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Show Summary
In this episode of the Real Estate Pros podcast, host Michelle Kesil welcomes Jeffrey Peterson, a Minnesota attorney and tax law professor specializing in 1031 exchange strategies. Jeffrey explains the intricacies of Section 1031 of the Internal Revenue Code, which allows real estate investors to defer taxes on gains from the sale of appreciated properties by reinvesting in similar properties. He emphasizes the importance of working with qualified intermediaries to navigate the complexities of these exchanges and avoid common pitfalls, such as receiving proceeds before setting up the exchange.
Resources and Links from this show:
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- Investor Fuel Real Estate Mastermind
- Investor Machine Real Estate Lead Generation
- Mike on Facebook
- Mike on Instagram
- Mike on LinkedIn
- CPEC1031, LLC’s Website
- Jeffrey Peterson on LinkedIn
- Jeffrey Peterson’s Phone Number: (612)643-1031
Listen to the Audio Version of this Episode
Investor Fuel Show Transcript:
JEFFREY PETERSON (00:00)
By the way, you know if you could go through life without having to recognize gain, you know cha-ching, cha-ching, cha-ching, never having to recognize any gain, imagine how fast you could accumulate wealth. The rest of us have to go get a paycheck and give half of it to the government and then the other half go to our life expenses. But with real estate, you had sort of an easier way to accumulate that wealth because you are able to defer the gains and keep that money working for you.and also in real estate you get to use leverage. You can borrow money to increase your buying power and you get to deduct the interest on the loan that you take out for business purposes to acquire the property. So there’s a lot of advantages for building wealth in real estate, tax deferral, OPM, other people’s money. These are all important trends that are in your favor.
Michelle Kesil (02:24)
Hey everybody, welcome to the Real Estate Pros podcast. I’m your host, Michelle Kesil. Today I’m joined by someone that I’m looking forward to chatting with, Jeffrey Peterson, who is a Minnesota attorney and professor of tax law, helping specifically with compliant 1031 exchange strategies. So excited to have you here today, Jeffrey.JEFFREY PETERSON (02:47)
Thank you, it’s so nice to be here, thank you.Michelle Kesil (02:50)
Of course I think our listeners are really going to take something away with your expertise on tax strategies for investors. So let’s dive in.JEFFREY PETERSON (03:01)
I’m excited.Michelle Kesil (03:03)
First off, for those not yet familiar with you and your work, can you share what your main focus is?JEFFREY PETERSON (03:09)
So Section 1031 is a provision in the Internal Revenue Code. I can tell people are falling asleep already. And it allows you to not have to recognize gains when you sell appreciated real estate. So if you own a single family investment, a duplex, a triplex, small apartment building, a farm, industrial building, whatever you own, and it’s appreciated in value.You may not want to sell it because you’re concerned about triggering a lot of taxes. And so this is an avenue, a vehicle for you to defer those taxes, but it requires that you continue your investment into other real estate that will also be held for investment or business purposes. So it’s not a get out of jail free card. It’s a reinvest, don’t cash out, and we’ll let you roll over the gain for a while kind of provision.
Michelle Kesil (04:02)
Absolutely. That’s super helpful and important for investors. How do you support them through these tax codes?JEFFREY PETERSON (04:14)
So there’s a lot of different people that might be involved in someone’s 1031 exchange. They’re a real estate agent, the title company or escrow company that’s closing the transaction, a law firm that might be involved in closing the transaction. There is your accountant or your tax preparer or TurboTax, whatever you might use for your tax preparation.You need a qualified intermediary. And so that’s what we do is it’s a very niche business where we act as sort of the third party administrator that facilitates the mechanics of your exchange. We prepare the 1031 exchange agreement that makes us become your intermediary. We become sort of the synthetic seller of your relinquished property. And we actually are being paid by you to hold your money.
and apply your proceeds to the replacement investments that you designate during these exchange deadlines. So the first deadline is a 45-day deadline in which you have to designate or identify the replacement investments that you want to purchase. And the second deadline is the 180-day exchange period in which you have to acquire the replacement property.
and there is an opportunity for the IRS to shorten your 180-day down to the due date of the filing of your federal income tax return. So be careful if you’re starting an exchange late in the year and you file on maybe March or April 15th, you may not get the full breadth of your 180-day exchange period unless you extend your tax return filing deadline.
