[00:00:00] Hi, everyone. This is the how to lower your tax bill 
[00:00:10] podcast. I'm your host, Terrence Hutchins. I'm, a financial and tax advisor in the Dallas Fort Worth area. And the goal of this podcast is to help you listeners get 
[00:00:20] educated on different tax strategies. That you can implement to improve your tax situation immediately? Each episode, we'll break down useful tax tips you can use to save 
[00:00:30] money no matter what your personal or business income situation. Because our motto is keep more of what you earn. So let's get into today's [00:00:40] episode. All right. Welcome back to another episode of the how to lower [00:00:50] your tax bill podcast. I've been going over a series talking about W-2 filers and how they use real estate to reduce their tax bill. 
[00:01:00] Today, we're going to dive into an area that actually applies to W-2 filers or real estate investors is this idea behind the 1031 or otherwise known [00:01:10] as the like kind exchange. So, the idea behind the 1031 was the fact that if you're investing in property [00:01:20] and you want to sell that property, what you do with those proceeds is what's going to impact your taxes. So, from the IRS's standpoint, they would like you to continue to invest because the 
[00:01:30] more you invest, the more you create housing for other people, the more you potentially might hire contractors. You employ real estate agents, you employ 
[00:01:40] attorneys, title companies. So, if you sell. properties and you buy new properties, that stimulates the economy. The IRS wants to incentivize this, but one of the barriers to 
[00:01:50] that is if you are to sell a property and you have a gain in that property, that it will discourage you from selling it because you have to pay taxes. The IRS stepped in and said, Hey, what if there 
[00:02:00] was an option to defer the gain on the property so that if you wanted to buy another property, you wouldn't have to pay taxes on it. This only applies though, if you're using it 
[00:02:10] for investment purposes. So, this is your primary house. It doesn't work. Okay. In fact, I'm going to talk about a court case at the end, where the IRS doesn't actually like you doing business with yourself. 
[00:02:20] So stay tuned for that. So essentially whenever you're doing this type of exchange, then you got to think of it like a company reinvesting their profits. So, if I'm a 
[00:02:30] business and I make profits, I can decide to either keep those profits.
I pay tax on them or I could put those profits back into my business and reinvest in things like 
[00:02:40] equipment, hiring people, whatever the case is. And then I won't pay taxes on those profits. Same idea with the real estate. Except when you're doing a 1031 exchange the 
[00:02:50] IRS gives you some specific rules that you have to follow number one you have to be the same taxpayer on the front and back of the transaction. So, for example I own a 
[00:03:00] property, I can't sell that property to a partnership I have to be the same entity. So, I can't say, hey, I'm a partner in this business and I'm going to sell it to another partnership that has different 
[00:03:10] partners. It has to be the same taxpayer. Now, there are some exceptions. If you sell to a single member LLC that you are the sole owner of, that's essentially you. So 
[00:03:20] the IRS lets you do that. Same thing with the trust or an estate. So the IRS will allow your estate to conduct a 1031 exchange if you pass away, or if 
[00:03:30] you sell to a grant or trust where you're the grantor, they'll let you do that. You also have to have what they call qualifying property, which just means this property has to be real 
[00:03:40] estate. In the past, prior to 2017, there was an avenue where you could actually make exchanges for non-real property. So, for example, if I wanted to trade a car for a 
[00:03:50] car, I could do that and not pay taxes on it is assuming I followed the rules. Now you can only do real estate for real estate. Pretty much. Now it doesn't have to 
[00:04:00] be the same type of real estate. You can go from land to building. You go from building to land, commercial to residential. So, you have the ability to exchange out. You could 
[00:04:10] even do, things that are considered real estate interest. So, for example, like a, a Dell store, a taxatory trust would qualify, natural resources depending on your 
[00:04:20] state. So, if I have land rights, if I have oil rights in land, I can exchange that for another right, depending on my state. But it has to be in the United States, unless it's one of the 
[00:04:30] territories like the Virgin Islands. So, you can't say, hey, I'm going to, trade a U. S. property for a property in Mexico. That wouldn't work. You also have to hold it primarily for 
[00:04:40] investment. Not for sale. So house flippers, this wouldn't work for you. And we'll get into that a little bit more in a second. A few other things that are baseline is going to be 
[00:04:50] around the purpose of the exchange. So, you can't do a 1031 exclusively just put it into another property. So, for example, if I wanted to buy [00:05:00] an apartment complex, I can't say, I'm going to go ahead and buy a restaurant building and then flip it into this apartment. You have to hold the first property for investment 
[00:05:10] and you have to hold the second property for investment. So, your intent is what the IRS looks at. Now they do give you a get out of jail free card where they basically say, hey, if you hold the first property for 
[00:05:20] two years and you've treated it as an investment property, meaning you've at least rented out for more than 14 days or 10 percent of the time, you can basically have that looked 
[00:05:30] at as a rental property or an investment property. Same thing on the back end. If your other property that you hold, because you could theoretically buy a property, hold it for investment, and 
[00:05:40] then sell the property, defer the gain, and then sell that second property. Okay, immediately thereafter or shortly thereafter So when you do those kind of things IRS 
[00:05:50] is gonna evaluate what was your intent at the beginning?
