The Magic of 1031 Exchanges—The Most Powerful Tax Benefit Left in America

Ed Aloe (00:02):
Welcome to the Real Estate Wealth Podcast. The show about how you can build wealth by investing in real estate. I'm your host, Ed Aloe, Founder and CEO of CALCAP Advisors. I'll dive deep into multi-family investing in today's current market. I'll also help you acquire the knowledge and tools necessary to generate passive income for life, for discussions with friends and experts in the industry.

(00:24):
I'd like to welcome my guest today, Skip Keesler.

(00:45):
Skip is a partner at Greenberg Glusker. He is a nationally renowned expert in Section 1031 real estate exchanges, and I'm happy to have him on the show today. For those listeners, not familiar with the 1031 Exchange it's name comes from the section code of the IRS, the 1031 Section, and it essentially allows investors to defer capital gains when they sell a property by swapping or exchanging one property for another.

(01:13):
I first met Skip... Gosh, I think now probably six or seven years ago. I was speaking to a friend who was working on a complex 1031 scenario and I had a similar problem, which was we often have 20, 30, 35 people in these deals and sometimes you get a situation where some of the partners want to sell and some of the partners don't want to sell. And so I was lamenting to this friend several years ago and he said, "Ed, I got just the guy for you. I was in a transaction recently with 27 partners, half of them wanted to sell, half wanted to stay, and there's a guy named Skip Keesler that you need to meet. He's brilliant, he's creative, and he can help you solve this problem." And he really did wonders for us on this transaction.

(02:01):
So with that, Skip, welcome to the show today and maybe give our listeners a little background on who you are and how you got in this business.

Skip Keelser (02:10):
So thank you very much for that kind introduction. I've been doing this for a long time. In 1978, I wrote an article in the Journal of Taxation about a case called Starker. Starker is a synonym for the kinds of exchanges that we do now, which are deferred exchanges. You know you sell one property called the relinquish property and some time later you buy a second property called the replacement property and there's a deferral of time between the two events.

(02:40):
Lawyers write articles all the time and nobody cares about them. I was fortunate enough to have written that article about what I thought the outcome of Starker might be, and it has been part of the basis for my whole career. And I can't tell you how many 1031 Exchange transactions I've worked on, but it's certainly thousands and the dollars involved are certainly billions particularly of late.

Ed Aloe (03:06):
Yeah, that's great Skip. And I think since you and I have met, we've probably done six or seven transactions together. Maybe more than that and it has been great. I really think the 1031 is a vehicle today. When people ask me about it, I always tell them, "Well, it's the last greatest tax benefit left in America," which I kind of believe it is because it's a tremendous vehicle and a great way for real estate investors to grow their net worth and grow their wealth. Would you mind just explaining to the listeners what a 1031 Exchange is? The roles that the accommodators or qualified intermediaries play and kind of the basics of how it all works?

Skip Keelser (03:46):
All right, let's take it slow, particularly for the people who are listening who have never done a 1031 Exchange, or maybe you have only done one 1031 Exchange. To start with, Congress simplified what kinds of property are eligible for a 1031 Exchange when they passed the 2017 Tax Cuts and Jobs Act. Beginning in 2018, only real estate is eligible for 1031 Exchange tax deferral, and I'll explain that in a minute.

(04:17):
And the kind of real estate that's eligible has to be investment real estate or real estate used in a trader business. And I'm using the words trader business in quotes because it's tax jargon. So investment real estate is usually land that is unimproved or triple net. The drug store chains have these triple net locations that they sell to investors and they are investment property because other than collecting a check, there is nothing else to do.

(04:48):
Real estate trader business though, covers a very wide area. For tax purposes, being a landlord and running real estate to third parties is a trader business. So any kind of rental real estate is eligible for 1031 Exchange treatment and that includes apartment buildings, office buildings, mobile home parks, and shopping centers. I should note that your personal residence is not eligible and I want to make that clear that you can't use your 1031 rules to trade your house into another house.

Ed Aloe (05:26):
That's right. And having said that, there are ways, I believe, to convert a single family property into a rental property and still affect an exchange, correct?

Skip Keelser (05:37):
So what you would have to do is move out of your house, rent it for, in my opinion, at least two years to an unrelated third party, not your cousin or your niece or your aunt, but an unrelated third party at fair market value rent. And then at the end of the two-year period, you're probably eligible to treat that property as a 1031 eligible property.

Ed Aloe (05:59):
But you really have to be a landlord, rent it, have a proper lease in place, and truly make it your investment property for at least two years.

