The Private Equity Real Estate Podcast – Show 18
Summary
On this week’s episode, we will be discussing 1031 exchanges with the senior vice president of Asset Preservation, Inc., Scott Saunders who has been involved in structuring 1031 exchanges for over 32 years.
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Speaker 1:
You’re listening to the private equity real estate podcast brought to you by First National Realty Partners, where investors learn from Private Equity experts and insiders. We share our own real-world experiences, so you know exactly what it takes to be highly successful at investing in passive commercial real estate opportunities.
Eric Murphy:
Hello, and welcome to the Private Equity Real Estate Podcast, which is brought to you by First National Realty Partners. I’m your host, Eric Murphy, and on this program, we sit down with experts in real estate. Each week we’re going to talk about different topics across the real estate landscape.
Eric Murphy:
This week we want to go over 1031 exchanges, and in order to do so, we’re going to bring in an expert in that field. He’s been involved in structuring thousands and thousands of 1031 exchanges in his over 32 years in the industry. He’s the senior vice president of Asset Preservation, Inc. In addition, he was a contributing author to the book Real Estate Exchanges: Using the Tax Deferred Exchange in Real Estate Management, so, obviously, a man who knows what he’s talking about. Mr. Scott Saunders, thank you so much for being on the program today.
Scott Saunders:
Hey, Eric. It’s great to be with you today and talk about this topic. It’s such a exciting topic for commercial investors. Look forward to going through some of the basics.
Eric Murphy:
You’re obviously very knowledgeable in this field, and it really seems like you are extremely passionate about teaching strategies as well. You hold a wide variety of classes on this topic. Can you tell us a little bit? What is your background, and how did you get started?
Scott Saunders:
Yeah, great question. Believe it or not, I’ve been doing nothing but 1031 exchanges since 1988. My background is in business economics and business. I stumbled into this field before there even were treasury regulations. I’ve been doing this now… This may be my 33rd year doing nothing but 1031 exchanges. I think our company’s done something like 200,000 plus.
Scott Saunders:
It’s a great tool for investors, big and small. Investors start with it, maybe the single-family. They move into multifamily, a fourplex, work their way up. Commercial investors use it, people on ranches and farms, just lots and lots of applications where if you want to redeploy your equity and use that equity to go into better performing property, 1031 exchange is such a powerful tool. I’ll [inaudible 00:02:11], right now, we’re at the 100-year anniversary of 1031 exchanges being in the code. So it’s something that’s been around for a long time. I think, over time, more and more investors are beginning to understand the value of it and how much it can help them.
Eric Murphy:
Well, before we get too deep into it. Can you just give us an overview? What is a 1031 exchange, and what are the different types?
Scott Saunders:
Yeah, sure. Happy to do that. Simply put, when you hear the word 1031 exchange, it’s referring to a section of the tax code, section 1031. Section 1031 allows any investor holding any property or investment or in their business to exchange it for another like-kind property and then defer paying all of those taxes that would otherwise be owed if it was a taxable sale.
Scott Saunders:
There are a lot of different ways to do an exchange. Some that were done in the past, which were a simultaneous exchange, two people would swap properties, very rarely. Today the most common exchange format is what we call a delayed or deferred exchange, where we’ve got some timelines to do it. So you sell a property, and you’ve got a period of time to reinvest. There’s some other variations out there that are called parking arrangement.
Scott Saunders:
Those of you that are commercial investors might look at some of these, but we’ve got a parking arrangement. That’s a reverse exchange, where we buy the new replacement property first and approve an exchange where we build a brand new property from the ground up or refurbish an existing or we combine both elements. We do what’s called a reverse improvement exchange, buy the new land, begin making improvements to it. Sometimes we see people that are maybe owner users taking advantage of that strategy. You got to run your existing business. You want to go to a bigger and better location, so you do a reverse improvement exchange, but circling back the most common format, which I think we’ll focus on today, Eric, is what we call the delayed-type exchange.
