Table Of Contents
In this episode, Brandon Hall and Thomas Castelli discuss 1031 exchanges and qualified opportunity funds and how they can help you reduce taxes when selling your rental real estate.
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Full Transcript:
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.
Brandon Hall 0:00
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Thomas Castelli 0:30
Already, buddy, thank you for tuning in. And we're back with episode two of the exit strategies for rental real estate. And today we're going to be discussing 1031 exchanges, and qualified opportunity funds, and how they can help you reduce taxes or defer taxes when you are selling your rental real estate.
Brandon Hall 0:49
Yeah, and you know, 1031 exchanges are currently under fire with the Biden administration. So we'll see what happens with that, hopefully by the end of this year. But the qualified opportunity funds was kind of interesting that came into effect with the 2017 tax cuts and Jobs Act. And we really haven't had a whole lot of clients that have really either started qualified opportunity funds or invested in them. I think it's the What's your take on that, Tom, I think from the feedback that I hear, and I could be making this up, it's really that 10 year hold period, that scares a lot of people off.
Thomas Castelli 1:21
Yeah, it's a 10 year hold period. Because really, to start a qualified Opportunity Fund, there's a lot of costs to get started a lot of compliance items, you need to check off and check the boxes. So some people are shying away from them. But really, for the passive investors to people who would typically invest in like a syndicate, a 10 year hold is kind of a big Horizon, a lot of people are used to investing on a three to five year period, or maybe a five to seven year period, you put 10 years, this is an uncomfortable situation for people to lock their money up. And that's kind of why you're not seeing so much excitement. But I think there's some other reasons to think one of the biggest reasons as well is that it's kind of confusing. So basically, the way a qualified Opportunity Fund works is that you're able to defer your capital gains, right, just the capital gains, unlike a 1031 exchange, where you have to invest the entire sales proceeds with the qualified Opportunity Fund, you have the ability to take your principal back or take your original investment back, put that back in your pocket and just invest the capital gains. And when that happens, if you're hold it for five year period, which actually the last time you can actually get this five year period hold period will be on 1231 2021. If you invest for at least a period of five years, you get a 10% step up in basis in your original investment. So for example, if you invested $100,000 In gains in 2021, and five years from now, and 2026, your capital gain, you only have to pay tax on 90% of that, or $90,000 at the capital gains rate in 2026, which we'll get to in just a second. And the
Brandon Hall 2:56
reason for that too, is that it is a 10% step up, like Tom said, but then he said 90% of the investment in it. So just want to clarify that when you invest $100,000 of gain, when you roll forward $100,000 of gain into a qualified Opportunity Fund in First off, it's just the gain portion, right? You don't have to roll forward your basis. And you know, so it's a little bit different, like I could actually cash my basis out, take my cost basis back and just push the gain into the qof, the qualified Opportunity Fund. But when I put $100,000, in what is my basis, my basis is $0. Right? Because it's again, it's all gain money, I haven't paid tax on it yet. So my basis is $0. It's like a traditional IRA, when I put money into traditional IRA, my basis on that contribution is $0. Because if I cashed it out, I've got to pay tax on it. So what you're doing is you're saying I put $100,000 in, I get a 10% step up on my investment, which means my basis goes from $0 to $10,000. And that's why I only pay tax on $90,000. Again,
Thomas Castelli 3:56
yep. And that's one of the one of the benefits of investing in the qualified Opportunity Fund is that you get to defer your taxes. So you're not paying taxes. In the year you sell that asset, if you invest in the qualified Opportunity Fund until 2026. If you hold it for five years, you get that step up. But then you have to pay tax, you have to pay tax on that original capital gain investment, you have to pay tax on that capital gain in 2026. So you have to recognize that taxable VAT in 2026 Whether or not you actually sell the investment in the qualified Opportunity Fund or not. And I think that has been causing some pause and some confusion around what that actually means. Some people think that if you hold the qualified Opportunity Fund for 10 years, that that original gain is actually what is eliminated, but it's not that gain has to be paid in 2026. And what makes matters worse, as we kind of head into this new year with the proposed Biden tax changes is that it 2026 There's a good chance if these proposed regular are passed, that the capital gains rate if you make over a million dollars can shoot up 39.6%. And then you have to add in the net investment income tax 3.8%. So you're paying over 40% in taxes, potentially in 2026, which is giving some people who might be facing those tax rates pause from investing in these qualified opportunity funds, because you just don't know what the type of gains rates gonna look like in 2026.
