Ep. 3 | Supercharge Your 1031 Exchange Knowledge
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John Tripolsky:Hey, everybody. Welcome back to the Mr. R Show. I'm John Topolsky here from the Monthly Recurring Revenue Institute team. On episode three today, we're gonna bring on great guy to talk about ten thirty one exchanges.
John Tripolsky:So the title that we gave to this episode is supercharge your ten thirty one exchange knowledge. So if that's not direct enough on what we're about to talk about, we're bringing on Scott Saunders. He's a senior vice president over at Asset Protection Inc over in Colorado. So if you ever do a Zoom with this guy, someone's got a great picture behind him by the way. So a great picture, I believe, was the the mountains or somewhere over there.
John Tripolsky:It makes me jealous. I'm up here in Michigan most of the time. It's either really hot, really cold somewhere in the middle. But couldn't think of a better guy to talk to us about 10:31 exchanges than Scott. So the best advice I can give you before we dive into this topic with Chris Pacuro and myself and discussing these with Scott, grab plenty of paper, grab a pen or a pencil, grab a lot of coffee, and be ready to press pause and rewind.
John Tripolsky:So I mean this wholeheartedly. Scott is probably one of the best explainer educators in this space that I've ever or actually in many spaces. Scott's just all around a great guy, really good at explaining things. If you've been lucky enough to see one of his presentations around the country or virtually, you know exactly what I'm talking about, but I won't give away too much. Just be ready.
John Tripolsky:This could potentially blow your mind with an extreme amount of knowledge you can take back home in your practice as well and obviously would greatly benefit your clients and beyond. So no more details. We're jumping to the show here in one moment. But, again, hit the pause button. Be ready to press rewind.
John Tripolsky:Be ready to take those notes. Enjoy the show. Hey, Scott. Thanks for joining us here on the podcast as always. You know, we were thinking of this topic that we mentioned earlier.
John Tripolsky:Couldn't think of anybody better than yourself to go over this. I know Chris and and really our whole team over on the other side of the fence at teaching tax flow. We always put you out a pedestal. You're our go to guy with ten thirty ones. So let's jump into it a little bit.
John Tripolsky:Before we get too much into the detail, let's give a little intro on your background. Where where have you been in your past? How did you actually get into this? And how did you become the expert in the, quote, unquote, space?
Scott R. Saunders:Yeah. Well, hey. It's great to be with you guys. Love talking about ten thirty one exchanges. They're such a great strategy for investors, business owners.
Scott R. Saunders:But believe it or not, I actually got involved in ten thirty ones right out of college. Back in 1988, I joined a qualified intermediary pre treasury regulation. So we didn't even have the guidance that we now have under the treasure eggs. And I stumbled into the space. I wanted to get into investment real estate, and and that was kind of cowboy country.
Scott R. Saunders:We were operating off of the old Stalker decision. You know, identification rules were wide open. You could exchange into other countries back at that time. It was really it was a fun time to kinda be in the industry. And as times got on, the industry got treasure eggs.
Scott R. Saunders:We've got a lot of guidance and clarification. So I've kinda grown up in the ten thirty one exchange industry. I'm, I served a a few terms actually on the board of directors and in the past president of the National Trade Association, the Federation of Exchange Accommodators, which is a mouthful of of title. But, 1031.org is their website, and and most reputable qualified intermediaries belong to that group. So I've done that and just kinda grown up in the ten thirty one space.
Scott R. Saunders:It's been really exciting. Awesome. And I know you
John Tripolsky:do a lot of education. Right? So as far as for, you know, working with clients, working with organizations, I mean, obviously, this is geared towards tax professionals, for the for the most part. So have you worked with those a lot? I mean, have a lot of people reached out to you in the past with questions, or is this something that you're you find yourself more or less informing them of the opportunities with this, or or how does it look in that space?
Scott R. Saunders:I get a lot of questions every day. I've got people reaching out. I'm wanting to understand the code, what's possible. A lot of people just reach out and say, here's my scenario, you know, and then I can kind of identify issues. And you're right.
Scott R. Saunders:I do a lot of, education. After this today, I'll be doing a two hour training for CCIM for commercial brokers. So I do things like that. And then the other thing I do a little bit of, which is really critical, which is just educating people in congress on the value of the ten thirty one exchange, why it it helps create transactional activity. So it's not really a partisan issue.
Scott R. Saunders:It's a matter of educating people in congress that this creates a lot of jobs for everybody up and down the food chain for tax advisers, for brokers, lenders, investors, appraisers, you name it, anybody involved in a real estate transaction. This is critical. We did a study, and it contributes something like $98,000,000,000 annually to the GDP. So Wow. It's a creator of jobs.
Scott R. Saunders:And so we find that as we get new people in congress, we need to educate them on why this is valuable and important for the real estate industry and for business owners. Awesome. Well, I feel like the
John Tripolsky:only thing I brought to the table is longer hair than both of you than the boys. I mean, hanging out with better looking smarter people, I guess, is my big accomplishment for the day. I know, Chris, so so, basically, in in layman's terms, I know the littlest amount when it comes to this. So, obviously, you're you probably know the most. Chris, I'm gonna I'm not gonna let you be number one.
John Tripolsky:You probably know the second most here. You're beating me. I'm sorry. That's not really saying a whole lot. So let's jump into some of the details.
John Tripolsky:I know, Chris, you had you had some really good questions, and, really, you could steer this in a great direction, especially from a tax preparer standpoint. So Right.
Chris Picciurro:I mean, as a tax professional and most of the, you know, the people that are listening to this podcast, want to understand and not be not be intimidated by 10:31 exchange. For for tax professionals, I mean, our our niche is obviously real estate investors, so we come across this all the time. I also wanna say Scott and his team helped me out with my personal ten thirty one exchange last summer, which couldn't have went any more any better. And, you know, we always say that that smart people make things that are hard, easy, and vice versa. So you guys made it really easy.
Chris Picciurro:But, you know, for for the tax professional out there, I would recommend that that you talk to Scott, and we will leave all of his information and his team, by the way, in in his information and their educational resources. But for the tax professional, we're most of us have a per we're pretty deep into the Tax Cuts and Jobs Act. I know that that changed things on the ten thirty one exchange front quite a bit. Can you tell us a little bit about the typical, rules from a 30,000 foot view? I know a lot of people understand.
