Real State

1031 Exchange Deep Dive: Mistakes You MUST Avoid

The 1031 exchange is a strategy that helps investors build more passive income, with fewer properties, all while avoiding the tax man. While many real estate investors know about this strategy, only a few of them know it well enough to pull it off. The rules are simple; sell a property, buy another property with the proceeds, and pay no capital gains tax. But, this is far easier said than done, and it’s much easier to make mistakes than most people think. Even our real estate hero, David Greene, had a 1031 exchange go awry.

To clear up the misconceptions, highlight the common mistakes, and guide us to tax-advantaged freedom, we’ve brought on 1031 exchange expert, Ryan Finch, to the show to share everything he knows about this misunderstood, often misused strategy. Ryan is a real estate investor at heart, house hacking as a sophomore in college to live for free. After working at multiple commercial real estate and development companies, he got the itch to start investing heavier himself and help others propel their wealth.

Now, Ryan works to help real estate investors and everyday homeowners make the most out of their equity. Ryan has unlocked the tools that have allowed those with home equity to build passive income streams, buy bigger, better properties, and reduce much of their landlord burden, all in a single transaction. If you’ve been sitting on some post-2020 equity, this episode will teach you how to use it as fuel for your financial freedom fire, all while ditching the tax bill that comes with selling!

David:
This is the BiggerPockets Podcast show 707.

Ryan:
One of the most common phrases we get is, “Ah, I wish I talked to you three months ago. I wish I talked to you six months ago. I wish I would’ve sent my mom to you last year when she was in the middle of this.” So we really like to talk with people early so they’re aware of their options so that no one needs to be paying taxes unnecessarily.

David:
What’s going on, everyone? This is David Greene, your host of the BiggerPockets Real Estate Podcast here today with a very, very, very good episode for you. Today, I interview Ryan Fitch, who is a 1031 expert, runs a company that helps people with 1031s and does consulting to help people build wealth through real estate. And we get all into the 1031 exchange. In this episode, you’re going to hear things that you didn’t know existed. You’re going to hear about common faux pas that you can avoid. You’re going to hear about strategies that you probably didn’t know were open to you and how you can go from being an active investor into a passive investor. This is an amazing episode. I’m very happy to bring it to you today.
So I don’t want to take too long before we get to Ryan. But before I do, today’s quick tip is don’t delete all the knowledge you have as an investor. We often make decisions based on our emotions, and if you get in a bad emotional state, you don’t like your portfolio, you’re in pain from what’s going on, you just want to get rid of the whole thing, you can easily make bad choices.
In fact, buyers look for sellers that are in a position where they’re in pain and they just want out, and that’s how they get the best deals. Use the BiggerPockets community to help you. There’s people out there that can give you advice that you didn’t even know was a possibility. An example of that is a podcast that we have today. So if you’re ever in a situation where you’re in a problem with your portfolio, don’t just sell it. Don’t just despair. Don’t get too negative. Don’t forget everything that you’ve learned. Reach out to somebody from BiggerPockets. Let them know what’s going on and see what options you have available to you.
With that being said, let’s bring in Ryan. Ryan Finch, welcome to the BiggerPockets Real Estate Podcast. How are you today?

Ryan:
Very good. How are you, David?

David:
I am doing wonderful. Thank you for asking. All right. Let’s hear about your business, your life, your investing portfolio. Tell me who is Ryan Finch and how did he get involved in real estate?

Ryan:
Great. So my name is Ryan Finch, president and founder of Tangible Wealth Solutions. We’re a wealth management firm that specializes solely in investment real estate. I got really interested in real estate at a young age and actually bought my first home, my sophomore year of college. I read a book on invest in real estate, got really interested, went to my parents, asked for my second year room and board in cash up front, ran my own painting business and that was my down payment. So I found I could rent the bedrooms out and live for free and was able to get my parents to co-sign on the loan. It took several months to convince them, but that was my first foray into real estate and trying to get started in building my own portfolio.

David:
So what were those initial stages? Did you have thoughts in your head like, “I’m going to be a real estate investor, I’m going to work in real estate”? Was it sort of just, “Well, they’re into it, so I’m going to be into it”? At what point did you get passionate about being able to help people build wealth through real estate?

Ryan:
Sure. So going back before that, my mom was a paralegal in commercial real estate and I did not understand how she worked at a law firm without going to court and was just like, “How are you actually in law?” Not like the attorneys and paralegals I see on TV. So she brought home the plans for what at the time was Elitch Gardens, was a large amusement park that was in Northwest Denver. It was being moved down to these railroad tracks just outside of downtown Denver. So it was a massive redevelopment.
She brought home the plans and said, “Why work on this? This developer is going to build this?” And then I stopped her and said, “Well, who’s that guy? What do they call it?” So that’s a real estate developer and they redo these things. And so show me that. Another big project in downtown Denver and I just was like, “That is what I want to do. I want to look at land property and I want to change it to something better.” And it was just as downtown Denver, the urban core was starting to change.
They were starting to bring fun stuff to do downtown. ‘Cause up until that point everyone just… After they got off work, left downtown Denver. So I got to see that right at the very beginning. And then to see Elitch get built and know like I remember now it was just a piece of paper. So that was the initial spark that really got me going down the fascination with real estate.

