All Forum Posts by: Anthony Freeman

Hello @Anthony Freeman,

We have completed over eighty 1031 exchanges to date, and our largest number of replacement properties in one exchange was five. It was a bit of a scramble, but it worked. In this post, I will discuss some potential pitfalls that can result in you losing your tax deferment.

Before I continue…

The exchange process is illustrated below:

The 45-Day Identification Period

The 45-day replacement property identification period starts when the relinquished property closes. Identifying the replacement properties is the first potential pitfall.

Although you are only required to identify replacement properties during the 45-day window, you may lose your tax deferment if you are unable to or choose not to close on them. This could occur if you are outbid or if a serious issue is identified during the due diligence process, making it not worthwhile to complete the purchase.

Our Process

Our goal is to put replacement properties under contract immediately after all contingencies are complete on the relinquished property. We then aim to close on the replacement properties as soon as possible after the relinquished property closes. Typically, cash purchases close about two weeks after the relinquished property, while financed purchases close four weeks later. The steps are illustrated below.

By utilizing this method, if something does not pan out with one or more of the replacement properties, we still have ample time to locate, put under contract, and validate (due diligence) another property within the 45-day identification period.

Movement of Funds

A regular question I receive is if a 1031 exchange agent is required. The simple answer is yes. If the funds touch your accounts, you lose your tax deferment.

Below is an illustration of the flow of funds during a 1031 exchange. The funds must move from the closing escrow agent to the 1031 exchange agent. When you close on the replacement property, the funds go from the 1031 exchange agent to the escrow company handling the closing. The funds must never be in your hands, or the 1031 exchange may be void.

Other Potential Pitfalls

• You are not allowed to use the proceeds from the relinquished property to pay for renovations. Some of our clients have opted to pay capital gains tax on a portion of the proceeds and use that money for the renovation.
• Not all purchase contracts include the 1031 exchange language. Make sure to have your listing agent obtain the correct language from your exchange agent for your state. The agent should include it in the agent-to-agent remarks, specifying that the 1031 text must be included in offers. If this does not happen, you can counteroffer specifying the required 1031 language.
• To fully defer the capital gains tax, you must reinvest all the proceeds from the sale into the replacement property. Any cash or other non-like-kind property received during the exchange will be subject to capital gains tax.
• To accurately determine the cost of the replacement property for tax purposes, it is important not to make any assumptions. Instead, obtain the required replacement cost from a 1031 exchange agent. We once had a client who assumed that their replacement property had to cost $300,000 or more, only to discover through the exchange agent that they actually had to spend over $500,000. There is no room for error in this process, so it is crucial to work closely with an exchange agent. If anyone would like a referral to a good 1031 exchange agent, DM me. We can provide you with the contact information for three exchange agents who are known for being easy to work with and highly knowledgeable.
• If there is an existing mortgage debt on the relinquished property, it's important to consider how it will be handled during the exchange. Any reduction in debt or cash received may be treated as taxable boot, resulting in potential tax liabilities. Do not assume, ask your 1031 exchange agent.
• Qualified Use Requirement - Both the relinquished and replacement properties must meet the requirement of being held for investment or used in a trade or business. Personal residences or properties primarily held for personal use do not qualify for a 1031 exchange.
• State Tax Considerations - While 1031 exchange tax deferments are allowed under federal tax law, not all states conform to these rules. It's crucial to understand the state-specific regulations regarding like-kind exchanges, as some states may not recognize or fully conform to the federal provisions. Consult with a tax professional familiar with your state's laws.
• The Biden Administration's proposed FY 2024 budget includes the creation of “capped deferral” for 1031 exchanges. In this proposed change to 1031 exchange laws, taxpayers in FY2024 would only be able to defer capital gains up to an aggregated amount of $500,000 for each taxpayer ($1 million for joint filers). Source. If you are considering a 1031 Exchange, 2023 may be the last year to do it.

Hope this helps,

…Eric

Yeah, that's a good question since REP status only makes sense if your primary job is a qualified real estate profession, and you can't qualify as just a W-2 employee (unless you own 5% or more of the company).  So, when does it really offset W-2 income?  A common scenario we see a lot is when there is a married couple filing jointly and one spouse has W-2 income and the other is a real estate professional (such as a real estate agent, or if the spouse manages their own rental portfolio).  It's perfect for that situation.