Chris Picciurro:They hear about forty five days, a hundred and eighty days. Oh, I need you know, I I know my client can't teach take the money, but I
Scott R. Saunders:know that there has to be a a qualified intermediary involved. Can you give us the the the $10.31 exchange for dummies, summary to start, then we're gonna dive into some really cool situations as well. Yeah. Happy to do that. So taking it about 30,000 feet up.
Scott R. Saunders:If we just break it down and keep it super simple, an exchange a ten thirty one exchange is in the code, section ten thirty one, been in the tax code now for a hundred and two years. So it came about back in 1921. So we're talking about something that's been around for a long time. What the code says, essentially, if you boil it down to the most simple level, you take any property that you've held for investment purposes or used in your business. You give it up and you receive back what we call a like kind property, also held for investment or used in a business.
Scott R. Saunders:So So you give up a property and you receive back another like kind property. And if I were to make it super simple, a typical taxable sale would just be I give a property and I get back cash or some other consideration. So that's what it is at the most simple level. Most exchanges today, and we'll get into some of the more complex and and unique planning strategies, but your typical exchange today is what is called a delayed exchange or a deferred exchange. Sometimes you'll hear it referred to as a Starker exchange from a old 1979 tax court decision.
Scott R. Saunders:But in that type of transaction, you, your client gets a property under contract. And prior to closing, they contact what is called a qualified intermediary. Sometimes you hear us referred to as a QI, an accommodator, facilitator. And what happens is that contract, that purchase and sale agreement is assigned to us. So we now step in and sell the property on behalf of that taxpayer to the buyer.
Scott R. Saunders:So the title goes directly from the taxpayer to the buyer. The money then comes to the qualified intermediary, and this starts that time deadline that people are, fairly familiar with. When you close, it's day zero, and then you have forty five calendar days to identify property. And so I I mentioned it was calendar days. They're gonna go through holidays.
Scott R. Saunders:They'll go through weekends. They're just sequential days. It ends at midnight of that forty fifth day. And so that's what we call the identification period, and we'll talk about how you can identify. Then after that, you have another hundred and thirty five days to close on property that you've identified.
Scott R. Saunders:So it's a maximum of a hundred and eighty calendar days. The first forty five you identify, the remaining hundred and thirty five, you've got to close on what's identified. And so we call that a delayed exchange. So the next step, the qualified intermediary then hold is holding the money. And we'll talk about the importance of that as putting it in a separate account.
Scott R. Saunders:The taxpayer buys a property they wanna buy. They get it under contract, and then that contract is assigned to the qualified intermediary. We now step into the shoes as the buyer of that property. So we take the money we're holding, we purchase the replacement property, and we have a deeded directly from the seller back to the taxpayer. So on the most simple level, that's what we call a a delayed exchange or sometimes referred to as a deferred.
Scott R. Saunders:And there are a few issues in there. You know, in that forty five day window, if you close on a property, it's considered identified. The other thing you can do is you can identify several properties early on. You can revoke those if you find better properties and substitute anywhere up till midnight of the forty fifth day. The question we get asked all the time, and I'm sure you've heard it too, is, you know, that's really challenging.
Scott R. Saunders:You know? How do we find properties in forty five days? And what if I find a better one? The code is statutory. So you've got these fixed time parameters that you really have to adhere to.
Scott R. Saunders:And just a practical planning tip for the tax professionals out there, in most markets, particularly now when things are, you know, relatively tight on inventory, what I recommend is that your clients start looking for they wanna purchase as they're listing the property they're selling. Start making offers, at least working with the broker, get that process going earlier, and that takes a little bit of the time pressure off that, delayed exchange process.
Chris Picciurro:And as far as identifying properties, I know there are some rules with that. Can you give us some some general rules of thumb? Because, obviously, if you don't wanna identify too little prop too, too little properties, because if if they fall through or or you have, you know, inspection or you have issues with financing, which we're gonna touch on some remedies for that later on, Why can't you just take every property in the city and just slap it on a spreadsheet and say, yeah. I'm identifying every property for sale. That's we go there's some rules against that, but I'd love for you to talk
Scott R. Saunders:to the tax professionals about that. I I will. You know? And, Chris, I'll tell you. Back in the old days, pre treasury, we actually had somebody do that.
Scott R. Saunders:They sent in the entire MLS book for all of Hawaii, hundreds and hundreds of properties. Gonna buy one of these. And so the IRS came out with three different identification rules. And so you've got to pick one of these three rules to identify your property with, and they do provide flexibility. They're not unlimited.
Scott R. Saunders:So let me let me kinda walk you through the ones that are probably the most common. So the first one is what's called the three property rule. You can identify three different properties of any fair market value. So if I'm selling for a million dollars, I could identify one at a million, 1 at 2,000,000, and one at 5,000,000. So I'm not limited on the value, but I'm limited on the number to just three specific properties.
Scott R. Saunders:And as you kind of alluded to, I will mention it's probably a good idea to identify a backup property or two. If you're doing due diligence on something and all of a sudden you find an issue that you can't get over, that's that's really gonna be a deal killer, it's nice to have one or two spare properties that you can go after and pursue. So that's just kind of a a sound tip. Don't put all your eggs in one basket. Give yourself a backup or two so you've got a little flexibility.
Scott R. Saunders:The second rule is what we call the 200% rule. And so this one is, basically, you now have an unlimited number you can identify, as many as you want, but no more than twice the fair market value of what you sell. So if you sell for a million dollars, I can identify a bunch of small parcels, but they can't go over 2,000,000 in total value. So the first one, the three property is probably the most common. The second one is used what if somebody wants to go from a commercial property into a bunch of small pieces of land or maybe small single family residential, they're gonna need a lot of those.
Scott R. Saunders:So if you're going from a large property into a bunch of small ones, the 200% rule is probably the way to go. And then there's a third rule, rarely used. I will tell you, I personally use this about fifteen years ago, and it's called the 95% rule. And what this states simply is, you identify more than three, so you've got more than three properties. You're over 200% of the value of what you sell, then you must close on, at minimum, 95% of the value of all those properties.
Scott R. Saunders:So and if you wanna just make it really practical, what do you say? We call it the 95% rule. You really need to pretty much buy everything. You know, if I gave you 10 properties at a hundred thousand each and I bought nine, that's only 90%. That would be, not a valid exchange.
