Dave Foster On Avoiding Taxes Using 1031 Exchange Real Estate Investing

Posted on January 26, 2023
In 1031 Exchanges

The REI Diamonds Show - Daniel Breslin | Dave Foster | 1031 Exchange

Guest: Dave Foster is a 25-year real estate veteran and coach who has used 1031 exchanges to increase his buying power while minimizing his tax obligations. He has a keen understanding of how to use this under-utilized tax provision to create wealth in real estate.

Big Idea: 1031 exchanges can be used to defer taxes and leverage capital when transitioning from one real estate investment to another. With the right strategy, investors can keep their own tax dollars working for them, creating more buying power and limiting their tax obligations. Dave Foster can show you how to unlock the benefits of 1031 exchange real estate investing.

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Resources mentioned in this episode:

https://www.The1031investor.com

View the Episode Description & Transcript Here:

https://reidiamonds.com/unlocking-the-tax-benefits-of-1031-exchange-real-estate-investing/

Dan Breslin: Welcome to the REI Diamond Show. I’m your host, Dan Breslin, and this is episode 210 on 1031 Exchange Real Estate Investing to Avoid Taxes with Dave Foster. If you’re in building wealth through real estate investing, you are in the right place. My goal is to identify high-caliber real estate investors, and other industry service providers. Invite them on the show and then draw out the jewels of wisdom.

Those tactics, mindsets, and methods are used to create millions of dollars and more in the business of real estate. Dave Foster is an expert in 1031 exchanges. Real estate investors who have mastered the use of 1031 exchanges avoid their investment gains from being taxed heavily at each transaction. The 1031 exchange allows investors to postpone paying income taxes on large real estate profits. This keeps your gains compounding over time, leading to more substantial wealth over time. Think Warren Buffet, who has been a master at Tax Advantage Investing.

Dave Foster & I Discuss 1031 Exchange Real Estate Investing:

What are 1031 Exchanges
How to Use 1031 Exchanges
Trends and Strategies of 1031 Exchanges

Relevant Episodes: (There are 210 Content Packed Interviews in Total)

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Watch the episode here

Listen to the podcast here

Dave Foster On Avoiding Taxes Using 1031 Exchange Real Estate Investing

Welcome to the show, Dave. How are you doing?

I’m doing awesome, Dan. It’s great to meet you and to be with you. You and I were talking before. I love that real estate sign behind you. That’s the thing every realtor should have.

I know.

That’s awesome.

Family History, Hurricane Impacts, And Real Estate Investment

I will for the readers, because I don’t think I’ve ever discussed it, but that’s from my grandfather and the signs probably from the 1950s. He was a broker for the Catholic Church in Philadelphia. He was like a property manager, and that was his shtick. We were joking about being me third generation. My dad, like, flipped or, like, had 2 or 3 rentals that he did a renovation on and, like, gave him to his partners. That was the extent of his second generation. Ed Kelly was my mom’s side. He was the grandfather who passed when I was like eight years old, maybe. It’s a stretch for me to say I’m third generation. It helped me have the confidence to get started back in 2006 and do those first couple of deals when I had zero dollars, zero experience, and zero connections.

That’s awesome. We all start somewhere, man. That’s for sure.

For us to get a start, Dave, whereabouts are you physically located in recording?

I’m in Sunny St. Petersburg, Florida, where winter came. It was 54 degrees. We’re at the height of our big winter. Don’t cry for me. We’re okay.

Did you guys fare okay with a hurricane that came through a few weeks ago?

Yeah. For everybody who watches those sorts of things, it looked like we were in the crosshairs. Everybody started bugging out. Most of my family, we take what we call her occasions where you just grab a copy of your insurance, pack the dogs up, and go visit friends. It took that turn and ended up going south of us and messed up Fort Myers, Lee, and Collier County pretty bad, but we just got not much at all. We’re fortunate, others not so much.

I was surprised as the hurricane was coming toward your area, how many friends and people who literally work as service providers within our organization, graphic designers, the mail house, the print shop. I’m like, I have, I don’t know, 5 or 10 pallets worth of printed material that are now in jeopardy. That’s like not any small, let alone all the friends, family lives and all that.

We feel like we as a company really dodged a bullet probably the same way that you do, but prayers for the families of everybody who did not dodge. I did notice last night I saw a video and I see that in Naples, there is this influx of listings now for vacant lots that just hit the market. People are refusing to rebuild. Time to get out. What interesting insight or observation have you might maybe seen a little closer to the ground there in Florida with what just occurred with the hurricane?

I think the model is out there. It’s just who we are. People love, especially in that area, they love to buy their dream retirement home. Many times, that’s a lot to be built on, or it’s a home, and you go through something like this, and it’s like waking up and starting to question your own mortality again. It’s like, “Wait a minute, do I want to live through this?” The reality is that they always rebuild.

