Air Date: 07.23.2020
1031 Exchange Pros & Cons: The Good, Bad & Ugly
If you are in the syndication space, you will have likely heard of 1031 exchanges. Here’s what you need to know about 1031 exchange pros and cons.
Today’s guests, Michael Brady and Alex Shandrovsky, join us for a deep dive into these exchanges and demystify some of the misconceptions around this powerful tool. Michael and Alex both work at Madison 1031, a leading qualified intermediary that helps clients through the exchange process. We kick off the show with a definition of 1031s. In their simplest form, they are viewed as swapping one property for another to defer capital gains tax. After this, we get into the importance of the intermediary. While it could be tempting to go at a 1031 alone, using an intermediary is built into the swap structure, and Michael gives us some tips on what to look for to find one of a high caliber. From there, we take a look at when a 1031 does not make sense. Some of these instances include no capital gains, a bad deal or for a flip. Following this, we explore when a 1031 is advantageous. We wrap part up one with a discussion of how passive investors might use a 1031 out of a deal, and some of the complications this could bring.
Key Points From This Episode:
- An introduction to Mike and Alex, including their respective professional backgrounds.
- The definition of a 1031 exchange and how it encourages real estate reinvesting.
- How 1031 exchanges allow for capital gains tax deference.
- The role that an intermediary plays in a 1031 and why they are fundamental to it.
- Some of the technicalities the intermediary takes care of in a 1031.
- Why the ‘qualified intermediary’ does not have to be specially trained and tips on finding the best one.
- Hear some examples of when it does not make sense to do a 1031.
- Instances when doing a 1031 is most advantageous for investors.
- How 1031s work for passive investors on a syndicated deal and some of the planning they need to do.
- Why drop and swaps can be problematic for the IRS and individual states.
- Learn more about the Tenant in Common structure and the complications it can create.
- Why 1031s are a popular way for syndicators to bring investors onto the next deal.
“A 1031 exchange has been on the tax code already for over 100 years. It’s the government’s way of encouraging investors to reinvest money in the real estate market. Every time you’re going to be making a deal, there’s always going to be a silent partner that you may not be aware of and that’s the government.” — Alex Shandrovsky [0:04:08]
“Without a qualified intermediary, there could not be a swap. If you just sold, received cash, then went and bought another property, you’ve received cash. You haven’t received like-kind property.” — Michael Brady [0:06:59]
“You are supposed to do a 1031 for the purpose of investment property and that typically means you have to hold it with an intent of renting it out for typically two tax years. That’s what we advise.” — Alex Shandrovsky [0:13:23]
Links Mentioned in Today’s Episode:
Federation of Exchange Accommodators
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—Full Transcript Below—
[00:00:00] MB: Best use of a 1031 exchange, obviously is when you have significant capital gain and an investment property, and that can take many forms. If you’ve owned a property for many years, you’ve likely depreciated it. You may have more gain than you realize, because if you depreciate the property and let’s say you’ve held the property 15 years, well that’s going to really reduce your tax basis and increase the amount of taxation you’ll pay when you sell.
[00:00:25] KR: Welcome to Ritter on Real Estate, the show about how to passively invest like a pro. On each episode, I interview real estate experts who give their top investing advice, strategies and tools and I break down their insights into practical steps to avoid the pitfalls and make better investments. I want to help you passively invest like a pro. This is Ritter on Real Estate I’m your host, Kent Ritter.
[00:00:49] KR: Hello, fellow investors. Welcome to Ritter on Real Estate, where we focus on how to passively invest like a pro. I’m your host, Kent Ritter. Today we have Alex Shandrovsky and his partner, Michael Brady. They’re from Madison 1031. They’re here to talk to us today, do a deep dive into 1031 exchanges. They’re going to help demystify how as passive investors, you can leverage this great wealth-building tool.
I’m really excited to have you guys on the show. This is something that I admittedly am not an expert in. I haven’t gone through the process myself and through any of my current deals. I’m excited to learn right alongside with our listeners.
Thank you guys for being on the show. Before we get really into the meat, I’d love for you guys just to introduce yourselves, give some of your background and help the listeners understand where you’re coming from.
