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1031 Exchanges: Deferring Taxes and Building Wealth in Real Estate

In This Episode:

In Silicon Valley, the lack of understanding about 1031 exchanges could lead to significant tax savings being missed, especially given California's high capital gains tax rate of 13.3%. For instance, property owners might fail to defer over $260,000 in taxes on a $2 million sale. This issue is particularly pertinent in Silicon Valley's real estate market, characterized by high-value transactions and median home values often exceeding $1 million, a reflection of its prominence as a tech hub. The region's substantial capital gains tax rate further highlights the importance of leveraging 1031 exchanges for tax efficiency in such a high-value market.

Silicon Valley's Financial Illiteracy Problems:

  • Missed Tax Savings: In Silicon Valley, a lack of awareness about 1031 exchanges could cause property owners to miss deferring over $260,000 in taxes on a $2 million sale due to California's high capital gains tax rate.
  • Market Dynamics: Silicon Valley's real estate market is known for high-value transactions and its competitive nature, with median home values typically exceeding $1 million, reflecting the area's status as a central tech hub.
  • Tax Implications: California's capital gains tax rate, one of the highest in the U.S. at 13.3%, underscores the significant tax savings potential through 1031 exchanges, particularly in high-value markets like Silicon Valley.

"The most important thing in the 1031 is the timeline. You need to know what you will buy within 45 days and close escrow within 180 days. Both of these clocks start the day escrow closes."

About Ron Ricard:

Ron Ricard, the Vice President of IPX 1031, is a renowned expert in the realm of real estate investment, specializing in 1031 exchanges. With a prestigious certification as an Exchange Specialist, he has been a pivotal figure in educating over 50,000 investors and real estate agents since 2002. His expertise lies in strategic tax deferral methods, particularly through property swaps and like-kind exchanges, offering substantial tax savings in high-value markets like Silicon Valley. His insights into investment exchanges and equity exchanges are invaluable for those navigating the complexities of real estate investment, tax-saving exchanges, and capital gains strategies. Ron's role at IPX 1031, the nation's leading qualified intermediary, underscores his significant contribution to the real estate sector, particularly in leveraging 1031 exchanges for enhanced wealth building and tax efficiency.

"All of the equity, all the cash from the sale, must go to the next property. Any cash left over, you pay tax on."

Show Notes:

  • What Financial Challenges Property Owners Face in Real Estate Investment: Addressing the specific financial hurdles encountered in high-value markets like Silicon Valley, mainly focusing on capital gains and tax implications.
  • What Strategies Ron Advocates for Property Investors: Unpacking Ron Ricard's expert advice for property owners considering 1031 exchanges, focusing on tax deferral and wealth building.
  • How Ron Utilizes His Vast Experience in Real Estate: Exploring Ron's extensive background in educating investors and agents about 1031 exchanges enriches his approach to real estate investment strategies.
  • How Ron Engages with Clients to Navigate 1031 Exchanges: Detailing Ron's methodology in guiding clients through the complexities of 1031 exchanges, from initiation to completion.
  • Why Understanding 1031 Exchanges is Crucial for Property Investors: Examining the significance of 1031 exchanges in optimizing tax strategies and maximizing investment potential, particularly in competitive markets.
  • Why Ron’s Approach Leads to Financial Empowerment: Discuss how Ron Ricard's tailored advice and educational approach empowers property investors to make informed decisions and leverage 1031 exchanges effectively.
  • Real-Life Success Stories in 1031 Exchanges: Sharing transformative examples from Ron’s clients, illustrating the impactful benefits of strategic property investments and tax deferral through 1031 exchanges.
  • Essential Advice for Maximizing Real Estate Investments: Highlighting Ron Ricard’s essential recommendations for property investors seeking to navigate the real estate market with intelligent, tax-efficient strategies.

"You can sell one and buy multiple properties, or sell multiple properties to buy one property. As long as what you're selling and buying is investment real estate, it could be any kind of real estate."

Episode Transcription

So give us a brief background about yourself and your company.

The most important thing to note when you're exchanging is to plan. Okay. I cannot tell you how frequently I get a phone call from somebody: hey, I listed my property, I got a great offer, and I'm closing escrow in 10 days. What do I do now? Well, it's like, you should have thought about this beforehand. Do you know what you want to buy? What are you looking for? How much do you want to spend? I mean, so the most important thing I can tell you for a client is to plan. You know, before you sell your property, what will you want? What kind of property? What location? So that now, if my great agent has sold my property for me, they can say, okay, we're in contract, and I can go start looking for a replacement property. The most important thing people can do is be ready. Because the last thing you want to do is, you know, have an offer and then suddenly realize, I have a six-week cruise across the Mediterranean that I have to take. No, that's not going to work. Those 45 days are the fastest 45 days of your life. You want to be ready so that once you are in contract to sell your property, you can start making offers out there.

