When she's not looking for investment properties or investors for her syndication deals, Eileen Schwartz is also a full-time financial planner. We originally called her to talk about 1031 exchanges, but Eileen is so knowledgeable about financial planning and how it ties in with real estate investing, that we ended up asking her a whole bunch of other questions! What follows is her advice about finding and working with a financial planner who also understands real estate investing - and 1031 exchanges.

ForeclosuresMass Monthly: Based on our research, few people know about 1031 exchanges. Is this your experience, too, and if so, why?

Eileen Schwartz: I would say yes and no. Your typical "mom and pop" real estate investor usually doesn't know about 1031 exchanges. Generally, the more sophisticated - and let's say it - wealthy investors know about exchanges and how to use them. This is because the 1031 exchange was developed by lawmakers to benefit the wealthy.

In other words, the 1031 exchange is a planned tax loophole, much like the mortgage interest expense deduction, which is usually advantageous in saving people money on their Federal income taxes. But, you don't have to be seriously wealthy to take advantage of either one.

FMM: Why was the 1031 exchange developed?

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ES: Congress likes to drive dollars to areas where they want people to invest. For example, if they want developers to build affordable housing in expensive towns, then they give tax benefits to developers to build the housing.

On a smaller scale, it's the same for real estate investors who buy multi-families, renovate them and then rent them out. Your dollars have gone into helping a neighborhood build a community of established and well-run rentals. Once you sell that investment property (or properties), however, you are subject to capital gains taxes.

Congress wants to be sure investment dollars are continually injected into the economy. If investors are continually taxed, they'll find it less attractive to invest money and will have less money left to invest. Hence, the 1031 exchange, which is a way for real estate investors to defer capital gains taxes once they sell an investment property and use that money to invest in new properties or developments.

FMM: How can working with a financial planner who understands real estate help the typical real estate investor?

ES: What usually happens is that an individual or couple will make an appointment to see a financial planner because something has happened or will happen that has to change their financial picture.

For example, a couple who owned and lived in a two-family house was referred to me because they needed real help. Their plan was to convert the two-family house into two condos. They would continue to use one condo as their residence and sell the other rental unit. Then, they wanted to use the proceeds of the sale to pay off the mortgage on their residence. They assumed that this would help them in retirement because they wouldn't have a mortgage on their residence and therefore would have lots of free cash available to invest.

The problem with this thinking entailed several issues. First, they had not talked to their accountant, so they did not know the capital gains tax that they would owe from the sale of the investment unit. Second, they did not how much more they would have to pay in Federal income taxes once they no longer had the mortgage interest deduction on their primary residence.

After talking to them about their goals, we discovered that what they really wanted was to buy the retirement home of their dreams - but they weren't sure if they could afford it. I suggested they speak to their CPA and have him calculate the income tax results of their plan.

Once they had that information, I reviewed it with them and recommended that they go ahead and turn the two-family house into condos and sell the rental unit using a tax-free exchange. They could then buy their retirement dream home as the replacement property in the exchange. In order to comply with the 1031 exchange regulations, they would have to rent out the retirement house for a couple of years.

When they eventually sell their current primary residence condo, they can move into their retirement dream home - without having to pay any tax on the gain from the original sale of the rental condo. Free equity!

By discussing with them what they were trying to achieve, and by our input and knowledge about the tax laws, we were able to design a better plan with them. They were able to know that they could have their dream home and, in addition, realize a savings of more than $100,000 in taxes.

FMM: How much does it cost to do a 1031 exchange and can one's accountant or financial planner take care of it?

ES: That is a good question. A 1031 exchange is relatively inexpensive - it costs $1,000 to $2,000 to do one. To comply with the regulations, you hire an Intermediary who receives the cash proceeds from the sale of the relinquished property and payout the cash for the purchase of your replacement property. The cost of the exchange is the fee for the Intermediary. The process itself is very technical, so it pays to get an experienced Intermediary who knows what they're doing.

FMM: What other questions to do you ask new clients?

ES: It's not so much the questions I ask as it is the listening financial planners do. Good planners encourage people to talk about their lives, their dreams, and their families.

A good financial planner will also give you advice that is best for you, not for the financial planner. One Sunday I was showing an apartment for rent in one of the properties that I manage when a professional couple came in. Since I was wearing my "real estate" hat, I started asking them dozens of questions, such as "what do you do for a living?" etc. so that I could determine if they could afford the rent.

This couple was making *a lot* of money and really should have been looking at buying a home, not renting one. I instantly switched hats and explained to them why buying was more advantageous to them than renting. The gentleman could not believe that I was telling him to buy - versus rent - because it wasn't in my best interest to do so. I was losing a possible renter - and a really good one, too!

FMM: If someone is looking for a financial planner with a real estate background, what questions should one ask?

ES: First, ask what their real estate experience is and what have they done for themselves and their clients. You'll want to ask if they have helped clients with 1031 exchanges and what other areas of real estate advice they get involved with - i.e. syndications, commercial properties, etc.

Also ask if they have their real estate agent license - not that you expect them to be working weekends at a real estate brokerage, but because having a license means they have real estate knowledge.

Most important, ask if they are fee-only financial advisors or planners. Those who say they are "free" generate their fees by selling you products such as mutual funds, annuities, and the like.

Eileen Schwartz is a fulltime real estate investor and financial planner. The owner of six businesses, she works out of a "real" bricks and mortar office in Newton, Massachusetts. She can be reached by phone at 617-332-3535or by email at eschwartz@esscoweb.com.

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