Eric Murphy:
Great. Well, let’s talk about some of the advantages and disadvantages. Besides deferring the taxes, what are some other benefits of the 1031 exchange, and then maybe what are some of the risks involved as well?
Scott Saunders:
Yeah. Great question. The first one is you get the benefit would be tax deferral. Now, let’s be really clear. It’s tax deferral. You’re not avoiding any taxes forever. When you sell a property, the basis of the property now gets rolled into the basis of the new property. But it’s a timing mechanism.
Scott Saunders:
So what’s the big benefit? You now have all of your gross equity available to redeploy into another property. You’re going to be able to buy a larger property, or maybe you’re able to buy multiple replacement properties because you’re buying a larger property or more. You’re able to boost your cashflow. You’re able to get higher rents. So a lot of benefits there. Some other benefits: you can move around geographically, anywhere within the United States. If you’ve got a lot of equity in one marketplace and you want to get some diversification, you can do that.
Scott Saunders:
For those of you that maybe have some land, you can move out of land which doesn’t produce cash flow and into commercial real estate, where you get tax advantages and cashflow. You can consolidate. You have multiple properties. You can consolidate it into one larger one. You can go from one property into multiple. So many things that you can do to get a better return on investment.
Scott Saunders:
Let’s look at some of the negatives. One negative is you have to buy other real estate held for investment. You can’t go into other assets. You can’t go into stocks. You can’t go into [inaudible 00:05:38] shares or other things, but you’ve got to buy other real estate held for investment. The other piece, too, is your depreciation schedule on the property that you’re selling, what we call the relinquished property, gets rolled into the replacement property. You might be able to go up in value and get some additional depreciation, but maybe not quite as much as if you sold and bought a property right outright versus doing a 1031 exchange. So a few pros and cons on both sides of it.
Eric Murphy:
Does it have to be of equal or greater value? What would be the case if I exchange with a property of lesser value?
Scott Saunders:
Yeah. So what you’re alluding to there, Eric, is, what do you need to do for full tax deferral? Now, a common misconception, and you set me up really well for it, Eric. You don’t have to exchange for the same value. If you sell for a million, you don’t have to buy it for a million to get full tax deferral.
Scott Saunders:
There are two simple rules you’ve got to keep in mind. Number one, you need to reinvest your net equity. Whatever your net equity is after all your closing costs, that has to be reinvested. Number two, you need to have the same or a greater amount of debt. If you have a loan payoff of 300,000, then you need to have at least $300,000 of debt on whatever you’re purchasing. That could be on one property, or you can split that on multiple properties. For full tax deferral, those are the rules.
Scott Saunders:
Now, what you can do, and I’ll tell you today, in the marketplace, about a third of the investors do this, is they take advantage of a partially deferred exchange. They maybe sell for a million dollars, but instead of buying where they reinvest the net equity and debt, they buy considerably lower. They still get some of the benefits of the exchange, but then they receive some cash out of it that’s taxable. So they get deferral and another property. They also get some cash, and then the cash they receive, they pay taxes on. You may hear that referred to… There’s some terminology that’s very unique in the exchange field. But if you get cash, we call that cash boot.
Scott Saunders:
If you lower your mortgage liability with respect to your replacement property, prior to the one-year relinquishing, we call that mortgage boot. You add those two together. I’ll share one more thing here before some more questions, Eric, but be sure, in any exchange, to talk to your tax advisor about your unique facts and circumstance. Some commercial investors have suspended carry for losses that they can use to offset some boot. I always tell people, be sure to get with your CPA, your tax advisor, who can look at your unique facts and circumstances. Boot isn’t necessarily bad, and it’s not necessarily always taxable. It varies upon your specific circumstances.
Eric Murphy:
Scott, can you give us an example of a situation where a 1031 exchange might be a good use and then maybe another scenario where you might recommend a different strategy?
