Transcript
Intro
Stephan Shipe: Welcome back to the Scholar Wealth Podcast. This week, a question about buying a new home before selling the old one, and how to weigh the trade-off between selling investments for cash versus taking on some short-term debt.
Then we look at the growing trend of private market options showing up in 401(k) plans and what investors should consider before adding them to their retirement portfolios.
Finally, a conversation with Julie Baird, President of First American Exchange Company, one of the nation’s leading qualified intermediaries helping clients across the country navigate 1031 tax-deferred exchanges. Julie shares what investors should know about timelines, replacement property rules, and how these exchanges fit into long-term wealth and estate planning.
So let’s go ahead and get started with question number one.
Question 1 – Buying a New Home Before Selling the Old One
Listener: We are moving and have not yet sold our current home. As we look to purchase our new home, we can either get a mortgage or sell investments from our brokerage account to buy the new home for cash. Then when the current home sells, replace the funds in the brokerage account. There is an opportunity cost with removing the funds from the market, but there is also cost to setting up a loan and paying it off in a short-term horizon. How should we analyze this decision?
Stephan Shipe: For this type of situation, we have to weigh out whether selling versus the mortgage takes into account both the flexibility that you have at that time, but also the reality of selling the home.
I’d say that’s probably the biggest factor that comes into these decisions. When I’m speaking to somebody and we’re walking through this exact scenario, one of the first questions that comes up is: first, can you maintain both homes? So that’s rule number one. Is this a moot point — are you not going to be able to have both of them going on?
If you can, because the first home is paid off, it sounds like you would be able to. You just have one mortgage to deal with on maintaining the two homes.
The next comes in: how fast do you think you’re going to sell the home? Now this one you have to be a little careful on, because a lot of people think that their home is going to sell quickly — and then they find out that it might not sell as quickly as they hoped, or not sell as quickly as they hoped for the amount they were hoping to get from it.
So we want to be careful on any type of math that we’re doing or any type of modeling that you’re doing on this type of situation — is it actually accurate, and does it have some buffer room in there for if the house doesn’t sell for six months, is that still doable? Both in an ongoing cash flow perspective from the mortgage and just an overall sales perspective of the value you expect to get for your current home.
So assuming that’s good, then we get into: this all works, I want to buy the house, I’m ready to buy the house. Does the money come from the brokerage account, or does it come from a mortgage?
This one’s relatively easy, especially if it’s straightforward in the sense of: if you can go into your investment account and pull out the money you need to be able to purchase the home in cash for a minimal amount of capital gains.
Now, I know “minimal” is a tough word to use — it’s relative. But in times where the market’s dropping or you have recent additions into a portfolio, a lot of people are surprised that they could probably free up that amount of cash for three or four percent of the total amount of the portfolio they’re pulling if they do so strategically.
So if you’re pulling a million dollars out of the account and you have $200,000 worth of gains, and you’re going to go pay 15% on that — or $30,000 — to free up a million dollars at 3%, that’s probably worth it, especially when you compare it to the cost of a mortgage or anything along those lines.
And a lot of times it comes down to the ease of not having to deal with a mortgage and just paying for it in cash.
Now, let’s say you look at it and say, that’s not the case — I’ve got some huge gains in here, I have problems, I’m not going to be able to free up that much cash that easily.
So in that scenario, we start looking at short-term cash. This is one of the few times where you could tap into an emergency reserve. If you have six months, a year’s worth of cash, or a couple years of cash, maybe pulling a large amount of that could be useful — along with something like a bridge loan, or you start getting into lines of credit.
You have a couple options when it goes the line-of-credit route. You can go with a portfolio line of credit, if your broker allows it. These typically have higher interest rates. You have to be a little careful there about how long you’re going to keep that line of credit.
