Discussing the possibilities and future of the intersection of healthcare and commercial real estate
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Welcome to the 100th episode of this podcast. Today’s interview is with Dave Foster, The 1031 Investor. He shares how this investment tool can defer capital gains taxes indefinitely by investing strategically using a step up in basis and designing your exit strategy. He stresses that by using this investment strategy for income property investments, you never have to worry about the capital gains tax rate as you are always deferring your tax liability and creating more jobs as a result.
[2:08] 1031 exchanges for investment properties
In its simplest form, the 1031 exchange allows you to sell investment real estate. If you either have a significant amount of gain, or you have had it for a long time and it has significantly depreciated out on your tax return, then you can sell that and by purchasing new investment real estate, you get to indefinitely defer paying the tax that normally would be associated with that sale.
[3:13] Reverse 1031 exchanges
Dave refers to reverse 1031 exchanges as “the deep end of the pool”. The key to 1031 exchanges is that there is always a sale of real estate followed by a purchase, allowing you to defer the gain. A reverse exchange does not change that process, but what happens is that the qualified intermediary will actually take title to the new property before you close the sale of your old property. You can then hold that property for up to 180 days, while negotiating the sale of your old property. So you’re in control of your new property, but you haven’t closed on it yet and taken title – so it still qualifies for the 1031.
What is really powerful about that is that, first of all, it helps to mitigate some of the risk in the market. It’s easy to sell, but it can be harder to make a quick purchase. So by instead doing the reverse exchange, you have control of your new property. As long as you sell within the next 90 days, then the 1031 exchange works perfectly.
The other thing, particularly with larger assets, that this can be good for is that during that 180 day process you are not only in control of your new property but you’re also generating all the income off it. At the same time, you still own your old property and are generating all the income off that as well.
Reverse 1031 exchanges will cost you several thousand dollars more than a regular 1031, but they allow you to, in essence, double dip appreciation and income. You can take advantage of the appreciation on the sale and the cash flow from both sides, so they can actually be kind of a financial windfall in the right situation. They are, however, pretty complex and a bit pricey as well.
[5:32] The cost of doing a 1031 exchange
Dave says that 98% of the QIs (qualified intermediaries, or the people that do exchanges) make their exchanges fee-based. For a garden variety 1031, say of $1 million or less, you are probably looking at $900-$1,200. For a reverse exchange, you’re adding probably around $7,000-$10,000. They aren’t onerous, in terms of how expensive they are, compared to the bang you can get.
[6:14] 1031 exchange restrictions
The beautiful thing is that there is no restriction whatsoever on the limit. The restrictions on valuation are that, if you want to defer all tax, you must purchase at least as much as you sell and use all the proceeds to do that. Dave shares that his favorite client was a lady selling an $11,000 lot in southwest Florida. She paid $1,000 for it, so by the time she paid to do the 1031 exchange she was only going to save about $500. When Dave told her this, she responded, “Yeah, but that’s my $500 and I want it.”
It really comes down to convenience. There are some steps to go through and there are some time constraints, but if you’re more concerned with the hassle than with the result, then you don’t want to do the 1031. If you’re the kind of person that wants that $500, then do the 1031.
Dave points out that, inside of every healthcare professional, there lives a frustrated real estate investor. It’s such a great combination because they have trained for years (and decades in some cases) to make a lot of money for a relatively short period of time at an incredible cost of effort, personal life, and quality of life. So, what they can make that money do while they are practicing in their career is huge. We see many healthcare professionals that go into real estate investing as a sideline to gradually replace their medical income. They are able to borrow capital and generate a lot of capital on their own, so they can invest in real estate passively while also making it very lucrative for themselves. There is this great transition point where they are finally able to get out of the rat race and enjoy doing what they love to do, while being financed by their real estate portfolio.
