Robert Leonard  01:30

We were talking about this briefly before the show, but this is actually the first episode that we’re having two guests on, so I’m excited to get into this with you guys. I think today’s conversation is going to be especially interesting because I am truly learning with the audience today and nearly from scratch. That’s not to say that I don’t learn from all the guests that we have on the show because I do, but our topic today is one that I don’t know much about. I’ve heard a little bit about it, but I’ve actually never done it myself. Needless to say, it’s going to be a great learning opportunity for both the audience and me. 

Before we dive into the topic of today’s episode, which is 1031 exchanges, please both introduce yourselves to the audience, so they know whose voice is who’s since they can’t see you unlike I can. Also, please tell us a bit about your background and how you got to where you are today.

Michael Brady  02:18

Yeah, so this is Mike Brady, Executive Vice President for Madison 1031. We’re a Qualified Intermediary for 1031 exchanges. I’m actually an attorney by background, starting out doing real estate and corporate transactions predominantly, then started working in the qualified intermediary industry in 2005 when I ran the East Coast division for a large publicly-traded company. Since then, I joined Madison, where I oversee sales and marketing efforts for our 1031 exchange division that helps structure some of the more complex transactions as well.

Alex Shandrovsky  02:48

My name is Alex Shandrovsky, and I’m a small business owner in Silicon Valley. I ran a large catering company, servicing Google and Facebook among others. Eventually, I sold the company. While I was in the small business, I learned about real estate and the value of it as a great investment. It was a wonderful opportunity to be able to join Madison 1030, to be involved in the real estate world, and to help people build multi-generational wealth. It’s a real pleasure, all in all, to be able to experience two things for the first time, right? We’re going to learn about 1030, and you feel outnumbered. So it’s great.

Robert Leonard  03:22

It’s going to be a fun episode. Let’s start right from the beginning. Exactly what is a 1031 exchange?

Michael Brady  03:28

When someone invests in any type of rental or commercial property and sells it, they have to pay capital gains tax on net profit. If you make $1 million profit, you would pay taxes to the federal and state governments, and if you’re in a city like New York, you’d pay city taxes, as well. In total, that could take up to a third of your profit. So, if you made $1 million, you could probably wind up with about $700,000 to put in your pocket. Now, you could defer those taxes by rolling the proceeds into another commercial or rental property. What allows you to do that is the Internal Revenue Code Section 1031. That’s why they call it a 1031 issue. In a nutshell, a 1031 exchange happens as an investor swaps one property for the other, and burn their taxes by doing it.

Robert Leonard  04:20

I think it’s important to point out that you’re saying the exchange allows you to defer taxes, and not eliminate nor avoid nor get rid of them. Ultimately, you’re still going to have to pay those taxes at some point, which I think we’ll get into in the conversation, but it’s a deferral strategy that allows you to continue to grow your wealth tax-free for a period of time until you ultimately have to pay that tax bill.

A lot of our audience listening today is new investors or have just a small portfolio. Why should someone at the very early stages of investing, start learning about 1031 exchanges??

Michael Brady  04:50

A thing that comes up in 1031 exchanges, in particular, is the structure by which you hold title to your property. An early investor, first of all, should be thinking ahead if their goal is to continue to grow their wealth, which is probably a goal of many of your listeners. They will probably be cycling through properties. They may have a small rental property now, but at some point, they may want to buy a bigger property and roll the proceeds in. 1031 is built for that. It’s great for investors that have those types of properties.

But, if you structure your entity with a partner, when you ultimately sell the property, if you do not decide to go down the garden path together to the next property, it can be difficult to separate. That’s why you may want to do some planning now as you buy your properties to make it easier to sell them at the end.

Robert Leonard  05:42

When would an investor exactly want to do a 1031 exchange?

Alex Shandrovsky  05:47

It’s important to know that a 1031 exchange, again, is about deferring gains.

So, first, make sure that you’ve actually had a gain on the property. There are certain situations when individuals come to us and look to do a 1031 exchange, and we’d discourage them because they haven’t actually had the capital gains to defer. That’s really important to understand. Have you profited? Is this the right time for you to defer those taxes? It’s really important to understand this. Make sure that you have a gain in the first place.

The second thing is to understand that if an individual has a long-term investment strategy, potentially, they’re locked into a market. Right now, there are a lot of laws affecting certain markets. For example, some markets might involve rent control, some are individuals moving to potentially more beneficial areas, and some that intend to move from a single home to a multi-family unit.

A good example is cases here in Silicon Valley. There are certain individuals who no longer want to be in the magic properties in Silicon Valley. They want to move somewhere else, like venturing in a state like Florida, which has no state tax. They’re going to sell their property, with the intention to move to a different state, still be actively involved in real estate, but with a plan to diversify risk across several properties. Availing a 1031 exchange for those investors at that time isn’t a good idea as they are looking to move out to potentially better areas where they can have a great return on their investment.

Mike, anything you want to suggest? It’s a great question.

Michael Brady  07:34

We said it. If you’re selling a property and the market’s been very strong, and you’re going to buy something anyway, then it makes sense to do a 1031 exchange. But don’t let the tax tail wag the dog. Don’t do an exchange and buy garbage property just for the taxing because you could lose a lot more by buying a bad property plus taxes. It’s always important to make sure you do your homework. Whatever you’re buying to replace what you’re selling, you want to make sure that it makes financial sense, so it’s going to be a good crop.

Robert Leonard  08:12

Awesome. You both mentioned that to make sure there’s profit before doing a 1031 exchange. I guess my next logical question is if there is a threshold where it makes it worthwhile to do a 1031 exchange, right? Because if you’re selling your property, and you only have a very small gain, is it worth it to even go through all of the work of doing a 1031 exchange to buy another property? Is it sometimes better to just not worry about all that, and just sell the property?