Did you intend to have this be an investment from the jump or were you just looking to basically not pay taxes to some 
[00:06:00] degree,is how they want to look at it. Now. There are some specific specialized situations so one of them is if you were to convert your rental property to into a 
[00:06:10] personal residence. We've talked in the past about the section 121, which I'll also point out how that correlates to the 10 31 here in a minute as well. But if I 
[00:06:20] own a rental property, I've been depreciating it, using it as an investment. And then I say, hey, you know what? I want to live in that property. And then I decide I want to sell that new personal 
[00:06:30] residence. The IRS has to make me wait five years instead of the traditional two. So, if I had just bought it as my personal residence, it would be a two-year hold. And then I could sell it and exclude my 
[00:06:40] gain. If I held it as a rental, I have to wait five years before I can sell it and exclude the capital gain. But I would still have to pay taxes on the depreciation that I took whenever I had it 
[00:06:50] as a rental. You also have rules against a related party. So, if I sell to someone that I'm related to, like my brother, my kid, my mom, then I have to wait for two 
[00:07:00] years to sell it. Or the original seller is going to have to pay taxes on the initial transaction. So just to simplify that. to make sure I explained it correctly. 
[00:07:10] if I own a property and I sell it in a 1031 exchange to my sister, my sister now has to hold that property for two years. If she immediately sells it, let's 
[00:07:20] say 30 days later, then I'm going to have to pay tax on the first property. So even though I would have bought a new property because I would have qualified for a 1031 in this case, I would still have to pay tax with [00:07:30] the old property because she didn't hold it for two years.
Unless I passed away or there was an involuntary conversion, so there's a few exceptions that are always there. But generally, you want to be 
[00:07:40] aware that, hey, if I do sell it to you and we know each other because that's something you do report on your tax return, I need to understand what your intentions are with that property because now I don't want to have to pay taxes on 
[00:07:50] money that I actually put into a new property. So, getting through the type of property, who you sell it to, and all that stuff. The biggest thing is the timeline. So, the IRS has 
[00:08:00] specific rules around when you can get this executed. So, number one, if I sell a property and I decide I want to do a 1031 exchange, meaning I want to purchase a new 
[00:08:10] property with the proceeds from the property that I just sold; the IRS tells me I have to identify the new property that I'm going to purchase within 45 days. So, I 
[00:08:20] have to document the properties that I plan to purchase or property or properties, I should say, within 45 days. So, it has to be written and it has to [00:08:30] clearly specify the nature of that property. So, I plan on buying apartment building on 123 Main Street. I have to do that. Now, if I decide, if I [00:08:40] change my mind. I have to then in writing specify that, hey, I'm not going to buy apartment building 123 I'm going to park by apartment building 456. So, I have 
[00:08:50] to put that in writing. I can't just verbally say it and it has to be with the company that I'm exchanging with The property that I identify they also have to follow two criteria. Or these 
[00:09:00] are your get outta jail free cards, I guess you could say. So, either I identify three properties. So, I say I'm gonna, buy property A, property B, property C. It doesn't matter how much they're worth. 
