The 1031 Exchange with Dave Foster
Guest: Dave Foster
Topics: The 1031 exchange, The 1031 Investor, taxes
Chris Ressa 0:00
This is retail retold the story of how that store ended up in your neighborhood. I’m your host, Chris ReSSA. And I invite you to join my conversation with some of the retail industry’s biggest influencers. This podcast is brought to you by DLC management.
Welcome to retail retold everyone. Today I’m joined by Dave Foster. Dave is date 1031, investor and expert. I’m excited for him to be here. Welcome to the show, Dave. Thanks, Chris. It’s great to be here today. If tell us a little bit more about who you are and what you do? Well,
Dave Foster 0:38
you know, my friends, and I guess not. So friends describe me as a serial real estate junkie. I’ve lived and breathed, real estate and real estate deals of all kinds for about 30 years now. But the niche where I find myself most is in the role as a Qualified Intermediary. For 1031, tax deferred exchanges, I started doing them for myself, and became so captivated with what they were doing for me, and the potential for others that we set up a shop to do the brothers and that’s what we do now is fulfill to facilitate those exchanges.
Okay, that’s great. And give us some context, how many transactions are you involved in in like an annual basis, something like that? Oh, it’s a huge number of transactions a year 10s of 1000s of 1030 ones every year, nationwide. Although this is such a little niche world that a lot of people don’t even know about. There’s probably between 600,000 and 1,000,010 31 exchanges, which died each year, which is still less than 20% of all real estate transactions that might qualify. So, you know, although we’re dealing with a bunch of the potential that people have to sell investment, real estate, and have definitely defer paying that tax is just huge. What they can do. And that’s what we’re trying to do spread the word.
And so when you say we who’s we, we as myself and my team at the 1031 Investor. I had operating folks that exchange resource group, we’ve been together since the year 2000.
Doing these folks. Got it? How big is the 1031? Investor?
We’ve got? We’ve got about 20 employees? Wow. And our most intermediaries are is that some back of house people as well? Well, that’s a lot of backup house people as well. Absolutely. Yeah. You know, there are Qi eyes, that acronym for us. There are cute guys out there that will have several 100 or 1000 employees. And they’re churning, we’ve chosen the boutique route, where what we do is we try to develop that relationship with the client. So that we’re their go to, because as you can imagine, with an IRS statute, that’s one sentence long and 10,000 pages, pages of case law. This is something that needs a guide. And that’s what we seek to be as the guide that helps get people through these so they can effectively use them. And for those who don’t know, can you explain to everyone what a Qualified Intermediary is because it’s obviously different than a real estate broker. It’s not an attorney. It’s not a it’s not an accountant. And it’s none of these things. I think it’d be educational for those who haven’t done 1031. What is a Qualified Intermediary? Sure. So in order to take advantage of a 1031 exchange, which remember is you’re selling investment, real estate, replacing that with new investment, real estate, and not paying tax on the profit in between. In order to do that the IRS requires that you use the services of an unrelated third party, whose only role is to document the 1031 exchange, at the sale in the purchase, and hold the proceeds in between to route them through the IRS does not let you touch the money. So this is not one of those DIY processes, that your accountant simply reports at the end of the year, you actually have to have this person called the Qi and they have to be involved prior to the closing of your sale.
Otherwise, you can’t do the 1031. Now, this thing is like what my grandfather used to call it being two miles deep and a two foot wide crank. So it’s not something for just the average person knows or wants to know. But by and large, it is mostly attorneys and accountants that have gotten into this field. I’ve been redheaded stepchild in our firm on the accounting
But what happens is, we’re the only ones nerdy enough to want to develop this niche. And that’s all we do is the 1031 exchange, we can’t be your real estate broker, we can’t be your attorney, we can’t do your taxes. So it’s a very narrow role that we’ve built, but it’s required. So I guess at the end of the day, Chris, we’re kind of like, Switzerland, where everybody’s buying.
So okay, so let’s walk some people through the process of a 1031 for a second, right? So let’s just say I own a piece, as you say, of investment, real estate. For purposes of this podcast, let’s say on a free standing McDonald’s. Okay. round numbers, we’ll just use total hypothetical, to sell this McDonald’s for $3 million. I have a buyer identified.