Skip Keelser (06:06):
And this isn't tax advice, but what typically happens is that the condition of the house at the end of the two years is not the same condition as it was at the beginning of the two years. So there's always that issue and don't rent to a rockstar.

Ed Aloe (06:20):
That's good advice living in LA. Hey Skip, one thing before the show that you brought up that I thought was kind of clever was the concept of... I think you called it the greatest secret in real estate is having the IRS become your 35% silent partner. Would you mind kind of touching on that a little bit and what you meant?

Skip Keelser (06:41):
Let's say that a $2 million piece of property has a loan on it for $1,200,000, but the cost basis is only $800,000 and the cost basis is the amount of your investment in the property after all the tax calculations that you would use to determine your gain. If you sold the property for $2 million, you're going to have $800,000 cash, but you're going to have gain of $1.2 million, the difference between the $2 million and the $800,000. So it makes sense then to trade because rather than paying tax on that $1.2 million, call it and round numbers $400 plus thousand dollars, the government in effect is allowing you to invest that $400,000 without accounting to the government for any return.

(07:35):
They're not getting part of the profits and you get to buy more real estate by virtue of not having to pay taxes. So rather than have $400,000 left to invest in real estate, you have $800,000 left to invest in real estate because you didn't have to pay taxes. So in effect, the government is your partner. I mean, it's not exactly your partner because partners want a piece of the profit, but they're better than your partner because they allow you to invest all your cash proceeds from the sales. So all of our clients who do this regularly don't even think about it. I mean, it's just in their DNA that they know that they can buy more real estate if they don't have to use any of the cash to pay taxes.

Ed Aloe (08:18):
And they're a great partner because if you just continue to exchange until you die, they're a partner that never needs to be paid back. Right?

Skip Keelser (08:25):
That's right. That's right.

Ed Aloe (08:27):
That's a good partner to have.

Skip Keelser (08:28):
That's right. No, that's as good as it gets. And it's not as if they only own a little piece, they own a big piece.

Ed Aloe (08:33):
Hey Skip, let's shift gears here for a second and talk about a concept that I've actually never done, but I've had friends that have done it and I think it's another great tool that someone could use to build wealth, which is the reverse exchange. Would you mind telling our audience what a reverse exchange is and how that would work?

Skip Keelser (08:51):
Sure. Whenever I explain what a reverse exchange is, I always start by saying in a forward exchange you're essentially talking about a banking transaction. Seller sells the relinquished property, assigns the contract to sell to the QI just before the sale closes, and the QI gets the cash and deposits it. When taxpayer person goes to buy the replacement property, the QI takes that cash and funds the close of the replacement. It's essentially a banking transaction on the part of the QI. Reverse exchanges are real, real estate transactions.

Ed Aloe (09:33):
So these are the opposite of a standard forward exchange and sometimes happen when an investor identifies a potential property they would like to buy prior to having sold their relinquish property otherwise known as their down-leg property.

Skip Keelser (09:46):
Before the year 2000, there had been a lot of discussion about whether you could do a reverse exchange and people thought you could, and finally, the IRS agreed. In a reverse exchange they're selling a piece of property, they're getting ready to market it, but they want to make sure that they've lined up the replacement property before they've sold the relinquished property. So what they do is they contract with the seller of the replacement property so that it's acquired by this exchange accommodation titleholder whose initials are EAT. And the EAT will take title to that replacement property and can hold title for up to 180 days. And the EAT has to be unrelated just like the QI and the EAT essentially just gets a fee for its services. So put this reverse exchange in place, the EAT will form a limited liability company.

(10:47):
That limited liability company will acquire this larger apartment building, might even borrow some money from a lender on the apartment building. The LLC that owns it is the mere titleholder. So it'll enter into an agreement with an affiliate of Ed to manage the property and sort of sweep all the cash flow. So then what happens is Ed's down-leg finally gets sold. So the proceeds for the down-leg go to the QI. QI then pays those proceeds to the EAT and the EAT repays Ed for the money that Ed advanced at the beginning to acquire this replacement property. And then the EAT conveys that membership interest in the LLC that owns the replacement property to Ed's company and the exchange is complete.

Ed Aloe (11:39):
Okay. And just to clarify again, the QI is the qualified intermediary, also known as the accommodator. The EAT is the new entity that takes title to the replacement property known as the up-leg and the relinquish property is the property being sold also known as the down-leg.

(11:58):
Hey Skip, would you mind telling us some of the rules and restrictions? One of the biggest things about 1031 that people kind of get spooked about is the timing of all of it. Would you mind kind of walking through how that works?