Scott R. Saunders:So if you're gonna use that last rule, you essentially have to buy every asset that you identify. And so you pick one of those three rules to identify properties.
Chris Picciurro:That's a great point. Yep. I feel like, you know, there's always that that thing on Google if you put in your birth date and say a man from Florida, you're gonna have some whacked out story and you it's a story. But all I feel like all of my practical, private practice examples of things weird things happening are California residents. Because I had a lady from California that was selling a property there and identified she was she did a 10:31 exchange.
Chris Picciurro:Unfortunately, she didn't use Scott and his team. This is because this is before she was one of our she came to us because she had this big problem. Identified, I think, like, 12 properties in, in I'm not gonna name the markets, but let's say some lower value markets, and yet couldn't get them closed because she couldn't get finance. Inspections were bad. These were just lower end properties, and so she she blew number one.
Chris Picciurro:She didn't get the proper advice for her from her QI and blew number two, and then was scrambling to to close on 95%. Now the the end of the good news is is that she's actually rep status. So even though her done 31 exchange got blown, we're still able to do cost segs and get her almost to where she could have been. But, again, that's that's a very rare situation that you get that get out of jail free card, and it costs her significant amount of money on the cost segs. So in identifying the property, I'm gonna kinda dive into some identifying properties as far as you you'd mentioned something that you can swap them out.
Chris Picciurro:So for let's say someone is identifying a a well, I'm gonna backtrack talking about the tax professionals, thinking about what what what, like, kind is. So in other words, if you're selling a residential property, when you identify property, it doesn't necessarily have
Scott R. Saunders:to be residential. It could be a different asset class. Is that fair to say? Yeah. It it's really fair to say.
Scott R. Saunders:So that's probably one of the biggest misconceptions is what is like kind property. So let me give you kind of the myth or the misconception. Sometimes people think if I have raw land, I've got to identify other raw land or single family for single family, commercial for commercial. So let's kind of show you how big the universe is on that. Any real property.
Scott R. Saunders:So you alluded to the tax cuts and jobs act. One thing that did is it eliminated personal property exchanges. So prior to the passage of that, we could do personal property exchanges, artwork, aircraft used in business, heavy manufacturing equipment, rental cars, etcetera. Today, only real property qualifies. But here is the planning opportunity that I think is just phenomenal, for tax professionals and their clients.
Scott R. Saunders:Any real property held for investment or used in a business can be exchanged for any other. So that's really broad, and I'll give you some examples. I can go out of bare land into a single family, into a duplex, into a fourplex, into an apartment complex, then maybe I exchange out of that into, a triple net lease, and maybe I exchange into a vacation home held for investment under RevProc '2 thousand '8 dash 16. There are all sorts of things that are considered real property. And, you know, just since we're talking to tax professionals, I wanna share some of those things and just kind of highlight them.
Scott R. Saunders:And, you know, as you mentioned early on, it's really a great idea. As a tax professional, we're gonna go through the basics, but reach out to a local qualified intermediary to get cut some of their perspective. We're really good in this niche. We go really, really deep. As a tax professional, you know the whole tax code.
Scott R. Saunders:It's a big picture, and so lean on a good qualified intermediary. But you know, when we look at real property, it can be such things as water rights in certain states. So I'm in Colorado. You can exchange out of a water right into an apartment complex. In New York City, I can exchange out of what is called an air right or more specifically, a transferable development right.
Scott R. Saunders:So I'm building a hotel. I've got a hotel 10 a hundred stories tall, and I've got the right to add 10 more. That is literally exchanging out of that air air right into like kind property. Certain, easements qualify, agricultural easements, conservation easement, a perpetual communication easement. Certain oil and gas programs can qualify, if it's a royalty, not a production payment, but a royalty.
Scott R. Saunders:And so, you know and there's another one that you're very familiar with, I know, Chris, which is what is called a Delaware statutory trust. Fractional ownership in a larger commercial building, which with a bunch of investors. So it could be done as a TIC, tenant in common, or you can do it as part of a Delaware statutory trust, sometimes referred to as a DST. And so like kind is very, very broad. That that's kinda it it it it encompasses any property held for investment, and I'll I'll just kind of add one more piece.
Scott R. Saunders:Let's look at what doesn't qualify. So there are two types of assets that won't qualify for an exchange. The first one is the house you live in. So if it's your primary residence and you live there, section one twenty one applies. You can't do a ten thirty one exchange out of a primary residence or into one.
Scott R. Saunders:The other one is a little bit trickier. It's any property with the intent to hold for sale. So that could be a developer or a dealer. They're flipping lots or somebody's putting up a new building to sell it. In real estate, it could also be that fix and flip investor.
Scott R. Saunders:Right? They get an undervalued asset. They renovate it, and then they're gonna sell it immediately for the profit. So even though they make a profit on it, if the intent is to hold for sale, not to hold for long term investment, you can't do an exchange on that. And so that's very much a a facts and circumstances test as to determine what's held for investment versus sale, and there's a whole series of factors to consider in that.
Scott R. Saunders:But if you think of it, if it's not your primary residence and the intent is not to hold for sale, generally, it's gonna qualify if your intent is to hold it for long term investment.
Chris Picciurro:No. That is really good. We're gonna touch on some interesting scenarios later on in the show about, with primary residences. I wanna touch on the something else that tax professionals do, struggle with some time is understanding when when you sell a property. So if what what happens if an entity owns that property?
Chris Picciurro:I know there's some special rules with single member LLCs, but what happens if Johnny, t, and I here buy an apartment complex fifty fifty in an LLC? We we wanna sell it. I don't wanna pay tax on it. John John does. He wants his 50%.
Chris Picciurro:So we can't can't cut the apartment building in half and do a half ten thirty one exchange. So what are some of the things that that tax professionals need to be aware of when it comes to, entity an entity selling property? And then and then an entity is buying replacement property.
Scott R. Saunders:Yeah. So the great question. This comes up a lot. Particularly with commercial real estate, so many people hold title in partnerships and LLCs. So let let's kind of let let's analyze it analyze it from a couple perspectives.