David:
I’m glad to hear you say that. I just realized as we were talking, there’s quite a few people that have an answer similar to yours where they’ll say, “I love the idea of driving down a street and seeing dilapidated homes and making them nice. Or, I love the idea of seeing a boring interior and fixing it up and making it pop.” Sometimes they love to do it on a budget. And then there’s other people I’ll talk to and say, “I just love seeing how the math works out. Or I love chasing the deal. Once I get the property, it’s boring. I don’t want it anymore, but then I want the next deal.”
And I’ll bet you that there’s a limited number of avatars of why we’re motivated by real estate, why we like it that we never ask. I think we just always assume real estate is all the same thing. But that’s fascinating. I hear you saying that you like this idea of the creativity and the improvement. You’re pushing the ball forward, you’re taking something ugly, making it pretty. You’re taking something less valuable, making it more valuable. How did that drive manifest itself in the way that your career ended up going?

Ryan:
Yeah. I always professionally would take the next job that I could learn more. So I was not trying to climb the corporate ladder because in my head, my initial goal was, “I’m going to just build a real estate portfolio. I’m going to learn finance. I’m going to learn everything from these jobs I take, but eventually I’m going to go on my own and I’m just going to have my own real estate investments.” And then founded Tangible Wealth Solutions with that sole purpose back in 2016 to really advise people on how to invest in real estate, base it on their goals and really try to help them avoid a lot of the pitfalls I saw over my career in banking development, special assets, and then also try and promote those qualities and values that I saw the people that were really successful.

David:
And then once you were there, that’s where you actually started consulting with people and you took this passion for real estate, developing it, helping other people understand how to manage their assets, how to grow them. And it all sort of culminated in this 1031 approach where you were taking people that had some form of equity or money they’d built up in real estate and reinvesting it into an asset or a situation that worked better for their life. Is that a fair summary?

Ryan:
Yeah, absolutely. And the 1031 exchange is an incredible tool and we started helping clients with strategizing how to use the 1031 exchange to benefit. One of the biggest ones we started working with or type of client was clients selling in California, particularly the San Jose area where we could sell one home, 1031 exchange and buy three or four homes in Denver. We were able to increase their cash flow significantly and help them get closer to those goals.
So the 1031 exchange started with helping clients move from one property type to another property in a different location that got closer to their goals, especially the ones that were more cash flow oriented.

David:
Yeah, I love that. I wish more people thought along those terms. I think when someone says I want cash flow for instance, they often go to the areas where they get the properties that cash flow the most and just try to buy a lot of them and it’s very slow versus if you say I want cash flow, how do I get there? Well, it’s very difficult to increase cash flow. You’re held hostage by market conditions. You can’t make rents go up, but you can create equity by buying in the right areas, by improving properties, by buying them below market value. You have a lot more influence and control over creating equity.
And then once you have it, vehicles like this let you take this massive amount of equity like somebody in the South Bay and build and move it into a cash flow market and they get there in 10% of the time as it would be if someone was repeatedly buying in Denver. Are these the type of solutions that you’re often offering to your clients?

Ryan:
Yeah, absolutely. It’s doing that upfront analysis to see if selling the property. One, understanding the performance of your property. One of the biggest mistakes or parts that we see people missing is they look at their total amount of cash like, “Oh, I love this property. It pays me X amount a month.” And then we run the math and divide it by the equity and show their return on equity and be like, “Well, relative of the large amount of equity in your property, that’s actually a really low cash flow.”
So when we start talking about percentages, it’s much more adaptable to look at other markets than using whole dollar amounts. think people get stuck on that whole dollar amount. And they don’t realize sometimes, “Well, you could be getting this same cash flow in a CD or now that interest rates have gone up, you could get this in a high interest savings account.” And a lot of people aren’t doing the math to look at the percentage and they just look at that whole dollar amount not realizing they were in a market that properties have taken off in value and that’s actually a low cash flow relative to your equity.

David:
So in my world, we often refer to this as return on equity And investors, like you said, they notice, “Well, when I bought it was cash flowing a thousand a month and now it’s cash flowing 1,800. So I’m doing good. I’m up 80% from where I was.” But if you look at the actual equity in the portfolio, they’re often getting a 1% return, 2%. It’s very, very common for me to see in the last eight years that we’ve had just prices going up. Sub 3% return on equity, which no one would go buy a property at a 3% return on their money. They’re always going to want more.
But they’ll look at the stuff that they already have and they’ll never think twice about it. They’ll just accept it. It’s one of the first things that when someone comes to me for consultation, they say, “David, can you look at my portfolio? I want you to tell me what to do. You pull that open and it’s staring you in the face.” They’re vastly underperforming.
Money is so lazy. You would never let an employee that comes in and you get paid for eight hours but you work for 30 minutes. But that’s what your properties are doing. Is that similar to what you see in your space?

Ryan:
Yeah, it’s dead on. That’s exactly what we’re seeing when we’re running the math and trying to understand. Also, add that with someone wanting to pay down debt early and there’s the thought of getting a property free and clear, but not having that leverage work to you, especially if you’re in growth mode and you’re trying to really build wealth. We see that often as the case too where they’re the stigma with debt or they’ve got their own beliefs against debt. But when you do the math and you see the power of debt, when you use it as a tool, a lot of that time that return on equity with the power of debt is really, in my opinion, a math solution. And it’s a math problem that you’ve, you’ve got to figure out.

David:
Now, I understand that you have a funny motto that your company operates by when it comes to helping your clients find their next deal. Can you share what that is?

