wrote off a big chunk of that apartment building and I literally could have held it for a year and now I'm buying a replacement property. It needs to be of greater or equal value, and I need to use the same accounting methodology. I will not pay tax under that circumstances, but I don't get to read depreciate the new property either.
It just means I don't have recapture of the depreciation from that apartment. Building. It moves right on over that first property when I acquire the new property or new properties.
If I bought like two apartment buildings for equal or greater value and I could do greater value, like I could sell this for a million and buy $1. 3 million to the property, exchange a million of it and bring another $300,000 of cash to bear. I could certainly do that or debt or whatever, as long as I am equal or greater value.
And then keeping the same accounting methodology so I need to make sure that I'm doing a cost sag on the replacement property. If you're not doing cost savings, you just traditional, you know, real estate person who buys single families and hey, they just go up in value like we just had this huge run up over these last few years. So let's say you're sitting in Las Vegas, my town, and you've had property double in value in two years.
And just like, you know what? I just don't see the growth being like that. And my cash flow is so much better in North Carolina.
So you sell your Vegas properties and you go to some North Carolina. It's because you want more cash flow. That's fine as long as it's equal or greater value.
And I use the same methodology I never cost saved the first one. I don't have to cost seg. The second one, I could still do it, but my depreciable basis is going to be the is going to be the first property.
So it gets a little bit mucky in that one. Here's another fun one. Let's say you're in California and you ten a new 1031 exchange California property and acquire new property.
Well, California still wants to get paid. You made money in California and they're franchise tax board, board of Equalization. It's like vampires.
They they need their blood. Right. So even though let's say you went and you sold some California properties and you did what a lot of people are doing, you're going to Texas, Florida, and you're buying all these other properties in those states, California is going to track that exchange.
And they're going to require you to and they're going to require your. Q I send them paperwork that says, here's the amount of deferral that is owed in California. If you sell the replacement property.
So there is a ramification to doing these. If you don't continue them on that in the future, your state may want to get paid back. So let's say I get it.
I'll use my me as an example. Buy a property 100,000, it goes up to 500,000. Exchange that and I buy.
I think I used three different properties. I had some land well, we won't use land. Let's just say we did five single families all at 100, and those ones go up 500%.
So I have my basis was my $500,000 or $100,000 purchase goes up to 500. I buy five more, those go up. So now we're at 2.
5 million that's the value and I do another exchange. My basis is still that original 100,000 and I took some depreciation right. I don't get to read depreciate the new acquired but I don't have to pay tax.
So now I have $2. 5 million with the property. If I sell that and I don't do a 1031 exchange, I have a large amount of taxable income like I now have very low base, it's less than 100,000 in theory because I've done depreciation.
So I have some recapture and I have $2. 4 million of long term capital gains. And then you have the states that were skipped along that that might come in and say, oh, you owe tax on 400,000 in my state.
So for example, if I was in California, about 100,000 went to 500 and then I exchange the 500 for five properties in North Carolina. California is always going to say we want to get paid on that 400,000 if you ever recognize it, we want to get paid on it. So just know that those little things stick out there.
So if you're starting to realize that 1031 exchanges have some nuances and there are some issues. Yes. Now I'm going to leave you with one last thing you can 1031 exchange something that you used as a personal property.
So let's say that I had a residence and let's say that I lived in that residence for the last five years and I'm going to sell that residence. I bought it for 500 and now it's worth a million that wouldn't even be really good unless we use this example first married filing, filing jointly. I bought a property for 500 and it's worth a million I wouldn't worry about the 1031 exchange because under section one 21 I have a capital gain exclusion of 500,000.
So I would just sell that property for a million and I don't have to pay any tax on that gain. Yes, I now have a bunch of money that I can put in my pocket not to pay tax on it. What if that $500,000 property, let's say it was in Seattle and now it's worth 2.
5 million or San Francisco or heck Las Vegas in Summerlin. You bought a property and your basis is 500 grand and now it's worth 2. 5 and you're looking at it and you say, Hey, I could sell it.