[00:01:36] MB: Sure. My name is Mike Brady. By training, I am an attorney. I’ve been practicing law for over – it’s about 26 years now, predominantly transactional work doing commercial and residential real estate transactions, corporate business sales, some internal sale of goods documents, things of that nature.
Got involved in 1031 exchanges right from the get-go when I first started practicing, was one of the first projects I worked on was a 1031 exchange for a firm that I worked for. The partner I worked for at the time said, “Mike, we have this great project we want you to work on. I have a client that wants to do a 1031 exchange.” I said, “Great. What’s that?” He said, “I don’t know. It’s something to do with taxes in real estate. Go hit the books and figure it out.”
What I ultimately discovered was after many hours that we were not able to charge the client for was that I needed to find a good qualified intermediary to walk me and my client through this process of basically exchanging one property for the other, because the tax rules were when you just read them, they’re clear as mud, until you get into some of the nuances.
I developed the proficiency in exchanges over the years. Then I actually got involved in the qualified intermediary industry in 2005 when I ran the East Coast for one of the largest companies in the industry. I joined Madison about two years ago to head up sales and marketing efforts and help some of our clients structure their complex exchanges.
[00:02:55] KR: Thanks, Mike. I appreciate the bio. Really excited to have you here today.
[00:02:59] AS: Yeah, yeah. Thanks for having us on. I’m looking forward to it.
[00:03:01] KR: Absolutely.
[00:03:02] AS: Awesome. Well first, Kent, I really appreciate the fact you got my last name correct. That’s a big step forward. Clearly appreciate that. My background is a little different. My background is that I am a small business owner. I found a round large catering company in Silicon Valley that serviced Google, Facebook, Airbnb among others. It was a social enterprise, which also hired people coming from prisons. I taught business entrepreneurship a lot in maximum security prisons as well, and then transitioned from having that business to learning more about assets and capital.
When I had a chance to join Madison 1031 in the business development role is very exciting for me to be here, because again, I talk to investors and those who are looking to build multi-generational wealth every single day. I’m very, very happy and very proud that we have such a great tool that we can share with them that so many people are still not aware of. So, Kent, thanks for helping people get educated about it.
[00:03:54] KR: Absolutely. That’s what the show is all about. Excited to bring, I think such a useful topic to the viewers today. Let’s dive in and let’s start at the top with what is a 1031 exchange.
[00:04:06] AS: I’ll start us off.
[00:04:08] MB: Yeah, go ahead.
[00:04:08] AS: A 1031 exchange has been on the tax code already for over 100 years. It’s the government’s way of encouraging investors to reinvest money in the real estate market. Every time you’re going to be making a deal, there’s always going to be a silent partner that you may not be aware of and that’s the government. Uncle Sam is investing alongside every time. Any time your investment has appreciated the value and you’re going to sell it, you’re going to have to pay capital gains tax.
That tax could be up to 30% between city and state and federal. It could be more than 33% off your profits. The government wants you to continue reinvesting money into the economy, into real estate, so they’ve designed this 1031 exchange tool to take the proceeds of your sale and reinvest into another investment property. That allows you to defer your capital gains. That’s what the 1031 exchange in a nutshell is, done in a very short period of time.
[00:05:09] KR: That’s a great explanation. Essentially, we’re deferring our capital gains by continuing to invest in real estate. It’s an interesting perspective about the government incentives around that and how they drive behavior, but –
[00:05:23] MB: Part of it is that it’s viewed as a swap of one property for another for tax purposes. That’s really the simplest form of exchanges. If Alex and I each had a property the other liked if we traded deeds, an exchange of one property for another, there’s no cash involved in that transaction. There’s no cash available to pay the taxes. This allows us both to keep our capital working in the real estate economy and hopefully each buy bigger and more profitable properties. It’s very hard to find people that have their interests aligned like that. They actually allow you to do an exchange with a qualified intermediary, which is the service we provide.
