Real Life Planning Podcast Ep 40: Financial Planning for a 1031 Exchange

In Episode 40, Cynthia Meyer, CFA®, CFP®, ChFC®,  shares insights on financial planning for a 1031 exchange, explaining what it is, its strategic benefits, and key considerations for real estate investors. Learn how to optimize your real estate portfolio by understanding like-kind properties, strict time limits, and the importance of pre-planning.

"...this is a powerful strategic planning tool in your real estate business if you use it correctly." - Cynthia Meyer

This week on Real Life Planning Podcast:

Takeaway Quotes:

"You're going to want to get some tax help in the year you do a 1031 exchange. That is not the time to DIY your taxes.” - Cynthia Meyer

"Knowing well in advance what you want to do and what your end goal is, can help you optimize your tax situation in the long run.” - Cynthia Meyer

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About the Real Life Planning Podcast

Hosts Cynthia Meyer and Vekevia Tillman-Jones explore practical steps for real estate investors to build financial freedom and make working for someone else optional.

Transcript- Episode 40

[00:00:11] This is the Real Life Planning Podcast Episode 40 and today we're talking about financial planning to get ready for a 1031 exchange. So as you know, I'm a CERTIFIED FINANCIAL PLANNER™ and I'm not a CPA or a tax advisor. So I want you to think of this conversation as being educational. There's a lot of tax planning involved in financial planning, but for tax advice, of course, you're always going to want to see your tax advisor.

[00:00:41] However, if you're a real estate investor, you know that there are a lot of tax planning decisions that go into making changes in your real estate portfolio. And it's important that you get well ahead of those decisions. A lot of times by the time you sold the property, for example, it's too late or the time is scrunched to make a decision about the replacement property; what you're going to put that money into. And So knowing well in advance what you want to do and what your end goal is, can help you optimize your long-term tax situation in the long run. So today we're going to talk about 1031 exchanges. What they are. Some special tips about them and how you can plan for a successful 1031 exchange that's going to help you build and scale your real estate portfolio.

[00:01:39] So what is a 1031 exchange? This comes from IRS section 1031 and it allows the taxpayer to defer the taxation or what's called the recognition of a capital gain if proceeds are invested in a like kind property. So when that happens, the adjusted basis carries over into the new property. So the original purchase price of the property that you sold, adjusted for improvements and depreciation that you've taken, carries over into the replacement property.

[00:02:21] Why is this so important in real estate investing? In short, it's because you get to reinvest, especially if you've had an appreciated property, you get to reinvest the entire proceeds from the sale net of the cost of sale into the new property. So you can scale your real estate portfolio a little bit faster.

[00:02:45] You can also borrow beyond what your original borrowing was for the property that you sold, which is called the relinquished property and you can buy a property, a replacement property, that has more units or doors. You can also buy a larger property that generates more cash flow. So this is a powerful strategic planning tool in your real estate business if you use it correctly.

[00:03:14] Let's dig in a little bit about what it means to be a like kind property. It's not as cumbersome as you would think. According to the IRS, properties are of like kind if they're of the same nature or character, even if they differ in grade or quality. So practically speaking, what that means is that you can exchange a single family home for a triple net lease. You could exchange raw land for a multi family property. You could exchange a small multi family property for a large apartment building. You could exchange basically one kind of real estate for the other, right? A self storage facility for for an apartment building. You know, sky's the limit really as long as the property is a similar in nature or character. So pretty pretty broad ability to exchange into a replacement property. 

[00:04:10] What you can't do in general is you can't exchange, for example, you can't exchange a rental property for a financial planning business. So those are not in the same nature or character. Few things that people should know about a 1031 exchange well in advance of actually putting their original property on the market. The first is that a replacement property cannot be for personal use. A 1031 exchange is done for property used in a trade or business investment or business purposes, not for personal use. So you cannot 1031 exchange your single family home that you live in. You can't 1031 exchange into a. a property that you plan to live in or use as your 100 percent personal vacation property, right? That's not allowed. 

[00:05:01]The other thing is that it must be from same taxpayer or taxpayers to same taxpayers. So if you own a property individually, you must exchange it into a property that is also hold held individually. If you own a property joint as joint tenants with your spouse, the replacement property must be held as joint tenants with your spouse. If you own a property in partnership with your best friend, then you have to exchange it into a property held with your best friend. 

[00:05:33] Sometimes, well in advance and preferably many years in advance of making a 1031 exchange transaction, you want to think about the structure of, corporate structure of what you want to end up in. So, if in the long run you want your properties in an LLC, for example, a limited liability company, the time to do that is preferably a year or more before you actually do a 1031 exchange of the property that you're looking to sell. So you want to get ahead of that. 