Scott Saunders:
Absolutely. Number one scenario to use a 1031 would be if you like real estate as an asset class, and you want to keep continue to be invested in real estate. It’s a great tool to do that if you want to keep investing in real estate. However, if you’re looking for other investments or maybe you want to diversify, maybe you have everything in real estate, and now you’re getting closer to retirement, you maybe don’t want the management responsibilities then it might make sense to sell and pay the taxes or do a partially deferred exchange. There are some vehicles that are out in the marketplace. There are things like, what are known as a Delaware statutory trust, referred to as a DSG, that provide relatively passive ownership. There are some products on the marketplace that are very creative, that might allow you to be more passive and still do a 1031 exchange.
Scott Saunders:
Another strategy would be if you have a loss on a property. You don’t want to do an exchange if you have a loss. That would be another one. Then, probably the very last one is if you bought an asset and there’s not a lot of gain in it, it really doesn’t make a lot of sense to do a 1031 exchange. But a word of caution. Always before you sell, get with your CPA to determine what your tax liability is going to be. When we talk about things like deferring taxes, it’s a little more nuanced than that. We think of capital gain taxes. When you sell a commercial property, you have four potential taxes you can pay. First off, you pay taxes on the depreciation recapture at a rate of 25%. Then, the remaining federal gain is taxed at either 15 or 20%, depending upon your taxable income.
Scott Saunders:
Number three, and this is going to apply to a lot of commercial investors. This is what we call the net investment income tax. There’s an additional 3.8% tax on all net investment income. It’s a [inaudible 00:10:33], but just think of it as unearned income, that would include things like capital gains from the sale of an asset, partnerships, things of that nature. Any unearned income over $200,000 for single filers or 250 for married filing jointly is assessed the additional 3.8% tax.
Scott Saunders:
Finally, don’t underestimate state taxes. You pay state taxes on all of the gain. Some states have no tax. If you’re in Tennessee, or Florida, or Texas, or Wyoming, a few of these states, that’s not an issue. But many states have taxes in that 5, 6, 7, 8% range. In California today, the highest state tax rate is 13.3%. You have to add up the depreciation recapture, federal capital gain, net investment income, and state tax to get your total tax [inaudible 00:11:23]. Do that before you close.
Scott Saunders:
What I find is a lot of investors, in their mind, they think they may have a smaller number. They’re going to have to write a check out for in terms of taxes, but when you add up all four levels, a lot of times, the number’s a whole lot bigger than maybe they thought I was going to be originally.
Eric Murphy:
Yeah. You briefly mentioned it earlier. When it comes to the process, is there a particular timeline that an investor should be aware of?
Scott Saunders:
Yeah. When you do what’s called a delayed exchange, which is the most common format, first thing you need to do, very important, before you close on the property you’re selling, you need to hire what’s called a qualified intermediary. Sometimes they’re referred to as a QI, an intermediary, an accommodator, but the IRS calls them a qualified intermediary. They need to get their documents in place prior to your closing. So just keep in mind. You can’t set up an exchange after the fact. You’ve got to go into it before you actually close. Once you close and you set up an exchange, the qualified intermediary steps into your shoes as the seller of the property. They’ll actually sell it to the buyer. That’s day zero. You have 45 calendar days to identify property that you want to buy. It ends at midnight of the 45th day, and they’re calendar days. They’ll go through holidays and weekends. They’re just sequential days.
Scott Saunders:
From day 45, you have another 135 days. A maximum of 180 days, or the date your tax return is due, whichever is earlier, to purchase properties that you’ve identified. This is what we call the identification period. The total timeline of 180 days is called the exchange period. I’ll tell you. From doing this for a long time, the area where you really want to focus on is that identification period.
Scott Saunders:
You have to identify specific properties. You can’t after day 45 shoehorn in anything. You’re going to really have to move pretty quickly once you set up an exchange. Particularly now, the marketplace, as we’re talking today, is really pretty strong in a lot of markets. Things turn over if they’re priced right.
