You might know at a high level that a 1031 exchange means deferring real estate capital gains taxes. But the details are important to avoid dumb mistakes that will disqualify you.
So this week, I invited Bill Exeter to teach us about 1031 exchanges. He is the CEO of Exeter 1031 Exchange Services and has been doing 1031s for nearly four decades.
- Different types of 1031 exchanges
- Key criteria and deadlines + step-by-step process for executing a 1031
- How to optimize timing your buy/sell transactions
- Like-kind replacement property rules
- Domestic vs. foreign property exchanges
- What constitutes “Qualified Use” + holding period requirements
- State tax consequences
- Why investors can’t do 1031s themselves
- The role of a Qualified Intermediary, how to vet one, and how much they cost
- Tax impact of converting a 1031 property into owner-occupied housing, and vice versa
- Common mistakes that disqualify you from a 1031
- Proposed Biden administration changes to 1031s: likelihood of passage + actions you can take now to mitigate adverse tax impact
Ever done a 1031 transaction? What was your experience? Anything you would do differently next time? Let me know by leaving a comment.
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Links mentioned in this episode:
- Exeter Group
- How to avoid capital gains taxes when selling your house
- How the Home Sale Capital Gains Tax Exclusion Works (HYW033)
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:23
My guest today is Bill Exeter.
Bill is the CEO of Exeter 1031 Exchange Services and Exeter Trust Company.
He’s built a career in real estate tax since 1986, with a focus on 1031 and 1033 Exchanges, Self-Directed IRAs, Title Holding Trusts, and custody accounts for Alternative Investments in real estate.
He has administered over 125,000 1031 Exchange transactions during his 37-year career in the industry, and he is a co-founder of the Federation of Exchange Accommodators, an industry trade group.
I invited Bill to the podcast today to share his insights and wisdom about 1031 exchanges for real estate investors.
Bill, thanks so much for joining us today to talk about this important tax topic!
Bill Exeter 02:05
My pleasure. Thank you for having us.
Andrew Chen 02:07
I would love to start out just by learning a little bit about your background. How did you decide to focus your career and business on this aspect of real estate?
Bill Exeter 02:15
Like many people, it’s completely by accident. I was a controller of a bank up in Los Angeles, and the chairman of the board decided to start a 1031 exchange qualified intermediary.
Outside counsel said, “You don’t have the escrow subsidiary running it. We think that’s a problem.” So, all of a sudden, he threw it at me, and I had no idea what a 1031 exchange was.
And then, about two or three months after that, UCLA had a two-and-a-half-day extension program specifically on 1031 exchange processes and what have you. I took that, and that was in the mid-‘80s, and my career did a left or a right turn there, depending on how you look at it.
And here we are. Now I’ve been doing 1031 exchanges and financial services mostly in the trust area ever since.
Andrew Chen 03:05
Got it. Thank you for that background. Right now, it’s a very active real estate market, so I look forward to really getting your thoughts on how to navigate a 1031.
But just to level set, many real estate investors understand, at least at a very high level, that a 1031 exchange is a legal mechanism afforded under Section 1031 of the Internal Revenue Code that allows you to sell real property that is used for business or for buy-and-hold investment purposes, so not primary residence, not fix-and-flips…
And purchase like-kind replacement property in a way that generally defers taxes and depreciation recapture from the first property, and instead, rolls the legacy tax basis into the second property, so that you only deal with the cumulative tax consequences if you sell that second property at a future time.
And if you don’t, you can theoretically keep using 1031s on your investment real estate until you die. After which, your heirs can take a step up in basis to fair market value, avoid all tax liability, subject, of course, to estate tax limits, which don’t apply to most people. So, I think a lot of real estate investors get this at just a very high level, but there’s a lot of detail they may not know about how this all works.
I wanted to start off first by asking: What are the key eligibility requirements for a transaction to qualify for 1031 status? And what are the key steps to properly execute a 1031 transaction?
Bill Exeter 04:27
Good question. That’s probably the most important thing, a topic, when you’re talking about 1031 exchanges. It’s broken down into two subtopics.
First one is qualified use. The property they sell, the property they buy inside the same 1031 exchange have to be held for some type of rental investment or business use. And as long as it falls into one of those categories, it satisfies the qualified use test.
But you also hit the nail on the head that if someone is buying a property to rehab, fix up, and then sell or flip, they’re really holding for sale, so that doesn’t qualify.
Same if you are a developer/builder/contractor. Typically, you buy, build, and sell. You’re holding for sale (like inventory) your development business, so that doesn’t qualify.
And if you’re a condo conversion specialist, it’s the same thing. You buy, you convert, and you sell.
Now, if you did buy, and then you rehab or develop or convert, and then you hold as rental property, then you could do a 1031 exchange, and it would qualify.
That qualified use, a lot of people get hung up on: How long have you held title to the property? Did you hold it for at least a year, a year and a day, or two years? It’s important to note that those are opinions, and that’s all it is.
The tax code, the regulations, and the rulings have no holding period required, but so many investors get hung up on the timing: how long have you held title to the property? The real issue is: did you have the intent to hold for rental investment or business use? And if you can prove that, then the timing is not really an issue.
Of course, the longer you held title, the easier it is to prove that it was held for rental investment or business use. The shorter, the less easy it is to prove intent.
And then, going back to the second subcategory which is like-kind, it is amazing how much misinformation is out there. There’s still curriculum that says if you sell a condo, you have to buy a condo. If you sell apartments, you have to buy apartments.
That’s absolutely not true. Like-kind literally means you are selling real estate, you have to buy real estate. Simple as that.
And people don’t even realize what that could be. That would include things that are like air rights, water rights, mineral rights, oil and gas interests, etc. Anything that’s considered real estate, for the most part, under state law, would count.
Andrew Chen 06:50
Got it. And it sounds like there’s no safe harbor for a duration requirement. You’re just purely proving intent, and that is circumstantial?
Bill Exeter 06:59
That is exactly right. There’s no safe harbor whatsoever. A lot of people say that if it’s under one year, you don’t qualify, and that’s not true.
I’ll use an example. For us, we had a client who sold, did an exchange, bought a condo, didn’t read the CCNRs, and just a few days after closing, he finally read them and realized he couldn’t rent. It had to be owner-occupied.
So, of course, he panicked and emailed and sold immediately, did another 1031 exchange. He was audited by the California Franchise Tax Board, and they actually allowed his 1031 exchange even though he was in title for about a month and a half, because that clearly proved, especially with all those panicky emails, that his intent was to hold for rental.
Andrew Chen 07:40
That’s an interesting example. Got it. So that flushes that out.
I understand there are criteria that the replacement property must satisfy in terms of purchase price, equity rolled over, even mortgage amount in order to get the full tax deferral. Could you help us understand what those criteria are?
Bill Exeter 07:58
That’s another area where there’s a lot of misinformation out there. What you’ll see in brochures and websites, etc. are statements like “You must trade equal or up in value” and “You must replace your debt” and “You must reinvest your equity.”
For the most part, that’s true if you want to defer all of your taxes, but it’s a little misleading. The two real requirements are that whatever you buy, whether it’s one property or two or three properties, the total amount you buy, the aggregate, has to be equal or greater than what you sold.