I think perhaps what I was discussing with some of my colleagues is a microcosm, an identical scenario as what we had in 2014 with the fires in Pigeon Valley or Pigeon Forge, Tennessee, and Gatlinburg that destroyed 80% of the rental stock of properties. As you can imagine, at that same time, the exact same thing happened. Everybody that could not stomach the risk or could not rebuild sold the lots. Those started getting bought up and rebuilt.

Now, if you just say Pigeon Forge and Gatlinburg, those are hot topics on everybody’s radar for the massive amounts of vacation rental. South Florida, anywhere, or Northern California in the wildfires, any one of those places is going to experience the same resurgent. They always come back because there are always people who are optimistic and who see the ten years of benefit. The problem is if you’re one of the people that have to live through the one year that can sometimes cloud the other ten. It’ll take some time.

They’re going to come back stronger. Don’t believe everything you see on the media, some sensational pictures. If you notice most of those pictures or stick-built construction, trailer homes, and older types of buildings, you don’t have to go very far in England at all and see that most of the properties built in the last 15 to 20 years did just fine.

I wonder what the pricing is on those lots. I imagine that there must be some market force at work with supply and demand, and those same lots even three months ago before the hurricane must have sold for some percentage more than they’re going to get now.

It could be or, strangely enough, in many cases, I bought a lot like this where my choice was between a lot with the house on it. I chose the lot because I was going to have to tear down my house. If the hurricane took care of that, now might be the time to put a premium on a lot that already has plumbing to it. Who knows?

Understanding And Utilizing The 1031 Exchange For Real Estate

True enough. I think we’re going to get into the 1031 exchange here in a few moments, Dave, but do you want to share your background in real estate as a framework, I guess, and then maybe how that progressed into doing the 1031 exchanges as a business model?

That’s a very fun story to tell because it feeds exactly right into it. The 1031 exchange we’re going to be dancing around is a process that lets real estate investors sell investments or real estate that they hold for productive use and then go and buy new investment real estate. If they use the 10th year loan process, they get to indefinitely defer paying tax on the profit and depreciation recapture, which just basically means the IRS lets you keep the tax and use it for your own benefit.

When you stop and think about that, if you’ve got $100,000 tax and you get to use that for yourself, let’s say you put it into a stock, if you were going to put it into a stock or if you put it into a real estate that makes 10% an investment, that’s $10,000 a year. I don’t know about you, but that’s real money to me. The 1031 exchange is huge. The way that I found it was by learning a lesson in the School of Art Knox. We wanted to find a way to create financial freedom that would give us time to enjoy our family because time’s the greatest commodity we have.

A whole lot of people over the last few years, we said, “Let’s do real estate. It’s got to be easy. Anybody can do it. Let’s go.” 23 or 24 years ago, I bought a duplex in Denver, Colorado, fixed it up, and sold it. Life was awesome. Until I went to my accountant, and he said, “Dave, didn’t you have a silent partner?” I said, “What do you mean?” Goes, “Uncle Sam and Uncle Sam’s about to make more on this property than you are.”

That just didn’t sit well. Not to mention the fact that it put my plans many years down the road and behind. It was right at that moment in 1997 that there was a huge court case settled between the IRS and a guy named Stoker, and the IRS lost. This whole new way of doing 1031 exchanges was going to be available for everyday investors. When we started to look at what the impact on that would have been, I said, “We would have totally jumpstarted our own career.”

I had friends saying, “We want to do this for others. Do you want in?” I said, “Absolutely.” From that moment, I’ve embarked on a 23-plus-year career of doing 1031 exchanges for others and using it in our portfolio and business practice. We managed to transition to three different geographic markets and ended up with a portfolio, strangely enough, in Cape Coral, Florida. Back in the day, where we were able to buy a 53-foot sailboat and live on it for twelve years while raising our family and paying for that with income from our rental properties. All without being a penny in capital gains tax. When that happens to you, you get pretty excited about it. I love doing that for others. That’s what got us into it.

Nice. Still got the boat?

We sold the boat when the kids started talking about college because that’s where all my money goes these days.

Fair enough. My daughter’s got two more years of the college payments there. Cool. Let’s dive into it. You describe what the 1031 is. I think people who get into real estate hear about it. For me, it felt like a very far off, distant thing when I first thought of doing, “How do I get the first property that’s going to appreciate it and give me a gain?” The one 1031 exchange I did do was a two flat unit here in Chicago. I bought it.

Renovated it, had it a year year and a half something like that. Sold it versus keeping it and made like $25,000 or something like that. I did a 1031 exchange just for the sake of doing it. I didn’t need the $25,000. I was like, do the exchange, and I had an eight-unit building lined up. I put some more cash with the 1031 money to get into the much larger deal. I still have that eight unit. Now it’s a ten-unit, and it’s one of the better deals in my portfolio that I’ll hang on to. Now that I’ve gotten that thing stable and brought it up to speed. Looking back, Dave, it felt like it was almost too small of a deal for the 1031 for me.

