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Full show notes below
Joe Bauer: Welcome to the Seattle Investors Club podcast where we talk about the nuts and bolts of real estate investing. My name is Joe Bauer. I’m here with my cohost, Julie Clark. Julie, how are you doing today?
Julie Clark: I’m excellent, Joe, and I’m here with my cohost, Buddy Clark, who is also here today with us.
Joe Bauer: Oh, yeah.
Julie Clark: Hey, Buddy. Buddy is our sidekick. For those of you who don’t know who Buddy is, if you follow, I think our Instagram account might have some pictures of Buddy on there. Do you got some on there, Joe?
Joe Bauer: Buddy is on there, but he’s going to be making a special appearance in the next few days. So, check it out.
Julie Clark: Oh, excellent. Well, he is getting his hair cut next week in case we need to prep him for any serious interviews and things like that, but all right, Buddy. I’ll take it from here. Thank you very much. So, Joe, for those of you that follow us on the nuts and bolts of real estate investing, you might be aware that Joe is on a year long road trip with his girlfriend, Emily, hitting all the national parks and everywhere in between in his kick-ass, I don’t know what I want to call it, van, sprinter van, The Vantastic Life. You can follow him. So, Joe, every time we do this each week, we want to know where you at. So, what’s up?
Joe Bauer: So, right now, I’m a sweet little campground outside of Lassen Volcanic National Park, which is in Northern California. It’s pretty darn cool. We went and saw some basically boiling water coming out of the ground on some trail runs yesterday. It’s quite the place.
Julie Clark: That sounds a little bit like Yosemite National Park to me.
Joe Bauer: Yep. Very similar to Yosemite National Park. I would say just about a hundredth less people.
Julie Clark: Right on. That sounds good. It’s probably, what, 800 degrees out there?
Joe Bauer: It’s probably about 78 right now.
Julie Clark: Nice.
Joe Bauer: Yeah.
Julie Clark: Good stuff. Well, I’m in Seattle, sitting enjoying the beautiful weather. It’s going to be 85 here today. Totally awesome. Our guest today is in San Diego, another beautiful place. What’s up? How you doing, Bill?
Bill Exeter: I’m doing terrific. Thank you.
Julie Clark: I’m going to let Joe introduce you and take it from there.
Bill Exeter: Okay.
Joe Bauer: Well, yeah. We have Bill Exeter on the call today and Bill, we always start this podcast out with just trying to get to know you a little bit better. So, if you could share your history, how you got into real estate, and what you’re doing now, we’d love to know.
Bill Exeter: Sure. I actually ended up in a commercial bank in Los Angeles as the controller and the chairman of the board had decided to start a 1031 exchange company. This was about 35 years ago. The outside counsel said, “Hey. Don’t give it to the escrow subsidiary.” So, they threw it to me and I had no idea what 1031 exchange was at that point and had to get up to speed pretty darn quick. That’s what got me into real estate and into 1031 exchanges. The rest is history, as they say. So, we’ve been doing 1031 exchanges and trust services for 35 years.
Julie Clark: That’s awesome. Has anything changed in your business in the 35 years, like everybody used to do this and now they do that or what?
Bill Exeter: Yeah, quite a bit. When I got into the business, the IRS still nation regulations. So, it was kind of the Wild Wild West. We’d go to some small group meeting and it was like, “This is how I do it. How do you do it? I don’t know. What do you think?” Everybody was just trying to figure it out because the IRS hadn’t spelled it out yet. So, that was in the early ’80s and then the regs actually came out in ’90, ’91.
Julie Clark: Wow. Yeah. Then what an advantage to be on the inside of how all that rolls. Are you also a real estate investor yourself or are you smart enough to know that people are out there overpaying for all their deals and [inaudible 00:04:15] right now?
Bill Exeter: True, true, true. I do invest myself. I have some single family duplexes and whatnot. Haven’t bought any recently. I think the market’s frothy, if you want to put it that way.
Julie Clark: It is. But we’ll say [crosstalk 00:04:28].
Bill Exeter: So, you see a lot people buying stuff. Say that again?
Julie Clark: Definitely frothy. I said it is definitely frothy, but we are experiencing a leveling out slowdown. I don’t know if you guys are down there in San Diego, but Seattle since June has completely shifted. So, I think we capped out. Unless something’s priced low, it’s listed for what you expect to sell it for, I think it’s still a solid market. But definitely having a change over here.
Bill Exeter: Yeah. We’ve seen the same thing. I think our transaction volume for July has leveled out quite a bit as well. So, I think that’s exactly what we’re seeing.
Julie Clark: I always wonder, so you are a 1031 exchange facilitator or qualified intermediary. Would that be the correct way to say it?
Bill Exeter: Yes. Absolutely.
Julie Clark: So, this is a little side note here. So, I work with my favorite stager, which is White House Staging, Stacey Masterson out here in Seattle. I find it interesting to ask different people in different parts of the business of real estate, because she is staging 25 homes all at one time for investors, for regular agents, and so forth like that, and she has a different vantage point and sense and feel of what’s going on in the market based on when she’s being called to pick up her staging.
Bill Exeter: Interesting.
Julie Clark: It’s just a simple insight and she can sense how long … She says that her, starting in June, I think she said, that her inventory was sitting out for way, way longer for the first time in four years. So, just because she’s a stager, she had a touch of knowing that the shift had happened. I find that super interesting and I’m wondering if there’s anything in your business that you sense from your perspective.
Bill Exeter: We’re the opposite. We’re the trail end of that, if you will. Once everyone has listed and sold and opened escrow and whatnot, then at that point, they contact us. We get the tail end of that, if you will. So, we’re not really a leading indicator. But we do see trends that bounce all over. We’ve seen a shift probably a year ago or so where in the multifamily market, people are selling maybe A class properties and going into C+, B- and then doing a little rehab and bumping it to a B+ property.
Bill Exeter: So, they’re doing value adds. So, I think that makes sense in this type of a market. So, you’re seeing shifts like that because people are trying to obviously figure out how do we make money in today’s market? Then we’re in California, so we see a lot of people who are selling Californian and buying in other states where the cashflow makes more sense.
