Business Management

The Exchange Files: 3 Buy & Hold Exit Plans Designed to Save Big on Taxes

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blue vacation beach rental property with blue siding and white trim and two upper floor balconies on beach

We’ve all heard of investors who hang up the towel and move everything into passive holdings. But if Stephen Covey is right and “your most important work is always ahead of you, never behind you,” that might not be your best exit strategy.

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Here are a few real-life examples of real estate investing exit ramps less traveled, which I've dubbed my "1031 exchange files."

The Grand Exit

After a lifetime of farming, our clients were ready to put up their boots. Their grandchildren, living in three different states, figured largely into their ultimate exit strategy. In addition, they incorporated estate planning in their decision process. Once they identified what they wanted, they discussed options extensively with their adult children.

When the time was right, they sold their farmhouse and the adjacent land not used in farming tax-free under the primary residence exemption and purchased a new home. They also sold their farmland and avoided a tax hit with a 1031 exchange.

They then completed a diversification exchange. This allowed them to take the farmland proceeds and purchase an investment property close to each of their grown children.

They identified replacement properties that fit both their income needs, as well as their children's individual interests and expertise. They purchased an apartment building, interest in an oil well, and a mixed-use property. When the transactions were completed, they had holdings near each of their children and all of their grandchildren.

real estate investment, rental, housing

Additionally, each asset was designated as the inheritance of the child for and with whom they had selected it. Consequently, with this vested interest, the children became partners with their parents.

The new investment properties were managed for the parents’ immediate benefit and the child’s long-term gain. Proximity placed ongoing management under the children’s purview. This did not stop our clients from routinely checking in on their “investments.” Not all exit strategies let you write-off every visit to your grandkids!

Related: What’s Your Exit Strategy? A Case for Converting Your Real Estate to Paper Assets

Vacation Exit

These investors identified their desired retirement city years before they were ready to slow down. They selected a condo community that was a perfect fit and watched for units coming up for sale. Then, they would sell one of their other investment properties and use a 1031 exchange to buy the unit. Eventually, they transitioned all of their investment properties to vacation rentals in anticipation of their eventual relocation.

Upon retirement, they qualified to sell their primary residence tax-free and added those proceeds to their retirement kitty. After that, they moved into one of their vacation rentals, converting it to their primary residence. They hired a management company to look after the other units. Now they keep an eye on their rental agents while sipping margaritas by their pool.

When their cash flow needs dictate OR when it's time to redecorate, they plan to sell the converted unit and move into another one. Under the primary residence exemption, after as little as two years of owner occupancy, they can sell it and receive a pro rata share of the proceeds—less depreciation recapture—tax-free.

For example, they operated that first unit as a vacation rental for three years prior to moving in. If they sell it after living in it for two years (two years of the minimum five total years of ownership prior to sale for this conversion), they can take two-fifths of the proceeds up to $500,000, l—less depreciation recapture—tax-free. And the longer they live in the unit, the more they can cash out tax-free.

Their vacation rental exit strategy is to repeat the conversion/cash out process. An unexpected bonus? They get to pick their own new neighbors!

Active Exit to the Hills

Sometimes an opportunity shapes the exit strategy. This is the case with other clients of mine who are in the middle of planning for their exit from both their 9 to 5 routine and their buy and hold investment.

Woman in warm blanket relaxing and drinking morning coffee on cozy bed in log cabin in winter

They found a beautiful tract of land that stirred a deep desire in them. Their goal is to live on it and manage their own tiny home campground in the hill country near Austin. To that end, they put their investment property up for sale while they used a reverse 1031 exchange to purchase this large tract of land that was substantially cheaper.

As their qualified intermediary, my team formed a single purpose entity called the Exchange Accommodating Titleholder (EAT) and purchased the new property before they sold their old property. Shortly after the EAT took title to the land, they sold their old property. They were able to use funds from their exchange account to improve the land toward their goal of a tiny home campground.

