Ep. 3 | 1031 Exchange. Use It, or Lose It.
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Speaker 2:Welcome back to the podcast, everybody. It's episode three time already with teaching tax flow. I am your host, cohost, little with the most. Host with the most. I will take it.
Speaker 2:You know what? They always say to hang out with better looking, smarter people than yourself. That's why I'm here with Chris Pacuro. Again, CPA, m m m m a, a, b, c, d, e. Now that wrestling.
Speaker 2:Right? The the credentials just blow my mind. Anyways, I'll I'll stop I'll stop with that one because we'll go on forever.
Speaker 3:Check the show notes. Check the see them all. Why?
Speaker 2:I I mean, my can you read all my notes all the time? This is this is stuff that that gets exciting to me. But in a little bit of my notes, I see one thing in there and and here's the title. Ready? Drum roll.
Speaker 2:Sound Ten thirty one exchange. I like that. You know? We think we can do, like, a little sauce. That's nice.
Speaker 3:Real proud of you. It's real nice.
Speaker 2:Thank you. I you know, I tried. I tried. My drum roll skills are no. They're not on point.
Speaker 2:Let's not lie. So ten thirty one exchange, what is Yeah. What does this mean? It's not a lotto number. It's something that's pretty important.
Speaker 2:Obviously, a lot of people in the in the REI, so the real estate investor world or or not even the real estate investor. I mean, you could just be going from one property to that. Maybe you like to move. Maybe you did move. Obviously, the market's changed.
Speaker 2:So let's talk about this. What's actually, Chris, let's start off. What is a $10.31 exchange? Hit hit me with that definition.
Speaker 3:With the hardcore.
Speaker 2:Straight to the straight to the Alright. So I won't
Speaker 3:I have no more wrap up for me. So they we talk about in teaching tax. So first of all, thank you for listening. John was so rude he didn't thank our listeners.
Speaker 2:You know, it's it is.
Speaker 3:We appreciate your open mindedness and your time. We talk about in teaching tax law that tax laws are written to encourage or discourage certain financial and social behavior. Poor John's gonna have this he's gonna be thinking about this this line all the time.
Speaker 2:I already have it tattooed on my army today. Oh, that's
Speaker 3:pretty cool. I'm impressed.
Speaker 2:Right. That's really nice.
Speaker 3:Did you get it did you get it done here at Panama City Beach?
Speaker 2:I'm I did it myself, actually.
Speaker 3:Oh, cool. A little yeah. Personal style.
Speaker 2:It may it may have been a Sharpie. But yeah. So let's start.
Speaker 3:Alright. So we are actually sitting in a 10:31 Exchange property right now.
Speaker 2:And that's not your address here. Your address is not 1031. No. Even though that would be on That'd be pretty sweet. 31 On Exchange Avenue.
Speaker 2:Probably in Charleston. There's meetings between I'm sure we can find it.
Speaker 3:Anyway, so 1031. What is it? Well, 1031 is a section of the tax code that allows for you, if you own a piece of real estate, to sell it and exchange it for like kind property and defer any tax on that exchange. Now there are certain rules that I'm gonna touch on from a 30,000 foot view to consider. But when we're thinking about, excuse me, we're thinking about that transaction, there's a big tax advantage if you and if if it makes sense for you.
Speaker 3:So if you're engaged into selling a property and you don't necessarily need the proceeds from that sale in within your lifestyle, it would make sense and it makes sense to deploy those proceeds into additional investments. Then why pay your involuntary business partner, I e taxing agencies, a portion of your profit?
Speaker 2:So what you're saying there too so let let me let me get this straight here. So a $10.31 exchange. Okay? So say say we have a property that is we'll just say a hundred thousand dollars. Okay.
Speaker 2:Just a just a simple number so we can say this. So say I bought that property for say it was a distressed. So say we bought it for $30. K. We put 20 into this thing.
Speaker 2:So now I'm 50,000 into this property, have it for a couple years. Say it's a primary residence. We won't we won't complicate it or it's an investment property. So 50 k into this and I sell it for a hundred. What do I do?
Speaker 3:Well, let's let's think about it as an investment property because a primary residence has there are different rules and that's section one twenty one. Spoiler alert, we're gonna have an episode on that in the future. But if it's an investment property, what's gonna happen, you're gonna let's say you have $50,000 into the property, you've owned it for a couple years, it was a rental property, you've taken a depreciation deduction on it, which we're gonna have some episodes on that. And your adjusted cost basis, meaning what the the capitalized portion of that property of 50,000. Let's say you've depreciated $3,000 or depreciation is just a fancy word for a tax deduction.
