What's going on BiggerPockets? It's Matt Faircloth. So, one of the things that it sounds complicated,
that a lot of people talk about on BP and in the real estate world, is the 1031 exchange.
Let me explain briefly what a 1031 exchange is, and then we'll talk about mistakes that
people make in the real estate in the 1031 exchanges. I made one that was very painful.
I talk about in my book, Raising Private Capital, in detail. But, I made a major mistake on
a 1031 exchange that I'll tell you guys about in a second.
Here's what a 1031 exchange is, okay. Let's say I own a piece of real estate right here,
okay. That's a lovely little home here and I decide, "Hey, the market's gone up, or for
one reason or another, I'd like to sell that piece of investment real estate." This is
not a fix and flip. This is not a property I lived in, not my primary residence. This
is a investment property, okay, and it qualifies as an investment piece of real estate. This
could be a single family home. This could be an apartment building. This could be a
strip center. This could be anything as long as I can show that I held it for investment
intent. That that was my intention on the property. Okay. I have to be able to prove
that I held it for investment intent.
Okay. So, I sell the property. Okay. All Right. If I didn't do a 1031 exchange, that sale
would create a taxable event and I'd have to pay income tax on the money I made. So,
if I made $100,000 in the sale, good for me. Great. But, I might have to pay short or long-term
capital gains tax on that. If I want to avoid that tax, a 1031 exchange allows me to take
the profit from that sale and roll it into something larger. Let's say I've bought myself
an apartment building. Okay, I've bought myself an apartment building, or I buy something
else or whatever. I buy a strip center, or I buy something. It doesn't have to be a residential
property. I can sell a residential property and trade into something commercial or whatever.
There's a lot of rules. This video is not about the rules around 1031 exchanges. This
is about mistakes that people make. But, in general, it can be other types of real estate.
General rules are, as long as I hold the property in the same name, so if this is under the
name of Matt Faircloth personally, right, which is not what I would want to do, or hold
under Matt Faircloth LLC, or the DeRosa Group, it's the name of my company or something like
that. But, as long as this property is held in the name of an LLC or one, two, three,
LLC, this needs to be held under the same name as this one, okay. All the proceeds from
this, need to get moved from here to here.
So, if I made 100K, okay, all 100K needs to be here. If I sell this property for 200,000,
this property has to get purchased for more than my sell price of this property. So, this
could be for 201 or it could be for a million bucks, whatever, okay. Whatever it is, this
has to be more than this one. I have to roll all the profit over, and the name of this
has to get held in the same entity. Those are the general rules, the biggest.
Now, let's talk about the mistakes. That's what a 1031 exchange is, before I get to the
rules. The 1031 exchange allows me to take the profit I made here and roll it here. And,
I defer... It's not tax-free, I just defer on the taxes. So, I may have to pay taxes
when I sell this. I may have to pay it... If I 1031 into a big thing, then I might have
to pay taxes when I sell that, unless I just keep doing 1031 exchanges until I pass on
and my heirs inherit the property. And then, a lot of that deferral gets wiped out. Talk
to a CPA more about that for more details on how you can defer taxes all the way down
the line, unfortunately, until you pass away. That changes the tax structure altogether.
Talk to your CPA about that. It's beyond today's video, but that is an interesting conversation.
Something that should get noted, that falls into mistake number one, okay, is when I sell
this property, day of closing. Let's say I sell it on January 1st, 2019, okay. I then
have 45 days that I have to identify the new property, okay. I have to identify this property
within 45 days. If I don't identify that, then I fall into violation of the 1031 exchange.
I have to identify it to the IRS and to the 1031 exchange custodian. I'd have to document
that I'm saying, "Hey, this could be the property I want to close on." I can identify multiple
properties and only close on one of them. But, bottom line, if I don't identify in 45
days, the properties that I want to trade into, then I'm in violation. I lose the tax
savings and I'll have to pay capital gains tax on that $100,000, okay.
Now, the next timeline here is 180 days. Now people get this confused, and this is a mistake
that people make that I'll file as the mistake number one. This is a 180 days that I actually
have to close, okay. Now, I have to identify it here. This is actually called nominating.