For tax purposes, the taxpayer gives us their property, we sell it and we take the proceeds from that sale and we buy a property from somebody else and then give that property to the taxpayer in exchange for the one they gave us. That’s how it works for tax purposes, but that would be very, very cumbersome. We’d have four deeds on each side of the transaction. One of our affiliate companies is Madison title, they’re a title insurance company. They would love that. If there were four deeds on each side of a transaction, four title policies, four sets of recording fees, transfer taxes, etc., etc. Could be four loans, it could be four loan policies, but they instead made it much simpler than that.
They allow, essentially all we need to do is take assignment of the contract of sale on each side of the transaction and the money flows through us. The taxpayer is not receiving money, they’re receiving property. They receive money, they have to pay taxes. If they receive property, it’s tax deferred as Alex was saying.
[00:06:43] KR: Got you. Talk a little bit more about your guys business as a qualified intermediary. I mean, why can’t investors go out and just do this exchange themselves? Why do they need to work with a qualified intermediary?
[00:06:55] MB: It all falls back on that swap structure. Without a qualified intermediary, there could not be a swap. If you just sold, received cash, then went and bought another property, you’ve received cash. You haven’t received like-kind property. It dates back to the 1920s when they first introduced this concept of swaps or exchanges and the tax deferral that they’ve stuck with that, that as long as you’re not receiving cash, you’re receiving property for a property, you’ll be able to defer. They added the qualified intermediary to allow flexibility to be able to sell to one person and buy from yet another person.
Otherwise, you would not be able to do it. It keeps the money out of the taxpayer’s hands. We play a structuring role in the transaction to ensure that the taxpayer abides by the deadlines that the IRS set up, which we can get into. We also provide a service in educating people about what they can and cannot do in 1031 exchanges, what types of properties qualify, what kind of use qualifies, what are some of the things that we’ve seen.
[00:07:54] KR: Sure. Definitely want to cover all that with you guys as well. Stick with the qualified intermediary just to make sure that it’s clear to me and hopefully for the listeners. You guys provide the service and that you’re able to complete a transaction on each side by taking money and doing – and facilitation without the investor actually receiving it. Then you’re just essentially passing through the properties and creating, facilitating that swap, that trade like you said.
[00:08:21] MB: Correct. We do all the documentation that’s involved. There has to be assignments of the contract on both sides that’s being exchange agreement that basically restricts the taxpayer’s access to the money during the exchange period. While we hold the money, the taxpayer really can only use it for the acquisition of property. They can’t change their mind mid-stream and say, “Oh, we don’t want to do this.” They have to wait till the exchange is actually over to get excess funds back. That’s the role that we play.
It’s important to note that the term qualified and qualified intermediary does not necessarily mean what you think it does. When I first heard the term back in 1994, I thought it meant that the person I was dealing with had some special training. They went to some qualified intermediary school, where the IRS instructed people on how to be qualified intermediaries. What I discovered was that qualified really means that you are not a disqualified person.
To be a qualified intermediary for any transaction, the requirement is that you cannot be an agent of the taxpayer who’s doing the exchange. That would mean, anybody’s provided agent services within the prior two years prior to the exchange, such as an attorney, an accountant, a real estate broker, an investment banker, or broker for the exchanger and there’s some exceptions to that. Or any relative of the taxpayer as well, any mother, brother, daughter, son cannot be that taxpayer’s qualified intermediary, and any entity in which the taxpayer or a related entity owns more than a 10% interest. Those are anybody else could act as the qualified intermediary.
It always makes sense when you’re selecting a qualified intermediary, realize that we are a largely unregulated industry, so you want to do some homework and kick the tires when you’re selecting a qualified intermediary. Number one, you want to make sure they have some technical expertise, that they know what they’re talking about. We belong to a group called the Federation of Exchange Accommodators, which is sounds like it’s out of Star Trek, but it’s actually a trade group for qualified intermediaries and people in 1031 exchanges.
They issue a certification program that you can take a proficiency test and get certified as an exchange specialist. I’ve taken that test I’ve been certified as an exchange specialist. We have two other certified exchange specialists on staff. We also have three attorneys working in our team, as well as anywhere between 10 and 15 people to handle the day-to-day processing of the exchanges.
