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Unlocking Real Estate Tax Hacks For Beginners - 1031 Exchange

If you don't manage your real estate investments properly, especially in the transition between selling one and buying another, you could pay an extra 50% in taxes. If you're not careful. That's right, doing things wrong at this stage can cost you huge. 

Today we're gonna talk about the ins and outs of 1031 exchanges, which if you don't know, is one of the most amazing benefits of real estate investing that we have today, but also has very big hurdles for you to clear that must be followed to a T, but the upside is if you do follow the 1031 guidelines to the letter of the IRS, you have the ability to defer all taxable gains of a property sale, and then can transition into a bigger, better, beautiful and more expensive exchange property. That's right. Completely tax-free. 

Also, in the end, we're gonna talk about a strategy to use a 1031 to transition into investing in a fund model, which is an amazing strategy. If you are moving out of a property and want to move into something where someone else is managing the day-to-day and where you as the investor can work with a highly trained set of professionals all while maintaining a huge amount of tax strategy and tax advantages. 

Hi everyone, Nic DeAngelo with Saint investment group. We currently have over 150 million in real estate assets under management, and we are currently raising an additional 100 million more. As a reminder, always check with your professionals that know your financial situation before making any massive financial decisions. 

Let’s jump into it. If you are considering 1031 in exchange for the amazing tax benefits that it can offer or you're just curious about what 1031 is. Here are some of the basics that you need to know. 

So first off, what is a 1031 exchange? 

Let's start at the bottom broadly stated in the simplest terms a 1031 exchange known as the like-kind exchange, is a swap from one property to another property. You are selling one property and using the proceeds from that sale to then purchase the second property. 

Now, most swaps in real estate are taxable as sales. However, if you stick to the 1031 guidelines outlined by the IRS to the T, then you should have either no tax whatsoever or a much-reduced tax due at the time of the exchange in effect, you can essentially change from one investment to the other through the eyes of the IRS as long as it is a like-kind investment as defined by the IRS and you can do this in a tax-deferred setting. How cool is that? 

Additionally, there are no limits to how many times you can do it in 1030 as long as you stick to the IRS guidelines for 1031 exchanges. 

Now let's dive into one layer deeper with the next question. Which is how you qualify your property for a 1031 exchange? 

The first thing to note is, and I kind of mentioned it earlier, but it must be a like-kind exchange.  Now, what does this phrase mean? Because it can be kind of vague. Let me start with what it does not mean. Most people assume that like-kind means something like multi-family to multi-family or strip multi to strip mall or office building to office building. It actually does not mean that.

The IRS has moved forward with a less restrictive definition of what like-kind means in this case. So what does like-kind actually mean in this case is investment real estate for investment real estate? 

It means that you can't actually, sell your strip mall and you say, Hey, I don't like how this is performing and 1031 that into a class, an office building that you like better, that you think is better suited for your portfolio and then maybe a few years later that class and office building is something that you want to get rid of, and it's not a good fit for that time. You can then sell that class, an office building, and via class B, an apartment complex somewhere else, and all those funds have transferred multiple times, tax-deferred, as long as you stick to the IRS guidelines and you have created immense value from this exchange process multiple times.

Now additionally, and I don't have personal experience with this because we don't operate in this space, I'm actually told that you can do the same thing using 1031 guidelines for businesses as well. But I'll tell you what, I'll make you guys a deal. 

If you are interested in the details of how to use that 1031 exchange on how to buy and sell businesses, leave a comment below, and if we get enough interest we will make an entire video on how to use the 1031 processes to buy and sell businesses. 

Another important note on this is that both properties must be located within the United States in order to qualify for a proper swap using the 1031 guidelines. So just like everything in real estate, location matters. 

In addition to location, let's jump into some of the hard and fast rules that surround the 1031 exchange process. 

First, timeframes in 1031 ones are extremely important and there are several that you must be aware of in order to be compliant. The first timeframe that is absolutely crucial is the 45-day rule. This 45-day rule relates to designating the replacement property. So when you own a property, you wish to sell it and you sell that. It must be replaced per the 1031 guidelines, and that replacement property or the property that you buy after your sale must be identified within a 45-day window of the closing of the first property. 

