1031 Exchange EXPLAINED with Jon Queen, CFA, CAIA, Realtor - YouTube

Today I'd like to talk about a very interesting

loophole in the tax code for deferring capital gains

on vacation homes real estate properties properties that are not your primary

residence and this is the 1031 exchange.

Hello, this is Jon Queen with the Queen Team at Coldwell Banker real estate

in South Denver, your real estate experts for everything: relocation

property selection investment properties. We get a lot of calls every day about

people with a wide variety of real estate questions. So

please don't hesitate to call us or you can always email us at

[email protected] and we're happy to talk about anything that you like. Feel

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topics because we will be uploading them on a regular basis each

week so you can stay up to date and please if you have any questions

feel free to leave them in the comments below

and Violetta and I are happy to address them and walk you through it

the 1031 exchange is section 1031 of the internal revenue code which says if you

have property and you exchange it for similar property

within a fixed number of days you can avoid paying capital gains tax and this

is very important because capital gains tax can be between 15 and 20 percent

depending on your tax filing status so in other words it's a way to

accumulate and grow a portfolio of either vacation or investment

properties without paying 15 to 20 percent every

time that you want to grow it more my favorite use of the 1031

exchange is when you have a vacation home or potentially

you have a home that you are moving into a larger home but you don't want to sell

that first home you want to become a landlord you can

sell that property use a 1031 exchange service provider and

then split that property from maybe one

six hundred thousand dollar home into three

three hundred thousand dollar homes you know with mortgage picking up the

balance and all and and you can collect the

delta on those rents and so all of a sudden you've gone

from you know having one property with one rent and now having a series of

properties with a series of rents and you've not paid tax to increase that

portfolio your tenants are paying down the

properties for you and you are creating wealth for your

family and for your future and of course if you contact me at

[email protected] I can walk you through the whole process

and also feel free to talk to your attorney or your tax accountant

about this because they are the experts in this area

and if we were to proceed together in a transaction it would be in your best

interest to take tax and legal advice so what are

the 1031 rules if you want to take advantage of the 1031

exchange and grow your real estate wealth without paying capital gains tax

well it's actually pretty simple the first is

you have to invest in property that is of the same

or greater value than the property that you're exchanging which means if you're

selling a home for instance for half a million

you have to exchange that into properties that are worth

at least a half a million combined. It can be

one property it can be more than one property but it has to be at least a

half a million dollars from whatever the net proceeds was from your original sale

Rule number two you have to acquire equal or greater financing

to the financing that was on the original property so that means

that if you had a 200 000 mortgage on the property that you are selling the

combination of properties that you're exchanging into must have at least in

the aggregate hundred thousand dollars worth of

mortgage between them in order to satisfy the equally greater financing

problem of the 1031 exchange. So who can take advantage of 1031

exchanges well it can be pretty much any person or legal person so that means

you can be a family you can be an individual you can be a corporation, you

can be a partnership, you can be a trust, you can be

pretty much anything that qualifies as a legal person

under US law so that means that the 1031 exchange works equally well for the

family looking to grow their real estate wealth

and become landlords without paying capital gains tax on

their growth of their portfolio or the estate planner who already has

their property perhaps moved into trust but they're also looking to grow that

property and they don't want to pay capital gains tax

both situations you can take advantage of the 1031 exchange

and in fact corporations do this all the time in the commercial real estate

context. I mean it's very rare that someone a

corporation will sell a piece of property

and then realize capital gains on that sale without using a 1031 exchange

to transition into new property. So what's the timeline to the 1031

exchange the timeline is very important if you want to take advantage of this

tax loophole and the timeline is as follows so before you

contemplate undertaking this transaction and doing this exchange you already want

to have your 1031 service provider identified. You want to have them lined

up and ready to go because as soon as you sell that initial

property or begin this transaction you're on the clock and the clock is as

follows. You have 45 days from the sale of your

initial property to identify your replacement property

and that means you have to come up with a list and submit that electronically or

in person to your 1031 exchange service provider

then once you've crossed that threshold in time.

You have a total of 180 days including that first 45 days to complete

all of your 1031 exchange transactions. So what does this mean

this means that once you sell your for instance your vacation home that

you're not using anymore in Maui and you're exchanging that into three

really highly rentable single bedroom apartments downtown

Denver. You have 45 days to come up with those

initial properties that you're going to trade

into and then you have 180 days to complete the transaction

including that first 45 days so you're on a strict timeline. You want to make

sure that your 1031 service provider is there lined up ready to go

so you can just do what you need to do without worrying about being under

pressure of time. So a common question that comes up is

how do you identify the types of property

that you can use to exchange the property that you're getting rid of

under this 1031 exchange. Well there are three general rules

the most commonly used rule is the three property rule

and this means you can exchange your property for

any three properties of any value so that means if you sell your one

property for five hundred thousand dollars

and you move it into three properties that you pay five hundred thousand

dollars down on maybe the balance of mortgage

you satisfy that rule and you've done a 1031 exchange.

