GI157: 1031 Exchange Explained with Dave Foster

Dave Foster started fixing and flipping houses in the 90s and realized that about 40% of his profits were going directly to the IRS. He founded The 1031 Investor and is a qualified intermediary and consultant for tax saving strategies such as the 1031 exchange and the section 121 homestead exemption.

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Announcer:
Welcome to the Global Investors Podcast, a show that focuses on helping foreign investors enter the lucrative US real estate market. Host, Charles Carillo, combined decades of real estate investing experience with a professional background in international banking to interview experts in all areas of US real estate investing. Now here’s your host, Charles Carillo.

Charles:
Welcome to another episode of the Global Investors Podcast; I’m your host Charles Carillo. Today we have Dave Foster. Dave started fixing and flipping houses in the 90s and realized that about 40% of his profits were going directly to the IRS. He founded The 1031 Investor and is a qualified intermediary and consultant for tax saving strategies such as the 1031 exchange and the section 121 homestead exemption. So thank you so much for being on the show, Dave,

Dave:
It’s great to be with you at Charles.

Charles:
So give us a little background yourself, both personally, professionally prior to getting involved with your current business.

Dave:
Yeah, well, that’s actually the impetus part of the impetus is part of the story we were. My background is that I’m a great accountant but like so many people who discover that there’s more to life than just work way back in the early to mid nineties, my wife and I were both in fairly high profile careers and this magical thing happened. We had our first child and, oh my gosh, I don’t know if you’ve got children or those that do you realize the first thing you do is you throw the TV away cuz you don’t need it anymore. <Laugh> you sit there and watch this little bundle. And we realized that life was a lot different than just let’s make money and have double income. And that there’s time is what we really needed. So we started to embark upon a decade long search for our week at best maximize time or minimized time maximize the amount of time that we spent with our family.

Dave:
That was the goal. And just like, you know, the folks that, that tune into you regularly, we’re looking at how to develop lifetime sources of income that minimize the time we spend in them. And so right off the bat, you know, just like everybody else, one of the first things that popped up was, well, heck let’s just become real estate investors easy as that. Right. <laugh> so I did a typical day. I ready fire aimed and bought a duplex in Denver, fixed it up and sold it. And man was I the coolest guy till I went to my accountant that fall <laugh> and he said, boy, you know, a lot of tags. And that was the moment when I truly realized that no matter where I went as a real estate investor, I had a silent partner and his name was uncle Sam. And he was not gonna let me make money without him taking his bite out of the tax apple.

Dave:
And I just saw that, that wasn’t gonna work for our model because we wanted to be out in 10 years. Our specific goal was he wanted to live on a sailboat and raise our family, which is kind of weird, cuz I’m from Kansas. My wife’s from Minnesota. We lived in Denver. There’s not a lot of ocean there <laugh> but it just seemed like the thing to do so right at that moment in time, now this would’ve been Charles mid nineties mm-hmm <affirmative> there was a huge court case that had been settled on this statute of the IRS code called 10 31. It’s been part of statute since 1920, but everybody for 25 years had been waiting for this court case to settle out. And it was settled in favor of the taxpayer. There’s a miracle by itself. And all of a sudden now from that moment on regular investors in real estate, moms and pops and Daves and just general people were going to be able to sell investment real estate and buy new investment in real estate without having to pay tax on the profits.

Dave:
You use the tax to leverage what you buy. So it’s a form of compound interest where the tax or profit you use to make more profit, which then you use to make more profit on profit. What a powerful tool. Yeah. And we discovered that and I said, well, that’s it for me? This is what we’re doing. And so that’s exactly what we started. And of course some friends of mine started a business. They said, Dave, do you wanna? I said, you know, this is so good for me. It’s good for others as well. So it was really out of the sense of boy. I’ve got something that can really help people. And I’m like Switzerland, I’m everybody’s best friend because the IRS requires that you use a qualified intermediary. So we’re just the ones that help people take advantage of it. And so that was kind of how we got started in it. And low and behold, if you fast forwarded 10 years to the day to the week, we took off on our sailboat to raise what ended up being four boys. Wow. On a sailboat, buying the sailboat and having our cash flowing real estate without ever paying another penny in capital gains tax.