It was like, “Was all that even worth it?” I saved like $9,000, $10,000 in tax. It was worth it. I had the experience, and I have the new building, which I may not have even stepped up to and bought that eight unit. It may have never been a motivation for me if it wasn’t for wanting to do the 1031 exchange. I’m curious. With 23 years’ worth of investment deals and 1031 transactions for clients, what is the optimal deal size that you’ve seen take place or maybe the most common deal size where the 1031 is, like, worth it, really moves a needle? Maybe there’s an example of a deal there, too, that you would share.

1031 Exchange Strategies: Optimizing Deals And Compounding Gains

I think it’s really important to remember that just like you treated it, the 1031 is a tool. Now, it’s a tool that you can use strategically, but it’s a tool that, like any other tool, can have many different uses depending on what the person wielding it knows or what they’re trying to do. I can make a hammer work for all kinds of electrical problems. I just have to use it right. That being said, when I think of it over the years, it depends on where you’re trying to get to. One of my favorite clients of all time was like, in 2004, there was a lady that sold a lot, and she literally made $10,000 on the lot.

Now, as a resident of the state of Florida, she was looking at $1,500 in tax. By the time she paid for her exchange and everything, she was literally only going to save like $500 or $600. I asked her about this, “Are you sure you want to do this?” It’s just not that much and whatever and she goes, “That $500 is mine. You bet I want to.” See, there’s a lot of just personal philosophy about how you feel about paying taxes. What’s important is to see what she did.

That $500 became part of a down payment on a larger property. Just like when you got started, that first amount of gain wasn’t that much, but it gave you an extra boost on a down payment for a larger property. That starts to roll forward. It’s basically a form of compound interest. It’s just compounding. I wish that we had an ability for me to put some screens up here, but I’ve got some examples where we take the exact same investor, and one of them does 1031s, and one of them doesn’t.

That’s the only difference. They sell a piece of property first, and then they take whatever is left. Now, on the $100,000 game for the investor doing the 1031, they’ve got $20,000 more to put in as a down payment of the next property. The other investor doesn’t. We do that in four steps. Literally, at the end of four steps, twenty years, and four transactions. The investor that has deferred the tax has a down payment that allows them to control almost $12 million of real estate.

Whereas the investor who does not do 1031 exchanges has the down payment in the cash to control about three and a half million. That’s how huge that difference is in using the tax for yourself versus paying for it now. It’s the same principle as your 401(k) and IRAs. It’s just the tool that exists outside of those retirement accounts to let you do the same thing. Grow tax-deferred.

You touch on something that I think is an elusive topic, and I learned it best reading The Snowball, which is the story about Warren Buffett that came out maybe ten years ago. He would talk about those same compounding gains. You see the chart, $12 million for investor A who did the 1031s and 3.5 for investor B. We’re like, “That’s great. That makes sense.” I can tell you, I don’t know, realize the impact of compounding that tax portion of your investment.

It took me a few years to really have the maturity and the patience to put the money down there and set it to work because investor B was not going to have access really to that cash pile from the sales. I’m sorry, investor A, who got to 12 million in Yen, he’s not going to get access to any of his cash whatsoever. It’s like do other flexible stuff outside of real estate for that full twenty-year period. He’s not going to touch it. I think that for me, at least when I was a little younger, I liked the hit of flipping a house and there’s a 30K profit.

Balancing Fix/Flip With Long-Term Investment

You are an adrenaline junkie. I got a little bit of that in me as well. You’re absolutely right. There are those people that gravitate to that. Number one, they love the deal to get in, to get out. They’ve created value. They love having that cash in hand, but there are so many things. This is not a knock on the model because I do it some too, but you have to just recognize there are opportunity costs for that.

Opportunity cost is number one, you’re going to pay a truckload more in tax every year. You have no preferential treatment. Number two, you don’t get the tax write-off of depreciation when all you’re doing is buying and selling. You’ve got to recapture all of that. Number three, as part of the calculation of the internal rate of return, one of the things that is huge that people forget is the amortization of the loan.

If you borrow money to buy a property and then rent it to someone, the tenant is paying the mortgage payment. Part of that mortgage payment is a return of your capital that you borrowed. Plus, you get the tax write-off on the interest there. There’s a whole number of different tax-related opportunities you don’t get when you’re fixing and flipping, but talk on it does feel good. It does. There’s a reason for doing that. Can I give you the answer? This is what so many of my investors do. It is an awesome strategy to get the best of both worlds.

If you borrow money to buy a property and rent it out, the tenant is paying your mortgage for you.

