How 1031 Exchanges Can Grow Property Management
Today we’re joined by Eric P. Hoglund, Broker (DRE #01420325) with Estey Real Estate & Property Management. He explains the benefit of understanding 1031 exchanges for property management companies, even if your company doesn’t do real estate.
After doing a lot of traveling with the Navy, Eric decided he wanted to be closer to home so he could raise his kids and be with his family. His wife’s family had owned a property management company since 1946, and he began learning everything he could about the real estate and property management industry.
Eric knows that getting your real estate license doesn’t mean you know anything really important about real estate. Terms like ‘escrow’ sound scary, even to professional agents, and there are lots of acronyms.
When he closed on his first home, he was a licensed agent but still felt outside of the loop. The entire process made him nervous, and that allowed him to think about how his clients and his owners felt during this process.
He sees his mission as demystifying things for his clients. Currently, he’s managing around 300 properties and his company does between 15 and 20 million in sales.
Why do we have Eric here today as a guest on The Property Management Show? Because we’re talking about 1031 Exchanges, and that’s one of those terms that might need to be demystified. It’s a term that gets thrown around a lot. Everyone is aware that it exists, but not everyone is clear on what it is.
Defining a 1031 Exchange
The tax code scares people right away. But, a 1031 Exchange is not as complicated as people think. It’s simply a way to defer taxes.
This exchange is a way to move gains that you’ve earned on one property into a new property that you’d like to purchase.
Here’s an example. Let’s say you bought a home years ago for $100,000, and you just sold it for $200,000. That’s a gain of $100,000, and it’s taxable.
But, if you take that $100,000 and put it into another property, you can defer those taxes.
You need to buy a like property, but that isn’t as restrictive as you might think. It simply means you have to buy another income-producing property. So, you can sell a condo and buy a fourplex. For a while, everyone wanted to own a winery. It’s possible to sell a rental property to buy a vineyard.
One thing you need to know is that you never actually see that gain from the property you sold. The money immediately goes into an exchange holding company, and you’ll pay some fees. So, it moves from one escrow account to another.
Many investors find this is a great way to do business, especially when you don’t overcomplicate it. Some investors, for example, want to take their $100,000 gain and only roll $70,000 into the next property while keeping $30,000. It’s possible to do that, but you’ll have to pay your tax on that $30,000.
The 1031 Exchange isn’t mystical, but if you don’t know the rules, it’s easy to get into trouble. There are some timelines that are important:
1. From the time you close on escrow with the house you’re selling, you have 45 days to designate up to three different properties for your next purchase. You don’t have to close on those; you simply have to demonstrate that you’re moving towards a purchase.
2. You have 180 days after your first sale to close escrow on your purchase. So that’s six months. After that, you cannot leave the money there indefinitely. If it looks like you’re not going to close within those 180 days, get your tax expert involved.
When you finally liquidate and get out of the income producing property business, you’ll have to pay those taxes. But, the 1031 Exchange is a great way to stay in the business even when you’re ready to sell an investment.
It’s hard to escape taxes forever, but you can minimize what you pay. This is similar to what happens when someone inherits a property. If your parents bought a fourplex in 1962 for $40,000, and you inherit it when they die while it’s worth $1 million, that will seem like a big tax bill. But, you get a step-up adjustment, which means your tax clock starts ticking at $1 million. If you sell that property in two years for $1.2 million, you don’t have to pay a tax on the gain from the original $40,000 value. You pay on the $200,000 gain your property has earned.
This doesn’t always make sense. If you’re selling a property and you only make a few thousand dollars, the capital gains tax will be equal to or even less than the fees you’ll need to pay to the exchange company. It might not be worth it, but at least run the numbers to find out.
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Buying and Holding Real Estate Investments
Investors always grumble about how rich they’d be if they had just purchased a lot of Apple stock back in the day. Here’s something most people don’t realize: that house you inherited from grandma is actually your Apple stock. If you hold onto it, you stand to make a lot of money.
Real estate is one of those things that provides some great returns if you buy and hold. The richest people you meet will be rich because they bought a home and paid it off. Then, they bought a rental property and paid it off. Then, they bought two more rental properties – and so on.
The 1031 Exchange allows a lot of investors to hold onto the value that they’ve accrued in properties.
1031 Exchanges for Property Management:
What if Your Property Management Company Doesn’t Do Real Estate?
A lot of property management companies are 100 percent focused on management and they don’t do real estate sales. If that sounds like you, there’s still a lot that you can do to benefit from 1031 Exchanges.