Scott Saunders:
What I recommend, practically speaking, is as soon as you get the property you’re selling under contract, start looking for the replacement property. Work with your real estate broker, looking for properties that, maybe, meet your criteria, your price requirements, your asset class. By the way, when we talk about asset classes, anything held for investment qualifies, so a commercial property, an apartment building, a retail, industrial, warehouse, or even a vacation home held for investment. As long as you hold it for investment purposes, that’s like-kind with any other real estate also held for investment purposes.
Eric Murphy:
If I’m not able to identify a property or purchase something in that subsequent period of time, what would happen then?
Scott Saunders:
Great questions. If you don’t identify anything within that 45 day period, then you received the money back on day 46, and then you’re on the hook for the capital gain tax. That’s one window. If you don’t identify, there’s no way you can complete the exchange. Then, you’d have to pay your taxes when your taxes are due. Likewise, Eric, as you mentioned, if you identify, but you don’t buy anything within that 180-day window, same outcome, you then know the capital gain tax. You’re really paying a relatively modest fee to a qualified intermediary; most charge somewhere around a thousand dollars. It could be 800. It could be 1200, 1500, but right around 1,000. So you’re paying that fee and your money tied up during that 45-day window. You can’t touch it. You can’t access it during that 45-day window. If you don’t identify, or you don’t buy what you have identified, then you’ll just be paying the capital gain taxes as if you didn’t do an exchange at all.
Eric Murphy:
Yeah. With such a small window of time, and you touched on it earlier, what sort of advice would you give to an investor to make sure they’re prepared so they can make that transition maybe go a little smoother?
Scott Saunders:
A couple of tidbits. Number one, I already mentioned it, get with your CPA. Make sure that they’re on board with you doing an exchange. Some CPAs might run the numbers and say, “You don’t need to do an exchange because you’ve got enough losses.” Most of the time, in today’s market, an exchange is going to be beneficial because we’ve seen property values, after the downturn, go up so much. People have significant taxes. The next piece would be, consult with a reputable qualified intermediary. Get an overview of the process of what you’re going to do. You’re going to have to get loans and financing in place. You’re going to want to look at things like, how do I hold title on the property I’m giving up. You’ll want to be the same tax owner that’s purchasing the replacement property. So look at the [inaudible 00:16:03] and how you hold title.
Scott Saunders:
But the other piece, practically speaking, is what I’d already mentioned, which is, start looking for the replacement property assets. In the market, right now, if you price your property properly, it’s not too hard to get the property under contract in a reasonable period of time. It tends to be a seller’s market, but now you’ve got to buy into that seller’s market. It’s wonderful when you sell your property, and that’s fun, but now you’ve got to go back into that same marketplace and now go buy a replacement property. I would say really discuss with the broker or brokers that you’re working with. Here’s what I’m selling. Here’s what I like to buy. Let them know, do I want full tax deferral, in which case you need to reinvest the net equity, same or greater debt, or do I want partial tax deferral.
Scott Saunders:
Let them build the assets that you want. Maybe let them know are you open to go to a bigger geographic region if you’ve got a lot of investments in one area. Maybe, you can open that up a little bit to see more replacement property. Those are some things you want to do well in advance of the exchange.
Eric Murphy:
Outside of missing deadlines, are there any other factors that might cause the process not to be completed?
Scott Saunders:
When they say, “Not going through,” it could be you didn’t buy the replacement property. So sure there are. For example, a great question, what if you identified one property and you went and did your due diligence on that property, but you’re outside of day 45, and you found some problems. Maybe you did a phase one environmental, and there’s some issues there. That’s going to bring up a really important issue, which is when you can identify properties in that 45-day window, and I didn’t touch on this earlier, you can identify properties different ways. You could identify one. But if you identify one and there’s a problem with it, you’ve got nowhere else to go. You’re either going to have to buy a property. You don’t really like or pay the taxes. You can identify multiple properties during that 45-day window.