Brandon Hall 5:24
That's a really, really great point. Really great point. And yeah, wow, that's a really great point. One that I didn't think about, so Wow. Yeah, nicely done. Yeah, you're right. Because if you are deferring today, but you could have paid tax at 23.8%. Today, but you defer through this qualified Opportunity Fund, you know, you might get a good return on investment. But in 2026, you have to pay tax on the net gain. And that net gain may be taxed at roughly 40%, not factoring and I guess state actually be even higher be like 42%. So, wow, yeah, you're right, that's, you gotta be careful about that, you gotta plan for that. Now, I mentioned Tom, that you have to invest by December 31 2021, to get that 10% step up in basis. And I just want to clarify that for folks. The reason that that's the case is in 2026, you are going to have to pay tax on the gain. So if you invest by December 31 2021, you will have allowed the five years to accrue by the time 2026 rolls around, right 2022 2023 2024 2025 2026, I'm counting on my fingers, for those of you listening in your car. But that's five years that a lapse in that allows that five year step up to happen, right. So if you invest on January 1 2022, you're not gonna have a full five years elapse before, you have to pay tax. And so what that means is, you're not going to get that 10% Step up and basis. So you gotta be really careful on the timing of these investments. You know, another thing too, is that while you can roll forward your capital, it's a really cool qualified opportunity funds, you can roll forward your capital gain, you don't have to roll forward your basis. So different than a 1031 exchange, right? 1031 Exchange, you have to roll forward everything. But in a qualified Opportunity Fund, it's just the game, you can cash out your basis, which is really neat. But you can't you can't roll forward your 1245 and 1250. Recapture. That's depreciation recapture. So if I sell a rental property, can't roll that forward, I got to pay tax on that I can only roll forward the game. So who's a qualified Opportunity Fund really good for at the end of the day, it's good for people that have large equity stakes in businesses, whether that's stock market investments, or whether it's just private equity, or venture capital type of arrangements. So if I've got large stakes, large apple stock holdings or large Tesla holdings, Tom likes Tesla, what are the other ones you like? Tom, you were just telling
Thomas Castelli 7:52
me about him before Netflix, Apple, Google.
Brandon Hall 7:55
Netflix, man, Netflix, I haven't looked at Netflix, I'm sure they've crushed it during the pandemic, I was sitting at home. Just watching watch. I know I have, I've watched a lot of shows a lot of new shows. So you're sitting in one of those, you're investing in one of those stocks, you are investing one of those companies, you've experienced large run ups, you've got large gains, well, you cash out those gains, you take your basis back, you can cash your basis out and you roll forward your capital gain, and what are you doing, you're moving out of the equity markets, and you're moving into real estate, you're shifting your portfolio around, you're moving out of the equity markets out of the stock market out of private investments, and you're gaining real estate exposure. And I think that that's probably why we haven't seen a whole lot of our clients jump into this because, you know, a lot of our clients we have we've hundreds and hundreds of clients. And they really, you know, they do a pretty good job diversifying. But but because they're already diversified, they're not really like looking to, you know, pull out of the equity markets and gain more real estate exposure, or some of our clients that, you know, don't diversify and just believe real estate's the way to go, which I'm not, it's not a wealth planning episode or podcast, so do your own due diligence. They don't have anything in the equity markets, they're already in real estate. And if you're already in real estate, and you're looking at Should I do a qualified Opportunity Fund, you start looking at like the 10 year hold period, most of our clients are in deals for five to seven years. So 10 year hold is a really is a negative, you start looking at the 1245 to 50 recapture depreciation recapture not being eligible for the roll forward thing, you start going well, I don't know if I should do this. Or maybe what I'll do instead, is I'll just go buy a bunch of assets in qualified opportunity zones, and I'll sell them to the qualified opportunity funds. So we've had quite a few clients actually do that instead, that that is what they deem a little bit more opportunistic than investing in a qof. That's what we've kind of seen, you know, a lot of our clients aren't really interested in qualified opportunity funds, but the ones that are it's typically because they have large equity holdings, either in the stock market or in private businesses that they're looking to cash out, roll forward and gain real estate exposure. As a result,
Thomas Castelli 10:01
yeah. So to kind of summarize the qualified Opportunity Fund conversation, basically, the way a qualified Opportunity Fund works is you, you would take your capital gain, again, excluding the depreciation recapture, you invested in the qualified Opportunity Fund to qualified Opportunity Fund. If you do that between now and the end of 2021, you'll be eligible for the 10% step up, which takes five years you need to hold in the fund, but you do have to pay taxes in 2026 on the original capital gain at the rates and 2026, not the rates in the year you invested. That can be a negative for some investors out there. And then if you hold your interest in the qualified Opportunity Fund, then your actual gain on the qualified opportunity fund investment itself is exempt from taxes. And that is pretty much what a qualified opportunity fund investment would look like from the investor's perspective. And just because of some of the complexities of not knowing where the capital gains tax rate or where your income will be in 2026, give some people some pause as well as the 10 year hold, man, just the confusion around how that works. It hasn't been such a widely used tool, as I think it was hoped to be. And we'll have to see how that all plays out. But most of our clients have not opted to use a qualified Opportunity Fund is their exit strategy. But something you should be aware of nonetheless, because it might work out for you. You know, one of the biggest problems we have in the CPA industry is people, the CPAs are too busy preparing tax returns to ever really provide any planning on how their clients can minimize their taxes, which is often costing their clients a lot of money. And Tom