Scott R. Saunders:Number one, if an entity wants to sell an asset, a partnership, you and John wanna sell something in a partnership, and you wanna do a like kind exchange into replacement property, you can at that entity level. So whether it's a partnership, LLC, trust, s corp, c corp, any entity can sell a property held for investment, and that entire entity can stay intact and buy a like kind property. What comes up and what you're mentioning there is very, very common, which is you've got two partners in a partnership. One wants cash. The other wants to exchange.
Scott R. Saunders:And so everybody needs to know you cannot do a ten thirty one exchange out of a partnership interest or into a partnership interest. It's excluded. And it's pretty easy. You know, when you look at the rationale, the partnership is a personal property interest and an entity that owns real property. And we've already established only real property qualifies in a ten thirty one exchange.
Scott R. Saunders:So in your scenario, there are really two common approaches to this. And, you know, you mentioned California. I I will mention an an idiosyncrasy in the state of California with this. If there are two of you and you wanna go your separate ways, first off, we have to get it out of the partnership, right, because we can't do an exchange on that. And the term that you'll hear out there is what's called a drop and swap.
Scott R. Saunders:You elects no longer to be a partnership. So you take your partnership entity. It deeds out to each one of you where you own it now as a 50% tenant in common owner. At the closing, the one that wants to exchange works with a qualified intermediary and does a ten thirty one. The other person receives the cash, and it's taxable.
Scott R. Saunders:Well, that all sounds really easy. You know? That's what we call a drop and swap. The other variation of that, by the way, is you keep the partnership intact. You buy a replacement property together, and then after the exchange is over, you're then gonna go ahead and distribute an interest to the partner that wants to walk away.
Scott R. Saunders:That's called a swap and drop. It's very that one doesn't happen nearly as much. It might work with two of you. I see a lot of times it'll work with family members. You have two, three, four family members.
Scott R. Saunders:They all get along. But in most of the time in a partnership, you've got multiple members. Let's say I have 20 or 30 partners. They don't wanna buy a property together. They just wanna get paid their money, pay their taxes.
Scott R. Saunders:So the swap and drop on the back end doesn't happen nearly as much. 95% of the time, we see the drop and swap approach. And here's kind of the challenge with that and, you know, especially for tax professionals. One way that you can help your clients is to be proactive. If you know your clients in a partnership and they are gonna wanna drop out and sell in the future, you're much better off to elect not to be treated as a partnership now and then to seize in your holding period where you hold it for, you know, ideally a year or more.
Scott R. Saunders:The longer, the better. And then when you do your exchange, you're doing it with that tenant common interest. So the problem that happens is when you do the dropout right before closing, and I'll tell you practically, that happens a lot. Chris, I'm sure you see that all the time. Yeah.
Scott R. Saunders:It's a dropout two, three, four weeks before closing. The problem is there is a higher risk there. The partnership held it for investment. Let's say you two held that for ten years. That's held for investment.
Scott R. Saunders:But now you drop out to the two of you as 10 in common co owners. You've only held it for three weeks. So there's a little bit of risk there that you have a new entity and you as 10 in common owners didn't really meet that held for investment standard. Right? That's a risk because you can't tack on the holding period at the partnership level to the two of you individually.
Scott R. Saunders:Now your choice is either pay all the taxes or be comfortable with a little bit of risk. Now I picked on you mentioned California, so let's kinda switch gears there. There are a whole bunch of tax court decisions where people have changed their ownership entities right before or after an exchange, and the taxpayers have prevailed. And there's, you know, quite a few cases on that. However, the state of California, the franchise tax board, the FTB is is referred to.
Scott R. Saunders:They have taken the position that the federal tax court cases don't apply to California. So if you do a drop and swap or swap and drop in California, you've got a very high likelihood of a state level audit. And for those of you that don't know, California tax rate is 13.3%. So there's a lot of revenue the state can pick up. They're very aggressively going after those, and, frankly, they're they're winning.
Scott R. Saunders:I've seen them in most cases. They actually win and get that tax revenue. So be very careful if you're doing a drop and swap in California because you've got that risk. And then the second one would just be try to get ahead of it. If you know your clients are in this situation, I think the best way to do it in a way you can really add a lot of value for your clients, drop out now and seize in the title.
Scott R. Saunders:Right? And when I say drop out, the two of you could drop out to your own single member LLC and still get the liability protection. So that's another way to do it. And then finally, it just hit me. The concept you wanna keep in mind when we look at entities, just the general principle is, the tax owner that relinquishes a property should be the same tax owner that buys the replacement property.
Scott R. Saunders:So I can sell a Scott Saunders, an individual, and if I buy in a single member disregarded LLC, it's same tax owner. So I can do that on either side. So that's just a principle. Where this comes up a lot is I'll see it with husbands and wives. They remarry.
Scott R. Saunders:They have their separate property. The wife wants to exchange her rental property, and then she wants to add her husband on the purchase. But the wife's held it for investment, So you gotta be really careful there when you're doing that. You either wanna have the wife just do the exchange and then hold on to it for a while and then quit claim and add her husband later. Or if you wanna exchange together, make sure you're going up in value.
Scott R. Saunders:If I'm selling for half a million, I wanna make sure my replacement property is a million or more so that the wife's interest is enough to complete her ten thirty one exchange requirement. So that comes up quite often.
Chris Picciurro:That's a good point. And so the single member LLC I wanna touch on just so I understand and other tax professionals because here's what's happening, especially I live in the Nashville area and we're when when we're working with short term rental properties, a lot of times, the short term, the certificate, or the license to be a short term rental property or permit, if you will. Almost like one of those taxi cab medallions back in the day in New York City that were so valuable. But the permit is owned by the LLC, so a lot of time the a lot of times, you have to sell the LLC, which owns the real estate. And if you're the seller, if that LLC is a disregarded entity, can they still buy replacement property in their personal name?
Scott R. Saunders:Is that yes. They can. So you're saying
Chris Picciurro:that the disregarded entity, if
Scott R. Saunders:I understood you correctly? It's a disregarded entity. Okay. So if you're disregarded, you can do that. And so we get this a lot.
Scott R. Saunders:It comes up a lot of times on the financing side. People would tend to defer to get the financing in their own name to get a better rate versus the LLC. So the LLC relinquishes. They buy in their own name. It's the same tax owner on both sides.
Scott R. Saunders:So great great question. And these are the sort of things, by the way, you wanna review this as a tax professional. You know, if I wanna say anything on the bigger picture, we're going through some of the basics, pull in a qualified intermediary. All the input I give on a phone is free. We don't charge for that.