Skip Keelser (12:16):
Sure. When you sell your property, you have to arrange the transaction so that an entity called it qualified intermediary receives the cash. But from the day that the sale of your property, we call it the relinquish property closes, you have 45 days to designate which properties you intend to acquire as replacement for the property that you sold. And the important thing to note is that if that 45th day comes on a holiday or a Saturday or a Sunday, you don't get a rollover to the following Monday. Those are hard stops. Whenever the 45th day comes out, that's the date by which you have to notify this qualified intermediary person of which properties you intend to acquire. And there are three rules that determine how you designate these replacement properties. But in the real estate context, really only two of them apply.

(13:18):
So the first rule on designating what we call the replacement properties for the relinquished property that has been sold is the three-property rule. And the three-property rule goes like this. You can designate as your replacement property any three properties regardless of their value. So if the relinquished property sold for $2 million, you can designate as an example, three $5 million properties. The way the rules work, you only have to acquire one of them in order to meet the three-property rule designation.

(13:57):
The second rule, which is a little bit more complicated is the 200% rule. And the 200% rule says you can designate any number of properties, more than three, but the total value of the properties that you designate cannot exceed 200% of the selling price. So you could designate five $800,000 properties, which would be $4 million and that would be exactly twice the amount of the selling price of the relinquished property. We always caution clients to stay below the 200% because you never know if one of the properties that you listed winds up selling for more or you wind up purchasing for more than the list price.

(14:43):
So the third rule is pretty hard for real estate investors to use. The rule says you can designate any number of properties regardless of their fair market value, so long as you acquire 95% of what you've designated. If you sell this apartment building for $2 million, it's difficult to meet that, call it 95% rule. So it almost never applies in any situation. The 95% rule in the real estate context is really 100% rule realistically.

(15:16):
You have to acquire one or more of the replacement properties and in order not to be taxable, the first hurdle is that whatever cash came out of the sale of the relinquished property needs to be invested. If you don't invest all of that cash, the amount that's not invested is called boot, which is tax parlance for taxable transactions. In addition to investing all the cash proceeds from the sale, you also have to pick up as much debt on the new replacement property as was on the relinquished property or more. And most people get hung up on that second leg about replacing the debt because it seems that cash is always taxable, but it's not intuitive as to why going down in debt is taxable. Without crossing anybody's eyes, I can assure you that is tried and true.

Ed Aloe (16:16):
Yeah, so Skip, you bring up a good point about trading up, trading down. Obviously, the general rule is you need to affect your replacement property or what we call up-leg in the industry, the purchase property, with a greater or equal value and also replace whatever debt you had on the relinquished or sold property. We recently had a situation where we sold the property for... Gosh, I think about $16 million. We were in an exchange. The only building we found that we really liked because we knew we were getting a good value on it was in the nine and a half million range, right?

Skip Keelser (16:57):
I mean, the important point is that while we're talking about saving taxes, it doesn't make any sense to save taxes and make a bad real estate investment. I always tell clients that the worst thing is making a bad investment and somewhere in the middle is paying taxes. Best thing is deferring the taxes. So that's where business acumen pays off.

(17:19):
I mean, if you think you've acquired a really nice piece of property and there's a little taxability that goes along with it, that's fine. And the point that you made, Ed, is a point that I always tell clients, they're buying an expensive piece of property compared to what they sold, but there's some boot for some reason perhaps because of debt relief. The new debt isn't as great as the old debt. What I tell clients is that you're probably going to sop up a lot of that because at the same time the Congress limited 1031 exchanges to real estate, they extended and increased the ability to write off a lot of improvements so that by the time you get to the end of the year you're tax neutral on the transaction.

(18:04):
I mean, that's a little complicated, but it's right there. I mean, the depreciation rules are very generous. So let's talk about the ultimate tax plan for individuals who do these multiple exchanges.

Ed Aloe (18:19):
Yes, and I'm glad you brought that up because I think it is a tremendous vehicle, especially, Skip, for families passing down wealth to heirs and using the 1031 Exchange to do that. So can you kind of explain how you can pyramid your wealth up by doing exchanges over your career and now you have this sort of large equity in a property or several properties that you might own. The owner passes away. What happens with the heirs and how is that treated?

Skip Keelser (18:51):
This is the most difficult kind of advice to give to a client. I'm always choosing my words carefully when I'm advising a client, but I've never been able to find exactly the right words to say to a client that even though you've done all these exchanges and you have pyramided the value from $2 million to $6 million, if you die tomorrow, under the Internal Revenue Code, there will be a step-up and basis the fair market of value and your heirs can sell that property without any income tax. You never want to tell a client the ultimate tax plan is that you're going to die, but that is the ultimate tax plan.

