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1031 Exchange

Do you own investment real estate? Considering selling your property, but would prefer to defer the tax hit until later? In this episode Bill Horan joins us with a rundown on the origins of 1031 Exchange, how a 1031 Exchange works, and what qualifies for 1031 Exchange.

 

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Bill (00:00):

That's all you're doing is moving it. If you cash out, you pay your taxes. It's a deferral, the gain doesn't go away.

Adam (00:14):

Welcome to episode eight of Keeping It Real. I'm your host, Adam Tabaka. Today we'll delve into 1031 Exchange with Bill Horan. A native of Vienna, Bill graduated from George Mason University with a degree in accounting. Founded by his father, Ed, in 1990, Bill is the president of Realty Exchange Corporation. He has 19 years of experience in the industry, serves the entire United States, and carries the certified exchange specialist designation. Bill is a retired board member of the Federation of Exchange Accomodators and of the National Organization of Qualified Intermediaries. Bill is also a former president of the FEA and is a two-time recipient of the FEA's President's Award for Outstanding Dedication and Service. It's my honor to introduce the one and only Bill Horan. Bill, thanks so much for joining us today.

Bill (01:03):

You're welcome. Thanks for having me.

Adam (01:05):

Oh my pleasure, my pleasure. So Bill, for anyone who isn't familiar, can you explain for us what exactly a 1031 exchange is?

Bill (01:15):

Yeah, the general concept of an exchange is that you're trading business, investment property real estate for other different business investment real estate. So the basic premise is that you, you shouldn't have to pay taxes when you're just trading old for new, you're just moving your investment someplace else. So that's the basic premise behind it. You're still invested, different location, different type, whatever it is. And you don't, you shouldn't have to pay tax to get from A to B, right? I'm moving my business. I want to move it across the street. Shouldn't tax me to get across the street. You know? Even if it's a rental business, or I'm a farmer and I want to trade land for different land, you shouldn't tax me to get from just to move my investment.

Adam (02:00):

Okay. That makes sense. And, and so, so tell us, you know, what are kind of the origins of the 1031 exchange? How did it come into being?

Bill (02:08):

Sure. I think this is a hundred years that it's been in the tax code, and the origins go back to farmers. They used to trade land all the time. And you know, the basic premise was that was a direct swap, you know, the farmer next door and I wanted to trade acreage. We would just trade deeds, and there was no money involved in that transaction. So there was nothing to be taxed, right? There was no money there, and only the farmers knew the value. So how do you put a value on that transaction? So the basic premise of a swap has been in the code for a very long time. It changed with the Starker case, which was a, a guy that was in the timber business. And he had structured a couple of transactions where he gave up his land, and the timber company that he gave it to promised to replace what they had given him, but it was in the future.

            And so he's the one that, you know, basically put a gap in time between ownership, where he gave up his land. And later it was, for him, it was a couple of years later before the timber company replaced his land. And he claimed it as an exchange and the government challenged him. And then they went to court and, and Mr. Starker won the court case. So nowadays what you see is not two people finding each other, right? Cause that's really hard, but the basic, you give up property and then later get replacement property. You still invest, it's just, there's this time gap between the two. And the way the government structured this stuff is you got to use a middle man like myself to bridge from the old to the new. Cause if you settle on the one you're selling, put the money in your pocket, that's a sale by definition, you just pay your taxes. So they created this, I'm going to use the word, safe harbor, the safe way to do it, to trade old for new, you got to use a middle man like us to get you there.

Adam (03:55):

All right. And, and that's, that's called a qualified intermediary. Is that right?

Bill (03:59):

Yep, that's our role, right. Qualified Intermediary. Yeah. We're defined by code. So we're a Fig Newton of the government's imagination. They made us up.

Adam (04:08):

Awesome. Okay. So, so tell us a little bit about, you know, maybe the, the logistics of that. So if I want to go ahead and sell my investment property right now, and I want to, you know, buy into something else, whether it's it's land, whether it's warehouse, whatever it might be. You know, what are kind of the guidelines and the parameters of that exchange?