Scott R. Saunders:And we can review things like, okay. How do you hold title? How have you filed your tax returns? How do you wanna do the financing? These are the types of issues that we kinda have a checklist that we'll go through to try and structure things from the very beginning.
Scott R. Saunders:Where people get in trouble is they don't ask these questions before setting up their exchange, and then they're halfway through. And now all of a sudden, they're boxed in because they've got some really tight restrictions, let's say, on the financing side that they didn't think through when they set up
Chris Picciurro:the $10.31. I know when the we and and I loop Scott into a question, from someone from the teaching tax law community that maybe we could touch on this as far as what should we be aware of as far as related parties, if if you're either selling to or acquiring properties from a related party. I know on the, say I shouldn't do this off. Remember, 80 8 20 4, the the 10/31 exchange, form, it asked specifically and it's it doesn't mean it's illegal to do business with related parties, but what are just maybe maybe one or two pitfalls that we have to be aware of when we're dealing with related parties in as far as ten thirty one exchanges?
Scott R. Saunders:Yeah. Let's let's do this. On related parties, let's first define who is a related party. It's anybody that's related to the taxpayer. So it's gonna be a lineal descendant, father, mother, brother, sister.
Scott R. Saunders:Aunts and uncles are not related, and stepparents are not related. So think of kind of a blood relative lineal. That's related. The other one that is an entity that you have more than a 50% ownership in. So if I'm Scott Saunders and I own 70% of Saunders Corporation, it's related to me.
Scott R. Saunders:The the initial concern with this back in the late eighties was basis shifting between related parties. Wealthy families would take a low basis asset, swap it with a related party for a high basis asset, and sell it to avoid paying taxes. Today, it's a little bit more nuanced. The overriding principle from the IRS is this. If one related party or the other comes off in a better tax position than they would be if they didn't do an exchange with a related party.
Scott R. Saunders:They tend to look at them as one single economic unit, and they might invalidate the exchange. So what I'll do is let me just go through with you four scenarios, kinda rapid fire unrelated parties. Awesome. Related party number one is a swap. So I wanna swap properties with my father.
Scott R. Saunders:They're both worth 200,000, all equity. We just do a even swap. This you can do, but you have a two year holding period. So I have to hold it for two years. My father does.
Scott R. Saunders:So and a swap permitted, two year holding period. Second scenario, delayed exchange, selling to related party. I'm gonna sell to my brother. This is permitted, and there's no mandatory holding period, so I can sell. Third scenario, which is the one that a lot of people wanna do.
Scott R. Saunders:They wanna purchase property from a related party. So I wanna buy my mom's house, and then I'm gonna lease it back to her. So I complete my exchange. She stays in her home. This is not permitted.
Scott R. Saunders:So you cannot acquire property from a related party where they get your cash and you complete your exchange. And the rationale is really simple. What if I give mom my exchange money and a day after closing, I say, mom, can you loan me a couple hundred grand? Well, she has all my money. I'm essentially getting access to my exchange proceeds from a friendly related party.
Scott R. Saunders:Now I wanna give you one caveat. We can buy from a related party if the related party is also doing a ten thirty one exchange and their primary objective is not tax avoidance. So if I buy mom's rental house, but then my mom exchanges for another rental house from an unrelated party, she isn't actually receiving my cash. Mhmm. That works.
Scott R. Saunders:So quick recap. Simultaneous swap permitted to your holding period. Delayed selling to related party permitted. Delayed exchange buying from a related party not permitted unless the related party is also doing a ten thirty one exchange. So you wanna be really, really careful.
Scott R. Saunders:There are there are a whole bunch of cases. And and as you mentioned on eighty eight twenty four, the like kind exchange form, you've gotta know, did you do an exchange with a related party? And then you have to describe the situation. If one party or the other comes out in a better tax position, they'll oftentimes not look at you as two distinct entities, but one single economic unit. There's a, a court case, Malalani, where they used NOLs to offset some gain, and they came out in a better spot.
Scott R. Saunders:And the IRS said you can't do that. So be very careful doing exchanges with related parties. They're permitted, but you gotta be very careful. Well, one thing as a tax pro I'm thinking of is if you I mean, if you had a taxpayer with a huge capital loss carry forward and they wanted to reset their basis, they wanted to
Chris Picciurro:sell their related party and, essentially, the seller would not pay tax on that and you're it's allowing the buyer to reset your base. You could see that as a I mean, the principle is is if you're doing something specifically for a tax benefit, that that doesn't fly. Right? It's good. There's gotta be some economic substance to this.
Chris Picciurro:It's got to be, for a fair market value in in that sort of
Scott R. Saunders:stuff, I would imagine. Yeah. No. Absolutely. Absolutely.
Scott R. Saunders:You know? And one thing I just wanna mention since we're talking to tax professionals, one comment that I hear a lot of times from tax professionals is sometimes they'll give input to their client to just sell now, pay the taxes because taxes are gonna go up. I think we all know with where we are from an economic standpoint, the likelihood of taxes going up is much more likely than taxes going down. And I find a lot of times tax advisers and tax professionals say, look. Just sell.
Scott R. Saunders:Pay the taxes now. Take your money off at today's tax rates. One thing you can do if you wanna access your equity in exchange, you can do an exchange, roll it into a like kind property. So let's just say I'm I'm all cash. I have a good equity position.
Scott R. Saunders:I buy a replacement property. And as long as the exchange is complete, right, and it's a separate event, I can come in and do a refinance, refinance that replacement property, and access my equity. So, you know, that's something that I think if if tax professionals understood, you can do the refinance of the replacement property, host exchange, make it a separate event. You don't wanna do it middle of it, and we could talk about how long to season it. You know, it just has to be separate.
Scott R. Saunders:Give it a little bit of time, a few weeks, a few months. Don't start the loan application in the middle of the exchange. Make sure it's separate. But now your clients can actually access that equity on a tax free basis when they do it on the replacement property. And then the other one is just keep in mind, so many people like real estate.
Scott R. Saunders:You know? Real estate investors like the asset class of real estate, but you can move from single family to commercial, into a DST. There are all these things that you can redeploy into different types of assets that are still under the definition of real property. And I find a lot of people when they realize they can do all that, you know, a vacation home. You could pick up a vacation home held for investment and create kind of a lifestyle asset for your family within the tax code.
