Craigslist's "Red Paperclip" Story...applied to real estate?

Question

For those of you who are unfamiliar, a man was able to trade his up from a red paperclip to buy an entire house in just under a year...

You can read the story and see the various trades he made here: http://en.wikipedia.org/wiki/One_red_paperclip

These trades happened all over North America, and were done as somehwat of an experiment. However, it has always had me thinking about how this can be applied to basic investment strategy, and with real estate in particular.

I'm just getting my feet wet into actually buying/fixing/and holding properties for my own portfolio after doing 60+ wholesale deals these last 2 years, but through 1031 or like-kind exchanges and such...can't this same strategy be applied directly to real estate? ie. trade up from a 1 br apartment to a 250 unit apartment building, through realistically attainable deals, rehabs, financing, and value plays?

Do you see any issues that would arise with this? Or is this generally the idea in the first place and it took me "the red paperclip" to fully grasp wealth building...?

-Dan

Dave Toelkes · Answer

Steve Babiak,

You may have misunderstood the question I am raising.  I have no problem with exchanging raw land for a rental property.  This satisfies the like kind rule and as long as both the relinquished property and the replacement property meet the Sec 1031 qualified use rule, the exchange can be tax deferred.

Dan posed the question of whether it is possible to start with a small 1 BR apartment and, through a series of 1031 exchanges, end up with a 250 unit apartment building.  Dan referred us to the bartering story as an example of how a number of sequential trades were used to trade something small and inexpensive for something big and costly.

Of course it can be done in a series of taxable events in a fashion similar to the paper clip story.  But Dan wants to use 1031 exchanges which implies that he wants the entire series of exchanges to be tax deferred.

The caution I was raising is that in a tax deferred exchange, both the relinquished property and the replacement property must be held for a qualfied investment use to validate the 1031 exchange.   A qualified investment would apply to property held for future appreciation (e.g., raw land) or to a property held for the production of income (a rental property).  There is no definite holding period specified in the tax code, though many exchange gurus suggest one to two years.  My concern is that I am not sure how Dan would convince the IRS that each property in each leg of the exchange was used for a qualified investment purpose if his holding period is so short that his intended "investment use"  for each replacement property acquisition is never clear.

Dave Toelkes · Answer

Tiger M.,

What you described as a "perfect" exchange IS a form of 1031 exchange.  It is a direct exchange that does not require a qualfied intermediary, but a §1031 exchange, nevertheless.

Your client who traded up could have taken advantage of the tax deferral benefit of a §1031 exchange if s/he had traded up in both equity and debt.

Aaron Mazzrillo · Answer

Only the first purchase requires 1 year of hold time before a 1031 can be used.

While I like the idea, if you haven't read the book, you should. You will learn that a lot of his trades were not as much about the item being traded as they were about the publicity involved. I'm not saying it isn't possible though. If you can find the right parties with the right situations, I'm sure you can put together some great trades.

You might consider looking for 1031 exchange events/meetings. I'm not sure they are as popular as they were 20+ years ago.

Tiger M. · Answer

Dave T I'm no CPA, just a natural born fool, so possibly they could have, but they chose not to after weighing out the situation. Balancing the equities kept the exchange a totally nontaxable event. Both parties used their own CPA's for advice BTW. 
From the IRS-Nontaxable Exchanges:
A nontaxable exchange is an exchange in which you are not taxed on any gain and you cannot deduct any loss. If you receive property in a nontaxable exchange, its basis is usually the same as the basis of the property you transferred. A nontaxable gain or loss is also known as an unrecognized gain or loss. On the link, click on the nontaxable http://www.irs.gov/publications/p551/ar02.html#en_US_2010_publink1000256980
I believe in most 1031's, there is usually a change in basis.

Jon Klaus Why not 1031? Because I believe the days of low capital gains rates are coming to an end. So why push off into a soon to be higher rate and stepped up basis when you could trade, then dispose of the asset in a traditional sale and take a paper loss? This is one of those topics that is defined by each individuals situation at the end of the day.

Jon Klaus · Answer

Why not, Tiger?

Tiger M. · Answer

We call these perfect exchanges. No 1031 involved. Straight value for value. I just closed a deal in October with 3 free and clear single family homes and a vacant 2.5 acre parcel traded for a 14,000 SF commercial building. In our case, our clients moved out of the commercial because they no longer qualify to renew a $1.9M loan. The other party wanted the greater cash flow and was willing to guarantee the commercial loan. Motivation is the finesse in these deals. I was very skeptical and it took me years to understand why people would be interested in doing this and how the IRS views it. I will never do another 1031 again. The investors in this deal that received the houses and land, will be taking big paper losses in 2013, even though they break cash even.

Steven Hamilton II · Answer

Dave T,

I agree with you.  Although based upon the appreciation, held for investment rule does not specify "held for investment" very well.  You could definitely argue that it was done if not a very high percentage of funds were added into the property.  Don't forget that you CAN purchase a property for less than the prior one and use the gain toward improvements as long as it is drawn from the QI.

I would argue that depending upon his frequency of trades, he could justify it if he regularly trades properties back and forth.  I would request a Private Letter ruling on each and every one if the value of the exchange was there.

-Steven

Dan Schwartz · Answer

OK, so in this instance, all properties would need to be converted into a performing investment before simply swapping deeds with someone via a 1031. So, it would require some capital, or just resourcefullness, to renovate/rent the assets.

However, that will make it easier to "trade up," because now you can exchange a turnkey single family home for say a vacant duplex. The seller of the duplex is just a motivated seller, but will gladly take a performing, cashflowing asset instead. Now, you will own a duplex with some equity, and you can rinse and repeat the process and trade up to a fourplex next...slowly raising your cash flows and property values as you continue to trade up your turnkey properties. It would be a proces of delayed gratification and forced appreciation...

Steve Babiak · Answer

In addition to what Dave T just said, there is a "like kind" requirement to be met as well - so no way to go from a paperclip to real estate via 1031 exchange; but from one kind of real estate to another kind of real estate, now that is permitted in a 1031 exchange.

To answer the question raised by Dave T - I believe you can have some kind of raw land that you purchase, and then later relinquish via a 1031 exchange for say a house or apartment building.  The raw land had never been developed, so it never even produced income, but I believe that would be acceptable as the relinquished property in a 1031 exchange.  And you would probably have to bring additional money into the deal to buy an apartment building this way.

Jon Klaus · Answer

If capital gains taxes go up substantially I believe the section 1031 exchange will become well used again.

Craigslist's "Red Paperclip" Story...applied to real estate?

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