Build Wealth Faster with This Tax “Loophole” (1031 Exchange) (Rookie Reply)
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Let's get your questions answered. I'm Ashley Kerr and I'm here with Tony J. Robinson. And welcome to the Ricky podcast where every week, three times a week, we bring you the inspiration, motivation, and stories you need to hear to kickstart your investing journey. And today we're jumping back into the bigger pockets forums to get all of your questions answered. Now, Ricky's

The forum is the absolute best place for you to go to quickly get all of your real estate investing questions answered by experts like me, Ashley, and so many more. All right, so today we're going to discuss 1031 exchanges and how to properly utilize them, if you should sell or rent your property, and finally, how to decide if you should focus on rehabbing or growing your portfolio. So let's get into today's show. Okay, let's start with our first question. It starts off with, my mother lives in her primary residence in Florida and owns a second property there.

She would like to sell that second property and is looking for ways to avoid paying capital gains tax on the sale. While researching, I discovered the 1031 exchange, which seems to offer a way to sell that property and avoid capital gains tax as long as she immediately, within 180 days, purchases an additional like-kind investment property.

I live in upstate New York, and if this process works, she is considering purchasing that like-kind property near me and possibly end up renting the property to me. I have a primary question about the like-kind definition. Specifically, I would be interested in any additional feedback anyone has about this potential plan.

First, what are the exact specifications of a like-kind property? For example, if she clears $400,000 on the sale of the existing investment property, how close to that exact amount would the like-kind property need to be?

If, for instance, she finds a property that costs $550,000 and I would like to loan her the additional money needed to purchase the higher-priced property, would that cause any issues with the like-kind definition or issues with me being an additional investor in the new property?

Okay. 1031 exchanges. We don't get to talk about these enough, Tony. Do you want to kind of define real quick what a 1031 is? Yeah. So basically it's section 1031 of the tax code that allows real estate investors like us to defer paying taxes on the sale of a piece of real estate, assuming that you use the proceeds of that property to go out and buy another piece of real estate.

Now, there's obviously some pluses to this that you get to defer the taxes. But as this person mentioned, that's also a bit of a time crunch. And you also have to make sure that you use a qualified intermediary to handle this transaction. So we've done one 1031 exchange in our business before. And the way that it works is you sell the property that you're looking to sell.

And instead of those proceeds being sent to you, they actually get sent to this qualified intermediary. So there's a company that you have to hire who then accepts these funds on your behalf. And then you work with them to fulfill all of the steps of the 1031 exchange to help you purchase that subsequent property. So that's the path that we went down for our 1031 exchange, but at a 30,000 foot view, that's what the process looks like. So the first question here is, um,

what are the exact specifications of a like-kind property so does it need to be 400 000 because the sale of the existing property was 400 000 i think the first thing we need to clear up is that like kind doesn't mean price point or the cost of the property or what you sold the property for it's more of the type of property for example an investment property that is um like if you have a commercial property purchasing another commercial property so

in that sense, like kind. So for Tony's example, you sold a single family home and purchased another single family home, correct? That's correct, yeah. So those properties are like in that similar way. There are limitations, and I don't remember the exact limitations, but there are limitations on, like there are limitations on the purchase price of that next property, how much of that capital you can deploy. I don't even remember what they are. Do you know what those limitations are, Ash? I didn't think there were any.

So like the $400,000 that you can use all of that for the 1031 exchange and then you're not paying capital gains or you can use $100,000 of that and then you're paying capital gains on that $300,000. Because I worked for an investor before that did...

a 1031 exchange and he had like 50 000 he didn't actually use for the 1031 exchange and he just ended up paying taxes instead of scrambling to find a 50 000 property i just did a quick search so someone can check me here if i'm wrong so validate this information because i can't say that it's all correct but um so there's two parts of the 1031 exchange

The first phase is your identification period. And then the second phase is where you actually have to close in the property. So you have, I believe it's 45 days somewhere in that ballpark to identify a potential replacement property. So like for us, when we did our 1031 exchange, we literally had to submit like a form to our intermediary that said, hey, here are the properties that we're currently considering purchasing.

And then you have, I believe it's 180 days from the closing of that initial sale to actually close on the replacement property. So there's kind of two phases there.

And again, quick Google search. You guys check me here if I'm wrong. Validate this information for yourselves. But what it says here is that during your kind of like that first phase of looking for your replacement properties, that you can only go up to 200% of the property that you sold. So if you sold a house for half a million, you can go up to a million bucks.