Julie Clark: What states are they buying in? There’s a little insider tip.
Bill Exeter: It’s all over the place. You see a lot of people who buy in states that have no state income taxes, so they’re repositioning for the future sale where they won’t have to pay state taxes. You get people who are going into a lot of the areas like Tennessee and Kentucky and what have you with some really good prices. You get a lot of people go still into the Sun Belt because that’s where really the growth is forecast for the many years to come. So, it just depends on what their goals and objectives are. But a lot of repositioning.
Julie Clark: Yeah. So, are you seeing people in these hot metropolitan markets, say, or like Seattle and things like that, that they’re starting to cash, not cash out because we’re talking 1031, but they’re starting to trade out because we maybe are saturated or hitting some sort of peak and they’re taking advantage of that sale and moving their money somewhere else?
Bill Exeter: Yeah. We certainly see a lot of that. Then you get the other group who doesn’t really want to leave the area. They don’t want long distance management issues to worry about. So, then the question is what the heck do you buy? I think that group tends to be more of the value add, value play type investor. Then you get investors who are just repositioning, trying to put themself in a better position, but they’re not really changing the market they’re in. So, hopefully the property the buy is a better property.
Julie Clark: Right. It’s crazy. Everybody’s going after value add. I tell you. I feel like even in the smaller investor world, not the institutional investor world, all of a sudden, everybody’s looking for multifamily and buy holds. It’s amazing how just the coin flipped over and that’s everybody’s focus right now, it seems like, at all levels of experience and all levels of value. Seems to be the hot topic right now. It’s crazy to me. People, when they start investing in multifamily, they should maybe initially invest for cashflow, but those value add deals are hard to find.
Bill Exeter: Very true. I think in this market, you have to invest for cashflow because it’s pretty pricey.
Julie Clark: Right. I guess some people are probably forced to invest for just appreciation and park their money, though, when they have exchange needs and have to meet those deadlines. Do you feel that you have people that sometimes buy stuff that they just buy it because they’re forced to buy something because they don’t want to break the deadlines?
Bill Exeter: Yeah. We certainly see that. A lot of people who just jump at something. You get toward the end of your 45 day identification period and you panic and they go after anything. We always try to tell people, don’t let the tax implications drive the decision. It needs to be an economic decision. Then if you can defer the tax, that’s great. But it really has to be a good business decision. It’s amazing how many people just buy junk just so they don’t pay taxes.
Julie Clark: Right. Let me ask you that. So, there’s a little, maybe there’s a synergy. Do you get brokers calling your office directly saying, “Hey. I’ve got this pocket listing on this multifamily. Do you have any 1031 buyer needs?”
Bill Exeter: We do. Yeah. We get calls quite a bit. In some cases, we can refer business. But in a lot of cases, the clients are working with other folks and we never really get a phone call from them. So, we don’t know what they’re up to or if they’re, have a need. But it doesn’t hurt to reach out and give us flyers, whatever you might have on the property, a package, and we can keep it handy.
Julie Clark: Then you pass it on to their broker. There’s ways to structure any deal. I just think that you guys are such a great resource for buyer needs.
Bill Exeter: True. Yep. Absolutely.
Julie Clark: True that. Okay. Well, we got a little sidetracked there, of course, like we like to do. So, let’s kick it off and just say, maybe just to start things off, maybe we can cover the different options, like a 1031 exchange and beyond that. This is all available on your website as well, but maybe what an installment sale is and how that’s different or a structured sale and maybe some of the other options, zero equity, 1031, or improvement 1031. Without a deep dive into the details of each, can you just share-
Bill Exeter: Sure.
Julie Clark: … what those are and what that means and how they’re a little bit different?
Bill Exeter: Absolutely. So, the 1031 exchange, of course, only applies to rental investment or business use properties. It gives the investor a chance to sell the asset, defer the payment of their capital gain taxes, their depreciation recapture taxes, and avoid the triggering of the Medicare surcharge or the Obamacare tax by going through the 1031 exchange. They just do that by reinvesting in other rental investment or business use property by trading equal or up in value. So, straight across the board or up, if you sell for a million, you buy for a million or more.
Bill Exeter: By doing that, they defer all the taxes that are, it’s not tax free, it’s tax deferred, and just keep kicking the can down the road. Then of course, when they decide to continually exchange throughout their lifetime and then pass, whoever they leave the property to will get a step up in cost basis. So, at that point, it does become tax … to recapture completely goes away. So, that only applies to rental properties and it assumes that the investor wants to stay in real estate. So, it allows them to defer the tax as long as they’re reinvesting equal or greater.
Julie Clark: Then when they go to pay that tax later, they pay it at whatever the capital gains tax rate is. Right?
Bill Exeter: Exactly.
Julie Clark: Do you find that people … I don’t know. What are we at today? What are we at today on the capital gains tax? Is it 15 or 20?
Bill Exeter: It’s either 15 [inaudible 00:13:40] depending on their tax bracket.
Julie Clark: Right. I don’t expect that’s going to go down anytime soon. Do you?
Bill Exeter: No. It surprised me. I think we’ve had all the tax cuts we’re going to get for a while.
Julie Clark: I think you’re right there. So, definitely beneficial to defer that. Then the people don’t understand probably what depreciation … I own apartment buildings and have bought and sold apartment buildings myself, so I understand the pain of what a depreciation recapture is. Do you know? You’re not a CPA. So, we’re not holding this to you. But if I recall correctly, it’s around 25% tax rate?
Bill Exeter: Exactly. Yeah. So, if you’ve got an investor who’s, let’s say, bought multifamily, then every year, they’re going to write off a percentage of that or depreciate the property on their tax return, let’s say 10 years later, they just decide to sell and not do a 1031 exchange. Then they’re going to take all that depreciation they’ve taken over the years and add it back to the income or what they call recaptured and it’s all taxable. At the federal level, it’s 25% and then whatever the state rate is. In a lot of cases, that’s a big surprise. People don’t think about the depreciation recapture until it’s too late.
Julie Clark: It takes a big, big bite out of your proceeds.
Bill Exeter: Absolutely does. Yeah.