Ryan:
Sure. So we look at DSTs for clients, other 1031 properties, direct real estate, other real estate syndications. When we’re looking at these different deals, we like to say we kiss a lot of frogs. So we kiss a lot of frogs trying to find what makes sense for clients. And then sometimes we have to remind them when we’re making recommendations of we’re highlighting these three or four. To them, it can look easy like, “Oh, here’s three or four good strong option.” It’s like, “Well, we probably kiss 20 frogs to find those three or four deals that do make sense.”
And some people, because they don’t see the legwork going into it, they sometimes get a biased opinion of, “Oh, it must be easy to find four good deals.” It’s like, “Man, you got to really sort through to find those.”

David:
I can so relate to that. We’ll have buyers come to work with the David Green team. When I was an agent or my agents now, all pour through every house on the MLS and there’s 300 of them and I’ll narrow it down to the four that are the absolute best opportunities. I’ll show them those four and they’re like, “Yeah, but that’s only four. I want to see some more.” I’m like, “Oh, I didn’t let you see that there was 296 other ones that don’t work. So that’s definitely something in our position we need to make sure we communicate to people like the work that was done to get to the point where you’re showing them that opportunity. Because kissing frogs is not fun and it’s why a lot of people don’t actually go do the 1031 is, “I don’t want to have to analyze a bazillion properties, but having the right people can help.”

Ryan:
Yeah, absolutely.

David:
All right. Now we talk about this all the time, but let’s take a walk back in time. So tell me where does your background on 1031s come from?

Ryan:
So background, 1031 exchanges, always research it to know it for myself. And then we help clients doing 1031 exchanges. And then just through the process of doing exchanges, understanding the nuances, we really started then finding the other avenue. So within a 1031 exchange, there’s multiple options. There’s direct real estate. So selling one property, buying another property, they’re what are called DSTs, which stands for a Delaware statutory trust. And that’s where you can sell property and exchange and be a partial owner of institutional real estate and get rid of the management component. And then one of the lesser known is actually oil and gas mineral rights.
So just from helping people with their 1031 exchanges and establishing ourselves as an expert in the field, we’ve figured out these different options for clients and even the nuances between them to really help people come up with solutions based on their goals where clients would come in and they’d say, “I want exchange from this to this.” And then we’d listen to their goals and we’d say, “Well, did you know that this might work a little bit better. Or maybe we need to take this into account.”

David:
Now, can you explain or clarify why we even have this rule in the first place?

Ryan:
Sure. So the first legislative action in 1921 that really made the 1031 exchange legal or put some parameters around it to allow… It was done to really guide or drive people into reinvesting in more properties and investing capital, building capital. One of the bigger reasons people were doing this was for farmland is so they wanted farmers who owned small farms to grow into bigger farms. And instead of every time they went from one property to a larger property and growing and ding them with taxes, they felt that everyone in the investors would benefit better if that money was kept working for them.
So it started more with farmland and then years later there was a big lawsuit between a timber company and the IRS because when they first started out, you had to exchange on the same day and this timber company fought and said, “Well, nothing really states that it has to be the same day and can we have some more parameters because it’s almost impossible to exchange one property for the same property on another day?”
They ended up winning. And so from that point on, the IRS then went back and added these dates and deadlines and made it much more functional and put the exact parameters around the 1031 exchange. So it started out very loose, encouraging reinvestment in property and then there’s been several iterations since, but then they had to add the timing parameters. And those time parameters, at first they sound like, “Oh, 45 days, that’s plenty of time. 180 days to close plenty of time.” And then as you’re in that window, it’s like time speeds way up.
That 45 days goes by much, much faster than you would expect. And so that’s the history of the 1031 exchange. So even though they did give you this timing parameter, it’s not the same day. 45 days in my opinion is a lot shorter than a lot of people realize.

David:
Oh, a hundred percent. And then there’s also rules about what has to happen in the 45 days that I ran into that were not something that was explained to me and I ended up with less than 24 hours. I know a lot of people that have these issues that come up with 1031s. There’s a lot of nuance that goes into doing them.

Ryan:
From the government standpoint, the best reasons to have the 1031 exchange and the 1031 exchange has come up several times in the last several years about changing it. But the big argument is it really allows for more fluidity in the real estate market. It allows for more transactions to happen. It allows for the trade and improving because typically someone sells ability to someone else or sells a private to someone else and they’re going to come in and improve that building. And so not only is it help real estate and areas in real estate continually improve, it creates a lot of jobs as well.
You have the real estate brokers. You have the mortgage lenders, title insurance companies, then you have the construction and trades and there’s just so many people in the economy that benefit from the continued transacting of real estate that there’s a lot of economic drivers.
So even though they’re deferring these taxes, the benefits of deferring those taxes to the overall population, workforce, demographics, all that stuff benefits so much from the 1031 exchange. I’m also very biased because I work in the 1031 exchange, but I do see all these moving parts and people who are involved and professional partners that everyone is earning a living doing this, that it’s really a big benefit. And then when you look at it from the investor standpoint, one of Warren Buffett’s quotes is one of the most powerful things in the world is compound interest.
If I can do a 1031 exchange and I can go from one property and then I think this other one is better, I can keep all of my equity working for me. So say an easy 10%. Okay. Well, I have 100 grand. I go from one property to the other. Well, now I’m going to have my 100 grand still working for me in the other property. But if I had to pay 15, 20% capital gains, now I have 80% or 85% working for me. I had to get a much bigger return just to get back to a hundred.
Investing in real estate allows me to continue to invest but keep all of my equity growing at that higher rate. And so the fact that when you trade from one asset, one property to the other property that you’re able to keep all of that invested for you, take that over a 20, 30-year career and that difference than if you did a different type of trading and another type of asset that got dinged with taxes every trade, yeah, it’s a massive gap.