Related: 5 Real Estate Investing Lessons Learned From Building a Campfire

Phase 1

They started by putting up a caretaker’s cottage, creating roads and internal infrastructure, and placing several campsites strategically. At the end of phase one, they had spent enough money to fulfill their 1031 exchange. So, they took title to the land and improvements. This completed their 1031.

They started using these as weekend camping sites for folks from the area looking to getaway. They advertised on Hipcamp.com.

Phase 2

They plan to turn the campsites into tiny home sites over time. Once built, they plan to market the tiny homes as weekend getaways for people from the surrounding areas.

Phase 3

This is their favorite goal. Phase three will be to move into the caretaker’s cottage after a few years and convert that to their primary residence. From there, they plan to manage the tiny home vacation village on their land through retirement.

Phase 4

This final phase involves estate planning. They plan to divide the tiny home sites into parcels with their own acreage. Upon their passing, each heir will inherit a parcel.

The Graceful Exit

Many investors seek to exit into passive investments. Delaware Statutory Trusts (DSTs), Tenants in Common (TICs), and Triple Net (NNN) holdings appeal to many nearing retirement. They qualify as replacement real estate for 1031 exchanges, which defers the tax on gain and depreciation recapture. They are generally seen as more stable.

With these, the most active part of your management may be accessing online banking to check your balance after the lease payment comes in. Sounds appealing, but is that your best path?

Courtesy of www.ellishammond.com

Ellis Hammond’s infographic suggests that people who retire often feel burned out from a lifetime of work rather than positioned to embrace the rest of their life. That is why these client stories are inspiring: They set their own terms. They charted courses to finish strong, be financially free, and do what they love.

No matter where you are in your investing journey, I would encourage you to consider their examples and follow Covey’s advice to “begin with the end in mind.”

What’s your retirement plan? What steps are you taking to get there? What obstacles have you encountered? 

Let’s talk in the comment section below. 

Dave Foster, real estate investor and qualified intermediary, has 20 years of experience working in all phases of real estate investing, from large scale development to single family homes and vaca...
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    Joseph M. Investor from Boulder, CO
    Replied 10 months ago
    Love this article, Dave. I have been questioning my resolve and my strategy, but this was a good reminder to not only the financial benefits I will reap, but all of the other more important ones; freedom, autonomy, choices, time.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 10 months ago
    Thanks Brian. You're absolutely right - cash is a powerful drug. But the 1031 investing path can help your resolve and discipline to stay the course and reap much much more in the end. Hang tough. Good things await!
    Jason Turgeon Realtor from Boston, MA
    Replied 10 months ago
    Lots of food for thought in here, Dave. Hopefully in a few years I'll be ready to move into the retirement planning phase of my real estate activities!
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 10 months ago
    You're on the right path Jason. Keep it up!! Glad we can be a part of your journey.
    Mark Creason Real Estate Lender and Broker from Dallas, Texas
    Replied 10 months ago
    @Dave Foster I read the whole article and was disappointed that there were no retirement on a boat stories. Mark
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 10 months ago
    LOL. There's a boat story on my website. Wouldn't want to disappoint you Mark!
    Keith Gehring from Waukee, Iowa
    Replied 10 months ago
    I believe “exit stategies” are one of the most non-discussed topics of RE investors. However, i love this article! Great job, and i would love to hear about more real life examples!!!!
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 10 months ago
    Thanks Keith, I agree it's those success stories that inspire me and show me how I can do it too!! As you can imagine after 20 years of this we have plenty of real life stories - stay tuned!!!
    Matt Deibel Real Estate Investor from Sunset Beach, California
    Replied 10 months ago
    Hi I’d like to get your advice on an exit strategy from a SFR investment property my parents own they plan to sell. Can they tax free exchange it into anything besides another investment property?
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied 10 months ago
    Hi Matt, The 1031 exchange is specifically for the sale and purchase of investment real estate. However, there are some interesting things that the IRS counts as real estate that are not really. And a couple other opportunities to generate tax deferral outside a 1031 exchange. I'd be happy to chat with you privately. IM me here at Bigger Pockets and we can start a dialogue. Dave