1031 Exchange Trifecta - Unlocking Tax-Free Real Estate Profits

Most of us have a general understanding of what a 1031 exchange is. However, most people have not done one or know someone that has. At JB2 Investments, we have completed three 1031 exchanges in the last 24 months. As such, we thought we would share with you the combined power of all these exchanges and how if planned correctly, a 1031 doesn’t have to be a stressful ordeal.

What is a 1031 Exchange?

 “Broadly stated, a 1031 exchange (also called a like-kind exchange or a Starker) is a swap of one investment property for another. Although most swaps are taxable as sales, if yours meets the requirements of 1031, you'll either have no tax or limited tax due at the time of the exchange.” -Investopedia

 To begin, you will want to hire an intermediary to help you with the 1031 exchange process. This professional will guide you to make sure you stay within all the rules and regulations. The intermediary is also the party that holds your funds in a trust to later be deposited into the escrow for your new purchase.

 There are two major time constraints that you should be aware of:

 1.)   45-day selection period- Within 45 days of selling the relinquished property, you need to designate three properties in writing to your intermediary, of which you need close one.  

 2.)   180-day closing period- Within 180 days of selling the relinquished property, you need to close on one of the designated properties. 

 Lastly, you also need to buy real estate that’s of equal price or higher. Additionally, you need to have equal or higher debt than you previously had in the newly purchased property. Of course, there are more rules and every situation is different. Thus, consulting with your intermediary and CPA is of utmost importance.

 The First 1031 Exchange

 First of all, these exchanges came about because we looked at the actual equity we had in properties, and the return on that was 3-4%. By equity, we mean the value of the property minus any debt against the property. We knew we could do better than a 3-4% return on that. 

We completed the first exchange in April 2019. This was a duplex that was bought in April of 2010. Before this time, we were talking to brokers in Kansas City and had possible property lined up before the sale. The one complexity we had with the sale of the relinquished property was that one unit was presently occupied by a lower-paying tenant. So that made some buyers shy away.

We did end up getting into escrow at a good price and during the escrow period, we were able to negotiate for those tenants to move for $38,000. For context for those not familiar with Los Angeles rent control, that isn’t all that bad.  

So, we sold the property and after paying off the debt and closing costs we had about $700,000 to move into the next deal. At the last minute, an opportunity came to us to place the investment into a commercial property in Hollywood within an opportunity zone. In that deal, we were guaranteed a 7.5% return and the flexibility to be bought out after a year. So not only did that move $700,000 tax differed into the new property, but also increased our cash flow from $2,000 a month to $4,500. We are in a more passive position on that particular deal. 

The Second 1031 Exchange

The second exchange was completed in November 2019. The relinquished property again was a duplex that we had purchased in December 2011. We had both units occupied when we decided to sell that asset. One of the tenants was an easy negotiation and he moved out for $7,800. The back unit ended up being a bit of a fiasco. The back tenant had illegally moved in a tenant and they didn’t have the best relationship. 

We were dealing with our legal tenant. This other tenant thought we were trying to take advantage of the situation and sued us both for relocation money. We ended having to go through a lawyer-drafted settlement with each of them to get it done.  

At the end of the day, it was about $30,000 spent on the relocation of the tenants but it was a headache, nonetheless. After they moved out, we did some cosmetic upgrades to get ready for sale.

In the meantime, with all this happening, we were again in communication with brokers in Kansas City. From our previous KC trip, there was a deal on a building that we had walked mid-project. That was a property that worked for the metrics we were going after. We put that building in escrow while we were still in escrow for the soon-to-be relinquished property. We closed on the duplex in Los Angeles and had $500,000 ready to invest into the new 14 unit deal we had under contract. We did eventually get that closed though the loan was a bit challenging. We moved the $500,000 tax-deferred and increased our monthly cash flow from $1,400 to $5,000.

The Third 1031 Exchange

The third exchange was completed in September 2020. The relinquished property was another Los Angeles duplex that was bought in January 2010. This was an interesting one since one of us had lived there for two of the last five years. For this reason, we were able to exclude $500,000 of the gain from the sale and exchange the rest. This amount is for people that are married, and for single people is $250,000.

The main challenge was that we had sold on March 20, 2020 right when the COVID-19 pandemic was closing us down. Many sellers were in a wait-and-see approach, so there was little inventory to look at. We went into sale knowing we possibly wouldn’t find a property to exchange. We were fine with this, however, as a lot of the gain was going to be exempted and it was just such a large windfall in the first place.

At this same time, we were transitioning our focus to multi-family units out of state. So, we began the hunt by traveling to Kansas City, Memphis, and Oklahoma City. We were getting close to our 45-day deadline for selection. We ended up getting lucky because due to COVID, the IRS extended any deadlines that fell between April 15 - July 15 automatically to July 15.

Our original deadline was May 5, which got extended to July 15. This gave us an extra 71 days for a total of 116 days for selection. We got lucky and opened escrow on the selected property on June 30. The one caveat was that our closing deadline didn’t get extended since it didn’t fall between those dates. We had to stick with our original 180 days for closing.

We pulled it off and got it closed about a week before that deadline. We moved over about $400,000 tax-deferred into the new deal and were able to keep some substantial cash to the side. Additionally, we increased our cash flow from $3,000 a month to $4,750 with only about half the equity. This one was more stressful but because it didn’t feel forced, it felt better.

The Power of Three 1031 Exchanges

In total with the three transactions, we created about $2.1 million in gain either tax-deferred or exempted altogether. We also created an additional $94,200 a year in additional cash flow which is a 123% increase. Not to mention, we still had some money left to the side to invest in other future deals that will increase our cash flow that much more.

As you can see, there is power in the combined effort of implementing the 1031 exchange into higher cash-flowing properties. Though this all didn’t happen easily, we got it done without losing our cool. We do offer to others to help facilitate and manage the timing of their exchange into new deals we are doing, as long it's under some minimum parameters. Though things can get complex, the reward can be astounding and life-changing.