Is that when they call you do they call you before they decide to sell? What’s what actually happens? And then what do you think is best practice? Sure, exactly. What actually happens is that I still get calls every month, from someone saying, I sold my property just two weeks ago, the money’s at the title company, or it’s in my account, I’m ready to do a 1031 exchange. And I have to say, No, you’re not. And then I weep with them a little bit, and we get it rounded up for next time. The best practice what needs to happen is when anybody is starting to develop their paradigm of investing, they want to begin thinking whether a 1031 exchange is going to fit into their model, is it going to be something where they want to take a long look and investing and use the deferred tax dollars for their own investing benefit, which means sooner rather than later, for purposes of developing strategy to model. Realistically, anytime you get a contract, to sell a piece of property, and Escrow is opened up, that’s the best time to involve a Qi. Because we’re going to work with the attorneys, or the title company that’s handling that closing.
So we have to be involved soon enough that we can work with them, that they’re not inconvenienced, so that we can get the temporary one set up. Because the 1031 officially starts with the closing of the sale of your old property. So that’s Yep. I’m super familiar, I think. So. One of the things that I think is interesting is, what is that? You mentioned? You’re calling the attorney and accountant, what is the QI doing? And you mentioned, set up the 1031? What are you setting up? Right? So there’s three roles that the Qi has to play. The first one is documentation. And there’s some very rigid and specific documentation that’s required, there has to be an assignment of the contract rights from the seller to the Qi. Now, this, the QI does not take title to the property, we should not take title to the property, the deed should go directly from the seller to the buyer. But in this strange quirk of IRS thinking, it has to look like the Qi is actually selling.
And then on the backside, the exact same thing happens, the contract rights are assigned to the Qi, but the DEA transfers directly from the seller to our client, to complete the tip 31. There also has to be an exchange agreement that outlines definitely, much like a listing agreement, for sale of property, that kind of thing, but it’s for the temporary one. And that there also has to be some notifications without the transaction. Now, the reason for all of this rigmarole is that at the end of the day, the IRS wants to ask the question, did you Chris sell a piece of property? The answer’s no. If the QI sold a piece of property. Well, Chris, did you buy a piece of property? No, the QI bought the property. It’s just the deed went from either the buyer and for the seller to me with it. Chris, what did you do?
I exchanged properties with the Qi. And that’s where that term, tip 31 tax deferred exchange comes. And it’s actually there’s actually had a case decision on the Second District Court of Appeals, where they call it 1031. Exchange, a work of legal fiction.
How’s that for a backhanded compliment, right. But that’s the documentation that they require. So the key is to document that very special
Typically, the key is to consult to make sure that you’re falling within the rules. There’s timing requirements, there’s requirements for how the entity must be how the entity and the old property, and the entity that owns that new property is going to be. There are reinvestment requirements about what you have to purchase, in order to defer all tax. All of that is part of the purview of the QI working with you through that. So documentation consulting, and then lastly, it would be security funds. Because you’re not allowed to touch the money, either by active receipt,
by a constructive receipt, or actual receipt. If you touch the money, you can’t do it to 31. So the money has to go to your qi, obviously, we’re talking billions and billions of people’s dollars,
you better have some protections, right. So all of that is what’s built into the 1031 exchange. And like I said, the IRS requires it. So we do it. But the power is that you get to take all of the deferred tax and deferred depreciation recapture. And use that to go buy new property where the income is going to be to your benefit, not the government’s.
Yep. Super helpful. Question. I’m gonna get a little, little personal here. Can you handle personal Dave? I get a handle personal. All right. So I think everyone kind of has an idea of like, what closing costs, cost on a deal? What does it cost to pay a real estate broker? Obviously, it’s, I’ll say it’s market driven. But it’s, you know, it’s the most loosely market driven thing. It’s really like the deal you make with the broker. But I think what how the costs work for Qi,
they aren’t going to be somewhat spread out, but it’s like gas stations, for some reason, we all kind of congregate around the same number. They’re not cost prohibitive at all, a 1031 exchange for a property, less than a million dollars, is going to run you anywhere between 902,000 bucks, got it, most of that’s going to be dependent on where the queue is to pay for an office. So as you get to each coast, they’re a little more expensive, into the heartland, they’re a little a little cheaper.
But they’re not cost prohibitive at all. So you’re going to be hard pressed to find a transaction that ends up being more than say, 5000 bucks, even for the largest of sales. And it gets because our role is so limited.
That, you know, we’re not doing nearly as much as you are as the broker.