Michelle Kesil (06:43)
Yeah, absolutely. And are you operating nationwide?JEFFREY PETERSON (06:49)
pretty much nationwide.Michelle Kesil (06:50)
Awesome. What are the most common roadblocks or like pitfalls that you see your investors go through?JEFFREY PETERSON (07:02)
think generally speaking there is a lot of misinformed and ill-informed people about how 1031 exchanges work and oftentimes I feel like I’m being punked ⁓ like that television show that Ashton Kutcher had.because people call me up and they say, I’ve already received the proceeds from my sale. I closed on the relinquished property and now I want to do a 1031. And they are misinformed. They thought that they had 45 days after the closing to get set up with an intermediary. But in fact, you need to get set up with the intermediary before your closing takes place, before the benefits and burdens of ownership shift so that you can be insulated from receiving those proceeds. Once you receive the proceeds,
you have a recognition of gain. There’s also some other requirements. You have to give certain notices to the other parties that you’re doing an exchange, and there is sort of a formula or framework in which you have to do the exchange to make it compliant under the safe harbor for qualified intermediaries. So we have to restrict your ability
to hold your own money. We have to restrict your ability to receive those proceeds. What you’re going to receive instead of your proceeds is like kind real property investments that you designate and acquire within the deadlines that we talked about.
By the way, you know if you could go through life without having to recognize gain, you know cha-ching, cha-ching, cha-ching, never having to recognize any gain, imagine how fast you could accumulate wealth. The rest of us have to go get a paycheck and give half of it to the government and then the other half go to our life expenses. But with real estate, you had sort of an easier way to accumulate that wealth because you are able to defer the gains and keep that money working for you.
and also in real estate you get to use leverage. You can borrow money to increase your buying power and you get to deduct the interest on the loan that you take out for business purposes to acquire the property. So there’s a lot of advantages for building wealth in real estate, tax deferral, OPM, other people’s money. These are all important trends that are in your favor.
Michelle Kesil (09:22)
Yeah, absolutely. Those are important strategies. Do you find yourself working with new investors or are you like working with experienced investors that maybe aren’t aware of some, you know, maybe higher level tax codes that they can also work with?JEFFREY PETERSON (09:42)
I would say that about 70 % of our customers are first time 1031 exchange candidates. They’ve accumulated some wealth, they’ve built some equity, and now they have an opportunity to sell it. Sometimes the opportunity has just fallen in their lap because they haven’t even advertised the property for sale and they have to you knowdecide, do I want to pay the taxes and just get this over with or do I want to continue my investment in real estate to defer the gains? That’s the decision that a lot of them have to make. ⁓ I think that some people have real estate in their blood and they really don’t like paying taxes unnecessarily. So sometimes the decision is very easy. I want to defer the taxes and I’m not going to do a sale unless I can structure it in a tax deferred manner.
Michelle Kesil (11:06)
Yeah, absolutely. Besides 1031, are there other strategies that people can use as well?JEFFREY PETERSON (11:15)
There are a number of other strategies.For one’s principal residence, your home that you live in, there’s a different code section, Section 121, that has to do with the sale of one’s principal residence or domicile. And that’s an interesting code section because it actually excludes the gain as opposed to 1031, which merely defers it. But the exclusion is capped at 250 if you’re single, 500 if you’re married. Now what’s really interesting is if you own a property that’s a mixed-use property, maybe a portion of
is your principal residence and a portion of it is used for investment rental purposes like a duplex is a good example or a lot of people that are doing the housing hack will live in one bedroom and rent out the other bedrooms to their friends.
Well, when you go to sell that property, you can take a principal residence exclusion for that portion of the property that’s been your domicile, your home, but for the other portion of the property, say a duplex, the other half of it, you could do a 1031 exchange and split the baby, if you will, split the proceeds to maximize the benefit of both the principal residence exclusion for the domicile part and the 1031 exchange for the rental business part. And then you get the maximum benefit.
Now here’s a really interesting strategy. In places where appreciation has increased far more than the exclusion amount. Let’s say that you bought a home in Los Angeles in 1977 and now it’s worth a million and a half dollars more than you bought it for. That’s more than $500,000 if you’re married, more than $250,000 if you’re single. And you may say to yourself, I’m going to get my clock cleaned.
if I sell this Los Angeles property because my exclusion isn’t enough to cover my gain. So you might consider moving out of your Los Angeles home and turning it into a rental so that when you do eventually sell it, now it’s eligible for both the 1031
but the look back period for the principal residence is five years. So you have to be able to say within the last five years it was my domicile for two of those five. Now you’re also able to take the principal residence exclusion. Again, it’s kind of like the duplex but it’s different. You’re able to take the 1031 for their excess over and above the exclusion amount. Awesome strategy.