Dave:
Wow. It’s that powerful?

Charles:
Wow. so give us for investors that haven’t heard of it or are not aware of the specifics. What, what is the 10 31 exchange?

Dave:
So it was originally designed for in particular cash trapped farmers. Mm-Hmm <affirmative> because we’re coming out in 1920, we’re coming out of the agricultural era, going into the industrial slower farms are starting to consolidate and we’ve got the rise of corporate farming just starting. And what happened was, if a farmer wanted to sell a farm to go buy a bigger farm, many times they weren’t able to do that because by the time they paid the tax on the profit, there wasn’t enough left to go buy the bigger farm. So this was meant to incentivize land ownership and increasing your real estate holdings. And that’s exactly how it works today. So someone who starts out maybe like me, I buy a little duplex, but when I sell that duplex, instead of just paying tax on the profits, maybe I’ve got a hundred thousand dollars gain. I reinvest all of that to go buy two small duplexes or maybe a little larger fourplex and that a hundred thousand dollars of profit, which would’ve cost me $20,000 in tax ends up going towards the purchase.

Dave:
Mm-Hmm <affirmative> and that’s what you just keep rolling forward. We do a really interesting spreadsheet performer for, for folks. When we teach classes where in four transactions, over 20 years, two investors can do have the exact same occurrences, the exact same profit appreciation, everything, but they differ in one aspect. One investor takes the 20,000 in tax 20% and defers it and uses it to buy new property. The other investor pays the taxes. They go, that’s all they do differently. And at the end of 20 years, Charles, the investor that does the 10 31 exchanges owes almost $500,000 in tax. Wow. But they own almost 12 million of real estate. The other investor doesn’t owe a penny in tax, but they only owe about three and a half million in real estate. That’s how much buying value there is in that deferred tax. And that’s what 10 31 lets you do sell investment property, buy investment property and indefinitely defer paying the tax.

Charles:
Wow. That’s that’s extremely powerful. So there was one other thing that you you’re you’re that I’m not aware of. I’ve heard 10 31 and I’ve done ’em before, but with this other one it’s you move throughout the us for 10 years using a section 1 21 homestead exemption. What is that?

Dave:
That is that’s like that’s the gasoline that goes on top of the 10 31. <Laugh> it’s actually the most, I think in my mind, the absolute best tax strategy for anybody, because section 1 21 allows you to sell a piece of property that you have lived in as your primary residence. And as long as you have lived in it for two out of the five years prior to selling it, mm-hmm <affirmative> then you get to take, if you’re married the first $500,000 of profit tax free, you don’t have to reinvest. It’s just free because it was part of the old statute. Again, trying to encourage home ownership mm-hmm <affirmative> and if I stay in a starter home forever, then I never sell that. And the next person coming along, can’t get their starter home. So it’s designed to let you progress throughout your life. Now remember that the statue says you have to have lived in it for two out of the five years prior to selling it. So if all you do is buy a house, living in it for two years, sell it voila. The profit is tax free and here’s what’s incredibly cool is that you can do this once every two years. Wow. Wow. So throughout your life, if all you do is buy outs, move into it, live in it for a while and then sell it. You will be the benefactor throughout your life. Probably eight to 10 times of a tax free gift from the government. Doesn’t get much better than that, right? No,

Charles:
No, it, it doesn’t at all. That’s fantastic.

Dave:
Here, like it’s kind of cool though. Well, go ahead. I’m sorry. No, go on. Go on. Well, I was gonna say where it gets kind of cool though. And what we did is we figured out to combine section 1 21 and section 10 31. So what, because there is 10 30, 1 is only for investment property. 1 21 is only for your primary residence, but when you do a 10 31, you don’t have to leave that property as investment forever. You can convert the property into your primary residence after a period of time. And there’s not, it’s not a taxable event. So what we did was a whole series where we would buy an investment property, use it, make the money off of it, do a 10 31 exchange, buy more and then periodically we would move into one of those and convert it into our primary residence. Two years later, we could sell that property.

