Independent Exchange Services (IES) is a full-service 1031 exchange firm that has been in operation for over 50 years. President of IES, Ian Bunje, joins us this week to share his wealth of knowledge on all things 1031. Justin and Ian dive deep into the details of how to execute a 1031 exchange, as well as a reverse 1031 exchange. If you ever had any questions on how to use the 1031 exchange to defer capital gains tax, how to determine a like-kind asset, or ways to secure lending, be sure to tune in to this week's episode to hear about it from a 1031 exchange expert.
In this episode, we discuss:
- What a 1031 exchange is and how it works. (1:55)
- Using the 1031 exchange to defer paying capital gains taxes. (3:30)
- Using the 200 percent rule to purchase multiple assets in a 1031 exchange. (6:09)
- How to recapture depreciation. (8:48)
- Identifying your buy-box criteria before you initiate a 1031 exchange. (10:58)
- The roles and responsibilities of a Qualified Intermediary (13:50)
- How to increase your 1031 exchange equity. (15:38)
- Defining qualified like-kind assets for a 1031 exchange, such as Delaware statutory trusts ("DST") and Tenant In Commons ("TIC"). (20:19)
- How to create an Exchange Accommodation Titleholder ("EAT") and overcome lending obstacles to execute a reverse 1031 exchange. (29:41, 37:48)
- Benefits of a reverse 1031 exchange over a traditional 1031 exchange. (34:52)
- Potential impacts of eliminating the 1031 exchange. (42:53)
- Section 121 exclusion.
- States that charge transfer taxes.
- Joe Biden’s proposal to get rid of the 1031 exchange.
- Starker Case of 1980 that started the 1031 exchange.
(1:27) Justin Alanís: Ian Bunje. Welcome to the podcast.
(1:30) Ian Bunje: Very good to be here.
(1:31) Justin Alanís: So I want to start, Ian, with a little bit of a high level question. You're an expert on 1031 exchanges. You run a company called Independent Exchange Services that helps people with their exchange services and doing 1031 exchanges and reverse exchanges. People always talk about the tax benefits of owning real estate and the 1031 exchange being a big reason why, so I'd love a really quick overview of what is a 1031 exchange and how does it work?
(1:57) Ian Bunje: Great. 1031 exchanges are used in the trading investment based property. Investment property can be commercial or residential. It could be raw land. It's basically any type of real estate that's used in trade or business. Now, an exchanger may have held on to a piece of investment property for a number of years and they purchased it at a, let's say a level of 500,000 and now it's worth a million. Well, the difference between that million and 500,000 is going to be as capital gain. Now, if you sell the property, they will pay their capital gains tax, but they have the option of doing a 1031 exchange into another piece of investment property. Now, if that piece of investment property is equal to or greater than their net sales price, then they will defer, not get rid of, but defer all their capital gains into the new property. Now, if they buy for more than a million dollars, let's say, then they would add that difference onto their basis and continue to depreciate it. Now, in addition to paying capital gains tax, if you were to sell your property outright, you would also recapture your depreciation as well that you've held on the property too. So there is a good amount of tax savings by doing exchanges, by rolling these over. Now, eventually, you will have to pay your taxes if you eventually sell that replacement property or you can keep exchanging over and over and over again. Really the only way around not paying your taxes is to leave the property to your heirs and they'll get a step up in basis. There's also some ways some folks will hold on to a piece of investment property for multiple years. If it's residential, then convert it into their primary residence, hold it for 5 years, live in it for 2, and then they can take their section 121 exemption, which is 250,000 dollars against a gain per owner. And that's one way people avoid paying capital gains taxes as well. So the taxes are gonna be different from state to state and how much stated income the exchanger has. Base federal taxes is 15 percent. It can go all the way up to 20 when you kick in state income tax as well. So that number can get can get up there.
(4:07) Justin Alanís: So in California for example, if I am in a high net worth bracket and I bought a 1 million dollar asset 10 years ago, let's say yesterday sold for 2 million dollars, I then have a 1 million dollar capital gains on that asset. And then in California, I would have a 37 percent capital gains tax on that 1 million, so that's 370,000 dollars. Is that accurate?
(4:37) Ian Bunje: Right. Well you probably will get knocked up to 20 percent federally, around 10 percent state. You have 3.8 percent for national health care. And then on top of that you have that recaptured depreciation at 25 percent. So you're gonna have something right around that area, especially in California.
(4:55) Justin Alanís: Okay, so that's a big cost that would normally eat into my overall returns. Huge cost, right? And so now what size of asset would I need to exchange into? Basically I've sold this asset for 2 million dollars. I have to find a new asset that's worth at least 2 million dollars, so that means I need to get leverage in this situation. If I roll my 1 million dollar gains into a new property, that's worth 2 million, because I have to buy a property that is of greater or equal value, right? And so if I then roll that 1 million dollar gain, I've got to then lever up another million dollars to buy a 2 million dollar property. Is that accurate?
