JF1517: Defensive Investing Using 1031 Exchanges #SkillSetSunday with Dave Foster

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Dave is back to drop some more knowledge on us today. He’s a 1031 exchange expert, probably the most active such expert on BiggerPockets. Today he’s telling us about what he calls, defensive investing. Curious what that is? Tune in now. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

 

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TRANSCRIPTION

Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.

First off, I hope you’re having a best ever weekend. Because it is Sunday, we’ve got a special segment for you called Skillset Sunday… And here’s something fun – we’re gonna talk about defensive investing using 1031 exchanges. I’m not exactly certain what that means, but our guest, Dave Foster, who’s an expert with 1031s, will tell us what that means. First off, how are you doing, Dave?

Dave Foster: I’m doing awesome, Joe. It’s great to be here.

Joe Fairless: I’m glad that you’re back. Best Ever listeners, if you recognize Dave’s name and voice, then you’re a loyal Best Ever listener; episode 566, about 1,000 days ago, titled “The skinny on 1031 exchanges, and how you can win”, he talked about his best ever advice there, so you can go check it out. He’s an expert on 1031s, and I’m looking forward to our conversation. So what is defensive investing using 1031 exchanges?

Dave Foster: Defensive investing… Awesome question. By the way, I love it that this is no-fluff radio, because that’s exactly where we’re heading – right into the deep end of things for seasoned investors that are wanting to maximize what they take out of this next market cycle. My gosh, has it really been 1,000 episodes, Joe?

Joe Fairless: It has been 1,000 since we’ve caught up… 1,500 for the show.

Dave Foster: IN-SANE. So what has happened over the course of that time is we’ve seen a market go from gold nuggets on the ground, to being mature, to where everybody is starting to ask the question of “When’s this thing gonna crash? When is it gonna turn around? How do I protect myself?” And if you recall what the 1031 exchange does – it allows investors to sell and then purchase investment real estate to keep building their portfolio. Now, usually it’s used to expand portfolios, to move their portfolio from one location to another, to expand the portfolio in terms of different classes of properties, but it always ends up with a purchase. So when people start to get a little nervous because they’ve made some money, they try to figure out “How do I get it out?” because the 1031 is not necessarily set up to do that. So they wanna protect themselves.

A long, long time ago I happened to be watching a poker game; now, not one of these TV production poker games with the millions of dollars piled up on tables and stuff… This was a real-life poker game, and it was funny because I realized after a few minutes, Joe, that the person who was doing the best at that table was not the person with the most chips in front of him. They were very quietly, occasionally taking chips off the table, and I’d watched them put them into their pocket, and leave a few. And it was funny, it fascinated me so much–

Joe Fairless: You’re not supposed to do that, by the way, in poker… [laughs]

Dave Foster: But that was what was happening.

Joe Fairless: It worked, they got away with it.

Dave Foster: Exactly. So what this guy said, he goes “We call it rat-holing.”

Joe Fairless: [laughs] That’s a good term for it.

Dave Foster: Yeah, rat-holing. “And what it is we’re taking the bank’s money and leaving that in play, and I put my money in my pocket.” I thought, “What a beautiful metaphor for where I want to end up at the end of a real estate market – only with the bank’s money in play, and with my money safely in my pocket.” So I started to let that percolate with how you can do that with 1031 exchanges, and  here’s the gist of it… What it is, Joe, is an opportunity and a very strategic practice to begin to separate your debt and your cash. Debt which we associate with risk, because if you’re in debt, there’s always  risk going into a market downturn, of not being able to cover that [unintelligible [00:07:05].15] ending up having to adjust rents too low to meet your obligations… All those sorts of risks. Whereas cash is usually associated with very low or no risk. That cash is mine, nobody can touch it; I’ve got it rat-holed for a rainy day.

In a 1031 exchange, what difference in investing is it referring to? It’s the idea that instead of selling a property and buying several properties, instead of selling several properties and buying one property, what you’re gonna be doing is selling a property, and you’re gonna probably purchase multiple properties, but you’re going to allocate the cash proceeds in a different way.

Let’s do a for instance. Let’s say you’re selling a $500,000 asset that’s got $100,000 in debt on it. You sell the property, you come out of that into the 1031 with $400,000 in cash. Now, if you remember, from the rules of 1031, your obligations to defer all tax are to purchase at least $500,000, and to use all $400,000 in cash to do that… But you don’t have to allocate that $400,000 in any particular way, so what you can do is take $300,000 of that and go buy a debt-free cash asset. And that starts to feel very good. You’ve now protected that, you’re still generating return, it just may not be as good a return as you could get with a highly leveraged asset. But remember, our goal here is not to maximize return, but to maximize safety; we’ll be in a defensive, because we’re anticipating a market shift of sorts.