Scott R. Saunders:Right? And there's just a few basic rules to accomplish that. And I know so many investors who would love to have a a legacy ski condo or a place on a lake property where they go water skiing and they hang out with their family, and all you have to do is meet RevProc two thousand eight dash sixteen, and you're in good shape to do that. Well, Scott, this is why we love having you. You are absolute money.
Chris Picciurro:I'm right here on my notes. The next thing I was gonna ask about is refi. Right? Because we talk in in our private practice and and this is what we really want accountants to and tax pros to understand is, Scott, this is what you're saying. Sometimes clients come to us with questions and we're trying to answer the question.
Chris Picciurro:We need to step back and say, what are you trying to accomplish? And sit well, I don't wanna tie up all my equity. Well, you're maybe you're tying it up for six months. You could still you could still solve the problem of that yeah. Tax rates are gonna go up, but but once you take that money and pay your involuntary business partner, which are tax agencies, that money's gone.
Chris Picciurro:So now you have less money to put into play. So that was one of my questions. Are there rules on the, you know, refinancing post, post 10:31 exchange? The other thing is, what I wanna touch on, I've got this and then we wanna we definitely, where we leave, wanna hit on some interplay between the section one twenty one exclusion. I'm gonna get John involved in a real life example here.
Chris Picciurro:But what we wanna talk about is with with interest rates being up at the time of this this recording and and and also property values high, sometimes taxpayers have issues with finding a, replacement property. We did touch on that Delaware statutory trust. We also someone also could run into challenges with qualifying for another mortgage. We kinda touched on that with the entities. So could we touch a little bit on the Delaware statutory trust as a remedy for a challenged exchange due to either interest rates or I mean, we you know, Scott, when dealing in this world, we have we have clients in our private practice that have multiple millions of dollars, maybe just retired.
Chris Picciurro:So now they have no w two wage. They have no and they have no history of taking money out of their IRA. So they don't have any income when it comes to underwriting.
Scott R. Saunders:So what let's talk about way back. The DST is 2004. The TIC was 2002 with the Red Pac 2,002 dash 22. But these are what we call fractional ownership, and this is a really interesting hybrid. The SEC considers them as security, and yet they qualify as a like kind property under section, ten thirty one.
Scott R. Saunders:So what we what a DST is is you have as, an unlimited number of co owners in a Delaware statutory trust. And the real benefit of this is it's perfect for people that look for passive. Right? They're tired of active management. They wanna have somebody else manage the asset.
Scott R. Saunders:They wanna move into a better grade of asset. And then as you alluded to there, Chris, the reason why they're so, flexible is the people that have these. So you've gotta be, first of all, an accredited investor. You need to meet that requirement. They're offered through a private placement memorandum, and a sponsor puts these together, and you've got all these different offerings.
Scott R. Saunders:And as you know, there are, you know, dozens and dozens of sponsors. Some have student housing, some have medical, some have retail, some have apartment. So you can look at any given time in the market and look at the return. What's nice about these is the sponsor takes on all the management, and you're generally gonna be going into a higher kind of institutional grade asset. You're gonna go into a class a building of some sort, and you've got long term leases.
Scott R. Saunders:So as an investor, you wanna study the PPM. You wanna look at the leases, the rent escalation. You wanna look at the sponsor. Have they been around for a long time? What's their track record?
Scott R. Saunders:When the downturn happened years ago, did they weather that well? So those are some questions you wanna ask, but the beauty of a DST is you've got a whole bunch of these products that are sitting out there with these sponsors that literally you could call them on day 42 of your exchange and say, I'm having a hard time qualifying. I can't find anything in the marketplace. What's out there? And because the sponsor owns the asset, they can carve off the exact slice that you need for your ten thirty one.
Scott R. Saunders:So if you need $832,000 of equity and you need 360,000 of debt, they can find an offering out there that will meet your exchange requirements very well. So they're really great from that perspective and that they can really save your deal, and they're really nice for people that are maybe been investing for years, and they don't want the active management. They wanna offload that to somebody else. It doesn't mean you know, you hear that term mailbox money. Probably a little stretch, but but somebody else has really taken on all the management and the hassles, and now you're just in with a bunch of other co owners.
Scott R. Saunders:And as Chris knows, you can look at all sorts of different offerings, and some have a little better return. They might be in a secondary market. Some are in primary markets. But you can look at a a menu of these, and some people put all the money into one. And now I've seen people diversify.
Scott R. Saunders:If I've got a million dollars, I'm putting put a third of a million into three different DSTs, getting a little bit of geographic diversification. So, again, it's just a great another tool or a tax planning strategy that
Chris Picciurro:a lot of people aren't aware of exist out there. And that's why we find a lot of our clients in our private practice will identify DST in that identification as a as kind of a a safeguard. Right? As as a as a in case they find a property that maybe, you know, maybe they sell a vacation home for 800,000. They find another one for 700,000.
Chris Picciurro:They need to place a hundred thousand. Not a hundred thousand of cash, but maybe you'll pick up some debt on that. And and it's just again, it's kind of that that that, I don't know, three o pitch. You know what I mean? It's it's good.
Chris Picciurro:You could take it and maybe you walk or you could or you can I don't you know, you could really load up on it for you know, you gotta have a baseball, baseball in in this? I do have a couple as a couple more questions. I know we're we're, on the I'm gonna go back to when we're talking about a property that you're selling and that personal property is not eligible for ten thirty one exchange under TCJA, what happens if someone had done a cost segregation study on the property before they sell it? Is that does that and and I know that could be a whole other episode, but does that play a role in their the what portion of the property could be exchanged or or not?
Scott R. Saunders:No. It doesn't. So, you know, cost seg is a great strategy. By the way, you know, ten thirty one, you do a disposition. Cost seg, you do while you own an asset.
Scott R. Saunders:And if you marry those two concepts together, you've essentially kind of supercharged your returns. You're getting the best of both worlds.
Chris Picciurro:Mhmm.
Scott R. Saunders:But the reality is when you do a cost segregation study for ten thirty one purposes, that doesn't change it. And then we see a lot of people that will do an exchange into a new asset. And then right after they acquire it, what are they gonna do? A cost seg study to front load those depreciation benefits. So, that that's a great tool.
