The Power Of The 1031 Exchange
John Larson and the Real Estate Cowboys talk passive income real estate investing.
Hear new episodes every Sunday morning at 8 a.m. The Cowboys invited special guest Hector Bilbao, a CPA who helps investors take advantage of the tax benefits available to them to talk the ins and outs of a 1031 exchange.
Keep the #CowboyCoffee hot while listening to John, and the Cowboys talk about how to #BeACowboy and earn passive income in real estate.
Announcer: Have you thought about becoming financially free through real estate investing, but don’t have the time or knowledge to get started? Welcome to the Real Estate Cowboys podcast. Each week we discuss passive income investment opportunities in the red-hot Texas market. John Larson and the Real Estate Cowboys will show you how to leverage their team to build wealth in real estate through passive investment opportunities. And now here’s John.
John Larson: Hey, welcome back to another edition of the Real Estate Cowboys. This is your host, John Larson. Hope everybody had a good week. This week we have a really great topic. We’re going to be talking about the power of the 1031 exchange. For those of you who are listening to the show that don’t know what a 1031 exchange is. It is a, I’ll call it a loophole almost that the IRS grants real estate investors where if you sell a property and take the proceeds, if there is any capital gains, any profit from selling a property, if you take those proceeds and identify another investment, so investment home to another investment property and take that profit and roll it into another investment home. Uh, you can avoid paying capital gains tax on the profit from the money earned from selling the first property. And it’s not that you avoid the taxes, but you defer the taxes out.
John Larson: So you would not have to pay any capital gains tax, which could be 25, 30 percent of the profit from selling the first property. Uh, you’d be able to defer that out by just taking those profits and rolling it into another investment. So it is a great tool that the IRS gives real estate investors to defer their taxes out. And we also have a guest that’s on the show that’ll be coming up in a little bit here. His name is Hector Bilbao and he’s a friend of mine. He’s a CPA. He’s from Austin, Texas, just moved to Florida, but he’s been helping his clients for years on ways to build wealth through real estate, by saving money on taxes. And so he’s done a lot of 1031 exchanges for his clients and he will be on the show in a little bit to discuss some ways, uh, to go about taking advantage of the 1031 exchange and just provide some additional knowledge.
John Larson: But before then I want to go through some things, um, about the 1031 exchange, some rules that you should be aware of with a 1031. And so let’s get into that. So rule number one with the 1031 exchange, it needs to be the same taxpayer, meaning that the tax return name and whatever name is on your tax return and whatever name is on title for the property that you’re selling, that must be the same. Okay, so you can’t have your wife on the tax return or whatever it may be or whatever it is. And you own the property and it’s in your name. It must be the same name. Okay. Rule two would be the property identification rule. You have 45 days to identify a potential replacement property. So when you sell a home and you bring in those capital gains, you have 45 days at that point to identify a replacement property.
John Larson: That means getting that property under contract or you know, letting, letting whoever’s in charge of your 1031 exchange know that, hey, I’m going to buy 123 Main Street. This is the property that I’ve identified. So 45 days to do that. Then there’s something called the three property rule. You can identify any three properties regardless of value. So you can identify a group of three within 45 days and maybe not necessarily buy all three, but you’ve identified these homes as opportunities of interest, these homes, multifamily project, whatever it may be. You have those 45 days to identify those properties. Then there’s also something called the 200 percent rule, and that means that you can identify four or more properties as long as the value does not exceed 200 percent of the property that you’re selling. Does that make sense?
John Larson: So we’re selling a property for $100,000. It cannot exceed 200 percent of that value. There’s also the 95 percent exception rule, which basically states that if the value exceeds 200 percent, then 95 percent of that value of what’s identified must be purchased. And so rule number three is the replacement rule that basically means the new property must be purchased within 180 days following the closing of the first property or 180 days following the extension of your tax return. So you have 180 days to close on the home. 45 days to identify a replacement property. And then you have 180 days following that to close.
John Larson: So for example, some of my investors who go through with a 1031 exchange, they’ll come to me and identify a home. That home could be under renovation. It could take 60 to 90 days. Let’s just say in a worst case scenario, to complete the renovation. Maybe they identify that they want to invest in that property right when I purchase it. Um, but we still have to carry it through the renovation process before we sell it to the investor. So they have time. They have 180 days, basically six months to identify, you know, almost six months to identify or to close on that property. Rule number four would be something called trading up. Uh, the net market value and equity of the property sold must be less than or equal to the replacement property to defer 100 percent of the tax. Otherwise, the exchanger, you, would need to pay tax on the difference. Does that make sense? So if you’re selling a property, the value and equity of the property sold must be less than or equal to the replacement property to defer 100 percent.