So the day you sell the first property, you have 45 days up to three properties that you may purchase as your replacement property. Now, depending on how you organize this, you don't have to close all three. You can close one or two, or you can close all three, but you can identify up to three and you must close on one of those in order to qualify for that new property, being your 1031 valid purchase. 

Now let's push a quick pause on the process to teach you guys some insider industry jargon that will be extremely helpful and will make you seem very professional. When you're working through your own 1031. 

For the case, I just described selling one property and buying one property. There are terms already associated with this process because it can be so complicated and easy to jumble when you're explaining it to your accommodator or other people involved in the transaction or escrow, etc. 

Terms have evolved to identify these properties. The terms used in the industry are downleg and upleg. The down leg property is the property that is being sold. It is the first property that you already own and then you sell that is the downleg property and on the other side of the transaction is the upleg property. That's the property that you are purchasing with the proceeds of your down leg. So the down leg comes first, and then you use that money and you purchase the up leg. 

So in this case, when we talk about the 45-day rule for identifying property, you are identifying three potentials for your upleg. These terms are very important. So I wanted to just take a minute and explain these in detail for you guys throughout the remainder of this article.

I'm gonna use the terms downleg and upleg regularly so that, you know, very clearly which property I'm referring to, and also to get you guys used to the jargon of real estate in 1031 exchanges, let's jump back into the process. 

So you have your downleg, the property that is about to sell. Once you sell your property because you're in a 1031 exchange the proceeds of that sale. Don't just go into your pocket. The proceeds of that downleg sale go to an intermediary between the downleg and the upleg, somebody right in the middle.

A third party, the accommodator in the middle, receives the proceeds of the downleg sale and manages those monies until the time of purchase of the upleg property. At which point, when you've identified the upleg appropriately, then you use those funds in escrow from the accommodator, and then purchase that upleg. 

Now, who is the accommodator? Do they work for the government? Do they work for the IRS? Who are they? 

Well, the answers are actually much better than either of those accommodators, typically law firms or escrow offices that manage this process full time, because it's such a specialty and important and high risk. If you do it incorrectly operation that they put together and they focus on it`s full-time and if you're asking yourself why an attorney's office or an escrow office it's because compliance on this is very important and those fields already understand high compliance situations in real estate, escrow situations where there's transfers of properties, etc.So it's kind of a natural fit for those types of vendors. 

So now the real estate industry is huge. So the best accommodation, well, that can kind of change pretty often, but I'll tell you what if you are in this situation and you need a recommendation for who the best accommodators are, reach out to me personally and I will give you an updated list of the best accommodators that we use at that time because when they don't operate well, we drop them off of our preferred vendor list. 

And when they do great, we bump them up to the freakin top. We seem to be constantly in exchanges with all the buying and selling we do. 

So why use an accommodator at all? Why do you need an accommodator and what does that have to do with anything? 

Well, the first is that the IRS says so, you need to tow the freaking line and play it by their rules. Otherwise, you're gonna end up with a fat tax bill, but the real reason behind that is actually a smart reason on their part because you can't just get the proceeds of the sale and then tell the IRS, Hey, I promise that I totally followed all the rules. Trust me, even though I'm extremely biased as the seller of the property, right? You can't do that. So you need a third party that has a lot to lose, and that will make sure compliance is on track. 

The accommodator will track all of the details. They will check all the boxes and they are your friend that makes sure that you are compliant and can prove it to the IRS. If God forbid an audit comes. 

So let's jump back into time frames a little bit. As we mentioned, there's a 45-day timeframe in which you must identify three properties, meaning you are putting all of your 1031 eggs into three baskets. So one of those freaking baskets needs to work out. So choose accordingly and make sure that the identified properties you're doing have a high likelihood to close. So you don't get stuck in a position where you just have a tax bill, cause none of the properties went through. 

Let's jump into the second timeframe a rule that the 1031 exchange uses as a hard and fast concrete deadline and that is the 180-day rule. 

The simple definition of that rule is that from the date of closing your downleg, you have 180 days to close your up leg. Also as a reminder, this is a must. So if the downleg sale happens on day one, then you must close on or before day 180 for your upleg. 