Speaker 3:So your cost basis, 50 minus the three is 47,000. You sell it for a hundred thousand, you have a $53,000 gain. A portion of that gain is considered depreciation recapture. A portion is long long term capital gain. But you don't need that $53,000.
Speaker 3:You want to buy a multi family home. And that multi family home is going to cost you $200,000. So instead of trying to come up with your down payment, you use that $53,000 and roll it into your down payment on the multifamily property and finance the remaining amount. Now, you do you avoid paying the tax on that $53,000 gain based on your marginal tax rate. And that's let's say it's 20% with long term capital gain in state.
Speaker 3:Obviously, everyone's situation is different. But in that case, you would have had to pay your business partner, involuntary business partners, $10,000 of your profit.
Speaker 2:And the IRS is the
Speaker 3:Yeah. IRS or state taxing authority or local, some there's some localities that have state income tax. So instead of having to pay them, you roll it into a like kind property. $10.31 is a like kind exchange. Now, remember, let's assume you bought a single family home, you can roll it into a multi family home.
Speaker 3:You can roll that, you can exchange it into a commercial property. You can exchange it into various types of real estate. Like kind the term like kind is loose within the tax code. It doesn't mean single family home for single family home, residential for residential. Now, that's the the 30,000 foot view of what you're doing.
Speaker 3:But this is not something that you should do on your own.
Speaker 2:Right. So that being said, so just to make sure that I got this right. So obviously, everybody always has their first investment property. Right? So we we've either all been through this or will be through this at one point.
Speaker 2:So you sell that house. Say it's on 1031 Exchange Avenue. Mhmm. You you you have a profit you have to work with. I just got the money in the bank.
Speaker 2:Bam. Hit my bank account. Excellent. I'm a happy camper. I made money on this.
Speaker 2:I've been you know, it's been cash flowing for the past few years, etcetera, etcetera. Got the money in my bank. I think it's time I I'm gonna go start looking for a property. How much time do I have to do that?
Speaker 3:Good question. Well, we do have a little problem in this scenario, my friend. If you want to engage in a ten thirty one exchange, you cannot take the money into your and put it in your personal bank account. You must use what's called a qualified intermediary. And that qualified intermediary is typically a law firm, a title company, or some type of third party that takes the takes the funds that you received at closing when you sold the property and puts them in escrow for you.
Speaker 3:And they are in escrow for you to be deployed into the next property. There are rules as you've you've heard about where you have forty five days to identify replacement property and you have a hundred and eighty days not six months, a hundred and eighty days to actually close or complete the exchange. Those are key dates that your realtors that are you're gonna be working with are gonna help you with and you're in the qualified intermediary.
Speaker 2:Well, now the audience knows. Right? So there you go. There there's the piece of information. There's a lot more to it, obviously.
Speaker 3:Exactly. But this is important, and that's that's a common mishap. And that's why we're use that's one of the main reasons we have teaching tax flow. We want people that might only sell a property once or twice in their life to have the same access to the professional network that we have for people that are selling three, four, five properties a month.
Speaker 2:And that too. Right? Like, that that first check you, in a sense, have to have to write on capital gains tax. Hopefully, people can avoid that. Right?
Speaker 2:So the so let me make sure that I'm hearing this right. So we have this property. It's let's let's go back a little bit. Let's say it's under contract to be sold. It hasn't been sold yet.
Speaker 2:That $50 has not hit my bank account yet. Mhmm. So it's it's not sitting in my my checking account. The vacation's not looking fantastic. Right?
Speaker 2:It looks fantastic, but, you know, heck, I don't have the money to do it yet. So this $10.31 exchange that you speak of here, sir, this is something that needs to be part of a strategy ahead of time. Right? So before you get to that closing table, you need to have that discussion with your team, or your board of directors as we like to call it, and and you're planning for this activity, this exchange.
Speaker 3:Very important to do yes. You you need to know that you are you have to do something called open an exchange. And when you open that exchange, that means that the the title company or understands that that money is going to your qualified intermediary. At that point, it's probably a good idea to start looking at replacement property. You don't have to officially identify a replacement property, but start looking at it.
Speaker 3:There's one other thing that's very, very important, another pitfall that I see. You need to deploy the gross sales price of the relinquished or sold property minus, like, closing costs and that sort of stuff into a new property. You you're not deploying, in our example, the 53 the 50,000, 3 thousand dollars. You have to buy replacement property for a hundred thousand dollars. And, funny, we say that because that's one of the three laws of teaching tax flow.