Michael Brady  08:37

If you don’t have a significant gain, it probably does not make sense. I wouldn’t do this for a $20,000 gain. I wouldn’t do this for a $30,000 gain, necessarily. It might save some money, but you’re not going to save a tremendous amount of money. Once you get to about $100,000 gain, now you’re talking about a $30,000 tax bill. Then, it starts to make sense because the fees are relatively nominal. You can do a forward exchange. The range is typically between $850 and $1,500. If you’re going to spend that money, and you can save $30,000 I think it’s a good investment. It makes sense to do.

Alex Shandrovsky  09:14

Adding a side point, certain individuals, in cases for tax planning, would leverage a 1031 exchange in order to split them into the next tax year as since they don’t have receipt of that property yet, the gains don’t show up in the bank account, so the cash won’t be taxed. Certain individuals might decide around November, “I want to sell this property, and now is the right time, but I don’t want to be showing capital gains and have to pay taxes this year.” So, they’ll use a 1031 exchange in rare cases to be able to sell the properties at 1031 and push them to the next tax year and tax planning strategy. But that’s quite rare.

Michael Brady  09:51

Additionally, people who do that have to have a bona fide intent of completing the exchange in order for it to work. You can’t do it just as a way to push your taxes off the road a year. You’d have to demonstrate and got audited that you were actually looking at property, and were trying to complete the exchange. It is a trick, a useful tool, for a failed exchange that straddles two tax shields.

Robert Leonard  10:18

What role does depreciation play in a 1031 exchange? There’s been a lot of talk, and I’ve heard a lot of things about depreciation recapture when you sell a property. What role does that play in a 1031 exchange? And, for those who don’t know, what exactly is depreciation recapture?

Michael Brady  10:35

Let’s start with depreciation. A benefit of owning real estate properties as an investment is that you get to take an income tax deduction each year to the extent of a portion of the value of your investment in the property. For residential properties, you have the 27 1/2-year depreciation schedule. For commercial properties, it’s 39 years. And so, you’re taking a tax deduction for a 39th of the value every year. That’s going to offset your rental income, and so you may actually have losses or very minimal income because of depreciation.

Now, the downside is when you sell a property, you have to pay that back. Granted, you had tax savings for all those years, but now you have the depreciation recapture. That’s taxed at a higher rate than traditional capital gains tax. The real estate portion of your recapture is typically taxed at a rate of about 25% as opposed to 15% or 20% for federal and long-term capital gains tax. That’s the downside of depreciation. 1031 exchanges will allow you to defer the depreciation recapture as well by doing a 1031 exchange so you’re not just deferring your capital gain but also that depreciation recapture.

Alex Shandrovsky  11:52

I will just add one caveat right now. You’re missing certain investors’ leverage tool called bonus depreciation, which is essentially accelerated depreciation. It’s a great tool to offset not even capital gains tax, but actually income tax. It’s a great tool. We highly recommend that, and actually have a cost sec team that specializes just in this area. There is a higher rate of recapture that happens to the bonus depreciation, but again, that would be deferred through a 1031 exchange. At a certain point, you will have to pay back that tax but that deference allows you to leverage that money right now. The dollar today might be more valuable than the dollar later when it comes to investments.

Michael Brady  12:20

The ultimate technique in 1031 exchanges is swapping until you drop. It’s where you continue to do 1031 exchanges during the course of your lifetime, and ultimately die owning a piece of appreciated real property. Under current tax laws, the capital gain tax disappears. Your estate will get a step-up in the cost basis, and the capital gains will disappear. Of course, as a consequence, at your last dying breaths, you’ll think, “Well, at least my kids are getting away from paying capital gains taxes.” A good way to create generational wealth is by doing that. You may escape both the depreciation recapture and the capital gains tax just by dying.

Robert Leonard  13:12

I definitely want to dive into that a little bit more a little later on in the conversation. But I think some of the newer investors that are listening to the show today that hear you talking about paying back depreciation recapture, and this isn’t necessarily related to 1031 exchange, but more just real estate taxes in general, is it possible to not take that depreciation?

Alex Shandrovsky  13:32

The strange and the difficult thing is if you did not take the depreciation, you will still be taxed. They might as well take advantage of that because, regardless, even if you take it or not, there will be that phantom depreciation that backs them. So please, if your accountant is not taking depreciation for you, please have him call us.

Michael Brady  13:50

Yeah, it’s imputed. Yeah, so if you don’t take it, they impute it, they treat it as if you took the depreciation, they still tax you on it.

Robert Leonard  13:56

Yeah, so you’re definitely better off taking it.

Michael Brady  14:01

Even without that, I think you’re better off taking it. As Alex said, you’d rather not pay taxes now if you can pay them later. Keep the money working. That’s what this is all about, right? It’s basically, anytime you can defer taxes, whether through depreciation or through deferral through a 1031 exchange, essentially, you’re using the government’s money to make bigger and more profitable investments.

Alex Shandrovsky  14:19

An important piece to talk to investors about is putting your money at work immediately. This notion of the dollar today being of much more value than in 5 to 10 years is really crucial to speak to newer investors. I think we missed that part a little bit. It seems a little strange to us. Why would the dollar today be more valuable than it would be in 10 years from now, right? But in simple terms, I would refer to Back to the Future. I remember watching that movie and noticed the prices of goods. Do you remember what you could actually afford with $1? Right? There is a reality of inflation.