Julie Clark: Ideally, because if you’re not making any cash net proceeds out and you got to pay that, that could be troublesome, to say the least.
Bill Exeter: Absolutely. It’s usually a surprise and it’s not a good surprise.
Julie Clark: Not a good surprise. So, what that means, guys, is that when you own, let’s say, an apartment building and you have your net income from operations at the end of the year, you also have what I’ll call balance sheet. You get to reduce that number by the amount the property depreciates over. So, you could essentially, in some cases, even have a tax loss sometimes but still be collecting cashflow from your property because it’s just on paper, right? Does that make sense?
Bill Exeter: Yeah, absolutely.
Julie Clark: Yeah. But then what happens is then when you go to sell the property, that, we’ll call it phantom loss or that phantom income comes to light and you have to deal with it. It’s a big deal. If you guys currently own apartment buildings and you don’t know what depreciation capture is, it’s worth a call to your CPA right away to have them give you some scenarios, even if you have to pay them a consulting fee to break it down for you, so you understand what we’re talking about here when you go to sell one of your properties. That’s why we’re talking to Bill today because maybe a better choice for you is to defer those capital gains and those taxes on depreciation recapture. Then once the Obamacare, the Medicare surcharge, is that 3.8% or is that number bounced around?
Bill Exeter: Yeah. There’s actually two. So, the there’s the 3.8%. There’s another one that’s a .9% and they get triggered based on different things. Typically, the Obamacare is anything that it interest income, dividend income, or capital gain income and if it exceeds a certain level, depending on your tax bracket, so that’s one of those things that really catches people off guard because they’re not thinking about the Obamacare tax. So, if they do an exchange, then any of that income, that capital gain, depreciation recapture is deferred so it doesn’t get counted toward the Obamacare limit.
Julie Clark: That’s on top of the capital gains tax, the depreciation, recapture, and this is on top, right?
Bill Exeter: Exactly. Yep. That is on top and it’s frustrating because people just don’t think about it. Then when they do their tax return, they get surprised.
Julie Clark: Right. I remember when that came out back in the day because I’m also a commercial broker. Brokered my fair share of land deals to the institutional guys and stuff like that. But dealing with sellers or those properties, they were writing into the contracts right when that thing was getting passed, if it gets passed, the price on the contract was going to be adjusted by that Obamacare thing. That was a big deal for a while, caused a big pause with sellers having to [inaudible 00:18:02] negotiate that into the contracts back in the day. I’m again myself a little bit.
Bill Exeter: Yep. It was certainly a surprise and it gave everybody a chance to sit back and rethink it for a while.
Julie Clark: Exactly. All right. So, we’re going to jump back on track again here. So, 1031 is when you want to defer your capital gains tax and all those other crappy taxes on top, either indefinitely if you can defer them until you pass and it goes to your heirs because they get a step up in value. That’s one option. How about installment sale? What the difference with an installment sale?
Bill Exeter: An installment sale is really when you’re selling property and you’ve decided to do a seller carryback note and you’re helping the buyer finance the purchase, essentially. So, you’re acting as the bank. The difference is that you’ve actually sold the property, triggered the gain, but you can defer it over the term of the installment note. There’s a lot of moving parts there, so it depends on how you structure.
Bill Exeter: But typically, any cash that you get in your pocket at the close of sale would be taxable and then any other gain that’s not taxable would be deferred over the term of the note. So, it’s one way to get out of the real estate investment, not have to reinvest, and then defer some of your taxes over maybe a five, 10 year period, depending on how long you structured that note. So, really, the difference with a 1031 is it is deferred into the future until you sell the property.
Julie Clark: Not triggered at all.
Bill Exeter: It’s not triggered. With the installment note, you’ve triggered it. You just get the deferred until you start to receive principal payments over the period of time.
Julie Clark: Let me ask you a question on installment sales. So, I sell a property and I carry back a note and I’ve got a five year term or whatever the term is, but I know that my own personal tax bracket is going to be changing because I’m retiring or something like that. One the installment sale, does the cap gains tax applies? If my rate was going to go down because my tax bracket was going to go down, do I benefit from that capital gains tax at the lower rate? Let’s just say if I could qualify for that in the year that I take that money down the road?
Bill Exeter: Yes. So, each year, a percentage of your capital gain would be taxable, depending on how much principal payment comes in. You’ll pay tax on that year’s capital gain rate. So, if you’re going into a lower tax bracket at some point in the future as you get those payments in or even get a payoff, you’ll be taxed at the lower tax rate. So, if you know that’s going to happen for sure, that would be one way to do it and make sure you get taxed at the lower rate.
Julie Clark: Right. There’s some planning that needs to go into that kind of thinking, for sure. But the interest income is ordinary income, I think, isn’t it?
Bill Exeter: That’s right. Yep. There’s no way to avoid that. Other people, they want to get out of real estate, but they don’t want to get hit all at once and they don’t want to have an installment note where it forces the payment at some point in the future. So, what you can do, which is a blend between the two, I guess, is a partial 1031 exchange. So, maybe you sell an asset for a million and you reinvest at 900 or 950. Then you can specifically plan how much gain you’re going to trigger in that particular year. Then maybe a year or two later, you sell again to another exchange and trade down a little bit more. So, you can slowly take your chips off the table, so to speak, and control how much gain you trigger in whatever year you’re looking to do that in.
Julie Clark: Oh. Interesting. Partial 1031. So, that’s totally different than our next category. That’s different than a structured sale, correct?
Bill Exeter: Yes. It’s still at 1031 exchange, and unfortunately, there’s a lot of material out there that says you have to trade equal or up in value with a 1031 exchange and that’s not true. You can certainly trade down, but it will trigger taxes. So, generally, the amount you trade down by or, in other words, you don’t reinvest would be taxable. It doesn’t hurt the rest of the 1031 exchange. It just means you’re going to pay some tax.
Julie Clark: That’s a very valid point. People might be confused about that. You hear that, guys? You do not have to trade up or equal. Basically, if you need to do a 1031, you need to call Bill. But we’re going to talk about that at the end. But it’s like going to a restaurant. There’s a lot of options, right? There’s a lot of options. So, depends on what your diet is and, yeah, what your dietary nutrition needs are on how you need to structure these things and what’s going on in your life and the future and this and that.
