Guest Speaker: Tom Phelan

1031 Exchanges

Tom Phelan has been licensed in real estate in Arizona, California, Colorado, New York, and Wyoming. Tom has been Certified to offer Realtor® CE Credit Classes for 1031 exchanging for National Real Estate Brokerage companies like ReMax, C-21, ERA, Coldwell Banker, Keller Williams and a host of others since 1998. He has been personally involved in real estate as an investor since the 1980s, investing in fix-and-flips, fixer-uppers, and buy-and-hold properties where 1031 exchange knowledge and strategy is essential to build a retirement. Whether it be a single-family rental, multi-unit apartment house, ranch or office building, 1031 exchanging may have tremendous tax benefits for the investor. Unfortunately, too many investors are not 1031 exchange savvy, nor are their realtors. Tom’s mission is to change that. He is also the author of ‘Million Dollar IRA , ‘Rich IRA Poor IRA’ ‘How To Buy And Sell Real Estate And Never Pay Taxes’, ‘Rich Realtor® Poor Realtor®’, and has been published by Wall Street Journal Internet, Business Insider, Financial Times, Escape Artist, International Living, Live and Invest Overseas, ETR, Agoura, Simon and Schuster – Bantam Books.

What you’ll learn in this episode:

*Tom has been involved in real estate since the 80’s, investing in fix and flips, fixer uppers and buy and holds where 1031 Exchange knowledge is essential to building one’s retirement very quickly.

*1031 Exchanging is a key tool providing a tremendous tax benefit, but many people are still unfortunately not very “1031 Exchange Savvy.”

*Tom has a one-word answer for why so few people including realtors know so little about these exchanges: education. The public has never been taught about 1031 exchanging and the fact that it’s the greatest tax tool ever given to Americans by Congress back in 1921. People can’t consider 1031 Exchanges as a tax tool if they have never been educated or had it explained to them.

*1031 Exchange is not complicated. The key is being aware of the rules before you have an investment property under contract. The property you’re selling is called the relinquished property. You get a settlement report and realized you’re making a good chunk of money and that will mean a pretty good chunk of taxes. If you know about the 1031 Exchange, you can eliminate that fear.

*A layman’s definition of a 1031 Exchange: a loan made by the IRS to you the taxpayer, at 0% interest with no repayment schedule and possibly never having to pay the loan back.

*When you have a relinquished property, you have 180 days to find and close on a replacement property or properties. There are restrictions within that time frame. Once you close there are two time periods that run concurrently. There’s the 180 days to close the exchange on the property that’s replacing the one you’re getting rid of, and 45 days to identify replacement property rule. That 45 days ends at midnight on the 45th day, and can be on Saturday, Sunday or a holiday. If you use your profits to buy another property within 180 days, you avoid any capital gains tax.

*One of the more confusing aspects of the 1031 Exchange is the Three Property Rule. The IRS has said if you identify over three potential new properties, you could be in a minefield unnecessarily. You have 45 days to identify and conveyed this to the intermediary, and they have proven that they’ve received a legal description of the property you’ve identified. You have to provide an actual address. During the 45 days, you can revoke, identify, and consequently revoke as many properties as you want. At the end of those 45 days, the window closes, and you can identify no further properties. It’s good to identify a second or third property as backup in case of extreme changes like the death of a property owner or divorce.

*The property you end up closing on within the 180 days must be equal to or greater than the value of the property you just came out of. So to qualify, you can’t go from a $300,000 property to a $200,000 property. If you do that, there will be tax consequences. They call it “boot” or “debt.”  In theory, you can come out of a $300,000 property and identify three $100,000 properties, but if one falls out, then you’re in “boot” territory.

*Tom defines a “mortgage boot”: You sell a property for $300,000 and identify another property that’s $300,000. But you have a $200,000 mortgage on it, and it’s paid off. The property you go into only has a $100,000 mortgage, and that would be called “debt relief” and you will be taxed on that reduction in the mortgage as capital gains. That’s why a strategy, crunching the numbers, is so important before you go under contract. You want your mortgages equal to each other.

*You are liable for taxes on any cash taken out or any debt relief. IRS considers that taxable.

*Tom says the mortgage can be seller carry. Let’s say you found someone willing to carry back. That would be fine. You can do an assumption as well. Once it’s equal to or greater than, you’re not going to face a tax liability.

*The beauty of this is that as long as it’s equal or greater value, it doesn’t matter what type of property it is. You can go from house to apartment, or apartment to an office…There’s a misconception that the next property has to be the same type.

*Tom explains why her thinks a strategic series of 1031 Exchanges is a better approach to securing a retirement than a traditional IRA or 401k. He shares how different transactions can lead to great profits over the years, with only one real moment of financial pain, when you first bought a single-family home rental. He concludes with: “If everything goes to hell in a handbasket, you can’t move into your stock portfolio. You can’t move into your IRA. But you can move into a unit.”