John Larson: Rule number five, hold time. The IRS is going to want to determine whether the property was acquired immediately before the exchange. Was it purchased as a flip opportunity or held for productive use or as an investment? So 1031 exchanges rule out home flippers. Because the IRS would be able to identify, okay, you just bought this property 90 days, 120 days ago and you already sold it. That’s not going to qualify for a 1031 exchange home. Flippers are subject to capital gains tax. 1031 exchanges are just for investors that are holding property for rental use basically, for investment use. And so the shorter the time frame for the hold, the more substantial facts you’ll need to provide to the IRS to support your investment. If you occupy the residence yourself for more than 14 overnights per year, the property could qualify as a second home and you would not be able to perform at 1031 exchange, you would not qualify for it because if you’re staying at the property for over two weeks a year, the IRS is going to look at that as basically, that’s a second home for you. That’s not an investment property. So it would not qualify at that point. So typically, you know, a good rule of thumb would be that you need to hold a property for at least one year’s time as a rental, as an income producing property that you did not occupy for more than 14 days and nights over that period. If you own a rental property for strictly investment purposes for at least one year, you would be able to qualify at that point for a 1031 exchange. And I would imagine that that’s probably the minimum requirement. That’s a safe bet.
John Larson: Rule six would be a related party. You cannot sell your property to any relatives or anything like that. You cannot sell the property to your kids and take advantage of the 1031 exchange. Okay? And so the 1031 exchange rules, you know, they are gonna require that both the purchase price and the new loan amount must be the same or higher on the replacement property.
John Larson: So basically a good rule of thumb would be if an investor was selling a $250,000 property in Dallas and they had um, you know, $100,000 loan on the property, they would have to buy a property that was $250,000 or more with the replacement property with at least $100,000 or more in leverage. Does that make sense? So there’s some rules that you need to abide by with the 1031 exchange. But if you abide by all those rules, work with a good CPA that understands how to take advantage of the 1031 exchange. It’s just another way where investors can save money on taxes. And really take full advantage of, you know, all the tax benefits that are available to you as a real estate investor and you know, you can continue to just recycle this process until you’re retired and you’re coming into a different tax bracket or you pass away and leave the property to your family members and Hector will elaborate more on the options that are available to you in his interview that’s coming up here.
John Larson: But a lot of power in the 1031 exchange. And I see a lot of my investors, especially from California, some from Denver, Colorado, some from Phoenix, Arizona, where they’ve purchased properties back coming out of the recession in 2010, 11, 12 maybe during the recession. They purchased some property at a low value. And now today the property has gained so much in value in these markets. Even my investors who purchased properties in Dallas back in 2011, 2012, some of them are sitting on $100,000 in equity or more because the market has moved so much in the past eight years. As the economy’s gotten better. And the real estate market has just continued to gain more and more momentum year over year. So I see a lot of my investors from California who are sitting in a situation where, wow, okay, I’m sitting on $100,000, $200,000, maybe even more in some cases, in equity in this property that I purchased back when property values were low during the recession or just coming out of the recession and they’re starting to see the market you know, how, how much higher can it go? They’re starting to see it maybe plateau. They’re starting to see that, well, I feel like I don’t think the market could go any higher. So instead of continuing to hold the property and run the risk of the property devaluing again in another market correction or slight recession, they’re selling the property and capitalizing on getting these capital gains, getting the equity out of the property, and then taking advantage of the 1031 exchange and taking that profit that they made from selling their property. Now in a market where the values are at an all-time high, and then diversifying that money into other markets across America, that makes sense. One being Dallas because you see all the jobs and people moving into the market. You know, and the real estate market here is just much more affordable.
John Larson: It’s a fraction of what the real… you know, the median home value in Texas is a fraction of what it is in California, but you still see population growth and job growth. So I feel a lot of investors are taking advantage of that and taking advantage of the 1031 exchange and basically dispersing this profit over multiple properties and other growing markets. And we see the same thing with clients from Denver, Colorado. That market has really increased a lot over this past decade and now you’re having the same situation. The market’s become a bit overvalued in terms of being able to find properties that make sense for cash producing rentals. The property values are going up, but now it’s just got to a point where the median value is just too expensive. So you have a couple different options, you can buy a property in a riskier lower class neighborhood where you might not get as good tenants and not have a truly passive experience, or you can sell the property, take the capital gains, take advantage of the 1031 exchange and place that money in a more affordable market in America where it does make sense. So that’s just the true power of the 1031. There’s so much that you can do with real estate from a tax standpoint, but a very, very powerful tool. So we’re going to take a quick break and when we come back we’re going to have Hector Bilbao on the line, a CPA that is very familiar with the 1031 exchange and very familiar with other tax benefits that are.