Buying your properties, fix them, rent them out. Now, right there, you just opened up the door for a great internal rate of return. You’re going to get depreciation. You’re going to get rent flow. You’re going to get depreciation. You’re going to get amortization of the loan. You’re going to get the tax write-off on interest. While you own that property and that tenant is paying all the bills, do a cash-out refinance. Pull the cash out of refinance, and use that as a down payment to go buy your next project. Fix it up, put a renter in it.

As soon as that happens to another cash-out refinance. The next thing you know, you’re juggling 3 or 4, what feels like fix and flip properties, but they’re fixing flip properties on properties that you’re going to hold over a one-year mark. When you sell them, you’re going to 1031. Here’s where we throw gasoline on it. When you sell that property in 1031, you’re not going to buy one. You take the down payment, and you’re going to use that to buy two cheaper properties.

If you want to grow that way. All of a sudden, you got more fix-up work than your crews can handle. Yet all of it is going as capital gains, and all of it is 1031 eligible, and you’re using that deferred tax, but you’re also still getting those refis out either to invest in something else or to buy braces or college or whatever it is that you need. I’ve got a couple of clients that will do 20 to 30 exchanges a year. Every one of the properties they’ve owned for more than a year, because that’s just their model.

They’ve gotten one year removed from the fix and flip, but they still get their adrenaline fix, but then they just hold the others long enough to do the 1031 out of. That can be a great way to get the best of both worlds. You’re describing the level of patience, and that was not what I had. I was a liquidity junkie for lack of a better word. I just wanted to have access to it’s why people buy into, I think some at some level stocks, the stocks give you this a lure because they’re liquid.

Intent And Timing In 1031 Exchanges

Bitcoin gives you this allure because it’s liquid. I can get it back out. There’s some security there and being able to make an instant withdrawal, which is not there if my plan is to hold the property for a year or twenty years. I hear you mentioned the year deadline. Is that a minimum in order to be able to do the 1031, or is that arbitrary for the investors? It’s fairly arbitrary. There’s no statutory holding period. Anything more than one year is generally seen as totally safe.

The true standard is your intent. If you have a property that has been your intent to hold for productive use, then it qualifies for 1031 treatment. If you buy a property with the intent of primarily reselling it, it does not qualify. Now, the things that a year does, and my industry is even guilty of this. We used to use a mantra called a year and a day. It doesn’t do anything magical. What it does do is this. Any property you own for more than a year generally gets afforded long-term capital gains treatment. That feels longer term than ordinary income.

Secondly, any property you’ve owned for more than a year or a year and a day at least is reported on two consecutive tax returns because you owned it in two consecutive years. Thirdly, there are several different case rulings out there where the IRS trying to get a handle on this gave an idea of what three different appropriate holding periods would be. They use the phrases two tax years, and two calendar years.

It did not take the bright attorneys in America long to figure out that if you want to take that at face value, that’s anything in between 2 days and 730 days. To keep it simple, but also to give them plenty of gray, the iris makes the standard intent. Intent is whatever you can demonstrate. One of my favorite exchangers from two years ago is up in Tennessee, which we were talking about earlier.

He sold a cabin that he bought 30 days after he bought it. He wanted to do a 1031. I said, “No, dude, cannot just buy and sell. That’s not what 1031 is for.” He said, “Dave, I had to honor the long-term lease that was in the contract. It was part of the contract to buy. I had to honor this long-term lease because the tenant was a friend of the seller.” I said, “That’s a nice try, but how come you’re not honoring that lease?”

He said, “It’s because she broke it.” I said, “That’s a little bit different, but still what you’re dead.” He said, “I think the problem is the bear. A bear had literally taken up residence at the trash cans for that house. The tenant felt unsafe. She broke the lease.” This guy said, I don’t want to try to rent something with a bear.” He had ring photos to prove it. His accountant was perfectly fine. Guess what? That’s pretty easy to demonstrate his intent, wasn’t it?

I guess it is. Assuming he made money 30 days later.

Pigeon Forge 2017 or 2018. He did okay.

Nice. How about the deadline? I believe that eighth unit I was referring to early in the episode. I think I had that lined up and was going to buy it anyway. I was already under contract or something, and then I think I had the other one selling. It wasn’t like I set out and said, “I’m going to 1031 this $27,000 into another building and then go find something. I was simultaneously had them working.

The deadline wasn’t an issue, but a lot of the other times I was going to consider the 1031, it was more of an issue of having something of high enough quality for me to 1031 into the next one. I’m going to be honest. I love selling properties to 1031 buyers because they’re typically motivated, and they pay more than the average entrepreneurial investor buyer. How does your client or what is your suggestion to not get burned by being a motivated buyer once you’ve put the 1031 in place?

You’re speaking right to it. The first thing that you got to just burn into your mind is that nobody in history has ever gone broke by paying tax on profit. It may feel like it, but nobody has ever gone broke paying tax on profit. There is no transaction in the world that is worth it if you have to overpay to a point where it is more than it would have cost you not to do it.

Nobody has ever gone broke paying tax on profit.