Going back to that initial concept of how long it’s going to take for you to sell your house — if you said, “Well, I’m not going to go pay the $30,000 in capital gains, but I’m going to go take out a portfolio line of credit for a million dollars, and now I’m going to pay seven or eight percent on it, and I’m not going to be able to sell my house for six months” — well, you already paid your $30,000.
You should have just gone and sold the cash out of the portfolio and gone that direction, especially with the market where it is.
Whenever we’re looking at overall valuations and cash deployment, we have to look at valuations on the market now versus what the expected returns should be in the future.
If valuations in the market are higher, then we can’t use the average return as an expectation of the future. If valuations are lower, then we’d probably use something a little higher.
So I’d say that opportunity cost that you’re bringing up of selling investments — that opportunity cost is lower the higher the valuations are on the market, which I’d argue is where we are right now from a historical context.
Your other option is always a home equity line, depending on what your current home value is.
So it sounds like it’s paid off — going in and pulling out a large home equity line of credit on the current home and using that in combination with some short-term cash and maybe selling off some of the securities that have the lowest amount of capital gains could give you this combination of cash and liquidity that you need to go buy the home in cash.
And then when you sell your current home, you pay off the equity line at that time.
So we still have to watch the interest rates there, but what it really boils down to is we want to be able to stay flexible but not overthink the tax and opportunity cost situations of selling brokerage holdings to free up that cash — because a lot of times those tend to be overstated.
Let’s go into our second question.
Question 2 – Private Market Investments in 401(k) Plans
Listener: I’ve heard that my 401(k) will be offering some new private market investment options. How can I tell if they’re worth considering?
Stephan Shipe: We have to be careful when we’re investing in any type of private investments. And it’s not to say that private investments are a bad idea or that they’re unnecessarily risky — it’s a different type of risk and a different type of transparency that’s required of these private investments.
What’s made that really interesting over the past few months is that, with the executive order in August, we’ve now allowed — or at least, in theory, allowed — private investments into 401(k) plans, or allowing private investments to be included as an option for 401(k) plan participants.
There’s still some limitations on that yet as we wait for guidance from the SEC and Department of Labor on what that’s going to look like in terms of protection, because you have to think: if you’re a 401(k) provider and you’re adding that list of all of those different funds, you have to assess things like, is the risk appropriate? Is the fee appropriate? Does it make sense for it to be included in a list of potential funds for plan participants to choose to put their retirement savings in?
Because of the issues of private equity, there’s been a pause from some of these sponsors saying, “I’m not ready to jump in yet and say all the employees of this company can have access to this private equity fund,” because they don’t really know what protections they have as a fiduciary in those scenarios. So it’s still not there yet.
When we start looking at why we include them or whether you should participate in them, I’d be pretty cautious upfront. The reason for that is that typically we’d recommend no more than maybe 10 to 15 percent in private investments — and that’s after you’ve hit some pretty major milestones in your finances.
In other words, we want to make sure you have adequate liquidity, that you’re an accredited investor, that you have plenty of wealth to get you to retirement. So now we’re talking about a portfolio that’s truly building up not a base level of retirement savings, but an excess amount of discretionary capital that’s free to use.
So when we start jumping into the private markets, the problem with the 401(k) is that, by definition, the 401(k) participants are everyone. Traditionally, private market investments are only allowed to be given to accredited investors — so you have to meet a certain net worth threshold or income threshold before you’re allowed to participate in these markets.
The reason for that is because of the lack of transparency and the opaqueness of private investments. That leads itself to a lot of potential for risk, both in straight counterparty risk and in the risks of the actual investments. The government then set an accredited investor line and said, if you have a certain level of net worth, maybe we don’t have to worry about you as much, or you’re going to be classified as a sophisticated investor, so maybe you don’t fall prey to some of these traps.
Now, I’d argue that I don’t think net worth is a good measure of investor sophistication. There’s no test that gets taken for anyone to say you’re allowed to invest in highly complex instruments — we just use an arbitrary number of net worth or income and say, “Well, if you meet this, then you’re allowed to invest in a lot of things that have a lot of complexity built in.”