David:
It’s the velocity of money. It increases how… And that’s just something, I’ll take a brief break to explain to everyone how powerful real estate is with wealth building, not just for the people that own it, for everyone involved. I loved you pointed out how many people are involved in the transaction. Every time a property changes hands, there’s money that is exchanged, which means someone actually created wealth for themself and the government got a piece of it through all the different taxes.
It’s hard to get into now, but just when money changes hands frequently, the wealth of a nation increases rapidly. And not just the wealth of the people of the nation, but the government itself is also creating more. So if a dollar goes from me to you to seven other people, everybody made a dollar, everyone spends a dollar, everyone got the good that they exchanged for the dollar. When we all just hoard our money and no one spends it, everyone gets more poor.
This is one of the Keynesian economic factors why they support that type of an economic approach. And from that element, it’s true. If you get rid of the 1031, the thought would be, well, the government will collect more taxes because you can’t defer it. But all that happens is none of us would sell properties. We would all hold onto them a lot longer. And that’s why at BiggerPockets we are hammering this because it’s okay to sell something and reinvest the money, especially if you’re going bigger and better and you’re more experienced and you get to do good by helping all the people that are involved in that.
So from that perspective, let’s say that someone’s listening to this and they’re like, “Yeah, I got some equity in my portfolio. I bought it six years ago. I didn’t expect to have the run-up I did. But man, it’s amazing. I bought in Denver, Colorado at 400 and now it’s worth $600,000.” That’s life changing money for a lot of people, especially because it hasn’t been taxed yet. You have an opportunity to avoid the taxes. What are some things that they should be asking themselves? What kind of goals would you be digging into to figure out that they have? What are some options that they have? Tell me if they were coming to you to say, “What do I do with this property?” How would you handle that consultation?

Ryan:
Absolutely. So at first I would just talk to them, get to understand the property itself. What goals is this property satisfying and which ones is it falling short? Like, “I’d really like more cash flow or the cash flow is fine, but I’ve got a lot of equity I might want to unlock.” So really understanding what the property is doing for them. And then just in an ideal world, what would you rather this money doing? What could we be doing? I’d rather it growing at a more rate. I don’t need as much cash flow. I’d rather in maybe in urban core that’s really changing or I really want to try and hit some home runs. But really identifying what they’d rather the money do and then pick the strategy or the property type that’s going to work best for them and then decide, “Okay, I really believe that what you need exists and we could get there. We have a high confidence level and now let’s look at doing a 1031 exchange.”
I think sometimes people are so excited to maybe recognize the big gains they had and are like, “All right. I want to do a 1031 exchange.” And then they list it for sale or even go to sale and they’re under their 45 days and you’re like, “These properties that we’re looking at were not taking a step in the right direction or were not moving yourself forward or it’s a lateral move and why did we take that risk to move laterally?”
So really understanding what the property is doing for them today and in an ideal world, what they need it to do for them. And does it make sense to do that? If someone said, “Oh, I’m getting 10% cash flow but boy I’d rather have 40% cash flow.” Well, unlikely we’re going to be able to exchange and find you something for 40% cash flows.

David:
Yeah. Increasing the return on your equity, basically if you got a return on equity of two or 3%, that you can get a return on investment of eight or nine or 10% if you reinvest, that’s a very easy metric to tell. It makes sense to do it. But there’s other ones as well, right? You’ve got the opportunity where, “Okay, this property is appreciated. I fixed it up. I bought it for 400. It’s worth 650.” But the market is kind of stalled where you’ve got $250,000 in equity and there’s opportunity to sell it and buy a new fixer upper.”
And add another $200,000 to that property through forced appreciation and what I call buying equity, which is where you buy it under market value. Are there situations where you see that investors that are a little more active and they enjoy you fixing a property up, making it better, they’re not afraid of the elbow grease where they can grow their wealth that way too?

Ryan:
Yeah, absolutely. If they have the ability to create value themselves, then that makes it even more attractive to move forward for those types of properties. And then when you’re looking at the 1031 exchange, the other component that we like to run side by side is does it make sense to keep the property and borrow against it and use that for the next property?
We just want to make sure that, one, it fits their goals, they’re okay with that, but instead of a 1031 exchange, sometimes leveraging into the next property can make sense. And then other times the cash flows really tight on this property and maybe it’s not high enough on the next property. And cash flow is really what can protect you in a downturn. And then they can kind of be in a tight where you don’t want to take that risk.

David:
I like the opportunities where you can get a little bit of both. Maybe you’ve got a single family home in San Jose or some area that’s had a recent explosion, Seattle, but the projections aren’t going to be that it’s going to grow as much as maybe South Florida, Texas, one of these other opportunities. And you sell a single family home that you’ve already maxed out the value and you go buy a triplex in a growing area that has value opportunity also.
So you get some extra value or equity in the property. And because that area is growing, you start combining all of these factors that build wealth through real estate. Sometimes people think buying and holding is just the only thing to do and they buy a 90,000 place. I’m going to own it for 30 years and pay it off. And they stop thinking about, it’s not about owning a property, it’s about owning the energy that property contains. And if you go roll that energy into something more and grow it like the snowball, real estate starts working for you.
I’m only saying this because I assume in your position you frequently come across people with a locked fixed mindset that they just think, “This is my portfolio. This is what I have.” Maybe they’re emotionally attached to the property and you can see possibility that they might be missing.