Bill Exeter: Absolutely. Yep. Along the 1031 lines, there’s another exchange called a 1033 exchange. A lot of people haven’t heard of that. The 1031 usually is a natural disaster where the property’s been destroyed, either fully or partially, and they submit a claim, get an insurance check, and they reinvest by repairing the property. So, they’ve done a 1033. They just don’t really realize it. But where I think it has a lot of impact is if you’re in a position where you’re selling property to a government agency and they have eminent domain authority, or some people call it condemnation authority, if you can get them to take your property through eminent domain or threaten you with eminent domain, then you qualify for the 1033 exchange.
Bill Exeter: Now, with that one, you have anywhere from two to up to five years to reinvest, depending on what section of the code you fall under. So, much more flexibility in terms of timing and you could actually pull cash out and it doesn’t trigger cash boot like it would in a 1031 exchange. The 1033’s got some neat planning opportunities.
Julie Clark: That’s a 1033?
Bill Exeter: Yeah. 1033 exchange.
Julie Clark: Well, that’s interesting, especially up here in the Seattle are where we have all our light Link rail projects and those sort of things going on where we are having the eminent domain things happen as we build out our infrastructure here. A little tip for all you ninjas out there that like to be doing the deep dive, I can think of a few of you people I know off the top of my head that should be paying close attention to this 1033 exchange. You could maybe even reverse engineer some ideas around that, guys. There’s another little ninja tip of the day from Seattle Investors Club right now. But that sounds pretty cool. Makes me think. So, what’s a structured sale?
Bill Exeter: Structured sale is similar but different than the installment sale. We have to be careful here. There’s probably four, five, six providers out there who’ve come up with different structures, different ways to do the structured sale. They call them different things. They’ll all say that they’re drafted under Section 453 of the tax code, which is the installment sale code. So, it’s the same exact section of the tax code that the installment sales fall under. The difference is they’re drafting things a little differently, they’re approaching it a little differently, but they’re saying it’s drafted under Section 453.
Bill Exeter: At this point, there’s really no IRS guidance on the structured sales. There is one where there’s a court decision that covers the structure. So, in structured sales, you’re effectively the same thing. You’re selling property, but you’re doing it through a structured sale. You’re triggering your taxable gain, but you’re deferring it through the structured sale mechanism. So, it really depends on the term of the structured sale and what have you.
Bill Exeter: With this, because there’s little or no guidance from the IRS and only that one court case and a little bit else out there in terms of special rulings from the IRS, I’d always talk to your accountant first and really do some research and make sure what you’re doing, it’ll work and it’ll qualify if you’re comfortable with the risks there. We’d like to see a lot more IRS guidance in this area, if possible, and at some point, we’ll get it.
Julie Clark: What is the concept, though, that you can pick your term? Or what’s the because between installment sale and structured sale? Because they both trigger gain and they both-
Bill Exeter: Yeah. Good question. They both trigger gain. The difference is with the installment sale, the buyer’s still in the picture. So, you’ve sold property to the buyer, the buyer has executed the promissory note as the buyer and borrower. With the structured sale, effectively, you’re selling the property through some type of a mechanism, either a trust or something like that. Then the trust turns around and sells it to the ultimate buyer. The buyer’s actually paying for the property either through cash or financing, then the buyer’s out of the picture.
Julie Clark: I got you.
Bill Exeter: So, that’s one way to do it when the buyer doesn’t want to hang around. People are worried about the buyer. If they do an installment sale and the buyer trashes the property or defaults on the note or what have you, there’s risks. So, the structured sale results in a sale, defer the tax over the period of time you choose, but the buyer’s not involved anymore.
Julie Clark: So, you take away the-
Bill Exeter: The risk with the structured sale is there’s no IRS guidance.
Julie Clark: Right. So, if somebody was to slap somebody’s hand on a structured sale, it’s a way to not have to worry about foreclosure and having to take a property back because it’s more of a cutting it off sale situation. But you might get a spanking from the IRS or something or the potential’s there for some weird audit that then might put you back in the position of an installment sale?
Bill Exeter: Good question. If an audit were to occur and they disqualify the transaction, it could recognize immediate tax consequences. It depends on what position the service would take.
Julie Clark: So, you got to be a little bit of a cowboy and a pioneer, or cow-gal and pioneer woman, to maybe dive deep into that. We won’t make you go into details on that today. Just covering basically the basics. Let’s move on. What’s a zero equity 1031?
Bill Exeter: A zero equity is something we trademarked a while back and it really happens mostly during recessions. So, as an example, let’s say you buy property for $100,000 and then over 10, 15 years, it goes up in value and every couple years, you refinance. You’re pulling your equity out, but you haven’t sold it. You haven’t paid any taxes yet. At some point in the future, let’s say it grows in value to a million, then you keep refinancing. At that point, you’ve got a million dollar value, maybe $900,000 in debt, and then a recession hits.
Bill Exeter: So, let’s say that million dollar property drops in value to maybe 600,000. So, it’s a 40% drop. But you still have a $900,000 loan. It’s worth less than what you owe the bank, but you still have a taxable gain because you only bought it for 100,000. So, a lot of people will, if they lose the property through foreclosure or something like that, they think, “Well, I’m losing the property, so I don’t have a tax consequence.” The reality is you’ve refinanced over and over and over. You pulled your gain out, but you haven’t paid tax on it yet, so it’s still sitting there.
Bill Exeter: So, when they lose the property through foreclosure or deed in lieu of foreclosure or short sale, whatever, you can still do a 1031 exchange, even though you have no equity. The challenge is how do you pay for replacement property when you have no equity? So, it can be done and we just want to get the message out there. If you’re under water, it’s still possible to defer the taxes.
Julie Clark: Interesting.
Bill Exeter: First thing, talk to your accountant and find out if you’ve got a tax problem. That’s the big one.