Money will lose value over time, so there’s a certain value that you’re losing over time. But also, if you invest money today, you could also leverage it more effectively against debt. That’s what a lot of people availing 1031 exchanges are doing. They’re leveraging the money they have today in order to take on more debt, purchasing a larger property that’s going to have a larger return in terms of rental income, as well. Investors need to recognize that the dollar today is probably the most powerful it will be.

Robert Leonard  15:29

And when you start doing that, it allows it to start compounding even earlier and faster and at a higher degree. Albert Einstein said “Compounding is the eighth wonder of the world,” so the earlier you could take advantage of that the better.

Why is a qualified intermediary so important when completing a 1031 exchange? What exactly is a qualified intermediary?

Michael Brady  15:54

Traditionally, a 1031 exchange, which has been in the tax code since the 1920s, was designed for two parties to trade properties. That is automatically a 1031 exchange for tax purposes. What happens very rarely, though, is *inaudible* are aligned. To trade deeds, you need a three-party structure where you can sell to one party and buy from another.

To execute that, in the Treasury regulations, they created something called a qualified intermediary. For tax purposes, taxpayers use the qualified intermediary for their property, sell it, and then take the proceeds from that sale when they buy a property from another third party, and give that property to the exchanger so that they’ve been swapped with us. The tax code included the qualified intermediary concept as the middleman. We basically keep the cash from the sale out of their hands, so they’re receiving one property for another, which is a tax-deferred transaction. That’s why you actually will need us in most transactions.

It’s important to do your homework with a qualified intermediary because we’re not an accredited industry in most states. There’s no training involved. We’re not qualified in the sense that we have no education training nor any kind of requirements. I happen to be a certified exchange specialist, which is a designation that’s given out by our trade association federation of exchange accommodators. That just shows that I have some proficiency in 1031 exchanges, and I passed a qualifying test. But by and large, you do not have to have that to be a qualified intermediary. So, it makes sense to do your homework. A good qualified intermediary will lead you to your process, help you defer those taxes, and get you safely from one property to the other without Uncle Sam reaching into your back pocket.

Robert Leonard  17:30

How does somebody go about finding a qualified intermediary of the highest quality, and who will help them successfully navigate that transaction?

Alex Shandrovsky  17:41

The easiest way to find them is to listen to this podcast, and reach out to Michael or myself, and have that conversation with us. We are a great option for individuals. I’ll share about some of the things that we’ve put in place, to also set a bar or measure for identifying if a QI is a good option for you.

One of the most important things to understand is that security is really, really crucial. The QI is holding funds of one of the largest investments you’re ever going to make, so it’s important that those funds are secured. In Madison 1031, each investor’s 1030 exchange has its own dedicated fund that has its own escrow, which we cannot remove money from unless it’s a double signature, both from the owner of the property or the sale and ourselves. Also, you may want to make sure that you’re protected by insurance and the bond, so that the funds are protected.

What’s really crucial, as well, is that the staff that’s working as a QI has vast experience. You’d want there to be CPAs and lawyers that are on staff to be able to support you as we get deeper into it. There’s a lot of counsel that you want to have from your UI. There are various situations in 1031 exchanges where you want to make sure that you have experienced law professionals guiding you through the process, so you have a clear vision of how to execute your 1031, effectively, given your specific situation.

Mike, do you want to add a few more factors?

Michael Brady  19:12

As Alex said, you want to make sure you know how the funds are being held. You also want to know that you’re dealing with a company with some financial resources. We are part of a much larger company. Madison 1031 exchange is a pretty substantial company in and of itself, but we’re part of Madison commercial real estate services. You want to know whom you’re dealing with, at the end of the day. It is important as there’s only a handful of states that regulate qualified intermediaries, and most of those regulations really pertain to how the funds are held, which is certainly important, but it does not require anybody to pass any kind of significant testing or education requirements.

Robert Leonard  19:51

I’ve mentioned earlier in the show that I know a little bit about 1031 exchanges, but not a whole lot. But one of the things I do know is that there’s a tight timeline when you’re completing a 1031 exchange. Talk to us a bit about that.

Alex Shandrovsky  20:03

The timeline begins with the identification period, which is really crucial. What’s really important, just taking a step back, is to make sure that you have the Qualified Intermediary set up before the closing. You have to identify the Qualified Intermediary because they’re going to be the ones to actually hold the funds ready. As soon as the seller receives funds, those funds become taxable. Make sure that you have a QI to receive and set aside the funds.

Now, one of the challenges of a 1031 exchange is the tight deadlines associated with it. The first deadline is the 45-day deadline, in which you have 45 days to identify three properties of any exchange value. You want to make sure that all the proceeds are put into exchange properties because anything that’s not placed inside of the exchange property is going to be considered boot and will be taxed. That’s why, for 1031 exchange individuals, as they’re selling a building for a million dollars, they’re going to want to exchange it for another building with the value of at least a million dollars, so they can delay the capital gains tax.

What’s crucial in the 45 days are three really important rules, three properties of any value. If you do want to pick more than three properties, make sure that the combined value of those properties is going to be at 200%. Essentially, if you sold a property for a million dollars, and you want to dump at four or six properties, or whatever number, make sure they meet the 200% rule, which is going to be $2 million in combined value. Now, if you look into more than that, well that means you’d have to purchase 95% of all the profits, and that is quite rare because it really forces you to personalize effects on the property. Those are the three rules when it comes to the 45-day identification period.

Mike, do you want to talk about the next stage?

Michael Brady  22:01

I just wanted to just reiterate that, first of all, the deadlines run from the date of closing, or whenever you transfer the property to the buyer. And the 200% ROI, just to clarify that is it’s up to 200%. Just to be clear, you don’t have to identify 200% but you can identify no more than 200% of the 200% rule.