Dave:
And prior to 2008, we could take a hundred percent of the gain tax free. So that tax free money became the war chest for the boat because it was tax free. And we kept 10 31 in, I had you and I were talking before the show about Connecticut. So when we were ready to move from Colorado to Connecticut, we 10 31 to Connecticut. And then when we moved there, we simply converted one of our investment properties and did the same thing to move to Florida. So all along the way, we’re positioning real estate as investment to provide income, but we’re also periodically pulling out tax free dollars that we use to buy the boat.

Charles:
Interesting. So I would imagine to do the conversion, it’s the two years in the property to do the conversion from 10 31 to 1 21. Is that right?

Dave:
Yeah. That’s part of it. Mm-Hmm <affirmative> the statute says that with 10 31, when you do one and buy the new property, your intent has to be to hold that property for productive use. So you can’t just buy it, meaning to move into it. Yeah. You’re buying it to hold it as an investment, but most folks feel that anytime after a year or so, you’re okay to convert it. There’s actually a safe Harbor from the IRS at two years, you use it for investment for two years, convert it to your primary residence, no issues at all.

Charles:
Oh.

Dave:
And then once you’ve lived in it for two years after that, then it would be eligible for you to sell. Now, the only thing that happened was that the IRS I’m pretty sure they got a picture of me up in their lunchroom. Because they figured out this was happening and in 2008, they tweaked the statute a little bit. So that now when you do this kind of conversion from investment to primary, you only get to prorate the gain, but you still get part of the gain tax free. Yeah. And that’s a whole lot better than not of it.

Charles:
Yeah. That’s great. Especially for people. I mean, we’re both down here in Florida for people that are moving to these areas and they they might be buying a property first. Like my parents did, they bought a property, they rented it and then they moved into it down Florida. So that’s it’s yeah. I mean I can definitely see it in a lot of these areas where retirement friendly, let’s say areas or retire, big retirement areas where people can do that. So that’s, that’s awesome. The one thing I wanted to talk about, which you made a point when I, when I met you, you were presenting at a meet up years back in Tampa, pre COVID and you had talked about what is a qualified intermediary and, you know, can you, first of all, explain what that is.

Dave:
Sure. So qualified intermediaries are folks like me that perform the 10 31 exchanges on behalf of an investor. One of the quirks about section 10 31 is that the Iris requires that you use the services of an unrelated third party. They cannot have a relationship with you other than doing your 10 31 exchange. So your attorney can’t be your qualified intermediary, your realtor, your sister, or your spouse’s gotta be unrelated in every way. And their role is to document the exchange at the sale and at the purchase and to hold your proceeds while you’re shopping. Because the other big part of the statute is that the Iris does not allow you to take possession of the money. It has to go into escrow, but by using a third party by not touching the money, that’s what allows you to do the 10 31. So folks like us, that’s all we do because I can’t, I mean, I’m an accountant, but I can’t do your taxes in my firm were attorneys and accountants, but we can’t do wills or trust for you. All we can do is process your 10 31 exchange. And that’s the role of the qualified intermediary.

Charles:
Okay. Now this is one thing that you had talked about at the meetup. And I remember it, and this is why I want to bring it up. Was that the proceeds now picking an in a qualified intermediary, if you’re not picking the correct one, it could put, if they get into like legal litigation, right? Your, the, the qualified intermediary, you pick the firm, you pick your firm, your funds, if it’s in their possession, incorrectly could be, I mean, could be at risk. Can you explain how that kind of works or what, what you have to look for when you’re picking one of these QIS?

Dave:
You know, it’s see, it’s one of those things where 99.9%, oh, the QIS in America are solid companies.