The problem I have with this — the worry that I have — is how private investments are actually priced, and the lack of them being marked to market.
So being marked to market would say that if I pull up the price of Apple right now, I can tell you exactly what it’s trading at in the market. The problem with private equity is similar to your home. Think of your home value and saying, is my home marked to market? It’s not — no one’s trading your home on a daily basis. You can have an idea of how much your home is worth, but you really don’t know until it sells.
Private equity is even more opaque than that, because there’s no Zillow out there that tells you how much your private equity is worth. So when you get a private equity position, you may buy into something in your 401(k) — let’s say you go put $100,000 into one private equity position — how do we deal with situations like returns that are delayed, or the value that gets placed on your quarterly 401(k) statement?
Do we just put “N/A” for not applicable? Or a question mark for the value component? It’s really hard to verify that amount, and when the value is given, that’s usually given by the private equity fund. So now there’s some conflict there — is that truly an independent valuation of that investment in your portfolio?
Not to mention, what happens when we start doing things like Roth conversions or different types of IRA investments? Or what happens when somebody goes and invests in a private investment that keeps them locked up for 20 years when maybe the prospectus says they’re only supposed to be in for a three- to five-year investment?
That’s not a guarantee. But if you’re not an educated investor in that area, you don’t know. I could come up with a private equity fund and call it the “Super High Growth Private Equity Fund,” drop that in a 401(k) option, and show you a few years of returns of 30%. You look at that, and if you’re not a sophisticated investor, you think, “Well, I’m looking for high growth,” and you see a fund called the Super High Growth Fund with a 30% return — so you drop 100% of your money into it.
And then maybe it’s not liquid for 20 years. How are we going to handle that situation with longer lockup periods, balancing giving investors the flexibility to invest in whatever they want within that 401(k), and also balancing the complexity that comes with some of these more advanced investments?
So we have these issues of classic behavioral traps — both on the fear and greed side, and also on the 401(k)-specific side. There have been studies that show that people invest their 401(k)s based on the names of the funds. No one ever reads the prospectus that’s out there. So they just go through and look and say, “That sounds like a good fund, that one sounds like a good fund,” and they go through — 10% here, 20% there, 30% there, 40% there — and they’ve allocated their portfolio.
Or they’ll use what’s known as the naive approach, where they’ll just say, “Well, there are 10 funds in my 401(k), so I’m just going to throw 10% into every single one of them.” Which makes absolutely no sense whatsoever.
Can you imagine if somebody’s having that much difficulty allocating a 401(k) to index funds and traditional mutual funds — what happens when you start throwing private market investments in there? There’s not going to be enough asterisks that you can put on top of the returns to educate somebody on all the different types of liquidity risks, counterparty risks, and overall risks of a lot of these investments.
So I’d be very hesitant to throw this type of investment into a 401(k). I think it’s a great opportunity if you have your 401(k) set up in what I’ve always called kind of the “boring portfolio.” Set your 401(k) up in the boring portfolio.
If you have excess funds outside of the 401(k) — in a brokerage account — that you want to allocate to private equity, maybe that’s a better place. Especially when we look at the overall market and the overall market participants in the country.
From the Field – Interview with Julie Baird
Stephan Shipe: And for today’s From the Field conversation, we explore how real estate owners can use 1031 exchanges to defer taxes and reposition their portfolios for the next stage of growth.
Today we’re joined by Julie Baird, President of First American Exchange Company, one of the nation’s leading qualified intermediaries for 1031 exchanges. Julie started her career as a real estate attorney and now leads a team that handles some of the most complex exchange structures in the country.
Julie, it’s great to have you join us today. Maybe give us a little bit of background on how you got into the 1031 world and what that means.
Julie Baird: Yeah, absolutely. And thank you for the opportunity. It’s such a thrill to be here, and I’m really honored and excited about the conversation.