Then you have 180 days from the closing of the sale to complete the closing or the acquisition of the replacement property. You can buy multiple properties, but they would all have to be closed and purchased within 180 days. Now, those are calendar days, so there’s no tolling of the period for weekends or holidays. If your 45th day is Thanksgiving, you have to get your identification by midnight of Thanksgiving. I just want to reiterate the point that these are hard, fast deadlines. It doesn’t matter what else you have going on.

Robert Leonard  23:09

What exactly does it mean to identify a property? What is that process? Whom do you have to tell? Is there paperwork? What does that look like?

Michael Brady  23:16

Regulations give you a couple of options, but typically, you would identify with us as the Qualified Intermediary. What we do is that if you close on Monday, on Tuesday, you get a letter from us saying, “Dear taxpayer, we have your money, and here’s a form to fill out.” They have to then complete that form, including as much detail as is reasonably practicable. That’s from the statute at the time of the identification, so that means a street address including city or state. If you don’t have a street address as it’s vacant land, you would want to have some sort of meets and bounds description or a tax map or parcel number. If you’re buying percentage interest, a tenant common interest, or something called Delaware statutory trust, you would want to indicate what percentage you were buying, as well.

Robert Leonard  24:00

What happens if you’re in this period, and you identify those three properties, then you’re not able to purchase any of those properties. Are you able to identify additional properties after that?

Alex Shandrovsky  24:10

Unfortunately, that 45-day period is really strict. So, if you are not able to get identify the properties or were not able to purchase those properties, the exchange is disallowed, the investor gets the funds back, and it would be liable in tax.

Robert Leonard  24:30

Is it common for investors to not be able to meet that deadline? I know you deal with a lot of 1031 exchanges. How common is it for somebody to meet that deadline versus somebody who does not? I’m especially curious because of where we are right now in the market cycle. I think a lot of markets in the US are very competitive right now, so it might be hard to find a good deal that’s actually worth putting your money into. I think Michael mentioned earlier in the show that you don’t want to just dump money into a deal to take advantage of a 1031 exchange as you could lose more on a bad property than you’ll save in taxes on the 1031 exchange. It can be difficult to find a property that’s worth paying within such a short period of time, so I’m curious to hear how many people are actually successful with that, versus how many people actually have a hard time.

Michael Brady  25:09

The majority of our clients are successful. It’s hard to tell you percentages. I would say, maybe 20% of our clients. Some maybe fail, and you know, they are not able to close in 180 days, but the large majority of our clients do complete the process and buy replacement property. There are some options. That’s why you have three properties that you can identify gives you options in case one deal falls through, but it’s not failsafe.

I would say the most important note to get out of this talk today is that if you’re planning to do a 1031 exchange, you want to start shopping either before or at the same time you were trying to sell your property, because, as you said, we’re in a competitive market. For most of the good areas of the country, it may be hard to find a property that makes sense, so you want to start shopping and do your homework right away.

Alex Shandrovsky  25:52

Now there are two unique scenarios that we will also mention that you could look at. There are strategies to make sure that you work in that timeline. There’s DST, which is Delaware statute trust. For that, I like to give an example of applying to college. Basically, you normally have certain safety schools, right? You have options that are great schools. There are some home runs that you’re looking at and have some potentials. So, for Delaware statutory trust, Mike, can you speak a little bit about it and why it’s a safer option?

Michael Brady  26:25

Delaware statutory trust. Basically, you’re buying fractional ownership in a property with a bunch of other people. Typically, these are run by funds. You may have a subsidiary that sells Delaware statutory trust. What they do is they buy a property in a land trust typically formed under Delaware law, and then they sell off beneficial interest in the trust to 1031 exchange investors. Under a revenue ruling that came out in 2004, 2004-86 says that it’s like real property that they sold, even though you’re buying a trust interest. It’s very similar to a tenant and common interests, which is maybe something people are more familiar with, but this is the structure they use on an institutional level.

The benefits of a Delaware statutory trust is that you have certainty of closure. They’re not going to go away. If you put a reservation in on day one, after your closing, they will close with you provided you meet certain pressures. You have to be an accredited investor. There are some other loopholes to jump through, but once you identify it, it will close. You don’t have to worry about disappearing. As I said, they’re safety investments. Some people will buy them because they’re sick of the three T’s, tenants, trash, and toilets; and they’ll buy this passive investment that somebody else manages.

It’s also a good backup for 1031 exchange, or it’s a good gap filler. If you sold for a million dollars, and you found the property that you love, but it’s only $700,000, we had to fill that gap of $300,000. You might buy a second property, and do that in DST. That’s an option, you have people doing that quite often.

Alex Shandrovsky  27:57

The other option is actually called the reverse exchange, which is you may have a property that you really love, and you want to make sure it doesn’t get bought up. There’s such a hot market. So what you can actually do is you can, you could set up what’s called an “eat”. That would essentially allow you to lend money to the QI to purchase the property in your behalf, and once you sell, then you would sell your property within a 180-day period, and purchase using the funds from the sale purchase the property from the QI. Mike, you want to clarify that a little bit?

Michael Brady  28:36

A reverse exchange is useful in that it allows you to buy before you sell. You may know that it’s such a hot market and that you’re not going have any problems selling your property, but you might have trouble finding a property. So, what you do is you go out and you find a property first, and then you list your property, but that, as a result, you might have to close on your purchase before your sale. And so, what happens is you basically are parking title to the property you’re purchasing. We become the buyer. You and your bank loan us the money, we buy it, we take title to it, we hold the title until you sell your property, and when you sell your property, you’re essentially buying the property from us with sales proceeds. Then, we’ll take the sales proceeds we received, and we repay the funds you advanced buying the property. That’s called a reverse exchange. That’s also a useful tool that many of our more sophisticated clients use pretty regularly.

