Three years ago, I sold four of my single-family properties to take advantage of what I thought was the top of the Indianapolis real estate market.
However, the sale would trigger a significant capital gains tax (fortunately I was making money on them), and I would also have to pay the depreciation recapture since I hadn’t held the properties that long.
I had a problem. A tax problem.
My initial strategy to defer the capital gains and depreciation recapture was to perform a standard 1031 exchange. I secured a qualified intermediary to handle the transactions and everything, but I could not find a suitable replacement property for the portfolio.
With my clock ticking on the exchange, I needed a plan… and fast.
Why Consider a 1031 Exchange at All?
I was a bit distraught to find an option to defer my capital gains tax and depreciation recapture. I had the financial IQ to understand that paying taxes is possibly my largest life expense, and if I could legally defer paying this tax and reinvesting all my proceeds, my wealth build would accelerate more rapidly than if I handed over the money to Uncle Sam.
So, I sat down with my CPA to discuss my options to trade into a “like-kind” asset (spoiler alert… I was asking the wrong question!):
1. I could complete the 1031 exchange. While I was selling close to the top of the market, it was also the worst time to buy, as I couldn’t find a satisfactory asset to invest in that would yield the same cash flow (or better).
2. I could invest in an opportunity zone fund. Opportunity Zones (OZs) are great development plays to help defer capital gains tax. However, OZs are not something I understand well, and the rules of the OZs are very new and untested. Additionally, I needed cash flow, and these types of deals typically don’t generate that much cash flow.
3. I could invest in a Delaware Statutory Trust with an investment banker. This seemed like a viable opportunity; however, given that my basis in the properties was so low, any deal I could go into had very little cash flow and were generally businesses I didn’t fully understand.
None of these options would allow me to defer my taxes without giving up my cash flow… until…
The Light Bulb Moment
On a hike with my daughter, I got a call from my property manager. Someone had copied the key from the lockbox on my vacant rental and stole the HVAC and water heater.
Ughhhh!!!
Then it hit me like a ton of bricks. Why was I so married to the idea of trading for a “like-kind” asset?
Why not cash out my funds from the sale (take the capital gains and recapture hit) and invest into a passive deal that had great tax benefits to offset that gain? I would save myself the brain damage of trying to find a suitable replacement asset. I would step up my basis in the next asset. I would reset my depreciation clock (generating another bucket of passive losses). I would even offset most of my tax burden and get my time back to focus on the things that really matter to me.
I thought to myself… This could work! So, I sat down with my CPA to discuss my theory and model my potential tax bill again. My CPA simply stated, “Oh sure, you want to do a ‘Lazy Man’ 1031.” Sure enough… I could eliminate 80%+ of my estimated tax burden and reset my depreciation clock. Moreover, I could break up with Home Depot and get my time back!
How to Complete a Lazy 1031
While completing a Lazy 1031 is fairly straightforward, I’ll offer up a framework to make the process smoother:
1. Consult with your tax strategist early in the year to model which assets might be good candidates to sell. (Side note: Your CPA may not actually be a good tax strategist. Please reach out if you need a referral).
2. Sell the assets and set all proceeds (down payment and gains) aside in an account. I like completing all my sales by June, so I have plenty of time to find a suitable passive deal (or deals) before the end of the calendar year.
3. Invest in a passive asset with a reputable operator that has bonus depreciation and cost segregation. This will help maximize the first-year passive losses on the asset. It is key that the asset close by December 31st of the same year, so you realize the gain from the sale, and the loss from the new asset, in the same calendar year.
As A Bonus:
1. Make sure the operator has a track record of completing 1031 exchanges for commercial assets, so you aren’t having to do the same thing again in the future. At PassiveInvesting.com, we help our investors do just this!
2. Regularly invest in passive assets and build up a bucket of passive losses that you can use to offset passive gains (either from your personal property sales or passive deals cycling out) in any given year. My friend Jim Pfeiffer from Left Field Investors calls this the “Golden Bucket.”
Now that you have the “fly-wheel” spinning and your taxes driven down, there is one last step to help you in your generational wealth plan. That is to keep the assets in place so you can pass them onto your heirs… potentially tax-free due to the step-up in basis tax provision. I know this may not be a pleasant topic to discuss; however, the wealthy actually plan to do just this.
Wrapping Up
Fast forward to today, I’m currently selling another round of personal real estate assets in order to move my equity from “controlled” single-family real estate to truly passive real estate. This time, my plan is solid from the beginning, and I couldn’t be more excited to continue to reap the rewards of real estate while tapping into the freedom that passive investing affords.