(5:29) Ian Bunje: That's correct. As long as you buy equal to or greater than your net sales price and use all the equity that came out of the relinquished property, you will defer all your capital gains tax. Now you can also buy a combination of properties. In this scenario, you could buy two 1 million dollar properties and then split the basis between the two and split the gain between the two and still fall under the rules of 1031. So, you don't just have to buy one. Under normal circumstances you can identify up to three properties and choose to buy one, two or three.
(6:02) Justin Alanís: Got it. Can you do 10 properties? Can you allocate it into 10 single family homes?
(6:06) Ian Bunje: You could if you follow what's called one of two rules. One is the 200 percent rule, which means you can identify 200 percet of the gross sales price of the property that you sold. So if you sold for 2 million, you could identify 4 million dollars with the property. Or in that case, you could identify four 500,000 dollar pieces of real estate and choose to buy any number of them. What you couldn't do is buy five of them because you'd be going over your net sales price, you don't want to go over that 200 percent rule.
(6:39) Justin Alanís: Got it. So you want to stay under 200 percent but you want to be over 100 percent because if you don't go over 100 percent, then you lose some of that capital gains savings with what's called a boot. Is that right? Did I research that correctly?
(6:52) Ian Bunje: Yeah, exactly. You would pay tax on the on the difference and usually that tax rate on the difference is going to be whichever is higher. The recapture depreciation or the capital gains.
(7:03) Justin Alanís: Okay and when you say recapture of depreciation, walk us through that really quickly. So you're able to write off the depreciation of an asset on your taxes over a period of how many years? Is it 20 years? 27 years.
(7:15) Ian Bunje: 27.5. Yeah.
(7:18) Justin Alanís: So how does that work in relation to the capital gains?
(7:21) Ian Bunje: Okay. So each year that you own the asset, you depreciate it, and the depreciation only happens on the capital improvements to the property. The raw land that could property sits on does not get depreciated. You get that taxable benefit every year. If you sell your property outright, then the service will generally recapture your depreciation at 25 percent. Some people will also do accelerated depreciation but that's where you take the assets, such as an air conditioning unit or other industrial items in your building, and then depreciate them at 3, 5 or 7 year periods. Now, one challenge about that is that turns those assets into personal property and no longer turn it into real estate. How you're going to reflect those on your sales, that's between you and your tax advisor. Some people are rather aggressive on it, some people are more conservative on it. We saw a lot of that in the past. Not as much anymore because you're taking your real estate and turning it into something that's no longer exchangeable.
(8:25) Justin Alanís: Got it. And so you take this 25 percent of this depreciation. This is in an event where you do exchange it or this is an event where you just sell it outright?
(8:34) Ian Bunje: No, this is where you sell it outright.
(8:36) Justin Alanís: So you lose some of that depreciation benefit that you've had previously?
(8:41) Ian Bunje: Well when you roll the first property into the second, your depreciation follows you. So, you'll still continue to depreciate on that original year by year basis. Now, you can add on to that basis by buying something for more and then that layer of depreciation will have a new period of 27 years.
(9:01) Justin Alanís: Understood. Okay, so if I have a 2 million dollar asset and a million of that is depreciable because half is land, half as the asset itself, then over a period of 27 years, I can depreciate that down and save on my taxes. But if I've sold that asset in 10 years, then I still have 17 years of depreciation left on my new asset but if I buy a 3 million dollar asset then I add to that depreciation schedule.
(9:25) Ian Bunje: Correct. I mean, there are many cases where if you bought straight across the board, you may not even have any depreciation. If you've held the relinquished property assets for say 30 years and you buy just equal to or greater than, then you don't have any more depreciation, unless you do capital improvements later on.
(9:41) Justin Alanís: Then you don't have that tax benefit anymore. Got it. And so this is one reason why people do a lot of refinancing and get cash proceeds out and then exchange assets and buy higher valued assets and get a bigger loan is because then they get the benefit of the additional depreciation. So the depreciation doesn't start over, but they can add to it. I got it. Now, the rules of the 1031 exchange are that buyers have 45 days to locate and 180 days to buy a replacement asset. That doesn't seem like a lot of time to do that, especially for some of these small and independent landlords who don't have a lot of great services out there. So how is that done today? How is that possible? What do you see with your clients?
(10:19) Ian Bunje: The 45 days and 180 day rules. The 45 days is somewhat punitive. The 180 days makes sense because the service wants everybody to file their return in a timely manner. If it was open ended, then everybody would be screaming that they couldn't, that they would need more time to file the return because they couldn't. They haven't completed their exchange. But the 45 days starts on day zero. The day that you no longer have title of that property or the title is passed to the buyer. And from that day on a clock starts. You have 45 days to identify, as we spoke earlier about one, two or three properties or use the 200 percent rule. But the hard part is that 45 days goes by really quickly. You really need to know where you're going before you leave. And what type of class of property you want to buy. What area you want to be in. What community. Are you going from commercial to residential, residential to commercial or both. As an exchanger, you're selling the property thinking, oh my God, I've made this great amount of money. And then not knowing where you're going, you can end up scrambling a lot to find that perfect property. In many cases, the exchanger won't find exactly what they want, they'll have to pay their taxes, or they'll acquire a bad investment just to avoid the taxable consequence.