Julie Clark: Right. That is good to know. These are all just resources, guys. Bill is somebody that you should have on your team, no matter what. It’s just like the basics of your team. You got your title and escrow people, you got your attorney, you have your CPA, and now you have Bill Exeter from Exeter 1031 as a crucial player on your team. No doubt, for sure. Especially, I feel, it makes me nervous that people are paying top dollar for all these buildings, yet there’s more buildings being built, apartments being build, and we’re starting to have absorption issues. There’s a lot of people that … There’s something called the Peter principle.
Julie Clark: Do you know what that is? You guys know what that is? That’s when you’ve done something well. Let’s say you flipped houses and you did real well and you [inaudible 00:30:37] maybe you’ve started building a few houses. You’re now a developer. You’re a home builder because you flipped houses and now you’re a home builder and you’re doing well at that because you’re hitting the market when it’s super hot.
Julie Clark: Well, then all of a sudden, now you’re going to start buying all these apartment buildings because you got the golden touch. Boom. The Peter principle, I think what it means is when you think you’re good at something that you think you’re an expert in the rest and then you get a spanking. That’s the Julie Clark, not the Wikipedia version of Peter principle. But be careful.
Bill Exeter: It hurts.
Julie Clark: It hurts. That’s a spanking that you don’t want to get. I know some of you dirty birds out there might want a spanking, but you don’t want that kind. Let me tell you what. I always got to take it to the gutter a little bit, Bill. We got to make sure these guys … Right.
Bill Exeter: True, true.
Julie Clark: I don’t know, Joe, if that qualifies for that you can, whatever you write on these podcasts, “expletive” or whatever. But I attempted to get in the gutter right there for a second, guys. Sorry about that.
Bill Exeter: Who’s got that “bleep” button?
Joe Bauer: Yeah, right?
Julie Clark: Yeah. The beauty is we don’t have one here at Seattle Investors Club. Okay. Well, last one and then we’ll get onto some other stuff is that’s what’s the 1031 improvement? Is that something that we need to know about?
Bill Exeter: It can. It comes into play occasionally. So, if you’ve got somebody who is selling property and they’re going to buy a replacement part, like may dirt, and they have exchange funds leftover and they want to use those funds to build out the property, you can do and improvement exchange. So, you sell, buy dirt, or buy something you want to improve and then use the 1031 exchange proceeds that’s leftover to pay for whatever the improvements are. It’s a lot more complicated. We have to hold title to the property. It’s what the IRS calls parking title. But can be done and it’s a great way if you want to use some of the exchange proceeds to make the improvements.
Julie Clark: So, for all you Peter principle followers out there that want to break out of your apartment building and now go buy some apartment dirt because you think you’re going to build one, that might be for you, right?
Bill Exeter: That’s true, yep. Absolutely.
Julie Clark: I’m just teasing, guys. You guys go for it. Right? I’ll be your broker. Just call me when you need me. All right?
Bill Exeter: I just don’t want to get a phone call right after this and say, “Hi, this is Peter.” I’m like, “Oh, God.”
Julie Clark: Exactly. Okay. So, we already covered what we’re looking to, the components of taxation. 1031, guys, we know 1031 exchanges and all these other types of installment sales and options to protect your hard earned equity are meant to avoid taxes, which there’s a lot more taxes than just capital gains for you guys to be aware of. We got your deprecation recapture and all your thank you, Mr. Obamacare stuff. But let’s go into just a little bit of nuts and bolts, for lack of a better word, we love that word, on the timeliness, the basics there on a 1031. It’s 45 days, what, to identify, 180 days to close, that kind of thing?
Bill Exeter: Exactly. Yep. I think the most important thing to remember is you’ve got to get the exchange set up and in place before you close on anything. We get calls literally every day where they closed last week or yesterday or something and they want to do an exchange. Once the closing occurs, it’s too late to set up the exchange. So, always get everything set up, signed, and ready to go before you close. Then closing is what triggers it. So, a lot of people think it’s when you execute the contract or open escrow or things like that. But it’s not. It’s the closing that actually triggers everything.
Bill Exeter: So, when you close on the sale, you convey title to the buyer, that triggers your 45 days to identify. That’s the tough part. 45 days moves very quickly and in today’s market, trying to find something in 45 days is suitable and makes sense, it could be really challenging.
Julie Clark: Very much. So, does that 45 days, includes weekends and everything. Straight up 45.
Bill Exeter: Yeah. So, basically, you have six weekends to find property.
Julie Clark: Almost impossible. I often am telling my clients if you want to do an exchange, I have somebody that wants to exchange out of two single family rentals right now and buy an apartment building in Tacoma. I said, “Well, we really almost need to have an idea and get talking to brokers about pocket listings and this and that and identify it before we get started because the houses are going to sell fast.” That can be hard to fill those shoes. So, what happens? So, you have 45 days from the date of closing that you can identify up to how many properties?
Bill Exeter: Usually, it’s three properties. There’s a couple of rules you can look at. So, most people are going to probably sell one and buy one of a little bit more value. If they’re selling for a million, they’re probably going to buy for a million, two, three million, five, something like that. So, they’ll use the three property rule, identify up to three, but not more.
Julie Clark: What happens-
Bill Exeter: If you are and invest- … Oh, go ahead.
Julie Clark: What happens if you’re trading out of something and you might have to buy two properties instead of one? Now you got an issue because you got your two that you need to buy and you only got one extra, if you get what I’m saying.
Bill Exeter: Yeah, one backup slot to use, so to speak. The tough part in today’s market is you may identify three with the intent to buy two. If one of those two doesn’t work out for some reason, the third property you identified as a backup property is probably long gone. Normally, you’d identify three, some of them would be backup, and that works perfectly well. But in today’s market, it doesn’t. It’s a challenge. They’re probably long gone. The second rule, which you may look at if you’re diversifying, some people are selling one property and going to try to buy two or three or four smaller properties, is you look at the 200% rule.
Bill Exeter: That just says whatever you sell for, so let’s say you sell for a million dollars, 200% would be two million, you could identify as many properties as you want up to a total of two million in value. So, it’s either or. [crosstalk 00:36:51] It really depends on whether you’re going to trade up or if you’re going to diversify.