[00:09:10] Then I just need to close on one of those properties within 180 days for me to be able to defer the gain from my original sell. Or I can 
[00:09:20] identify more than three properties, but the fair market value cannot be more than double of my original property. So, if I have a $500,000 property that I'm 
[00:09:30] selling, I can't now pick four properties that are more than $1,000,000. Okay, if they're more than $1,000,000, then that wouldn't be qualifying for me 
[00:09:40] unless I close on 95 percent of those properties. So, in that example, if I say, hey, I sell a property is $500,000 and I 
[00:09:50] decide I want to pick four properties that total value is $1.1 million. I pretty much have to close on all of those properties to make sure that I didn't fail the test. Because if I 
[00:10:00] don't close on all four of those properties, then I would basically have to pay tax on the original investment and that. generally is not going to be good for me, in relation to what I'm trying to do. my timeline is 
[00:10:10] 180 days. Now, if you think about it, if I did this in February, then 180 days isn't going to impact me because everything is going to close in that tax year. However, if things extend to the next 
[00:10:20] tax year, then your 180 days is either going to be 180 days, or the due date of your tax return. So, if the due date of your tax return comes before the 180 
[00:10:30] days occurs, then you're gonna wanna do an extension on your tax return. And so let's say, for example, I do my exchange in November, so roughly we're looking at six months. So, I'm saying, okay, around April 
[00:10:40] timeframe, I'm gonna have to have closed this exchange. Well, my due date for my tax return. If it's a partnership is March 15th. So, either I have to complete my exchange by March 
[00:10:50] 15th, or I do an extension to where I can still get the full 180 days.
Now, my reporting is still going to go on my prior tax return. So even if I close this part, this 
[00:11:00] deal at the end of March, I'm going to report everything as if it was closed the prior year as far as how it's going to be reported on my tax return. Now, whenever I do this exchange, I have 
[00:11:10] to send them. I can't receive the money from the exchange. I can't say, hey, IRS, I sold this property and they sent me the check for the proceeds. And then I use that 
[00:11:20] money to go into a new property. That's going to work in a traditional 1031. So, you would actually have to use what's called a qualified intermediary. There's a few other strategies that you could do, but 
[00:11:30] that's generally the best place to do it. And that qualify intermediary, it cannot be someone who has an interest in this transaction. So, it can't be your attorney or your accountant or, you know, if a 
[00:11:40] company that you own a stake in. So, you have to have kind of a disinterested party that the money goes to. They hold the money in escrow. And then whenever you find the new property, they send the money to 
[00:11:50] your title company to close the transaction. So, as you're doing this, you're going to have two types of gain that are going to occur. You're going to have recognized gain and then you're going to 
[00:12:00] have realized gain. All right, so not to get too much into this jargon, but the realized gain is what you could gain. That's the amount that you don't want to pay tax on. So, if 
[00:12:10] I sell a property with a $200,000 gain, that is what's considered realized. However, if I execute my 1031 exchange. properly, then I won't pay tax on that 
[00:12:20] $200,000. If I was going to pay tax, it would be considered a recognized gain. So either I have recognized gain when I don't complete the 1031 correctly, 
[00:12:30] and so the whole thing blows up, and now I have to, report the full gain. Or, if I receive what's called boot. So boot is generally going to be money or a 
[00:12:40] reduction of debt that I take on in this property. So when you do the 1031, you have to trade up. So I have to go from a $500,000 property to a $600,000 property, right? I got to go 
[00:12:50] up and the debt that I take on has to go up as well. If the debt I take on goes down, then I'm actually going to have a taxable gain. So if I receive [00:13:00] cash or the debt that I take on is less than I'm actually going to have to have a recognized gain on that transaction. So I would basically pay tax on a 
[00:13:10] portion of my earnings versus deferring the full amount. OK, so that's important to be aware. And this sometimes can happen on accident. If my loan ends up being lower, then all of 
[00:13:20] a sudden I'm paying taxes. Or if you have what are called non exchange expenses. So like your loan origination fees. Your property taxes, your mortgage interest. You want to look at your escrow 
[00:13:30] statement or your buyer statement to make sure that whenever your company is paying those dollars out, if they're paying money towards property taxes, you want to say, Hey, I want to pay this money out of pocket because if [00:13:40] I pay the property taxes out of my escrow account, then that's considered boot in this situation, and you'd actually have to pay taxes on that property tax as if it was a capital gain. So you're going to 
[00:13:50] want to make sure that you pay attention to this, you work with a good company, and then you report everything properly. Alright, now there's a few other types of exchanges, that's considered a deferred 
[00:14:00] exchange, where you have the 45 days and the 180 day period.
There is also what's called a simultaneous exchange, where essentially you kind of buy one property in exchange for another one and it all 
[00:14:10] happens at the same time. And then you have what's called a reverse exchange. So just to simplify this, this is when I've identified a property that I want to buy. And I haven't 
[00:14:20] sold the property that I currently own. So if I can still. Close my transaction within 180 days, then the IRS will let me defer the gain on the new property, except I have to 
[00:14:30] buy that property. So I buy the property and then I park it. So I say, you know what, this hot new property came up. I don't want to wait until I sell my property to close it. 