So a part of your 1031 goes to buy a debt-free cash asset. Then you take the remaining $100,000 and you leverage that maybe 50% or maybe even 25% to go buy another $400,000 asset. So at the end of the 1031, did you purchase at least as much as you sold? Well, absolutely. You bought a $300,000 asset free and clear, and you bought a $400,000 asset with $100,000 down. So you did purchase at least as much as you sold. Did you use all of your proceeds to do that? Absolutely you did. You just allocated them in a slightly different way.

What’s that impact of what you’ve got going? You’ve got $300,000 rat-holed. That’s gonna be safe, that’s the nest egg, that’s protection, it feels very good. Meanwhile though, you do still get some of the benefit of leverage, because you took the $100,000, leveraged that into a $400,000, so you’re actually still getting some of those normal benefits of higher ROI’s because of the cash on leverage in the arbitrage between what you’re able to borrow from [unintelligible [00:09:56].05] and what you’re able to make on the open market. And that’s what defensive investing is – it’s simply a placement of your portfolio that starts to separate cash and debt.

Joe Fairless: And I guess the challenge that I can see is the intention of this is to take – we’ll keep using the poker analogy – some chips off the table… But if you’re 1031-ing, then you are keeping the chips on the table because you’re still using those chips to buy another property, although in this case one of the properties you’re not buying with leverage. In my mind, if we’re selling at the top of the market, and the intention is for this to get some chips off the table, when we do a 1031 it’s likely we’re also gonna be buying in a similar market cycle, because it’s not that much time that’s gonna go from sell to buy the new property… So we’re still buying at a high point. Please elaborate more on those two points, just so I can understand a little bit better.

Dave Foster: Well, that’s always one of the biggest challenges of the 1031, is that because it starts with a sale and ends with a purchase within a compressed timeframe. The worst time to have to sell to start a 1031 is in a buyer’s market, because you’re offering to sell your property. The worst time to have to buy a replacement property in a 1031 is exactly where we find ourselves now, at the top of a market.

Of course, the reverse is also true – the best time to sell is at the top of the market. So it’s kind of one of those Dr. Doolittle’s dilemmas, the push me-pull you, or a chicken and egg, if you will. The best time for the first half of your 1031 is always gonna be the worst time to accomplish the second half.

Joe Fairless: Right.

Dave Foster: Defensive investing simply acknowledges that that’s just gonna be kind of the way it is, and what you’ve got to do is try and find that property which might lead you with your leveraged property to say “Because this might be something that I might have to hold through a cycle – if I’m buying at the top, I may have to hold it through a cycle, so I’m going to make sure that the leverage I take on it can sustain what I would deem a normal and possible hit on value, or a reduction in rent rolls, or whatever impact I see coming from a downturn.”

So I’m always gonna look at it with a conservative eye, even the leverage side. But because I have part of my portfolio over here in cash, the only function I’ve got to be able to do is keep my rent rolls above taxes and insurance and capital expense. So I can go through a down cycle very easily with a cash-owned asset. On the other side, I’ve just got to manage the brake and the accelerator pedal of leverage, to make sure that I don’t leverage it too high, so I can sustain the downturn, but I also leverage it high enough that if the market keeps going up for a year or two – which, hey, I don’t have a crystal ball; I hope it does, it might, it has before in the past… You just never know. But I position myself so that it can sustain the downturn and still get some benefit on the upside.

Joe Fairless: Do you have clients who do this?

Dave Foster: We do, and they all start to come out of the woodwork at about this time in the market… Because traditionally, the best way to handle a 1031 exchange, to get cash out, is to sell your property through the 1031 exchange, buy your new property, and then refinance. That’s conventional wisdom. Take cash out, and do whatever you want to with it. Well, the problem is that exposes you to an over-leverage susceptibility.

Joe Fairless: Yup.

Dave Foster: And in addition to that, where’s the cash-free safety net? So instead what they start to ask is they say “Dave, I want cash, but I don’t want to have to carry on all this debt.” Well, let’s find a good cash-performing asset that you can buy for cash, generate an income, and then let’s manage the debt over on the opposite side”, and that’s where they start to get to.

Now, even a further application of this, and what we’re really starting to see more and more, are investors who are saying “You know what, my time is over. I had a great run, I’m 60, 70, 80, whatever…”, I had a guy who’s 80 years old from Anchorage, Alaska, yesterday called me up and goes “I’m finally done with it. I’m done being a landlord. I’m 88.” I said, “Okay, good for you.” So what he’s doing is this exact thing, but he’s putting his properties into additionally not just cash, but passively-managed properties, either through fractional ownership, or tenants in common syndications.