Most importantly, you also want to ask what do they do with the money while they’re holding it, because as an industry, we handle billions of dollars each year, so you want to make sure that the money is handled very, very safely. We only put it into escrow accounts. Basically, it’s a Madison Exchange account with a sub account bearing the taxpayer’s name and tax ID number. It’s a segregated account for most of our exchanges. It’s identified as being part of the exchanges. Proceeds, we were also bonded and we’re also insured against malpractice as any professional really should be.
[00:11:11] KR: Right. Obviously, 1031 exchange has to do with sale of property. Take us through when an investor would find it advantageous to do a 1031, versus when are situations where they would not want to do a 1031?
[00:11:25] AS: I’ll handle a few of the cases. We have situations where people give us a call and they said like, “I heard about the 1031 exchange and it sounds like a really excellent way of deferring capital gain tax.” Some of the cases it’s not. Let’s focus on some cases it would not be appropriate for them to do a 1031 exchange. Again, our interests are in the best interest of customer, of the investor. You’d be surprised how many times we are encouraging them that 1031 is not the right approach for them.
Some of the cases are for example, well a good one is when you don’t have capital gains tax to pay. If the property is not appreciating value, there’s no tax to defer and therefore, you should not do a 1031 exchange. That’s a really easy example.
Another example is if you have to have the 1031 exchange has to be for the intent of investment. If you’re looking to invest a 1031 on money with a thought process, “Look, I want to move to Indiana and what I’m going to do is I’m going to basically purchase a property and go live there with my 1031 funds.” That’s not going to work either. It has to be for investment purposes.
You can purchase a property, use it for investment purposes and then two years later move in there, that’s possibility potentially, but you don’t want to do it. That cannot work. You cannot just do it and then move in.
Another example is something that’s really popular, people are thinking they could do a 1031 exchange and they can do a flip. Essentially, I’m going to find a property that’s dilapidated. I’m going to bring in my crew, do a 1031 exchange into that property and then fix it up, three to six months I watched a lot of TLC, the fix love brothers, whatever their names are.
[00:13:06] KR: Property Brothers.
[00:13:07] AS: I wouldn’t be like that guy. What are their names?
[00:13:10] MB: The Property Brothers.
[00:13:11] AS: The Property Brothers. I want to be like The Property Brothers. Exactly. All the YouTube shit. I’ll do a 1031, I’ll do a YouTube channel at the same time, I’ll do a podcast. It’ll be great.
Look, you’re more welcome to be a YouTube star, you’re more than welcome to do that, but you are supposed to do a 1031 for the purpose of investment property and that typically means you have to hold it with an intent of renting it out for typically two tax years. That’s what we advise. Those are some cases where a 1031 would not be good.
Another one and then Mike, maybe you’ll share about when it would be advantageous is when’s a bad deal. That’s a really good example of not doing 1031 exchange, when we have the individual who is coming and they’re having – there’s someone who reached out to me recently a few days ago and they said, “Look, I’m looking for the following returns.”
I said to them, “I don’t think the returns that you’re looking for are really on the market right now.” Just doing a 1031 exchange without having a plan, the long long-term plan of what property you want to reinvest into, not a good idea. Don’t defer taxes simply in order to get into a bad deal that’s going to make you lose money.
[00:14:17] KR: Yeah. I think that’s a great point. That’s talking about letting the tail wag the dog. You are constrained by the 1031 and you’re so concerned about saving the taxes that you get into a bad deal. Ultimately, I mean, that’s going to have a much worse effect on your income and your investment portfolio than just taking the hit on the taxes and waiting to find a good deal. I think that’s a great point you made there.
What are some of the, I guess, when are the times that you want to use a 1031 exchange? Mike as you’re talking to that, think about our listeners a lot of which are passive investors, folks that are investing as limited partners. Talk about it from their perspective as well, please.
[00:14:58] MB: Sure. The best use of a 1031 exchange obviously is when you have significant capital gain and in an investment property. That can take many forms. If you’ve owned a property for many years, you’ve likely depreciated it. You may have more gain than you realize, because if you depreciate the property and let’s say you’ve held the property 15 years, well that’s going to really reduce your tax basis and increase the amount of taxation you’ll pay when you sell, because many people don’t realize that depreciation deduction that you get to take, which offsets a lot of your income is a very, very powerful tool for real estate investors.