So, as you mentioned, I’m the President of First American Exchange Company. I’m a real estate attorney by training. I started in private practice in San Francisco and did a whole bunch of different types of law — litigation, bankruptcy — and then found my way into real estate transactional work, which I really love and think dovetails nicely into the work I do now.
Real estate transactions are really a puzzle. You’ve got a purchase and sale agreement, maybe some financing, maybe a lease or a conservation easement, and there are all these different pieces of the puzzle that you want to put together to make a transaction work. A 1031 exchange is really just another tool in your investor’s toolbox.
What a 1031 exchange provides is that an investor can defer the payment of capital gains tax that would have otherwise been due on a sale if they instead trade into like-kind property. As long as that real estate is being used for investment or business use, a 1031 exchange can be a tool as part of the toolbox to put the transaction together.
So it’s really fun to have that kind of real estate law background and now have this other tool — the 1031 exchange — to help investors make their next real estate investment, take their next step in building wealth, planning their business, or doing what’s right for their estate plan.
Stephan Shipe: Whenever we have clients going through a 1031 exchange — or at least thinking about them — they get nervous because of the timelines associated with it and everything else. What are the big pitfalls that you see, the common ones that end up derailing the plan? Because being able to delay taxes is a great option.
Julie Baird: Yeah, no doubt. And it’s such a great question, and your point about understanding the rules is so important. One of the big things that we do as a qualified intermediary is education, for exactly this reason — it can seem complicated if you’re not doing these transactions every day.
There are a couple of critical timelines. The first is the identification timeline, and that is really the most immediate and sometimes the biggest pitfall if folks aren’t prepared. From the date of the sale transaction, you have 45 days to identify your potential replacement properties, and it’s got to be in writing. You have to have a clear identification — an “unambiguous description” is how it’s stated in the tax code.
So you can’t just say, “Gosh, I want to buy a duplex in Manhattan.” You actually have to have a street address or a legal description, and there are a variety of ways you can identify multiple properties.
The typical way people identify is three potential replacement properties, and then you don’t have to worry about their values or anything like that. That gives you three options for your potential purchases. If you want to identify more than three properties, you can — you just really want to work with your tax advisor and your qualified intermediary because there are additional rules that can add some complication to that.
Once those properties are identified within that 45 days, the next timeline you need to worry about is actually completing the exchange transaction. You have 180 days total, including that first 45 days, to complete the transaction. But that 45 days goes fast — especially in the market we’re seeing now, where maybe supply is more limited or there are financing challenges.
So we’re seeing investors start very early, figuring out geographically where they want to go, what type of asset they want to trade into, so that once they sell, they’ve already got a narrow pool of potential replacement properties.
Stephan Shipe: Does it have to be a one-to-one scenario? Because I know a common scenario, especially in retirement planning, is someone says, “I’ve built up this portfolio of five to ten properties, I’ve been managing it for years.” Do they just wrap all those up, sell them all, and then go buy one large commercial property that’s easier to manage?
Julie Baird: Great question. It absolutely can — and it works the other way too. If you’ve got one large asset and you want to diversify into several, it does not have to be one-to-one. What you’re looking at is your exchange value in total.
So if you have a portfolio of assets that you’re going to sell at the same time and maybe they’re all worth $500,000 to $700,000 each, but the total value is $5 million across all of those assets, then your replacement value that you trade into has to be $5 million or above. So it’s more about the total value versus the number of assets involved in the trade.
Stephan Shipe: Yeah, absolutely. I’m sure that gets fun trying to figure out when the 45 days start and everything.
Julie Baird: That’s right — you’ve got to be a master of Excel spreadsheets to track those timelines and make sure you’re complying with all of them for each asset. But it definitely can work, and it’s a good tool for that.
Stephan Shipe: So a couple of the other ones come out of these reverse or build-to-suit exchanges. When do those make sense, and what should investors watch out for?