Michelle Kesil (13:41)
Yeah, absolutely. That is awesome that people can utilize these and grow their wealth in these unique ways.JEFFREY PETERSON (13:50)
A lot of business owners are trying to sell their small inner city parcels where they may be kind of constrained and locked into a too small of a facility and too small of a neighborhood and they want to expand and grow out in a different area. they’re doing 1031 build to suit exchanges where they sell their relinquished property and use an intermediary to not only facilitate the exchange but also to facilitate the construction of a new facility.buy a piece of dirt and quickly assemble or construct their new facility in which they want to do business. A lot of times people are selling in an inner core area and they’re moving out to where land is cheaper and the regulatory environment is a little bit more friendly. So you see people constructing new facilities and using their tax deferred dollars to pay for the construction of those improvements.
That really gives them a double benefit because they’re able to fund the construction and then that construction allows them to be more productive because they built the property to their specific needs and specifications to maximize the profitability of their business and make them more efficient. So it’s a win all around for business owners to do a build to suit construction exchange.
Michelle Kesil (15:53)
Yeah, definitely. And when you’re supporting people, like what does your role look like in their process with these tax codes?JEFFREY PETERSON (16:05)
Well, we’re not their accountant, we’re not their attorney, we’re not their best friend, we’re not their nursemaid. We are a third party acting as a principal to facilitate the mechanics of the exchange. And so we’re very knowledgeable, but really our role is to prepare the 1031 documents precisely and correctly for this transaction to hold the money from the sale and then coordinate the logistics.If they need to make an identification, they can send the identification or written designation to us before the deadline passes. If they need to acquire replacement property, they can designate that property and direct us to purchase it for them.
So there’s a very unique role here. It’s a very narrow role in that we’re only in this relationship with them for up to 180 days and oftentimes much shorter than that because people tend to get in and out of these exchanges very narrowly and quickly because they want to get their money redeployed. They want this money to get back to work for them and they want the certainty that they’ve locked in this tax deferral.
The longer this exchange goes on, the more uncertainty there is whether or not this looming tax bill is going to come home to roost and they’re going to have to pay a lot of taxes. So lots of people want to finish out the exchange and get it done with as quickly as possible.
Michelle Kesil (17:31)
Absolutely, that makes sense. What are you most focused on solving or scaling to next when it comes to the next piece of your role in this business?JEFFREY PETERSON (17:44)
I think that the thing that’s going to change this industry is the securitization of real estate. That more and more real estate investment trusts like REITs are dropping properties down from their REIT into what are calledDelaware Statutory Trusts or DSTs. When you buy a beneficial interest in a DST that’s properly set up, you’re deemed to have bought the underlying real estate that’s in that trust. So they’re using the DST as a vehicle to mop up and soak up, absorb all of this 1031 money that’s floating around looking for a home. The REITs are using this money to acquire the designated property
And then after a few years, if they elect to do so, they can absorb that property back up into their REIT and make all of those beneficial owners now partners in an up REIT transaction where the only interest of the partnership are the REIT shares. Effectively, you own REIT shares through the partnership. And now,
rather than having all of your eggs in one basket, you’ve got the broad diversity, the geographic and business diversity of the entire exposure of the REIT. So you probably have a less risky investment and you may have even more lucrative returns because the returns are more variable when you get up into the up rate. So that’s a really interesting development and it gives a lot of people an avenue
to redeploy their money into a real estate investment that’s not going to require them to be heavily into the management and heavy into the risk. They want a steady, eddy, relatively low risk.
low management opportunity. The financial planners are loving this because it allows them to solve a problem for their clients and get more money under management. Clients love it because when you get older you’re less able to adapt to problems and to resolve those problems and you just don’t have the energy to do it anymore.
Michelle Kesil (19:57)
Yeah, absolutely. That’s awesome. is there like a difference when it comes to every client and the tax strategy or is it like a blanket approach for each person?JEFFREY PETERSON (20:15)
You know, everyone’s situation is different. Some people have lots of gains because they’ve owned a piece of property for a long time. And every year that you own the property, you’re entitled to and required to actually take a deduction for the theoretical wear and tear on that property. That’s called depreciation.So if I owned an apartment building for 27 and a half years, over that 27 and a half years, I would have depreciated it down to zero, which means I took a tax deduction for each year for the theoretical wear and tear in that building. And each year that I took that deduction, I had an incremental reduction in my basis. So let’s say I bought it for a hundred over time, I will depreciate my basis down to zero or near zero.