Robert Leonard  29:19

You talked about the Delaware trust. Can you put your 1031 exchange money into larger apartment syndication? Does that work as well?

Michael Brady  29:30

Yeah, you can, but it’s tricky. Syndicated deals are typically structured as a partnership. So, you have a limited liability company. The syndicator will be the general partner in the partnership, and the investors will be limited partners. The problem you have is that a 1031 investor cannot buy into a partnership with other people. They have to have the same taxpayer on each side of the exchange, so the taxpayer that sells has to be the same taxpayer buys the other property. If you’re buying in the name of an LLC, without the people, you’re really just buying a partnership.

And so, what you need to do as a syndicator is to buy into a syndicated deal, buying in with the syndicate as a tenant-in-common so you have the syndicated entity. Let’s say you own 75% of the property. If they need the cash from a 1031 investor, the 1031 investor will buy in as a co-owner of the actual property, and so they’ll take the remaining 25% and buy as a tenant-in-common. The difficulty here is that there are many things that you could do within the syndicated entity, like give the syndicator who has not invested much capital, if any, some profit participation. Usually, the investors get a preferred return and they get a portion of the remainder. You’re giving them equity that they haven’t contributed capital for. That doesn’t work in a 1031 exchange-oriented take situation.

So, you can do all those things in your syndicated entity, but your 1031 investor is going to have to receive income proportionate to his ownership interest. If he owns 25%, he’s entitled to 25% of the profits. You could keep that arrangement for a period of time, like a year or two, then at some point, you could kind of roll it all up into the syndicated end. That’s typically what we see being done. It’s not the most popular technique for syndicators, but if they really need that capital from a 1031 investor, it’s a useful way to do it.

Robert Leonard  31:17

Yeah, if the syndicator needs the money from a 1031 exchange investor, it sounds like the 1031 investor will be in a good negotiating standpoint, right? They could get $1 for 1%. And they can get their return equal to their percentage without being diluted.

 

Michael Brady  31:34

Right? Initially. Depends on what he contributes to the partnership, maybe there’s a different arrangement. If it’s a multi-year project, it’s a technique that could work.

Robert Leonard  31:40

We’ve talked about how the timeline can lead to a 1031 exchange not being successful. What other things lead to 1031 exchanges failing other than just not meeting those deadlines?

Michael Brady  31:51

Title defects. You identify a replacement property, and you go to contract and you’re all good to go, then something shows up in the title report, and the seller cannot cure the title defect. It may be something like a judgment, or an outstanding lead, or something else along those lines. It may be a boundary line discrepancy. Title defects can a wrench in the process.

Alex Shandrovsky  32:12

Just keep in mind, again, that the 180 days cannot be extended for that reason. So, you might be ready, there might be intent and everything, and you’re at the last stage, but because of a title defect, there could be a negative push past 180 days, and the exchange could potentially fail because the other party is not a place where they could actually sell the property.

Michael Brady  32:32

Right, then there could be other due diligence items that come up, like typical real estate transaction issues. The title is certainly one of them, but failure to get a mortgage could be another one. Those are, typically, your real estate risks. The real estate risk that you have in a normal transaction will also carry forward into a 1031 exchange.

Robert Leonard  32:48

Yeah, that’s exactly what I was going to say. Those title issues are just some of those potential issues that could come up. Those sound like they’re just general real estate transaction issues that could happen, regardless if it’s a 1031 exchange.

Michael Brady  33:01

The downside is that you have less time to deal with them. If you really love the property, you may be willing to extend your contract period for indefinitely until they’re able to clear those issues. Now, the buyer, or the seller rather, really only has a maximum of 180 days to clear those issues up.

Robert Leonard  33:22

Yeah, that’s a really good point. I remember when I first bought my first ever property. They were putting a special assessment on the condo association, and it was taking forever for the homeowners’ association to figure out all the details and get all the paperwork to the bank to be able to land on the property. I really liked the house, and I wasn’t in a situation where I had to move, so I was able to just kind of wait it out. The seller was also fine with it because they weren’t going to be able to find anybody that could buy it before that anyway. So, I was able to let it on indefinitely, as you said. But, if I was in a 1031 exchange, I would not have been able to do that because of those timelines.

Michael Brady  33:54

Yeah, that’s the big issue. Other than that, there’s not too much else that would really throw your exchange off course.

Robert Leonard  33:59

We started briefly talking about it earlier, and I don’t want to necessarily get too deep into a morbid subject, but I’ve heard people recommend that long-term investors should just continually do 1031 exchanges until they pass away as a strategy for building multi-generational wealth since they wouldn’t be paying taxes on that money their whole lives if it’s done correctly. Because of this, I’m guessing there’s no limit on the number of 1031 exchanges that can be completed by a single person, is that correct? And if so, what impact does this have on the people that ultimately inherit the properties?

Alex Shandrovsky  34:33

This is what’s called the swap till you drop, and it’s a very popular method for creating multi-generational wealth. It’s called multi-generational because the true benefits are going to be enjoyed by the next generation, and you will experience that tremendous joy and pleasure of knowing you’re taking care of your children.

Essentially, the swap till you drop is going to be beneficial because, at the current tax law, the investor, at the point of death, has all of his properties, and all his assets go on to a step-up basis. The value at the time of his death, not the previous sale, but the value the time his death. Essentially, that step-up basis is crucial as it’s going to eliminate the taxes that we’re going to be owing on capital gains. It’s going to eliminate that depreciation recapture, and all those challenges, all those taxes will be not just deferred but eliminated.