John Larson: Hey, welcome back to Real Estate Cowboys Radio Show. This is this is your host. John Larson. My guest today is a CPA. His name is Hector Bilbao. He started doing tax returns at the age of 16. That’s pretty crazy. And back then he said he would go to his clients’ homes and gather and prepare the returns at their kitchen table. And he said he still has some of those clients today, Hector is going on 16 years of experience in accounting and taxes over the last two years. He’s worked with some of the most elite attorneys, financial advisors, and CPAs in the country. And he’s developed advanced strategies for tax reduction of wealth creation. He has run Bilbao Financial LLC since 2013, helping his clients create wealth. So please welcome to the show Hector Bilbao and let’s get right into it with our first question. Okay Hector, let’s just start off simply by asking what is a 1031 exchange?
Hector Bilbao: Alright, so from a very high-level point of view, a 1031 exchanges is really nothing more than a sale and a purchase that is tax-deferred. Meaning taxes that are due today will be due sometime in the future. Or maybe never.
John Larson: Okay, great. And how would a client, how would it set up with a 1031 to where they would not have to pay taxes eventually on the sale of a property when the capital gains come in?
Hector Bilbao: Okay, well, the way that’s done is, you keep repeating the same process over and over again. And if you do not sell the property and you die, and you don’t sell the property, you can pass it along to your heirs and they will get a step up cost basis. Basically what that means is, let’s say, let’s go ahead and illustrate it. Let’s say I bought a property for $200,000 original, and I’ve been doing 1031s all my life. I never paid any taxes. Well, now the final property that I’m going to pass on, it’s worth a million dollars. So that $800,000, if you sell the property before you die, that $800,000 will be taxed. But if you pass it along to your kids, they will get a step up cost basis. Basically what that means is their cost basis will be equal to the fair market value of the property. So in other words, if the property’s worth a million dollars, their cost basis will be a million dollars. Uh, so if they go and sell the property after your death, then they will pretty much pay no taxes or very, very little if they sell it for a little over a million. Make sense?
John Larson: Yeah, no, that does make sense. Okay. So yeah, so the 1031 is awesome for real estate investors because like you just said, if you keep selling the property and you go from one investment to another. So example of single-family home with single-family home, you avoid paying the capital gains tax, the IRS, if you just roll those proceeds and the profit and the capital gains into another investment, correct?
Hector Bilbao: Uh, yes and it doesn’t have to be single family to single family. Uh, as long as it’s an investment property, you can swap a single family for a multifamily. Now, you cannot sway your main home for an investment property because it has to be the same type of classes. So investment for investment.
John Larson: Okay. I got you. And so Hector, how does one qualify for a 1031 exchange?
Hector Bilbao: Well, there are rules for that, but in a nutshell here’s what happens. you hire an intermediary. You don’t touch the money. You sell to the buyer and then the intermediary holds the cash. You buy your replacement property using the cash that the intermediary holds, and that’s it.
John Larson: Okay. And is there a specific timeframe? I think it’s, it’s a year, correct? You must own the property for at least a year to qualify for the 1031 exchange, so that rules out any house, flippers, retail flip opportunities. So like investors who are buying properties and then renovating them and selling them on the retail market, within a year, they would not qualify for a 1031 exchange. Correct?
Hector Bilbao: Correct, yes. House flippers are properties that are designed for a quick purchase and resale? No, they do not count for 1031s.
John Larson: Okay, so basically for an investment property, like a rental, you must hold it for at least one year. Correct? In order to qualify for that 1031 exchange?
Hector Bilbao: Yes, correct, you can. Properties must be like kind, so a change from a duplex into an apartment complex will be allowed; a change from a piece of raw land for a rental house will be allowed, a change from a vacation rental property to a straight rental home would be allowed.
John Larson: That’s what I thought. And so how do you cash out of a 1031 exchange?
Hector Bilbao: Well, there are different ways to cash out of a 1031. Uh, the most common option is paying the taxes or at least the ones that a lot of people use. They just take the tax hit, as they call it. But there are a lot of options available. For example, there’s section 453m of the IRS code that allows you to get about 95 percent of the sale proceeds and defer the taxes for 30 years. Uh, also a deferred sales trust, a charitable remainder trust, section 721, a structured sale, and the list goes on there. Uh, there are a lot of options for cashing out of a 1031.