(11:36) Justin Alanís: Yeah. It seems like they lose their negotiating power as well through this as the timeline starts ticking down. Doesn't the sell side typically know that they are a 1031 exchange buyer because of the fact that they had to file?
(11:48) Ian Bunje: You have to disclose. You should be disclosing in the contract that the buyer, in this case, is doing a 1031. If you have a pretty savvy broker, they can come by and they can inflate the price of it more or negotiate it up, because they know this is something that you need to have, especially as it gets closer. The buyer doesn't have to disclose when they sold, but the seller will do everything they can to get to get the price up. If there are resources for exchangers to find properties quickly or even engage someone to find properties for them earlier on, they're gonna be much better off.
(12:29) Justin Alanís: So the lesson here is to start early when you know that you have an eye towards an exchange and your current asset is on the market and you're going to sell it. Start looking, start identifying now, start understanding your buy box. So that when the 45 days comes, you have those few assets that you can at least have identified, and then another 130 days from there to actually buy.
(12:55) Ian Bunje: Yeah. I mean, as soon as you've made the decision to put your house property out on the market, you should you should be looking for that replacement property. That relinquished property, once the decision is made to sell, it is no longer doing anything for you. You need to be out there finding the next investment. Whatever is going to bring you in the most cash flow. The real down to the brass tacks, you want to find something that is going to carry the property, the property will appreciate. But especially in days like we're having right now, something that's going to provide cash flow to you. That's the king in exchanging.
(13:29) Justin Alanís: And so, this is where you guys come in, right? So, your company, Independent Exchange Services, helps clients with this exact exchange scenario where a client has sold an asset. When do they engage a company like yours and start thinking through the exchange intermediary services?
(13:49) Ian Bunje: Well, there's not much a qualified Intermediary can do until someone is in contract for the property. Although we are open on the sales side.
(13:55) Justin Alanís: On the sale side or on the buy side? So on their down leg?
(14:00) Ian Bunje: Well actually, on either side. Because if they got the buy side going and they can't get the sales side ready to go on time, then they can engage in a reverse exchange, which is something we'll probably talk about in a little bit. But the qualified intermediary, really there's not much for them to do other than just hand holding and giving the client ideas of what to look out for, until they're in contract. Once they're in contract, the QI engages with the settlement agent, which is either an escrow company, title company, settlement attorney back east, and sets up the exchange docs, makes sure that the buyer of their property is notified and acknowledges the exchange. It's important. If the buyer of your property doesn't acknowledge your exchange, and this happens sometimes, then you can't do it. You have to have all parties to the transaction acknowledge that the exchange is taking place. Once everything is in place, the exchange docs are there, the QI should also then audit the closing statements set up by the settlement attorney. And what we're looking for there are any operational costs. These are property taxes, HOA fees, security deposits, rents, any prorations that might be there. Anything that the exchanger would expense on an annual basis, as opposed to capitalize. Now, if these costs are paid out through close of escrow, these costs are then recognized as capital game. And in some cases, if it's under 3,000 dollars cost, not such a big deal. You can offset that with ordinary income expense. But if you get into larger deals where you have a couple hundred thousand dollars of operating costs, the exchanger then may elect to put a deposit in to offset those costs at that close and thereby increasing the amount of exchange equity that they have going through. They're not losing any money and they're not having to pay any capital gains tax by putting that deposit in. A deposit goes in with the rest of the exchange funds and then goes into the new property.
(15:54) Justin Alanís: And the Qualified Intermediary holds the actual asset, or not the asset but the the gains are held in your bank account? So you've created an escrow account that then holds those assets?
(16:06) Ian Bunje: So, the equity from the sale goes into a segregated exchange account, which is held for the sole purpose during the exchange period to be used to buy replacement investment real estate for the exchanger. Now the exchange can be terminated if the exchanger wants to then say I'm definitely gonna do an exchange and cash out A, by not identifying within 45 days. Then the exchange will essentially be done at that point. Between us, there is a lousy rule that's out there that is if the exchanger did identify something and it's past the 45 days but let's say that property that they identified got sold, the Qualified Intermediary is supposed to hold those funds until the next termination point, which is day 180. These rules were put in 15 years ago, maybe more than that. And that's because some of the banking QI's, and power to them for doing it, wanting to hold on to some of the money longer. It's a hard one because if you have an exchanger that's got a hardship, what do you do? I mean, in some cases, as an industry, we've said well, if the exchanger were to write to the Qualified Intermediary that they're going to sue them. And then get a letter from the attorney, then it gives the QI the, not that they want to be sued, but at least some assurance that you know, hey, we did this because this had to be done. We didn't want to get sued and put our other clients in jeopardy. That's one way for the exchanger to get their funds back earlier. But generally they've got to follow the 45 day termination point of the 180 days if property has been identified.
(17:48) Justin Alanís: And the QI, so you guys as a QI make money on on a fee that is charged at the time of closing?