There’s a real cost analysis that has to go in place, but it is very true that many times a 1031 investor will look at this and say, “This deal, I’m going to have to overpace something for it, but the tax I would have to pay if I don’t do the 1031 is this. It would take me 4 or 5 years to recoup all of that tax if I have to pay it right now as opposed to putting it in this, which brings me maybe a little bit less or cost me a little bit more.”

You’ve got to really dive into those so that you can know and be sure. There’s no penalty for starting and not completing an exchange. The idea is if you’ve got a tax bill you want to defer, start the exchange and look around. You’ve got 45 days to shop around. If you don’t find something, let your exchange die. Exchanges are cheap. For a carton variety exchange, $1,000, $900, or something like that. That’s a tax write-off, anyway.

It really is going to cost you maybe $500 or $600 to kick the can down the road and see if you can find something that you like. What you did was a great strategy because you already had your acquisition target, and it was probably a seller’s market. You then looked at your portfolio and said, “I want to buy this. Do I have any properties that are ripe to sell that I could move into this that would then position me better? I’m going to sell those into a 1031.”

You remember this, there was a period of time in particular in California where people would put things on the market and they would get 20% over list day one cash offer, five day close. It was insane. What we told people was to take care of the hard job first. In that type of market, the hard job was finding your replacement. Go find your perfect replacement, get it under contract, then go sell your other property because it’s going to take a week.

That gives you plenty of time. You don’t have to worry about them finding a property. You don’t have to worry about somebody like Dan holding you hostage because he knows you’re a 1031 buyer. All those good things start to happen. I think also along with that though is don’t forget that the second half of your 1031 is going to happen the same way your first half happens. People who complain about having to overpay for a purchase need to remember that the reason is that it’s a seller’s market, and they probably got overpaid when they sold.

You got to take the market where it comes. Those are the primary strategies that we would tell people. Now we’re in a transitioning market where things are hanging on the list a little bit longer. Now might be a good time to wait, be patient, and get a sale, but get an extended contractor for your sale and then go shopping because every week you shop, people are getting a little more anxious to sell. I think this is great market to be a 1031 seller because you sold and you’re going to buy into a depressing market, not depressing.

Opportunities exist.

There you go. That’s exactly depressing. Sounds too much like 2008.

Patience And Long-Term Thinking In Real Estate Investment

We’ll be careful how we’re talking about that here for the time being. I think that’s an interesting observation is that the California market was super hot. At the same time, we here in Chicago, I’m one of the markets where we do business. There is the California buyer buying the 4 flat, 5 flat, 8 flat, 22 flat. They don’t exactly know the nuance of the neighborhoods. A lot of times, California buyers are going to buy in areas with more challenging tenant base but higher cap rates. I guess they keep getting the appreciation too, and enough people pay the rent, but all the locals will not touch a lot of those buildings for the headaches that come with them.

In Philadelphia, we have the New York buyers who operate and behave a lot like the California buyers. Atlanta, the entire country seems to be just buying into those single families. There’s not a hell of a lot of apartment buildings there. Interesting observation there. To get the 1031 is probably what they’re doing. It’s probably why they overpay a little for these places in these marginal areas. When we’re looking at it, explains the psychology going through the mind of that buyer there.

I think, too, I come back to the patience and the liquidity and what you described a minute ago, Dave, and I wrote it down was you’re selling a property and I’m picturing myself. Maybe even a reader who’s got a flip something to flip. They’re selling it, and they can taste the liquidity. It’s like, “Man, to have this $50,000, $60,000, $80,000 hit my account is going to feel good.” Instead, taking a detour, committing a $500, $600 or $700 fee if the exchange fails. Going into the 1031 and putting some forced patience against that liquidity and having a deadline for 45 days to intentionally go out and select something that might be another level up as a property.

Two more of the property you just got rid of are in slightly better locations than the one you got out of as far as future appreciation. Otherwise, I don’t really find myself digging through the real estate market and hunting for the eight unit that I bought unless I have the 1031 lined up. I feel like it forces you to be a little more patient and put the liquidity off. You still might end up having to take the liquidity and pay a tax anyway, but at least you’re forecasting a 30 to 45-day search period, and you got the money in the bank, and now your mind’s thinking on levering up the investment.

Now I’m more like investor A, who ends up with the twelve million because he’s being patient. I don’t want to understate the amount of patience required. That’s what I took from Warren Buffett’s book. It’s not run out and buy jets as soon as he could afford jets. There was this lifelong patience of compounding that took place. I almost feel like from my own experience, that patience and being that long-term investor, it took me, I don’t know, 8, 10, 12 years to see the value in. Now, I was building a business that turned out to be, very much thriving through that period of time.