The second requirement is that all of the cash equity that comes out of the sale needs to be reinvested in your new properties that you acquire. You don’t have to replace debt. You could replace the debt with out-of-pocket cash.
For example, if you sold the property for $1 million, and maybe it had $600,000 debt, $400,000 equity, you could buy another replacement property for $1 million and pay it all cash, and that would qualify because you replaced the debt with cash. The issue is most of us don’t have that kind of cash laying around, so you usually do have to replace debt.
Andrew Chen 09:06
I may be mistaken about this. In my research, I was reading around the mortgage requirements, and I thought I read something around if the mortgage value in the replacement property is less, then the reduction in the mortgage amount is imputed to you as taxable gain. If that’s incorrect, could you help me set the record straight?
Bill Exeter 09:26
No, it depends. For example, what some people will do is, going back to the same example, they sell for $1 million, $600,000 debt, $400,000 equity, and maybe they go buy a new property, and maybe they buy it for $900,000, and they put $400,000 equity in the new property and only get $500,000 of debt.
So, they’ve traded down by $100,000. In that case, the real issue is they’ve traded down by $100,000. The net effect is they got a lower debt.
People call it mortgage boot, and it’s taxable. It’s really that they just traded down in value.
But if they sold for $1 million, bought for $1 million, and only got $500,000 of debt, that means they’d have to put in another $100,000 of cash out of pocket to replace that debt they didn’t replace.
Andrew Chen 10:14
But that extra $100,000 would not be considered gain of any kind?
Bill Exeter 10:18
Correct. It would all be tax-deferred in that situation.
Andrew Chen 10:23
So it sounds like the really key requirement is greater or equal value, and you have to reinvest all your equity proceeds.
But let’s say in your replacement property, you actually bought a more expensive property. You put in more cash in there. In fact, you put 100% cash, so there’s no debt.
There’s no tax consequences from that, then, in that case. Is that correct?
Bill Exeter 10:40
Exactly. You could certainly do it all cash. Or anything you trade up by, you could certainly finance with more debt, and that would also qualify.
Andrew Chen 10:50
I understand there’s this 45-day hard deadline, it is not alterable, except by the President of the United States, for identifying property, and then later, there’s a 180-day deadline. Both clocks start at the same time for actually closing a transaction. There’s this property identification requirement for identifying like-kind replacement property.
And just to briefly summarize for listeners, you have to either: (1) identify up to three, but no more than three, replacement candidates, or (2) identify any number of replacement candidates, so long as the total combined fair market value of them does not exceed 2x of the sale price of the property you’re relinquishing…
Or (3) identify any number of replacement candidates of any value, but then you’re required to purchase 95% or more of the fair market value of all the replacement candidates combined.
As an investor, it’s not exactly intuitive why these three tests exist. What’s the purpose of it? What is the IRS trying to accomplish with these tests?
Because if you successfully purchase a like-kind replacement property, what does it matter if you satisfy or didn’t satisfy one of these three tests?
Bill Exeter 11:55
Many of us have been wondering that same thing for 37 years. It doesn’t make any sense whatsoever. In fact, there was about 55 that went back to testify before the U.S. Treasury, and this was back in ’88 or ’89, just before the regulations came out and went final.
All of them testified against the 45-day period of identification requirement, and not one testified in favor of it, and they still put it in. One of those things you scratch your head and wonder, “What the heck?” But at this point, it is what it is, and we have to make sure we comply with it.
And I realize I didn’t quite answer your first question thoroughly, so I thought I’d combine it all with this one. And that is, a lot of investors don’t realize you have to get the 1031 exchange set up before the sale closes, or before any of the closings occur. The reason for that is whoever is listed in the documents as the seller has the right to the funds when the sale closes.
So, if you had set up a 1031 exchange, and the qualified intermediary has been assigned into the transaction, then we have the right to receive the proceeds, and that’s what defers the taxes. If the 1031 exchange is not set up prior to when it closes, the client, the taxpayer, has the right to receive the funds.
So, even if you tell the escrow or the closing attorney, “Don’t disperse the funds. I’m going to do a 1031 exchange,” it doesn’t matter.
It’s too late. It’s taxable. There’s no way to go back and fix that.
So, you have to be very careful to get it set up prior to. And then the closing is actually what triggers the 45 days and the 180 days. You have the 45 days you mentioned to identify what you’re going to acquire, you have an additional 135 days after that to complete your exchange, for a total of 180 days.
Andrew Chen 13:39
In the second of the three tests for identifying like-kind replacement property (identify any number of candidates, so long as the total combined fair market value does not exceed 2x the sale price of the property you’re relinquishing), I just want to understand, since the sale, the closing of the relinquished property, may not occur until the future, even past the 45-day mark…
If the investor is trying to satisfy the second test, that’s the way they’re going to do it, then do they just bear the risk that the final sale price may be higher or lower, and there’s a risk that they might actually run afoul of the second test? Does that make sense? Because you can’t be sure that it’s going to be 2x until you know the final sale price.
Bill Exeter 14:31
That’s true. Especially in this market, that’s a huge risk because it could end up being a lot more than 200% with all of the bidding wars and above asking price that we’re seeing out there. So we always advise, “Don’t go right up to the exact 200% mark.”
But usually, people will identify the listing price. Or if they have an idea of what they think the fair market value will be, or what they’ll end up paying for it, or their top price, they really should work with their advisors and put it all together and determine what they think is appropriate and what is defensible if it’s under audit.
Andrew Chen 15:14
We’ve talked a little bit about this already, but I wanted to double-click to see if there’s more detail that’s worth fleshing out. What makes a property like-kind for 1031 eligibility purposes? Are there criteria?
Bill Exeter 15:26
There are criteria, and it goes back to the qualified use requirement: as long as it’s rental investment or business use. To flesh out a little more, the rental means you’d rented it or leased the property to somebody, or somehow it’s producing income, whatever that means. And that would qualify for 1031 exchange purposes.
I classify the second area as held for investment, because you could buy a real estate, whether it be any type of real estate with a dwelling on it, it could be a vacant land, whatever it might be. You could buy real estate and hold it for appreciation, and not rent it or lease it out. So, it doesn’t have to produce cash flow, but it does have to be held for investment purposes.
And the third category is business use. If you buy any type of real estate, and you run or operate your business out of it, that would also qualify. So, it has to be something along those lines where your intent is to buy and hold for rental investment or business use.
Andrew Chen 16:23
And the investment, that would be true even for purely speculative? Is that correct?
Bill Exeter 16:28
Yes. Certainly, if you think, “The development for this particular area is going this direction. Let’s buy a bunch of land in that direction and hold it for capital appreciation, and then we intend to sell when it hits a certain price point.”
That’s held for investment. That would certainly qualify.
If they buy specifically to build as a developer and then sell, then it would not qualify. You get into the risky area where you buy land, you’re holding for appreciation, and then what if you subdivide at the very last minute, sell, and do an exchange? Did your intent change?
That’s the critical area. Some people will take the position, “No, I have no intention of developing. I’m not going to do that, but I can maximize my value by subdividing.”
But just keep in mind, if you get audited, that’s the risk. They may come in and try to allege that you are really holding for development and then decided to sell instead of finishing it. So there’s some risks that you look like you’re developing or rehabbing.