Ryan:
Yes, absolutely. Or they want to go. I want to go from here to here. And you’re sometimes like, “Well, that is a path, but there might be another way to get there.” I think some people come in with one focus and we talk through it with them and we help go in another direction. So I do think it’s real important to listening to where they’re headed and then pointing out some other options that sometimes this direct path be open to that changing.

David:
Yes. So on that note, common sense is not always common practice. You might hear this, but you might agree with it in principle, but that doesn’t mean you’re going to take action to do something different. So what are the top things that Ryan Finch wishes that people asked or knew before trying to do a 1031?

Ryan:
Sure. So one misconception we constantly see as you only need to exchange your equity. And so people think, “I have a million dollar property, I have half a million debt. I just have to exchange my half a million and I’m good.” You need to exchange the equity and the debt. So your net sales price is the total amount you need to exchange. So I’d say that’s one of the most common misconceptions we have.

David:
Let me jump in real quick. So what you’re saying is if someone has 250,000 in equity, they think they can sell it and pay cash for a $250,000 property. Right?

Ryan:
Exactly. That’s exactly it. Yes. You need to replace the debt. You could replace the debt with more cash. So I just have to make sure that my total properties I bought in my exchange equal my net sales price of the relinquished property. So that’s one. The like-kind test, like-kind exchange. People hear that term and they think like-kind means industrial for industrial, single family rental for single family rental. It’s very broad. You can sell a single family rental and buy an office building.
An office building can buy investment farmland. You could sell farmland and buy an industrial complex. It’s very broad and in oil and gas, mineral rights qualify because that’s the real estate below the ground. So there are 1031 misconceptions they have in their head, “I’m going to sell this condo and I got to buy a condo.” So like-kind is very broad.

David:
Can I dive into that a little bit? Like-kind does sound like if I sell a duplex, I have to buy a duplex, right?

Ryan:
Yeah.

David:
How does the government define what like-kind means?

Ryan:
Great. So it is a real estate property held for investment purposes. So when you paint that brush or use that umbrella over the top of everything, that’s what it really needs to be. So just to help the client currently that was wanting to me to help her with a 1031 exchange, she bought a property 10 years ago. It’s appreciated significantly, put her parents in the home 10 years ago, but she’s never filed that in her tax return as a rental property. And so the advice from the CPAs, everyone we talked to was it’s really never been held as a true investment property.
And so it’s really going to be shown as a single family home… I’m sorry, a second home, so you can’t 1031 exchange that. So in that case, that like-kind exchange is what we were trying to help them with but weren’t able to because it’s not a property held for investment purposes. We were trying to show, well it was investment purposes, but because it was never on the tax return, or we didn’t deduct, there’s no way or story to back that up. But really any property held for investment purposes falls under a like-kind exchange.

David:
Now, can I sell a property and buy Bitcoin?

Ryan:
Not without paying taxes.

David:
Okay. Right. That’s not eligible for a 1031. I can’t go buy a piece of art. I can’t go buy a baseball card or some form of NFT. It has to be real estate, right?

Ryan:
Correct.

David:
That’s so good to know because there’s so many misconceptions in our space. You’d be amazed or maybe you wouldn’t be amazed maybe you know about it, but I was amazed how many human beings still think you have to put 20% down to buy a house.

Ryan:
Yes.

David:
Right? It’s amazing in the era of social media where I forget that there’s people that still think that, and I’ll say it and you’ll get this record scratch like what? So there’s so many things like this where listening to these podcasts or talking to somebody at your firm about what options you have explode with possibilities. I can’t tell you how many time people book a time to speak with me and then when I say you could do this, you hear this like, “You mean this entire time I could have done that?” And I’m like, “It popped out to me in 1.2 seconds.” That’s an obvious answer and they had no idea.

Ryan:
The one I point out is the three property rule for 1031 exchange. There’s actually three different rules that you can choose which one you want to use for naming replacement properties. So the most commonly known one is three replacement properties. Any value, you got to name them during that 45-day window. The nice thing is you don’t have to commit to the rule until the day you name.
So I may be having a strategy based on the three property rule, but on my 44th day it makes more sense to switch to one of the other two rules. I could do it on that day. So I’m not locked in at the beginning of my 45-day to using one.

David:
What are the other two rules?

Ryan:
Yeah. The second rule is the 200% rule. So I can name as many properties as I want as long as when I add them up. They’re not more than 200% of the net sales price of what I sold. And so a lot of times when we’re breaking people into smaller ones, the 200% rule is the one we tend to use.

David:
That was not explained to me when I did mine and it was mostly… Most of my portfolio was paid off. So I sold about $4 million worth of real estate and I only had a note of 500,000. Long story short, there was actually another note of 500,000 that escrow missed that I now have to just pay cash for because I bought more. That was a little frustrating. But for the purposes of this, I had to reinvest right around 3.5 million out of the 4 million I sold for. And they did not explain to me the 200% that never came up.
So what ended up happening is I submitted a list of a lot of real estate that I was during my 45-day period that I was then going to go pursue over 180 days. They said, “Oh no, you can only pick $8 million worth of it.” I’m like, I have to invest 3.5 Million. How could I only identify 8 million of real estate? I had about 24 hours to do it. So had I listened to a podcast like this ahead of time or known about these three rules, that would’ve helped me a ton. Even with someone who’s been investing as long as me and who teaches this stuff, it just never came up and no one explained to me that there was a limit on how much you can identify.