He’s generating the benefit of cash investing, protection in the market, and he turned himself from a landlord into what I call a lazy-boy landlord. He checks his bank account or goes to the mailbox once a month.

Joe Fairless: Any unique challenges to this approach, where you’re separating it out, buying one cash, leveraging one, that we should be aware of?

Dave Foster: Yeah, there’s a bunch of things you wanna really pay attention to, because they can kill your return really quickly. Cost of borrowing of course is always a huge deal. We liken that to the brake and the accelerator pedal of leverage. As the market matures, typically, interest rates start to creep up, so you have got to have an eagle eye on your ROI. You’ve gotta know what that quarter percent of interest uptick is gonna do to your return.

I usually counsel that people avoid any sort of resettable debt, any sort of variable interest kind of thing. Lock it in. Again, get rid of the risk that three years from now or five years from now, in the middle of a downturn, you see an interest reset that pops things on you at the same moment when you’re having to reduce rents to keep tenants. You don’t wanna get in that position.

So watching your interest rates, keeping an eagle eye on the actual return on investment on the leverage side is key. On the cash side, you’ve got to make sure that  you’re gonna be generating enough cash that it’s gonna be livable for you even in a downturn, because when is the worst time to sell an asset? At the bottom of the market. And whether it’s owned for cash or not, you don’t want to get caught having to sell that asset once it’s lost 15%-20% of its value in the correction… For a couple reasons. Obviously, number one because I just always hate selling things for less than I buy them, but number two, because when you’re a 1031 investor, no matter when you sell, if you sell an asset without doing another 1031 exchange, you’re going to end up paying tax on the profits all pulled forward. So the worst thing that you can do as a 1031 investor is sell because you have to in the middle of a downturn market…. Because that not only basically wipes out everything you’ve done up to that point, it leaves you with a big tax bill, and there’s not enough real estate moving to help you overcome that.

Joe Fairless: Yeah, that’s a great point, just the locking in the interest rates, making sure we have enough cash, and then not being forced to sell. When people ask me about my thoughts on if they should 1031 or if they shouldn’t, my thought process is “Yes, you definitely should, but don’t force yourself into a 1031, because there could be a risk factor of buying a property for the sake of buying a property, versus it actually being a good investment.” What you really don’t wanna lose is the original amount of money that you had if you buy a bad deal, but then when you do find a good deal, then do these other things that you mentioned and you’ll mitigate the risk for the downturn and whatever else happens.

Dave Foster: Yeah, that’s exactly right. Of course, when you are early on your career and it’s your first 1031, or your second, the gains many times are not so substantial that the pain of foregoing a 1031 isn’t nearly so bad. But when you think about an investor who’s at the end of their career,  they had 20-30 years of investing, they’ve seen the ups and the downs, they’ve kept their tax deferral in place. I’ve got a family from Connecticut that right now we are on their third generation of 1031 investing.

Joe Fairless: Those musical chairs will not stop. They will always 1031, right? [laughs]

Dave Foster: Crazy, crazy, crazy. Yeah, grandpa 1031-ed, dad got the properties at a step-up basis, so the tax went away, but he immediately embarked on his own investing career using 1031’s, because he watched his dad, and now we’re doing 1031’s for the children. When you get to that kind of [unintelligible [00:19:15].18] in your blood, and there is so much pent-up gain after you’ve taken a property four or five properties forward, that you really want to do the 1031, you need to do the 1031… But you’re right, you’ve got to do it smart, and not just for the sake of avoiding the taxes.

Joe Fairless: Anything else as it relates to the concept of defensive investing using 1031’s, which is basically splitting the baby in half or splitting the baby in some way, paying cash…

Dave Foster: That’s so  Solomonic, oh my gosh…

Joe Fairless: Paying cash for one deal, leveraging the other, that way you’re mitigating risk by not having a lender on both…

Dave Foster: Yeah, absolutely. There’s a couple other things that are really nice little twists that you can use, that will help you to hedge the risk. The property that you pay for cash also many times could be a property – actually, I guess either property would work – that might be something you would want to live in one day.

Now, remember, the 1031 exchange is only for investment real estate. The property that you live in has different rules, and they’re actually very beautiful rules. They follow under section 121 of the IRS code, and what they say, Joe, is that you have lived in a property that you own for two out of the previous five years, you can sell that property and take the first $250,000  in profit tax-free. And if you’re married, you get to double that to 500k. Now, that by itself is a huge deal. The average American stays in their house five years, so over the course of 25-30 years of a normal life of an investor, you could literally move in, live for a few years, sell, and do that five times, and each time take 500k in profit tax-free.