So that’s typical cost. So I think, you know, this 1031 was a hot topic in the, you know, in very recent times come in as new presidency happened in the United States. We were talking about, you know, they were talking about getting rid of 1031 or changing dramatically. What were you thinking? Is that was all going on?
My exact thoughts. Here we go again, because every president I’ve been under republican and democrat, both, you have all looked at 1031 with an eye towards eliminating why? Because it’s low hanging fruit. They all think, Oh, if we get rid of that, we get all these capital gains tax dollars.
The problem is, though, and Ernst and Young, several other really respected accounting firms have done studies on this.
In exchange for getting the capital gains dollars from investors that can’t do 1030 ones, you give up ordinary income tax dollars, from two real estate brokers, from two title companies, from two attorneys, from two inspectors, to appraisers, to House Painters, to whatevers that are all involved when a real estate transaction happens. And you start to do the math, you realize that wait, getting some capital gains dollars that 20% is not nearly as good as capturing a bunch of dollars and 30 to 40%.
From other trades, so it’s keeping the volume going. It’s also a great inflation edge. Because the tip everyone exchange makes dollars work harder. It keeps turning them over, rather than printing new money. And so it can be aggregates that it’s kind of interesting. temporary ones have been around since 1922. Yeah, and in their original
state, they were meant for farmers who would wanting to grow and build and buy bigger farms. But if they sold their property, and they’d have to pay the tax, they would not have enough money left to buy the farm. And our nation desperately needed growth in the agribusiness industry. So that’s what tip 31 came into play. So that they get them by their new property without having to lose the tax, which also meant that new farmers could come in and buy the small firms. And you just keep this whole industry journey. We’ll think about that from real estate. If we stagnate the real estate market, by getting rid of it, they’re going exchanges, you’re just not going to sell your properties, you’re gonna look at that tax bill, say, Nope, I’m making a good enough return, we’re gonna sit. When you do that, that means the guy above you is not going to sell his property to you, he loses. That means that the younger guy below you isn’t going to be able to buy yours and move up. And we stagnate the industry. So calmer heads prevail. President Biden’s plan went away. The Senate unanimously voted to leave it alone and completely. And once again, that day was saved and temporary one continues to do its thing.
Correct? That’s how it played out?
The let’s talk about asset classes.
Do you see it you know, it’s all real estate asset classes. But do you see you working better in certain asset classes than others? You know, in, in, in my world, I see.
It geared towards just what I would call a specific type of investors and certain types of asset classes and some asset classes in the last asset classes. I’m talking all investment real estate, but sub right multifamily industrial office retail, when I’m talking the asset classes, are you seeing anywhere like it seems the investor stay away from doing a 1031. And for good reason.
stayed away from it and 31? Well, I wouldn’t say so much that. But there’s really two types of investors out there, that there are those investors that are niche oriented. And they’re really not what I would call pure real estate investors, what they are our hotel management firms, retail management firms, self storage management firms.
But because it’s real estate, they’re real estate investors. But their desire really is to stay in that niche. They don’t want to stray from it. Now, for those folks, they won’t go more quiet, the hotter their niche gets, because there’s fewer opportunities to buy. So later as the market matures. So 1031 does kind of slow down until there is the opportunities within those. But they’re not going to stray from it, where the real opportunity to take advantage. And this has been kind of the flip side of your question. But the real opportunities with people who are tied back now agnostic, who is wanting to grow their money at well, from real estate investing. And this can get really interesting, because as the market grows through its cycle, different types of real estate, and asset classes will emerge for a while. So in the early in the early days of this market, the foreclosures were everywhere. Were those foreclosures, single family homes. And so all kinds of people jumped in to become real estate investors, buying single family homes, and then being able to sell them for multiples very quickly as the market eat it up. Many of these people recognize that, wait a minute, what I can make off of one home, I can make off of two. So they use the 1031 exchange to move into small multifamily and strategically identifying what market is emerging first. And the key to successfully typically winning for these people is you sell your asset that’s in a hot market. And you go find what I call the holes in the market, the asset class that hasn’t emerged yet, or the location that has any merchant cash Live for you as a huge run always early in the market. But you know what was crazy on everybody’s radar? In 2014? Austin, Texas. So they sold out of California and in Austin, Texas. What what happens in 2019? Austin, Texas isn’t such a bargain. So what is Cincinnati Omaha, for? Take your bid. The same thing is true of asset classes. The market goes from single family homes being the Darling to multifamily. When you can’t find multifamily deals, no matter how big you go, what do you do? Everybody moved into self storage. And all of a sudden Self Storage became the thing in your class, you then saw, didn’t you? These incredibly compressed cap rates in retail. Because when you’re sitting on retail real estate, you’re the king. But it’s hard for people to find bargains to dip 31 into. And that’s what everybody wants when they did 31. Unfortunately, there’s a poison pill. And that is that the best time to sell it started 1031 is the worst time to buy and finish one a seller’s market, because you can sell it a high. But you’re probably gonna have to buy higher. Let’s be realistic.