And then there's a 95% rule. And again, check all this, but this one says that the value of the replacement property has to be at least 95% of the previous sale.

So I do remember there being some some specifications around like how much we could buy and how much we couldn't buy for. I do know also that you don't have to use the entire amount and then whatever you don't use, you can just pay taxes on on that. So that's why talk to talk to a qualified intermediary who can give you those exact rules. But I did believe there were some some guidelines around the purchase price of that next property. Yeah, I definitely didn't know that about.

the 95% of what the sale price was for doing the 1031 exchange at all. How much did it cost for you to hire your intermediary to do, give you all this information and do this transaction for you? Very inexpensive. You know, I don't know, maybe a thousand bucks. Yeah, it was 1200, but I mean, this was like 10 years ago. It was $1,200. I remember. Yeah.

It couldn't have been more than a thousand, maybe 2000 bucks. And when you talk about the tax savings, it's, it's, you know, it's far worth, you know, the, the cost. And I believe you have to use an intermediary. Like, I don't, I don't think you can do this by yourself. Yeah. Cause they actually hold the funds for you too. Yeah.

When you sell the property and hold it for when you purchase the new property. So I think you kind of answered her second part of the question as if she finds a property that costs $550,000. Can I loan her the additional money needed to purchase the higher priced property? So what you read was you could do up to $550,000.

200% of whatever the sale price was. So if the sale price was 400,000, that 550,000 would definitely be in the realm of that. What is allowed the part here and you could be the, you could loan the money. You could be the private money lender on it. You could also they could, somebody could go to a bank, get a bank loan for it. They could just use the sale proceeds for their down payment on the property.

The part here that I think there's issues with is being an additional investor in the new property. So if you're loaning your mom the money, are you the lender or are you giving her capital to invest in the new property?

If you're a lender, I don't see an issue and you're being paid back, whether it's a lump sum in 10 years or whatever, but you don't have equity in it. But if you want equity in that property, I do believe there are limitations as to the ownership of the property that is sold has to retain ownership in

in the new entity for at least two years. I don't know the exact timeframe. So yeah, the two years sound, sound solid, but yeah, I do know that the ownership has to be the same as you go through that 1031 exchange process. So anyone that's in a partnership, if you're thinking of selling a property, keep that in mind. If you're going to do a 1031 exchange that you would have to maintain that partnership with somebody for two years in that new property that you're purchasing. So if you're deciding to sell a property because you

don't want to be partners anymore, a 1031 might not be the best thing for you. But you can also, though, buy more than one property, right? So say you sell this initial home and you go out and buy two, maybe that's how you guys kind of navigate that ending of the partnership or say, we're going to sell this property, use the proceeds through a 1031 exchange to buy two separate ones. And then after this time,

you know, requirement. We can then separate. You keep your property. I'll keep my property. And that's how, that's how we kind of go about it. So that, that's always an option for you guys as well. That's actually what one of the investors I worked for did too, is him and his brother did a 1031 exchange. They both bought separate things, but for two years, they owned them under the own, their LLC, but they,

kept track of, you know, each property separately as you should. And then after they had a joint venture agreement, almost it was, it was some kind of contract that stated that within two years they would dissolve that LLC and they would each take whatever their properties were.

to. But 1031 is a great approach, right? And I think the thing that some people think is it just means that like it erases the tax liability. It doesn't do that. It just kind of transfers it into the next deal. So at some point you're going to have to pay taxes. But a lot of people, you know, I've heard CPAs refer to it as swap till you drop. Well, they'll just never realize those gains. They just continue to 1031 until they, you know, until we all die. So just know it's not erasing the tax liability. It's just deferring it further and further down the road.

And then you put it into a trust for your kids so that when you do die, they're not paying taxes on it when you first purchased it 20 years ago. So...

yeah, lots of, lots of loopholes. And that's why it's always great to check out bigger pockets, real estate tax books by Amanda Hahn. You can find them in the bigger pockets bookstore, just to give yourself kind of an idea of what the tax benefits are that are out there for real estate. And then you should obviously hire a qualified CPA in the real estate realm that can actually implement these strategies for you and guide you along. But

I think these books are a great starting point as an investor to see what is actually out there and the potential for you to save in taxes. Before we jump into our second question, rookies, we want to thank you so much for being here and listening to the podcast.

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I lived in this condo for two and a half years and just recently moved into a single family home. My original plan was to rent it out once I moved out, but I'm having second thoughts. I bought it with cash at 120,000 bucks. I would say it's worth about $180,000 today.