1031 refers to a section of the tax code. The tax code section allows you to sell real estate used for business or investment purposes and reinvest that money into other real estate for business or investment purposes. In doing so, you get to defer paying taxes on the profit that you've made. So you have a rental property, let's say it's a rental house, and you want to sell that and buy a fourplex. So you list the property, and at the close of escrow, the money comes to a third party called the intermediary. That's what we are. We then send the money to the title company when you're purchasing the replacement property. So you're selling investment real estate, you're buying investment real estate, and because you use a third party called the intermediary, you never sell the money. Therefore, you get to defer paying taxes on your profit.

The process is pretty simple. Again, you're selling and buying investment real estate. So, you're going to hire a great agent like yourself to list the property and go through the regular selling process. Once you're in contract with a buyer for the property, that's when we get involved. We work with the title company or escrow officer handling the sale so that the money from the sale comes to us at the close of escrow. Again, that then starts a clock for you to tell us what you will buy in replacement. Once you're in contract to buy that replacement property, we work with the title company or escrow officer and wire them the money. So again, you're selling investment real estate; you're buying investment real estate, we hold the money in between, then the key by doing this for you is, you're really, it's not any different from selling a regular piece of real estate and buying a piece of real estate. It's just that there are some timing issues and a few other things that we will be talking about shortly.

This is one of the common misconceptions because people often hear the term kind, and they think to themselves, oh, if I'm selling a house, I have to buy a house. And that's not correct. 1031 is for any investment real estate or any other kind of real estate anywhere in the country. So you can sell a rental house and buy a shopping center. You can sell a farm and buy an apartment building. You could even sell bare land and buy a rental property. As long as what you're selling and what you're buying is investment real estate, it could be any investment real estate. Also, you can buy multiple properties. So you can sell one and buy multiple properties. Or you can sell multiple properties to buy one property. Also, 1031 is federal law. So it's good anywhere in the United States. So you can sell in California, Florida, Texas, or Hawaii.

As long as what you're selling and buying is investment real estate, it could be any real estate. The term like-kind goes back many years ago when we used to do things for when it used to do exchanges for things other than real estate. So, in my career, I've done exchanges for airplane artwork or farm equipment. That's what, you know, you sold an airplane, you had to buy an airplane. Sold farm equipment, you had to buy farm equipment. We no longer have personal property exchanges. Now, 1031 is only about real estate. And so any investment in real estate is for any other kind. The term like kind isn't very relevant anymore. 

Probably the most essential thing in the 1031 is the timeline. So there are two important dates to remember. First, you need to know what you will buy within 45 days. And you need to close escrow within 180 days, which is about six months. Now, both of those clocks start the day escrow closes. So, nothing has happened the entire time your property is in contract. Once escrow closes, which means once the buyer buys that property from you. that starts the clock. And so, you have 45 days to identify to us what you'll buy and 180 days to close escrow. Now, when I say identity, what does that mean? Well, it means you can give us a list, a minimal list of properties, and you're giving us the exact address of the property. So, most often, people only buy one or two properties. You can identify up to three properties.