In practice, what this means is that you must manage your time effectively throughout that 180 days, while that might sound like a lot, Hey, I got six months. I got half a freaking year to get this whole thing done. No! It goes extremely quickly. So you need to be miles ahead of this curve. Trust me when people miss this, it could cost six, seven, or sometimes even eight figures for the big players. So you cannot mess this up. You can't afford to, it's a dead stop from that point. 

So, what do the pros do to make sure that this process goes as smoothly as possible? What's the expert tip here? 

I'm glad you asked. Here's something that we've done in the past that has been tremendously successful and while it might be slightly annoying for the buyer of your downleg, it allows you as the seller and you as the 1031 exchange buyer to manage your time frames extremely efficiently. So here it is when you are selling your downleg, including the terms of that purchase and sale agreement that the seller or you has the ability to extend escrow for X amount of 30-day periods. 

We typically pursue about four 30-day periods, which means we can extend escrow by four months. So what does that mean? Let's say this down leg was supposed to close in 30 days. You can extend that by an additional four months. If you include that in your purchase and sale agreement and you leave the sole discretion to you, the seller. 

So here's what you do. You remove all contingencies in your down leg sale and you as the seller have those extensions during this period of time, you are on a hunt for what your up leg property is while you're already in escrow of your downleg, you pre-search for your upleg property, that new buy that you must make per the 1031 guidelines of the IRS. You search for that while you're already in escrow and get way out ahead of it, then you tie your first choice upleg property into escrow before the down leg closes. 

So what does that mean? That means you control both deals. So the path between the deals, the bridge between the deals is much smoother. You don't have to make bets on three random properties, cause it's already in escrow over here and then as soon as this is an escrow and you have some certainty of closure on your upleg, then you can pretty much close your downleg as soon as possible. But if this one gets stalled out at all.

But guess what? You have multiple 30 days extensions from there and the second you close that you have an additional 180 days to close your upleg. So let's say you're an escrow on the lake and its six 30-day extensions, or six months' worth of extensions. Then from that close date you have an additional six months to close your up leg. 

Now this is complicated to manage both, but if you do it properly, you have way more than enough time to get your 1031 done and it's what we see mini pros do and it's what we pursue in every single 1031 exchange that we do today. 

Also worth noting. I'm gonna make a point here. Have you ever had to get something done, but you're on an insane timeframe.

You're on an insane clock. That's just ticking really loudly in the background and it's just causing you stress and you're not thinking clearly and you're just having to rush into something that may or may not be the best fit. Now imagine that's a seven-figure problem. 

In addition to that timeframe, you don't make your best investment decisions and you don't find the best deals when you're aggressively on a time clock to find the best deals you must have time in the market. You must be able to survey the market, see what's available and pick from a whole heap of opportunities. Cause then you're gonna find that needle and a haystack of the best freaking upleg, the best freaking purchase deal that you can. 

So while managing your time frame is important for the 1031 exchange for the IRS, it's equally as important for you as the investor to make sure you have the time to be the best acquisition person that you can be for the portfolio. 

One final note on timeframes, the 45-day window, and the 180-day window run concurrently. So if you close on day one, then by day 45, you must close on your properties and by day 180, you must close the upleg property and both timelines start on day one. So if you identify your properties on day 45, then that means you only have 135 days to close the purchase of your upleg. So while the 45 days and the 180-day rules are the most commonly known rules of 1031 exchanges, let's talk about something that's a little more complicated and a little less common, but can be very valuable if you know how to use it within the 1031 exchange ruling. 

Let's talk for a second about reverse exchanges. That's right. It's also possible that instead of selling your downleg and then buying your upleg, you can actually reverse the process. 

Now while the 45-day and the 180-day rulings still are in effect for this, you have an understanding of those. So we're gonna go into more detail about how this swap occurs and the pros and cons of it. So just like the 45-day and 180-day rules are in effect, you also must have accommodation to make sure that the reverse exchange is done properly. 

Now let me make a note from my experience and tell you most 1031 accommodators do not understand reverse exchanges. What does that mean? That means that they can screw it up. We've had people screw it up in the past and we pulled it off at the last second by putting a lot of different people on it and a lot of really smart minds to make sure it was on track, but somebody made a potential a seven-figure error that would've ended everybody in a big lawsuit. Everybody would've lost it. Would've been a nightmare. So choose the correct accommodator to make sure they follow the rulings to a T and that they're the best operators in the space because you're here to save money but you're here to save money correctly and do it correctly. So pay them the money so that you can save a bigger chunk of money. 