[9:33] Exit strategy for real estate investors
Dave shares the 4 Ds of 1031 investing. The first D is DEFER, because that’s your goal. You buy a piece of property, it generates significant appreciation, and then it’s time to sell for whatever reason. You do a 1031 exchange, and two things happen. First, you defer indefinitely paying all that tax. Second, all that tax is used to buy more real estate.
The second D is also DEFER, because anytime you sell that new property and again do a 1031 exchange, you will indefinitely defer the tax and that tax goes to purchase your new real estate. As long as you own that property, you will never incur tax. That could be your last, or you might keep selling and buying using the 1031 exchange to continue to defer tax. This is where the power of the 1031 flexibility really comes into play, because when you sell you can use those proceeds to transition into any investment real estate located anywhere in the United States. So if you have enjoyed riding the appreciation train in Austin, TX, for the last seven or eight years, but now realize that when you buy properties you can’t rent them for an amount that makes money for you, now might be the opportunity to sell that Austin property that has highly appreciated in value and use the deferred tax and the proceeds to go buy properties in Kansas City, MO. Or maybe it is time to transition into commercial investing, or move to a different area. Maybe it’s time to go into short-term rentals because you kind of want a beach place. The 1031 lets you do that and continue to defer paying tax on the profits.
The conversion process we were talking about gives you the opportunity to convert properties into personal residences at any time, without triggering a taxable event. All the tax stays deferred, but you get a new place to live. What are you going to do with your old house? Well, that falls under section 121 of the IRS code, which lets you sell that property. If you’re married, you can take the first $500,000 in gain tax-free. You can do this as many times in your lifetime as you want, as long as you have lived somewhere for two years. So in essence, your only limitation is waiting every two years.
If you’re a medical professional, you typically don’t move that much. The average statistics on moving, however, show us that people move around every eight years. So if all you do is buy a property to live in, move, and sell it, you are going to have 7-9 times in your life where you can pull $500,000 tax-free. If you’re converting properties, you get sort of the same bang for your buck. So you defer the tax, then you move into it.
Once you move in, the rules are a little bit different. Before 2008, we were able to take the full amount on converted properties. Dave shares that he and his family took several opportunities to convert properties to primary residences, sell them, take the money tax-free, and put that into the “buy the boat” fund. That’s how they ended up buying a sailboat to live on with tax-free real estate dollars. Since 2008, you have to live in the property for two years and you have to have owned it for five. When you sell it, you’re only going to get to prorate the amount of gain between when you lived in it and when you rented it.
Here is an example. You do a 1031 exchange, rent the property out for a couple of years, and then decide it’s time to retire to that property in Sarasota. So you sell your house, put $500,000 pocket tax-free, and move into your former rental property and live at the beach. Maybe this property is next door to another rental property you own, also on the beach. You live in it for three years. Did you own it for five years? Yes. Did you live in it for at least two? Yes. So you get to prorate it, and you take 60% of the gain tax-free. You pay tax on 40% and recapture that appreciation. Then, you move next door to the other property. You can keep converting them throughout retirement without ever paying a penny in tax, except for the time when it was not a primary residence.
So, those are really the first three Ds. It’s possible, throughout your life, to never have to pay that tax. It’s really just a form of compound interest, which is an amazingly powerful thing. The fourth D, is DIE. So we defer, defer, defer, and then die. This is extremely critical, particularly for high net-worth individuals. When you die, assets you own will go to your heirs on what is called a step-up in basis. This means the tax disappears for them.
So what are the practical aspects of all this? Number one, you could never pay tax throughout your life. Number two, your heirs get assets tax-free; that’s legacy wealth-building. Dave says he has never found a statute that is more powerful in what it can do to the average individual throughout their life.
[18:18] An example of a reverse conversion
A reverse conversion is an awesome opportunity as well. Let’s say you have a property that you have $1 million in gain on, and it’s your primary residence. If you sold it, you get $500,000 tax free and you would have to pay tax on $500,000. If you move out and turn it into a rental property before you sell it, you can do a 1031 exchange because it’s a rental property. If you also live in it for two out of the five years prior to selling it, you get the $500,000 tax-free and do a 1031 to defer the tax on the rest. You can then go buy a new investment property, and you can mix and match this throughout your life. “It’s like a game of Monopoly,” Dave says.