[00:06:04] Sometimes this comes up as a planning issue, for example, couples that are splitting up. They own a property, joint tenants, and one's divorcing spouse wants to do a 1031 exchange, the other one doesn't. That's generally very challenging to do, for example, because, again, they own the property as a unit, as a joint tenants unit, and they were trying, they would need to 1031 exchange it into a joint tenants unit.

[00:06:30] What folks do, and again, this is, I'm not, this is not legal advice, just education, if there are changes that you want to make to the ownership structure of the property, for example, switching from joint tenants with right of survivorship to a tenants in common structure which is more like a condo type, the way condos are owned.

[00:06:50] For example, how to extricate yourself after the 1031 from a relationship with a business partner. Then you want to do that again, well in advance, preferably at a year or more in advance of doing the 1031 exchange transaction. So again, talk to your accountant, talk to your attorney if you have issues around titling and taxpayer IDs well in advance of making 1031 exchange.

[00:07:18] The next thing you need to know is that the replacement property in a 1031 has to be of equal or higher value in order to have a completely tax deferred exchange. It, it, if you, If it is not of equal or higher value, you're going to pay some taxes on ,whatever's left over, and we'll talk about that concept in a second.

[00:07:41] The other thing to know is that the replacement property needs to have a similar leverage structure or you can put some cash in lieu of the loan. So the amount of the mortgage on the replacement property must also be the same or greater than the mortgage on the property that is being sold. So when you're moving from a property that you've sold into the replacement property the equity position needs to be the same and the loan position needs to be the same or can be higher. Now, you can always put more cash in the deal. You can put in more equity. You can put in You can put in cash in lieu of having a mortgage, but you can't take less without paying taxes.

[00:08:21] If you If it's an unequal exchange, so for example, the replacement property is worth more You excuse me, the relinquished property is worth more than the replacement property, or you take less of a loan with the replacement property, for example, you're going to pay what's taxes on something called BOOT, B-O-O-T, and BOOT is defined as the money or the fair market value of other property that's received by the taxpayer in a 1031 exchange.

[00:08:47] So it includes all the cash equivalents. plus liabilities, and that's an important concept to understand, that are assumed by the other party, or liabilities to which the property is exchanged, property exchanged by the taxpayer is subject to. So that sounds like a lot of, a lot of taxpayer legal stuff there, but what it means basically is that you have to put the same amount of equity or higher and the same amount of loan or higher or cash in lieu, otherwise you're going to pay taxes on BOOT.

[00:09:15] So common thing that folks don't understand is they think they can just 1031 exchange the equity right but not the loan part of the property that they're selling and that unfortunately is not true. If you don't take the same amount of loan or higher or put cash into the exchange in lieu of having the mortgage then you will pay taxes on the loan that doesn't carry forward.

[00:09:40] Important concept to understand. 

[00:09:41] There are really strict time limits to a 1031 exchange and as a financial planner, I encourage clients to start planning well in advance of putting the property that they want to sell, which is called the relinquished property; of putting that property that they want to sell up on the market.

[00:10:03] So, Know what you want to exchange into before you even get started and here's why. When you sell the original property, your money is going to go with a qualified immediate intermediary, a trust company that's going to hold that money for you during the 1031 exchange process and you have 45 days from the sale of the relinquished property to either close on a replacement property or properties or to identify properties and there are three formulas that you can use to identify properties on day 45, if you haven't closed the exchange by the end of- meaning bought a new replacement property by the end of 45 days.

[00:10:43] You also have only 180 days from the day of the original sale to close on any of those identified properties that you identified by day 45. So, practically speaking, think of it this way. You sell your replacement, You sell your relinquished property, the money goes to the qualified intermediary, you're sitting there with cash.

[00:11:06] You can buy as many properties, You can buy properties between day zero and day 45 and close on them before day 45, but if you have any of the funds left over from the exchange on day 45, then you must identify up to, in the typical formula, up to three replacement properties, and you have to close on one of those replacement properties by the 180th day.

[00:11:28] So it's just, It's not exactly 6 months, it's 180 days exactly. And that's a very strict deadline, and it's not negotiable. So 

[00:11:36] There are a number of different ways to meet that window, right? But again, the most common identification formula is called the three property rule. You identify three properties of any value within those 45 days, and then you have to close on one of them within 180 days after the sale of the original property.