So, at 45 days, I have to identify the property, which is saying, "I think it's going to be
123... I'm selling 456, second street, and I'm going to buy 123, main street." That's
then called identification.
So, identify this property or nominate it as one that I'm going to buy. I actually need
to close on it in 180 days, okay. Now, some people think, and wrongly, that this 180 days
begins at the point of nomination. That's not true. This 180 days actually begins, and
this a big mistake people make, it begins here at the time that you sell this property.
So, this is property one, this is property two, okay. When I sell property one, the day
of closing, I now have 180 days before I have to close on property two, or I lose this.
There is no extensions. There was no way to work around it. You got to close on this within
180 days, or you'll lose that tax advantage, okay.
The number one mistake that people make on a 1031 exchange, and let's just call a spade,
a spade. If you mess up this timeline, it's because you didn't clearly understand, or
you didn't clearly plan for it, is breaking the timeline. Okay, breaking timeline looks
like not identifying or nominating in 45 days, or not doing the 180-day window to close on
this property. It's clearly because you didn't understand it and that's okay. But, you broke
it and you'd have to pay tax, right?
I'll give the mistake and I'll give the way around it, okay. The way around this is by,
when you put this property up for sale, it's not like you get surprised by the closing
date of you selling the first property, okay. Once you put it up for sale, you know that
at some point you're going to sell. You're going to close and this 45-day time window
begins. So, what you really want to start doing, is at some point, this is you standing
here and you're just having a thought saying like, "You know what, I think I'm going to
sell this property. I think I'm going to sell that property."
So, when you have that thought, that moment here, way before the closing date of this
property, that is when you start looking, okay. It's you buying yourself... What's this?
This is at least another 30 to 60 days, that you start looking for this property. If you
start looking for this property at the day of closing, you're going to be under the gun,
because you're only going to have 45 days that it's going to take the close this, okay.
In the 1031 exchanges that we've done, we had this property identified before we closed
this, right? In some circumstances, we had it under contract, okay. So, it's very easy
to do that. If you started looking the second you have the thought of selling property A...
If you started looking then, you can very likely find property B well before this closing
date. You can nominate and close very quickly, and this timeline collapses real fast. But,
you got to start looking here, not at the time of closing, okay.
Now, mistake number two that people make on 1031 exchanges, is that they don't clearly
use the right custodian. Now, this money gets moved from here, as it gets held by a third
party company, okay. The money gets held and this person holds the money. And then, when
you're ready to close it, they give it here, okay. If you use the wrong custodian that
doesn't understand the process either, or that is someone who doesn't have a good reputation
or someone that's going to... Whatever it is, if you choose the wrong custodian, this
person, and unfortunately in the United States, the custodians are not a well-regulated industry.
It doesn't take much to become a custodian of people's 1031 exchange capital.
So, it's a very, very low bar. It should be something that causes a lot of regulations
to do and a lot of licensure and insurance and things like that. But, unfortunately,
it's not. It's something I believe we're working on in this country, to hold these people to
a higher standard, but it's very easy today to become a third party custodian for people's
capitals. So, what that enables people to do, is for folks that are maybe not the highest
scruples or not the best decision-makers or maybe people that are just straight up bad
actors or criminals or whatever, to get into being 1031 exchange custodians.
It is the most source of real estate capital theft, is 1031 exchange custodians. It's a
bad thing, and it happened to us. We got involved with a 1031 exchange custodian that had really
great marketing, really great testimonials, a really great profile out there. They had
a strong presence online. But, we ended up selling a property, rolling capital into a
1031 exchange custodian. And, it turns out they were a bad actor and they were running
a Ponzi scheme. So, we ended up having to litigate. We're in the middle still, this
is a year and a half ago, we're in the middle of collecting the capital that they locked
up as a 1031 exchange custodian. They had a strong presence. They were vetted. We spoke
to other people that they worked with. You should be very careful on who you work with
in that situation.
What I didn't do, is to check to make sure they were bonded and insured. But, I interviewed
several people they'd worked with, I checked out their website, I'm a people person. But,
what I would have done differently, is to check out the insurance. So, let's just say
the mistake you make is choosing the wrong custodian. Okay, choosing the wrong custodian
is a major mistake. That just means not doing the proper due diligence. It's not vetting
their insurance, not doing all of the due diligence you could do on this party, because
you think that... The mistake that people make as well, is they think that, "Well, if
they've got the license to do it, they must have a certain level of insurance. They must
have been vetted."