The main reasons I'm considering selling this property is, one, I can avoid capital gains if I sell now. Number two, HVAC will need replacing in the next three years, most likely. Number three, we will have an $1,800 special assessment coming up, and they are planning on making all residents replace their decks within a year, which will be about $4,000 to $5,000.

Rent would be about $1,800 to $1,900 per month. Taxes are about $2,200 per year. And HOA is currently $200 a month. The condo is located in New Jersey. Just looking to get second opinions as I'm on the fence about what to do. My current home is in the same town as the condo, so management would be easy. Okay, so with this property, he has the option to sell it or to rent it out.

So the first thing is to run the numbers on it. If you were to sell it, how much cash, how much capital would you bring in today from the sale of the property? Then looking at what could you go and do with that capital? What would be the return that you could make on it if you deployed that cash to something else?

Then if you rent the condo out, first of all, what's your mortgage payment? What can you rent it out for? So what's your cash flow every single month? How much of your mortgage is being paid down? So now he mentioned a couple of things about the capital improvements that will need to be done, like the HVAC being replaced, okay?

So set yourself a timeframe, five years, okay? You sell the property, you have this capital. What can you do with that capital in the next five years? What does that return on your investment look like? The next is running the numbers on if you rent the property out for the next five years as to this is what your cashflow is for year one, year two, year three. This is what your mortgage pay down is for each of those, that equity buildup.

any appreciation that you are projecting to get into that property. And then also like you mentioned the, the HVAC, what would be the cost of that? So that's coming out of your, your cashflow, you know, and any other big repairs that you're thinking of that you're already not accounting for. And just like the, you know, five to 10% maintenance expenses, things like

that. And I would look five years down the road as to what is your situation if you were going to sell the property then in five years, how much equity and appreciation have you built into that property and kind of compare the two.

and see which will give you the better return. Yeah, I definitely agree, Ashley. I think there's a lot of value in digging into the numbers here. But I think even before, like the very first step is you just need to decide on what your goals and what your priorities are.

Is your goal with this condo to generate as much cash flow as humanly possible? Is your goal to maybe have an asset that's going to appreciate over time so that when you maybe retire from a day job in 20 years, you've got a fully paid for or you already paid for it in cash. Maybe a condo that's appreciated a ton. So like what are your motivations for doing this? And if like that'll help us decide. But let's assume that it's cash flow, that that's the reason that you're doing this is because that's maybe your primary motive.

You said you can get up to about $1,900 a month in rent. You've got no mortgage expense because the property is paid for. You didn't mention insurance, so maybe you're self-insuring because it's fully paid for. Maybe you do have insurance, but let's assume that you don't because you figured something else out there. So $1,900 a month in revenue.

You're going to take off about 5% for CapEx, 5% for vacancy, maybe another $400 a month for your HOA and your property taxes. That leaves you with about $1,300 a month in cash flow on this property. Maybe even round it down to a little less if you've got some insurance in there. Maybe we'll just call it like $1,200 a month, right? Do that times 12.

That's $14,400 a year on your $120,000 investment. That's a 12% cash on cash return.

it's not a bad return, honestly. And I think the question is, can you redeploy that capital somewhere else today and get better than a 12% cash on cash return? Possibly, right? But then again, it goes back, do you want to invest time, effort, and energy to go out and find another deal? Do you want to invest the time, effort, and energy to go and find a new market, to build a new team, to do all that comes along with buying another property? Or do you just want to be happy with 12%

every single year on a property that you already own that's in the same neighborhood as you. So a part of it is definitely the numbers to help you make an informed decision, but I feel like a big part is going back to what you want out of it. Yeah, that is a great point, Tony, as to starting there before you even run the numbers. And I think, too, in this example is since he owns it free and clear, you have the opportunity to put a line of credit.

to get a home equity line of credit, especially before he moves out of it, go and get that home equity line of credit. And then you have those funds to actually borrow from and deploy into another property if you want to do that too. So I like that opportunity there as well. And then also the tax advantages of holding on to the real estate, especially if you have a high W-2 income.

Then the next thing is, is maybe you do hold it for another three years. And the rule for not paying capital gains tax is if you've lived there for two out of the last five years. So you could rent it for three years and then sell it at that five year mark and not pay capital gains on it too. So.

I think I'm leaning towards renting it out. What about you, Tony? I think so as well. I think the only other caveat here that I might look into is that he or she says that they think it's worth $180,000. I would just maybe validate that, right? Either talk to an agent and say, hey, I'm thinking about selling this. Because what if you do that and it's really only worth $130,000?

