Due to the vast amount of coveted real estate—from beachfront property to idyllic suburban hideaways—and opportunities for investment in Greater Los Angeles, the area has almost become a safe haven for prospective buyers. People are now wanting to own multiple properties and many are now able to do so by taking advantage of the 1031 exchange. With tax implications lessened, wealth builders are benefitting from this deferral process when buying and selling.
For a unique perspective on 1031 exchange we speak with Senior Vice President of Partners Trust Commercial, Morgan McMullin. Morgan, with more than $240 million in transactions to his name, continues to grow his business through unsurpassed observation and knowledge of the commercial market. Many in the industry view him as a regarded expert who understands the nuances of sales and acquisitions like no other. And when it comes to 1031 exchange, Morgan agrees that this has proven a smart choice for many in the LA area as well as for international buyers.
In the past few months alone, Morgan has completed six different 1031 exchanges, improving his clients’ positions in real estate. So we sat down with Morgan to discuss 1031 exchange in depth—from what it is, exactly, to the benefits and potential challenges it presents.
Let’s start with the basics, in a nutshell, what is a 1031 exchange?
If done properly, a 1031 exchange allows an investor to sell a property and reinvest the proceeds into another property and defer capital gains taxes.
What are capital gains taxes?
These are taxes that you pay when selling a property that has gone up in value; they can often amount to up to 25% of your gain proceeds. By doing an exchange, you defer the payment of those taxes and essentially you get to invest with the government’s money.
How often do people do these exchanges?
I would say that 80% of the transactions that I have done over the past decade have an exchange party involved, either on the sell or the buy side. There are huge financial benefits to exchanging income producing property (rental homes, apartment buildings, retail centers, etc) into other investment properties.
Aside from the obvious tax savings, what are some of the benefits of doing these exchanges?
It allows property owners who have a lot of equity in their property to reinvest that equity, without paying capital gains taxes, into another property that can give them more income on that equity and more future growth. At Partners Trust, we have been very effective at exchanging rental homes into apartment buildings where you get significantly more cash flow and similar or better equity appreciation.
Ok, can you put this into dollars and cents perspective?
Sure. Let’s say you own a $2,000,000 house, free and clear, that is renting for $5,000/month. At the end of the year, assume that your annual net income (after property taxes, insurance, and maybe a few miscellaneous costs) is $50,000. Well, that amounts to a 2.5% return on your equity. Now, say you exchange that $2,000,000 into an 8 unit apartment building at a 4.5% cap rate, that would amount to $90,000 NET INCOME (an 80% increase in annual cash flow). That cash flow also tends to grow at a much faster rate than a single family home because of your ability to increase the rent in all units every year–not just one renter. You also minimize the effect of vacancy by having many units, as opposed to one.
Can you give us an example of a recent exchange that you have completed?
I just recently completed the second exchange for a long term client who started with a small rental house in Orange County. The client sold and exchanged this into an apartment building and after a few years exchanged again into an Absolute Triple Net Single Tenant KFC. His income increased significantly on both exchanges. He now owns this NNN asset which has great income and a 20 year lease. This is attractive to him because he is retired, depends on the income to live, and doesn’t have to deal with any management. I have also exchanged many clients from poorly producing assets into much better producing assets and have helped to grow their net worth and holdings tremendously.
When does someone know that they should do an exchange?
It all comes down to a case by case analysis. After analyzing thousands of these scenarios, we are very adept at identifying situations where a client can benefit from doing an exchange.