But, unfortunately, it's a low bar to get into it. So, no, unfortunately not. It's very
easy to get into this position, to be this person. So, it's very easy for someone who's
a bad actor to get into that position, unfortunately. We talk more about that situation in my book,
Raising Private Capital. We're in the middle of settling with that party. They're not going
to get away. We're going to get our money back, and then some, from them. So, thank
you for your concerns, but we're good to go. I learned a lot and I'm happy to share with
you guys what I learned out of that experience.
Number three. The third thing, the mistake that people make, is just in general misunderstanding
the rules. This is in general, just in general, there's two different ways you can misunderstand
the rules. The first thing is on timeline. But, I've seen people try and do 1031 exchanges
and try and find a way to take a few of those dollars out for themselves. "Hey, can I take
a few dollars out to put in my pocket? Or, can I take some of this money and use it for
the down payment on the new property?" No, you cannot. At this point, it needs to live
with the custodian and you can't use it for anything, except for the actual closing activity
when this property changes hands, okay.
So, it's just misunderstanding the rules. Okay, misunderstanding the rules. Now, breaking
timeline is also misunderstanding of rules. But, when I say misunderstanding the rules,
I also mean with regards to the money and with regards to... The second thing that happens
is, let's say me and three investors get together and buy property one. So, me and two limited
partners or people that invest privately with me or something like that, whatever it may
be. We sell this property and only two of the three investors want to get into this
property. Or, only one investor... Like let's say, this is a syndication. I take my shares
to this syndication and I want to take it and not have to pay tax and roll my syndication
profit from here to here, whatever it may be. If you own shares of a company or shares
of an LLC that owns this real estate, that cannot be transferred as a 1031 exchange into
this. It can't be done.
If some of your investors want to get out when you sell this and some of them want to
stay in, unless the investors buy each other out and the only people that are left are
the people that want to stay in before you sell this, those things can't happen either.
So, I've had many, many people, because we do syndicate some apartment buildings where
people that have bought shares of larger assets with us and they say, "Well, when you sell
the property, I don't want to pay taxes. So, can I take my shares of your company and do
a 1031 exchange when you sell it and roll it into something larger and not have to pay
tax?" No, unfortunately you can't do that.
The only way that you can do a 1031 exchange, is the LLC that owns this company, transfers
its ownership into the new property. It's the only way you can do it. People misunderstand
that, or they plan on taking their proceeds from this as part of the partnership and transferring
it into this. This is all part of misunderstanding the rules. All these things can be done by
doing the right research, okay. Can be answered. These problems can be avoided, that's what
I'm trying to say. These problems can be avoided by doing the right research, breaking the
timeline, choosing the wrong custodian, and just general misunderstandings on the way
the transfer has to happen or trying to use part of the money for your down payment or
for your due diligence.
For any of the things that you need to use that money for, you can't touch it until the
closing date on the property. So, you can't use any of this money for a phase one environmental
study or for an appraisal or any of that kind of stuff. None of that money can get used
for this. That is just a misunderstanding, but you're not doing your homework, okay.
The bottom line for 1031s, is yes, they're complex, but they're extremely lucrative.
Say, if you've got a lucrative sale and you don't want to pay tax on it and you and all
the owners of the property are all on board, a 1031 exchange can be phenomenal wealth builders
by allowing you to transfer your proceeds tax-free into the larger piece of real estate.
A lot of the big boys and girls of real estate do them. So, I highly recommend you look into
it. But, make sure you do your homework and don't trigger one of these mistakes that people
make during 1031 exchanges, okay. Lots of questions you guys may have about it. Please,
ask them in the comments section below. Love to chat with you guys about 1031 exchanges
more, or talk to you about the bad situation we got involved in. That, I'm happy to talk
to you guys more about that as well. What do you guys want to get into? So, let's chat
more about 1031 exchanges in the comment box. Please, do that. Thanks for watching guys.
Have a great and profitable week.