Julie Clark: Okay. 200% rule. That’s very, very important because I was sweating right there. But now that makes it a little more, that makes it, sometimes can be a little bit more of a relax, not, I wouldn’t say relax in this market. But yeah. The problem is they’re all gone, right? In order to get a 1031, you have any tips on how to do that for people out there that are in need of that? You almost have to set it up ahead of time, identify it ahead of time, get going. Maybe can you put an option down or, I don’t know, lock it down somehow?
Bill Exeter: Yes. In fact, you hit the nail right on the head. So, one, you want to get started ahead of time. Don’t wait until you’re in the 45 days. If you do, you’re just asking for trouble. Start looking for property, and then there’s various ways to do it. So, if you happen to sell first, see if the buyer’s willing to cooperate. It’s still a seller’s market. So, you may be able to say, “Look. I’ll sell to you, but I want a long escrow. I want options to extend by 30 days for two or three times.”
Bill Exeter: Now, if you find the property you want to buy first, you can put it under lease with an option to buy or just an option, first right of refusal. If you can somehow tie up the property so you don’t close on it, but you have control over it, then you can time your closings just right. So, really depends on the market and it depends on what the other party’s willing to do and how cooperative they are.
Julie Clark: It’s a jigsaw puzzle a little bit. It’s all doable, otherwise that’s why you’re in business. It is all doable and it’s all worth it if you can pull it off. But you guys definitely need to be working with somebody that understands the components and all the moving parts. Don’t use your brother who’s a broker because he wants to get that commission and you want to give it to him. You need to have an experienced A team that can help you with this sort of coordination. So, again, I’m available. But let’s just say you guys get my [crosstalk 00:38:57].
Bill Exeter: That is true, though. That’s exactly right because if you get somebody who doesn’t really get it, you’re going to be in trouble.
Julie Clark: You’re going to be in trouble. Exactly. Well, let’s talk about some of these other … Okay, we have 45 days to identify, let’s say, 200% rule or up to three properties, and how many days to close?
Bill Exeter: Beyond the 45 days, you have an additional 135 days to actually close and wrap up your exchange. It’s a total of 180 days.
Julie Clark: Okay. So, it’s 45 plus 135 equals 180 combined.
Bill Exeter: Exactly. The other thing they can look at is a reverse 1031 exchange. This is probably about 3% of the market. So, it’s not for everybody. But the reverse allows you to actually buy and close on your purchase first and then you have 180 days to sell your current property. So, it works really well in today’s market because you actually close on your purchase. It takes the risk out of it. The problem is that a pure reverse means you can go out and buy a new property, take title to own both and then sell the old one later. That’s not permitted.
Bill Exeter: So, they’ve come up with this mechanism where it’s a parking arrangement. So, we have to take title or park title to the property. So, lenders aren’t terribly thrilled with that. The question is you’re buying first, you haven’t sold yet, your equity’s trapped, so how do you pay for the new property. So, there’s issues there. It’s a lot more complicated. But if the investor’s in a position where they can buy first and pay for it somehow, then that would solve a lot of the risks.
Julie Clark: Do you have a list of lenders that are user friendly for that sort of stuff if some of these people wanted to use your firm for their exchanges? Are you familiar?
Bill Exeter: We do. We have some. Usually what’ll happen is it depends on the geographic area. Usually, it’s going to be a lender who covers that local area. Anybody who’s a conduit lender that’s going to make a loan and sell it off to Wall Street, any of the big banks probably won’t touch it. So, it’s probably going to be a local community bank, a regional bank, or a bank that you got a relationship with that’ll do that. Or it’s going to be hard money, private money, or sell carryback or something like that.
Julie Clark: Right. That gives me an idea, Joe. I know you’re there. You’re probably on a hike at the top of a mountain listening to this right now, I know. But we should check into some community banks meet and greets for Seattle Investors Club. Just a little admin note on the side, guys, while we roll through this because it’s just like we’re three pals talking to each other today. We’re not actually having to please anybody but ourselves. That’s why we love this podcast. So, okay. That’s all good info on the timeframe there and reverse exchanges. Let’s see. Let’s go down to those questions that we thought you had some ideas, some tips and some problems you see with that investors are asking you these days, your list of stuff that we looked at this morning, Bill.
Bill Exeter: Sure. Probably one of the biggest areas we get questions about is, well, what type of property qualifies for 1031 exchange purposes? It’s amazing all the different opinions you get out there. So, probably the biggest one is how long do you have to hold title to property in order to qualify? The code, the regulations, the rulings actually has no holding period. So, when people tell you that you don’t qualify because you haven’t held title for at least one year or one year and a day, that’s not really true.
Bill Exeter: The whole issue is if you get audited, can you prove that you had the intent to hold the property for some type of rental investment or business use? If you can, you qualify. So, the one year mark, it just makes it easier to prove intent because you straddle two tax years and you got 12 months of rental income. 24 months, that’s two years, three tax returns. Makes it much easier to prove intent. But it’s not a black and white answer. So, if you held property for a month and then you sell again, so you’ve only had a one month holding period, you can still qualify if you can prove that you had the intent to hold.
Bill Exeter: So, as they say, stuff happens. So, you may have bought a property and then a month later, you get an offer that’s double what you paid for it. Most of us would jump at that. So, if you can show that you really had the intent to hold it, but you got this offer out of the blue and you can document that, then you would still qualify for another exchange. So, don’t get hung up on the length of time you’ve held title to the property. That’s certainly a big part of how you prove intent. But it’s not the end all to the whole equation. It’s all about what your intent was, not the length of time.
Julie Clark: So, that covers qualifying for a 1031, right? There is no rule to hold it for any length of time. It’s based upon intent to qualify for a 1031. But in order to kick yourself from ordinary income to a capital gains tax bracket, that could be a different requirement. Is that sound accurate? Meaning that I guess if you’re exchanging, that’s the point. You’re trying to defer your taxable whatever, regardless of whatever the tax bracket is. That’s the point, right?
Bill Exeter: Yes. That’s a good point. Yep. If you do the 1031, it’s deferred. If you’re just selling and cashing out, then the 12 month mark would be important. Once you get over the 12 month, then you’re considered capital gain vs. ordinary income.