Ryan:
Exactly. Those are the two most common rules. The third rule, which I’d say is the least common, the least used, and not a lot of reasons or situations I would see it being used, but it’s called the 95% rule. And that’s where now I can name as many properties as I want for as much as I want, but now I have to buy 95% of what I named. So that is in my opinion, a pretty scary spot to put yourself in, especially with real estate is you lose a little bit of that ability or that the hammer to hit you if you walk away from that deal gets much bigger. And so I feel like that 95% rule is one where, “Man, I have to have a really good reason for using it.”
But the three property rule and the 200% rule, the two most common rules, but I’d say a lot of people that come to see us the first meeting have in their head the three property rule only and not realizing that we can do this 200% rule.

David:
Well, and sum up for me what the three property rule is.

Ryan:
So three property rule means I can name any three properties for any value so they can all add up to… If I sold a million dollar property, I could name three $1 million properties. I could name a $4 million property, a $2 million property. So the total amount that I named dollar amount doesn’t matter as long as I only named three properties.

David:
That would’ve been nice had that come up. I did not know.

Ryan:
Yeah.

David:
What ended up happening was I ended up putting more in contract than the 200% because I had too much money that I had to invest and I couldn’t make the numbers work, so now I had to close on 95% of them, which meant anything I put in contract I had to close on. Trying to negotiate with a seller no one in the back of your head if they say, “No, there’s nothing I can do,” is a terrible feeling to be in. It feels like you’re in a standoff and you got no bullets in your gun and you’re just like, “Ah, I hope this person doesn’t figure out it’s a terrible movie scene type of situation.” This would’ve been very good to know before I was in that point where I had literally one day to try to make all these decisions. It was terrible.

Ryan:
We typically recommend clients start… If they’re doing direct real estate, start putting properties under contract 30, 45 days before they’re closing. And the real estate market we had six months ago that that was very tough to do. You’re getting outbid and someone is like, “I got to wait. Your property hasn’t closed yet.” In this market now, it’s easier to do. It’s a little more acceptable. But if you could tie a property up before your 45-day, what you’re doing is basically just stretching that 45-day window, giving yourself more time.

David:
All right. Now, what about some of the tax benefits that you get when you invest in real estate and then you go do a 1031 exchange. So you gain from depreciation on a property and now you sell it. Do you get to start over a whole new clock and get new depreciation again?

Ryan:
Your basis will be the new basis that it’s been depreciated down to and then you’ll get to continue to depreciate that basis down. You don’t get any additional basis to depreciate.

David:
Which is good to know because people may be expecting, “Oh, I’m going to start all over again with a new $5 million property.” That’s not the case.

Ryan:
Yes. One caveat to that is you could 1031 into a property and if you do what’s called cost segregation analysis, which for a higher price property or for a multi-family property, what you can do with that is they can go in and look at the furnace, the cabinets, all the stuff that could be depreciated on a much shorter window and then depreciate that.
So in a way you could grab all that depreciation that was going to be depreciated over 29 and a half years and some of that could be done in the first several years. So you could move up your tax benefit. And then as long as you 1031 exchange, that depreciation doesn’t get recaptured, it continues to get deferred. The other misconception that people have is, “Oh, well, my depreciation recapture comes out. That’s fine because I’m in a low tax bracket.”
Depreciation recaptures that 25% regardless of your income tax bracket and that is oftentimes… We’re calculating what someone’s taxes are going to be or helping them with their CPA, that’s a part like, “Oh, I’m in the 10%, 12%, 15.” It’s like now it’s 25 regardless of your income. And that can really make a big difference in someone saying, “Yeah, it makes sense to continue to 1031 because the pain from taxes is just way too high.”

David:
Absolutely. Now what about if you buy a property through a 1031. You exchange one for another. You know that you have to reinvest all the equity, but what happens if you do a cash out refinance after the sale?

Ryan:
Sure. So after the sale would be okay. Doing a cash out refi before your sale can get some scrutiny. But once you’ve completed that 1031 exchange, pulling cash out will not affect your exchange.

David:
A lot of people don’t realize that either, that you can get equity out of the property, but it’s not through the sale. It has to be through the refinance. A lot of people’s minds are blown. So what I ended up doing with mine because I ended up in this terrible situation, is I bought some properties just pure cash and then after it was done, I refinanced those properties and now that cash that I could pull out was not taxed. I didn’t have to worry about waiting for the cash flow to build it up because I was investing, I think it was around $4 million.
A lot of them I bought with 80% down. Or sorry, 20% down, 80% loan. And then three, four, five of them I just paid cash for and then it was done. I refinanced and now I have that capital restocked back in my account where I have reserves. I have money I can put into the properties to fix them up. It was actually incredibly easy to do and I thought there’d be some rule that said, “You can’t do that because it was like a loophole.” But not at all. They don’t look at a refinance as a capital event where you owe taxes.

Ryan:
Yeah, because it is after the 1031 exchange, right? You’ve followed all the rules, you’ve checked all the boxes, and once you’ve done that and your exchange from one property to the next property is completed, that’s really all they’re looking at that you’ve completed all those stages and now you’re in a different part of the life cycle of that property, but it’s no longer having to be done within the rules of the 1031 exchange because it’s been completed.

David:
Now, the last line of questions I have for you have to do with common faux pas that you come across with helping people do this. What are some of the most common mistakes or misconceptions people have?