*Tom says your heirs inherit property on a stepped- up basis, based on the fair market value at the time, rather than annual depreciation. When you pass away, you can be sure it’s a legacy they receive intact, without paying a dime in taxes. “It doesn’t get any better,” he says.

*Tom proposes a scenario that even Ron LeGrand didn’t know. You have 45 days to identify three properties. What if you have identified 4 or 5? No problem. “It’s just that it can trigger some ratios that make it more complex.” One is called the 200% rule, the other is the 95% rule. If those properties you’ve identified as an aggregate are 201% more value of what you’re coming out of, you have to close on 95% of them. Everything depends on knowing these strategies beforehand.

*Tom agrees with Lance’s concept that it’s important to consider investment options beyond your own backyard. Versatility is important, because the profits from one small apartment building in one state can be bad while in another state, they can be amazing. “I think you would agree would be totally discouraged on a $900,000 duplex that is pulling 4000 in rents. It’s not a great deal. But in Macon, Georgia or Oklahoma City and it’s a nice looking 12 unit for six hundred thousand, it flies.”

*In 1976, President Gerald Ford signed the IRA into law, which was welcomed by employers because it shifted the responsibility of an investment strategy for retirement to the employee. Wall Street saw an opportunity and made their favorite product mutual funds. The idea was they could take $200 from your paycheck every month and this would lead to a good retirement at 65. They never tell you about other options. Couple that with that the National Association of Realtors never push the 1031 Exchanges onto their members as a great vehicle to build a retirement, and the fact that 95% of the $13 trillion dollars on Wall Street are in IRAs and 401ks. Wall Street acts like the only game in town and no one opposes them. “My goal is to oppose them,” Tom says.

*Tom summarizes: A 1031 begins upon the closing of the first relinquished property and runs 180 days, by which time you have to close on your replacement property or properties. When you close on your first relinquished property, you have 45 days to identify your replacement properties. After the 45th day, the window is closed. You’ll have to pay taxes.

*Tom responds to Lance’s question, “What if your tax return comes in the middle of the 180- or 45-day windows?” If you’re getting a big chunk back, you can file and extension on your taxes and wait. If you owe taxes, wait until your 180 days are up or you have closed, and the intermediary says the period is over.

*It’s best to declare your intention to use the 1031 Exchange before you put your house up for sale. You can put it in a clause in the agreement, that buyer agrees that seller is conducting an exchange and will cooperate at no additional liability or money.

*Tom tells several stories about how 1031 Exchanges have helped clients sell properties to help out their children with businesses and an apartment to live in while going to school

*Tom says there are times (especially for clients making very small down payments) when he recommends that a 1031 Exchange would not make sense. Sometimes he starts them on a small scale and helps them work their way up into a scenario where it fits. Fix and flippers are another category where it might not make sense. He says, “I’ve seen a fix & flipper buy a property be in it for eleven months to get it ready take it to market and sell it maybe make fifty thousand one hundred thousand but then they get killed by taxes ordinary income. OK where if they would have been rented it for six months or a year and now have held it for at least a year and exchange it they wouldn’t pay any taxes.”

*Tom explains another scenario: “Intent is huge. Let’s say you bought a property and day one you put a For Sale sign in it and 13 months later you can’t get rid of this dog for whatever reason and you finally do. And you managed to make a profit you say I’ll do a 1031 exchange. You probably wouldn’t qualify if they audited you the IRS because you’re intent in the beginning was dumping.”

*Tom says you cannot own the property under one name and during the exchange create an LLC; no “switching horses” in an exchange. He discusses one scenario where friends might form a cloverleaf partnership and have to dissolve it if one partner leaves or there is a falling out. He says, “You either have to dissolve the partnership and go into four individuals a year prior to exchanging or exchange into something else.”

*Tom has been certified in five states to teach 1031 Exchanging, but is no longer. He is now consulting on a national basis.

*Tom explains that you can do an international exchange. If you bought a condo in Mexico and sell it a few years later for a great profit, you can do a 1031 Exchange on it.

*An intermediary is an unbiased third-party entity that takes the money from the closing of your relinquished property and warehouses it until you close on your replacement property. Then it disperses the funds as per your request. They are sometimes owned by title companies, and sometimes they are standalone. Tom can email people the names of organizations that most intermediaries belong to.

*There is no cap on the value passed on to heirs.

*Tom discusses the 1031 Exchange fee. Intermediaries working with one property into another property charge from $750 to $1000 – a real bargain. If there are more replacement properties involved, they may charge $100-150 per extra property.

*A reverse exchange is basically where you buy the replacement property first, the 180 days start to run and you get rid of and sell your relinquished property. You can get all the same benefits as if you had sold your other property first. Reverses have the same equal or greater than value requirement.



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