(17:54) Ian Bunje: We're a fee based industry. Any QI, the way the funds should be held are instantly in liquid accounts. A Qualified Intermediary should not be investing funds. They're not an investment company. They're a warehousing company.
(18:10) Justin Alanís: So no buying Bitcoin, no buying Ethereum with the exchange money?
(18:14) Ian Bunje: No buying even a triple A rated, whatever it is. The idea is that the that the cash is ready to go if the client were to call me before the close of the Fed being able to wire the money out. So you want to call me today, you found a property, it's got to close instantly or it's closing early, that money's ready to go. Where it's right there and we wire that immediately. Additionally, as far as our clients security, we will do whatever they want. We have relationships with multiple institutions, and we do that just because we don't want to put everything with one bank. Just to be just in the safe side. But if the client has a banking relationship with another institution, we'll set up a segregated account with their bank. We will set up an account where the exchanger has to sign off on the release of funds, as well as one of our principals signing off. So it's a dual signature relationship there. We can set them up a qualified escrow, as well, if that's what they prefer. It's whatever the client wants in terms of security. I mean, we did have one funny time. It's actually happened a few, where we had a client that had a, let's say, he was going to have a million dollars with us and he wanted to spread that million dollars over multiple banks or in different accounts, so he would get FDIC insurance on each one in case something happened. In that case, we would do it. Obviously there would be extra fees involved with it. If it gets too overwhelming, then we'll just say, maybe this is something you want to rethink. Because I think if any one of the banks or series of banks start to go downward, everybody's in the same boat at that point.
(20:04) Justin Alanís: Hopefully it doesn't all happen in 180 days also, right? So we talk a lot about in the 1031 exchange world about the term like kind asset. But it seems like this term is fairly loose in terms of its definition. If you're exchanging a 2 million dollar multifamily property, that doesn't necessarily mean that you need to buy a 2 million dollar multifamily property or a 3 million dollar multifamily property as an exchange asset. So what does fall into like kind as a category?
(20:34) Ian Bunje: Any piece of real estate that's used in what they call trader business. So in most cases that means rent. So any piece of real estate that you can rent out. There's one exemption. You can exchange into raw land which you may not be renting out unless it's, timber land or something like that. But when you exchange the raw land and hold it for appreciation, that also qualifies as like kind. In the acquisition of raw land, you may have to recapture your depreciation, in that case, because there's no capital improvement to take it into. Other items that are also investment real estate are Delaware statutory trusts, tenancy in common arrangements. But there are also items out there like a REIT or a real estate investment trust. Now even though a REIT owns lots of real estate, you're not buying real estate. You're buying a security. And securities are not like kind. Similar to if you had a friend or an associate that had a piece of real estate that was owned in an LLC and then you bought in as a member of that LLC, that would not qualify because the LLC is a security. The LLC owns the property. You are part of the membership of the LLC, so that's about like kind.
(21:48) Justin Alanís: Got it. So the UPREIT is not like kind, but a DST and a TIC are like kind?
(21:54) Ian Bunje: Yes. There's different types of TIC's. Let's say you and I wanted to buy a piece of property. I put in 5 bucks. You put in 5 bucks. We own the property 50/50. The TIC arrangement and the percentage of ownership in the TIC is based on the equity each person brings to the table. You cannot create a TIC with one person bringing the cash and one person bringing the sweat equity. That doesn't work. That's a partnership. Once again, not like kind. Then in the past there have been these really large TIC arrangements with qualified buyers where up to 35 people would own an asset. And there would be a sponsor that put these deals out and a broker-dealer that bought the exchangers in. And 35 strangers would own a fractional interest of this property. In most cases, the exchangers and their assets would be on the hook for the loan. Then usually these loans were 5 to 7. And a lot of these deals imploded when everybody went to go get refinancing on these at year 7, year 5, and it was no longer available and all of a sudden the exchangers are stuck with this asset that needs to be sold off, in many cases at a loss.
(22:09) Justin Alanís: I'd love to dive into DST really quickly. So you talked about TIC, a pool of people. There are those sponsors that support and move into the TIC structure where they get existing exchange investors into their deal and they then run that deal. But to your point, a lot of these TIC sponsors front load the value of the property with fees and other things like that erode value over time?