Now, you do need to be aware of the state tax, of course, that the inheritors will have to deal with, but at the same time, it’s an amazing tool for building multi-generational wealth because you’re giving your children an asset that’s going to be tax-free.

Michael Brady  35:38

Yes, and non-estate taxes. Right now, the thresholds for paying estate tax is really only the top echelon of wealth. We don’t worry too much currently about estate taxes, but it is something to keep an eye on in future administrations. Congresses may lower those limits, and estate taxes could again become a problem. You’d rather pay capital gains taxes, quite frankly, than estate taxes, because the rates are much higher.

But swapping till you drop is something investors do. Just to answer your question, there is no limit to how many exchanges an investor can do during their lifetime. That being said, you should hold your properties for investment rather than reselling. 1031 exchanges are not designed for people who are flipping short-term. By short term, I mean, probably anything under a year would be subject to scrutiny. It’s really for your longer-term holds, like two to five and on years, otherwise, somebody is going to just be in and out of those properties constantly.

Robert Leonard  36:40

Alex, you mentioned that step-up value. I think that’s the key point to this swap till you drop opportunity or dynamic, so I want to make sure that we really drill this home. I think a lot of this is new to the audience listening, so I want to make sure that we fully cover that, and make sure we fully understand what that means.

If I understand you correctly, the step-up means that if the property was purchased for, say $100,000, and they were going to sell it in the future for, say, $400,000, they might have a $300,000 gain. Whereas now, the step-up value, when the person passes away becomes, rather than their original purchase price is $100,000, their “purchase price” now becomes $400,000. That value is stepped up to the value of the property at the time they passed. Is that correct?

Alex Shandrovsky  37:21

I think it’s exactly correct. 1031 exchange clients are typically looking to defer capital gains of more than $100,000. A person could potentially have a home purchased in San Francisco in the 1970s for $150,000, sold it with a $2 million leverage, and moved to Kansas City for $4 million. You’re talking about going from $100,000 to $4 million. From that, the capital gains tax would be $3.9 million. If the individual passes away, the value of that home, in terms of taxation, would actually be $4 million, with no capital gains tax.

Michael Brady  38:14

The accounting term for your initial investment in the property is called your cost basis. That’s what gets stepped-up. So, your cost basis gets stepped up to the fair market value at the date of your death so that any capital gain to that point disappears. Now, if your kids wait 10 years to sell the property, there’ll be an additional gain that might be taxed, but the capital gain accumulated during your lifetime disappears.

Robert Leonard  38:35

That’s a good point that you just brought up. That’s assuming that it’s sold right at the death. If it’s held after, their cost basis is still stepped-up to what it was when the person passed, but now the gain is probably smaller.

Alex Shandrovsky  38:48

It could be going for that $4 million, or maybe a $4.1 million, but it’s just a *inaudible day. That difference is so huge.

People should really be aware of this, and for the individual out there reaching the point of thinking about multi-generational wealth, they can still, of course, use those properties, for rental income. They can live off the rental income, and at the same time, know that they are going to leave an asset to their children. That’s a really, really beautiful idea.

Robert Leonard  39:20

Michael, you briefly mentioned before we started that little conversation there about not wanting to use a 1031 exchange in a flip. I wanted to ask about that. A lot of our assumptions so far throughout this conversation has been that we’re long-term buy-and-hold rental property owners or investors. Can this be used in any other strategy? You said, it’s probably not great for flipping, but could it be used for flipping?

Michael Brady  39:48

They do make a distinction under Section 1031, specifically saying that you cannot use a 1031 exchange for a property primarily held for resale. That’s your flipper. When you buy, you have to intend to hold it for investment rather than resale. Your flippers always intending to resell the property. Now everybody’s going to sell and intends to sell their property at some point, but the guy who’s going to buy it on Monday fix it up, you know, over the course of seven months and then sell it, that guy should not do a 1031 exchange.

Alex Shandrovsky  40:10

Mike, can you talk about the Godfather offer?

Michael Brady  40:13

The Godfather Defense. So, we were talking about a holding period, and essentially, that’s one of the factors that would determine whether a property is held for resale rather than investment. And so, as I said, there is no set holding period in 1031 exchanges. However, it’s suggested that you hold the property for maybe two years, conservatively, before you do a 1031 exchange property on it. During that time, rent the property, and maybe as little as a year could qualify, especially if you have a solid year rental and you’re straddling two tax years, so it raises less scrutiny on your tax return.

But that’s not to say that you could not do a 1031 exchange on a property held less than that. I call this the Godfather Defense. Let’s say you buy a property in January and you rent it out solidly to tenants for seven months. Now, let’s say it’s August, and you get an offer you can’t refuse. Maybe somebody offered you double what you paid for the property, or maybe somebody has some other leverage like what The Godfather might have, which makes it physically prudent for you to sell the property to them. With that, you have some other reason for selling. That wasn’t your initial intention as your initial intention was to hold it for long-term, but things changed. You can make that argument, and I think you would be able to do a 1031 exchange. Or, if you got audited, I think you’d be able to substantiate to the IRS that you had good intentions, but it changed due to market conditions, etc. Also, there are some cases where the effect may be not directly on point, but generally leading to decrease, that the tax courts will find that if you can demonstrate your intention that at the outset was pure, you may be able to sell it in under a year.

Robert Leonard  41:53

All of this really comes into play if you get audited from the IRS, correct?

Michael Brady  41:57

Correct.

Robert Leonard  41:57

And so, you just need to be able to somehow demonstrate that what you just said is what was actually occurring, and you weren’t trying to game the system.