When you sell, you have to pay the piper that depreciation gets recaptured and on the real estate portion of that it’s typically at a rate of 25%. If you’ve done a cost seg study, which our company also does, our affiliate company Madison SPECS does, well at the extent to classify as personal property, well the personal property depreciation gets recaptured at ordinary income tax rates, which are much higher than the capital gains tax rates. When you have that tax bill, if you’re going to buy property anyway, then a 1031 exchange makes all the sense in the world.
For somebody who’s a passive investor in a syndicated deal, you have to realize that that is a special circumstance that requires some advanced planning. If you’re in a syndicated deal, you’re in an LLC, you’re a limited partner, somebody else is the general partner, she’s running the show, she manages the property, she brought the buyers in, and ultimately, she’s going to find the buyer when this project turns over, the limited partners for them to get out, they cannot just let the whole project sell through the LLC and then take their money and do a 1031 exchange.
They’ve got to get out of the syndicated entity prior to closing. Typically, the structure that they use for that is what’s called a drop and swap. This requires advanced planning. Very important. What you could do is have the LLC, essentially whoever wants to do an exchange, they could deed out to those investors, a Tenant In Common interest in the property. They basically give up their membership interest in the entity and get a deed of interest in the actual property. Then as Tenant In Common owners, they’re free to go forward and sell as individuals, or through what we call disregarded entities, which are a single member limited liability companies and then they could do 1031 exchanges.
The problem is that if you’re doing that on the eve of closing, the question becomes the partnership may have held the property for a very, very long time, they’ve held it for investment. The partners only own the property for 10 minutes before the closing looks more they’ve held it for resale, rather than an investment, which is the flip scenario that Alex was talking about. It’s to my mind, a ridiculous distinction because these people owned it in a different form. It just changed the form, but that’s not the way that is seen in many purposes for tax purposes.
The IRS has challenged some of those cases in the past that when you have a short-term hold before an exchange, or drop and swap, but they by and large are not fighting that fight, because they’ve lost a couple times.
The states however may challenge it. For state income tax purposes, you might have a problem. California has been somewhat aggressive in challenging short-term drop and swap transactions. They in their own tax courts, California the state, lost in their own tax courts one recently, very weird or fact specific case, but it’s something to look at.
I was at a conference last year where an individual from the California, I forget the actual name of the board indicated that they still think that drops and swaps don’t work, so they’re still challenging them. Where I am in New York, they seem to be have some interest in looking at these transactions as well. You really need some advanced planning. You need good tax and legal advisors in structuring those transactions. That’s typically how your passive investor might be able to take advantage of a 1031.
[00:18:47] KR: Got you. While it’s possible, it’s not such a direct path as if you’re the owner, because most passive investors don’t actually own the property. They own shares in LLC, which happens to own the property.
[00:19:00] MB: Correct. Exactly.
[00:19:01] KR: What you’re saying is you have to leave that entity, you have to get direct ownership in the property typically through a Tenant In Common. In doing that, then you actually take the money forward through a 1031 exchange as part of the sale.
I imagine many syndicators on the other side may have an issue with creating the Tenant In Common relationship and having to move forward with that through a sale as well. I imagine there’s a lot of things to work out, needing to be I think very proactive upfront with both the sponsor of the deal and as you said, with the tax and legal prep, because it sounds like you may need to be in that Tenant In Common position for a year or so to be safe from as you said, being called out for a drop and swap and having your taxes challenged, essentially.
[00:19:46] MB: Yeah. There’s no set period I could tell you is safe, because just there’s no guidance on that. Really, the drop out of the LLC should really be a separate transaction from the sale. Ideally, you’d want to do it before you marketed the property for sale, before you found a buyer, before the contract was signed. It’s an independent transaction and that’s what the recent California case indicates, although their facts were not perfect by any stretch.