(23:50) Ian Bunje: It could be one large residential complex, but it can also be a series of properties that can cross state lines. You could have, 5 or 6 CDS's or some other commercial tenant real estate that would be inside the DST. The DST or Delaware statutory trust is deemed to be real estate by the service. Now, one of the benefits of the DST is that the sponsor holds the responsibility for the loan. And these loans in a DST relationship that you'll have with this sponsor and this property will generally last between 5 to 7 years. Once the loan terms have completed, there's a 5 year loan the DST ends in 5 years. The asset is then sold. They're not going to refinance the property. They're just going to sell it outright. Now, the DST exchange would participate in any appreciation on the property, but they'll also be getting a return on their investment as well. So, it's basically a triple net lease property, where they have really no responsibility. They'll get a quarterly check. And they'll participate in the depreciation and then at the end of the DST run, they have the option of exchanging it to something else. They could then go back into commercial real estate of their own ownership or they could roll it into another DST if they want it. where you want to be careful with the DST's is you don't want to get too far over your skis in terms of the debt. Because, as an example, let's say you sold for a million dollars cash and you went into a DST with a 50/50 debt to equity ratio, then you're actually acquiring a 2 million dollar asset. Now when you go to buy, when you roll out of the DST to go to buy or exchange into another asset, you now have to buy something for 2 million plus. That means that you as the individual now have to acquire a million plus of debt or bring more cash in if you want to replace that debt. So you want to make sure you get into the right DST for you based on the debt to equity relationship you had with your relinquished property.
(25:51) Justin Alanís: Because this goes back to the greater or equal value idea where you have to have an asset that is greater or equal value because as a DST member, I have a portion of the equity but then I also have a portion of the debt. And so my piece of real estate is basically my percentage of that deal. Is that right?
(26:08) Ian Bunje: Yeah. I mean, getting back to one of the basic things is what? Many people are confused on what is the net sales price? The net sales price to get equal to or greater than, the easiest way of looking at it is add your debt to your equity. That's your net sales price. So, if you're looking at a DST, there are DST's that are highly leveraged for those people that have a large amount of debt on their property. There are zero return DST's, which basically all the money coming in from the DST is going to pay down the debt to build up an equity basis in the property. There are all cash deals too. You just have to find the one that works best for you.
(26:42) Justin Alanís: Got it. Makes sense. And then with with the DST, the sponsor charges fees. Acquisition fees, asset management fees, property management fees in some cases. Do they also charge broker dealer fees associated with bringing the money in?
(26:55) Ian Bunje: You're not going to see them. A closing statement on a DST basically has about 4 or 5 lines. There's no break down of property taxes or all those other items. Basically, your cash, your debt, purchase price, and there may be a broker-dealer charge trudged there, but everything else is going to be built in. When looking for a DST provider, a great example of what you're looking for in a DST provider is a company that's really familiar with real estate. As an example, and not blowing their horn one way or the other, but is Inlet America. They do a lot of REIT's and they have tons of real estate holdings, but they're also going to be a part owner of the DST as well. They're not just going to sell it all to exchangers. They're going to use a chunk of it and they're a good management company. And they're going to run it almost like a REIT but it's not a security. It's deemed to be real estate. So you're looking for a DST provider that is going to stay in the DST with you. And that has a track record of doing both. I like to see that they're doing both REIT's and DST's.
(28:08) Justin Alanís: Got it. And always look at the fee structure under the hood as well to make sure that you know where your money's going.
(28:14) Ian Bunje: Yes, you need to inquire about that. What is loaded in with this purchase price? Because that'll affect you at the time of sale. You don't want to come out of this thing with a loss, because the property, you know... Unless the real estate market turns. There's nothing you can do about that. But if the market is still good or robust, then you shouldn't come out of it with any type of loss because of built-in overhead at the time of acquisition.
(28:38) Justin Alanís: Now does the real estate investor, the exchanger into a DST, also get the same tax benefits? Not just of the like kind exchange and the 1031, but also the depreciation and the interest tax benefits?
(28:51) Ian Bunje: Yeah, they should. You still treat it as real estate.
(28:55) Justin Alanís: Yep. So very similar to that to the TIC in that instance, but this is just a fractionalized interest and the sponsor holds control of the asset, whereas in a TIC, it's spread out.
(29:05) Ian Bunje: Yeah. So they are participating in the loan on that. It's going to be built into their purchase price even though the sponsor is financially responsible for that loan.
(29:19) Justin Alanís: Got it. Makes total sense. I'd love to shift gears and talk about a reverse 1031 exchange. So we talked a lot about an exchange. And a lot of the same principles apply to a reverse 1031 exchange, though, obviously, just like the name implies, it is reversed. So now this allows an exchanger to buy a property before they sell a property. And what's the benefit of the reverse 1031 exchange? What are the drawbacks of it? Talk to us about the differences.
(29:46) Ian Bunje: Right. Well, I've always found that the term reverse exchange is somewhat misleading. All it basically is the parking scenario. You're buying real estate on the so called 'layaway plan'. So under 1031, you're not allowed to exchange something that you already own. So you couldn't acquire a piece of real estate in your name and then exchange into it later. So, what is done is an entity called an exchange accommodation titleholder is created.
(30:12) Justin Alanís: Also called an EAT right?