[19:25] Moving from commercial real estate to rental properties
This is relevant for medical professionals, because they can invest in commercial real estate over and over again. When they want to start moving toward their exit plan, they can start buying rental properties to eventually move into for two years and then move out to another rental property and sell the first one.
Dave shares that his clients will do a kind of composite of everything. If they transitioned into commercial investing, they will typically stay there the rest of their lives because commercial investing involves very little tenant work and much longer leases. They will often die holding those assets, and they then go to their heirs tax-free. The rest of their portfolios, they will turn into maybe a series of vacation rentals.
[21:07] Capital gains tax rates
While Dave says they are seeing a huge uptick in 1031 exchanges, he thinks the tax rate is the bigger factor than capital gains. It’s not just gain, it’s also that tax writeoff of depreciation that you get.
If you look historically, all the way back to around 1920, you’ll see that aside from a couple outliers where capital gains was 40% and a little bit of time when it was zero, it has really fluctuated between 15%-25% the entire time. It really does not change as much as people think. He doesn’t stay up at night worrying about the gains rate, because whatever it is he can defer it by doing a 1031 exchange.
Dave points out that while big investors certainly do 1031 exchanges, small investors take advantage of them as well. The average size of a 1031 exchange right now is $400,000. If an administration were to put limits on 1031 and shut it down, a bunch of things would not happen. Realtors would not get commissions, title companies would not get closings, attorneys would not get to review docs, house painters would not get to paint houses, appraisers would not get to appraise, and it goes on down the line. What every one of those people have in common is that they pay tax on their income at ordinary income rates, which are much higher. So if they shut down capital gains, they are going to shut down ordinary income from a lot of other people and actually lose money in the process. Last year, the Senate unanimously voted to preserve 1031.
[24:47] Dave’s first job
Dave grew up on a farm, so he can’t remember a time when he didn’t have a job. His first real job was to push a shopping cart loaded with data documents across the campus at Kansas State University, delivering them from the data processing center to the various departments.
[25:34] What Dave would be doing if he wasn’t working in the 1031 industry
When 2008 happened, there was nothing going on. Dave took care of his private clients and he went to nursing school. He got his RN, because his wife was already an RN. They lived on a boat, and they wanted to go down to the Caribbean and do medical missions work in the islands. This is related to his pitch for doctors, as they can let their real estate take care of their bills and they can have fun taking care of people in outside-the-box ways.
[26:19] What Dave reads for news, information, or inspiration
Dave tries to limit his intake of news content. He allows himself to spend about five minutes per day looking at news headlines from whatever source. That has to go along with at least 30 minutes per day spent reading the Psalms and the Proverbs in the Bible, because that is where he believes wisdom truly is. Dave also spends at least 30 minutes a day talking to a live individual who he is not related to, allowing him to learn about people.
[27:03] What Dave does for self-care
Dave starts every day by making the bed. It’s the first accomplishment of the day, so he always starts on a positive note.
[28:36] Whether leaders are born or trained
Dave believes that man was created in the image of God. With deference to The Wizard of Oz, there are always parts scarecrow and lion within all of us. What truly makes a leader, the lion, is being willing to go somewhere they have already been that wasn’t so fun and take someone with them, or being willing to go into the unknown and take others with them. What makes that person is practice and experience in small doses.
The greatest way to get to a big goal is to start with small goals, and that’s all nurture. That is what is so important about raising our children to not be ignorant. Letting them do whatever they want will not turn them into leaders. Instead, they will fail on a massive scale. If we protect them for too long, the failures are too big to recover from. They never know what it’s like to face adversity. Invest in children, and teach them how to stretch themselves. This is how they will become true leaders.
Links to resources:
The 1031 Investor
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