How Do 1031 Exchanges Work?

Karen Malanga: Hi, this is Karen. I want to welcome you to House Talk. And today, I’m so excited to have Danielle Brock here. She’s with a local company called 1031 Corp. Actually, I think they’re nationwide. She’s our number one go-to exchange officer for 1031 exchanges. And I just found out as we sat down, Danielle, that you’re also the regional manager.

So, thank you for taking time from your day to be with us here on House Talk.

Danielle Brock: Thanks for having me, Karen.

Karen: Oh, we’re so excited. So I would love for  you to do for our listeners is to take us—first, explain what a 1031 exchange is, and then take us through the process step by step. For people that haven’t done a 1030 exchange with property, it can seem overwhelm. And I would love for you to try and simplify that for us.

Danielle: Yeah, I hear that a lot. People get very nervous about it. It seems complicated, but it really isn’t.

Karen: Then simplify it for me.

Danielle: So, I’m going to do my best.

Karen: Okay.

Danielle: So, 1031 exchange refers to a section of the IRS tax code that provides a mechanism by which an investor can sell their business or investment use real estate and exchange that for new investment or business use real estate and defer their taxable gain in doing so.

Karen: And can you define what type of property again because I know I’ve had people just do a 1031 exchange on bare land?

Danielle: As long as the property has been held for productive use in a business or as a long-term investment. So it need not necessarily be income-producing.

Karen: Alright, I think that’s a key factor.

Danielle: It is. And another key factor for people to remember is that, also, you can’t exchange property that has been held primarily for your own personal enjoyment.

So, primary residence, second homes, strictly a second home, those don’t qualify. Inventory or dealer properties also don’t qualify.

Karen: Okay. So when someone decides that it’s their time to sell that investment property and do a 1031 exchange into another property, how do you start the process? They come and meet with you…?

Danielle: Generally, they’ll come and meet with me, or I’ll have a phone consultation. We work with people all across the United States. Sometimes, it’s people that are median assets to Bend or from Bend.

So, I’ll have a phone consultation, and I’ll just have them tell me a story about what it is that they’re doing. What are you selling? What are you looking to reinvestment in? And that’s kind of how we got started.

And the point at which in which we actually would initiate an exchange is once they have a contract to sell their property

Karen: Okay. And then, generally, that person calls me and I say, “I have…”—how many days to identify a property for this exchange?

Danielle: Right. So once the property closes escrow—so we get involved, we set up the 1031 exchange, you go to closing just like any other real estate transaction. And from the date of closing on that sale, the exchanger has 45 days to identify potential replacement property. And they have a total of180 days to acquire any replacement property and complete the exchange.

During in the period of that exchange, we’re holding the exchange proceeds. That’s a key element.

Karen: That’s what I was… yeah, I was just going to ask you that.

Danielle: Yeah. And that’s really one of the major functions of our business, why we exist, what’s called a qualified intermediary in the tax code. So we make sure that all the appropriate paperwork is handled, that the timeframes are met, and importantly, we are in control of the exchange proceeds until they’re ready to spend those on their replacement property.

Karen: Yeah. I think sometimes that’s hard for the sellers initially to grasp if they haven’t done one, that “Oh, no. The money is not going to into your account.” It’s going into the 1031. It’s like a holding company.

Danielle: Right! And that’s why it’s very important to be having those discussions before the sale closes, hopefully before they even have an offer, so they understand what needs to be done.

We do get phone calls from people that are sitting at the closing table and realize, “Oh, my gosh! I need to do an exchange. What do I do now?”

Karen: Is it possible to fix that?

Danielle: If they haven’t closed yet, yes. We may have to delay a day or two to make that happen. But if they’ve received their proceeds—

And I have also received phone calls from people saying, “I’ve got a check in hand. I haven’t cashed it yet.”  And then, it’s too late.

Karen: It’s too late at that point. Yeah, you have to be in communication with whoever—whether it’s an attorney state or an escrow state, whoever’s closing that property to make sure the money goes into your…

Danielle: Right, we work really closely with the closing agent. We give them specific instructions for language to insert in the documentation, and to make sure that they wire those funds to us at closing.

Karen: And so, just so our listeners understand, what is the basic advantage of a 1031 exchange—just basically?