(30:15) Ian Bunje: Correct. And in almost every state, except for California, this will be held in the form of an LLC. And so we'll create ABC LLC to acquire the property for the exchanger. Now, one of the challenging parts of doing the reverse exchange is the financing component. You go to a bank and say, I'm going to buy this property, and they say, okay great. Is it going to be in your name? No, it's not going to be in my name. It's going to be in the name of this entity that has no assets, that's gonna hold on to it for me for up to 180 days until I sell my relinquished property. Then I'm going to go into this property through a forward exchange. Then I want to assume my loan. Well, a lot of lenders are just going to shake their head at that. What you're looking for in terms of lending is either a portfolio lender. One that'll keep that loan in their bank or a private lender, or in many cases, the exchanger just lends us the money themselves to acquire the property. Now during this period of holding, the property is then master leased back to the client for just a nominal amount so they have complete control over the property. Even though we technically own the property, we'll never step foot on it. We will never receive rents. We will not collect security deposits or any of those items. Under the master triple net lease, that is all the responsibility of the exchanger. That basically give them tenants rights on the property as well. In structuring financing too, if the exchanger brings in money to pay 20 percent down or even more ideal, the amount of equity coming out of the relinquished property. They could put that as the down. Then when they sell the relinquished property, do the forward exchange into the parking entity. All the exchange money that came out of the relinquished property can then go to pay back the exchanger for their loan they made to the EAT. So, if the exchanger loans us the money, that will get paid down. If the exchanger didn't loan us the money, let's say it was 100 percent financing from a third party source, then that exchange equity from the relinquished property needs to be able to pay down those loans. And we want to make sure that those loans are structured in such a way that there's not some large prepayment penalty, or if there's a portion alone that is going to carry forward that the exchanger can assume it. Also, we take into consideration due on sale clauses. So when we transfer the property, we want to make sure that that loan can be assumable and there's no due on sale clause to that loan. In a sense, it's a win win for the bank or the lender, because the lender, they're doing a normal loan that's going to be in place at the end of the day. They can also do a bridge, as well. So they can actually have two loans and they're going to have a long term relationship with the exchanger on the first steps on the property.
(32:59) Justin Alanís: Yeah, so it sounds like the lender is more involved in in the EAT structure or the reverse 1031 exchange structure. So just to rehash really quickly, the EAT structure actually owns the property through a special purpose vehicle, an SPV. Then you master lease the property back to the exchanger, the person who actually gets the loan, but the lender actually loans to the EAT and it needs to be assumable when you transfer them the property back to the exchanger once they sell their current property.
(33:27) Ian Bunje: Right. Correct. Whatever amount of loan is left over after all the exchange proceeds have been used to buy the property, that loan should should be assumable. I mean, you could have the exchanger get a new loan and use their equity but then you're getting into a lot of additional loan costs there.
(33:44) Justin Alanís: Yeah, that's some huge loan fees. And this is one of the concerning things about this is. What are the benefits of a reverse exchange versus a regular exchange? It sounds like you have more loan costs, maybe double transfer taxes. Do you have double closing costs as well? Or no?
(33:58) Ian Bunje: The exchanger will pay double. There'll be a secondary escrow fee, so they get to buy the property a second time. And there are no commission's or big ones there. Usually the bigger costs associated with a reverse exchange are loan fees and transfer taxes. And I think there's 37 states that have some form of transfer tax. It might be 39. And so that cost you need to take it into consideration because since the EAT has no financial benefit of this property and doesn't have any money to pay off these costs, all the closing costs are passed on to the exchanger. So everything goes on the buyers side when they acquire this property. One of the neat things that, and we find this more often than not, is most of our clients make more money by doing a reverse exchange than a forward exchange. First of all, when you do a reverse exchange, you basically eliminated your 45 day period, because you've already captured the property you want to buy. As an example, let's say you found the perfect property and then you try to quick sale your relinquished property by saying I'll knock 20 grand off of it to sell it more quickly. Then you're losing money that you could have kept on a reverse exchange. Secondly, it gives you more time to sell your relinquished property at a price that you've decided is good, as opposed to fire selling it. And yeah, between that and the 45 day issue, you get the property you want.
(35:31) Justin Alanís: So, what you're saying is the extra cost, potentially, is worth it in most cases associated with the surety of the actual getting the exchange done. Not having a proverbial gun to your head in terms of trying to offload your asset and then really quickly turn around and buy an asset and then getting the rug pulled out from under you when you you identify three assets. And then you don't get any of those assets and you lose your negotiating power as a result of this scenario. So you end up overpaying on the new buy, even though you have now the proceeds to be able to do it. And the risk of not being able to complete an exchange makes it worthwhile to look towards a reverse exchange, even though it has the additional transfer taxes in most cases, as well as potentially additional loan fees.
(36:19) Ian Bunje: In some cases of transfer taxes, especially in California, in most counties and cities is 1 dollar and 10 cents per a thousand dollars of acquisition. S it's not a huge, huge expense. There are some communities where on top of the 1.10 that goes to the county, the city also collects the transfer tax as well. And that can get kind of steep, especially in some areas of the greater Bay Area, southern California. They do have higher transfer taxes in other parts of the state. Other states have, I think Delaware has a 1 to 2 percent transfer tax on the purchase, so that's considerable. That's almost like putting in sort of a junior commission on it. You could in many cases, instead of deeding the property back over to the exchanger, you could transfer the membership interests of the LLC ,as long as it would be a single member LLC. So as long as there's just one exchangee, or let's say a husband and wife that file's as one entity or just a single member LLC that's selling the relinquished property. As long as it's not multiple non related parties, you should be okay to do it. And if they accept the membership interest in lieu of deed, I mean, there's an argument that there's no transfer tax due because no deed was recorded at the time.