Speaker 3:Cash flow does not equal tax flow. What you receive at closing, all that is is how much you sold your property for minus the closing cost, minus any liens or mortgages against it. That has nothing to do, and it's not directly correlated to what your cost basis is on your tax return. And that's why you have to understand that cash flow versus tax flow. We have clients that receive a ton of money at closing, but not much is taxable.
Speaker 3:We have some clients, or some taxpayers, or some even people in the teaching tax flow community that might receive a small amount of money at closing but have a huge capital gain because maybe they pulled some equity out of that property previously. So understanding the tax flow versus cash flow and making sure that you have the resources available to complete the ten thirty one exchange is very important. Now those resources could be financial resources. Those resources could be bankable being bankable because your financial situation could change and your board of directors that we always refer to. So there are other more creative ways to complete a ten thirty one exchange if you're having trouble finding replacement property or you're having trouble getting financing, to make sure that you can complete an exchange.
Speaker 2:And I know the conversations we've we've had around this. It's always mind blowing to me. So me personally, I I'm not a CPA. You you literally are my my guiding light in the financial world. So let let's let's put this in in simple terms, AKA terms for myself.
Speaker 2:So going back to this property on Exchange Street. So say I'm saying 50,000 in it, you know, 47, 50 grand, sell it for a hundred. I have my 50,000, say, in actually, it never touched my bank account. We're still in that scenario. So it's with a qualified intermediary.
Speaker 2:Correct. So they have my 50,000 there. I'm out looking for properties. I know I got a little time. Mhmm.
Speaker 2:The area I live in will say that it has a lot of inventory, so a lot of opportunity. I come across a great distressed property Okay. For, say, it's 55,000. So it's a little over my 50 in cash. Gotta put a couple more bucks into it.
Speaker 2:It's a great opportunity for me. I say, yes. This is it. I want I wanna go ahead with this, and then Chris throws up the giant stop sign. I'm like, well, what do you mean?
Speaker 2:I'm using I'm using the cash that I have available. That's what you're saying is even though you've got the quote, unquote cash, so your profit per se in this property, that's not you're not gonna go buy a property for that. It has to be that entire amount what that property sold for. So that hundred thousand ish
Speaker 3:You have to buy well, yes and no. Pretty much every quest answers. Right?
Speaker 2:Well, you're in the tax room. Right? There's no there's no definite definite
Speaker 3:answers. So that can be part of a replacement property. You can ten thirty one exchange from one property and buy multiple properties.
Speaker 2:Okay. So I could buy two for 50,000. You could buy two. Collectively, it's that hundred.
Speaker 3:Exactly. So it could be part of the replacement property. And we see that quite often.
Speaker 2:So really that's how somebody could build a build a smaller portfolio.
Speaker 3:Yes. Because you're not exactly. So this hits on the teaching tax flow. It hits on our red diagnosis, which is needing a tax reduction. Purple, which is tax deferral.
Speaker 3:And gold, tax free income and growth because the nice thing is, especially if you buy investment property, let's say you in your example, you bought property for $50,000 and, you depreciated something and you sold it for a hundred thousand dollars. Let's say you buy that replacement property for that hundred thousand dollars. Right? And that property increases in value to 200,000. Okay?
Speaker 3:Let's say you get hit by a beer truck. Well, guess what? Your child inherits the property. That property, they they get what's called a step up in basis and they get to start depreciating the property or their cost basis is at the 200,000. So we don't want to get into the weeds too much about stepped up cost basis, but just understand that the ten thirty one exchange is it hits our red, purple, and gold tax strategies.
Speaker 3:So we're not recommending that just because you sell a property do a ten thirty one exchange. What you need to figure out is does it fit your personal lifestyle? Your personal financials, picture right now? And we always say don't let the tax tail wag the dog. So figure out where you would be, we always talk about the our four step process.
Speaker 3:Figure out where you're at if you do nothing. Diagnose yourself. And is a ten thirty one exchange exchange a prescription? For my myself personally, it worked out. It worked out to complete the ten thirty one exchange.
Speaker 3:But if I was in a different situation, it might not. So really a lot of time and and there's we've run into clients that this one really, you know, is a toughie where they have a huge what's called capital loss carry forwarding. They have all these capital losses on their tax term they'll never be able to use. And then they do a ten thirty one exchange. When they could have had these capital gains, tax free.
Speaker 3:So teaching tax flow is what remember what's important is legally and ethically reduce the tax you pay in your lifetime. So diagnose, prescribe, for a lot of people ten thirty one exchange makes sense. And it's not always real estate investors. You could ten thirty one exchange land. What if you bought land five, ten years ago and you're gonna build a cabin and it just never worked out and you and you wanna sell it and and put that money into something asset income producing that you're not really involved with.