Aside from that, REP status can also offset your business or self-employment income.  So someone who is a real estate agent for commission is again a good example of that situation.

@Anthony Freeman Here are some of the LLC ownership requirements for DSCR programs that I utilize frequently:

o Program A: 1.00+ DSCR minimum, 80% LTV for purchase, 75% LTV for cash-out refi, 8.25-9.25% rates, good credit flexibility - any member with at least 20% ownership can be primary guarantor

o Program B: 1.10+ DSCR minimum, 80% LTV for purchase, 75% LTV for cash-out refi, 7.25-9.00% rates, strong credit helps - member with majority ownership can be primary guarantor, 50/50 split in ownership takes lower credit score of multiple borrowers

o Program C: 1.00+ DSCR minimum, 80% LTV for purchase, 75% LTV for cash-out refi, 7.5-9.00% rates, strong credit helps - any member with 25% or greater ownership must guaranty, lowest credit score of multiple borrowers used for rate pricing

As you can see, there are many different ways that a program may consider ownership structures. These are a few examples out of many, but generally these are the parameters that we have to abide by.

let me try it a little slower for the fast thinkers:

take out loan.

buy house.

rehab house.

get tenant.

build equity.

cash out refi.

repeat the process.

Now, I don't know how long this process takes you. Different investors are going to have different timeframes. What I do know is that the cash out refinance comes after you build equity. 

ALL I AM SAYING IS TO DO THE SAME THING FASTER!!!

Did you guys get that? F. A. S. T. E. R. Faster.

From what I think I understand about Buy, Rehab, Rent, Refinance, Repeat is that you are taking out a loan. Not all investors even do loans so not all investors do BRRRR. Thank you for stating the obvious. For the rest who are following along with the book - they are taking out mortgages on each and every property. The whole leverage thing you guys keep going on about.

The house is not the most expensive thing, the mortgage is. Ring a bell anyone? As such, on a typical 30-year the monthly payment basically amounts to the relative minimum payment on a credit card: it is the schedule that will have you paying the most interest for the longest period of time. 

Understandably, some would counter this by basically saying "who cares? as long as my property is cash flowing I don't care what the mortgage is! I'll keep paying that mortgage forever as long as the house is paying me!!!!" 

And I get it. Get paid forever. Who doesn't want that?

But you're also saying that you'll pay the maximum amount of mortgage interest over the life of all your loans for the rest of your life... as long as you're cashflowing positive.

Let's repeat that slower:

Pay.

Maximum.

Interest.

Rest.

Of.

Life.

This is not about rate. This is about interest volume and the fact that by the time that house is paid off (never for most of us it seems) you'd have paid "X" amount in interest costs far, far, far above the value of the underlying asset.

You know what I am talking about? Of course you do.

My revolutionary idea is to pay the mortgage faster... so as to pay less interest... so as to effectively redirect money I would be giving TO THE LENDER anyways... and using it to buy more properties instead.

It. Is. Math. Yawl are missing my point.

You can keep the loan for your entire life if you want. But why wouldn't you want to pay it faster or asked another way - why would you want to give all that interest money to the lender that you could otherwise be using to buy more properties?

And even for the "lending professionals" in the room: why wouldn't you want people paying off mortgages quicker if they were gonna keep coming back to you to refi every time FOR THE REST OF THEIR LIVES?

But hey, everybody has their own $0.02 including me. I'm just following the math and it makes sense to me: less money in lender pocket = more money in mine.

Yes @Andrew Postell you can craft all manner of creative arrangements to bake equity into a property but I'm talking a straight a BRRRR situation as the book spells out. @Sam Yin is on the right track with the HELOC and I'll add to that the same idea can be done even with a checking & savings account. With discipline and/or the right tools...

Pay loan faster. Pay less interest. Buy more house instead. The math is exponential over time - just like the interest we pay to the lender. Only difference is we're hopefully using that money to build our wealth and not the lender's.

Doesn't seem so radical a thought to me.