I allocated my energy a certain way, but cannot overstate the patience factor in participating in the compounding effect of real estate, whether that’s just holding and managing right for the longterm, whether that’s 1031 exchanges like we’re talking about, or maybe it’s called segregation kicking a can down the line in another format or some other form of patience and hanging on to your investments long term. For me, patience is like coming now that I’m 41 or 42 years old. I’m learning it. In my 30s, I was not patient at all.

Real Estate As A Retirement Strategy: Converting Properties And Tax Benefits

I have never phrased it this way, but I was listening to you talk, and here’s exactly what it is. Anybody can go into real estate and create a job. You become a realtor, you buy and sell, you become a fix and flipper. Anybody can do that as a job. During up times, you’ll do really well, and you’ll buy a lifestyle as a job. The 1031 portion of it is like taking the job and adding to that contributions to your retirement.

Anybody can go into real estate and create a job. The 1031 exchange is what helps you build wealth.

The patience that you have reaps rewards for you later. As you said, you’ve got to be patient, but it’s like giving you the opportunity to indulge in that adrenaline side, but at the same time, start to prepare for the future and build that nest egg. That’s the mentality. We talk a lot about the life cycle of a real estate investor because, like your life, it changes. Your needs, desires, your targets, your energies will change as you grow older.

Early, like you said, when you’re young and impatient, you’re bye. Using the 1031, you can sell one and buy two. You can start to branch out geographically because the 1031 exchange will let you go anywhere in the country you want. We’ve hinted at this because it was with your 1031, but you can go from different classes. You could sell a single-family home and go buy an industrial building anywhere else in the country. Commercial buy raw land.

At some point in time, you may get a builder the edge. You use the 1031 to go buy a chunk of raw land. Create a land bank off of that and do some things with that. As you start to get older, your energy wanes, but your wisdom is increased. Now we start to 1031 into more passive opportunities because we have the ability to examine those and due to diligence to buy triple net commercial properties or 1031 compatible syndications, vacation rentals that we eventually convert into our primary residence. There are a ton of ways. They just have to be appropriate for you where you’re at.

Can you touch on that vacation rental thing that you just alluded to?

It’s my favorite thing of all. Here’s the principle. The 1031 exchange is a sale of investment property followed by a purchase of investment property. You do not have to use it for investment forever. The key is that you could say you live in Cincinnati and you’re getting ready to retire in a couple of years. You sell your Cincinnati rental, and you could buy something on the beach in Sarasota. Use it for investment for a couple of years, generating income.

Two tax returns?

There’s a safe harbor for the IRS. Those two years. There are still a lot of people who say a year is okay. One of the quirks of that law is that you being in it does not count as long as you are working on it. I know I had some people in Fort Myers that would have to go down and watch the automatic sprinkler system for 5 or 6 months a year because it was so prone to failure. Two years is a safe harbor.

They’re going to go from Cincinnati and retire where? In their former investment property. That doesn’t trigger a tax event. I feel like the Romco guy now, but wait, it’s even better when they sell their primary residence in Ohio. If they’ve lived in it for two out of five years, they get to take the first $500,000 in profit tax-free. They sell in Ohio, and $500,000 is tax-free. They move into a house with all the other money, tax deferred.

What a jumpstart on retirement that is. It gets even better. I have a guy on St. Pete Beach that did three 1031s into three, I mean, literally on the same floor, identical condo units on St. Pete Beach. He moved into the first one and converted it. That started his retirement. Now he’s going to live there as his wife says, “Until it’s time to redecoratel.” They’re going to stay there because as soon as he has owned that property for five years, as soon as he has lived in it for at least two, then he can sell it and take a proration of all of that deferred 1031 gain tax-free.

Tax Implications: Primary Residence Sales, Inheritance, And 1031 Exchange Concerns

That would count like on the 500 yen?

Up to 500. Correct. You only get a prorated. If he rented it for two years as he did and then he lives in it for eight, he will get 8/10th of the game. Where’s he going to move? Next door. He’ll do it all over again. Now, most of us who foolishly misspent our youth are going to have to be looking to deliver pizzas for Domino’s or bag groceries at the Kroger’s or something to supplement our social security. His supplement job is he lives in a beachfront condo, and he’ll sell one every once in a while and pay some tax just like I’m going to have to pay tax on my pizza delivery earnings.

Who would you rather be? What an awesome strategy. We did much the same thing in that we kept converting properties in each of our markets. Every time we sold one, we took the tax-free money and put that into our buy the boat kitty. That was how the boat was purchased for cash with tax-free dollars. The rest of our holdings, we simply generated income off through productive use.

Was it rental income going for the cash kitty?

No. For the boat kitty, it was the tax-free sales of our primary residences and the properties we converted. To live on, we use revenue from our rental investments. That’s my favorite way that the 1031 investor can get the money out. Again, like you keep saying all this whole thing, patience is the key, but patience will reward you. You want to know my second favorite way is to enjoy it all?

That’s right.

You got to die.

I don’t know if that’s enjoyable.