Brandon Hall 11:31
and I've worked with over 1000 real estate investors on tax planning over the past six years, we've saved them millions of dollars in taxes. And the reality is, is that tax planning, especially one on one is really expensive. It's not in the budget for all real estate investors. But real estate investors are near and dear to Tom and I's heart, we're real estate investors, our parents are real estate investors, we want to help every single real estate investor out there. So we created tax smart investors.com. There's three subscription tiers, you can get a content subscription tier that gives you access to gated content. And we write it in a way that you can digest it. But there's also citations that you can go to your own tax preparer and say, Wait a second, this is how it's actually supposed to be. And here's the citation. On that content subscription, you also get access to a weekly tax strategy newsletter. On top of that, we also have a subscription that gives you access to our insiders Facebook group, which just allows closer access to Tom and I and our team of CPAs. You can schedule paid calls with us. And you can get access to our monthly workshops. Through that subscription tier and those monthly workshops. We're doing tax planning, financial planning, we're going over accounting strategies and how to automate your systems. And then we have a top tier
Thomas Castelli 12:40
and that top tier, that's really where you get access to us and our team of experienced real estate tax planners. And you could do that through two calls where we'll take a look at your situation and determine what strategies you can use to minimize your taxes based on where you are, where you're looking to go. In addition to that what a lot of our clients have loved over the years is the ability to send emails where you could send in your question, and we'll get back to you with an answer within 48 hours. And you should definitely check that out. If you're sending questions to your CPA and they're taking weeks to get back to you if they ever get back to you. Or they're not providing with any planning, we can take a look at your situation and determine what can be done to help you save on taxes.
Brandon Hall 13:17
So another exit strategy is to do a 1031 exchange. We've talked a lot about 1031 exchanges. And it's funny on one of my YouTube videos on the tax smart investors YouTube videos that I put up one of the tax Mark daily videos, somebody commented and be like, Wow, you're really not a fan of 1031 exchanges. Actually, I'm a really big fan of 1031 exchanges. I love the fact that you can invest in real estate and continue rolling forward the game over and over and over until you die. And then you could pass it on to your heirs that have stepped up basis. That's called swap till you drop. So good strategy there. But But, but the reality also is that 1031 exchanges cost money and mental space. What do I mean by mental space, I mean, stress to 31 exchanges can be stressful to pull off because there are very tight timelines related to a 1031 exchange. So for example, let's say that I have a property and I'm going to go sell it. And I'm going to close on September 1, when I close to timelines immediately start so I'm selling my property, and I've got this big gain and I want to roll it forward. And in 1031 Exchange, I line up my Qualified Intermediary, because I cannot receive the cash from that sale and then 1031 Exchange, it doesn't work like that. So my Qualified Intermediary, my iqi has to receive my cash at sale. They basically set up an escrow fund, and they they take all my cash, they put it in that escrow fund, and the way that 1031 exchanges make most of their money, you would think it's off the fees, but it's not off the fees. It's off the interest bearing accounts that they put your 1031 Exchange funds into. So they're going to take my cash, they're going to put it into an interest bearing account, they're going to earn money, they're going to earn interest income, that's where they apparently make most of their income. But so QA QC steps in September 1, they take my money to timelines start immediately I have a 45 day identification period. That starts September 1, I also have a 180 day closing period that also starts September 1. So the first mistake that we see investors make is thinking that not 180 Day closing period only starts after I identify, I formally identify the properties that I'm going to 1031 into. And that's not the case, the 180 day closing period starts day one of sale. So September 1, the 180 day closing period starts. And that 45 Day identification period starts not during the identification period, you have to formally identify property, hand that to your QA, and you have to eventually close on some or all of those properties, there are three types of rules that you can adhere to during your identification period. The first rule is the classic one that most people are familiar with, it's the three property rule, you identify three properties, regardless of the market value, and you close on at least one of them. So I sell a sell property a September 1, my 45 Day identification period starts, I identify property B, C, and D. And I have to close on one of those within 180 days of September 1, that's the three property rule. The second test is the 200% rule, you can identify an unlimited, unlimited number of replacement properties, as long as the aggregate value of all of these properties you identified does not exceed 200% of the sold property. So if I have a million dollar property that I sold on September 1, I can identify as many properties as I would like, as long as the aggregate value of all the identified properties does not exceed $2 million. Then there's the 95% rule. And the 95% rule says that you can identify as many properties as you'd like, as long as you acquire 95% of the total value identified. And what's the point of the 200%, the 95% rule, those are just there to provide you a little more flexibility in how you roll forward your game. So instead of saying I can only identify three properties, if you want to identify more properties, maybe spread your risk, or maybe really, maybe you're bringing a lot more cash to the table, and you can go with that 95% rule, instead, you can identify more properties than three, you just have to be aware of the 200% rule and the 95% rule.
