Whether you are an investor or a real estate broker, selling investment or business real estate can be an expensive venture unless you are prepared to conduct a 1031 exchange.
Section 1031 of the federal tax code dictates that no gain or loss shall be recognized upon the sale of a real estate property held for business or investment purposes, as long as the seller purchases a replacement property of equal or greater value. This can be a solid opportunity, potentially, to preserve the gain and accrue additional wealth. However, the 1031 exchange can be a tricky process that has frustrated many amateur and professional real estate investors alike.
So, to help potentially avoid having your 1031 exchange blow up, here are six steps to consider as you advise a client on undertaking and entering into a 1031 exchange:
Step 1: Know the applicable deadlines. The IRS requires an investor to identify a replacement property within 45 days, and to close on the target property within 180 days of selling the relinquished property. That doesn’t leave much time to hunt for the right deal, but it’s enough time. Working with an expert 1031 exchange investment firm like Kay Properties can help investors successfully complete their 1031 exchange within these timelines.
Step 2: Get educated about acceptable types of replacement properties. The IRS requires an exchanger to reinvest in a “like kind” property. However, “like kind” does not necessarily mean the same type of property. There are a variety of options available. For example, if you are selling a duplex in San Diego, that doesn’t mean you need to replace it with another duplex. The 1031 exchange allows investors to replace relinquished real estate with a variety of asset types. It can be a medical building, single-family home, multifamily apartment building, raw land, self-storage facility or any other investment real estate. The type doesn’t matter as long as it is held for investment or business purposes. Ideally, investors should know what they are looking for in a replacement property well before going into escrow on the property they are selling. Again, working with a 1031 exchange investment firm like Kay Properties can greatly reduce the stress and confusion surrounding 1031 exchanges.
Step 3: Narrow down the options while in escrow. I cannot tell you how many times I have seen 1031 exchange investors in a desperate panic once they hit day 30 of their 45-day window with not a single replacement option identified for their exchange. This is an extremely stressful position. But don’t worry, this article should help spare you the anguish.
One good strategy is to locate five to 10 potential replacement properties as the closing date of the property you are selling gets closer. But be prepared that as you move through escrow, many of the new properties you have identified will likely be acquired by other buyers or will not prove to be satisfactory under the scrutiny of some due diligence. That’s why developing a short list of potential replacement properties prior to relinquishing the original asset can be one of the most important strategies for preventing having your 1031 exchange blow up!
Step 4: Make sure your financing is lined up ahead of time. Investors will often call me in a panic because they’ve located their replacement property, but they cannot access the financing necessary to purchase the asset. It is important to make sure that they have the financing lined up before closing on the property being sold to spare themselves from a stressful and potentially expensive predicament. That’s one reason fractional ownership structures for 1031 exchanges can be attractive for investors wanting to complete a 1031 exchange. For accredited investors, a Delaware Statutory Trust (DST) investment may be a suitable option. In addition, DSTs have a non-recourse financing component baked-in to each investment so the investor does not need to sign for a loan. A DST may be an ideal opportunity for an investor looking to a 1031 exchange to be a passive, turn-key solution with required financing already established.
Step 5: Have a backup property identified just in case. The IRS code allows investors to identify replacement properties using different rules. The most common rules used are to either identify three properties for their 1031 exchange or identify real estate valued at up to 200% of the property that’s being (or been) sold. This means there is room for back-ups. Take advantage of the opportunity. An exchanger should never leave an empty space on their ID form, which is submitted and filed with a qualified intermediary. More often than not, the exchanger’s primary option won’t work out … even if it looks like a sure thing! Also, I have often seen unscrupulous sellers exploit the buyer’s 45-day time clock in order to press their back against the wall, forcing the exchanger into an inferior negotiating position. Backup property options can strengthen the exchanger’s negotiating power by providing additional options.
For accredited investors, a DST can be an excellent option for a backup strategy. DST properties are already purchased, stabilized, and can potentially provide monthly distributions to investors. There is no negotiating and the due diligence is already complete. Additionally, an exchanger can often close on a DST in three to five business days. I often recommend my clients use a DST as a backup ID if there is room in their exchange and it is appropriate for their situation.
Step 6: Make sure to start to negotiate a 1031 contingency in your purchase and sale agreement. Many buyers are willing to allow a 1031 contingency that will permit the seller to extend escrow on the property being sold if the seller can’t find a replacement property. For example, try to negotiate a clause that extends escrow for you by including an additional 30 days if you are unable to identify a suitable replacement property. This can be a quick and easy way to buy additional time should you have difficulty locating the right 1031 exchange investment.
Bottom Line: a 1031 exchange can be a potentially great tool for building and preserving wealth, but it can be a daunting process if not properly prepared. If you decide to do a 1031 exchange, make a point to start early, get educated, narrow down their options, line up financing, have a backup ID, and negotiate for more time in case they need it. When appropriate and if they qualify as an accredited investor, use a DST as part of your 1031 exchange strategy. There are no guarantees in real estate, so it is always best to plan ahead when considering a 1031 exchange.