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Three Common Mistakes When Using A 1031 Tax-Deferred Exchange

Many real estate investors have seen property values bounce back from the worst financial crisis in the past 70 years. Depending on location and property type, some values have surpassed the high water mark in 2007 and early 2008.

by Brian E. Estes

Many real estate investors have seen property values bounce back from the worst financial crisis in the past 70 years. Depending on location and property type, some values have surpassed the high water mark in 2007 and early 2008.

However; in most cases values have increased to the point to where investors now have options to re-finance their loan for cash flow or sell the property and trade their equity for value-add properties with much higher investment returns.

Most investors will be looking to complete a Like Kind Exchange (LKE) or commonly referred to as “1031” exchange. The IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it not tax free. However; there are some basic rules that do apply which are included here below:

1. Same Taxpayer:
The tax return and name appearing on the title of the property that sells must be the tax return and titleholder that buys. A single member limited liability company (smllc) is considered a pass through to the member, consequently, the smllc may sell and the member may purchase in their individual name.

2. Property Identification :
Post closing of the first property, the Exchangor has 45 calendar days to identify to either the accommodator or the closing entity the addresses of the potential replacement properties. In a reverse exchange where either the replacement or relinquished property is parked, the Exchangor has 45 days to submit a final list of properties for sale or purchase.

Three property rule – can identify any three properties regardless of value.
Two hundred percent rule – can identify four or more properties as long as the value does not exceed 200 percent percent of the property sold.
95-percent exception rule – if the value exceeds 200 percent, then 95 percent of what is identified must be purchased.

3. Replacement:
Within 180 calendar days following the closing of the first property or extension of the Exchangor’s tax return, the property must be purchased.

4. Trading Up:
The net market value and equity of the property sold must be equal to or greater in the replacement property to defer 100 percent of the tax. Otherwise, the Exchangor needs to pay tax on the difference. Debt and equity in the replacement property must be equal to or greater than the debt and equity in the relinquished property. Additional equity in the replacement property offsets debt. Additional debt does not offset equity.

As an investment property broker helping real estate investors acquire and sell investment properties, I have been involved in many 1031 Exchanges, both as a seller’s broker and buyer’s broker and there are three common mistakes I see most often. All three mistakes basically deal with the time limits involved in indentifying the replacement properties.

Make an Early Decision: The best time to make a decision whether to do a 1031 Exchange is when you put the “relinquished” property on the market for sale. Many investors find it helpful to get their CPA involved early to discuss the tax implications of the sale and if a 1031 Exchange is beneficial and what acquisition metrics should be considered such as purchase price, loan amount, etc.

The common mistake is most investors wait until the week of closing to begin discussing a 1031 exchange and then hire a broker to begin looking for property immediately after closing. With only 45 days to identify up to three (3) properties, the investor rarely finds the replacement property or the “deal” they wanted and usually the process becomes more about deferring taxes rather than exchanging equity into a project with much higher returns.

Be Specific on Property Type, Geography and Investment Parameters: Another common mistake made by investors is once the 45 day identification period begins, no decisions have been made on the type of property, geographic preference or investment parameters. It is extremely important for the investor to begin having conversations about what type of property is preferred and what investment parameters are acceptable. Does the investor prefer stabilized or value-add projects? Will there be financing?

Due Diligence Periods Are Not Long Enough: When the market is hot, sellers will always push the buyer for a shorter due diligence period. It is not uncommon for due diligence periods to be 45 days or less in some markets. It is extremely difficult to properly underwrite a property and perform proper due diligence in less than 45 days. It is much more difficult to execute a 1031 exchange when trying to perform due diligence on three (3) properties at once AND make a final determination as to which property to purchase.

It is also very important to do the most important due diligence items early such as title commitment, environmental, survey and other legal research. Nothing is probably more important early in due diligence than title commitment, specifically in a 1031 Exchange. Any experienced broker or investor knows after spending weeks performing due diligence, a title issue will virtually bring the deal to its knees.

As a 1031 Exchangor, you do not want to make a final decision on a property only to find out later that the title issue will take six months to be cleared, which is well past the required time to complete your exchange requirement.

Although not part of the three mistakes listed above, it is also very important to chose the right real estate investment broker to help in completing your 1031 Exchange. An Investment Broker who really understands the 1031 Exchange process becomes more of an advisor to their clients and not just transactional agents. A good broker will ask the right questions and extract the wants and needs of their client.

Most important, a good broker knows that “time is of the essence” and by accepting an exchange assignment means a lot of hard work in a hurry. It also means that putting three projects under contract and performing due diligence to close one is part of the process.

In summary, a 1031 Exchange for investment real estate is a great tool for any investor, especially when trading stabilized projects at the height of its value to a more “value-add” property where the value is increasing. However, this process does involve some pre-planning and it is never too early to begin discussing an exit strategy for any investment real estate project.