A property manager has one of the more unique positions in the customer/client relationship. There’s a lot of trust between owners and managers; or there should be. It’s not an easy job to manage property. You need to understand a slice of the market that’s even larger than what real estate agents are doing. So if part of your business model is not to sell real estate, you still have a unique ability to have the owner’s ear. You can build in some value and some services.
Imagine this. Maybe you’re having a lot of trouble with an owner’s fourplex. There are problems with the roof and the foundation has some issues, and the market is good, so it might make sense to sell it. If you can get your owner thinking about selling that property, you don’t necessarily have to lose the business of those four units.
You can suggest your owner do a 1031 Exchange and buy a multi-family building with eight units. You can run the numbers on estimated rental values and occupancy rates. Your owner’s Realtor can take care of the sale and the purchase. You can look at deferred maintenance issues and help the owner decide whether the investment makes sense.
First, you’ve provided a valuable service to a client.
Second, you’ve developed a deeper relationship with a local real estate agent who just closed a sale.
Third, you’ve grown your own portfolio. Instead of managing four units for this owner, you’re now managing eight.
Everybody wins, and the win happened not because you were looking at your own bottom line – but because you were looking at your client’s bottom line. You’re the expert.
When Does a 1031 Exchange Make Sense?
Maintenance issues can tell you it’s time to look for a new investment property. There are other triggers.
First, it might make sense for your investment goals. Before any investor buys a property, he or she has to decide if the purchase is for cash flow or for equity. The beauty of real estate is if you hold the investment long enough, lines cross and you get both goals met.
But, your first question should be whether you’re buying for cash flow or equity. As long as the numbers work for you, an exchange is a good idea.
You should also consider a 1031 Exchange if you have an opportunity to buy in an area that’s growing. You’re looking for growth in both economy and population. Make sure you understand the market. This is another area where property managers are extremely valuable. An opportunity might look great in a specific market, but if there are a bunch of homes and no tenants to fill them – your investment will not perform.
Finally, know how long you’re planning to invest in rental real estate. You want to know your exit strategy so you make a smart decision when exchanging one property for another.
Property Managers Complete an Essential 1031 Exchange Team
Before investing or engaging in a 1031 Exchange, investors at every level will need to call in some experts. They need a real estate broker and a property manager. They need a tax person and an attorney. The team has to expand.
It’s tempting to focus entirely on property management, or to get comfortable managing properties and not understanding the benefits of selling homes or facilitating exchanges. But, investors and homeowners need a team to make the right decisions. Position yourself as a collaborator who will make people successful, and you’ll notice that the business will come. You may not do the buying and selling, but if you know how it works, the owner is more comfortable reaching out to you and including you on the team.
Relationships are everything.
A sin of almost every property manager is that they don’t reach out to their clients unless there’s a problem. Check in with your owners from time to time to tell them that everything is going well. Ask them if they’ve thought about selling any property or if they’re interested in picking up additional units. Maybe they’re not. But, they’ll know you’re thinking about their future and their opportunities.
Property managers are natural team builders. You’re required to wear a thousand hats every single day, and you have to talk to a lot of experts. You need to know a little bit about plumbing without being a plumber, and you need to know how a 1031 Exchange works, even if you’re not a real estate agent.
Different Types of 1031 Exchanges
Now that you understand the basic 1031 Exchange, you should know that there are other, more complex exchanges.
For example, there’s a Reverse Exchange where you already bought something and now you’re going backwards. It can be done, but it has to be done a certain way because you’ve already bought and sold.
For years, there was a trend where people wanted to shield themselves from the tax burden of selling rental property by moving into it. Maybe you have a rental and it’s never been your home. But, once you move into it for two to five years, it becomes a primary residents, and you can defer taxes without doing the exchange. You don’t even have to live there for consecutive years.
There’s flexibility. You can sell one rental home and buy another with the 1031 Exchange. There’s no limit on how long it has to be a rental, but your tax expert will probably say at least five years. You can move into it yourself to avoid the taxes, but you’ll have to live there for five out of five years.
Make sure you know the tax code or you work with someone who really knows the tax code. Things change all the time.
Property managers can utilize 1031 Exchanges by helping their existing owner and investor clients get more properties or better properties. Upgrade your portfolio by increasing your doors and the quality of those doors.
Stop looking at your bottom line. Look at your client’s bottom line. And, don’t discount yourself. You are a smart and intelligent property manager. You know what a good property looks like.
We hope you feel more comfortable with 1031 Exchanges, and that you know how it can help you build your property management business. If you have any questions for us or for Eric, please contact us at Fourandhalf.