Andrew Chen 17:24
Interesting. On that point, to satisfy the intent requirement, is it true then that you have to show that you had the intent for rental investment or business use both on the way in and the way out? What if that intent did change?
Bill Exeter 17:43
Yes, absolutely. Both on the relinquished property and the replacement property would have to demonstrate that intent.
Andrew Chen 17:49
Sorry, I meant on the relinquished property, when you acquired it and when you sold it, do you have to show that at both points, there was that intent?
Bill Exeter 17:59
Yes. The intent is critical all the way through, both in and out. Intent can change.
For example, probably the most common example for intent to change would be someone sells, does a 1031 exchange, buys a single-family residential property, rents it for two years, which straddles three tax returns. That’s really solid proof that was the intent.
And then, at that point, they think, “I’m going to change my intent. I’m going to move into it and convert it to my primary residence.” As long as their intent for the first couple of years is truly to hold for rental purposes, that will qualify.
And then intent can change later. If they can show under audit that their intent was always to live there, then they’ve got a problem.
Andrew Chen 18:42
I do want to circle back to that scenario in a bit, but just to expand upon that, if the intent did change, they converted it into a primary residence, then when they sell that property, if it’s still their primary residence, they can no longer use that as a 1031, even though they had started out with the intent to use it as a rental property. Is that correct?
Bill Exeter 19:01
Good point. Yes, because the intent has changed.
Now it’s held for personal use. It’s no longer held as a rental property. That’s a good point.
Andrew Chen 19:09
And I assume the same would be true if they started out as a primary residence, then later moved out to convert it to a rental. As long as the intent existed at the time that they were going to relinquish that property, they could avail a 1031?
Bill Exeter 19:22
Yes. And actually, that scenario, that structure, has a couple of potential planning opportunities. Let me use a specific client as an example.
We had a couple, husband and wife, bought property in La Jolla, California, lived in it for 42 years as their primary residence. They were having health issues, wanted to go back east with the kids and grandkids. But their capital gain was $8 million.
If they had sold, they would have gotten $500,000 tax-free as the 121 exclusion, but they would have gotten killed on taxes for $7.5 million.
There’s actually an IRS ruling they’ve put out where you can move out of the house, convert it to investment property. So I would say, you rent it for probably two years, which straddles three tax returns, really solid proof that was your intent to hold for rental purposes, and then you’ve got one more year to sell and close on the sale.
And at that point, you still qualify for two out of the last five years, so you can still get the $500,000 tax-free exclusion. And you’ve rented it for two years, so now you’ve qualified for a 1031 exchange. So, in their case, they got $500,000 tax-free and $7.5 million deferred through a 1031 exchange.
Andrew Chen 20:41
Interesting. In that case, you would want to structure it, so that almost exactly $500,000 is recognized as gain because that’s tax-free, and all the rest of it gets rolled into the next transaction?
Bill Exeter 20:53
Exactly. And we can actually structure our documents where we assign into the escrow for everything except for $500,000. That way, the $500,000 will automatically be taxable, but then you get the exemption, so you don’t pay tax.
Andrew Chen 21:05
That’s brilliant. Got it.
Bill Exeter 21:07
The key there is when they move out and start that process, the day they move out, they’ve got a three-year window to do all of that. And if you miss the three-year window, you’ll lose your $500,000 tax-free exclusion, but you would still qualify for a 1031 exchange.
Andrew Chen 21:23
Can you exchange a domestic U.S. property for foreign property, or vice-versa?
Bill Exeter 21:27
Good question. No. You used to be able to.
I think in ’88 or ’89 or so back then, the U.S. Congress got wise to the fact that people are selling U.S. properties, exchanging into properties in countries that had no tax treaty, so it became a tax-free exchange. So they put the kibosh on that.
Now, contrary to what you read on the internet and brochures, you can sell foreign property and do a 1031 exchange into other foreign property. Basically, that boils down to if you are a U.S. citizen, and let’s say you own a rental flat in London and you’re going to sell that, then you have to calculate what taxes you pay in London or in the UK, and that is what it is, of course. They don’t have a 1031 exchange.
Then you calculate what you’re going to pay over here in the U.S., including that foreign tax credit. And if there’s still a net tax due, then it makes sense to do the 1031 exchange. And you just have to exchange it to some other foreign property that’s also held for rental investment or business use.
So, all of the properties have to be foreign, or they all have to be U.S., but you can’t go between the two.
Andrew Chen 22:34
If they’re both foreign, do they have to be in the same country, or can they cross countries? And are there any restrictions? Can it be any pair of countries?
Bill Exeter 22:41
No restrictions whatsoever. As long as it’s foreign property, it could be any country, so it doesn’t matter. We’ve done exchanges now in about 45 different countries.
They’re always interesting. Each country has got their own laws and regulations and closing processes and customs, so it’s always a challenge.
Andrew Chen 22:59
That’s super helpful to know. When it comes to state tax considerations, what happens when you do a 1031 exchange in one state and then purchase a replacement property in another state?
When you later sell the second property, the replacement one, do you owe state taxes in both states, or just in the second state? And how would it even be apportioned?
Bill Exeter 23:17
Good question. It’s my favorite answer: it depends. Just a couple of comments off the top.
First of all, the 49 states pretty much follow the 1031 exchange; Pennsylvania does not. So, if you’re selling rental investment or business use property in Pennsylvania, you can defer the federal taxes, but you’ll pay the Pennsylvania state taxes. I can’t remember, but I think the Pennsylvania state tax is 3%-3.5%.
California has what people have nicknamed the “California claw back provision.” If you sell in California and 1031 exchange out of state, it is tax-deferred. But California has always taken the position that it’s deferred, and if you ever sell and cash out and pay the tax in the future, they want their “fair share.”
But as long as you keep exchanging over and over and over, and then you exchange until you pass on, and you get that step up in cost basis that you had mentioned, then California gets nothing. The only time they would get paid is if you actually decided to stop exchanging, you sold and cashed out and paid the tax.
Andrew Chen 24:24
In that case, how would it be apportioned?
Bill Exeter 24:27
Good question. California really calculates the tax based on the gain while it was in California, so they don’t tax you on gain that was out of state. And generally, if you’re paying California tax and you’re also paying tax in the other state, you get a foreign tax credit.
Really it’s a credit for the state tax you paid in the other state on the California return. So you’re not paying double tax, but you’re paying the higher tax, which is typically California.
Andrew Chen 24:53
If I had property in California exchanged out to property in Texas, and then later, just for whatever reason, sold it, I may owe tax to California on the portion of the gain that accrued while the property existed in California, but I would never be in a situation, it sounds like, where I’m paying taxes to both California and Texas on the same dollar of gain. Is that correct?
Bill Exeter 25:18
That’s correct. If Texas did have a state tax, you’d get a credit for whatever tax you paid in Texas on your California return. So you wouldn’t be paying double; you’d just be paying the higher tax rate.
Now, I think most of the tax attorneys and tax advisors who would speak to you, and I agree with it, think that that whole California claw back is unconstitutional. So I think it’s just a matter of when somebody finally steps up to the plate and decides, “Enough. I’m going to fight that.”
