How I Beat Economic Armageddon Using a 1031 Exchange

Pacific Heights MansionThis guest article was written by Shilpan of Street Smart Finance, Common Sense Personal Finance.

Armageddon is viewed as a spiritual battle or struggle in the present age between the forces of good, i.e. righteousness, purity and virtue, and the forces of evil. Well, my battle wasn’t spiritual, but it certainly was righteous as it involved saving hard-earned money from the hands of our wasteful government.

Let me end the suspense here. It all began when I wrote an email to Sam asking if I can write an article for Financial Samurai. I wanted to write about why most people can’t retire early. Soon I received a samurai like response from Sam, “Maybe your $500k in tax-free profit in the depths of Armageddon? How anybody can make money anytime and the boon of real estate as a great tax shelter for singles and couples?” How can I say no to the guy who has uncanny ability to find catchy titles?

Let’s rewind back to 2004. The commercial real estate — especially hotels — market was doing well. Lehman was still considered a major financial institution. I bid on a Comfort Inn that was owned by the Laselle bank. This hotel was doing well, but the owner recently refinanced it, took over a million dollars cash out and happily handed the property back to the bank. It was ridiculously easy to screw banks back then.

I knew that hotel required a few hundred thousands in improvements. But, I calculated that in the price that I bid to make sure that I can run it profitably from day one, should I get to buy it. I knew that there were many bidders, so my hopes weren’t too high.

Luck knocked on my doors

This hotel generated most of its revenue in summer months. I renovated the property and increased ADR (Average Daily Rate) to capitalize on the improvements. As expected, hotel revenue climbed steadily for the first three years in a row. And then something happened. Do you remember that gas prices skyrocketed in the summer of 2008? To make things worst, my hotel depended heavily on loyal seniors traveling from the mid west to Florida during the summer months. Well, they stopped making trips to the sunny state.

As I was contemplating ways to cut spending amid revenue short fall, a gentleman offered me $2.4 million for the hotel. I found out that he had to invest his proceedings from another real estate transaction using 1031 exchange to avoid paying a handsome amount to Uncle Sam.

I figured the timing was ripe as my hotel revenue was sliding while this gentleman needed to invest in another similar, commercial real estate in 45 days. So, he was extremely motivated to complete this deal.

How I beat the Armageddon

As I was feeling a sigh of relief after selling the hotel on the day Lehman Brothers collapsed, my accountant advised me that I will owe about $110,000 in capital gains taxes ($545,000 profit plus $194,000 in depreciation at 15%) . Ouch! That was a shocker for sure.

Since I heard a great deal about the buyer who exercised 1031 exchange vehicle to complete the transaction, I quickly searched for the term 1031 exchange to find ways to betray Uncle Sam.

1031 Exchange

I firmly believe that American tax code is written by the landlords. There is no tax shelter available for the windfall stock profits, but there is a powerful tax shelter, 1031 exchange, for real estate owners to avoid paying any taxes on the capital gains.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. — 1031.org

As long as you can find a like kind real estate investment within 45 days of selling your real estate, you can beat the Armageddon. You have to find a qualified intermediary company to facilitate the transaction. These agencies are qualified by the treasury to facilitate the entire 1031 exchange process. You have to pay a small fee, but you are saving thousands or hundred of thousands in capital gains by participating in 1031 exchange process.

I found a shopping center and commercial land at a bargain due to the worst recession we were in the late 2008. The only caveat of the 1031 exchange is that you have to follow 45 strict timeline to enter into another like kind investment. Fortunately, I did find these investments after 30 days.

Uncle Sam is definitely not happy with those who betrays him, but you have to do what is best for your money. This is exactly why I think that the “Buffett Rule” won’t work unless we get rid of the progressive tax system and adopt fair tax. Do you agree?

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Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    Hi Shilpan,

    Thanks for sharing your story! That’s pretty sweet you had the ability to bid on a hotel! I don’t think that crosses many people’s minds.

    Some follow up questions:

    * What percentage did you put down and what type of rate (duration, interest) did you get?
    * If you didn’t sell the hotel, how much do you think it is worth now?
    * Why not just keep such incoMe producing properties instead for cashflow since cash returns are so low nowadays?

    Thx!

    S

    • says

      Hi Sam,

      1. I put down 15% or roughly $270,000. I took SBA 7A loan. Conventional loan on a commercial property requires 25+% down payment.

      2. In fact, current owner called me few months back and offered the same hotel for $1.8 million again. I countered him $1.4 due to current cash flow which is lot lower.

      3. This is exactly why you don’t want to hold commercial investment for too long. Hotels sell for multiple of 3 times revenue. When I sold, hotel had revenue of $800,000. Now, due to bad economy, it has revenue of $550,000. This hotel depended heavily on seniors traveling from mid-west to south.

      Thanks for the opportunity to share my story, Sam! I am humbled and honored.

      • says

        I missed part of your first question. I was paying 5.625%. Normally rate is higher when you finance through SBA as government gets cut monthly from the bank. The term was for 20 years. It’s hard to find financing on a commercial property for longer than 20 years.

  2. says

    I’ve always been intrigued by the Fair Tax because it is a direct shot at the leech that is financialization.

    Too much of our economy is simply moving money around to different buckets and collecting the coins that fall out each time our money is churned.