Danielle: Tax deferral.

Karen: They’re differing taxes. But it is deferred. Taxes are always due someday.

Danielle: Potentially. However, if you continue to re-invest until you die, your inhertance get a step up in the basis of the property. And it steps up to fair market value as of the time of death. And so the capital gains in that case do go away.

But oftentimes, clients might use it as a state planning strategy, or maybe I’m in a higher tax bracket now, but in 10 years, I’ll be retired. I’ll be a lower tax bracket. It’ll make sense to sell and pay the taxes then as opposed to now.

So, that would be a reason to defer for some time.

Karen: Oh, that makes a lot of sense. Okay, let’s come  back in a few minutes. We’ve got to thank  our sponsors for having this incredible show called House Talk. And we’ll be back with Danielle Brock and some more information on how to complete a 1031 exchange.

Voice Over: Stay with us. More House Talk is straight ahead on 104.5 FM, 1340 AM, and KBNWTalk.com.

Voice Over: This is House Talk. Now, once again, here’s your host, Karen Malanga.

Karen: Hi this is Karen Malanga. And we’re back at House Talk with Danielle Brock from the 1031 Exchange Corp. She’s an exchange officer and also regional manager for  1031 Corp throughout the Pacific Northwest.

Danielle, welcome back to the program.

Danielle: Thank you Karen.

Karen: So, in our first section, you went through what a 1031 exchange was. And we got to the point where the person initiating a 1031 has decided to sell the property, they’ve closed on that first property, and they’ve entrusted their money with you to hold as part of the 1031 exchange process. So then what happens?

Danielle: So now we’ve entered the identification period. Again, the exchanger has up to 45 days to identify potential replacement property. And there are some rules around that identification.

Karen: Can you tell us those?

Danielle: We provide them with a format in which to do that. One can identify up to three properties of any value. And they need not buy all of them to give options. Or they can identify more than three properties. But the fair market value of all the properties added up together that they’ve identified cannot exceed 200% of the fair market value of what they’ve sold.

Karen: So, they can buy a property that’s more expensive than the property they sold…

Danielle: Certainly.

Karen: But only to a certain limit?

Danielle: Well, it’s the identification. What the IRS is trying to do there is prevent people from must attaching the entire MLS listing and say, “I want to buy one of these.” They really want you to be specific. They want to narrow it down. And so the rules require for full tax deferral that you buy equal or greater in value to what you’ve sold and that you reinvest all of the cash.

So, yes, you can buy up in value. It’s just that the identification is a limit of three or a maximum of 200%.

There is another caveat there that if you’ve identified up to 200%, then you must buy at least 95% of everything you’ve identified.

So, we try to prevent people—I know, it’s very confusing. I just lost you.

Karen: You just lost me completely.

Danielle: That’s where I usually lose everyone.

Karen: So, just for the sake of not wanting to get lost, can you just explain that a little differently?

Danielle: Well, I’m just trying to think of a different way to go about it. There aren’t limits on how much you can buy. There are limits on how much you can identify.

Karen: Okay. So there’s limits on how much you can present basically that you may be purchasing? And

Danielle: Correct.

Karen: Okay.

Danielle: And honestly, right now, with the market as hot as it is, the majority of my files are closing on their replacement property within the 45-day identification period right now.

Karen: That’s what I was thinking because most sellers on that second property aren’t going to want to wait around either. You’ve got to hold the property if you want it. You’re going to have to move an offer in.

Danielle: Generally, when we see transactions taking up more of that 180-day timer period if it’s new construction, if people are buying residential rentals that are under construction currently.

But usually, people are very nervous because inventory is so low that they won’t be able to find what they want. So generally, folks are looking for their replacement property before their sale has even closed.

Karen: And that’s a really prepared purchaser.

Danielle: That’s true.

Karen: I got a call last week from a client in Texas. And it was Wednesday and he said, “I need a multi-family, and I need it by Friday.” And I said, “What’s going on?” He said, “I’m at the end of my timeframe for a 1031 exchange.” And he said, “I’ve looked at everything on the Internet. I don’t like anything that’s on the market in Bend or Redmond.” And he said, “Do you need of anything else?”