Julie Baird: Absolutely. So I’ll give you a little bit of background about what a reverse exchange is, because there might be a lack of information about it since it’s not utilized as often. But a reverse exchange can be a really fantastic tool, and we’ll talk about a couple of scenarios where that type of structure — or a build-to-suit structure — really makes sense.
What a reverse exchange is, really, is a tool that allows an investor to buy their replacement property before they want to or before they’re able to sell their relinquished property. If the investor gets on title to both properties — both the replacement and the relinquished property — at the same time, they’ve lost the ability to trade into that property.
So what needs to happen is that a QI typically creates an entity that will close on one of those properties and take title to it for a period of time on behalf of the taxpayer. The typical way we see it is that the QI — the qualified intermediary — will create an accommodation title-holding entity. It’s an LLC, and we will take title to the replacement property instead of the investor. Then, when the investor is ready or able to sell the relinquished property, they sell that and then buy the replacement property from us.
Sounds pretty simple, but there are multiple timelines involved. Once that accommodation title-holding entity takes title, the whole transaction has to be completed within 180 days. The EAT can only sit on that property for 180 days. Usually that’s fine, because the investor already knows what they’re going to sell — they’ve got 45 days to identify what they’re going to sell and then trade into the replacement property that the EAT is holding title to.
These transactions are a bit more expensive because there are multiple closings. And the thing to remember, that a lot of people don’t immediately think about with a reverse exchange, is that the investor doesn’t have the cash proceeds yet from their sale, because the sale property hasn’t closed. So they need to have cash on hand, or a cooperative lender, to help make the financing work — because the QI isn’t putting money into the deal to buy the property. The investor loans us the money to do that.
Stephan Shipe: So it truly is more of a holding scenario. The qualified intermediary isn’t putting up the money or the risk to hold that property for a potential purchase later on — it’s got to be purchased, it’s just whether or not it’s going through the 1031.
Julie Baird: Exactly right. There are non–safe harbor parking transactions that allow for more time — much more complicated and sophisticated — and they work in some situations. But by and large, the revenue procedure that spells out the safe harbor procedure is what’s used for reverse exchanges.
You asked when this might be a good tool. In this environment we’ve been in for the last couple of years, we’ve seen a lot more reverse exchanges because of the shortage of inventory and the challenges with financing. Investors who are able to use a reverse exchange proactively have been doing so. What that allows them to do is go out and find that perfect replacement property — they’re not yet bound by any time constraints. They find exactly what they want to buy, engage the qualified intermediary, the EAT takes title to that property, and now they’ve secured that perfect replacement property. They can go ahead and sell their sale property and trade into that asset, and it gives them more flexibility and control in this type of market.
Stephan Shipe: How do you see these 1031 exchanges coming into play when it comes to estate planning — whether it’s step-up in basis or trust scenarios? Do you see a lot of that?
Julie Baird: We do, absolutely. And just like any business or family, every situation is unique, so working with estate planning attorneys and tax advisors is critically important.
With families, we see a couple of different scenarios. Sometimes the family may know that the heirs aren’t going to want to be actively involved with property management. So using a 1031 to trade into an asset that may have less management responsibility — or maybe something more easily divisible among multiple heirs — can make sense.
Things like a Delaware Statutory Trust, or DST, might be a really good option in those cases.
You mentioned the step-up in basis, which is exactly right. Investors who have been holding and maybe trading property over their lifetime may have a ton of built-up gain because that original cost basis starts with the first investment property. They may be doing 1031 exchanges, diversifying their portfolio, getting different kinds of assets — and now they’ve got a bunch of built-up gain because of that original low cost basis.
With the step-up in basis rules that currently still exist in the tax code, upon the death of the owner, the heirs who inherit that property get a step-up in cost basis. In essence, all of that gain is wiped out at the time of death.
It’s good for investors to understand that as they plan, and to make sure that ownership is structured in such a way that they’ll actually get the benefit of that step-up in basis — rather than, say, changing ownership to an LLC that’s not disregarded, which could inadvertently take them outside that benefit.