Bill (04:28):

Right. So you got to have somebody like me hired before closing. So if I become part of that transaction, so what gets me going on an exchange is a sale contract. So typically we see a client selling a rental townhouse or something like that. They hire us before settlement. So now we're a part of that transaction. We get assigned into the sale contract, and then we send instructions to the title company and say, hey, we've been hired. This is now a 1031 exchange. We do the transfer, by definition, and we take the money and tuck it into escrow. So when the client closes, they don't get anything, they're not gaining anything. My agreement says, I'll buy what you tell me to buy on the replacement side. So just from a mechanical standpoint, you got to have somebody like me on board before settlement. And then I become part of that transaction.

            Take the money from that sale, client picks out something new, goes and gets a contract just like normal. And then I need to get my hands on that contract so I know what we're buying with the money. And then I will move the money towards that purchase. So fundamentally the client gives up property. They get nothing, but they still own property when we're all said and done. The property, they want it, right? That they pick out. For most clients, they see a sale and a purchase, but technically it's a trade. They traded old for new. And there's this time gap between the two.

Adam (05:49):

Okay. And, and there are restrictions on, kind of, the number of properties you can exchange for any one property. Is that right, or?

Bill (05:58):

No, you can, you know, you could sell one and you could buy 500 if you wanted to. What you bump into is the, the government gives you 180 days to trade old to new. And that goes back into the Starker case, because his transaction was over a couple of years, and Treasury weighed in, said, wait a minute, we'll lose track of these transactions if they're crossing tax years. So they gave us 180 days and everything gets reported on the, the year that you sell. So that's why it's 180 days, because they wanted everything on one single tax return. And then they give you 45 days to identify. In the early generations of when this stuff was going through Congress, Treasury, actually asked for the identification to be done in the sale contract of the one you're selling. So you would've had to known where you were going when you were selling. Cooler heads prevailed. And they gave us 45 days. I think they just reached in the air and grabbed 45 days to designate that. So there is a restriction on what you can identify, not what you end up with, right? So that's, that's what you're talking about. There's a restriction.

            So there's three rules. One is called the three property rules. So that's what most people use. They give us a list of three properties they're thinking about buying. So it doesn't mean a contract, but it, the list can't change after that 45th day. So in reality, most people have a contract to buy something new by the 45th day or they should.

            The second rule is called the 200% rule. Meaning the list can have as many as you want on it, but that list value is limited to two times what was sold. So if I use an example, I sold a rental townhouse for half a million bucks, and I want to give, do a list of 10 properties, that list combined, all 10 is limited to 1 million dollars, two times the half a million dollar property I sold. So that's where the restrictions are.

            The, the third rule is called the 95% rule, which we, rule, which we never, rarely see. If the list is more than three and the value of the list exceeds two times what was sold, you have to buy the whole list. So that's why I'm using the example. You could buy 500 properties if you wanted to, if all 500 were on your list and you bought them all, you'd still be okay. So they just rarely see that rule. Most people target what they want and then they put a couple of backups on the list just in case.

Adam (08:20):

Got it. That makes sense.

Bill (08:22):

Yeah. In today's market, that's the, the biggest change that we've seen because it's a great time to sell, but man, it, you, with an exchange, you got to go buying. You got to go right back in this hot market and compete. It used to be, our exchanges were running 60 to 90 days. So somebody would sell, close, and it would take them 60 to 90 days to buy the new property. And nowadays we're at about three weeks. So somebody sells, they're already under contract to buy the new one, which is perfectly fine because the exchange is about ownership dates, not contract dates. So those clients are out hustling to find the new replacement property and quickly closing on their replacement property. Well before the 45th day, because that's the lock in date, that's the date you got to commit to a list, and they've already bought their property by then.

Adam (09:11):

So, so you're saying people be more, a little more proactive, just.

Bill (09:13):

Have to.

Adam (09:15):

Caught with their pants down.

Bill (09:17):

Yeah. Otherwise, it's going to get messed up. And then that's the definition of a taxpayer. That's what you're trying to avoid is taxes.

Adam (09:22):

Yeah. Now you have an oppressive array of credentials and accomplishments, so.

Bill (09:29):

Cause I'm old, I've been doing this a long time.

Adam (09:32):

Yeah. Yeah. You don't look old, so. When, when somebody's interviewing a Qualified Intermediary, you know, what are some of the most important attributes or, or competencies that, that a seller should be kind of seeking out?