So, I dug down a little deeper, and I got three properties over to him. But he still didn’t like those. He ended up buying something in Texas. But he left to the last minute. Do a lot of people do this?

Danielle: Well, I like to think that when people do that, it isn’t necessarily driven as much by the person, it’s just the market and having a lack of inventory, and like he said, not really liking anything that was out there. And unfortunately, you’ve got this clock ticking. And when that day 45 hits, there’s no more time to identify, so you either have a failed exchange or sometimes people will end up maybe buying something that wouldn’t have been their first choice.

So, I always try to encourage people to start looking. As soon as they know they’re going to do an exchange, just get out there and start looking.

And we can delve into this a little bit later. We can talk a bit more about how a reverse exchange might help in that circumstance.

Karen: Yeah, I was thinking about that.

Okay. So now they’ve moved forward on their second property. What happens at closing then, when they go in to close on that second property?

Danielle: On the replacement?

Karen: On the replacement property, sorry.

Danielle: That’s okay. So they submit the identification in writing to us when they’ve made an offer on a property. We get a copy of that contract and get in touch with the closing agent there. And then, when they’re ready to close, we wire the funds that we’ve been holding over to close. And if there’s any additional funds needed, the buyer would just take those into closing.

Karen: It’s very much like a cash transaction to the seller of that replacement property in some ways.

Danielle: It really is, yeah. There is a requirement that the seller, we notify that there’s an exchange. But it doesn’t affect them. And oftentimes, when buyers are placing offers, we send in proof of funds letters to be submitted so that the seller can see that the funds are on deposit with us.

Karen: Yeah, and that’s very helpful especially in our competitive market when you’re just trying to write a strong offer.

Danielle: Right.

Karen: Yeah, that can be difficult.

So, what happens if someone sells their first property, and then picks a replacement property that’s a little less. How high are they taxed on that remainder?

Danielle: The remainder is taxed at the capital gains tax rates, long-term capital gain, which is a more favorable tax rate. Short-term capital gain is more taxed as ordinary income. They are tiered based on your income level that year.

Karen: Sure…

Danielle: So your federal tax would either be 15% or 20%. And then, the state of Oregon, for example, would be between 9% and 11%. And all of the states in the nation other than the state of Pennsylvania follow 1031 tax code as well. So when you’re doing a 1031 exchange, you’re not only deferring your federal taxes, you’re deferring your state taxes as well.

Karen: Okay. Yeah, that makes sense. So it also makes sense then to try not to have a remainder or a balance.

Danielle: Right. Sometimes, people may just want to take some cash out for some other purpose. And in that case, I consult closely with them to determine how much of a taxable gain they have on the property to make sure they’re not taking out so much cash that the exchange is not benefiting them.

Karen: Ah, I got you. It sounds complex, but you’re helping to make it simple.

Danielle: I hope so. I try.

Karen: Anyway, you’re listening to House Talk. And we’ll be back with Danielle Brock from 1031 Corp in just a minute.

Voice Over: Stay with us. More House Talk is straight ahead on 104.5 FM, 1340 AM and KBNWTalk.com.

Voice Over: This is House Talk. Now, once again, here’s your host, Karen Malanga.

Karen: Hi! Welcome back to House. This is Karen Malanga. And again, I’m speaking with Danielle Brock from 1031 Corp. She’s our expert in 1031 exchanges here in Central Oregon. We use Danielle a lot actually, don’t we, Danielle?

Danielle: Yes, you do. You refer quite a few people to me. And I so appreciate it.

Karen: So, in the beginning of our program, we were speaking about what is a 1031 exchange and the process of making a 1031 exchange. Now, some of it seems a little complicated, but she helps simplify it.

Now, if you even want to go a little deeper, now, Danielle, I want you to explain to our listeners what is a reverse 1031 exchange.

Danielle: So, a reverse 1031 exchange is when a client has found the property that they want to purchase and needs to close on the purchase of that property before they sell the property that they intend to exchange out of. And we are seeing a lot more of these. I’m getting many more inquiries this year for reverse exchanges.

And I think the reason for that is that people get very nervous that they only have 45 days after the sale close to identify their replacement property. They’re afraid they’re not going to find what they’re looking for, but they have a fair bit of confidence in this market that if they take their time to go out and find what they want first, and then put their house on the market, it will probably sell pretty quickly.