So your point are you seeing are you seeing given there’s just overall less transactions on in the in the real estate market right now? Are you seeing less activity right now?
Oh, absolutely. Yeah, absolutely. Get there. What’s now the question is going to become Christmas. We don’t know yet know how it’s gonna play out. But we’re seeing significantly fewer temporary ones. But significantly more expensive. 1030 ones. Oh, interesting. But from 2000 5000. Appreciation,
got it fair enough.
appreciation from 2000 to 2006. We always had a holiday slowdown. The markets just shut down from November until February. And they would go crazy from March until October November. That has not happened for about four years. It’s just been full speed ahead. 12 months, 365 days a year. This is the first year that we’re seeing a downturn. And it started in November. So the question on everybody’s mind is, is this back to a normal seasonal slowdown? Or have interest rates, availability? The fact that sellers aren’t budging much yet? Starting to cause a cycle type slowdown? I don’t know, we’ll find out.
We will find out. Okay. You have a story of a 1031. You know, I think I think I’ll preface that 1031 has been a great advantage for most. And it’s a really, you know, an interesting opportunity for many investors. I think it’s, you know, a great advantage that we can take at times and it is, you know, something where many real estate folks are for. But sometimes it doesn’t work out. Can you give a story on when the 1031 didn’t work out?
Absolutely. So, you know, let me go back for a quick second, go to your McDonald’s example. Because this is how it all starts. You mentioned you’re gonna sell a McDonald’s for 3 billion hypothetically, yeah, this is always going to work out, et cetera, et cetera. Let’s suppose that you bought that several years ago, for 2 million. While you’re sitting there, you’re gonna make a nice million bucks on it, right? That’s beautiful. What people forget, is that there’s another shoe that’s gonna drop if you don’t do the temporary one. And that is for the last number of years, let’s just say it was 15 years, you have been taking depreciation on that, which reduces your basis. So if you bought it for 2 million, and it depreciate it out by half, you’re actually selling that property as if you had paid a billion dollars for it. So you don’t have a $1 million gain. It’s taxable. You have a $2 million taxable gain exposure. That catches people by surprise all the time. So that makes the tip 31 even more critical. Here’s what happened. Our poor guy This was back in oh eight. The market had blown up and crashed. He was over leveraged. It is asset which was a strip Center in Fort Myers, Florida and lost 60% of its value yet to sell or get foreclosed on, the problem was he owed more than he could sell it for, by several $100,000. But he still did a 1031 exchange. Why? Because he felt the thing forever, and his basis that it was zero. So even though he had to bring as the seller, a check to the closing table for a bunch of money, he still saved money over time. Because he then did a 1031 exchange. And actually, guess what, he had to bring a check to that one as well, to the purchase. But he’s still saved money because of the depreciation recapture, that he was able to avoid. The lesson he learned was pay attention to that. And don’t be over leveraged.
There you go. Well, I really appreciate the time today. Interesting story. Thanks for bringing us through the 1031 from a QI ‘s perspective, haven’t had that on this show before really, really interesting stuff. To take us to the last piece I got three questions for you. unrelated to what we talked about, but they’re fun questions you read the day.
Let’s go for him.
What extinct retailer Do you wish would come back from the dead?
Okay, the one that’s really distinct is Books a Million. But I gotta tell you, my heart is with Sears. Got it? I hope they make it but I don’t think you’re gonna
question too. What is the last item over $20 that you bought in store?
Silverware from Bed Bath and Beyond? It was my wife’s choice.
All right. Question three. If you and I were shopping at Target, and I lost you what I would I find you in
you know in the in the list, Jennifer Lopez is doing an in person visit to that target that day. You’ll probably find me just one allover from you in sporting goods.
Got it. Fair enough. Really appreciate the time today. Dave. was a pleasure. Thanks for teaching the audience about 1031
I pleasure anytime.
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