(19:30):
There might be some estate taxes to pay, but there are no income taxes to pay. So one could sell that property and use those proceeds to pay off state taxes and make distributions to the heirs. 1031 is a great vehicle for intergenerational transfers and partnerships as well. Let's say you've got a partner who's a 10% partner and that particular partnership has done really well and it's on its third or fourth property and starting with the second property, they've all been acquired through 1031 exchanges. So the value is significant, but the deferred tax gain that would result if there were a cash sale is also significant.

Ed Aloe (20:17):
Right. Because the tax liability continues to build as you defer more and more capital gains each time you exchange.

Skip Keelser (20:24):
But if one of your investors dies, you are allowed to do what's called a step-up and basis of that partnership interest. If for instance, that person were to sell the partnership interest to sponsor, that person would incur no gain because that partnership interest goes from a very low value to current fair market value. And the nice part about it is the real estate is stepped up by the amount of the gain that the deceased investor deferred. So it's a win-win all around and that's plus the cash flow that comes to real estate, the depreciation that comes from real estate. It's all good.

Ed Aloe (21:04):
And I think the important thing to realize, and for those listeners who don't understand, stepped-up basis means the property you inherit is now valued at today's fair market value. So if you sold it for that value, theoretically, there is no gain to be taxed upon, right?

Skip Keelser (21:22):
There's an interesting conflict that results, let's say, two women who've been buying real estate and one of them lives to 86 and dies, and the other one is also 86, but alive and well. So you've got a little conflict because the partner who is alive and well wants to do an exchange because the real estate has appreciated, but the partner or the heirs of the partner who died don't care because they get that step-up in basis and they can sell the whole portfolio and not pay any taxes.

Ed Aloe (21:55):
Very good point. Interesting. Something I learned recently, which I did not know myself, was we were in an exchange. We decided a couple months in and you know what? We're not having luck finding a replacement property. We don't like what the market's doing currently. Let's just bite the bullet on this one, take capital gains tax and just sell it, right? Because you never lose money making a profit. What's the old saying? And what we learned through the process when we went to the exchange accommodator to get our funds was we actually had to wait until the end of the 180th day before we get any of the proceeds back, even though we decided we weren't going to do an exchange.

Skip Keelser (22:33):
The exchange ends at different times depending upon the circumstances. If you employ an accommodator and your funds are sitting with the qualified intermediary, then if at the end of the 45th day you haven't designated any replacement properties, then on the 46th they, the exchange period ends and you can get the money that's sitting with a qualified intermediary.

Ed Aloe (22:57):
Let's shift gears a little bit. We've brought up the term accommodator, QI, qualified intermediary. They're used interchangeably. When I first got in this business as a young broker, I was with CB down in San Diego selling apartment buildings in my early twenties at the time. But I remember early on there was an accommodator in San Diego who basically absconded with investor funds.

(23:20):
And I was shocked as a young broker that it seemed like these qualified intermediaries had little regulation and someone could actually use the money for their own personal expenses or steal. And then of course, years later, there's a great American greed where this guy was buying multiple accommodators and using them basically as his piggy bank. And when he would spend all the money, he would end up buying another accommodator, and he would have enough funds available to try to fund their closings. And eventually, the music stopped and came to an end. So let's talk a little bit about the role of the accommodator, how they're regulated, and what they do exactly.

Skip Keelser (24:01):
Sure. So the accommodator or the qualified intermediary, the QI, same person. Let's just call them accommodator for these purposes. It has to be a person who is unrelated to the person doing the exchange. Can't use your attorney. You can't use your CPA. You can't use the real estate broker and you can't use your sister-in-law or brother-in-law. But there is a whole industry of businesses that serve as accommodating, and they include banks that have divisions that do 1031 accommodations. All the large title companies have affiliates that do 1031 accommodations. And then there are a lot of independents who do a lot of 1031 accommodations.

(24:41):
One of the things that I always insist on is that the accommodator set up a separate account for each transaction, and it can be what we call an FBO account for the benefit of, which is a form of trust account or it can be a separate escrow account. But we insist that our client's funds all be segregated into an account that we hope... Keeping my fingers are crossed right now as I'm saying this, that if there's the bankruptcy of the accommodator, the funds will be safe. They may not be safe within 180 days, but they'll be safe and eventually returned. To me, as a practitioner, those trust accounts are extremely important.

Ed Aloe (25:21):
Yep. So I think the lesson here is just kind of know who the accommodator is, do your research, do checks on them, get good references because it's a loosely regulated industry.

Skip Keelser (25:33):
And ask if your funds are going to be invested in a separate account, either a trust account or an escrow account for your specific benefit.