Thomas Castelli 17:30
So 1031 Exchange is a great alternative exit strategy. If you don't have suspended passive losses, like we talked about in the last episode, you could use the 1031 exchange in that instance, or combine the two defer part of your gain using a 1031 exchange, one of the things you have to watch out for in a 1031 exchange is basis erosion. So as you each time you do a 1031 exchange, your basis in the asset is not going to be the same as the cost of that asset. So you might have a $4 million property that has a basis of $2 million, it's going to impact the depreciation expense over time, which could inhibit your ability to shelter the rental income from your assets, especially as you acquire larger and larger assets that that that produce greater and greater amounts of rental income. Yeah,
Brandon Hall 18:21
an example of that basis erosion. So that's not like a technical term. It's just one that Tom and I made up after we've helped hundreds and hundreds of real estate investors with this type of stuff. But what happens is, I start with a $100,000 property. And my cost basis is $100,000, because that's what I paid. And then over time, I 1031 exchange that $100,000 property, maybe now it's worth $200,000. So my cost basis is 100. Now it's worth 200. And I want to sell it in 1031 into the next property. So I sell it for 200. And then I go buy a $200,000 property, well, maybe my $100,000 property was a single family home, maybe my $200,000 property is now a three unit property. Okay, so my three in a property, what is it going to do, it's going to spit off a little bit more cash flow for me. But I have to carry forward my basis from that original property. Right. So when I buy this $200,000.03 unit, I don't have a cost basis of $200,000. I have a cost basis of $100,000 minus whatever depreciation I've previously claimed on that original property. So my cost basis might actually only be $80,000. But I have a $200,000 property. And I have a $200,000 property producing cash flow that a $200,000 property produces. So I've increased my cash flow, but I have not increased the amount of my annual depreciation expense. So what happens is over time, like that three in a property might go to $300,000 in value, and then I sell that and I buy a four unit property for $300,000. And now my four unit property has a fair market value of $300,000. But it has that original cost basis minus depreciation. So now maybe my adjusted basis is $70,000. And the $300,000 property, again, I've increased my cash flow because I'm adding units, but I have not increased my annual depreciation expense. So what happens over time, is that my depreciation expense does not keep up with my cash flow, increasing my cash flow, and I end up with taxable income at some later point. Because if I do this five more times, I'm going to end up with a, you know, one and a half million dollar property with a really, really, really, really small basis, maybe I have a one and a half million dollar property, but I'm depreciating it like a $300,000 property. And so it's producing cash flow like a $1.5 million property would. But it's producing depreciation like a $300,000 property. And that is very realistic in big market run ups, especially with where we're at right now. So you just have to be careful because that $1.5 million property is going to spit off a lot of cash flow, that's going to be difficult to shelter from taxes. So you might actually end up creating this taxable income stream, at some later point your life with 1031 Exchange is not a bad thing, because I'm sheltered all of this principle, right? All of this all this gain, I'm just rolling forward, rolling forward, it's just growing and growing and growing. And it's producing more and more cash. So it's definitely good thing, it's just important to be aware of the tax consequences,
Thomas Castelli 21:20
kind of following on with what Brandon was saying, when you take your asset. And when you buy the new asset, the replacement property, you're not actually restarting depreciation at the cost basis, right, you're going to be carrying forward the basis in the original asset and keep depreciating that on the depreciation schedule. And if you added any cash into the transaction, you're going to be able to allocate a portion of that basis in the new building and start depreciating that at its new rate, which could, which could help you increase your depreciation expense. So not always necessarily lost simply because of the basis erosion. So some things also with a 10th, or exchange that are interesting is if you're looking to, you know, quote, unquote, get out of the day to day management of all your rental properties. Maybe you've been on landlord for a few years, or maybe many years, maybe your entire life. And you're know what, I'm just tired of tenants and toilets, as they say, you could invest into what's known as a Delaware statutory Trust, which allows you to basically take your 1031 Exchange proceeds and