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SHOW NOTES FOR EPISODE 337: THE POWER OF THE 1031 EXCHANGE – PART 2
The dynamic capital gains deferring 1031 Exchange is perhaps the most misunderstood, yet powerful, wealth-building tool for all real estate investors. Yet few investors really understand the scope and benefits of this invaluable tool. In this second episode of a two-part podcast series, author, journalist, attorney, accountant and real estate investor Michael Lantrip concludes this information-packed podcast series with more insider information and a case study to illustrate the profit potential of a 1031 exchange.
What You Will Learn
- The challenges of selling your 1031 Exchange property to relatives
- What is a QI and why you need one for a 1031 Exchange?
- What happens to your claimed depreciation on the property you are selling
- Does the new Mortgage on the Replacement Property have to be at least as much as the Mortgage that was paid off at the closing on the Relinquished Property?
- How you can take the $50,000 you were supposed to pay to the IRS in capital gains and leverage it into $950,000 TAX FREE!
About Our Guest
Michael Lantrip
Michael Lantrip, Attorney at Law, is licensed to practice in Texas, North Carolina, Virginia, and the District of Columbia. He is also admitted to practice in the U.S. Tax Court, the U.S. Federal District Court, Eastern District of Texas, and the D.C. Court of Appeals. He has a B.B.A. in Finance from the University of Houston School of Business, and he has a Juris Doctor (J.D.) in Law from the University of Texas School of Law. He practices in the fields of Tax Law, Real Estate Law, Corporate and Business Law, and Wills, Trusts and Estates. As a Criminal Defense Attorney, he has taken three cases to the Texas Court of Criminal Appeals, winning two of them. As a County Attorney, he handled almost 2,000 misdemeanor criminal cases. Formerly a Tax Examiner for the IRS, and a Tax Accountant for a Big 8 Accounting Firm, he has also been a Newspaper Reporter, Radio Announcer, Radio News Director, Television Reporter and Anchorman, Television Executive News Producer, and Military Intelligence Analyst. In addition to 35 years of practicing law, he built one of the first computerized Abstracts Plants and operated his own Title Insurance Company, and has been an Approved Title Attorney for seven national Title Insurance Underwriters. He has handled over 2,000 real estate closings. As a Real Estate Investor, his activities have ranged from Travel Trailers to Office Buildings, and from on-campus Condos to hundreds of acres of land.
Prior to his law career, he was a Radio Announcer at WQTE in Detroit during the “Motown” era, and he was a DJ at KIKK in Houston when it was named “Country Music Station of the Year” by Billboard Magazine. He has written over 700 stories as a daily Newspaper Reporter, he has written and produced more than 1,000 half-hour Television Newscasts, has logged over 8,000 hours on the radio, was named a Top Writer 2018 by Quora.com, and is a Lifetime Member of Mensa.
CONVERSATION CONTINUED FROM “THE POWER OF THE 1031 EXCHANGE” – PART 1
(TO LISTEN TO PART ONE, CLICK HERE)
6. Within 180 days after the Exchange Date, you must close on the purchase of your Replacement Property.
7. You cannot sell your Relinquished Property to, or purchase your Replacement Property from, or swap properties with, a person related to you, a “related party,” without having certain restrictions imposed.
A related party is your spouse, brother, sister, child, grandchild, parent or grandparent.
– If you do sell your property to a relative, you must file IRS form 8824
– There’s a 2 year holding period before your relative can sell the property
A related party also includes a corporation, partnership, LLC, or similar business in which you own more than 50% of the interest in that entity.
8. You cannot have actual receipt of, or constructive receipt of, or control over, the Net Sales Proceeds from the sale of the Relinquished Property.
At closing, the escrow officer usually hands over your check. That doesn’t happen. The funds must go to a third party Qualified Intermediary (QI). The QI holds your funds until you’re ready to by the Replacement Property. Then, the QI transfers the funds to the Title Company or your closing attorney.
You never receive the funds or have control if the funds.