Or what if you do that and you see it's worth 230, right? That kind of changes the calculus a little bit. So I would validate that number first. But based on the information that we have so far, I'm leaning towards keeping it as rental as well. As you can tell, we love talking about real estate. We love answering questions like this with you all. And we'd love it if you'd hit the follow button on your favorite podcast app wherever you're listening. We have to take one final ad break, but we'll be back with more after this.

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All right, guys, welcome back. We've got our final question here. Ashley, what are we, what are we finishing today's episode with? Yeah. So our last question is my first rental property is a quad plaques. It grosses 3,200 per a month. So that's without any expenses. And I end up with $1,200 in profit after expenses. I owe 95,000 on it and pay six and a half percent interest.

I need to replace the siding of the house. It's pretty old. The house is 110 years old and replace the windows beforehand. My friend quoted me 60,000 to do everything. It's a massive house. If I do a cash out refinance or a construction loan, I can do this plus replace the front porch. But my profit will go down from 1200 to 800 since I will have to refi once the construction is done.

Here's my question. Do I focus on fixing up the property to perfection with that 60K and affect my cashflow? Or do I take that money and possibly buy one to two more single family houses? I like this question because it talks about adding value or not even adding value to the property, I guess, as far as appraisals and appreciation, but

this would this actually replace the siding actually increase the rent?

for the property. Because most times we talk about investing your money back into your property so that you can increase the monthly rent or the daily rate. Where in this situation, it really depends if that would even make an impact on the rent because the inside of the house is still staying the same. And it probably depends on what market you're in. So I think this makes it a more difficult decision that you're putting this money into the property

property, but it may not increase your rent at all. Or you could leave it as is and go and deploy into one to two more single family houses. So I definitely have an opinion on this, Tony, but go ahead. You take the floor first. Yeah, I think you hit on exactly what was in my mind as well. I mean, this person is assuming that

this expense on the siding and the front deck is only an expense, but won't necessarily impact their ability to charge more for rents. But I would assume that some better curb appeal could potentially allow you to maybe charge more for those four units. So I would question if your 1200 would really decrease all the way down to 800, or if it would stay a little bit higher.

I think the other question that I'd ask here is let's assume that you can get a lift in your – in the rents that you charge. Very similar to the question that we asked – or that we answered previously is –

Can you redeploy that 60 K somewhere else and potentially get a better return on those other one to two single family homes, right? Like let's, you know, and actually you're obviously a much more of a longterm rental expert than I am, but I don't know. Let's say that you can get maybe a, whatever, $200 increase per unit per month, something like that. I mean, you're under charging right now, but it's like, can you get a relevant or an equal increase or return on your 60 K by going in and buying two more single family homes? So I feel like I would need to know, um,

that rental increase to really break this down to just a mathematical type question. But my gut here is telling me that that probably makes more sense. And then I think the only other thing that I'd add as well is that if the house is 110 years old, it's going to have to get replaced eventually. It's not a matter of if, but a matter of when. So it's something you know you're going to have to budget for. So if you can take care of it today, it's one less problem you have to worry about 10, 15, 20 years down the road.

And just like we talked about in the last question, there's that time and energy that will have to go into purchasing those one to two more single family houses.

And so it says like, do I take that money? So that would be in the situation if he does a cash out refinance with what the property is worth now. But also we don't know what the value of the property is right now as is without the siding in the new windows. And I'd like to see that comparison of what the property would be valued at after that 60,000 is put into the property. So if he's putting in,

60,000, even though it may not increase the rents, does that increase the equity of the property by a hundred thousand that if you got an appraisal and went and did the, you know, the construction loan and then did a cash out refi, what would that appraisal end up? So not only looking at your cashflow, but look at the, uh,

the equity of the property and the value of the property after you've done that repair. And I would compare that also too. So if you're going to put in 60K and you're going to add $100,000 in equity to that property, I think that's a pretty good deal to be able to go and do that. And then maybe you can go and

you know, refinance again and then go and buy those other one to two single family homes. It's a great call out on the equity piece. I didn't even think to mention that, but yeah, obviously there there's maybe you spend the 60, but it increases the home value by a hundred right now. You just built an additional 40 K in equity as well. So yeah,

things to be considered. If you want to get involved in the community, like all these real estate investors, you can go to the bigger pockets forums at biggerpockets.com slash forums to submit your questions or to answer some. Thank you so much for listening to this week's rookie reply. I'm Ashley and he's Tony. And we'll see you guys next time on our next episode.