I always tell clients, “If that’s what you want to do, I wouldn’t stop and not do it just because of the California claw back.” All you have to do is file an extra tax form with your tax return each year that just says, “Look, I’m still holding the property. It’s still tax-deferred.”
It’s just one extra tax form, so it’s not a huge deal. It’s a little pain, but not a huge deal. And at some point in the future, if you go to Texas, like you said, it could become tax-free in the future on a state level if they finally fight California.
Andrew Chen 26:16
California has lots of rich commercial real estate investors. Why haven’t any of them fought this?
Bill Exeter 26:23
That’s a good question. Franchise Tax Board is not fun. When they sink their teeth into you, they’ve got unlimited resources basically, and they’re known for fighting that kind of stuff.
But I think it’s a matter of time before the tax liability is great enough and they decide to do that.
Andrew Chen 26:42
Could you talk a little bit about the differences between the different types of 1031 exchanges: forward versus concurrent versus reverse?
Bill Exeter 26:50
Forward exchanges, by far, is the most popular. That’s about 97% of our volume.
A forward exchange is where the investor sells their current property or their relinquished property first, and then they have the 45-180 days to identify and close on the new replacement property. That’s just a lot more streamlined, the fees are much less, etc. That’s why most people do that.
The risk with a forward exchange is you’re selling. You’ve sold, you’ve closed, and once you’ve closed on that sale, you’ve triggered your gain. So then it becomes an issue of: can you identify and can you acquire the replacement property?
And if you can, it’s deferred. But if you can’t, it’s taxable, and there’s no way to go back and undo that. So that’s the risk, and in today’s market, that’s a big challenge.
The reverse exchange can solve a lot of those risks because you’re buying first, so you actually spend all the time you want to find the right property, make sure it’s suitable, go under contract. You can close on the purchase. The challenge is it’s more complicated, and it’s more cost-involved.
The first complication is you’re buying first, you haven’t sold, so your equity is trapped. If you have cash in your bank account and you can pay all cash for it, then it’s great. You can do it.
But if you have no cash, which most people are real estate rich, cash poor, how do you buy that new property first when you haven’t sold anything? So, that’s the first issue they have to look at and solve for.
Second is a pure reverse exchange would mean that the taxpayer could go out, acquire the new replacement property, hold title to both, and then sell their current property later. And the IRS doesn’t allow that, so they’ve set up this parking arrangement where the qualified intermediary has to acquire and hold, or what the IRS calls “park,” a legal title to one of the two properties.
Generally, we will acquire and hold, or park, a legal title to the new replacement property, and then that begins that 180-day window. So we’re holding the property on their behalf until they sell their current property. So, it’s really a parking arrangement upfront, and then a concurrent 1031 exchange at the backend.
When they sell their current property, they deed it to the buyer, and then we transfer the property we’re holding for them to them. That’s really a concurrent swap at the backend. Like I said, there’s that parking arrangement.
If there’s a lender involved, the lenders aren’t terribly happy with reverse exchanges. The traditional lenders probably won’t touch it. It might be a hard money or a private money lender.
Life insurance companies will do it, for the most part. Local community banks or regional banks will often look at it. So, it really depends on the borrower’s relationship with the institution.
Andrew Chen 29:33
And what is a concurrent 1031 exchange? Is it where title transfers simultaneously in reverse?
Bill Exeter 29:42
Exactly. It happens on the same day. Even with a forward exchange, you could sell and close on the purchase of your new property on the same day.
There’s a lot of moving parts there, and if something goes wrong, it causes all sorts of issues. Concurrent transactions are not that common. It’s usually better if you close, and then plan one or two weeks before, so if something goes wrong, there’s a title problem or an escrow problem or something, you have time to fix it before you have to close.
If you close concurrently and something blows up, then you’ve got an issue because the seller is going, “Come on, let’s perform.”
Andrew Chen 30:20
I wanted to talk a little bit about qualified intermediaries. To execute a 1031, you have to go through a qualified intermediary. Can you explain what that is, why QIs exist, what’s their job or role, and why investors can’t legally do 1031 transactions themselves?
Bill Exeter 30:35
That goes way back to the ‘60s. Actually, I should jump in there real quick and say this is the 100-year anniversary of 1031 exchanges, so it’s been in the tax code now for 100 years this year.
If you go way back, all the 1031 exchanges were concurrent. They would just swap properties at the exact same time.
In the ‘60s, a family by the name of Starker up in the Pacific Northwest actually did the first delayed exchange, or at least the first one that the IRS audited and disqualified. They had basically a five-year delayed exchange.
They sold land to Crown Zellerbach, Inc., and in return, Crown Zellerbach said, “We’ll put a credit on our accounting records for you equal to the value of your land. Over the next five years, you go buy something or tell us what you want. We’ll buy it for you and deed it to you.”
So, it’s really a five-year delayed exchange, and IRS audited, disqualified everything. Starker family fought, and they actually won in tax court.
That’s why we have today’s delayed exchanges because of the Starker family. So you might hear people still today refer to it as a Starker exchange, and that’s why.
But with that whole process, it’s very clear that the taxpayer is not supposed to have either constructive receipt or actual receipt of the funds. Over time, the industry developed…first, they called them “straw men,” and then facilitators, and then accommodators, and now we’re qualified intermediaries.
Those mean all of the same thing. We’re just a third party that drafts the documents to structure the 1031 exchange. We hold the cash proceeds between the sale and the ultimate purchase, or we hold the real estate, if it’s a reverse exchange, between the purchase and then the ultimate sale.
And then we’re really here in an advisory and consultative position where we jump on the phone with the client and all their advisors and walk through all the issues that might come up.
Andrew Chen 32:27
It’s very comprehensive. What distinguishes a good QI from a bad one?
Bill Exeter 32:32
That’s a good one. First of all, anybody can set up shop and serve as a qualified intermediary. There are no barriers to entry.
Anybody can open up a shop as a qualified intermediary. That’s the scary part because qualified intermediaries hold lots of money for lots of clients.
So, there’s a lot of things you want to look at. From my perspective, the most important element is some type of government or regulatory oversight. And we recognized that a number of years ago when we went through a two-year plus process of going through the regulatory review and approval process to get our trust company charter.
So now, all of our funds are held by Exeter Trust Company. That means a number of things.
Number one, a lot of people are familiar with Landamerica and the Landamerica 1031 exchange. They were probably one of the top five title insurance companies in terms of size and scope back in the pre-2008 era.
The recession hit. Long story, but the 1031 exchange company actually put the entire company down because of what they invested the funds in. Had those funds been regulated or subject to government oversight, that would have probably been avoided.
That’s the first issue. Second issue is they ended up in bankruptcy court, and bankruptcy court said, “You’re holding these funds in your corporate name. Therefore, they’re corporate funds, not client funds.”
That was a shock to the industry. It didn’t surprise us because that’s the way that contracts are drafted. We always thought that’s what the court would do.
For those reasons, we thought, “We need to do better. We need to go out and start a trust company, so the funds are purely held in a fiduciary trust capacity for the client, not in our corporate capacity.”
It also gives the clients a separate, segregated, dual signature, qualified trust counselor, clearly separate from all of their client funds, and they’re subject to an annual audit by the Division of Banking. I think it’s very important to have that.
