Learning from History and Experience. Over my 40-year career as a real estate broker and an investment advisor I have seen countless 1031 exchanges. The IRC §1031 exchange is a tool that has been used by investors for over 100 years in the US to defer capital gains, realign assets, create generational wealth and accomplish other goals.
By Al DiNicola, AIF®, CEPA ™
June 4, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
We have been fortunate to work with many investors who stayed on track with all the IRC §1031 requirements to successfully complete the exchange and defer capital gain taxes. We have also been able to guide investors into Delaware Statutory Trust (DSTs) that qualify for the 1031 exchange program and provide passive tax favored income. Along the way we have witnessed successful exchanges. Successful exchanges may get more attention than the exchanges that do not go well. We study history to learn from other’s mistakes. Albeit occasionally some investors may repeat the mistakes of others. We will attempt to review the biggest faux pas that will sink or blow up an exchange.
There are about ten situations that may turn into mistakes that we will outline and briefly comment on in this article.
- Failing to create a plan. Over the recurring cycles of real estate, investors will watch the value of their investment rise and decide to sell their investment. Excited real estate brokers & agents are ready, willing, and able to list the property, especially in a fluid market. Occasionally the investment property sells quickly, and the investor has not properly planned what the exit strategy is for the proceeds. Is the plan to pay the capital gains and move on or utilize the 1031 tax deferred exchange alternative. Exit planning is simply good business.
- The parties who assist you in setting up your exchange are critical. Simply using a real estate attorney does not guarantee success especially if the real estate attorney is not proficient in 1031 exchange process. Although you’re exchanging real estate, a 1031 exchange is a tax transaction as much as a real estate transaction, if not more so. If a 1031 exchange is not done properly, the tax consequences can be significant. The exchange company (referenced as a qualified intermediary or QI) should understand how to comply with the IRC 1031 exchange rules. Occasionally an investor will deposit their sales proceeds with an escrow agent or take constructive receipt of the proceeds rather than having the proceeds from the relinquished property placed with a QI. This will void the 1031 exchange. Proceeds must be held by a QI. Attorneys must also be set up as a QI if they are handling the exchange.
- There are many reputable QIs. Every day QIs effectively complete the exchanges for investors. There are no licensing requirements to be a QI. This is an unregulated profession if compared to a real estate license or investment advisors licensing requirements. There are professional organizations of QI who sponsor best practices and professional standards. However, if you use a QI without asking the right questions there may be a potential of the exchange not going well or worse yet losing your funds. Your due diligence questions may include how your funds will be deposited and if a separate account is used for your funds. Also check out the process for the release of your funds.
- Overpaying for the replacement property. Once you enter a 1031 exchange (with a QI) a big mistake is targeting your replacement property with spending all the proceeds being held by the QI. There are three elements when deciding on the replacement property. How to locate, how to negotiate and how not to overpay. Typically, sellers will know the investor is a 1031 investor based on contract language as well as real estate agent feedback. The listing broker on the replacement property as well as the seller may be reluctant to negotiate. The 1031 investor may simply want to spend all the cash. There have been studies that have shown 1031 investors may be paying 15% more for the replacement properties simply because to avoid capital gain taxes, the investor needs to spend all the cash.
- Buying anything that comes along. An investor may pull the trigger and sell their investment property and turn around and buy something that may not make sense. A hasty purchase with additional capital improvements may create investor remorse and wishing they had not sold their property in the first place.
- Understanding the numbers. You don’t need to be a rocket scientist to execute a 1031 exchange, but you do need to watch the details. Understanding the numbers on the cost of selling the property and acquiring the replacement property is critical to understand. Understanding the debt that may need to be replaced is also an important component. Taxable events can be avoided by ensuring the total understanding of all required cost items.
- 1031 exchanges are Deferral not Elimination of taxes. Capital gains taxes can be deferred to a later time but are not eliminated for the investor. Capital gains taxes are typically less than ordinary income tax. There would be the elimination of taxes would happen if the investors retained the property and pass the property to their heirs. This is known as a step up in basis upon the death of the investor.
- The clock is ticking. The 45-day clock starts ticking when the investor is closing on the relinquished property. Many times, 45-days seems like a long time. However, when you add in contract negotiation, inspections, loan approval (if needed) and other potential issues all compound the challenge. At the end of the 45-day period an investor may simply purchase something, anything, just to complete the 1031 exchange.
- This is tax planning. Tax planning for investment real estate is very important to provide the most efficient utilization of the tax codes. Investors need to understand depreciation, carry forward depreciation as well as other potential real estate write offs.
- Cash boot and mortgage boot. There is a double-edged sword with negotiating a better price and not using all the cash. You paid less for the property but need to pay capital gains on the cash you did not use. Likewise, if you paid off a loan and you cannot arrange non-recourse financing this would be mortgage boot and taxable. This may result in your total replacement price falling short.
There is a potential DST solution for many of the issues. Accredited investors seeking replacement properties with a passive investment will seek Delaware Statutory Trust (DST). The advantage with the DST structure affords the investor with non-recourse debt on the prepackage investment alternatives.
Leftover proceeds from strong negotiations may be invested into a DST. Proceeds as little as $100,000 may be placed in a DST avoiding capital gains.
Contact us for additional information on the DST structure and function for your potential investment solutions.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email firstname.lastname@example.org.
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