Ryan:
So one would be choosing the wrong 1031 exchange rule. The other would be letting the tax tail wag the dog where people are so focused on not paying taxes that they go into a subpar investment. And so we’ve seen that where they’re getting close to their 45 day and they’re like, “All right, I’ll do this property.” And they pick the property and you’re looking at it like, “Man…” Types of properties that we try to avoid is when I make someone else’s problems mine. Sometimes you’ll make their problems yours because there’s a value add component. But a lot of times people will… They’ll like the property so much, they’ll look past.
Maybe there’s some foundation issues. Maybe there’s some of these other issues. But all that person’s problems are going to become yours once you own their property.

David:
The tenant is a big one.

Ryan:
Yes.

David:
No one sells their rental property even if it’s not performing well. Most people don’t if everything is smooth.

Ryan:
Yes.

David:
You think about selling your property when you have headaches, you don’t want to deal with it. And it’s almost always, “Oh, I’m buying it with the tenant inside of it.” And you’re like, “I love that.| Thinking about the tax benefits and not the headache that you’re buying into is a big problem.

Ryan:
Yeah. So I think that’s a big one. One is a lot of people don’t realize they need the qualified intermediary. So we’ll have people set up and my closing, I’m like, “Who’s your qualified intermediary?” And they’re like, “The who?” And so having that qualified intermediary set up, we oftentimes recommend getting the qualified intermediary set up when your property to sell goes under contract. Why wait until two days before you’re closing. It doesn’t cost you anything usually to get it set up and have them ready. And they know that deals fall through all the time and they’ll work with you to get it set back up when you go back under contract. But getting that QI set up beforehand makes a lot of sense, so you’re not having to rush the last second or, “Oh, it’s deposited in my account.”
That’s okay. I’ll just send it to the QI. Well as soon as you deposit in your account, that’s the taxable event. So people not realizing they need the qualified intermediary set up beforehand is another problem.

David:
And it’s heartbreaking too. That’s one of those things where our people will message me and say, “Hey, I just sold my house and my CPA said I’m going to have this much in taxes. I want to do a 1031 exchange. I sold it five days ago, so I saw 40 days. What should I do?” And I’m like, “Oh, if you have that money, you can’t. You have constructive receipt. It needed to go to an escrow, a qualified intermediary.”

Ryan:
That’s exactly it. We see that with people. The other part is with the naming. I’ve had someone say, “I named mineral rights and so now you can help me.” And I’m like, “Wait, what did you…” Or I named DST? And they literally put DST on the 45-day naming. It has to be the actual mineral rights, the exhibit with all the wells, the legal description. So that actually… Another point. You can submit your 45-day naming deadline paperwork in on day 35 and have it as your placeholder. And then something changes six days later and you’ve got a better property. You want to place one. Name your paper again and say, “This is the updated one. Most current dated.” But it’s not a, “Once you’ve named it, you can’t change it,” until the 45-day.

David:
So coming back to long-term goals, what’s another step to think about as an end component to this whole process?

Ryan:
So when you’re thinking of your 1031 exchanges and you’re thinking of buying real estate, building a real estate portfolio, one component of that is the mental side of why. What do I want this money to do? And so sometimes we see people get so focused in a big balance sheet and then, “Well, how do you want that balance sheet to help you in your life?” So that’s where our planning comes in where it’s not just about building the wealth, but how are we going to use this wealth? How is this going to benefit you, benefit the people around you?
And then think about what type of real estate and at what stage of your life do you want to own that real estate? So a lot of our clients who’ve put in the work, they bought a rental, bought another rental, bought an apartment building, and have built significant real estate portfolios. They’re still very active in managing or managing the property manager.
And so there’s a certain time where they may want to take their foot off the gas on the growth and just start getting cash flow and not be so involved. A lot of times that will be where we see the DSTs, the Delaware statutory trust and the oil and gas mineral rights as a great 1031 component because it can allow them to be a more passive investor. What you are giving up is that ability to improve the real estate drive value, doing these things that are really growth-minded where you’re active in it, but if you’ve really hit your goals of equity and the cashflow is what you need now to live the way you want, those can be really good options.
And then when you’re thinking of passing your real estate to the next generation or you’re helping your parents understand how best to pass to you, really thinking through the assets that are going to be inherited or transferred and how that person receiving it, if they’re all about owning rental properties and a multi-family property, industrial property that can work great.
Person passes away. There’s a step-up in basis. You inherit it. You can go and grow those assets. And then these more passive tools can be great for someone who their heirs are all over the country and maybe the one brother wants to keep it and the other brother wants to sell it, but the brother that wants to keep it can’t afford to buy the other one out. And so inheriting real estate can be really challenging. And so there are steps you can take ahead of time and other 1031 options that people may not know about to position that portfolio for a wealth transfer.

David:
Yeah, it’s good to know that you don’t have to stay locked into owning real estate. You don’t want to own anymore or the headaches that come from it. There’s actually options to avoid taxes and get out of active ownership or the multitude of properties that you might have and you want to decrease that. Or like you said, sometimes inheriting real estate is a form of a partnership. You’re forced into a partnership with someone that you didn’t really choose and you have different goals.