But very importantly, you have to buy from that list. During the 45 days, you can change your mind as much as you want. Once midnight strikes on day 45, whatever you've identified, you are locked into. A common question is, do I have to be in contract by the 45 days? Technically, the answer is no. Technically, as long as you give us three addresses, you must buy from that list. So the problem is, if on day 46, all three of those properties get sold to somebody else, you're out of luck. So, for practical purposes, I always say by day 45, you want to be in contract on a property, you want your inspections done, your loan approved, and you want to be as locked in as possible by those 45 days. I will also add you are welcome to go into a contract to buy a property even before you sell yours. As long as the one you are selling closes escrow first, it's still a regular exchange. So, all that matters is when the escrow's closed. And how much of the money from the proceeds needs to be reinvested back? This is probably where people have most misconceptions. It's straightforward, though, all of it. I see. It's not just reinvesting the proceeds or reinvesting the profit. If you sell the property for a million dollars, you must buy something for at least a million dollars. Now, can you buy multiple properties that add up to a million? Yes. Can you buy for more than a million? Yes. If you buy less than a million, is that okay? The answer is still yes. but you pay tax on the difference. So if you sell for a million but only buy for 900,000, that extra $100,000 is referred to as boot. The boot is what you pay tax on. Most of us don't want to pay taxes; we want to buy equal or greater value. Part two to that, another essential thing is all of the equity, all the cash that comes from the sale, all need to go to the next property. Any cash left over, you pay tax on. So we had some situations. Not as much right now because the interest rates are higher now than they have been. However, when people were buying a replacement property, they were maximizing the amount of loan they got. And sometimes they got too big of a loan. So even though they were buying something more expensive, they had cash left over. If you do, you pay tax on that cash. Now, there's also a common misconception that you must replace your loan on the property with another loan. And that's technically not true. You need to replace the value of the loan. So, let's use a simple example. You're selling a million-dollar property; there was a $300,000 loan. So, if the property sells, $700,000 is the net proceeds that come to us. Whenever you buy the next property, that $700,000 has to go as a down payment toward buying the million-dollar property. Now, that $300,000 gap, that difference, which was the loan that got paid off, you need to make up that difference. Yes, you'll get another loan to replace it for most people. But if you have the cash in your pocket, you're welcome to use your cash instead of getting a loan. So the key, I always say, is to remember that an exchange is equal or greater in total value and use all the cash. And can the new property that a home seller purchases be used as a primary home, or does it have to be an investment property? Great question. No, the 1031 is for investment real estate only. So that begs the question. What is not investment real estate? Your primary residence is not investment real estate. Second homes are not investment real estate. Property that you're purchasing for resale, in other words, to flip, you buy it, fix it, and sell it. That's not an investment property. That's property purchased for resale. So that doesn't qualify, either. We may see many people do this these days, especially in the Bay Area, where you have highly appreciated primary residences. We see many people move out of their property and convert it into an investment property. Now, after renting it for some time, you could take advantage of both tax rules at the same time; because you've rented for a couple of years, it's now an investment property, but it still meets the criteria of primary residents having lived in the property two of the last five years. That's the tax code definition: living in the property for two years during the last five before the property is sold. And because you meet both criteria, you could take advantage of both tax rules simultaneously. So you can sell your property for $3 million, pocket $500,000, assuming you're a married couple, and then do an exchange on the remaining $2.5 million. So, even though you cannot exchange directly with a primary residence, it is possible to convert the property into an investment to take advantage of both tax rules. And again, in areas like the Bay Area with a very high, people have gained a lot of appreciation in their primary residences. This is a great tax strategy. That's very interesting. And what you said, the time limit is two years. The tax code doesn't say how long you have to rent the property. Most accountants like to see one to two years. Again, the key is that you've converted the property into an investment. Whatever you and your tax advisor feel is long enough, then that's between you and them. The tax code doesn't give us a specific amount of time. Now, If you have rented the property for more than three years, you no longer meet the criteria of having lived in the property for two out of the last five years. Now, the property is solely an investment property. But you can take advantage of both tax rules during that sweet spot, one to three years of renting it out. So it's an adorable advantage you have.

Everything we've talked about so far is a regular exchange. You're selling, then you're buying. The money from the sale goes for the purchase of the replacement property. One thing we see, especially in a market like today with meager inventory, is that people are afraid of not finding a replacement property because they figure if I sell mine, 45 days is not enough time to find a replacement property. So I want to find something first. A reverse exchange is precisely that. I'm buying a property, and then I'll sell it. As I mentioned earlier, if you go into a contract to buy something, but the seller is willing to wait, or the timing works out that you can sell your property first and then buy the replacement, then it is still a regular exchange. But if you need to close escrow on that property first, that's a reverse exchange. The first thing to realize about a reverse exchange is you cannot buy that property and then call me. Because if you buy that property, you now own both. And you cannot exchange for something if you already own it. So what happens in a reverse exchange is we take title to the property. There are different ways of structuring the transaction, but in most cases, what happens in a reverse exchange is you come into escrow with the money to buy that property. Then, we take title to that property and hold it until you sell it. So it is a little bit more complicated. Lending is challenging in a reverse exchange. It's also a more expensive transaction than a regular exchange, But for clients who have access to the funds to buy the property and, more importantly, Have a situation where they do need to buy the property before they can sell theirs, a reverse exchange is a great solution And what is the difference between?

Different 1031 exchange companies out there One thing to note is what we do is not regulated, so many petite mom-and-pop exchange companies are out there. And this is not to disparage anybody, but I think it's essential to work with huge, very established companies, not just because they're large, but because they typically have the backing of a large company. We are backed by the same company that owns Fidelity Title Chicago Title Lawyers Title Tycore Title, and many other title companies. We're a Fortune 500 multi-billion dollar corporation. With a parent corporation that has $2 billion in cash reserves. We are going to be around long term. We are not going to disappear with your funds. But more importantly, if somehow there's some wire fraud where you got your email hacked into and we send the money to the wrong bank, our parent corporation steps in and makes good on that. Small companies can't do that. So… It's worth working with large companies because larger companies are safer, and that is what we would recommend. The cost difference is nominal in most cases. They're all about the same anyway.