You certainly want to look at bonding in insurance: fidelity bond, errors and omissions insurance, etc. Because we’re a financial institution, we also have the financial institution bond package. But those are things you want to look at.
And then you always want to make sure the funds are held in a qualified trust account. A lot of exchange companies still hold it in their corporate name.
Andrew Chen 34:47
I want to dive into some of those other things that you’ve mentioned before, but just to clarify, when you say the QI is regulated and also does not comingle funds into their corporate account, does the practical implication mean that that money is stored in a trust account? That’s the way you would accomplish those two things?
Bill Exeter 35:10
Yes, absolutely. The industry standard in practice that started way back when was you open separate accounts, either individual bank accounts or one omnibus account. It’s under the corporate name, so it’s held by the corporate entity, but they’re kept separate as client funds.
The problem is you end up in bankruptcy, legal title in the signature card just says the name of the qualified intermediary, so they’re corporate funds. By putting them in the qualified trust account, that clearly makes them client or fiduciary funds.
Andrew Chen 35:41
And pre-2008, or maybe even still going on now, but at least in the example you gave, for QIs that would not do this more regulated holding structure of client funds, did I understand correctly: they would actually invest the money, say, in short-term securities, or even risky securities, because they were trying to get a little bit of extra return from that?
Bill Exeter 36:07
Yes, exactly right. There’s been some smaller qualified intermediaries that actually take client funds and invest at real estate, and thinking, “I’m going to make a lot of money. I know real estate.”
But then, a recession hits, and all of a sudden, the value of that real estate drops and they’re caught with their pants down essentially. When the recession hit, that’s when these things come to light.
In the Landamerica case, they invested in auction-rate securities. Those are not necessarily bad investments, but they’re not prudent for 1031 exchange transactions. And when the auction-rate market or the auction securities market froze in February 2008, I believe, Landamerica couldn’t pull the cash out.
It was still there, and they were still good investments. Ultimately, they got access to it later, but as long as that financial crisis was in place, they couldn’t get the funds out.
So it forced them into an involuntary Ponzi scheme, and then they started putting corporate funds in to cover it when the market got worse and worse, and they ran out of corporate funds. That’s what took the whole company down.
Andrew Chen 37:03
Wow. On your company blog, you write about the criteria that investors should screen for when deciding which QI to work with.
There are four risk factors that you pointed out: (1) depth of experience and expertise, which seems straightforward; (2) employee error or omission; (3) employee theft or embezzlement of funds; and (4) prior bankruptcy filings by the QI.
Can you talk a little bit about each of these in more detail, including what kind of documents or insurance verifications investors should request from the QI before doing business with them?
Bill Exeter 37:37
Sure, absolutely. And those are ranked in order of what we think is most important. A lot of people get hung up on fidelity bond and E&O insurance, and those are certainly important, but the biggest area we find losses occurring is where a qualified intermediary just didn’t understand the transaction, didn’t have the depth of experience, and they just processed it.
They think they’re just a processor. They do what their client tells them, and they try to hang the hat on “Your tax advisor should review this whole thing.”
But in reality, the qualified intermediary is supposed to be the expert. When you don’t have that depth of expertise, stuff happens.
For example, there was one case in Colorado where they sold as individuals; they bought as a corporation. That is clearly completely different taxpayers. It will not qualify.
But the qualified intermediary processed it like that, so of course, they got sued and lost. So, you need a qualified intermediary that really understands what the transaction is all about and all the intricacies involved in administering the transaction.
That’s part of the dangers. There’s people who just open up shop, and they’ve been in business a year or two, and they haven’t made all their mistakes yet.
For those, you just want to look at depth of experience. And with that, it’s really calling them, talking to them, asking a ton of questions, and see what you feel. And if you talk to three or four or five qualified intermediaries, you’re going to figure out pretty quickly who knows their business and who doesn’t.
The next one is different types of fidelity bond, errors and omissions insurance, etc. And that’s easy. Just verify what they’ve got.
Ask them for copies of their certificate or evidence of insurance. You can even call the insurance agent and verify that it does, in fact, exist. That would be critical as well.
Andrew Chen 39:18
Are there coverage amounts that you recommend investors see in documents to ensure that, should anything happen, there’s adequate insurance to cover any loss of funds?
Bill Exeter 39:40
Good question. There’s certainly a huge range of coverage out there. You’ve got a few, one or two, three maybe, that have $100 million.
If you look at that and you read the policy, it’s not per occurrence. It’s in aggregate. Those are generally the very large title insurance companies.
But it’s in aggregate, so if they have some major losses, three or four or five major losses in the same year, you may not be covered. So it sounds great, but it depends on the year, and it depends on how many aggregate losses they have.
Then you get a lot of the smaller qualified intermediaries that either have no bonding or very small. It would be $100,000 or $250,000. But most transactions are greater than that in size, so you want to look at that and balance it out.
We decided, at this point, because underwriters are difficult to work with today, after the ’08 recession, they’re hesitant to underwrite qualified intermediaries. Most transactions are under $5 million, so we get $5 million in fidelity and E&O coverage per occurrence, and then we also have the dual signature qualified trust account, so money can’t be moved without the client’s actual signature.
With all of that, we’ve balanced the insurance plus the control that the client has.
Andrew Chen 40:53
If the money is held in a trust account dual signature, so it can’t be moved, that would seem to neutralize the risk of bankruptcy impacting those funds. Please correct me if I’m wrong. It would seem to also neutralize the risk of employee theft or embezzlement because of the dual signature requirement.
Are those two things correct, first of all?
Bill Exeter 41:15
Yeah, that’s absolutely right. In our case, it requires at least four people within the company to get involved to move money: two from the administration side (one to request it, one to sign off on it), then it goes to the trust operations area, and it requires one person to process it, another person to release it and approve it.
So, there’s four people involved there, and it also includes at least one signature from the client’s side in order to get any of those funds released.
Andrew Chen 41:41
And what is employee error or omission? What does that even mean?
Bill Exeter 41:46
That’s where the qualified intermediary makes a mistake. Whether they omit something or they make a mistake, or somehow, to be blunt, screw up the documentation, screw up the transaction, it triggers a loss for the client. Then we can file a claim under the E&O insurance coverage for either error or omission that caused a loss.
Fidelity bond is really the crime insurance, so it’s theft, misappropriation of funds, embezzlement, etc.
Andrew Chen 42:12
If there’s adequate fidelity bond insurance and there is adequate error and omission insurance, are there any other ways that funds might be lost? Or is it basically bulletproof after that?
Bill Exeter 42:27
Of course, nothing is ever bulletproof. There’s always somebody smarter out there. And that’s what you’re always trying to plan for.
The other area is the financial institution, the bank where the funds are actually held at. In our case, because we’re a trust company, we can spread the funds across a number of banks. We currently spread across eight different banks.
That means we can spread it across eight banks, so the FDIC insurance is $250,000 times eight. So everyone gets $2 million in FDIC insurance. That’s what a lot of qualified intermediaries can’t do because they’re not trust companies.
Andrew Chen 43:02
How far in advance of closing a 1031 transaction do you recommend investors first engage a 1031 administrator? What is the lead time that investors should prepare for in working with a qualified intermediary to hit the deadlines they intend to hit?
