It can be argued that there has never been a time in history when the 1031 exchange has been more critical to preserving wealth for property owners than today. The US has experienced tremendous capital growth, and real estate owners are now sitting on an unprecedented amount of equity. Additionally, landlords in major growth areas like California are potentially feeling the squeeze of state and local regulations as they look to exit for more landlord-friendly states. Furthermore, the baby boomer generation is posturing to retire from property management. Many of these property owners will face a 30-40% tax loss upon the sale of their real estate. This is why these investors value the importance of the 1031 exchange.
Named after Section 1031 of the Internal Revenue Code, the 1031 exchange allows an investor to defer all their taxes by selling a property held for business or investment purposes and then immediately purchasing a replacement property of equal or greater value, also intended for business or investment purposes. The challenge facing the exchanger is finding the perfect exchange property in time.
Investors are working under the pressure of not just one, but two ticking time bombs. The investor has 45 days from the sale of the relinquished property to identify potential replacement properties. Then, investors must close on the replacement property within 180 days of the sale of the relinquished property (these timelines run concurrently). This leaves little room for error and may result in negative financial consequences if not navigated successfully. The following are steps investors can take to increase their chances of a successful exchange.
Step 1: Start getting educated months ahead of listing
Develop an investment criterion and understand your risk tolerance. From there, educate yourself on which asset types and asset classes best fit your investor profile. Consider what geographic locations you are interested in buying, how much control you want to maintain, and how passive you want to be? There are plenty of 1031 options available, and advisors such as RealtyMogul exist to help investors get educated and successfully navigate the 1031 market. A 1031 advisor can assist you with the education process and help you make decisions, such as how diversified you want to be. Would you like to split your property into two or three smaller properties. Or would you be interested in ultra-diversifying into a portfolio of properties through 1031 investment vehicles such as a Delaware Statutory Trust (DST) or a Tenants-In-common (TIC).
Step 2: Prepare the 1031 team ahead of time
To borrow a principle from Jim Collin’s book “Good to Great,” it is important to get the right people on the bus early! Spend time before you list your property selecting the best listing agent for your property, the best qualified intermediary, a CPA for tax advice and the 1031 advisor/broker that best fits your situation and investor profile. Make sure your team is on the same page with your plan.
Step 3: Consult your CPA/Tax Advisor
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts, and certain tax consequences may vary depending on the individual circumstances of each investor and section 1031 rules must be carefully followed to qualify for a 1031 exchange. So, it is important to discuss with your CPA/tax advisor whether a 1031 exchange is appropriate for your situation, and how much property is required to be replaced to defer all your taxes. There may be losses elsewhere in your portfolio that can offset your tax consequence or closing costs that may reduce the amount required to replace the relinquished property. Finally, it may be a good idea to discuss with your CPA/tax advisor if alternative real estate such as a Delaware Statutory Trust (DST) or a Tenant-In-Common (TIC) may be a suitable option for your 1031 exchange.
Step 4: Line up your debt solution early
In order to purchase property of equal or greater value, many exchangers need to replace a mortgage that was paid off in escrow when they sold the relinquished property. This can be a difficult task, especially for retirees or those who earn the majority of their income via real estate. For those who are unable or do not want to go through the hassle of taking on a new mortgage, a Delaware Statutory Trust (DST) may be an ideal solution.
DSTs are pre-packaged, turnkey 1031 solutions available to accredited investors, often offered with debt already built-in. Exchangers can utilize the debt in a DST without having to apply for or sign the loan. This simplifies the process and ensures compliance with 1031 exchange requirements, allowing investors to focus on their overall investment strategy.
Step 5: Don’t Touch The Money!
A qualified intermediary (QI) must be used to facilitate the exchange. The QI holds the sale proceeds from the relinquished property and uses them to purchase the replacement property. Make sure that your QI has connected with your escrow company and set up to receive the funds. If they are accidently sent to your bank account, it may be a very expensive mistake! Additionally, it may be helpful to put a clause in your escrow documents that allows an extension if there are delays finding a replacement property.
Step 6: Decide the best identification strategy for your situation
There are three different rules that can be used to identify 1031 exchange properties.
a. Three-Property Rule: An investor can identify up to three potential replacement properties regardless of their market value.
b. 200% Rule: An investor can identify more than three properties if their total value does not exceed 200% of the market value of the relinquished property.
c. 95% Rule: If the investor identifies more than three properties and their total value exceeds 200% of the relinquished property’s value, they must acquire 95% of the value of all identified properties.
Step 6: Make sure you have a backup ID
By designating one or more backup properties, investors safeguard themselves in case the primary option doesn’t work out. This proactive approach mitigates the risk of a blown exchange. Additionally, many investors can utilize a Delaware Statutory Trust (DST) or Tenants-In-Common (TIC) to increase the likelihood that the backup option will be available if needed. DST/TIC representatives can make reservations in DSTs/TICs to hold space in the property for the exact amount the exchanger requires for a set amount of time. This strategic planning helps ensure the successful completion of the 1031 exchange and protects your investment.
Step 7: Do you have a plan for the “boot”?
Often, it can be difficult to find a property that matches the price of the relinquished property. If the exchanger finds a property with a price lower than the relinquished property, there could be leftover equity that will be taxed, known as “boot.” This is another situation where a Delaware Statutory Trust (DST) may come in handy. DSTs allow exchangers to place the exact amount needed to satisfy their 1031 requirements. For example, if there is $135,472 leftover, a DST may be able to accommodate the amount down to the dollar. By designating one or more backup properties, investors safeguard themselves in case the primary option doesn’t work out. This proactive approach mitigates the risk of a blown exchange and ensures the successful completion of the 1031 process.
In conclusion, a 1031 exchange can be a powerful tool for preserving wealth and optimizing real estate investments, especially in today’s dynamic market. By starting your education early, assembling a knowledgeable team, and having backup options, you can navigate the complexities and strict timelines of the exchange process. Proper preparation and strategic planning are essential to avoid costly mistakes and ensure a successful outcome. Whether you’re seeking to relocate to more landlord-friendly areas, retire from property management, or simply maximize your investment potential, following these strategies can help you achieve your financial goals and secure your future.
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Disclosure
1031 Exchange Risk
Internal Revenue Code Section 1031 (“Section 1031”) contains complex tax concepts, and certain tax consequences may vary depending on the individual circumstances of each investor. RM Securities and its affiliates make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about the tax aspects with respect to your particular circumstances.Please note that RealtyMogul does not provide tax advice.
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