Exchange Your Way Through Your Self-Storage Career

I have had a few people ask me how a 1031 tax-deferred strategy can support them as they create their self-storage business.

I just assumed everyone knew about 1031 exchanges, but I realize that unless you have a real estate background, how could you?

One of the absolute best benefits of using real estate to create your wealth as opposed to investing in the stock market, or building another type of company, are the tax benefits real estate affords investors.

Depreciation, interest write-offs cost segregation, and the ability to expense capital expenses now are some of the tax benefits that investors in other types of investments don’t get. But at the top of the list is the 1031 “tax-deferred exchange.”

I put that in quotes because I have heard it referenced as “a tax-free exchange,” and that is incorrect. Other than the person in the white house’s new “opportunity zones,” where if you hold a property for over ten years, there are no “tax-free” options.

In a 1031 exchange, you are just deferring your capital gains. Let’s dive into what a 1031 tax-deferred exchange is.

Section 1031 Of The IRS Tax Code

Section 1031 was not part of the original Revenue Act of 1918. In 1921 Section 1031 was created to allow “like-kind-exchanges” to happen. It has been modified over the years 1924, 1928, and 1935.

I am not a 1031 expert but have utilized them over the years. As a commercial real estate broker, I have been involved in numerous 1031’s.

Basically, a 1031 tax-deferred exchange as evolved as follows:

1. When you “sell” an Income producing piece of real estate, if you have certain language in your contract, that piece of real estate becomes the first “leg” in an exchange.
   1. Hers is the good news, income-producing real estate can be anything from raw land held for investment purposes to a self-storage facility. Yes, you could exchange raw land for a self-storage project, or an apartment building. Usually, this cannot be your primary residence. It could also be rental houses in evolved in 1031.
2. After the first leg of the exchanges closes, you have up to 45 days to “identify” a “replacement property.” Now there are some rules for the replacement property. Without getting too in the weeds here, they are:
   1. The 45-day rule. The 45-day rule. You have up to 45 days from the closing of the first leg to identify some replacement property.
   2. The 3-property rule. This simply means you can identify up to 3 pieces of like-kind replacement property “without regard to the fair market values of the properties.” Most people use this rule instead of the 200% rule.
   3. The 200% rule. Any number of properties can be identified as long as their combined value does not exceed 200% of the fair market values of the first leg.
   4. Replace the “value “of the debt. This is the most misunderstood and confusing part, in my opinion, of the exchange rules. If the first leg has $100,000 of debt on it, you have to replace the “value” of the debt. In other words, you could bring in $50,000 more cash and have a $50,000 loan. Or get the seller of the replacement property to hold $100,000, replacing the bank loan of $100,000 in leg one.
3. When the first leg closes, you do not receive the money. You can not have a “constructive receipt” of the cash. It has to go to a “qualified intermediary.” There are companies that do nothing but assist people in 1031 exchanges and have a long history of successful exchanges. I recommend these companies. In essence, your money goes into an escrow account for the purchase of the “replacement property.”
4. Then, you have 180 days to close on the replacement property from the date of the closing of the first leg.
   1. If the replacement property is less than the first leg, then the difference (“boot”) is taxable at capital gains tax.

The above is a very basic explanation of the mechanics of an exchange. There are a lot of different applications and variations of a 1031 exchange, including a “reverse exchange” where you buy the replacement property first. This episode is not going to get into these variations. You need an expert of a lawyer to assist you.

Just suffice it to say you can sell a piece of income-producing real estate, and if you replace it with another income-producing real estate under the guidelines above, you can defer your capital gains tax and roll it into the new property.

 

 

Using 1031 For Wealth Creating

The real benefit is how someone can use this in a wealth creating strategy. I will be the first to tell you I have missed the mark here and did nit use it s well s I could have.

But here is how it can work. Early in your career, you could buy a rental house or some small piece of investment real estate. It could be a small self-storage facility.

You own it for a few years and create some value. Let’s say you purchased a small self-storage facility for $500,000, have $350,00 debt on it, ands five years later it is worth $1.2 million. 

You sell the facility, utilize 1031. You now have $1 million in equity. Instead of paying capital gains on it, that $1 million goes into a qualified intermediary’s account and you purchase a $1.2 million facility and place $250,000 of debt on it. 

Five years later that facility is worth $2 million dollars and you exchange it for a larger project.

You get the picture. Utilizing 1031 to go from a smaller project into larger and larger ones.

Theoretically, over a 30 or 40-year period, someone could go from the $300,000 project into $30 million of self-storage.

But remember, at some point, one is going to be sold and all that capital gains are due. Right?

Well, almost. There is one way to beat the IRS. It’s not the best plan, but it works.

You have to die.

When someone dies, the tax basis in all their real estate holdings is stepped up to the then market value. If the estate sells it, all that accrued low tax basis is gone, and only the gain over the current market value is owed.

Who said when you die, you can’t take anything with you. You can take your low tax basis.

Conclusion

Seriously, utilize the 1031 tax deferred exchange as often as you can. You can utilize all your equity to purchase your next facility instead of 75% or less.

There are some very advanced exchange strategies I am not going to even attempt to explain. There are some I still can’t figure out, but I bet you could.

I have been a member of a local “Exchange” group for 30 years now. I am a past President of it. If there is an exchange group in your area, I highly recommend joining. I have dome many real state deals from there. 

In the book I wrote, where I had only a week left in the due diligence period and my investors pulled out, this exchange group is where I found my new partner.

I had a mentor early on introducing me to the group and said: “Go there until you understand what they are talking about”.

I am still a member.