I still get a $500,000 exclusion. If I'm married, it's two 50. If you're single, as long as you lived in it two of the last five years.
It's not the last two years, but it's two of the last five years, then I could avoid the payment of the capital gains. I have an exclusion of 500,000. So again, I bought it for 500,000.
It's worth 2. 5, so I could exclude up to a million. Now I have a million five.
That would be taxed as long term capital gains and that would be taxed at 20% federal. 3. 8 not investment income tax.
And then if you live in a state that has state income taxes and there should be a tax there. So it could be 23. 8%, not a small amount on 1.
5 million, you can kind of do the math. It's over $300,000. Right, right.
Right in the kisser. So you don't want to pay that extra 300 grand plus of tax. So how do you get away from paying the tax on that you need to convert that primary residence into a rental property.
And what I would suggest that you do is if this is in your scenario, is that you actually turn it into a rental property for at least six months, just make it into a rental. I don't care if you did it furnished right I sold it. I have 2.
5 million. Oh, my gosh. It's going to be great before you sell it, turn it into a rental and then exchange it if you do that, you could avoid tax on that extra 1.
5. You still get to use your exclusion, the $500,000 exclusion, you get to double up and use the one 21 exclusion plus the 1030, the 1031 exchange. So if you did that and you made it into a rental property, let's say that you rented it for six months, then you would use that and you'd go find replacement property.
So if you have good credit or if you're liquid, you can always go out and let's say you're selling your house and you're buying a new one, or in a lot of cases people have two properties and they're just moving into the second one and they're selling the first one that's quite often the case and you're like, Hey you know, I just move into the next one is your personal residence. You take the, take the, the one 21 exclusion. It steps it up to $1,000,000 basis.
But we have to go buy replacement property again, then 180 days. Once we sell it, then we have 180 days. We would still use the qualified intermediary and then we would go buy replacement real estate.
What if you buy a an amazing property that eventually you want to live in? Like you see the most amazing property up in Breckenridge or whatever, you know, wherever that you might, you might see a property. It's in Montana and it's gorgeous that it's a ranch and you say, you know what, in three or four years, I want to move there, make it into a, into a investment property, buy it and rent it for those that period of time until you're going to move into it.
And the rules, the 1031 exchange rules contemplate that you will move in to and make a replacement property into your primary residence. They actually have a rule that says if you do that, you can't use the one 21 exclusion the $500,000 exclusion if you're married $250,000 exclusion. If you're single you can't use that for five years on a property that you 1031.
So the IRS knows that you're going to do this and it's okay as long as you follow the rules. So then you go to your QE you're like, Hey, here's my scenario. I have all this gain, I'm going to sell this house because the market's crazy and I can dump it and I know that I could step up my basis to a million bucks.
So I know that that's good. And then I'm going to I'm going to buy 2. 5 million.
Maybe I'm going to buy the dream home, or maybe I'm going to buy five properties that are all income producing properties. Whatever the case, you go to your QE, you sell your your house after you converted it into an investment property. And as long as you lived it in is your primary residence two of the last five years, you get the full one 21 exclusion and you pay no tax on that.
So that's actually pretty important. So I'm just going to put that feather in your hat so that, you know it's there. If you're in that scenario and you see big gain, just know that whenever you're dealing in real estate, there's a few different rules that we use A that if you're paying tax on real estate, it's because you don't own enough real estate.
Because if you know how depreciation works, if you're paying tax on rental income and things like that, all you really need to do is increase your basis that you're depreciable basis by buying more property. The other thing is the buy borrow dye is the ultimate strategy. Buy real estate.
It appreciates you borrow against it. It's not taxable when you buy die the basic steps up. If you want to sell properties along the way, you 1030 want them do this and you never have to pay tax on it.
And then you continue to let it grow, grow, grow, grow, grow. You keep borrowing, borrowing, borrowing, borrowing in Europe, pay tax on it. Then when you pass away, your heirs can sell it and not pay any tax on that.
So buy, borrow or die. If you pay tax on real estate because you don't own enough, think of those two things and and you'll be good as gold. All right.
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