(37:43) Justin Alanís: So you can save on the double transfer taxes in that way?
(37:47) Ian Bunje: You can. I would think though there may be a time where the city or the county could come back and say, well, it really was a transfer property because the sole asset was there, and they could come back and plead that case as well. It's something that if it's done, we do in connection with the tax advisor and see how aggressive they want to be. In many cases, we have to do the membership interest of the LLC because of the way the loan is structured. So if we're dealing with a Freddie or Fannie loan, where once that loan is placed under the EAT, that name of the title holder has to remain the same. It can't be changed. In that case, we'll use an LLC and transfer the membership interest as well. And in that case, it's up to, depending on what state it's in, then it's up to the exchanger how they want to handle the transfer tax.
(38:35) Justin Alanís: Got it. From the lenders perspective, what are you seeing with regard to loan terms on a reverse exchange. Both from a bridge perspective and a core LTV basis interest rates, all of that, related to the loans on reverse exchanges.
(38:50) Ian Bunje: Well the loans on reverse exchanges, the prime loan is the one that's going to be in first position. If it's done through an institutional lender, it's basically going to be your average commercial style loan. So the interest rates are going to be mainly based on the credit of the exchanger, who's personally guaranteeing the loan that the EAT's taking on. Now the second, if the exchanger is not putting money into that bridge, those numbers can go all over the place. The term of that bridge loan will generally be, let's say 181 days. Because that's the amount of time that we can hold on to the property. Day 181, if the exchanger does not sell their relinquished property, we will putt the property to them and then they will now own two properties. No taxable event has occurred because they haven't sold the relinquished property, but they can no longer exchange into this one. We can always exchange into something else, but not this particular one.
(39:52) Justin Alanís: And that term on that loan is typically 6 months. Then the lender comes and says, all right, hey, you owe me for this bridge loan, pay it down. And it's usually an interest only loan in the mid to low teens?
(40:04) Ian Bunje: Yeah, it can be because it's short term financing.
(40:09) Justin Alanís: Do they lever up to 100 percent usually for the reverse exchanger, or is the reverse exchanger still putting in some cash?
(40:16) Ian Bunje: I would say in most of our deals, the exchanger is putting in some money and one of the reasons that is true is if the exchanger doesn't have cash to put in to the deal, most of the lenders that are going to do the prime loan are not going to lend a ton. So, when you're doing a reverse exchange, usually the exchangers very well heeled, because they have to qualify for this reverse prime loan that we're getting put on.
(40:45) Justin Alanís: And will likely have to have a deep relationship with their bank as well.
(40:47) Ian Bunje: Yeah. We have several institutions that have done a lot of these. Some of the what we would say are the bigger banks, they may do some of these styles of financing, but those would only be on really large transactions. And so if you're talking 500,000 to 5, 6 million, they're probably not going to deal with a reverse exchange on that basis. That's why I mention, if you're getting prime loan on it you're looking for a portfolio lender. Might be a little bit more expensive than a loan you could get through one of the major institutions, but not that much more. And you'll get the job done. And you can always down the road, refinance your property if you want to. That's an option too. So once you own the property, if you want to collapse that prime loan and get another one, yeah, go ahead and do it. Just as long as you don't contemplate doing it until the exchange is completed.
(41:41) Justin Alanís: So really good information on both the traditional exchange and the reverse exchange. I think we talked about pretty much everything someone would want to know associated with executing on a transaction. Last week I read about Joe Biden's carrying economy plan that needs 775 billion dollars to be put into place. And Biden says that he would eliminate the 1031 exchange in order to fund it. Do you think that's a realistic outcome? Do you think the 1031 exchange could potentially go away?