place it into a passive investment. And that's what the DST is DST is kind of in some ways similar to a syndication, except the DST has been explicitly blessed by the IRS as being able to accept 1031 Exchange proceeds, because the problem is to people looking to get out of the day to day and I want to invest in the syndicate. Can I exchange my real property for partnership interest limited partnership interest with the syndicator? And the answer to that question is no, you can't exchange real property for partnership interest, because it's not like kind property and partnership interests in another themselves are not real property, despite the fact that the partnership may own the property, the interests themselves are not real property. So what's interesting is a Delaware statutory trust will actually go and purchase the property. And then you could extend their exchange from your real property into the Delaware statutory Trust, which again, has been blessed by the IRS. And that can get you out of the day, they imagined because you're going to have professional management and sponsors very similar to a syndicate operating the properties that are owned by the st.
Brandon Hall 23:31
Great discussion on that. And something that you just said that I also want to talk about is, if you are investing in a syndicate, it's really important to understand, like Tom said that the partnership owns the asset, you own a partnership interest, right? So you if you're investing in a syndicate, you own the asset, but in the eyes of tax law, you own a partnership interest, and you cannot 1031 Exchange partnership interest. But one thing you could do, and this isn't this isn't gonna work in like a syndication or a fund or anything, it's got to be like a smaller group. But one thing you could do is something called a drop and swap. So a drop and swap, the way that it works is I let's say Tom and I, we create a partnership. And we each own a 5050 stake in this partnership. So our partnership interests are 5050 each, the partnership goes and owns a million dollar property, and that million dollar property increases to $2 million. And let's say that Tom wants to go one way he wants to go do something with his increased capital, and I want to go and 1031 exchange it. So I want to stay in real estate, but I don't want to recognize the gain on this appreciation. Well, we have a problem because the partnership owns the asset, Tom and I each own a 5050 partnership interest, I cannot 1031 Exchange, my 50% partnership interest, but what we can do is I can actually drop out of the partnership and take a tick stake attendance and common stake in the underlying property. So the partnership or or I guess the Well wouldn't be a partnership anymore because Tom would be the only one in it. But the LLC would own 50% of the underlying asset. And Brandon Hall would own the remaining 50% of the underlying asset. And because I own the actual real estate at that point, I can 1031 exchange that Matt Rappaport did a great presentation on our 2021 tax and legal summit on this stuff, it is extremely technical, and that guy blows it out of the water every single time. If you're going to do a drop swap, I highly recommend the actually contact him and us we can all help you walk through it. But you can do a drop and swap to 1031 Exchange out of a partnership or out of a syndication, you just can't go partnership interest directly into real, you can't tend to want to change the partnership venture. So you got to drop out of the partnership, you got to directly own the underlying asset. And then you contend that one the ownership stake that you have in that underlying asset.
Thomas Castelli 25:55
Yeah, yeah, so So the bottom line here is kind of you can only exchange real property. For other real property, like you could exchange an apartment building for another apartment building or a portfolio of single family homes or a self storage facility, a piece of land, all these different things, but you can exchange it for partnership interests. So if you really want to go passive, your option there is to use a DST because that's going to allow you to exchange the real property for the real property. But if you're in a partnership, and people want to go their separate ways, that's when the dropping swap comes into play. Because now you have the real property or your partner's the real property and you can go your separate ways and still do what you want to do. So thanks, everybody for tuning in. That covers pretty much the most common exit strategies we see. Again, that's in episode one, we covered using passive losses, as well as tax loss harvesting. And then in this episode, we covered 1031 exchanges and qualified opportunity funds. There are some other ones out there, including installment sales, and we'll probably touch on that in a future episode. But that's all for this series, and we'll catch you on the next episode.
Brandon Hall 26:58
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