Bill Exeter 43:27
Good question. That kind of balance is all over, depending on the company you’re working with and what have you. I’ve seen some companies that say they need at least a week before they can do anything, or lead time.
If it’s a reverse exchange, some say two weeks or three weeks. Some can do immediate turnaround. So, it depends on the company you’re working with.
In our case, we offer same-day service, so we can get things turned around very quickly. The last minute rushes, though, are tough because you just don’t know how many you’re going to get in one day. And if it’s closer to the end of the month, and we get 10 or 15 rushes all of a sudden at the same hour, it’s pretty tough to get that knocked out in time for closing the same day or the next day.
I would say, once you go into contract and all the buyers’ contingencies have been signed off on, so you’re pretty sure it’s a solid deal, that’s probably the perfect time to contact us and get the 1031 exchange open. And that’s probably one week into the transaction, the closing process.
You probably got two, three, or four weeks before you actually close, so it’s plenty of time for us to review documents, catch any errors you might find in the documents and fix things. If it’s a last minute, “We’re closing today” or “We’re closing tomorrow,” we don’t have a whole lot of time to review stuff, so we may miss something because we just have to get it done to even close.
Andrew Chen 44:46
How do qualified intermediaries make money? Is it a flat fee, percent of transaction? And what’s the fee range, just for the QI, that the property owner should expect to spend to do a 1031 exchange?
Bill Exeter 44:58
On the forward exchange side, it varies across the country. On the West Coast, you tend to see more like $700-$750 on the low side to $1000-$1100, maybe even $1200, on the high side.
For a forward exchange, for one sale, one purchase, we’re at $899, so we’re right in the middle of the range. That should include everything. It should include the process, the documentation, the consulting, all of the transactions, the wire transfer fee.
We don’t charge anything extra. It’s a flat fee of $899.
Some people charge wire transfer fees or transaction costs. You’ve got to look at that and see the big picture. You compare apples to apples.
The further you get to the East Coast, you’re going to see some that are $1200-$1800, or even more. I think that’s because there’s less competition on the East Coast. You get more qualified intermediaries that are attorneys, so they typically charge more.
But on a national level, the national qualified intermediaries or institutional qualified intermediaries like us, typically, you’re going to see $700-$750 to, maybe at the high side, $1200. That should include one sale, one purchase. There’s usually additional fees, so if you sell more than one or you buy more than one, it can be anywhere from $300-$500 extra per closing.
And then the third area, which really isn’t a fee per se, but the qualified intermediary retains some of the interest. The bank actually pays the qualified intermediary interest. So, that’s the other area to make money.
In today’s world, interest rates are so small it doesn’t do a whole lot of good, but that is part of how they make money.
Andrew Chen 46:41
So it sounds like it’s basically flat fee. Is that true regardless of the size of the transaction, like if you’re selling a single-family rental property versus just selling an office building in Downtown Manhattan?
Bill Exeter 46:53
It’s pretty much a flat fee, until you hit $10 million. When it goes over $10 million, and you look at the transaction, evaluate it for risk, see what’s involved, there’s usually more consulting involved.
Obviously, we’re doing a transaction with a much greater dollar value, so there’s greater risk. For that, we’ll usually charge more.
If it’s a concurrent transaction, so we don’t hold the funds at all, then we’re not getting any interest, so maybe an additional fee there because we’re not getting revenue on the bank side.
Andrew Chen 47:23
What about reverse transactions, since those are a little bit more complicated?
Bill Exeter 47:26
Reverses are all across the field. I’ve seen some that are down in the $3000 range. Be very careful with those.
With a reverse exchange, there’s a parking arrangement. The qualified intermediary has to hold title to the property. They have to do certain things with that property.
One is they have to report it under financial statements as property acquired and held for sale. They have to report it under tax return as acquired and held for sale. There’s things like that behind the scenes.
Some of the qualified intermediaries that charge a very low fee aren’t doing that. Under audit, your transaction will be disqualified.
And then, next, because we’re holding title to the property, we always use a completely separate, brand new LLC just for that client’s transaction. We never reuse that.
A lot of the exchange companies with those lower fees reuse the same entity over and over and over. It’s just a matter of time before some kind of lien or judgment attaches to the entity, and attaches to all the properties involved.
So, when you look at that from the exchange transaction perspective, the parking arrangement transaction, the separate LLC just for that transaction, all the consulting, and the big one is we’re holding title to the property, so it’s liability.
Most of the reverse exchange fees for exchange companies that really know what they’re doing, you’re looking at $5500-$9500. That’s probably a good range. We’re at $6850.
Andrew Chen 48:54
That’s a helpful mental model for folks thinking about pricing. We talked a little bit about this earlier, but I wanted to drill on a couple of follow-ups regarding changing the use of the property.
If you move out of your primary residence, convert it into rental, we talked about the example of your client who had lived there for 42 years. You can do a 1031.
I just wanted to confirm. Even then, it sounds like there’s no safe harbor duration holding requirement, right? It’s just based on intent.
So, in theory, you could do this and show it even if you held it for investment or rental for a very short period of time. Have I got that right?
Bill Exeter 49:37
Absolutely. A perfect example is a client we talked to just a few months ago, where he did an exchange, bought his replacement property, and just a few months into the transaction, because of COVID-19, he lost his job, etc. He was starting to lose properties, so he sold off some properties and had to move into his rental property just to survive financially.
That will qualify because it was a 1031 exchange. He had the intent to hold it for rental. But there was a purpose: in this case, a medical economic catastrophe that hit him.
And it is what it is. So, if you can show you have the intent but something happened, there was a business reason, an economic reason, etc., it will work. Pandemic is certainly a good way to get around some of those things.
Andrew Chen 50:23
And the kind of documentation you would want to show if you were audited would be things like emails. Are there any other important documents you would recommend folks make sure that they keep a paper trail on?
Bill Exeter 50:39
Historically, it used to be, or it still is, but it was more important to do things like tax returns, financial statements, loan applications. You’d report the properties as held for investment, held for rental, what have you, on those documents. They certainly help, but in today’s world, emails.
And emails can help you, or they could hurt you. If they find the smoking gun in the email, you’re probably in trouble. So, be careful what you put in the emails.
But emails between your advisors, your tax, your legal, your realtor, or your escrow, and the qualified intermediary. All of those emails could help demonstrate what your intent was.
Andrew Chen 51:18
And the opposite scenario where you acquire an investment property through a 1031 exchange, but then, some years later, for example, you subsequently move into that property as a primary residence. What are the tax considerations that real estate investors should keep in mind?
Bill Exeter 51:41
At that point, you’ve done a tax-deferred exchange, it’s tax-deferred, and all you’re doing is changing your intent, so you’re converting it to your primary residence. So the conversion and you moving into the property does not trigger any tax consequences because you haven’t sold anything.
You would really just stop reporting it as a rental property on Schedule E, and you would begin to report it as your primary residence. But that’s really all that’s involved.
And then, somewhere down the road, if you sell it, then you’ve got to hold it for tax. That’s going to fall under Section 121 of the tax code. That’s the $250,000 or $500,000 tax-free exclusion.
Now, if it was investment property first, and then you convert it into a primary residence, it probably won’t get the full $250,000 or $500,000 because the gain is prorated between the number of years you rented it and held it as rental property versus the number of years you lived in it. So, the longer you live in it, the more gain becomes tax-free.