Julie Clark: Right. So, we just want to make sure we’re making that distinction clear to you guys. There’s no rule on holding it for a 1031. Obviously, your intention there is to defer your taxes. But if you were cashing out and you weren’t doing a 1031, yes, that one year does make difference in your tax bracket or your treatment of the taxable income ordinary vs. capital gains. So, if none of you understand what I just said, don’t call me. Call your CPA.
Bill Exeter: So true.
Julie Clark: Well, what else you got? You got some land? What’s your next one up here?
Bill Exeter: There’s still a lot of curriculum and courses out there that’ll tell people if you sell a condo, you have to buy a condo, etc. That is not true. Any kind of real estate qualifies as like kind. So, the only requirement is you have to sell real estate and buy real estate. So, as long as it’s defined as real estate, it counts. So, vacant land would be like kind to single family, to office, to industrial. It’s all like kind to each other. Even stuff like oil rights, mineral rights, gas rights, air rights, water rights, all of those are usually considered real estate. So, it would count. You can sell a single family and go out and buy some oil and gas interests.
Joe Bauer: Wow.
Julie Clark: Interesting. We know Brian, if you’re listening to this, Brian Faust, that might interest you. You probably already know that. But also, though, we want to point out, we’re talking about rentals, not your personal residence, in any of this stuff, just to uber-clarify that.
Bill Exeter: Absolutely. Yep. That’s exactly right.
Julie Clark: What about a vacation home? That doesn’t count, right? You have to rent it out for 14 days a year and you can qualify or what’s the scoop there?
Bill Exeter: Yeah, good que- … So, if it’s 100% personal use, it’s not going to qualify. But again, it all boils down to intent. So, they can always change intent. So, what you’re referring to the 14 days as a safe harbor the IRS has, so if you could rent it 14 days per year for two years in a row and keep your personal use to not more than 14 days, you qualify. Or you just stop using it personally, completely rent it for, I would say, at least 12 months. I’d try to go a little longer. Then you’ve converted it to rental property. So, then it would qualify. So, it’s the same issue.
Julie Clark: Well, jeez. I got a complicated question for you these days with our modern world. How about Airbnb? We actually have a big … Our Seattle Investors Club meeting, little side note here, if you guys are listening, we’ve already had that meeting because these podcasts are delayed as far as their release. But this meeting, this weekend, July 14th, we are having a Seattle Investors Club meeting where the topic is how to use your short term rental income or your Airbnb income to count that income in your loan qualifications and stuff with our buddy, Albert Bui, who’s a local investor and lender as well. So, how does it work? What’s the Airbnb play into your world or is there one if somebody Airbnb-
Bill Exeter: There is. Good question. So, if it’s a single property and the entire property is being rented out on an Airbnb type strategy, it would absolutely qualify as rental property. In some cases, it’s a house that you’re still living in and you’re renting out a portion of the house, maybe a couple bedrooms or something. So, then it’s probably a split use type scenario and it would depend on how the parts come together. If it’s to your primary residence, then you get the 121 exclusion when you sell it. That’s the $250,000 tax free per person if you own it and have lived there for at least two years.
Bill Exeter: If you’re also doing the Airbnb and the same time, you first want to see if you can qualify under that tax free exclusion. If everything’s tax free, you’re done. If your gain is more than that, then you’d probably say, “Okay. 60, 70, 80 of the house is my primary residence,” that portion of the gain is tax free under the 250 or 500 and the rest could be allocated to a 1031 exchange since you’re renting it through Airbnb. So, there’s a lot of moving parts there. It depends on each person and how they’ve structured it. But there’s absolutely ways to manipulate that when you’re getting ready to sell.
Julie Clark: That is fascinating to me as far as a big white boarding effort to map out your stuff. It’s a lot of effort. But if you like to geek out on that sort of thing, I know some of you out there do, what a cool mastermind group that would be to meet up and do that. If anybody wants to do that, hit me up at [email protected] If you have a property or a scenario and you want to talk about it and share it with all of us, that would be a very interesting exercise to go through. That would be cool. Maybe we can figure it out and run it by Bill and get his feedback. That’d be pretty interesting.
Bill Exeter: Yeah, absolutely.
Julie Clark: So, in my own house, I essentially rent out a room to my nanny, who I love very much, so I can live my life. Wouldn’t that be considered, if she’s been there for five years and that I could use that portion as … Kind of feels like it, you just said that.
Bill Exeter: Yeah. If you’re renting it out to the nanny and she’s been renting it from you for five years, that would absolutely qualify. We usually are very comfortable once you get past the 18 to 24 month mark because you’ve got plenty of proof that was the intent. So, usually, the accountant will sit down with you and allocate how much of that is considered rental property vs. your primary residence. They’ll usually calculate it on square footage or if it’s a ranch or a farm, it might be based on acreage, something like that.
Julie Clark: Here’s something interesting, though. What about a family member? What if people’s parents are aging these days? Does that disqualify? My mom pays rent at a retirement home, right? So, what if some point, I moved her in here and she paid me rent on an actual lease?
Bill Exeter: That would certainly qualify. You could rent to family members.
Julie Clark: Oh, my God.
Bill Exeter: You just want to make sure that it’s fair market rent.
Julie Clark: Hello. I’ve got a new tenant coming then, huh, fellas?
Bill Exeter: Uh-oh. Hello, Mom?
Julie Clark: There we go. You guys, I hope you guys are listening because a lot of people these days are cohabitating. If you just got to get your paperwork right, run it by your CPA, run it by Bill, run it by everybody in the world. But we just put out there an opportunity for you numbers geeks and techs people. If you want to jump in and spend time on that, this little something, little tidbit there. Right?
Bill Exeter: Absolutely. Yep. A lot of planning opportunities. It’s all about planning. If you have time to sit down and work through what you’re doing, how you’re doing it, how you document it, you can get to almost anywhere if you got time.