Scott R. Saunders:And and real quickly, I wanna just touch upon a a concept because there's a little bit of misinformation on it. When you do an exchange, just fundamentally, you don't always have to go even or up in value. Sometimes I hear people say, well, you've gotta go even or up. Let me give you the two rules. If your client wants 100% deferral, they need to, one, reinvest the net equity.
Scott R. Saunders:That's after closing costs, after the real estate commission and those closing costs. And number two, they need to have the same or a greater amount of debt or their mortgage. So if they reinvest all the cash, there's no cash boot. If they go up in mortgage, then there's no mortgage boot. And then the one caveat is if you wanna have less leverage, if you have mortgage boot, you can offset that by bringing in new cash.
Scott R. Saunders:So I just wanna address it because sometimes people think if I sell for a million, I gotta buy at a million, and it's really the net sales price. You gotta look at the net equity, and you just pull up the settlement statement, look at the proceeds, net proceeds, then you look at the mortgage payoff. You need to have that amount or a greater amount of mortgage, and you could do that on one asset or you can do it on multiple. So I I just wanted to address that issue.
Chris Picciurro:No. That is awesome. And we you know, I wanted to maybe touch on a reverse exchange, and then we also have a we're gonna throw our California now California people out there, but but I'm the guy right next to me, he has a single family home, not to get too personal here, has a is I'm still single, but No. I don't know. I don't see anything.
Chris Picciurro:Exactly. That's a that's a that's an interesting point. There you go. But, we wanna touch on your bill you're building a separate unit that's going to be, you're gonna rent out as as a commercial space on the bottom and and a short term rental on
John Tripolsky:the top. But exactly. Yeah. So say there was a single family home, say you were building another structure on the property, say you were gonna do kind of a split in half. So say it's a say it's a structure.
John Tripolsky:Say there's a commercial on a lower and say an ADU, so a short term or long term rental above it. Like, how does all that play into the play to the mix? So it's almost like a you're hitting the trifecta. Right? You got you have three on three on one piece of land.
John Tripolsky:So
Chris Picciurro:And and then but at least we're just throwing it out there that it's you. Usually, you know, at Tax Pros, you know when you get that, I've got a friend or my you know, no BS. It's acting for a prep. Yeah. It's you.
Chris Picciurro:You know it. But the thing is, let's say that gets built and then then yeah. John's primary residence does qualify for the section one twenty one exclusion, yet yet part of it is is business use. I know, Scott, you've seen a lot of that occurring, and there are some you can the misconception is you can't do a ten thirty one on anything related to a primary residence, but I'd love to hear hear your your thoughts on that.
Scott R. Saunders:Yeah. That is a misconception. So what I'm gonna do is look at how the asset is used. We call it what's what is called commonly is we call it split treatment. So if I have a primary residence and I rent out the bottom and I live at the top level, the top level I live in qualifies for one twenty one exclusion.
Scott R. Saunders:The commercial or the unit down below is $10.31 because it's held for investment. That could be in one residence. We're starting to see a lot of ADUs now, right, where you've got somebody lives in a house, but they've got a separate rental unit out back. If I have a fourplex and I live in one unit and I rent out three, I'm gonna get one buyer, and roughly 25% of that will be one twenty one if I've lived there for two years, that I do a ten thirty one. So there are all sorts of planning opportunities on this.
Scott R. Saunders:You could have Airbnb. Maybe you Airbnb some a dedicated bathroom and two bedrooms. That portion of your house is $10.31 because it's held for investment. I'm speaking to you from the basement of my house. The entire basement of my house, I use, for business purposes.
Scott R. Saunders:I own investment real estate. My daughter works for me. We have our offices down here. So I have a three story house, a basement, main level, and upper. Two thirds of my house is one twenty one.
Scott R. Saunders:The bottom basement, which is a third, will be a ten thirty one. So there are a lot of applications of this, and I think if people think about that planning, it opens up some doors. We see it a lot of times with farms and ranches. I've got a $4,000,000 ranch with a little half million dollar modest ranch house. 3,500,000.0 of the ranch qualifies for ten thirty one, and then the house is excluded.
Scott R. Saunders:So as a tax professional, let me give you some parameters. Number one, you can just do a square footage analysis. That would be the easiest. Another one you can do is you can look at the quality of improvements. If I'm in a fourplex and I fixed up my owner unit, put in new cabinets, and I put in quartz countertops, and I bumped it up, I might be able to have a little more value in the owner's unit.
Scott R. Saunders:So square footage is simple, but you could look at improvements. When you're dealing with a ranch or farm, an easy benchmark would be look at the minimum amount of subdivision size. If I can subdivide down to a five acre lot, five acres of the dirt goes with the house, but the remaining 200 acres of the ranch then is ten thirty one. So there are all these planning opportunities, and then I'll I'll touch upon something else that relates to it. You can convert a rental property into a residence down the road.
Scott R. Saunders:So I could do a like height exchange into a rental property on a golf course, rent it out for a period of time, let's say a couple of years. And then if my facts and circumstances change, I can move into that and live there. Now if you're gonna later sell it, you've got a minimum five year holding period that you have to live there, and you only get a ratio of the amount of time you lived in it over the total ownership for exclusion. But let me give you one other variation. We got guidance on this.
Scott R. Saunders:I think it's RevProc 02/2005 dash 14. Let's say I'm in California, so I'll take John's example. I bought a property for a hundred grand. Today, it's worth $2,000,000. It's been thirty years.
Scott R. Saunders:You got a $3,000,000 home free and clear, and that is the taxpayer's major source of net worth is that $3,000,000 home. What they can do is they can move out of the home as a residence, make it a rental for, let's say, a year or two. When they go to sell it, let's say they're married, they can exclude half a million of gain because they're a married couple finally jointly. Then the 2,500,000.0, they do an exchange and they come to Nashville, Tennessee, and let's say they buy five rental homes at half a million dollars each. What they just did is they converted the equity in their residence into investment equity that now gives them cash flow for retirement.
Scott R. Saunders:So in markets like California, Oregon, Washington, New York that have gone up by a lot, seeing people move out of a residence and make it a legitimate rental property, they can combine one twenty one with ten thirty one, do an exchange out of the difference, and buy investment property that now kicks off cash flow for retirement. So that's a just a a really great opportunity. I've got some write ups on that. I'll tell you what I'll do, Chris. I'll, I'll email them over to you.