Now, that by itself is huge, but where does that fit into defensive investing? Well, if you are anticipating a market correction, and if one does in fact happen, at some point in time you want to realize that you’ve actually got a three-legged stool [unintelligible [00:21:35].14] we’ve got a three-headed baby we’re dealing with. [laughter] You’ve got the leveraged property, you’ve got the property that’s held for cash, and you’ve got your primary residence. Now, if you are a real estate investor and it’s all going to heck in a handbasket and you need some cash, what would be the best property to sell? It might be the leveraged property, because you can get rid of debt, but remember, there’s a lot of 1031-deferred tax in that one, and that’s the one where you’re generating your highest ROI because of the arbitrage of the leverage. It might be the property that you own for cash, but same thing, you’ve got a lot of deferred tax in that property, and darn it, that’s a debt-free instrument that’s just generating cash for you. But you’ve got to sell something.

What if you sold your primary residence? That money is tax-free. Where are you gonna move? Why not into one of those other two properties? Because while the IRS requires that in a 1031 exchange you sell investment real estate and you buy real estate that you intend to also hold for investment, there is no prohibition against changing the use of that property after a period of time. Most of our investors feel pretty good at a year or two. There’s even an IRS safe harbor where they guarantee it after two years that you’ve satisfied the meaning of intent for investment purposes.

So if you were to sell your primary residence and take that money tax-free, you’ve now bought yourself some living capital, or even better, you’ve just bought a new war chest to start to invest in properties (where?) at the bottom of a real estate market.

Joe Fairless: So you could buy a property with your 1031 proceeds, you could buy a property that is say a large house, in an area that you wanna live in in 2-3 years, and rent it out, or at least post it to be rented out for that period of time (2 years), and then you can decide “Oh, I’m gonna sell my primary residence and move into that other property”?

Dave Foster: That’s exactly correct. Treat it as investment for a couple years, and once that has been satisfied, you could always change its use, and change your use by moving in. I have a gentleman here local to me in Saint Petersburg who is a realtor and has three condos that is 1031-ing into on St. Pete Beach. His retirement plan, the entirety of his retirement plan is that when he retires, he’s going to sell the house he lives in right now, and he’s gonna move into the first one of those condos. So what does he do? He gets a guarantee for a retirement house on the beach. Way to go! What an awesome deal that is.

After he has owned that and lived there for a while, he is going to sell that. Now, the rules when you are converting the property from an investment property into your primary residence are a little bit more restricting. We don’t have time to talk about it today, but contact me at will if you want at the1031investor.com and we can talk through it. He’s still going to get part of that profit tax-free. So his retirement plan is to move into a beachfront house, live in it and sell it in a few years, and pay a little bit of tax and take a bunch of profit tax-free. Where do you think he’s gonna move, Joe?

Joe Fairless: Next one?

Dave Foster: Exactly. And then the next one. And it was the funniest thing, because I asked his wife, who is the most patient soul in the world… I said, “So how are you guys gonna know when it’s time to move? What’s gonna be the trigger for this?” because that’s gotta be a little traumatic. And what she said to me was “Dave, we’re gonna know that it’s time to sell and move whenever it’s time to redecorate.” What a beautiful gig.

So that’s his retirement plan, and what he’s doing is slowly over time converting tax-deferred dollars into tax-free dollars. That’s the other half of the defensive investing equation.

Joe Fairless: That’s great stuff. I love learning, and I learn a whole lot whenever we talk, and I’m grateful that you were on the show again. How can the Best Ever listeners get in touch with you and learn more?

Dave Foster: You can always check us at our website, which is the1031investor.com. And by the way, for those of your listeners that are interested, we’re launching in September at that site on-demand video training on 1031 exchanges. This is the exact same training that I deliver nationwide as professional development courses for real estate agents and brokers, and we’re gonna make it accessible for free to the general public. So check us out at the1031investor.com, see the assets that we’ve got there. My address is very easy, Dave@the1031investor.com.

Joe Fairless: Defensive investing using 1031 exchanges… Basically, you are buying one property with cash from the proceeds of the original property, and another property leveraging that, and then you threw the wrinkle in there for maybe even having that be a property you wanna live in down the road. Really interesting stuff. Lots of ways we could discuss a lot more about this, and I know we just scratched the surface, but I’m glad that you talked to us about the concept.

Dave Foster: I’ll come back and let’s do it again.

Joe Fairless: There we go. Thanks again for being on the show, and I hope you have a best ever weekend.

Dave Foster: Thank you!

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