[00:14:40] So I'm gonna go ahead and buy it now. I'm going to park it with what's called an exchange accommodation title holder. So that company is going to hold title to the property that I just bought while I'm 
[00:14:50] now marketing to sell my current property. And as long as I close the property within 180 days, I'm going to be able to defer the gain on the property that I sold after the property that I 
[00:15:00] bought. That's another way to potentially reduce your tax bill. If you decide that, hey, I got a sweet deal, but I have a property. I want to get money from to use towards it. 
[00:15:10] That could be a way to do it without you having to pay tax on the property that you're about to sell. a few other things to be aware of, you have your basis and you have your depreciation. So, your 
[00:15:20] basis is effectively what you originally bought the property for minus depreciation plus any selling expenses or exchange expenses. So that basis is what's going 
[00:15:30] to carry forward. So, think of it, you know, whenever you buy a stock. And you buy that stock for 100 bucks. That's your tax basis. So, when you sell it later for 200 bucks, you pay tax on 100 
[00:15:40] dollars. Well, in this case, if you bought that new stock for 200 dollars, and you were deferring the gain on it, and then you sold that new stock for 400 dollars, 
[00:15:50] you would pay tax on 300 dollars. Because the basis from the first stock that you were dealing with carries forward to the new stock, or in this case, your real estate. So, you 
[00:16:00] have to keep track of, okay, what did I buy that first property for? Because some people do this multiple times. They'll buy property A, they'll exchange it for property B, and they'll 
[00:16:10] buy property C, and they'll exchange property B in exchange for property C. So, they may have three or four of these that they do.
And they have to keep track of, okay, what was the original 
[00:16:20] basis or purchase price plus adjustments of that first property that I got? So, they can report this properly. in this dynamic, if you've done this multiple times, you probably want to try to 
[00:16:30] die with the property because if you die with the property, not that it's going to impact you per se, as far as, your tax saving.
I mean, it will save you taxes, but it's more so going to save your 
[00:16:40] beneficiaries. So, you basically swap till you drop is as they call it. So, I keep swapping properties. And then when I pass away, my beneficiary inherits it and they get to step up and base it. 
[00:16:50] So if I bought a property for $100,000, I exchange it for a $200,000 property and then a $400,000 property and I pass away and now that property is worth $500,000. If 
[00:17:00] my beneficiary sells it for $500,000, they don't pay tax on it. But if I had sold it the day before for $500,000, I would pay tax on $400,000. That's important to be 
[00:17:10] aware of that you can do this. Now, the other component of that is depreciation. This gets a little bit into the weeds, so I'm just going to touch on it just briefly so that you don't fall asleep on me and we 
[00:17:20] get to our tax court case. So, this occurs on every property, but it's more so related to when you are changing from a property that is like residential to commercial or commercial to residential. 
[00:17:30] So the IRS, because they have their own self-interest, they always say, okay, either you're going to depreciate your property on your current schedule. So, if I have a residential property, I'm 
[00:17:40] going to depreciate it over 27 and a half years. If I exchange it for a commercial property, then I'm going to have to depreciate it over 39 years. On paper, 
[00:17:50] for depreciation purposes, it's going to look like I have two different properties, except both of them have to be depreciated over 39 years.
So, if my first property had a basis of $400,000 
[00:18:00] and I'm adding another $200,000, it's going to look like I have one property that's $400,000, one property that's $200,000. I can elect out of this treatment and actually treat it as if I have 
[00:18:10] one property that is $600,000. Which allows me to now say, okay, if I want to do a cost segregation study, I can do it on the full value of the property versus having them split.
[00:18:20] 
If I don't elect out, I would only be able to do my cost segregation study on the new Value difference between the new property and the old. So if I had a [00:18:30] $400,000 property and I buy a $600,000 property, that $200,000 difference, that would be the only amount I could use for my cost segregation study. Versus if I decided to elect out of this 
[00:18:40] split basis treatment, then I can do a cost seg and then I can split the $600,000 versus just the $200,000. This also makes sense if you go from a commercial property to a 
[00:18:50] residential, because if I have two different properties, on paper, the IRS is gonna make me depreciate my old commercial property over 39 years.