Scott Saunders:
Under the three property rule, you could identify three properties of any fair market value. I would tell you from a practical standpoint, identifying maybe a backup or two will give you some flexibility because we find so many times that somebody really liked one property. Maybe, somebody else buys it. Maybe, it doesn’t meet the requirements after an inspection. Three property really, you can identify three properties of any value. Under the 200% rule, you can identify as many properties as you want, but no more than twice the value of what you sold. If I sell for two million, I can identify as many as I want, but not over four million. But you’ve got a couple of rules to do that. I think it’s generally wise to identify one or two backup properties. That way, if your first property falls through, you’ve got property two and property three to look at as alternatives.
Eric Murphy:
Curious about your thoughts. Do you think the pandemic will lead to more uses of the 1031 exchange?
Scott Saunders:
Well, I’ll tell you what. The pandemic… I mean, I’ve been doing this now for 33 years. It is unbelievable what this has done. Right now, we’re seeing more 1031 exchanges today than even a year ago, and that was a fantastic market.
Scott Saunders:
Yes, the pandemic has done a few things. Number one, as far as commercial real estate, it’s had a big impact. We have people working from home. We’re going to have less demand for office. Retail less demand. Restaurants, bars, all of that, less demand. Hospitality, I know in 2021 they’re figuring about 75 billion less revenue and about 5 million jobs wiped out because we’re not seen as much business travel. We’re not seen as much leisure travel, and hotels were built land on that. So the pandemic had a big impact.
Scott Saunders:
Other trends we’re seeing are really interesting migration out of downtown urban cores. For a while, we saw a lot of migration into downtown areas, stacking it up, putting maybe living up top. Then, down below, you’ve got restaurants and retail. We’ve seen a big migration out of downtown metropolitan areas. People are going back to the burbs. They’re going back to apartment complexes that are farther out. They’re going into single-family homes, where, if there’s a lockdown and there is need for social distancing, they’ve got a little bit of elbow room. That’s been a big shift.
Scott Saunders:
The other one that’s a huge trend right now is we’re seeing people come out of urban areas where prices are high, and they’re buying in rural. It’s amazing what’s happened. Eric, you told me you’re in Brooklyn. The East End of Long Island, this year… We’ve seen about a 20% increase in prices on the East End of Long Island because people in the city are staying out east. They’re doing everything remote. I’m speaking to you from Colorado. The areas of Aspen, Vail, Steamboat Springs, Telluride, they’re seeing unbelievable price appreciation. Same thing at Lake Tahoe. Even rural areas that maybe are, what we call a little podunk town, people have looked at this pandemic and said, “Maybe I want to get out of some of the unrest in the city, and also maybe I can do a lifestyle change, live in that dream location somewhere rural or agricultural or mountain area, but still work remotely and still be connected.”
Scott Saunders:
So big, big change. Then, the third and final trend, and we’ve seen a lot of this in the last week, would be, there is a big migration out of high tax states and the low tax states. Eric, you’re in Brooklyn. New York, we’re seeing a huge migration going South to Florida. Same thing on the West coast. Investors are exchanging out of California, and they’re going to Texas. They’re going to Tennessee, is very strong, Wyoming, places that have very low or no tax structures, and a very business-friendly climate. This has been a really interesting year.
Scott Saunders:
I mean, it’s an unbelievable activity. I would say, if you’re a commercial investor, you want to look at some of these long-term trends to position your assets so you can maximize them. Things change. I don’t want to say they’re necessarily permanent changes. I think some of them are a reaction to fear of a virus, to social distancing, and just being close to one another, and some of it, we had the social unrest, which made things on a whole nother variable added on top of it. I don’t think this will happen forever and ever, but those are some short-term trends that we’re definitely seeing.
Eric Murphy:
Scott, in all the years that you have done this, do you see maybe some common misconceptions that people have when it comes to the 1031 exchange?