You've avoided capital gains tax on your transaction

while growing your wealth threefold. The second most commonly used rule

which is an alternative to the three property rule is a 200 percent rule

and that is when you want to acquire more than three properties. It can be any number of properties and 1031 exchange rule says that you can

do that so long as those properties don't exceed more than

200 of the original value of the property that you are exchanging

out so what does this mean this means if you're selling that 500

000 Maui vacation home moving it into highly rentable real estate downtown

Denver that you cannot exchange it for more

than a million dollars worth of real estate in

downtown Denver but having said that it can be four

properties each one two hundred fifty thousand.

And the third rule which is also an option that if you don't want to use the

three property rule or the two hundred percent rule is the

ninety five percent rule and this is when you want to exchange that five

hundred thousand dollar maui vacation home you don't use very

much anymore into the very highly rentable

downtown Denver real estate you do not want to be limited to three properties

and you do not want to be constrained to 200 percent of that

Maui real estate property the 95 rule means you can exchange that 500 000

property in Maui for any number more than three

of properties in the downtown Denver area

and it could have any value all in so you can exchange for instance

for your 500 000 properties for five uh for instance

three hundred thousand dollar properties with one hundred thousand

dollars paid down two hundred thousand dollar mortgage on each of them

so you've now transferred your 500 000 property in Maui to 1.5 million

in property downtown Denver. The only rule there is you have to

submit in your original property list to your 1031 exchange service provider

your list of properties within 45 days and you have to close on 95

of those properties at least 95 percent. So

if you submit for instance five properties it means you

have to close on all five of those properties you have to close on

virtually 100 if you submitted 100 properties

you would have to close on 95 of those 100 properties so that is the

95 percent rule it's not used as commonly.

For the usual taxpayer because usually we can get away with the three

property rule or the 200 percent rule but it is there

available if you need it. So what are the rules of

the 1031 exchange property identification in terms of the actual

steps? Well the first is obviously you have to identify all of

your property within 45 days and you have to identify it in writing

and submit that written list that unambiguously that's a legal

description or extremely detailed description to

your 1031 exchange provider within 45 days you've submitted an

unambiguous clear list of the properties that you're

going to exchange into giving it to them either electronically

or in person within 45 days of triggering this whole

process your list must be signed and dated by all taxpayers. This is also

important you don't want to miss that step

and just have one person sign if it's a husband and wife team

you want both and if you've done all that if you submitted your list within

45 days it's unambiguous it's in writing and signed by all the taxpayers and you

send it to your 1031 exchange service provider.

You're pretty much golden I mean you've done this and now it just comes down to

completing the transactions and switching your one property

into more properties so what are the types of 1031 exchanges well there are

three types and we're going to go through them all

right now in order of their popularity the first type is the

forward exchange that is the process that I've pretty

much been using my examples where you sell one property

exchange it into new properties within 180 days.

And as long as you follow all the procedures that we've described so far

you've avoided capital gains tax under section 1031 of the internal revenue

code. The second most popular method is the

reverse exchange this is a situation where you have

identified and closed on your replacement property first

and then you sell your original property within 180 days

of acquiring the replacement property so it's the 1031 exchange

but it is done backwards. And the third type of 1031

exchange which is used more in the commercial setting when you're buying

perhaps a strip mall or some property that

needs to be improved upon is called the improvement exchange

and this is a situation where you use part of the proceeds from your original

sale to do upgrades and improvements to the

new property so it's not the case that if you sell your maui vacation home and

say you want to buy a strip mall and that strip mall needs about a hundred

thousand dollars worth of improvements you don't need to put the five hundred

thousand dollars into your down payment on the strip mall you can put in

four hundred thousand dollars in the down payment on your strip mall

and then used a hundred thousand dollars improvements

to also qualify for the 1031 exchange but to do that

again you need to use what's called the 1031 exchange accommodator.

Your 1031 exchange service provider or attorney or tax professional can advise

you how best to do that but you do have that option if you're

going to be buying property that requires some upgrades

and you would like to use that upgrade money from the proceeds of the sale of

your prior property. 1031 exchange allows you to

wrap it all in and treat it for the purpose of avoiding

capital gains as one big exchange. So

folks that is the 1031 exchange why it's useful to you you can grow your

property portfolio by deferring capital gains if your stock

broker could tell you if you invest in this stock pay some

money down today and then you're going to be able to

split that stock out in the future for infinity as long as this tax code

allows us to and never pay capital gains tax and

just keep growing your portfolio well that would be the only stock that

I'd be interested in as an investor that would probably be the only stock

I'd be interested in recommending on a mass basis if I was a registered

investment advisor well this is what you can do with real property right now

under the internal revenue code, you can take some property that you are

maybe only getting one rent on or no rent on split it into multiple

properties it can be a very smart growth strategy to

create generational wealth for your family

and we're happy to talk to you about that or recommend

you to the tax and legal professionals who can better answer specific questions.

If you need those recommendations and don't

have ones of your own but in any case please feel free to

contact us this is something that we're very passionate about

and love to help people get into and do create that generational wealth for

their families, grow their portfolios and you can

contact us at [email protected]

I'm Jon Queen, it's been a pleasure talking to you and I look forward to our

next discussion related to investing in real estate.