Now let's talk about the advantages of doing a reverse exchange. Let’s say the upleg. Now reverse exchanges are most often used when you're trying to daisy chain transactions which means to sell one, buy another, sell another, buy another. Well, if you do this properly, you can move a huge chunk of your portfolio around. 

Let's say you have a huge real estate portfolio. You might want to position 40% of that portfolio out of a product type and get into something else. Now while maybe you're some mastermind of escrows and market conditions and all that, typically you gotta buy and sell one at a time. So you might have multiple escrows and 1031 exchanges happening simultaneously. That's where reverse exchanges come into play over the last several years. We've probably bought and sold maybe 40 to 50 million in real estate to reposition our asset management portfolio, and to make sure that we are well positioned for the new world post-COVID. So that meant 1031 after 1031 over and over. So we have this process down and we really know this well in the house of what our systems are to make sure we achieve this, but here's a drawback to reverse exchanges as well. 

Now, when you sell your downleg, guess what happens to that money? 

It goes to the intermediary or the accommodator and you use the same funds for the purchase of your upleg. So you're using the same money to buy the new property. That's fine if you structure it well, you typically don't have to come up with a lot of money to get from here to here, but a reverse 1031 is the opposite. So what does that mean? 

That means when you buy your up leg first, you have to buy all the cash. You gotta come up with that money up front, conceptually, you must come up with that money first and then you can sell that property and replenish the cash that you put out for the purchase, but you don't have the benefit of selling your downleg first and using that money for the upleg. 

If you start with the upleg, you gotta use money out of pocket to purchase. Initially. Now I can say this next piece out of experience in the market, most people don't have the cash to complete a reverse 1031 exchange. It's typically a small group that could pull this off now because we were trading so many different properties at a time and because we were well-positioned cash-wise, we did pull these off because it was within our strategy to do so, but just keep in mind. That's the number one thing I want you to learn strategically in a reverse 1031 exchange, you gotta have a lot of cash and that's absolutely mandatory to pull it off. 

Those are the basics of the 1031 exchange. Let's jump into the bigger level strategies and the bonus section of this topic, which is how to use the 1031 exchange to move into things like RES or DSTs or uprights, etc, how to use 1031 exchanges to get into investment vehicles and funds where it's very low management for you. 

The investor in this next part, I can't emphasize any more that you will need a competent team to pull this off and you must maintain compliance to an insane degree because this is where it starts to get a little more difficult. So you can exchange property on your downleg for it on your upleg, but it must go through a specific process. You do this process by selling your downleg and instead of buying the property outright, or you are upleg that you are going to have to manage and asset management and strategically figure out and make sure leasing's handled and making sure property management's handled and make sure maintenance is handled, etc.

Instead of selling your downleg and moving to an upleg where you own, you sell you downleg, you purchase shares of a structure called a Delaware statutory trust or a DST and once you own these shares in the DST, they then can convert either through the operating partnership agreement or through an umbrella partnership, or up rate, then they'll convert into the reitself through that process. 

So if your goal is to end up in a fund and or this DSD process is amazingly valuable, it offers you a hands-off vehicle with how to invest in real estate on a large scale with very big professionals that do an amazing job, but you don't have to do the work. You can sit back as the fully passive investor who will likely have access to bigger deals, better deals, better yields etc, 

Let them do their job for you. So while this is a little bit more work on the front side, in the 1031 exchange process long-term, this is actually tremendous value for you as an investor. If you're looking to be passive and most importantly, which is deferring your taxes legally and strategically, you can achieve this through the DST process because you're investing into shares of a partnership, however, make sure the accounting team and your compliance team are on track with this process, and they're knowledgeable. 

Now, if you're at this point and you're thinking through the DST process of how to transition out of properties and into a fund or reach scenario. 

Now, the biggest question at this stage is what fund is best. What fund model is best and what opportunities are best to invest passively? 

Well, we have an amazing video on an income fund masterclass that is completely free. So check out the below and find out income funds in the future. I'll see you guys again!

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