Our fee for 1031 is minimal. It's $1,000 when you sell the property and $250 for each additional property bought or sold as part of the same exchange. So, if you sell one, buy one for $1,250. It's an abnormal amount.

Well, there are a few. We've touched upon a few of them. One common misconception that even a lot of accountants have is that they don't realize that a property can simultaneously be an investment property and a primary residence. For example, suppose you have a home office or an ADU where you treat part of the property as a business or investment property even though you live there. In that case, a property can simultaneously be an investment and a primary residence. Another common myth is that… people don't know that they need to use an intermediary, or they think that their attorney or their CPA could be the intermediary, and that's not true. It has to be a neutral third party, and that's because that's all we do is provide this role. Another common myth about the dollars is that most people don't realize how much you need to reinvest. It's not just the profit, not the equity; it's everything into that next property. You want to get yourself educated about this before you move on.

You would think that the most common reason people do exchanges is to defer taxes because the whole idea of 1031 is, if I make $300,000 of profit on a property and I have to pay 100,000 in taxes, by doing the exchange, I don't have to pay the government that $100,000. But you do the exchange because you want to buy something better than what you own today. The easiest way to defer taxes is not to sell it. As long as you're not selling the property, you're not having to pay the taxes. 1031 is a tool that allows you to get from the real estate you own today to what you want to own tomorrow. Now, what do you want in the following property? Well, what you want is very subjective. Everybody has different needs about their real estate. Some people want to buy a property because it's going to have a better cash flow for them, or maybe they're moving to Texas, and they want to move their rentals to Texas, or maybe they want to buy a property that when they retire, they may want to move into. Or maybe they want to buy a less management property because now they're retired, they're tired of managing their real estate actively. So the reason people do exchange it is more because they want to buy something that's a better property for them tomorrow than what they own today. And 1031 has been part of the tax code for over 100 years. So you're selling investment real estate, you're buying investment real estate, and because you use a third party called the intermediary, you never saw the money. Therefore, you get to defer paying taxes on the profit that you've made. 

Well, the process is relatively simple. Again, you're selling investment real estate; you're buying investment real estate. So, you will hire a great agent like yourself to list the property. You're going to go through the… process of selling the property. Once you're in contract with a buyer for the property, that's when we get involved. We work with the title company or escrow officer handling the sale so that at the close of escrow, 45 days, you need to close escrow within a hundred and eight-period total value and use all the cash. So what happens in a reverse exchange is we take title to the property. There are different ways of structuring the transaction. In 2002, he had education or investment purposes; in doing so, you get to defer paying taxes on your profit. So you have a rental property, let's say it's a rental house, and you want to sell that and buy a four-plex. So you list the property at the close of escrow, and the money comes to a third party called the intermediate one or two properties. If you do, you can identify they had cash left over and then call me, Okay? I think something changed in the software or something. 

Believe it or not, 1031 has been around for over 100 years. It started in 1921. And we had a significant change in exchanges in 1984, when we allowed for this 45 and 180-day clock. But the 1031, as we know it today, has been around for almost 40 years. Now there has been talk, occasionally you'll hear that people in Congress or the president want to change the 1031 rules. I don't see anything serious happening. I believe it's something that is ingrained in our tax code. I believe that if the 1031 exchange went away, real estate, primarily commercial real estate, would have a very serious drop in the number of transactions because people don't want to sell something if they're going to have to pay hundreds of thousands or in many cases, millions of dollars of taxes. So. I don't see 1031 exchanges changing dramatically. You know, could they tweak it? Yes, I will also say that, you know, under current political conditions in Washington, I think it's gonna be very difficult to have any significant changes to the tax code, whether it's 1031 or anything else. So at least for the foreseeable future, I don't see any change happening in Washington as far as 1031 goes. I always tell people I'm not looking for a new job yet.

Believe it or not, 1031 has been around for over 100 years. It started in 1921. And we had a significant change in exchanges in 1984, when we allowed for this 45 and 180-day clock. But the 1031, as we know it today, has been around for almost 40 years. Now there has been talk, occasionally you'll hear that people in Congress or the president want to change the 1031 rules. I don't see anything serious happening. I believe it's something that is ingrained in our tax code. I believe that if the 1031 exchange went away, real estate, primarily commercial real estate, would have a very serious drop in the number of transactions because people don't want to sell something if they're going to have to pay hundreds of thousands or in many cases, millions of dollars of taxes. So. I don't see 1031 exchanges changing dramatically. You know, could they tweak it? Yes, I will also say that, you know, under current political conditions in Washington, I think it's gonna be very difficult to have any significant changes to the tax code, whether it's 1031 or anything else. So at least for the foreseeable future, I don't see any change happening in Washington as far as 1031 goes. I always tell people I'm not looking for a new job yet.

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