Like I said, it’s my second favorite. We’re all heading there anyway. Here’s what happens. For the 10th or for anybody, but for the 10th, everyone investor especially when you die holding real estate, that real estate is given what’s called a step up in basis. That your heirs inherited as if they paid market value the day you died. All of that profit over all of those years goes to your heirs tax-free.

It starts the depreciation clock for them all over again.

All over again. I’ve got one family we’re in our third generation from Connecticut, and they’re awesome. We did exchanges for granddad, who passed away many years ago. The portfolio went to his son, who again was 1031, and until he passed away a few years ago, and his children are now doing the same thing. Each time they inherited, all of the tax disappeared.

How much jeopardy is this in from a political sense? They keep tossing the 1031 on the table for the tax code. They’re going to pay for this and pay for that. Take away the step-up basis. What is your opinion or feel on the likelihood of the 1031 and the step-up basis that we were just talking about existing for the next 10 to 20 years?

I’m a firm believer. It was either Will Rogers or Gideon Tucker who said that no one’s personal liberties or property are safe as long as Congress is in session. You got to start from that point and never say never because lots of power is concentrated in a few silly answers. Here’s what’s happened over recent years. First of all, in the 23 years I’ve been doing this, every president I’ve been under has talked about getting rid of 1031 because it’s low-hanging fruit.

“If we just eliminate that, think of all the extra tax revenue we’ll get, and we’ll be able to make money.” The only president that did anything with it was Donald Trump. All he did was eliminate the personal property exception where you could 1031 things like his jet, heavy equipment for other heavy equipment, or airplanes, that thing. What he replaced that with, though, was this bonus depreciation.

I think he was seeing a way that he could get some extra bonus depreciation off of his plane rather than having to sell it because that’s what the impact was. Not judging. Just saying. Every president has talked about it, none of them have done it, anything. Why? It’s because, think about it, for every dollar that you get from long-term capital gains, which is at 15%, you’re going to slow down the real estate market because people will hold properties longer just to give them.

When people hold properties longer, what’s not going to happen? You’ll have much fewer. You’ll have two fewer real estate agent commissions, two fewer title company transactions, two fewer inspections, two fewer attorneys, and two fewer painters. All of these people that do ordinary income work, which is taxed at much higher rates. When you see the real numbers that have been produced, the cost to our economy is astronomical in the terms of billions of dollars that would be lost if they tried to simply collect the long-term capital gains from 1031 transactions.

To the point where when President Biden, I mean, he was loud and proud about it. He was going to get rid of it. That was right at the same time when you got my application for employment. Do you remember that? I sent that over to you because I thought I was going to be out of job. Right at that time, now the Senate was 50/50 red and blue. The Senate took a unanimous voice vote specifically to say no change will be allowed to Section 1031 tax-deferred exchanges.

Which was a resounding, it will not change. Now, the same thing has basically happened with the step-up in basis. Guess what? There’s a whole ton of representatives, senators, and people of influence that have property they’d love to be able to give to their kids and not pay tax on. I’m really not concerned about that because, ultimately, we’re all going to look out after our own self-interest, but 1031 looks very safe. It’s been around since 1920. No, it’s not. It’s one of the original parts of the code.

When you look at it, too, from the code is there to your point of keeping the transactions flowing. I own a shopping center. I own a couple of self like in a self-storage funds. They own apartment buildings. I wouldn’t have bought any of that stuff if it wasn’t for the 1031 exchange. I wouldn’t have invested money in those things if it wasn’t for the depreciation that I was going to get I would have had to pay a big tax bill, and I probably just would have needed to feel like I needed to hang on to whatever was left because I would have been wiped out.

Instead, the tax code incentivized me to put my capital back in place for society’s benefit. The code is doing what it is. We talk about the tax benefit side for us as individuals, but for the impact that the recycling of capital has on society, I think it’s a good thing. I hope even those in Congress and the Senate, regardless of what their background is, would, I hope, continue to see that benefit for society.

Market Influences: Tax Code, Interest Rates, And Transaction Volume

It’s a really counterintuitive way of looking at the tax code. If you don’t view it as how the government gets your money and start thinking of it as how the government incentivizes your behavior. In 1920, they wanted the small farmer to be able to sell their farms and buy bigger farms. They couldn’t do that if they had to pay tax on the sale of their own farms. That’s what started it. The incentivization is that they really want a bustling, robust, and strong real estate sales market. The way to do that is to incentivize behavior where you do that, and they incentivize it by giving you the 1031 exchange.

The government doesn’t just tax you—they use the tax code to incentivize your behavior.

Dave, I know we’re getting close to the end here, but I do want to ask you your observation. Let’s say January 2022 through we’re at October 21st, 2022. Most of us reading who aren’t reading years in the future. We’ve had interest rates go from 3% to 7% in that same time period, and we feel a slowdown collectively in the real estate market. Can you describe maybe your observation through the lens of transaction volume in 1031 exchanges that you’ve been a part of during that time?