Michael Brady  42:07

Right. If their evidence is introduced, and if the IRS finds out that you bought the property today, and you immediately listed with a broker, and you sold it a year and a day from now, well, that’s not going to help you. If you didn’t rent it, if you were constantly trying to sell it, the fact that you were bad at selling, it is not a defense to the fact that you are always intending to sell. So, there’s a number of factors, it’s just that the holding period is the number one factor that’s evident on the tax return. And so, you always want to do documentation.

Robert Leonard  42:40

I don’t want to necessarily get into the weeds too much on 1031 exchanges and flipping, and I think this might be getting into them a little bit, but I know that one of the big complaints about flipping is that it’s very tax intensive as you lose a lot of your profits to taxes. I’m curious if there’s potentially an opportunity for someone who’s doing a flip, and they work into their numbers that they’re going to rent this out, they’re going to fix it up, they’re going to rent it out for six months, nine months, or maybe even a year. They might take a little bit of a loss, or maybe they’re just breaking even, but in the grand scheme of things, because they made so much on a flip itself, that loss can be covered by the gain of the flip. In that case, could they then use a 1031 exchange? Is that kind of walking a gray line in terms of the tax code? Or is that something that could be done?

Michael Brady  43:23

I think the line that it’s walking is that if this is your business model, and you’re going to continue to do this, eventually you’re going to get audited, and that’s when you run into problems. You’re talking about playing audit roulette, which some clients do. They say they’ll just take their shot that very few people get audited, and so they’re going to take their chances and go. That’s rampant throughout the tax system. It’s not just with 1031 exchanges, but I think you have a better defense or you’re less likely to be audited if you have a longer holding period, and hold it for at least a year. Also, it’s more beneficial to sell the product because, at a year in a day, the long-term capital gains rates kick in. If you’re a flipper, and you’re flipping in under a year, you’re paying income tax rates. Instead of paying between 15-20%, you’re instead paying upwards of 28-30%. I wouldn’t necessarily play the game that way. I’m sure people are doing that, and are doing 1031 exchanges, and are playing audit roulette. That’s something I wouldn’t recommend, but I’m sure people are doing it and getting away.

Alex Shandrovsky  44:25

Just to add, I’ve seen a lot of interesting value-added deals. So, this has a lot of similar connotations of taking property and making massive improvements. We just spoke to an investor today who is making a series of purchases in the Long Island area, where he’s purchasing properties with a $600 current rent. The unit’s being rented out at $600, and he does a value-added project. He has staff already that’s going to be building it out, making improvements, and renting it out for $2200. So, that $600 per unit property has become a $2200 rent unit. And then, potentially, after three or four years, he is going to sell that property.

If you think about it that way, they’re providing tremendous value to the property by making improvements, renting at a much higher rate, selling the properties with 1031 exchange, and doing the same thing again with a different property, but this is higher-scale. Instead of taking in a department multi-family, they can go into a 22- or 50- or 100-unit, but they’re doing exactly the same thing again and again. Now, of course, that can become difficult in rent control areas.

I think, while there is obviously a lot of value in flipping, people can also look at this model of value development, and learn from that, as well, which is a more longer-term strategy that can definitely incorporate 1031 exchanges.

Robert Leonard  45:47

Now, does completing a 1031 exchange, increase your risk of audit?

Michael Brady  45:52

Audit rates are very, very low on the federal level. I haven’t heard the statistics in a while, but let’s say that 1.5% of returns are subject to random audits. That’s a random audit, without any red flags out. 1031 exchanges are probably in the mid 2% chance of being audited. It’s still very low as an increased risk because you’re not going from a 1.5% chance to 30%. It sits by an order of 1% or 2%.

Robert Leonard  46:25

Now, when you say 2%, is that 2% on the same basis of the one and a half percent, or is that 2% of all 1031 exchanges?

Michael Brady 46:34

It’s not so much of 1031 exchanges, but your overall chance of an audit is increased to 2%. I don’t know that for a fact, but it’s your overall chance of getting audited increases by like a factor of 1% or 1.5%.

Robert Leonard  46:50

So I wouldn’t say that the risk of being audited and the potential legal fees that you would have associated with that should even really be a major component of consideration for doing 1031 exchange or not…?

Michael Brady  47:01

If you’re doing a standard garden variety 1031 exchange, you have very little chance of being audited. But if you’re doing some of the advanced structures, which you probably don’t have a chance to get into if you’re reformulating your partnership, and foreclosing, if you’re flipping a property and under a year, you know, that’s going to be on the face of your tax returns, and that will subject you to more scrutiny.

Alex Shandrovsky  47:18

If you’re also in a state that has a state income tax, there’s a potentially higher chance of an audit. If you’re in California, or in New York, we want to make sure that you’re aware that they have their own audits that they can conduct at a state level.

Michael Brady  47:37

Yeah, the states that have been much more active than the IRS in auditing 1031 exchanges are specifically, as Alex said, California, and with respect to certain issues, New York has been fairly active, as well.

Robert Leonard  47:48

As your Qualified Intermediary or the company that you’re using to do your 1031 exchange, do they provide any service or guarantee in the event that you do get audited?

Michael Brady  48:00

No, because our role in the transaction is not to be the tax advisor or the legal adviser. We are just a Qualified Intermediary. We know a lot of things about 1031 exchanges, but ultimately, we need to work with your tax advisor, so we always recommend that you get your accountant involved early and that your legal team has to be as they’re closing the transaction. But we work with them, and, at the end of the day, we help you make informed decisions about what risks you want to take and what you don’t want to take. But we’re not, ultimately, the party that stands behind that. We don’t sign a tax return. That’s your accountant’s job. We just try to provide as much information as possible.