The Net Sales Proceeds must be held by the QI.
The QI is a totally unregulated entity. There are only 6 states that have bothered to place any requirements, such as bonding or insurance, but no licensing or monitoring in any way: NH, VA, WASH, NEV, COLO, CAL, and MAINE.
PA doesn’t have to because they don’t recognize Section 1031 in their State tax laws.
9. You claimed Depreciation on your property each year that you owned it and operated it as investment property, 27.5 years for residential real estate and 39 years for commercial real estate.
When you sell, there will probably be Basis still in the property that has not been claimed as Depreciation. You have two choices for what to do.
First, you can actually continue to claim Depreciation on this property even though you no longer own it. Identify it on your Depreciation Schedule as “Section 1031 Relinquished Property Basis.”
Your second choice is to add the Undepreciated Basis, called your “Transferred Basis,” in the Relinquished Property to the newly-created Depreciable Basis in the Replacement Property and add the new asset to your Depreciation Schedule.
Either way, you must tell the IRS what you decided to do. This is called “making an Election.”
When you file your next Form 4562, Depreciation and Amortization, check the box that says, “Election Made Under Section 1.168(i)-6T(i).”
10. There is a mistaken belief that one of the Rules of Section 1031 is that the new Mortgage on the Replacement Property must be at least as much as the Mortgage that was paid off at the closing on the Relinquished Property.
People think it means that you are supposed to go out and get new debt on the property. You don’t have to match the paid off mortgage with a new mortgage.
This is not correct.
You can add your own cash for all or part of the additional funds needed.
But if you do not add cash, the new debt created will be at least equal to the debt paid off just because that’s the only thing that will work.
A Real Life Example of the Power of the 1031 Exchange
FREE MONEY TIMES 4, THEN TIMES 19
This is a simplified view of a real transaction intended to demonstrate the power of Section 1031, and the concept of “free money.”
We are assuming:
One. You sold and investment property and your Capital Gains is $250,000. We are ignoring transaction costs for the sake of simplicity and assuming that there was no debt on the property to be paid off.
Two. Your other Taxable Income is $250,000 and you are MFJ. So, your CG Tax Bracket is 15%. We will assume another 5% in State Tax, for a total of 20%. (PA does not recognize Section 1031 for State tax purposes.)
Note: following CG Tax Brackets.
| SINGLE | 0 – 39,375 | 0% |
| 39,376 – 434,550 | 15% | |
| Over 434,550 | 20% | |
| MFJ | 0- 78,750 | 0% |
| 78,751 -488,850 | 15°/o | |
| Over 488,850 | 20% |
Three. Your Capital Gains Liability will be 20% of $250,000 = $50,000.
It would actually be more, because some of the $250,000 CG would represent Depreciation Recapture, which is taxed at 25% for Straight-line Depreciation and up to 37% for Accelerated Depreciation, but for simplicity and to illustrate the concept, we will use 20%.
Four. If you don’t do a Section 1031 Exchange, you will send the $50,000 to the IRS and the State, and the money will be gone forever. You will be left with just the $200,000, to do with as you please.
Five. However, you can do a Section 1031 Exchange and use the entire $250,000 to buy another investment property
Six. We will break it into two purchases, so that we can track the results of being able to keep the $50,000 of tax liability and using it for investment, instead of giving it to the government.
Seven. You use $200,000 as a Down Payment, get a 75°/o loan for $600,000, and buy an investment property for $800,000. We won’t track that investment
Eight. You use the $50,000 as a Down Payment, get a 75% loan for $150,000, and buy an investment property for $200,000.
Nine. This is why I call it “Free Money Times Four.” Your $50,000 of free money ends up being $200,000 available to you for investment.
Ten. Now, let’s look at what happens in just 10 years. We will assume a 6% annual appreciation in value for the property, even though the historic annual average is 6.7%.