There was evidence of some advanced planning years before, even though they didn’t effectuate it till the eve of the closing. They had facts indicating that there were independent purposes for doing so. Yeah. I would recommend and that’s why advanced planning is important and maybe something that you want to discuss when you go into the syndicated investment with the syndicator. We like to talk to syndicators also, because it educates them and lets them know what they should look for and even structuring their transaction in the first place.
[00:20:40] AS: Mike, just to add and I think this would be, Kent, really important. Imagine John, he just sold his property that he’s been really twirling, he’s been managing for a long time and he just really wants to be a passive investor. He wants to invest in a syndicator or syndication. He wants to do a 1031. Similar thinking process has to actually go about as syndicator receiving the funds from 1031. It’s not just so simple as this individual saying, “Look, I don’t want to be dealing with the toilets, the trash, the tenants. I just want to be a passive investor, but I want to pay the capital gains tax before investing was kept.”
Well, for Kent to be able to accept that money inside the syndication, he has to set up a Tenant in Common agreement in advance, because of the same thing, as you can only invest the proceeds of 1031 exchange into real property. They actually have to buy, set up a relationship where the LLC of the syndicator owns a percentage of the property and then the investor is going to own a Tenant in Common interest in the property as well.
Now that creates challenges for the syndicator as well. There’s ways of how competent CPA work can guide a syndicator in accepting 1031 exchange money and we can discuss some of them. What is really key to understand is from both sides, that the individuals who is bringing the money into the syndications of 1031 exchange needs to do it through a Tenant in Common and not directly invest in the LLC and the syndicator has to set up a Tenant in Common relationship with the investor. All of that, again I’m just bringing it all back together to make it really, really simple requires planning and strategy, because a syndicator is not going to do that for small investments; if it’s just 50,000, a 100,000, a 150,000.
Typically, you’re looking for a person, for a syndicator to be willing to do that transaction. He has to make sure that the 1031 exchange money is significant enough in order to make that worthwhile.
[00:22:43] KR: How common is this? Do you guys see this happening, folks going into syndications, or coming out of syndications with a 1031 exchange?
[00:22:51] MB: I wouldn’t say it’s common. We’re seeing it more and more. It used to be the market philosophy is, “Well, you just can’t do it. We have a syndication; we’re not taking any 1031 money. If you’re in our syndicate, too bad, you cannot do a 1031 exchange out of it.”
As people are getting educated and looking a little bit more creatively and planning, there’s been more opportunity. We’ve been talking to a bunch of people who – syndicators who have taken in 1031 money when it’s been worthwhile by setting up a TIC structure. We’ve seen a couple where you might have one or two investors who want out and the bulk are just going to pay their taxes. It makes it a little bit less cumbersome. If everybody wants out of the syndicate and everybody wants to exchange, it’s a little messier.
Although, I think if you have advanced planning two years ahead and you just dissolve the LLC, it makes a lot more sense. With a lot of the more last-minute stuff that we’re seeing in the marketplace, it works better if it’s only maybe one or two, or a minority interest.
[00:23:45] KR: Got you. What about a scenario where folks are already in the syndicate and they want to move from one property, one property is being sold, they want to roll it forward to the next deal. Does that fall into the guidelines of this process?
[00:23:59] MB: Yeah. That’s easy-peasy. If the syndicate’s staying together, you have 10 investors all in an LLC and the LLC is going to sell this property and is going to buy a new property, that works all day long. Partnerships or entities, or any entity can really do a 1031 exchange. We always look to see who the taxpayer is that owns the property. Partnerships, while they don’t pay separate levels of taxes, they are viewed as a tax payer, because they file a partnership tax return.
[00:24:22] KR: Got you.
[00:24:23] AS: I think this is why more and more syndicators and at least in our experience, we speak to syndicators all the time on podcasts and in conversations, it’s really popular. They want to be able to bring everybody along to the next deal with them. A 1031 exchange is a great tool for that. That’s excellent.
[END OF EPISODE]
[00:24:41] KR: Thanks for listening to another great episode of Ritter on Real Estate. Hit the subscribe button to make sure you don’t miss out on the content that will make you a better investor. Also, visit kentritter.com for articles, videos and tools curated just for passive investors.
Until next time, this is Kent Ritter with Ritter on Real Estate. Now go out and invest like a pro.