Scott Saunders:
You bet. Number one, it’s not tax-free. It’s tax-deferred. You’re postponing the tax. You don’t pay in this tax year, but the basis gets rolled over to property after property, after property. Now the flip side of that, I’ll share a benefit. You can keep reinvesting over and over and over again. Eventually, if you don’t do a taxable sale, your heirs get a full step-up in basis. Just keep in mind, tax-deferred is not tax-free, not the same.
Scott Saunders:
Second, like-kind is broad. If you’re in commercial, you can invest in another commercial, but you can invest in build-for-rent communities. You could invest in a vacation home held for investment that meets certain parameters of… It’s known as Rev. Proc. 2008-16. The main thing to keep in mind is like-kind is any property held for investment or used in a business, exchanged for any other like-kind property held the same way. That’s another one.
Scott Saunders:
The third one we’ll touch upon, which will be a surprise to many of you, our industry as qualified intermediaries, we are not regulated at the federal level. We’ve got state-level consumer protection laws in a handful of states. I might miss one, but Colorado, Nevada, California, Oregon, Washington, Idaho, Connecticut, and Virginia, so eight States. When you select a qualified intermediary, you want to ask them about the security of their funds. They literally hold your money for that 180 day period, very, very important. There are a lot of excellent companies out there. The most reputable qualified intermediaries belong to the Federation of Exchange Accommodators. That’s a mouthful, but their website’s super easy to remember. It’s 1031.org. Just investigate and make sure that you’re working with an intermediary that has good security mechanisms in place, and you feel very comfortable.
Scott Saunders:
Those are a few things to touch upon. The very last, Eric, would be not that expensive. When you sell an asset, people are used to paying commissions and all the fees. It’s relatively a modest fee. It’s about a thousand bucks to do a normal delayed exchange. It’s not a big deal. I’ll tell you. Today, we see a lot of investors setting up an exchange. Not sure if they can find property or not. They want to give themselves that month and a half, that 45 days, to see what’s out there in the marketplace.
Eric Murphy:
Great. If someone wants to get in touch with you, Scott, can you give us your contact or social?
Scott Saunders:
Well, you got all that. Here’s the company, it’s Asset Preservation. Our website is apiexchange.com, so apiexchange.com. The best one, honestly, to go old school, just talk. Because sometimes you want to talk through your scenario, call our national headquarters at 800-282-1031. We have an email monitored by myself and senior management info@apiexchange.com. In terms of social media, well, I’m on Twitter, 1031TaxExchange. We’re on LinkedIn and Facebook. If you look up Asset Preservation Inc., you’ll see our gold logo. We would love to be a resource to you as investors and brokers, guide you through the process. We can’t provide tax advice. We can’t provide legal advice. However, we’ve done hundreds of thousands of these. We can help walk you through the pitfalls to avoid, the basic requirements for deferral, and look at your specific situation to help you out.
Scott Saunders:
There are things we haven’t been able to touch on on that. Just a brief presentation, things like partnerships, and LLCs, and what do you do when people want to go their different directions, bring us in. We’d love to partner with you and provide our expertise, help you put a deal together on the sale, and hopefully a really good purchase opportunity as well.
Eric Murphy:
Yeah. I mean, it definitely feels like we can talk a lot longer on this subject, and we’d love to have you back on another episode. Maybe we could do a deeper dive into this.
Scott Saunders:
Right. No, I welcome the opportunity to do that, Eric. We covered the basics. This, at least, gets you out of the gates. Maybe we circle back some time and do that.
Eric Murphy:
Very informative, great stuff. Scott Saunders, senior vice president of Asset Preservation, Inc. I want to thank you so much for being on the show with us today.
Scott Saunders:
Thank you.
Eric Murphy:
My thanks again to Scott Saunders. You’ve been listening to the Private Equity Real Estate Podcast, which is brought to you by First National Realty Partners. You can find First National Realty at FNRPUSA.com. Please do us a favor, if you haven’t already, subscribe, rate, and review the podcast. I’m Eric Murphy, and we’ll see you again next week.