If I say, hey, I want to 
[00:19:00] actually combine them into one new property on paper, then they let me depreciate the new property over 27 and a half altogether versus having my old property at 39 and my new 
[00:19:10] property at 27 and a half. So that's kind of technical. Obviously, you want to make sure that you work with someone who knows what they're doing so that you can report that properly. And then you can make the proper 
[00:19:20] election to ensure that you're tracking everything according to. regulation and you're making the best tax decision so that you ultimately can save more money in the long run. so a few other 
[00:19:30] considerations. You can't owner finance a 1031, so you have to have financing from someone else. You can combine multiple strategies. So, for example, you can do an installment 
[00:19:40] agreement with a 1031, but any payments that you receive in that installment agreement, that's going to be considered boot, at least up to the gross profit margin. So, I'm going to get 
[00:19:50] into installment agreements on a later episode, so don't worry, you'll come back and we can talk through that. But just know, if you do an installment agreement in a 1031, you're going to pay tax on whatever cash you 
[00:20:00] receive. You can also combine it with a section 121 exchange. So this makes sense if you have like a duplex, for example, and one side is a rental, one side is your personal residence. If 
[00:20:10] I sell that whole duplex, then the portion of my house that was my personal residence, I wouldn't want to pay tax on that at all. But I could say, hey, 
[00:20:20] that portion of gain that was attributed to the rental house, I can use those funds as a, as a 1031 exchange and buy another investment property. I can't use the 
[00:20:30] funds to buy a personal residence, but I can do it to buy another investment property and defer the gain on it. One other point that you want to evaluate is if you have suspended 
[00:20:40] losses. So, we've talked about the W-2 earners. If you are above $150,000 of income, you probably are seeing suspended losses on your tax return. Those losses get carried 
[00:20:50] forward until you sell the property or you have positive rental income that's taxable. If I have suspended losses, I would evaluate, okay, does it make sense for me to do the 
[00:21:00] 1031 because I could use those funds against my capital gain. So if I have $100,000 of suspended losses and I have a $200,000, capital gain, I could use $100,000 to offset that 
[00:21:10] $200,000. I could combine the two. I could say, hey, what if I took boot of $100,000? I can wipe that out with my suspended losses. And then the $100,000 of gain, 
[00:21:20] I can defer that on. So, you can play a little bit depending on the suspended losses you have. To try to actually take cash that's nontaxable. So that'd be a way to basically take advantage of 
[00:21:30] those losses before you pass away even if you're trading up on the, property. So now, let's get into a tax court case that's related to a 1031 exchange. 
[00:21:40] So this is Declean vs. Commissioner. And this actually happened in 2000. So, I'm going to give you the skinny behind it. And what some taxpayers try to do to be slick. And the IRS 
[00:21:50] sometimes catches it, sometimes they don't. But in this case, he owns property A, and then he buys property B. Now property B needed some work to it. And so, I don't 
[00:22:00] know his financials, but he wanted to be able to take the equity out of property A without refinancing it and without paying the tax on the gain.
So, what he 
[00:22:10] did is he took property B that he just purchased and he exchanged it to an outside company. But he pretty much had an agreement with that outside company that he would rehab 
[00:22:20] property B. So, he got a loan, he controlled the rehab process. So, he got property B looking how he wanted to. Then he said, hey, give me property [00:22:30] B and I'll give you guys property A. And he tried to not pay tax on property A for the gain that he would have had to pay if he hadn't done a 1031 exchange. 
[00:22:40] So he reported this, the IRS stepped in and said, no, you can't do that. And the reason they said that is because they felt like he never actually gave up property B, 
[00:22:50] even though he transferred it to this outside company. He controlled the process. He paid for the cost of the rehab. And so, they pretty much said a 1031 has to involve two 
[00:23:00] separate taxpayers. It can't be you basically sell this and you have a inside agreement to control what happens to it. And then you guys basically make this swap so 
[00:23:10] you don't have to pay taxes. So, the IRS blocked it. He went to court and he lost. And essentially, it just tells us that if you want to play games you gotta play by the 
[00:23:20] IRS's rules. He could have potentially made this look differently, but the intent behind it is really what the IRS is looking at and in their minds his intent was never really 
[00:23:30] to hold the properties both for investment.
It was more so to say, okay, I want to get property B, I wanna get rid of property A, but I want to control what property B looks like. And because he wanted to control property 
[00:23:40] B, that was not in their minds as if there were two different taxpayers. so hopefully this deep dive into 1031's was helpful. Now if you do have any questions, 
[00:23:50] we are gonna allow you to email us and we'll take questions on the podcast. So if you can email those two questions@. Logos, that's L O G S, [00:24:00] F G, as in frankgarry. com. So questions@logosfg.com and we'll address your questions on this or any other tax related 
[00:24:10] topic. So most importantly guys, keep more of what you earn and we'll talk to you next week