Alex Shandrovsky  48:40

Just to add, if we were the accountant, we can’t be the QI. In the same way, an agent of the taxpayer, like a lawyer or the CPA, can not be the QI. We’re doing very different jobs from them, but at the same time, we’ll work hand-in-hand with them 100%.

Robert Leonard  48:57

So, the QI is really just helping to make sure that you are set up appropriately so that if you do get audited, they did their job right, you did everything right, and then your tax or accounting team can help you really navigate that audit.

Michael Brady  49:10

Exactly. And so, we’re the facilitator of the exchange, but all that outside structuring with some of the things like we talked about, syndication, some of those issues, etc., that’s all going to be structured by your tax legal team.

Robert Leonard  49:22

I get asked a lot about partnerships from people listening to the show, whether they should invest in real estate with a partner. I personally have a business partner that I invest in a lot of my real estate deals with. It’s just something that I enjoy. What happens when partners purchase a property together, and one of the two partners does not want to do a 1031 exchange? Assuming that they own 50/50, just to keep it simple, can one partner force the other partner to do a 1031 exchange legally?

Michael Brady  49:47

It depends on what your partnership agreement provides. Usually, in many partnerships, you might want to set up a tiebreaker. But essentially, this is a common partnership issue where the parties want to separate. As I mentioned, this is similar to a syndicated issue. You have to have the same taxpayer on both sides of the exchange, so if a partnership owns the relinquished property, the partnership has to buy the replacement property.

You could probably do a bit of restructuring, which is a little bit controversial and could be subject to audit risk. You would have to essentially get out of the partnership if you wanted to separate, and you would hopefully do that before you actually went to contract for the property that you were selling. You would have the partnership deed out to the two partners as tenants-in-common, and as tenants-in-common, when they sell the property, they can go their separate ways. You probably don’t want to wait to do this on the eve of closing. You’d rather do it as much in advance as you possibly could.

Alex Shandrovsky  50:42

Or alternatively, in some cases, one partner could buy out of the other partner as well.

Robert Leonard  50:47

In that case, when you mentioned the partnership, does it have to be a legal entity? Do you have to have a legal LLC or partnership that owns that property? What if it’s owned in two people’s names individually? Is that still considered a partnership?

Michael Brady  51:02

Not necessarily. You can own property in two people’s names, and that would be considered tenant-in-common ownership, typically. So, there are two parties, and in that case, you don’t have to restructure, provided you’re not filing a partnership tax return. Typically, you just show the property on each of your individual returns, right? 50/50. That’s fine. That’s what we’re actually trying to get to when we do the drop-and-swap. So, if you’re set up as a tenant-in-common that you’re good to go, you can go your separate ways, no problem.

Robert Leonard  51:29

So it sounds like if you don’t have it in a legal entity, you’re in a better situation than if you have it owned in an LLC.

Michael Brady 51:37

Yes, what I would recommend is you probably still want to have a legal entity for protection purposes, so you’re protected against lawsuits, etc. But then in that case, if you wanted to have a partner or a co-venturer, as a partner denotes legal relationship, you would each set up your own limited liability company. You can have two limited liability companies own the same property 50/50, and then you can still go your own separate way.

Robert Leonard  52:01

For someone just embarking on their real estate journey, as I mentioned, a lot of the audience is early on in their career or just getting started. Obviously, it’s important to plan for these types of things down the line, which is why I think this conversation is going to be so valuable, but what is the most important thing for them to know in relation to a 1031 exchange when they’re just getting started?

Michael Brady  52:20

I would just say planning. The deadlines are very, very short, and so if you want to have your exit strategies planned, if you think that you’re going to buy other properties in your lifetime, you would want to think about things, like “Well, how do I want to set up my ownership? Do I want to set up a partnership? Or do I want to set it up as tenants-in-common?” If you’re going to buy property, you want to make sure that you’re shopping as soon as you’re considering selling your property, so you have flexibility. It’s all planning, and the more planning you do, the better off you’ll be, and the smoother the process will go.

Robert Leonard  52:49

Guys, I’ve really enjoyed our conversation. It’s been a lot of fun having you both here. I think we’ve covered a lot of great information that I think the audience is going to get a lot of value from. I know I did, myself, and I look forward to having you both here back on the show again. I know there’s a lot more that we could talk about, so I look forward to that episode in the future.

For those interested in learning more about you and connecting with you guys, where’s the best place for them to go?

Alex Shandrovsky  53:13

A great way is to just contact me directly at alex@madison1031.com. Also check out our website, madison1031.com. I typically have the initial conversation with potential investors and see what the next steps would be. We love complicated situations. The more complicated the situation, the more we love talking about it and exploring it together. Michael has personally deferred over a billion dollars worth of capital gains for his clients, so really structuring challenging cases is our specialty. Every case is unique. Every investor is unique. So, reaching out and having a conversation, the initial call, and seeing what the needs are when the next person that they should talk to, that’ll be the next best step.

Michael Brady 53:58

Yeah, that’s perfect. You can find us both on LinkedIn, as well. We do also have a blog on our website, 1031zone.madison1031.com.

Robert Leonard  54:08

Awesome, I’ll be sure to put links to everything that we talked about throughout the show, as well as some books related to these topics, and then also the resources and ways you guys can connect with Alex and Michael in the show notes that you guys can go find that information there.

Guys, thanks so much for your time. I really appreciate it.

Alex Shandrovsky 54:25

Our pleasure.

Michael Brady  54:26

Thanks. It’s been great.

Robert Leonard  54:26

All right guys, that’s all I had for this week’s episode of Real Estate Investing. I’ll see you again next week!

Outro 54:34

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