Andrew Chen 52:40
That proration, is it correct that if you moved in as a primary residence, so long as you live there for two years, you’ll get some exclusion under Section 121?
Bill Exeter 52:55
Yes. For example, if you bought it, rented it for two years, then lived in it for two years, it’s 50/50. Fifty percent would be tax-free.
If you rented it for 10 years, moved in it for two years, then 10/12 is going to be taxable, 2/12 would be tax-free.
Andrew Chen 53:13
Sounds good. I wanted to talk a little bit about some broader strategy points for doing these transactions. Is it ever tax advantageous to do a cash out refi before doing a 1031?
And for sake of argument, let’s assume you do that refi sufficiently far in advance of the 1031 that it won’t be challenged by the IRS as being done in anticipation of. What are the circumstances, the conditions that would have to be true for that to be tax advantageous?
Bill Exeter 53:40
Good question. Of course, the risk there is if you refinance prior to, under audit, the IRS would say you really didn’t intend to reinvest the equity. But you hit the nail on the head, which is, if you do it well enough in advance, then it won’t look like you intended to cash out.
I usually recommend at least six months or more before you do a cash out refi, before you actually sell and do an exchange. Generally, advisors recommend that it’s safer if you do the exchange, and then you do a cash out refinance after you acquire your replacement property. Then you’d probably just need to wait two or three months to do the cash out refi.
But your question is: would it make sense to do it beforehand? There are certain scenarios: if you are going into a net lease property, if you’re going into a Delaware statutory trust, things like that.
For Delaware statutory trusts, you can’t refinance and cash out. With a net lease property, it would be very difficult to do that, or they’re cost-prohibitive.
There are ways we go, “What I want to do, my strategies won’t make sense, so I have to do the cash out refi in advance.” In that case, just do it well in advance before you sell and do an exchange.
Andrew Chen 54:48
If you do it in advance versus after the 1031 closes, assuming you had the flexibility to do either, the economic effect should be the same, right?
Bill Exeter 55:00
Andrew Chen 55:03
One thing I’m trying to get my head around is it can be hard to acquire the right property at the right time because it depends on a suitable replacement property even being available, a smooth negotiation and closing process to acquire that property.
And the same is true for the selling of the relinquished property. You need a motivated buyer who can meet your price expectations. You need a smooth closing process.
And when you’re doing a 1031, you have to manage both of these processes in parallel, so they both land at the right time relative to each other. What strategies or advice do you have for investors to maximize the chance that both of those processes go smoothly?
Should they shop for the replacement property first? Should you write offers with a 1031 contingency attached? What are the best practices for making sure you comply with all the deadlines and requirements, and minimizing the chance of things going awry?
Bill Exeter 55:52
Excellent question, especially in today’s market. The key with a 1031 exchange is planning.
Plan everything out. Know exactly what you want to do. Obviously, stuff goes wrong, but have your ducks in a row.
Have your plan ready to go. That way, you know what you’re doing. And then, when something catches you off guard, you can quickly maneuver and address the issue.
In today’s market, you’re getting multiple offers, bidding wars. You’re getting prices in excess of your asking price, etc. So it’s still very much a seller’s market.
On the sale side, you can probably sell your property, tell the buyers, “I’m in the middle of, or I’m trying to do a 1031 exchange. I need you to cooperate with me.”
And there’s enough buyers where you may give up a little bit of the sale price, but you’ll probably find a buyer who’s willing to cooperate and give you a long-term closing or options to extend or something like that. As long as you don’t close the escrow, close the sale transaction, you haven’t triggered your deadline, so you’re okay there.
On the buy side, it gets a little more challenging because it’s still a seller’s market, so the sellers probably aren’t going to cooperate a whole lot. But as you’re going through the process, I would start looking right away.
If you find property you like, see if the seller is willing to cooperate. Sometimes they will. Maybe you could say, “Can I lease your property, pay you a rent every month for whatever, with an option to buy?”
“If you need assurance, can I go under contract and have a long term closing? Can I have options to extend?”
Worst case they can say is “No.” But obviously, they’re getting multiple offers probably, too. So, depending on what you put in your offer, they may not even consider it.
But those are ideas you can look at. This is a tough market because, on the sale side, you’ve got control, but on the buy side, you’re not the seller and you don’t have control. So, really, the focus is probably on the sale side, see if you could get a buyer who could really cooperate with you.
Andrew Chen 57:43
For the property that you’re looking to purchase as a replacement property, if the seller knows that you’re doing a 1031 exchange, does that not give them a lot of leverage over you?
Since the exchange deadlines are non-negotiable, can’t be altered for any reason, if a seller drags their feet, or they’re unscrupulous, or they try to take advantage of the situation somehow, and then the transaction falls through, for whatever reason, you could get screwed. Is that something that 1031 clients need to worry about, or is that not a thing?
And if it is something they need to worry about, how can they mitigate that risk?
Bill Exeter 58:13
I think it’s a really good point. It doesn’t happen a lot because, by and by, most people are good people. But there are people out there who are not, and I have seen it happen.
So, there’s no magic answer to that question. It depends on the investor, their agents. And as you’re going through the process, use your gut instinct if the seller of your replacement property is a good person or not.
You don’t have to disclose that you’re doing a 1031 exchange upfront, from a 1031 exchange perspective. I know there are local laws, customs, and what have you. There’s state forms that require you to do that, but from a 1031 exchange perspective, you don’t have to disclose upfront.
And you’re actually right. If the seller finds out, let’s say you only identified that seller’s property and you’re past the 45-day period, so they know you can’t change your mind, they could come back and try to reprice the property and up it $50,000 or $100,000 just because they know they can, and you’re stuck.
So, you just have to keep your eyes wide open, and figure out what’s best for you and your transaction. But that is a concern.
Andrew Chen 59:24
Are there any common dumb mistakes that investors make that disqualify them from a 1031?
Bill Exeter 59:31
The most common are not doing their homework and not paying attention to the deadlines. It’s the old adage: “You can lead a horse to water, but you can’t force them to drink.”
You’ve got to do your own homework. You’ve got to have your plan in place. You’ve got to understand what your 1031 exchange is all about.
And it’s amazing how people just totally forget about the 45-day. We remind them at least three different times, and they still forget about the identification period, or they forget about the 180-day deadline, or things like that.
And a lot of people don’t get their tax advisor involved and don’t get their legal advisor involved, and then stuff goes wrong. So, to spend a couple of hundred bucks for your CPA to review the transaction is so worth it.
In some cases, it may not be worth doing a 1031 exchange. You may have other loss carry-forwards, or something else that would offset the gain, so it wouldn’t make sense to do that. So, it’s always better to spend an hour or two hours with your CPA and/or legal advisor before you do this, otherwise you end up getting yourself in trouble.
Andrew Chen 1:00:32
And there are specialists, I assume, like CPAs and lawyers, who specifically can very efficiently review 1031 documentation and identify any problematic issues?
Bill Exeter 1:00:43
That’s a good point. A lot of CPAs don’t specialize in real estate. They each have their own niche, so you want to look for a CPA who really has a strong niche in real estate.
And just by interviewing them and asking them open-ended questions, you can probably figure out if they know their real estate stuff or not.