John Larson: Okay, great. And with today’s back at an all-time high and in most cases in many markets across the US, prices are back up to where they were before the great recession. Would you say it’s a good time for clients to possibly look at taking advantage of the 1031 exchange if they’re sitting on a property with a lot of equity built up in it? Basically what I’m asking is, you know, with the temperature of today’s market, some of these investors in let’s say California or Denver, Colorado or Phoenix, Arizona or even Austin, Texas where you once resided, would you, would you say that this is a good time for investors to possibly look at doing a 1031, cashing in on some of the equity that’s built up in their property and then looking to expand into another market? Would that be a good? Uh, would this be a good time to do that?
Hector Bilbao: Well, I believe we really are at the height of the market, as you said, but of course, nobody knows it for sure. Nobody knows how long the boom is gonna last. One strategy that’s now worked pretty much, so it really depends what your goals are. If you need the cash if you’re looking to invest in another property. Depends if you want to retire today, if you want to retire in 30 years, you want to live somewhere else. I mean there’s so many variables to that question. It really depends.
John Larson: Yeah. The reason I bring this up, I’ve had a lot of investors from California who it seems like in the past three years have really been looking to take advantage of the 1031 exchange and I believe that’s because of the fact that they bought a lot of property coming out of the recession because property values in California had really had gone down. Um, but now the prices are right back up to where they were before the last crash. And I feel like a lot of these investors are worried that if we go through another crash, that property is going to devalue. So they’re looking to take advantage of that 1031 while they can and cash in on that. That equity is sitting there in that property. And so a lot of those investors have been taking advantage of the 1031 exchange and then looking to invest those dollars in other markets across America. Um, and one of those markets being Dallas, uh, I feel like I have a lot of attention from investors, not only from California but also Denver, Colorado, where you see the prices have gone up drastically to the point where it doesn’t really make sense for these investors to purchase property in their own backyard for multiple reasons. Uh, one California really isn’t the most landlord friendly state. Also, they would be buying property in California at the top of the market where there’s really no cash flow involved. And uh, so I can see that they’re looking for other markets in America that are on a growth trend. And I feel like Texas is really on that growth trend right now. So although one property in Texas might not be able to get you $200,000 in equity growth, uh, over the next five or six, seven years, like they experienced in California for the property values in Dallas and Texas are more affordable to where maybe four or five properties could get you that same type of result that you experienced in California.
Hector Bilbao: I mean, if your goal is to buy more properties, yes, always 1031 exchange is the best, best, best option. Always. I mean, if you’re goal is to buy more properties. Now if you want to cash out, that might not be it.
John Larson: Right. And so, one final question since you are, are you from Texas? I know that you were living in Austin. Did you grow up in Texas?
Hector Bilbao: Well, I was born originally in Cuba and I moved to the U.S. when I was 14 years old. Uh, I went to school here. I went to high school, I went to college, got my accounting degree. Uh, and I’ve been living in Austin since then, really. And just a few days ago, I decided I was going to chase my dream to come here to Florida and live by the water.
John Larson: And so you’ve seen then, Texas really grow in the past, you know, almost 20 years. So what are your thoughts, since this is a primarily a Texas real estate investing show? Uh, what are your thoughts on the Texas real estate market and would you say that this is still a good market for investors to build wealth?
Hector Bilbao: Well, Texas, this is great for real estate. Like I said before, I believe we’re in a boom cycle still. But we are at that 10 year period where we might start a bear market. Uh, so, uh, I mean, who knows how long the boom is going to last? I will not tell you if it’s good to invest in Texas, you’ve really got to do your due diligence. But Texas, it’s a great market, and it’s growing and it has been growing really, even in the recession it was growing slowly, but it was still growing. And it really didn’t affect us as much as other states. But you know, it really depends on your individual investment objectives.
John Larson: No, absolutely. And actually you know, I’m from Michigan originally, so I saw that Texas really held strong through the last recession and that was what me to move my business to Texas and into Dallas specifically, because I thought to myself that if a market like Texas could, you know, be resilient during a very tough economic time during that great recession, then that was definitely where I wanted to invest my money, uh, because I felt like my money would be, I guess safer here than any other market in America.
Hector Bilbao: Yeah, I do agree. I do agree. All I know is Texas. Honestly, I don’t know too much about other states. I just moved here to Florida so I have no idea how Florida works. I don’t even know how to get around without a GPS.