Speaker 3:Maybe you wanna buy 2% of an apartment complex. So, again, back to your board of directors, John. Make sure you have your board of directors. Make sure you have the people in your life that can help you with these decisions. And the beautiful thing about teaching tax flow, like I said, as a listener, you have access to the same resources that our clients in our personal or in our private tax practice that do four or five properties a month half.
Speaker 2:And And you've been doing this, you know, for what? Ninety years? You you've been doing this for about Years. Yeah. He said that he's he's one of the most fit individuals I know.
Speaker 2:So the and I'm over here kinda smirking, and I I know you you probably wanna backhand me because you don't know what I'm gonna say ever. But we have the we have these tools. Right? So we we've basically did a little brain surgery on you. That that's where teaching tax law, you know, TTF has come from.
Speaker 2:We've removed your brain. We put it on the table. We've dissected this, extracted all the information, and we created these little resources we like to call our calculators. So without going into detail on those, some of these calculators are obviously part of what you said. Again, available available for all of our audience on there.
Speaker 2:Part of, you know, part of t t or I can't talk. Teaching Tax Law. See, again, we stumbled on my words. I'm excited
Speaker 3:about this,
Speaker 2:but that and really these decisions are something that, again, need to be planned for. It's not something you can do, you know, just on the whim afterwards. Here's a question I've actually never asked you, though. So I don't know what the what the response is gonna be. And now Chris is looking at me with oh, boy.
Speaker 2:Here we go. It's almost like when a best man is gonna say something at your wedding, and he may have had a little too much fun
Speaker 3:Mhmm.
Speaker 2:Before he got up there. What if you what if you sell a property Mhmm. That money does hit your bank account and you go, oh, boy. I didn't know about a 10:31. Is it too late?
Speaker 2:Yes.
Speaker 3:It's gonna be too late. But in that case what I would recommend is take a look at different tax strategies based on your diagnosis that you could potentially deploy and we're gonna be talking about a lot of those strategies in other episodes. Excellent. It would be too late. Now, something to consider is there's something called the reverse exchange.
Speaker 2:Oh, I haven't heard this before. So what
Speaker 3:can happen is you couldn't potentially close on your replacement property if the closing on your your relinquished property gets delayed. Okay. So, again, we're going to make sure that anyone that doesn't have a qualified intermediary in their life and the professionals around them have access to that.
Speaker 2:Excellent. Well, thank you again for letting us dive into your brain. I'll get out of your head now. It didn't hurt
Speaker 3:that much. No. Thank you.
Speaker 2:And and I I think I'm still say I'm still a little bit shy, though, after that last episode we did about LLCs, you know, I I tend to not ask these questions. But although if we're recording it, it's documented if he clunks me over the head with a frying pan. Yep.
Speaker 3:Yep. Don't be so sheep don't be sheepish.
Speaker 2:I I actually I don't even know where your pans are in here now that I think about that. We're sitting in a new place that you I I assume you wanted to place. Absolutely. So here we are. And yeah.
Speaker 2:So and frankly, I think that's that's all we should get into now. I know there's a lot of a lot of different conversations we could have around this, but I'm gonna go enjoy some sunshine. If if I'm here in Florida and being from Michigan, I'm gonna I'm gonna work on my tan.
Speaker 3:I I I understand and I used to, you know, I used to reside in Michigan so I understand that the wind that the, it's not sunny all year round. But so and thanks again for listening. We appreciate your attention. Check out teachingtaxflow.com. We're adding content all the time.
Speaker 3:Please rate, review, subscribe, and any feedback is appreciated. Any show topics, any questions that you have. This this this whole platform is for you. You the listener, you the taxpayer. It's an opportunity for people that have been in this business for a long time to give back and for you to absorb it.
Speaker 3:So we want to hear from you. Excellent.
Speaker 2:Well, thank you as always, Chris. Thank you everybody for listening in on episode three, the 10:31 exchange. So if you haven't if you didn't know what that was before, now you know. It's just not an address.
Speaker 3:You know what we should call us? What do you got? The Halloween strategy because it's 10:31. From now
Speaker 2:on, I've never actually
Speaker 3:thought about that. I just thought of it now.
Speaker 2:And here we are. Here we are. What you know? Anyway. We'll put your face on the album cover.
Speaker 2:There we go. Hopefully, it doesn't scare the children. But that that
Speaker 3:that already does. Thanks for listening, everyone.
Speaker 2:Thank you, Chris. Thank you, everybody else, and be on the lookout here next week. I think we got a good one on the books for number four. So thank you, everyone. Talk to you soon.