Andrew Chen 1:01:01
I wanted to wrap by talking a little bit about the Biden administration proposed changes. Part of the administration’s economic legislative plan proposes to eliminate tax deferral for 1031 exchanges on real property gains that exceed $500,000. And there’s also a related proposal to eliminate the step up in basis at death for investment gains as well.
These two proposals taken together would essentially gut 1031 exchanges and would have a profound impact to estate planning. What do you think the likelihood is of this type of legislation passing? Are your clients worried about it?
Bill Exeter 1:01:37
That’s a good question. We’re certainly getting a ton of phone calls on it. And I think one of the reasons that the 1031 exchange volume has exploded since last August is partially because of this.
There’s certainly a lot of other issues, too: the pent-up demand for COVID, and all the cash that’s built up, and the stimulus, and the PPP loans, and all of those phenomenally low interest rates, etc.
But there’s the fear that “What if 1031s go away?” I’ve seen a lot of people who are trying to reposition today in case it does.
What I can say is I’ve been doing this for 37 years. This comes up every three to five years. Almost every Congress in almost every administration has proposed something.
And what happens is they think that if you change, alter, or eliminate 1031 exchanges, all the investors would still sell and then pay all the tax. In reality, what happens is 60%, maybe 70% of the investors say, “I just wouldn’t sell. If I can’t defer my taxes and trade up into a bigger property, I just won’t sell.”
And then you have two agents, two accountants, two attorneys, two title companies, two escrow, two lenders, etc. that don’t get revenue, and they don’t pay tax. So, rather than a revenue raiser, it turns out to be a revenue loser for the government.
And then you get people who are trying to make this a democratic thing or a republican thing, and it’s not. Every Congress, every administration, has tried this, or tried something.
It’s more of an educational thing where you have to sit down with Congress, you have to sit down with the administration, and really walk them through, “What is a 1031 exchange, what are the benefits, and what would happen if you did this?”
And the last threat was about five years ago. About 16 different trade groups formed a coalition and hired Ernst & Young. Ernst & Young came back and said, “If 1031 exchanges went away, GDP would drop by 0.8%.”
Now, GDP is the measure of the U.S. economy. And back then, the GDP was about 1.9%-2%, so that’s about a 40%-45% drop in the national economy just by eliminating 1031 exchanges, because of all the parties that it touches with each transaction. So, it’s a huge issue.
In this case, the Biden campaign proposed a little different, which was, if they made over $400,000, you couldn’t do a 1031; if you made less than $400,000, you could. They’ve now changed it.
The American Families Plan came out last week and said, “If you have more than $500,000 in gain, it can’t be deferred.” If you read it (actually, I’ll quote it), it says, “The President would also end a special real estate tax break that allows real estate investors to defer taxation when they have changed property for gains greater than $500,000.”
So, my question is: Does that mean if you have more than $500,000, you can still 1031 exchange, but only the first $500,000 could be tax-deferred? Does that mean that if your gain is over $500,000, you can’t do a 1031 exchange?
I’ve seen opinions on both sides of that, so I’m not sure exactly what it means. We’ll have to wait until we get more details out there. But as to how likely, in 37 years, we’ve managed to fight off all of the changes that would affect real estate, but it’s always possible.
Andrew Chen 1:04:53
You mentioned that there’s some evidence or studies to suggest that two-thirds of investors just wouldn’t sell. But if they’re doing that in anticipation of just holding it until death so that they can get a full step up in basis, but the Biden plan proposes to eliminate that as well, maybe the chance is very low, but were both of those things to pass, would you expect there to be a drastic change in behavior and activity in the market as a result?
Bill Exeter 1:05:28
I think there would certainly be a decline in the 1031 exchange business or transaction activity. I don’t know if it would be drastic because you’ve got a number of different issues moving there.
At the same time, he’s also proposing that if you make more than $1 million per year, your capital gain rate goes to 39.6%. So you’ve got people who are going to say, “I am not going to pay 39.6%.” So they may still try to do a 1031 exchange if they could defer some of their gain.
So, you’ve got that working there. And then I think most people would realize that if he takes away the step up in cost basis, it can be put back. So, it’s hard to say what would happen, and obviously, every administration makes changes.
I think it would reduce the level of activity. The question is how much. I’m not sure it would be drastic.
I think the definition of what I just read depends. If it eliminates anything and you just can’t do it, that would be probably a drastic reduction. If you could defer the first $500,000, it’s probably a reduction, but not necessarily drastic.
Andrew Chen 1:06:30
Is there anything that real estate investors can do strategically, potentially even now, to mitigate risk or perceived risk of adverse tax consequences that might result from these proposals?
Bill Exeter 1:06:41
Certainly, that’s one of the reasons we’re seeing a huge volume. People are trying to reposition their properties today and take advantage of the 1031 exchange just in case it does go away or gets limited somehow.
This plan is just the beginning. It’s not even submitted in a bill or legislative format. It’s just his plan.
So now, it goes into negotiations, and it’s going to change. There’s going to be a lot of changes in this plan. If everything were to pass, the economy would be in deep trouble.
This is just his wish list. And then, from there, we’ll see what happens.
But if you’re worried about the step up in cost basis, if you’re worried about the 1031 going away, I think you reposition today to make sure you could do it on a tax-deferred basis before any changes might occur.
Andrew Chen 1:07:30
How long would it take for something like this to play out in the legislative process?
Bill Exeter 1:07:35
Normally, it would take a little while. In this case, with the democrats in control of the White House and the House and the Senate for the most part, it could go through. They’re going to have to run this through with a budget reconciliation process.
They did the first stimulus package with that. I’m not sure they’re going to get this one through with a budget reconciliation process. There’s even some democrats that have come out, and they’re shaking their heads, thinking, “What is he thinking?”
With that, I think you’re going to have to make sure all of the democrats vote for it, and I’m not sure that’s possible. And there’s more democrat millionaires in Congress than there are republican leaders. These guys do 1031 exchanges also, and they want the step up in cost basis also, so that affects them as well.
Andrew Chen 1:08:23
Well, this has been insanely helpful and super insightful. I’m really glad to have chatted with you. Where can people find out more about you and your work and services?
Bill Exeter 1:08:33
They can call me direct if they want to do that. My office number here in San Diego, which is our headquarters, is 619 239 3091. They can go to our website, exeterco.com.
And if they want to try to weigh in on their opinions on the proposed changes, they can go to 1031taxreform.com. There’s all sorts of sample and form letters and what have you. It’s important to let them know what your opinion is.
I get a lot of people who say, “Well, I’m just me. Who cares? They’re not going to read all these letters.”
You’re absolutely right. They don’t read all these letters, but what they do is they tally them up to all the no’s and all the yeses. And if they get a ton of no’s, that tells them the constituents are not in favor of this.
So, I highly recommend going to 1031taxreform.com and let them know what your opinion is.
Andrew Chen 1:09:33
All right. Thanks, Bill. We’ll definitely link to all that stuff in the show notes.
Thanks so much again for sharing your thoughts and tips with us today. And I look forward to sharing this with our audience.
Bill Exeter 1:09:44
My pleasure. Anytime.
Andrew Chen 1:09:45
Cheers. Take care.
Bill Exeter 1:09:46