⁓ your cost is your initial basis and then the basis gets decreased over time by these deductions. That creates a gain in itself just because your original cost basis is deteriorating, but at the same time the property may actually be going up in value partly because of inflation because the US currency is declining in value in comparison to hard assets and also scarcity.
property in San Francisco is scarce. It’s hard to find something to buy and that makes the price goes up because the demand is high. So you can also have increases in value because of demand. So real estate owners have gains and everyone’s gains are a little bit different. Some are more heavily on the depreciation side, some are on the appreciation side.
These investors though have something in common. They generally don’t want to pay taxes unnecessarily and they want to think about things like a chess player and think two or three moves ahead. What is it that I have to be doing now in order to set myself up for success to get this tax deferral? And that might necessitate doing a reverse exchange which is where you have the intermediary acquire the replacement property first
and hold it for your benefit until you dispose of that relinquished property typically within 180 days. So if you want to know that you got a sure thing to exchange into and you don’t want to risk the 45-day period for identifying and you want something for sure, you can do what’s called a reverse exchange and have the intermediary as your surrogate, your substitute, purchase that property as your straw man if you will.
An alternative to that would be to go to the seller and say, seller, I love your property. Can I put the handcuffs on you? Can I lock you up with a contract or an option? And if the seller is patient and doesn’t have an immediate need to get this closing done, that might be a simpler way to lock up a sure thing. But in my experience, most sellers are not very patient and they want to get their deal closed quickly. They don’t want to have an indefinite closing period.
Michelle Kesil (23:29)
Definitely, thank you for that explanation, makes sense.JEFFREY PETERSON (23:32)
Have you heard of an app called or a program called PadSlip? Well, there’s all these different ways to rent properties. There was Airbnb, VBRO. This PadSlip is another way that people are renting out rooms in a house. So rather than renting out the entire house, they’re renting out a portion of the house.Michelle Kesil (23:37)
No.JEFFREY PETERSON (23:53)
And that is a way for landlords or owners to get a maximum return because they charge a higher amount of rent for a smaller portion of the property. They’re renting out the room rather than the whole thing. And I think there’s lots of investors that are looking for ways to maximize the yield, the cash on cash return that they’re getting for their investments. And they’re really being very clever and smart and there’s a lot of ingenuity going on.with real estate owners wanting to find new ways to maximize the income and make their equity work as hard as possible for them so that they can enjoy a comfortable life in their retirement and build wealth for their retirement.
Michelle Kesil (24:40)
Sure, yeah, that’s pretty innovative, but there’s all these ways now.JEFFREY PETERSON (24:45)
There really are. mean, the housing hack is a nice one that I think a lot of people are doing, and that’s a good way to get your feet wet. But that’s just the beginning. And there’s a lot of other tools available in the tool belt. After 2027, there’ll be another opportunity for the next iteration of the Qualified Opportunity Zone, QOZ, and that takes effect in 2027. And then there’ll be even more avenues, I think, for tax deferral on the sale of real estate.Michelle Kesil (24:51)
Mm-hmm.JEFFREY PETERSON (25:15)
Furthermore, these tax deductions that you’re now allowed under the big beautiful bill that became the big beautiful law allows for more rapid depreciation. So people are also offsetting gains that they incurred from the sale of real estate with new tax deductions that they’re accelerating on the purchase and construction of new facilities and improvements that they’re picking up. So that’s another way to kind of offset the gain is to createrapid depreciation deductions to accelerate your deductions when you buy new property. It’s not a 1031 exchange and it’s not quite the same, but it’s another tool in the tool belt that people didn’t have before when there wasn’t 100 % depreciation.
Michelle Kesil (26:00)
Right. Thank you for sharing that. That’s fascinating. So before we wrap up here, if somebody wants to reach out, connect, learn more, where can people find you and connect with you?JEFFREY PETERSON (26:02)
You bet.I love to talk to people on the phone. You can reach me on my phone which is 612-643-1031 or our website cpec1031.com. That’s Charlie Papa Echo Charlie1031.com. I like to collaborate with people and I like to build a team around you to create the maximum
possibility for your success. So we may want to involve your accountant, your lawyer, your real estate agent, your banker even, and building a team around you to basically make your plan come to life, whatever that plan might be.
Michelle Kesil (26:57)
Perfect, well, appreciate your time, your story, and your perspective. Thank you for being here.JEFFREY PETERSON (27:03)
Thank you for having me.Michelle Kesil (27:05)
Of course. And for those tuning into the show, if you got value, make sure that you have subscribed. We’ve got more conversations with operators who are building real businesses and we will see you on the next episode. -