Karen: Sure.

Danielle: So, on paper, you can’t purchase a piece of property before you’ve sold and still be able to consider that an exchange. So what we do is we set up an LLC, a limited liability company. In the tax code, it’s called an exchange accommodation title holder. And the EAT borrows the money from the exchange client and/or their source of financing, and we step in and take title to the property that they intend to ultimately purchase.

Karen: Okay.

Danielle: We give them a promissory note. We enter into loan agreements and pledge agreements with them. And from the date that we take title to that property, they have now 180 days to sell the property that they want to exchange out of, and then purchase from us the property that we’ve been parking in the EAT.

Karen: When the property is parked in the EAT, can they still rent it? Is it on hold?

Danielle: We lease it to them. No, we lease it to them, back to them.

Karen: Oh, you lease it to them, okay.

Danielle: So, they are still responsible for the taxes, the insurance, they can sub-let it, they can enter the property. It’s completely under their control. We’re really just in title and name only.

Karen: And that I think sometimes benefits some people. I know some people, they want to do the 1031, but they want to find the replacement property. And they don’t want to put their other property in the market because they’re afraid to notify their tenants, and they don’t want to lose the tenants during this whole thing either until they’re secure that they can find the property that they’re looking for.

Danielle: Yeah, there’s a lot of reasons why it makes sense for people to do it in the reverse. The tricky part for most people is the financing. You’ve got to be able to either pay cash for it before you’ve sold or obtain financing during that period of time which can be a little difficult since we’re taking title, that the financing is based on the credit worthiness of the exchanger themselves.

Karen: Sure. So are there additional fees in a reverse 1031 exchange?

Danielle: We do charge quite a bit more for reverse exchanges, yes.

Karen: And that’s because you’re setting up an LLC. You’re also managing a property.

Danielle: All of those reasons. We have to file a tax return for that LLC for the year, so we’ve got costs involved there. There is a lot more to it, yes.

Karen: So is it a typical difference in fees? Is there an estimate?

Danielle: Sure! Our fee structure is very straightforward.

Karen: Okay, perfect.

Danielle: So, for a standard 1031 exchange where you sell first, and then you purchase, if your sales price is under a million dollars, we charge a flat fee of $900. And that’s for the sale of one property and the purchase of one. If there are multiple properties involved, there would be additional fees. But that’s our most typical fee, $900.

Over a million up to $2.5 million, $1250. And then it goes up from there for the commercial properties, multi-family.

A reverse exchange adds a fee of $3500 to whatever your standard exchange fee would be.

Karen: That doesn’t seem—I mean I know that’s a lot of money, but it doesn’t seem that exorbitant for the tax deferral that the party is going to be able to take advantage of.

Danielle: Exactly. The fees are usually very, very minimal compared to what a tax payer would pay in capital gains tax if they don’t do an exchange at all.

Karen: Yeah, and you have it all organized, and they have the comfort of having purchased the property that they want, know and like. And now they feel comfortable putting their home on the market.

Danielle: Right, right. And then they’ve got 180 days to do that. So it’s a very nice strategy for people.

And I think it’s good to talk about—just this morning, I got a phone call from a woman who was interested in talking about a reverse exchange, but she had been told by a couple of people that it was kind of the shady thing and she was very nervous about it.

And I said, “Contrary to that, it’s a standard practice. The IRS has actually given us a revenue procedure that tells us how to move forward with a reverse exchange. And they are absolutely recognized.” There’s nothing shady about it at all. And she’d been quoted about $20,000 to do it. So hopefully, I can clear that up a little bit.

Karen: Is there anything else that you would like to say to the listeners here before we wind it up today?

Danielle: We do consultations free of charge. So if clients have any questions at all about whether an exchange might work for them or just clarifying questions about the process, feel free to give our office a call. You could either talk to myself or Emily in our office. Our number is 541-388-1031.

Karen: Perfect!

Danielle: And also, take a look at our website at www.1031Corp.com.

Karen: This is Karen Malanga with another edition of House Talk. I want to thank everyone out there so much for listening today. And Danielle, thanks for being here with us.

Danielle: Oh, thank you for having me.

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