Charles:
Mm-Hmm

Dave:
<Affirmative> you know, once every 10 or 15 years, somebody goes off the rails and does something stupid deliberately, and they get caught and then they go to jail and share a, so with Bernie Madoff and, you know, that’s how it goes. Yeah. But to come combat that you want to be able to have your proceeds as protected as possible. And unfortunately, if you have ever tried to file a claim on a homeowner’s insurance policy or a, for a car wreck, you realize a couple things. Number one, you’t all that easy. And number two insurance doesn’t do you any good until there’s already a problem

Dave:
And process that for a minute, right? Mm-Hmm <affirmative> we like to boast about how much insurance we have. Why do we have insurance on my house in case something goes wrong? What if I could magically prevent something from going wrong? I wouldn’t be nearly so eager to worry about what my insurance was, right? So we have created a focus. There’s a few QIS in America that, that, that will follow this, where we try to preempt that. So most qualified intermediaries, title companies, attorneys, and everybody else of that will keep a large as grow trust deposit, which means your 10 $31. And my 10 $31 are all in the same bank account. Mm-Hmm <affirmative>. Now it doesn’t mean that we’re at risk because they’re gonna walk away with them. But what happens if I have to file a bankruptcy or maybe one of my, or get a divorce?

Dave:
The first thing that happens in that situation is that there’s typically a receiver appointed by the court. And the first thing the receiver does is freeze am all where all my money is until they sort it out. Now, does that mean that your money’s gonna be a risk? Absolutely not, but might your money be tied up long enough that you miss a critical time date? And that’s always been my fear. So we do things a little bit differently instead of having a pool trust account, we use individual F D I C accounts for every exchange. So imagine that we’ve got like several hundred bank accounts open at any one point in time, thousands over the course of a year, which is kind of a logistical nightmare <laugh> but what it does for you is so incredible. Yeah. Because now your funds are in an account in your name.

Dave:
Nothing’s gonna happen without your signature, without your knowledge. And nobody else’s accounts can hinder or cause issues with yours. Secondly, if their F D I insured, and because we use a commercial bank, they’re always insured to the total of the deposit, as opposed to just the normal maximums. So it’s F, D I C insured. It’s totally under your control, but the IRS agrees that because it takes both your signature and our funds that, that keeps you from having receiving the money. So in one fell swoop, just a little extra step on our parts, save you any of the headache.

Charles:
Well, that’s, that’s fantastic. And that’s something that I haven’t heard of prior to listening to you and meeting you. So that was something great. And that our listeners can really take into consideration when they’re choosing, if they plan to go down this path. One thing before you wrap up and we touched on it right before recording, about half of our listeners are international, and I don’t wanna get too deep into it, but if you just can gimme a broad overview of what an international investor has to worry about who they should and have the conver. So they know to have this conversation with their QI at this point you know,

Dave:
You bet there is a five letter acronym that actually creates a four letter word for foreign investors. And it’s F I R PTA feta, which stands for foreign investment in real property tax act. It’s six, sorry, that’s the account of math in me, six letters that becomes a four letter word. So feta is a 15% withholding of the sales price of the property. When a non-US tax pay non-citizen, non-US taxpayer sells a piece of property and it’s required. They can get that back, but they have to file a tax return. And it’s pretty difficult for a non-US taxpayer to file a tax return. But one of the cool elements of that is that they are able to do a 10 31 exchange and that avoids the fer to tax.

Charles:
Oh, okay.

Dave:
Right. So they can do a ten third exchange, sell their property, go buy another property in the us and avoid having to pay tax and avoid ferta. Now, if they themselves are an ownership of the property, there’s a whole long list of hoops that have to be jumped through. So if you want to look at something like that way sooner, rather than later, you need to be getting some good counsel, but the best way to avoid ferta as a non-US based taxpayer is going to be to hold your property in us tax, paying entities.

Charles:
Mm-Hmm <affirmative> yeah.

Dave:
Such as an LLC and S Corp, whatever entity it is. If it’s a us entity in a 10 31 exchange, that is the entity that will be doing the exchange. And it’s just a regular 10 31 exchange. Okay. So that’s probably about the best 30 seconds we can give on that.