Julie Clark: You know what would be an awesome service for you to offer, and maybe you already do is for me to go, “Hey, Bill. Let me just dump my whole life on you and tell you my situation and pay you a consulting fee and then you just tell me how I should set up myself.” That’s like they have, what are those, people are using some of those NCH, they tell them how to structure their whole company and have this company own that company and this and that and they pay 5,000, $10,000 for that information. Do you do that?
Bill Exeter: We do some of that. When it gets to rental or investment property, we can certainly do a consulting arrangement and look at how it’s set up, how it’s structured so that you have the opportunity to sell on a tax favored basis in the future.
Julie Clark: Yeah. If you are somebody that’s built up a portfolio for your whole life and your stuff, something to think about, guys. All right. Well, we’re going to keep you on the phone here forever. We don’t want to go too long. Is there any other of these questions that you had that you want to cover that you think would be the most pertinent to share?
Bill Exeter: I think we’re probably pretty good. I guess the last thing I’d want to throw out there is if you own property in some type of an entity, living trust, LLC, corporation, etc., now’s the time to talk to your advisors to find out who is the real taxpayer? Probably the best example is an LLC. Investors come together, set up an LLC, maybe have two, three, four investors who fund the LLC and then go and co-invest together. Then when they decide to sell, they usually want to do a 1031 exchange.
Bill Exeter: But the challenge is that they don’t own real estate. They own a membership interest, which is a partnership interest in the entity. The real owner of the real estate is the LLC. So, if the LLC’s going to stay together and exchange together, that’s no problem. But a lot of times, the investors have decided it’s time to go different directions. In that case, they’re not the sellers. The LLC’s the seller. So, it can be addressed. We just need time to plan for that. So, if you’ve got co-investors in some type of an entity, talk to your advisors about what your exit strategy might be and then that way, you’re prepared for the ultimate sale.
Julie Clark: I have been, I’ll call burned by that. I know what you’re exactly talking about. I would say to everybody, you know how I feel like they do that, maybe I’m wrong or not, they do some sort of assignment of your interest to the other members and then you either get hoodwinked by them saying, “Well, we’ll give you your proceeds,” or maybe there’s an opportunity for you to charge an assignment fee, which is what I have done in the past when we were essentially breaking up. Still, it sucks. I would have the right in some ca- … Is there a way for me to then go do my own 1031, right?
Bill Exeter: It is possible. Yeah. It depends on all the moving parts. If everybody’s willing to cooperate, yes. There’s always a way to work it out. It all depends on how much time we have. When we get a call and they’re closing escrow tomorrow, it’s very difficult. But it’s still possible if everybody’s willing to cooperate.
Julie Clark: Right. So, I’ll just give you a tip from my own experiences, guys. When you have a partnership agreement and somebody else is running the show and you’re not the main managing partner or something like that, make sure in your agreements that it says that you will be and shall be notified of any intention or thought to sell immediately because if they say, “Hey, we’re selling the property. We’ve already got a buyer lined up,” and you’re a limited partner or you’re more of the silent partner in the thing, you just got side- … We’re not going to exchange together. You just got slammed with no time to take care of what you need to take care of on the exchange stuff. So, I’ve had to do that on my own partnership agreements just even in attempt to be told early, as early as possible if that’s going to be coming down. So, lot of things to think about there, in case you-
Bill Exeter: Absolutely.
Julie Clark: Well, that’s all awesome. We could talk to you-
Bill Exeter: Unfortunately, breakups happen a lot.
Julie Clark: They do, and they don’t necessarily happen for bad reasons. It just, sometimes they happen. Let’s see. Well, Bill, we’ve been taking up so much of your time. We would love, love, love to have you come in person to Seattle Investors Club and we get a crowd there for you. I’m sure we’d draw a big crowd for you. Your information is crucial. If you’re in the real estate investing business, I think you should have a real estate license and I also think you should have a team of experts, one of those being … The worst thing that can hurt you, real estate can be great. You can make a lot of money. Then you can just get spanked if you don’t handle the taxes correctly and plan that correctly. I know because I’ve been through some of that pain myself. Where can our listeners … Do you have a blog or how do we stalk you, Bill?
Bill Exeter: Stalking is always good. They can go to the website and all of our contact information is out there. I’m the only Bill in the company, so they just have to ask for Bill and they’ll track me down. But the website is exeter1031.com.
Julie Clark: Excellent. Do you have a newsletter or anything like that or are you working on-
Bill Exeter: We do. They can subscribe through the website as well. It’s supposed to be monthly, but you know how that goes. So, it’s not always monthly.
Julie Clark: I hear you.
Bill Exeter: But we’ll get it out there and it’s always an educational type. Then if they want, there’s a guidebook we can send them. It’s about 20, 28, 29 pages. It’s all on the basics of 1031 exchanges and it covers all the things we’ve talked about. It goes in a little more depth, but it’s designed to be concise. It’s not too techy. So, if they want that, we can email it or mail it to them.
Julie Clark: Super awesome. Well, we are going to continue to twist your arm and try and get you back here to Seattle. I know you got some family.
Bill Exeter: Oh, be happy to.
Julie Clark: That would be fantastic. Joe is point person on that. I usually do the talking, then I run the other direction. Try and get some deals done. Leave it to Joe who runs the show for us. It’s a totally awesome setup we’ve got here. But thank you so much. This has been super informative. I love when I can get selfish and get my own free advice and questions in while we’re rolling through these things.
Bill Exeter: Sure. Anytime.
Julie Clark: It’s been a pleasure and other than that, we’ll turn you back to the beautiful San Diego weather and we’ll let Joe hit the trail and Buddy and I will hit the streets and go take a walk.
Bill Exeter: Perfect. Well, thanks for having us and I look forward to seeing you up there.
Julie Clark: Sounds good. Joe, where can they find this podcast or what do we need to know?
Joe Bauer: Yeah, guys. The podcast notes can be found at seattleinvestorsclub.com/40. If you guys enjoyed this podcast, we’d also love for you to give us a review on iTunes at seattleinvestorsclub.com/itunes. You ever have any questions, let us know. All right, guys. Have a great day.
Julie Clark: Awesome.
Joe Bauer: It was good chatting with you.
Bill Exeter: Likewise. Take care. Bye bye.
Julie Clark: Bye bye.