Ryan:
Yeah, absolutely. What I find fascinating too is every one of the clients that have built these large portfolios and are at that point in time where we’re helping them 1031 exchange and it’s about estate planning. I’ve never ever heard the word easy. And so building a portfolio of real estate is work and you’re creating value and you’ve got to be ready for those things that go wrong, don’t go your way. And it’s really having that long-term focus.
But just knowing that investing in real estate is not easy. Things go wrong, tenants, and there’s so many people that you have to rely on to move your property forward. It’s challenging and you’re really earning those returns. So we just encourage people when we’re helping them, especially when they’re early on buying their first couple properties or just getting started is reminding them that there’s going to be bumps along the road and we need to keep our eyes on the long-term goal of where we’re trying to get to.
But what I often see is somebody who’s bought a property, it’s worked great for six years, they’ve got that terrible tenant. They’ve got the insurance claim. They’ve got all this in a three-month period and they’re like, “I just want out.” They want the pain to stop so bad that they take these huge losses. And if they could just take a breather, take a step back and think, “Hey, we had six good years. This is a short period of time.”
But that knee jerk reaction to get out of your real estate is one part where we try to get in front of the client, work them through it, and then yeah, the common sense isn’t always common practice that of course people know to buy low and sell high, but how often when you’re in pain or you’re really uncomfortable, your mind just wants to end the pain and you just sell.

David:
Which is what we teach buyers to go look for in a motivated seller as you have motivation. So here now we’re teaching people who own real estate, “Don’t be the motivated seller. Go talk to the professional and find a better way out.”

Ryan:
Yeah. Don’t be forced to sell. I’d say that’s one of the number one ways you lose money in real estate is putting yourself in a position where you’re forced to sell that quality real estate that you own.

David:
All right. Last question for you. Sometimes CPAs repeat misconceptions or misinformation. Either they don’t know or they’re not pursuing excellence in their craft and they’re just ignorant of this. So what are some good resources for people to look some of this stuff up if they don’t want to just rely on a CPA?

Ryan:
Sure. So a lot of times getting second opinion from another CPA can be really good. Some CPAs don’t deal with 1031s very often or it’s been a while since they re-looked at it. So they may not have all the information they need to give the advice. But a lot of the large qualified intermediary companies will have really good resources on their websites. So three large ones that we work with, we work with quite a few, but three large ones. One would be IPX. Another one would be Asset Preservation Inc and First American Exchange.
Those three have very detailed websites that have a lot of information about 1031 exchanges. They break it down. That’s oftentimes where we’ll direct clients who have technical 1031 exchange questions and CPAs where they’re getting information on a website that is typically has been prepared by their in-house legal counselor, their in-house CPAs where it’s not somebody giving it their best shot and throwing it up on website.
So I’d say those are three areas that you can have a high level of confidence if you’re reading it there for 1031 exchange advice. And they’re also very… Those three and several other [inaudible 00:45:18] we work with are very open to answering questions. They do not mind. They would much rather. From the ones I’ve talked to, they would much rather you call and get the right information so that if you do choose to work with them, things go the way they’re supposed to.
Then you didn’t call, you didn’t get the information and now you’re yelling at them because something’s not working and they’re like, “Well, that’s not how these work.”

David:
All right. Well, thank you for that, Ryan. We just might have to have you back to dive deeper into some of these topics in the future, because this is fascinating. You’re a wealth of information and we don’t want to keep people here for a four-hour podcast. But before I let you out of here for today, if people want to reach out after hearing this, where’s the best place for them to find you?

Ryan:
So our website is www.tangiblewealthsolutions.com. That has a lot of information. There’s a contact us website or you call our office number, which is 720-4396540 and we are here to answer questions, help people with their planning and offer solutions based on what people are trying to do or definitely want to be out there helping people. One of the most common phrases we get is, “Ah, I wish I talked to you three months ago. I wish I talked to you six months ago. I wish I would’ve sent my mom to you last year when she was in the middle of this.” So we really like to talk with people early so they’re aware of their options so that no one needs to be paying taxes unnecessarily.

David:
That’s right. So everybody reach out to Ryan, reach out to his company. If you’ve got questions about this, if you got a portfolio you’re not happy with, this is the best case. Don’t just assume you got to figure it all out yourself. There’s people out there that’ll help you and I’m one of them. You can reach out to me and I can see what I can do in the same way, because if you’ve already done the hard work of building up a portfolio, it shouldn’t suck. You shouldn’t hate it. You shouldn’t be sitting here like I wish I wouldn’t have done this. There’s a way to reallocate these assets that you can start to love real estate against. So thank you, Ryan. I appreciate everything that you’ve shared with us today. Keep doing the good work out there and we’ll have you back again.

Ryan:
Perfect. Thank you. No, I really appreciate your time, David, and in allowing me to be on here.

David:
General disclosure, not an offer to buy nor a solicitation to sell securities. Information herein is provided for the information purposes only and should not be relied upon to make an investment decision. All investing involves risk of loss or some or all principle invested. Past performance is not indicative of future results. Speak to your finance and or tax professional prior to investing. Securities offered through Emerson Equity, LLC member, FINRA/SPIC. Only available in states where Emerson Equity, LLC is registered. Emerson Equity, LLC is not affiliated with any other entities identified in this communication.
1031 risk disclosure. There’s no guarantee that any strategy will be successful or achieve investment objectives. Potential for property value loss. All real estate in investments have potential to lose value during the life of the investment. Change in tax status.
The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or the tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. Potential for foreclosures. All finance real estate investments have potential for foreclosure. Illiquidity. ‘Cause 1031 exchanges are commonly offered through private placement offerings and are illiquid securities, there is no secondary market for these investments.
Reduction or elimination of monthly cash flow distributions. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Impact of fees and expenses. Cost associated with this transaction may impact investors’ returns and may outweigh tax benefits.

 

 

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