John Larson: Well, I’m sure you’re going to figure it out, Hector, you just got there. Well, I appreciate you being on the show. And Hector, how could my listeners get in touch with you if they wanted to get any advice about a 1031 exchange or any other tax advantages that are available when owning real estate or, uh, you know, being a landlord and owning rental properties. How can my listeners get in touch with you?
Hector Bilbao: Yes. My phone number is 512-394-4305. And my website is RealTaxAdvisors.com.
John Larson: RealTaxAdvisors.com. Well, all right, Hector, you and I had a pretty good conversation before we got on the air today, I definitely think you know your stuff. So any of my listeners, if you are interested in learning more about all the great tax benefits that are available to you through owning real estate here in the U.S., please feel free to reach out to Hector. I’ll also have his contact information on our website, a RealEstateCowboysDFW.com. Hector, thank you so much for being on the show and we’ll have you back again because there are so many tax advantages that are available to real estate investors. 1031 exchange is just one of them.
Hector Bilbao: Oh yes. 1031 is the tip of the iceberg.
John Larson: All right. Hector, well you enjoy your time in Florida and we’ll be catching up again soon.
Hector Bilbao: Thank you, John. Bye Bye.
John Larson: Bye Bye. Well, that was some great information provided by Hector. Really, really happy to have him on the show and share his knowledge with our audience here on the Real Estate Cowboys. We’re going to take a quick commercial break
John Larson: Welcome back Real Estate Cowboys. This is your host, John Larson. We’ve been talking about a great topic today. The 1031 exchange. What a useful tool to put in your tool belt as a real estate investor. We had Hector Bilbao on of the Real Tax Advisors, Bilbao Financials. Um, he came with a wealth of knowledge. He specializes in helping real estate investors take advantage of all the tax benefits that are available to you through the IRS by being a real estate investor. And it’s just another way that you build well through this model. It’s the only way that’s guaranteed to provide a return to our investors through the real estate investment model, but it is one of the only investments out there that can give you a guarantee benefit by investing in it. And it’s all the greats tax advantages that are available through the IRS, but just today, we focused on the 1031 exchange, but we’re going to have Hector back on in the future to talk about more opportunities and other ways that he helps his investors build wealth through real estate by taking advantage of all the tax benefits that are available to you. So if you’d like to find out more about the information that we discussed today, you can go to my website RealEstateCowboysDFW.com. Put in your information and join our mailing list. We also revamped the website. We provided some videos and webinars that you can access on the website, so if you’re new to investing and just looking for strictly education, you can still find that on our website. If you are an investor that’s ready to take action and wants to find more information on passive investment, real estate options, uh, you can also go to our website and input your information and get our free passive incomes starter kits. Uh, I’m also very excited. My new book is going to be coming out, right?
John Larson: It’s actually in the design phase for designing the cover right now. It’s gonna be called the Passive Income Guide: What’s Your Return On Life? So I’m very excited for that to come out. That will also be available on the RealEstateCowboysDFW.com website. And if you’re an investor that’s listening to this show and you’re not exactly sure what option’s best for you, are you a single family rental investor? Are you a private money lending investor? Are you a vacation rental investor? We have a really great quiz that you can take that tells you what option is best for you. Maybe it’s one of the three, two of the three, or maybe it is all three. Uh, but the quiz will tell you exactly what type of investor you are. One that’s been very, very popular though lately has been the private lending option through your IRA or 401k. I have investors that are self directing their accounts and getting their money out of the stock market, putting their money into safe development opportunities in the Texas market because this is where all the people and jobs are moving to. So the demand for single-family homes here is at an all-time high. Same goes for commercial buildings, office space, tons of, tons of jobs moving into the Texas market; DFW leading the nation in corporate headquarters. So as long as that trend continues the people are going to keep moving in. So really great safe development opportunities in Texas where you can be the bank and earn fixed high double-digit returns on your money and have those dividends go back into the account tax free or tax-deferred, depending on what type of account set up. So if you’d like more information on all of these opportunities, please visit the website, RealEstateCowboysDFW.com. Get more information and when you’re ready to take action, the Real Estate Cowboy’s gonna help you. So this is John Larson signing off. Thanks again for listening to the show. Hope that you tune in again next week. Enjoy your week and for all of you remember, what is your return on life?
Announcer: All opinions expressed by the host of the show are the opinions of American Real Estate Investments LLC and do not reflect the opinions of guests or sponsors. No personal or professional advice on this program should be considered an endorsement to follow a real estate financing or investment strategy. Before acting on any information, seek advice from your financial tax, mortgage or real estate advisor, as the information is not guaranteed and investment strategies have the potential for profit or loss.