(42:10) Ian Bunje: The 1031 is always on deck for being eliminated. And this is a campaign promise. If the Democrats get the House, the Senate and that, you could see that happen. But the impact from eliminating 1031 would be somewhat devastating on the real estate community. Running right now, we have a task force that is working with, not only our group, which is the Federation of Exchange Accommodators, but the National Association of Realtors, Multifamily Association, a lot of construction associations. It would actually be a severe economic impact mainly on different levels. If you don't get the taxable benefit of an exchange, why would you bother selling the property. You just carry it, hold it, and then your heirs and would get a step up in basis. Would that limit the amount of improvements you would put on your property during that period of time? If you're building new investment based properties and you only have people to buy the property fresh, and you eliminate that pool of other investors that are going to rotate into bigger properties. That would be impacted. It would impact people wanting to buy into the market starting low and then building their portfolio for bigger and bigger properties. Now, it would definitely slow down the sale of investment properties which would, actually going back to transfer tax, would eliminate a large amount of community tax revenue, especially in California and a lot of other states. All of a sudden that tax revenue is gone. How do you make up for that? Well, you just increase your sales tax. So instead of it being just something that real estate investors pay for now, every taxpayer is going to possibly pay for the elimination of 1031, by increasing sales tax to replace that revenue. We as a group, this sort of taskforce we have going, we're engaging another study. We've done studies with Ernst and Young in the past on more of the macro level, which we're doing one on the micro level as well. Speaking and doing lobbying with both Dems and Republicans. They understand. I think a lot of them understand why it would be beneficial. A lot of the congressmen and senators we've talked to have actually done regular exchanges and reverse exchanges and so that's good. There are ways they're thinking about replacing 1031 with maybe just do like a section 121 style relief of up to a million dollars worth of capital gains relief. Others have said maybe more along the lines of 250 per owner. That may actually be beneficial for a lot of people between the coasts. But the gains in California, Washington, Oregon, New York, Massachusetts, that's just a drop in the bucket. There are a lot of capital gains if they own the property, especially at the commercial level. Your big office building owners and big residential complex owners, there'd be no need for them to sell their property. If they're not selling the property to buy a bigger asset, there's no need to build that bigger asset anymore. So that impacts jobs and construction workers, builders.
(45:36) Justin Alanís: Yeah. It creates a situation where the liquidity in the market starts to really stall out. And when that happens, when people aren't trading properties, brokers aren't getting their commissions. People aren't doing construction projects. People aren't trading up and increasing the value and their net worth. And so you're saying that this study shows and demonstrates that all of a sudden, if you introduce this friction, it could clog up the entire environment. And there are maybe other ways to solve this.
(46:04) Ian Bunje: I mean, it affects lending and the cost of capital. If you don't have that money coming out of your relinquished property now, your cost of capital goes up. How much more loan do you have to get? Or do you get a loan or deal with that at all? You can trickle it down to, okay, well, that office building that we were going to build that would have had maybe 100 people working to manage the building, those those jobs are gone too. So, it doesn't just affect real estate owners. The odd thing is, when people want to eliminate 1031 they think of these big fat cat real estate owners, like our current president, but about 70% of all 1031 exchanges are under 500,000. They're not big ones. They're mom and pop. It's your neighbor who, this is their retirement asset.
(47:00) Justin Alanís: Especially with the boom of single family homes where people are renting them out where they can buy in traunches of 500,000 dollars or a million dollars at a time or even less, in a lot of cases. Then they are exchanging these up and then building up their portfolio. And maybe exchanging into a bigger asset over time and a multifamily asset over time. So it does provide a ramp of opportunity for people to continue to build their net worth over time. And this just isn't reserved for people like Donald Trump, which I think is an important aspect of this. So it'll be really interesting to see what ends up happening here. And it's something certainly to track as the election happens in November and then obviously post election in 2021 and 2022.
(47:38) Ian Bunje: Yeah. I mean, we've always done business under the belief that if something should change, we have to work. Business is done within 180 days. If something were to happen along those lines, I mean, 1031 would still be on the books but it would just not be applicable anymore. But in 4 years, 8 years, the next turn of the wheel, it could be back on. Things that happen with whoever controls the government at the time will change when the next group comes in, so who knows. It could be a wait and see. Strangely enough it's not a Republican deal or a Democratic deal. In the past, the last time we came under threat it was from the Republican side and Dems supported us. This time the middle of the road Democrats, there more of them, but they're being overshadowed by the more extreme sides. The extreme side of both sides are always the ones that are controlling In the conversation, so we're hoping that our best allies are the people that understand compromise, and will just want to keep the economy rolling. So we'll see what happens. It'll definitely be a fun time, to say the least.
(48:55) Justin Alanís: It'll be interesting and we'd love to link to the previous plan and certainly also link to the new plan once you guys have that ready if that works for you.
(49:03) Ian Bunje: Sure, yeah, that's not a problem. The more people that know about what's going on, the better off they're going to be and the more knowledgeable they're going to be about it. The President can make a plan and say all these things, but it has to go through the House and the Senate to be ratified. And usually we find that some of the best economic times and are when no one party is in charge of everything. So one party has the House and one party has Senate or one party at the House and Senate and the other one has the presidency. The inability for them to get stuff done or whatever, or having to having to compromise with each other is always when we see our best economic times.
(49:44) Justin Alanís: Sure, well this has been really a fascinating conversation and I think this has been really enlightening for a lot of people. I think they'll tune in and listen for the exchange information, on how it can be done. And then also, they should stay tuned in to see how everything evolves with the 1031 landscape. But to your point, this has been threatened before. The 1031 exchange has been in place in its current form since 1980?
(50:09) Ian Bunje: Well, the way of doing exchanges has been the Starker case, which started this industry ended in 1980 or 79. We started the firm in 1980. But it's been on the books since the 20's, and 30's. So, it's always been there, but it has evolved with new regulations and new rulings and evolved into this industry that we have today. But it's been there for next to forever.
(50:34) Justin Alanís: Yeah. Well, let's hope it continues to stay there. Ian, thank you so much for your time today. This was great. Really appreciate it.