Bill (09:45):

Yeah. Experience is a big one, right? Longevity in the business and referrals. Right? And so it's not hard to figure out who we are and that we've been in the market of really long time, you know, and have a good bit of experience. So anybody that's really plugged into the industry, you should be pretty confident that they're, they know what they're doing. When I say plugged in, you know, been at it a really long time, got a good reputation on the street, a member of the association. That's what keeps me up to date. I have friends in the industry that keep me up to date on what's going on. So those, those are important characteristics. Bonding, insurance, all those sorts of things are key things as well. Right? Those are very core things to have.

Adam (10:25):

Sure. And, and what is kind of the biggest misconception in your opinion, about a 1031 exchange?

Bill (10:33):

Yeah. I think the biggest misconception is clients think all they have to reinvest is the cash proceeds that come from their sale or just the profit. And the idea behind exchange is you're replacing your investment, and all the money that comes out of that transaction goes to the new property. So if I'm selling my half a million dollar townhouse and I have a mortgage on it of a hundred, I'm going to come out of there with 400 of cash. To not pay tax, I still got to go buy another $500,000 investment, replace my investment, and put all 400 back in. Many clients think all they got to do is go buy 400, because what they see on the internet is it says you got to reinvest the proceeds. In their minds it's the proceeds is the cash that comes from the sale and the mortgage got paid off, right. But what that really means is what did the buyer give you? The buyer gave you 500 grand. That's the proceeds. You just happen to owe money on that property.

            So if it was an all cash deal, that's what you got to go buy, spend the money on that new deal. And it's a very, because most clients don't think about that piece, right? And there's two different things going on, right? You're, you're tracking cash in a, in a transaction. Pay off your debts, pay your expenses to get out of the deal, right. And then you're left with cash, but you've also got a tax calculation you're doing, which is basis and gain, which are two different sets of numbers. It can be completely opposite, and you're trying to square away both of those things. The basic premise, replace the value, like I'm using this example of selling out at 500 and whatever cash comes out of the transaction, go buy it at 500 again, or more, and put the cash back in. And I say, buy it 500 more. That could be two or three properties to make up the 500. It's not one for one, it's just how much real estate dollars did you give up? How much real estate dollars do you own when you're done, and are, is all the money back in? You're in good shape after that. You just keep going.

Adam (12:32):

Nice. And you were actively involved with the passage of law in Virginia regulating the exchange accommodator industry. You know, what were some of the problems that led to the passage of this law and, and how has the, the passage of the law benefited consumers since?

Bill (12:49):

Yeah. So, you know, during the last downturn, you know, everybody got crushed with the last downturn with real estate. There were some bad boys in the industry. One guy was stealing money out of the escrow accounts and he ended up going to jail. He just died in Texas here, not too long ago. So he's gone. And the other one was Land America, which was out of Richmond, and they were taking money out of escrow accounts and investing them. And when the markets turned, they and get those investments cashed out. And so this got kicked off by Chip Dix. He's an attorney down in Richmond. He was the Virginia Association of Realtors lobbyist down there. So he started the process to regulate our industry. And then we got wind of it. And I went down and worked with Chip on getting a, a law passed. So our industry had already pre-created a model law that would work in our industry, and it had been passed by several other states.

            And so when Chip and I started working on ... He decided to use our model law. It got tweaked around that, but the key things, the fundamentals that came out of there, which are very strong, which is good law, that you know, everybody's got to have a separate account. I got to have authorization to move money. If I sell my business, I got to tell everybody that I sold my business, so clients know what's going on. So it's more clarity, if that's the right word to use. And most of us in the industry had already been doing these things as good practice, and now it just got baked into the law.

Adam (14:16):

Okay. And, and then you're also actively, you know, involved with exchange regulations at the state and national level with Congress, the IRS, Treasury, you know, tell us a little bit about your work in that arena as well.

Bill (14:30):

Yes, because I'm part of our government affairs committee. So I'm kind of plugged into doing all that stuff. During the last tax reform, 2017, I think I spent, I was up on the hill just about every 30 days working on this. You know, sometimes the attitude on Capitol Hill is rich people not paying taxes and they don't understand the dynamics. I'm just moving my rental business somewhere else. So a lot of education has to happen. And it's constant, right? Because new members of Congress and new staff come in. They don't have all the history of all that stuff. So we have to spend a lot of time educating. But we got through that tax reform because they understood what we were doing, what 1031 is all about. And, and now in this go round, the President Biden has, has proposed, or part of his proposal, was to put a cap on deferral of gain of half a million dollars per taxpayer.