Eleven. In 10 years, the Fair Market Value (FMV) of the property will increase from $200,000 to $358,170.
| Year1 | 200,QQQ X 1.06 = 212,QQQ | 12,000 |
| Year2 | 212,QQQ X 1.06 = 224,720 | 12,720 |
| Year3 | 224,720 X 1.06 = 238,203 | 13,483 |
| Year4 | 238,203 X 1.06 = 252,495 | 14,292 |
| Years | 252,495 X 1.06 = 267,645 | 15,150 |
| Years | 267,645 X 1.06 = 283,704 | 16,059 |
| Year? | 283,704 X 1.06 = 300,726 | 17,022 |
| Year8 | 300,726 X 1.06 = 318,770 | 18,044 |
| Year9 | 318,770 X 1.06 = 337,896 | 19,126 |
| Year10 | 337,896 X 1.06 = 358,170 | 20,274 |
1.06 to the 10th power = 1.790847
1.790847 X 200,000 = 358,170
Rule of 72: 72 divided by 6 = 12
Twelve. The FMV of the $200,000 property has risen to $358,170 and that is a factor of 179%, or an ROI 79%.
Thirteen. Your Equity in the property, assuming a Note Paydown to from $150,000 to $120,000, is now $238,170.
Fourteen. This is an Equity increase of 475%.
Fifteen. And the $50,000 wasn’t even your money. It was the IRS1s.
Let’s look at what happens if you cash out at this point. We are ignoring transaction costs.
And we assigned $20,000 to the value of the land and depreciated the $180,000 building for 27.5 years, which is $6,540 per year.
| DEPRECIATION = 65,400
PROPERTY BASIS = 134,600 |
|
| CAPITAL GAINS= 158,170 & 223,570 | |
| GROSS SALES PROCEEDS | 358,170 |
| LESS: NOTE PAYOFF | (120,000) |
| NET SALES PROCEEDS | 238,170 |
| CG TAX (.20 X 158,170) | (31,634) |
| DEPRECIATION RECAPTURE (.25 X 65,400) | (16,350) |
| PAYMENT OF DEFERRED TAX* | (10,000) |
| CASH TO SELLER | 180,186 |
DEFERRED TAX: The original Capital Gains that was deferred was $50,000 and one-fifth of the Capital Gains was used for this investment, so one-fifth of the deferred amount must now be paid.
So, you have turned the $50,000 of the IRS’s money into $180,186.
This is a 260% ROI in 10 years. Except that it is really an infinite return because it was not your money.
BUT, if you sell and do a Section 1031 Exchange, the numbers are entirely different.
You defer the taxes on the Capital Gains and the Depreciation Recapture, and roll them into another property.
You use the entire $238,170 for a 25%> Down Payment, and get a 75% loan for $714,510 to purchase a new investment property for $952,680.
You could be looking at a smaller Apartment Building, or a couple of Fourplexes, or maybe four Duplexes. You could even consider a small strip shopping mall.
The $50,000 that you held back from the IRS has now become over $950,000 worth of income property, an increase of 19 times, in just ten years.
And, again, it wasn’t even your money.
We can also look at the other $200,000 of the $250,000 in Capital Gains that was invested in the other property.
Assuming the same 1.79085 increase in value, the $800,000 property that you bought with the $200,000 Down Payment, the FMV is now $1,432,600 with a paid-down Note Balance of $600,000.
Sale of this property would result in $832,600 in Net Sales Proceeds for you to use as a Down Payment, which would allow you to purchase a new Section 1031 Exchange property for $3,330,400.
Ten years after a $250,000 Capital Gains sale, you are holding title to $4,283,080 worth of investment rental property.
In addition to the cash flow and tax benefits, it is appreciating in value more than $250,000 each year.
What He’s Looking to do When He Relocates
- He’s not looking nor new clients
- He has a full roster
- Buy a mobile home park
- Become a hard money lender
- Has sold most of his investments
How to Reach Michael
Here is a PDF Outline of Michael’s Presentation for our 2-Part Series
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2019-06-25_12-07-34