[00:11:58] So in order to make that happen, you really want to know what you want to buy before you even sell your relinquished property because that's a really short timeline in real estate unless you're doing an all cash transaction. And 

[00:12:11] I have seen clients who did not successfully complete a 1031 exchange, not completed because they didn't find anything during that 45 day window that they really wanted to buy. So they didn't have a good pipeline of properties to put on their identification formula by day 45. 

[00:12:33] Now, if this is a complicated exchange or there are, for example, somebody is exchanging a whole portfolio of properties for another portfolio of properties, there are other identification rules. One's called the 200 percent rule. The other one's called the 95 percent rule. For most real estate investors, unless you're super sophisticated and have a large portfolio, that is probably not going to apply. So I'm not going to spend a lot of time on that right now.

[00:12:56] Now going back again to the idea that you can acquire replacement properties within that initial 45 day window, right? They're basically considered identified properties by default basis. So in that situation, you could exchange one property, for example, that was kind of expensive for multiple lower priced properties. Again, as long as in the end result, you have the same amount of equity or higher and the same amount of debt or higher.

[00:13:29] Another thing that you want to do prior to prior to initiating this transaction is to identify a qualified intermediary. That can't be you under any circumstances. It cannot be you. Okay. Any person who is the exchanger is a disqualified person. So typically, it's a law firm. It's a professional 1031 exchange company that specializes in 1031 exchange and who understands real estate transactions and real estate taxation.

[00:13:58] There are many reputable 1031 exchange intermediaries. And That intermediary acts like the escrow company. They hold the funds for you, so they step into the exchanger's position, and they prevent the exchanger, you, from accessing those funds transferred during the exchange so as not to violate that like kind property rule. Basically, So somebody is holding the money for you, in escrow for you, and you're going to when you're ready to buy the replacement property, then they're going to send that money to closing on the replacement property.

[00:14:30] So there is a little bureaucracy. There's some paperwork involved. You have to be respectful of deadlines and hopefully communicate in advance what the closing instructions are to your 1031 intermediary. For example, Everybody including your real estate agents on both ends of the transaction needs to be understand that this is a 1031 exchange and what the deadlines are.

[00:14:51] A few years ago, my husband, Steve, and I did something called a reverse 1031 exchange. That's when you buy the replacement property before you sell the relinquished property. And That's probably a topic for a whole other podcast, but just know that's possible. It's a more expensive transaction than a typical forward exchange and so it only makes sense when there's a very large capital gain that you're trying to defer and where you have a clearly identified replacement property before you've even put the relinquished property on the market. Just put that in the back of your mind. Know that it might come up in the future and put that in your menu of tools. So If it does come up, you can know to talk to your financial planner and your accountant about it.

[00:15:39] Again, you need to know well in advance of doing a reverse 1031 what you want to do before you actually do it.

[00:15:46] Just to sum up here, some of the most important points of planning for a 1031 exchange, right? In terms of what you do well in advance of the 1031 exchange actually happening.

[00:16:00] The first is to know what your end goal is. Are you trying to exchange into a property that is more expensive, that has higher cash flow, that has more doors, that's in a different state? If you have goals for ending up in a different corporate structure. You have got to execute on those goals well in advance of selling the relinquished property. You cannot do it at the same time as a 1031 exchange. 

[00:16:30] The other thing to know is that the property must, that you exchange into must be of like kind. It must to be of similar nature or character. That's a pretty broad definition and so the typical real estate investor is often trying to capture the, a highly appreciated property to capture those gains where the rental return as a percentage of the asset; current asset value has become lower because the asset has really appreciated a lot. They're trying to capture that and use that as a higher down payment on a more expensive property with possibly more doors and or higher cash flow for the replacement property. Right? So it's a scaling or a building tool in your real estate business. 

[00:17:13] Also know that original basis of the property that you sold carries over on an adjusted basis into the new property. And so You're going to want to get some tax help in the year you do a 1031 exchange. That is not the time to DIY your taxes. You do want a professional tax advisor to help you with tax prep during that year and to make sure that everything is reported correctly.

[00:17:38] If you've got a property that is highly appreciated or something that you're thinking about selling it, you certainly want to discuss this, not just with your REALTOR®, but discuss it with your financial planner and your accountant well in advance, maybe up to a year in advance of doing it so that you can dig through some of these questions and decide if any changes need to happen; what your strategic goals are for the 1031 exchange. That you fully understand the taxation of whatever is not going to be exchanged. So you're not caught unaware with the tax bill after the exchange and that you think through your strategic goals for the whole process. 

[00:18:17] So I hope that's helpful. We've got different content on the Real Life Planning Podcast and in our Question of the Week about 1031 exchanges.

[00:18:27] So leave me your notes or comments or questions below. And next time we'll dig into a reverse 1031.

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