Scott R. Saunders:You can put them in the show notes. I've got a good write up. And then you alluded to something I wanna jump into because I know we're running tight on time. We talked about your your basic plain plain vanilla delayed exchange. There's a whole another universe of other creative planning opportunities.
Scott R. Saunders:There are things called parking arrangements. So this is where an entity owned by the qualified intermediary is parked on title. They actually sit on title for up to six months. So a reverse exchange is where we buy the new property, the replacement property first, then we have a hundred and eighty days to exchange out of the one we own. That's a great tool for somebody in a really tight market.
Scott R. Saunders:Maybe it's an off market deal. Maybe inventory is low, but they find a great purchase that's a really good price. They lock it up and close on it. So the seller says, hey. I need to close on it within a month.
Scott R. Saunders:They buy it. Now they have a hundred and eighty days to sell their relinquished property or their current one. Couple more variations. You could do what's called an improvement exchange. I can buy a new property, and I can actually build a property to my exact specifications.
Scott R. Saunders:So I could build brand new from the ground up. I can also refurbish. What if I got a class c apartment building, and during the exchange period, I blow out the kitchens and bathrooms, and I really upgrade it to get more cash flow. I can do that with exchange money. So that's called an an improvement exchange, construction, or build a suit.
Scott R. Saunders:And there's a third variation, which is called a reverse improvement. I buy the dirt, I make improvements on it, and then I have a hundred and eighty days to sell the existing one. And so we see a lot of business owners will do that. If you need to build something to your exact specifications, a reverse improvement allows you to tie up the dirt and build exactly to what you need. So all three of these are are definitely more complicated.
Scott R. Saunders:There are a lot more moving parts. They're not for everybody. You have to have the capital to pull this off. Financing considerations come into play. But these are great strategies that are a little bit more advanced that can help solve a problem for business owners and investors.
Scott R. Saunders:So there's something to look into.
Chris Picciurro:Well, I would say this. Tax professionals, if you want someone to make you look really, really good, and it takes a lot of work for me to look good, talk to Scott and the team at API Exchange. Because when clients come in with their challenges, not all of them are gonna be fixable, but you can just, by listening to this podcast, understand or watching that some things are fixable. Not much is fixable after they sell the property and put the money in their pocket. So start establishing a relationship with a qualified intermediary.
Chris Picciurro:Again, I highly recommend API Exchange. It doesn't have to be them, but but you wanna work with the best, you're gonna wanna work with them. And that way, you and and absorb some of their content, and and it's gonna make you look good, and you're gonna improve your value to your client. And you're gonna be able to be compensated for the tax planning and strategy that you provided to your client by saving them a ridiculous amount of money by executing one of these exchanges. Well, that's quite the mic drop.
Chris Picciurro:That is quite yeah.
John Tripolsky:And, Scott, I have every conversation we have. I feel like we almost cut you off like you can keep going on and on and diving deeper into it, which is I mean, I don't have them back. It boils down to your skill set and your experience at it for sure. But, you know, Chris, like you mentioned, you know, choosing somebody to work with always makes you look better, makes the process go much smoother. And, Scott, maybe we'll have you back here soon, and and we'll talk about, you know, ways to kinda throw things off the rails.
John Tripolsky:Right? Like, what are the top 10 ways somebody can completely,
Scott R. Saunders:you know, jack this up? Man, love love love to do that. Yeah. I see there's some common things that people do that really, yeah, they really shoot themselves in the foot, and, it ends up in a blown exchange. So been great visiting with you guys.
Scott R. Saunders:Always fun to talk about this. For the tax professionals, you know, get a good qualified intermediary, pull them in, pick their brain. They can make you look good. Right? And they can really help you out because we're experts in this niche.
Scott R. Saunders:So take advantage of us. That's why we're here. Absolutely. Before we click off, Scott, what's the
John Tripolsky:best way people can get ahold of you at if they do have those questions?
Scott R. Saunders:Yeah. Best way. My email is just my name, Scott@APIExchange.com, or my phone, easy to remember, (888) 531-1031.
Chris Picciurro:Oh, I like it. Awesome. Scott, thanks again. We love having you on we loved having you on this podcast. We'd love having you in the Teaching Taxville community.
John Tripolsky:And, everyone, thank you so much for listening. Absolutely. Thank you. Thank you, Chris, here as always. Thank you, Scott, as always, and we will talk to everybody very soon.
John Tripolsky:Hey, everybody. John Drupalski is still here from the Monthly Recurring Revenue Institute team, whereas MRR Institute, as we say for short, Don't say I didn't warn you about a lot of information there, a lot of great information. Feel free to pause right now, take a breather, fill up the coffee, fill up the water, scratch out a little bit more and then sit back down. Welcome back. If you took advantage of that break, kudos to you.
John Tripolsky:If you powered through it, kudos to you as well. So all joking aside, fantastic topic as always that we talked about there. Scott, thank you so much for joining us, diving into the ten thirty one exchange knowledge that you have. I shouldn't say diving in. I know we just kinda scratched the surface.
John Tripolsky:So we look forward to having Scott back on the show, likely time and time again, as we dive further and further into really just the strategies involved in that and Scott will start to kind of pull some of that knowledge from you, with any updates that are coming across your desk. We know you're the guy for it that could best touch on that topic. So until then, if anybody has any questions for us, please feel free to shoot us a LinkedIn message. Be sure to check out our YouTube channel as well. We have some snippets on there that Chris from our team has popped on there.
John Tripolsky:And as always, feel free to email us at hello@mrrinstitute.com with any of those questions, or just go to mrrinstitute.com, our website. It's a contact form on there as well. Shoot us a message with any questions or comments or even topics you may want to hear in this show. We'd love to hear them. So until then, we will see everybody very soon.
Disclaimer:The content of this podcast does not constitute an offer of securities. Offerings can only be made through an offering memorandum, and you should carefully examine the risk factors and other information contained in the memorandum. The content provided is for educational purposes only. We encourage you to seek personalized investment advice from your financial professional. For all tax and legal advice, please consult your CPA or attorney.
Disclaimer:Investment advisory services are offered through Cabin Advisors, a registered investment adviser. Securities are offered through Cabin Securities, a registered broker dealer.