            So a husband and wife might get a million dollars of tax deferral on a particular exchange. Well, all we had was one paragraph in his proposal. So there were a million questions coming out of there. What about a partnership that's husband and wife, all these issues, right? Coming out. We've been working pretty hard on this for the last couple of years because we knew this was going to be under attack again. And so we've been working the Democratic side of the aisle for years and we're pretty comfortable at this moment in time that the 1031 provision that the president was proposing is not going to be in either the Senate or the House bill. Obviously the sausage making is happening as we speak, right, this week and next week. But we're pretty comfortable. We've gotten several signals from members that they're not including 1031 in the provision. We've been working on this a long time though. There's a lot of effort going into educating everybody to leave 1031 alone, so.

Adam (16:18):

Can only imagine what a, what a feat that got to be.

Bill (16:21):

I have learned a lot about sausage making, if that's the right term to do. And when, when you think of somebody making an argument about logic of something, don't do this because it, sometimes it's not logic. It has ... it's about power and other things are weighing in, right, that are higher priority. So I've learned an awful lot, so. But we know it now. I've done it now. This is our second time going through, you know, it's been in the code for a hundred years. There's a reason it's in the code for a hundred years. And so we just got to educate everybody on how it's done. You know, as part of this we've done economic studies, micro studies, macro studies, all these sorts of things. So we have numbers to back up what we're talking about. It's not just us that're up there praying.

Adam (17:03):

That's that's good stuff.

Bill (17:04):

Yeah. And there's a, there's a coalition. I think that we're up to like 43 associations that are part of our coalition. You know, the National Association of Realtors, The Round Table, the agriculture, the tree guys, hotel guys, everybody under the sun is on the same bandwagon to leave this thing alone. Don't touch it.

Adam (17:23):

Yeah. I mean it's, it's a great vehicle for, for moving, moving your investment.

Bill (17:27):

Yeah. That's what it is. That's all you're doing is moving it. You know, if you cash out, you pay your taxes. It's a deferral. It's, the gain doesn't go away. You're just moving it to a different location. And the reality is part of the studies that we had done, the reality is that 80% of these exchanges end up in taxable transactions. So there's a, there's a premise out there that you end up not ever paying tax. That's just, that's bad. It's not right. So we had a couple of professors do a micro study, and they got all of CoStar's data, which is the gigantic, you know, commercial database. And they tracked property by property. 80% of them only did one exchange and then they eventually cashed out. So 1031 is really a timing difference. You know, I don't want to pay the taxes now, I want to move to a different investment, and keep going. But then I'm going to end up selling out. 80% of them sell out and pay their taxes. So it's just timing.

Adam (18:18):

Yeah. Sooner or later, it's inevitable.

Bill (18:20):

That's right. That's right. That's right. Some, some people take it to the grave, but that's, it's a very, very small percentage, very small percentage.

Adam (18:28):

Bill it's been awesome having you on today. For anybody who wants to learn more, or has a property that they'd like to exchange, what's the best way for someone to contact you?

Bill (18:39):

Probably through our website, www.1031.us. You know, we got all contact forms on there and that sort of thing. And the phone number is (703) 754-9411. And there's 14 of us here doing these exchanges. So we're not just a one man shop. It's, there's a bunch of us here doing this. And we do exchanges all over the country, all kinds of property, because everybody's moving stuff all over the country. And these rules are federal, so it applies across the country.

Adam (19:06):

Excellent. Well, thanks again for joining me. I appreciate.

Bill (19:09):

You're welcome.

Adam (19:10):

And you have a great weekend.

Bill (19:12):

Yeah, you too. Thank you for inviting me. Appreciate it.

Adam (19:15):

Good day.

Bill (19:15):

Bye.

 

Adam Tabaka

Long & Foster Old Town Alexandria, VA - Realty
400 King Street
Alexandria, VA 22314
703-683-0400
703-589-6513
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