    While I’m no economist and can’t speak to the effects of switching to the Fair Tax, I do know that it will put a lot of people out of work, people whose only job is to collect taxes or help wealthy people avoid taxes.

    The Fair Tax would make the code understandable to almost anyone capable of earning a dollar.

    • says

      John, I would have not sold property if fair tax was enacted before I sold. I even go to an extent and believe that fair tax should be enacted at the state level as well. I was paying over 50K in just the property taxes.

      Imagine if I have 50K, I can hire 2-3 full time employees.

      I agree that this great nation can comeback financially strong in no time if fair tax gets enacted.

  3. says

    I love me some 1031 exchange. It’s a great way to keep all of your gains unrealized and get out of a business you don’t enjoy and into something else. It really is a great way to beat “Armageddon” as you call it. :)

    I have yet to do taxes for a person who has done this, but I’m chompin’ at the bit to celebrate victory with one of my clients who does! Pop those champagne bottles :)

    • says

      Jacob, American tax code favors real property investors. You can get so many tax advantages with real estate investment that normally are not available for the other types of investment vehicles.

  4. says

    Cptmrpants,

    You can do a 1031 exchange on any type of properties, whether they are single family, multi-family, or large commercial properties.

    I work for First American Exchange Company, on of the nation’s largest Qualified Intermediaries. Should you have any questions, feel free to contact me at 866-993-1031 or you can visit our website at http://www.firstexchange.com.

    Good luck!

    Carmine

  5. says

    Switching tax codes is above my pay grade, BUT I love 1031 exchanges. I also like 1035 exchanges for people who have ugly annuity products and need out. 1031 and 1035 are two of my favorite numbers.

  6. says

    Some questions about a 1031: Does the sale have to be completely done within 45 days or you just have to find a property and make an offer? I’ve also read that you have to name 3 potential properties, is that a myth? How strict is the similar property rule? Can you exchange single family home for single family home or do they have to be the same size, type, etc? Thanks.

    • says

      Great questions. First, You have to identify 3 properties within 45 days. This is very important as you are not allowed to go with fourth choice if you can’t invest in any of 3 properties that you identified.

      It has to be like kind, but you don’t have to have exact size or type. You can find rental apartment unit of similar investment dollars instead of another single family home.

  7. says

    Shilpan, forgive me if I am wrong, but is the goal to simply do the 1031 exchange and scrape off the result of: revenues – costs. Therefore they would receive a minor amount of tax on that as opposed to capital gains on the original real estate capital gains.
    What I’m still trying to understand eventually one will have to pay taxes (or the person’s estate will eventuall), when the real estate is sold off.
    I’m still trying to figure out why one would avoid paying 15% capital gains now, with the potential that capital gains rate may very well go up some time in the future.

  8. says

    You may be right that capital gains may go up. However, as long as you use 1031, you can escape paying taxes. The idea is to use that 15% leverage in your favor for long time to build substantial net worth.

    • says

      Perhaps a light is turning “on”. Effectively you’re saying that using the 15% capital gains tax extended for several decades has a vast multiplier effect via compounding. Thus when you start drawing down it is a one time hit of 15% (currently) for having to pay the tax. Hmmmm …. :-)

  9. Joel Corley says

    Another very important point is that if you do hold the property for a long time, then you depreciate the asset. A 1031 exchange also defers the depreciation recapture at a 25% rate.

  10. says

    I view this as a loan from Uncle Sam without interest to build your net worth. It’s hard to escape paying taxes unless there is no death tax on your assets. :)

  11. says

    This is something I knew nothing about, definitely a huge tax loophole. Not that I have any money to invest in real estate right now (besides my first house that I’m about to close on in less than a month and a half), but as long as this code doesn’t change it could be something to consider in the future.

    • says

      Agreed. Think how much government can get if I had to pay 23% sales tax( suggested by fair tax.org)? Fair tax can also bring money from the underground economy. Albeit this article is not about fair tax, it gives you an idea as to why it is so important to fix our 16 trillion dollar deficit problem by transforming current tax system.

      • says

        Tax code is a HUGE issue. If we could fix the tax code, we could fix our deficit problem….mainly because if there was ever enough political will to overhaul the tax code, there will be enough political will to also cut spending.

  12. says

    One of the best things about real estate and income property is the deferral of taxes. 1031 exchanges is is using the tax code to the fullest to defer taxes and build that balance sheet. I used a 1031 exchange several times when I owned income property. You eventually will pay the taxes, but why not in the distant future.

    • says

      Absolutely. No one can escape from Uncle Sam forever, but he is kind enough to let you invest his share for a long time to build your net worth. :) Congrats KC! I am ceaselessly amazed at so many smart people I’ve met in this great nation, who don’t pay attention to their tax bill. I am not against paying taxes, but I am all for lawfully avoid paying to build wealth.

  13. says

    Thanks for introducing me to this concept. I agree – the laws do seem to be written around those who own and invest in real estate. I’m impressed with your resume of resume of commercial real estate deals. You are quite ambitious to be making deals of this magnitude!

  14. says

    I totally see where you’re coming from. It’s a key part of life and as your guy above has said you need persistence. But as many others have commented in this blog I too don’t agree with all these rich people getting away without paying for tax’s. Here in New Zealand they are very strict.

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