Ed Aloe (25:39):
And skip, I think one thing to mention here that's important is funds. As a seller, when you sell a transaction, it's very important that the seller doesn't take any of those proceeds into his own accounts. Everything, if you're going to do an exchange, needs to pass directly to the QI or accommodator.

Skip Keelser (25:57):
Right. The funds that are held by the accommodator have to be beyond the reach of the taxpayer who just sold that relinquished property and they can be used to make deposits to acquire replacement property, do due diligence, even make deposits to a lender, but they can't be used to pay your American Express bill. The concern always is, let's say the accommodator is sitting on a million dollars of your funds from the sale. You say to the accommodator, pay my American Express bill. I mean, clearly something that the accommodator is not supposed to do according to the regulations, not to mention practical good sense. And the accommodator goes ahead and pays the $10,000 American Express bill. The Franchise Tax Board took the position that if you're in for a penny, you're in for a pound. If you can get the $10,000, you can get the million. And they were taking the position that the entire million is taxable because somebody took the $10,000 or small amount that they weren't supposed to take.

Ed Aloe (27:08):
Before we wrap up here, let's talk about the future of 1031 exchanges. Every 2, 3, 4 years, depending on who's in office, we hear that, "Oh, the 1031 is in jeopardy. They want to take it away. They think they can generate a lot more revenue by getting rid of it." And lo and behold, thankfully, it has gotten cut out of each one of these bills over the years. It might be in one actually currently, the Build Back Better bill might have a provision in there. I know the carried interest is part of that bill, but would you mind talking about 1031 and the fact that every couple years it seems to be in jeopardy and what you think the future is?

Skip Keelser (27:47):
1031 is constantly being challenged. And in fact in 2017, 1031 is cut back to real estate only. And as I said earlier, I think that there were good policy reasons that, at least if you're in the real estate industry, you could understand. The people who are in business and exchanging personal property have huge write-offs. So they're not really prejudiced. And the people who are trading the Ferraris and the Picassos, nobody has much sympathy for in the first place. I mean, this deferral shouldn't benefit those ultra-rich people who trade what we call these collectibles. Where we currently are seem to be a good use of that provision. I mean, I always say that if corporation A merges with corporation B, but for the fact that that's called a tax-free merger, that would be a taxable transaction. And in effect, that's what we're doing with real estate.

(28:55):
You sell one of the apartment buildings, a 100-unit apartment building, and you buy a 120-unit apartment building. It's sort of like a merger in terms of the synergy that it creates. So I don't see in the near future real estate and 1031 going by the boards and are investment structure has a lot of people investing in real estate and you are finding exchange properties for them and they benefit and they're not all the ultra rich by any sense, but they're people who've invested with you regularly whose net worth has grown and they're not billionaires. So I think it would be a tough thing. I will also tell you that the real estate lobby in DC, particularly the real estate round table, is geared up on any given day to fight any cutback of real estate being part of 1031 exchanges.

Ed Aloe (30:05):
Yeah, I think you're right and I hope you're right. And obviously, real estate is a gigantic industry, employs a ton of people, and the 1031 mechanism is a great way to continue to grow the real estate business transaction volumes. And I really think if it was eliminated, it would really slow things down tremendously and hurt from a job production standpoint for sure.

Skip Keelser (30:31):
Well, we were involved with any number of exchanges in downtown Los Angeles. People who had owned property in downtown Los Angeles for years that was a 50, 60-year-old office building or warehouse and none of those people who came to us were going to sell, but for the fact that they could do a 1031 exchange. So the 1031 exchange out of those downtown alley properties. And what do we have in their place? We've got all these office buildings. We've got all of the apartment buildings. We've got an entirely different downtown Los Angeles that was driven in no small part, I can attest to by 1031 exchanges.

Ed Aloe (31:16):
This has been a very informative episode. I want to thank you for your time today. If you're a listener interested in learning more about 1031 exchanges, do your research, hire a good attorney like Skip, find the right accommodator and really dig in because it's an extremely valuable tool.

Credits (31:39):
Thanks for listening to the Real Estate Wealth Podcast. The Real Estate Wealth Podcast is produced by Gusto, a matter company. Our producer and audio engineer is Jeanette Harris-Courts. With support from Gabe Gerzon and Susan Rangel. Maia Laperle is our writer. For show notes and more information about this podcast visit EdAloe.com. And for more information about CALCAP Advisors visit us at www.calcap.com or follow us on Twitter at CALCAP Advisors.

Ed Aloe (32:21):
I'm your host Ed Aloe and thank you for listening.