It’s a little too soon for us to tell simply because there is a normal pause in real estate in the fall. It’s just that people start school, we’re carrying towards the holidays, and builders all have their buildings under roof and weathered, so now they’re working inside. There is typically a reduction in volume, and we’re seeing that. We’re down about 20%.

It’s a little bit. Is some of that a factor of interest rates, of a cooling market, of longer days on the market? Possibly. It’s really hard to speak to it. I don’t think we’re going to know until next March or April for sure what’s happening. I do know this, though. I am so old that I remember when 13% was not a bad interest rate on a commercial asset.

Those who want to whine about 6 or 7, think again and take a history lesson. Yes, it’s high, and we’ve got to make sure in our analysis for people that they are able to make cashflow work with what they’re having to pay for the cost of money. By the same token, someone said it was great the other day. “You marry property, you find the property you want to keep and you marry it, but you date the interest rate.”

You marry property, but you date the interest rate.

If it’s a good property, you can make it work even at a higher interest rate. If interest rates come down for you in two years, that’s just an extra bonus on top of what is already a good return for you. it’s softening how much. It doesn’t feel urgent at all. Again, keep my resume on top of your pile, and next April or May, we’ll see what’s happening.

Real Estate Market Analysis: Historical Context And The Prevalence Of Renters

If we look in the context, I felt this way this time last year, and we didn’t know if the rates were going to start climbing earlier than they did. I could even see it in the comps. If I go in and pull single-family comps, I pay a lot of attention to the month and the date that they won our contract when he settled. We could see the cooling off in the transaction volume in the markets we’re in this time last year the same way.

I recall it being that way in history, too. These are recent memory. For context, coming through 2006, 2007, 2008, 2009, 2010, 2011, 2012, those time periods were rough. I believe 2009 was the lowest transaction volume at somewhere around 4 1/2 million. If I’m not mistaken, I think we had like 6 1/2 million last year.

We’re talking 20% or 30% more transaction volume in a country with 20% more population through that same year period. We had this increase in transaction volume from the population. Even if it were as bad as the 2009 crash, which we’re not seeing Goldman and big bank failures or anything catastrophic occurring right yet. I mean, who knows what the future brings. Even if we saw that same reduction in volume, I forget what it was, the volume in 2005 or 2006. It may have been 5 1/5 million.

I don’t remember if it peaked at six but 10%, 20% less transactions, we went down like 4, 4 1/2 million transactions now, that is still a lot of real estate transaction volume that’s occurring even at the bottom of the market in the worst cycle for our, at least my memorable history. I was too young during the ‘80, ‘89, ‘90, and ‘92, and I wasn’t around for the late ‘70s thing that took place. Even if the market is down, houses still have value, and they will still be transaction. It’s just a matter of buying the assets right and being able to make the improvements and do the value add.

People still have to have someplace to live. We are seeing a nation where the percentage of renters is increasing dramatically. Again, I can speak directly to the 1031, and in 2005, there were about 570,000 1031 exchanges done. 2008, that number plummeted to 68,000. In that crash, we saw an almost 90% decrease. That’s why I sit here and go, “20% no big deal. That’s normal market.” 2005 or 2008, that was not normal. I don’t have to cuddle up in a fetal position and worry about that.

That’s good to know because I sell a lot of houses to people who are going to live there. My numbers of 4 1/2 million were a whole lot of people who were taking advantage of the first-time home buyer credit that came out during those years. If it got that bad, there would be something of that nature for sure with the way that they come up. If we had a 20% drop-off and we were doing mostly owner-occupant transactions, which a lot of our flipper podcast audience is probably doing. Again, it all comes down to buying right and making sure that you did a quality product and you can still get out of it. I probably wouldn’t build the deal on the highest watermark that exists in the marketplace.

I had a ton of investors that lost 90% of their wealth in 2008. I mean, 90% of their wealth, but it was all on paper. Those that did not have to sell just kept renting those properties. Now, they’re worth many multiples more than that.

Key Advice For Success: Patience And Long-Term Ownership

Dave, in closing, the crown jewel of wisdom, if you were passing this on to, I don’t know, one of your kids or maybe someone just getting started in real estate, what would you consider to be the crown jewel of wisdom? What’s your piece of sage advice that you would pass on to someone?

You’ve been stealing it from me this entire time. There are two people in history, two groups that have always ruled the world, banks and real estate owners. Become one of those. If you’re going to go the route of owning real estate, be patient. It’s long-term, but it will produce for him.

Real estate owners and banks have always ruled the world. Become one of those.

Well said. Dave, I appreciate you coming on the show. Thank you for giving me the time. I got a couple of pages of notes here, and I had a blast. Really appreciate it.

It was so good to be here and chat through things. I feel better already, don’t you?

Yeah.

A good spot.

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