Charles:
No, that’s fine. Just, just so people are aware of it. If there are international, they have the situation or potentially will have the situation, obviously start sooner than later when you’re thinking of selling the property. That’s when you start doing your, your your research not after, when you’re closing in tomorrow, you know what I mean? So

Dave:
Although we do get those and we handle

Charles:
Them <laugh> I wouldn’t doubt that. I wouldn’t doubt that. David, as we’re, as we’re kind of wrapping up here, what are some common mistakes you see real estate investors make, it could be within taxes or within anything. I mean, you’ve been in this for so long in real estate investing.

Dave:
Yeah. Which really just means every mistake I see them make I’ve already made. So <laugh> so the real question is Dave, what mistakes have you made throughout your investing career? <Laugh> and we need another podcast <laugh> for this, that long, you know, real estate, like everything really. You’ve got to design it with an end in mind. You know, I joked at the very beginning about ready, firing. You can start that way, but real quick, if you want to maximize your profit, minimize your taxation and make it work best for you. You need to have that picture out there 20 years. What does my wife, what does my life, what do I want my life to look like? And then start backing it up. And that’s actually goal setting 1 0 1. You begin with what’s your ultimate goal. And then you say, now let’s start to break that up into bite sized goals. Each one of which is attainable and it’s measurable. And it always takes me toward my ultimate goal. So people that say, I wanna do a 10 31 exchange, Dave, my first question is why,

Dave:
Well, I’ve never done one before and I got to not a good reason why what’s gonna take you to your next step. That’s closer to your ultimate goal. Oh, well, Dave, I’ve had this property for 15 years. It’s got a lot of capital expense. That’s gonna start looming. I want to go buy something. That’s newer. There you go. That’s a strategic decision, Dave. I want to end up leaving in Florida. Perfect. That’s 10 31 from Texas and start buying in Florida. All of those things are part of strategy that has to wrap in a long term. Look, I’d say that’s that’s far and away. Number one.

Charles:
Okay, awesome. So how can our listeners learn more about you and your business, Dave?

Dave:
You know, the easiest way to find us is to go to the 10 31 investor.com. We have created an entire portal designed for today’s investors, nobody reads books anymore. So it’s videos. Nobody has time for long articles of scholarly nature. We try to make things available, accessible and understandable for the dumbest guy in the room, which is usually me. So if I can understand it, you and your folks will very easily, the 10 31 investor.com videos, calculators access to us, blah nine yards.

Charles:
Awesome. Yes. And I was I’ve I’ve spent some time on that website and there’s a ton of information. So if you have any questions or you wanna learn more about what this is, go to his website, I’ll put the link into the show notes. And thank you so much for coming on Dave and looking forward to meeting up with you again, face to face,

Dave:
Anytime in Tampa, right?

Charles:
Definitely. Definitely. So have a great week and I’ll talk to you soon.

Charles:
Hi guys! It’s Charles from the Global Investors Podcast. I hope you enjoyed the show. If you’re interested in get involved with real estate, but you don’t know where to begin, set up a free 30 minute strategy call with me at schedulecharles.com. That’s schedulecharles.com. Thank you.

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About Dave Foster

Dave Foster, Founder and CEO of The 1031 Investor.  Dave is a degreed accountant and serial real estate investor who is a qualified intermediary and consultant for tax saving strategies such as the 1031 exchange and the section 121 homestead exemption. Dave started fix and flipping in the 90s and realized that about 40% of his profits were going directly to the IRS. Dave tells us about the updated rules and regulations around using the1031 exchange to legally compound your tax interest that will stay with you instead of going straight to the government. Dave breaks down exactly how to use the 1031 exchange in layman’s terms. He explains to us how he moved his way from Denver, CO to Tampa, FL over 10 years using the section 121 homestead exemption, so that he and his family could move onto a boat (which was a huge dream of his). Tune in to listen to how Dave raised 4 boys on his boat while investing in properties with the 1031 exchange.

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