Stephan Shipe: I’m glad you brought that up, because it’s easy to look at this as a one-transaction scenario — “I have the gain on this one property, so I’ll do a 1031 for another” — but it’s easy to overlook that if this compounds over time, you could have a lifetime of real estate gains that all receive a step-up.
Julie Baird: That’s right.
Stephan Shipe: If it’s done correctly.
Julie Baird: If it’s done correctly, exactly right. There’s a phrase sometimes tossed around in the industry — “swap till you drop.” It’s shorthand for continuing to do these exchanges, and then at your time of death, your heirs get the benefit of that. I’m not sure planning for your death is the best long-term strategy, but it’s a tool — and it’s good to know how these different pieces work together.
Stephan Shipe: If somebody’s looking at a 1031 saying, “Does it make sense? Does it not make sense?” — do you have an example of a situation you worked on where it worked out really well that you point to and say, “That’s how it’s supposed to work”?
Julie Baird: Absolutely. One comes right to mind. We had a reverse build-to-suit transaction — one of those “parking” transactions we talked about, where the EAT takes title to the replacement property, but with the added benefit that, while that entity is on title, the taxpayer can use some of their exchange funds to make improvements.
In this case, we had a family office client that was going to buy a new logistics park for their business and sell a legacy retail strip center. We did the reverse parking transaction, the EAT took title to the future replacement property, and they had time to do the improvements and build out exactly what they needed for their business.
Then they sold that legacy strip center, traded in, moved the business into the new replacement property — full deferral, increased value in the new property — and the benefit of that structure was that it allowed them to have a lot less disruption within their business. It really created continuity, and it played out beautifully.
Stephan Shipe: Very cool. You mentioned that reverse exchanges are becoming more common. If you had to wrap up all the things you’re seeing right now, what are the big trends? What should people be watching out for in the current landscape?
Julie Baird: I think reverse exchanges will continue to be a really valuable tool as the market improves. We’re seeing more volume, but inventory is still limited, so the reverse exchange — using it proactively — is key.
We’re also seeing more people use the Delaware Statutory Trust — that more passive, syndicated investment option for replacement property. As people become more familiar with that type of asset and as more reputable sponsors emerge across the country, it’s spreading well beyond its California roots.
Other trends include disaster extensions. When there’s a catastrophic weather event — like a hurricane or wildfire — the IRS issues notices that extend certain tax deadlines, including 1031 deadlines. It’s not a proactive strategy, but it’s becoming more common as weather events increase, and it can give people more time to complete transactions.
Lastly, we’re seeing geographic migration — investors moving from high-tax areas like California or New York to more tax-friendly Sunbelt states. We’re also seeing moves away from areas with insurance and weather challenges to more stable regions that make better long-term financial sense.
Stephan Shipe: Thank you so much for coming on today. I learned a lot — and I know our listeners will as well — on something that’s such an interesting topic on the real estate side. Thank you so much for sharing your expertise with us.
Julie Baird: I always appreciate the opportunity. It’s such a narrow slice of the tax code, but it can be such a powerful tool in the right circumstances. Making sure folks know it exists — and understand that there may be complications related to the rules — but getting an expert to help you navigate the process is key. It can be such a great way to build wealth, plan for your estate, and make smart business decisions while deferring taxes in the long run.
It’s an honor to be able to talk about it and share a little bit of knowledge here.
Outro
Stephan Shipe: That’s our show. Thanks for listening, and we’ll see you next week.
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Disclaimer: The information provided in this podcast is for general informational and educational purposes only, and is not intended to constitute financial, investment, or other professional advice. The opinions expressed are those of the hosts and guests and do not necessarily reflect the views of any affiliated organizations. Investing in financial markets involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, you should consult with a qualified financial advisor who can assess your individual financial situation, objectives, and risk tolerance.