Structuring a 1031 Exchange
What is a 1031 Exchange?
A 1031 exchange, also known as a “like-kind exchange,” is a tax strategy used by real estate investors to defer paying taxes on the sale of a property, often indefinitely. The process involves selling an existing property (the “relinquished property”) and using the proceeds to purchase a similar property (the “replacement property”). The key to a successful 1031 exchange is that the replacement property must be of “like-kind” to the relinquished property, meaning that it must be used for the same type of business or investment. This tax-deferral strategy is permitted under Section 1031 of the Internal Revenue Code.
Throughout the 1031 exchange process, the investor must use a qualified intermediary (“QI”) to facilitate the exchange funds. A qualified intermediary is a neutral third party that holds the proceeds from the sale of the relinquished property and disburses them to the seller of the replacement property, in exchange for a small fee. Ultimately, the qualified intermediary’s role is to ensure that the investor does not receive any cash or other proceeds from the sale of the relinquished property, which would disqualify the exchange altogether, and that all of the rules of a 1031 exchange are abided by.
What are the rules and caveats of a 1031 Exchange?
The simplest rule of a 1031 exchange is that the relinquished property and the replacement property must be “like-kind” properties. Defined by Section 1031 of the Internal Revenue Code, this means that the two properties are of the same nature or character, even if they differ in quality or grade. In other words, the two properties must be used for the same type of business or investment, such as rental property, commercial property, or raw land, even if they differ in class. What presents the greatest challenge for 1031 exchange investors is the time constraints imposed by the IRS for an exchange to qualify.
- Identification – The exchange investor has 45 days after the sale of the relinquished property to identify their replacement property, as supported by documented evidence provided to the Qualified Intermediary.
- Purchase – The replacement property transaction must close within 180 days after the sale of the relinquished property.
With a total timeline from sale to identification and purchase within 180 days, investors are often presented with a herculean task.
The “boot rule” is an integral aspect of the exchange process, which requires that the replacement property is of equal or greater value than the relinquished property. At the core of the “boot rule” is the notion that if the investor receives more cash from the relinquished property than they invest in the replacement property, then they will be taxed on that difference. It is often to the investor’s advantage to exchange into a larger property, anyway, as an increase in their cost basis will extend their depreciation write-offs.
Another caveat of a 1031 exchange, which a qualified intermediary will monitor, is the topic of debt sizing.
If debt was a component of the relinquished property’s capital stack, the new loan amount on the replacement property must be equal to or greater than the loan amount on the relinquished property. Since the vast majority of projects include one or more components of debt, this is an important rule to bear in mind for the criteria of the exchange. The amount of debt recognized by the IRS will include both first mortgage debt and subordinated debt (including “debt-like” preferred equity.)
Investors who have a low level of debt before or after an exchange will often look to do a “cash out” refinance, as proceeds from debt are not taxed until an investor breaks their 1031 deferral status. This is often deemed acceptable, however, it is important to note that the best practice is to wait at least a year after an exchange to accept proceeds from a cash-out refinance.
Funding construction costs, or capital improvements, within a 1031 exchange can present a tricky scenario, as these costs cannot be funded by any 3rd party equity.
Take it easy: Reverse the process
One alternative process to ease the pressure of the conventional 1031 timeline is known as a ‘reverse 1031 exchange’.
This is a 1031 exchange structure in which the replacement property is purchased prior to closing on the sale of the relinquished property. Once the investor purchases their replacement, they have 180 days to sell their old property.
While this strategy can help to destress the investor’s timelines, it also presents a few limitations. For starters, to purchase the replacement property prior to closing on the sale of the relinquished property, the investor must have the capital for the acquisition of the replacement property prior to realizing the gains from the sale of the relinquished property. Further, the fee paid to the qualified intermediary increases under the structure of a reverse 1031. In any case, however, the fee charged by qualified intermediaries is typically a marginal portion of the overall transaction costs and is often considered de minimis.
Eliminate the management hassles by exchanging into a passive investment
Conventionally, a 1031 exchange investor is an active investor in the replacement property, but many investors have found that they no longer wish to manage their properties. There are ways in which they could take a passive role. Delaware Statutory Trusts (“DST”) and Tenancy in Common (TIC) are the two most common structures that 1031 exchange investors deploy to pool their capital as a passive investment. As a passive investors, they are treated to be somewhat similar to a limited partner (“LP”) with the DST/TIC manager akin to a general partner (“GP”).
With only 45 days to identify the replacement property, and just 180 days from the close of the relinquished property to the close of the replacement property, investors need to act swiftly and are often motivated buyers. Many companies promote DST or TIC structures as an easy way for investors to quickly identify their replacement property without any of the hassles of being an active manager of the property.
While DST’s and TIC’s provide a steady supply of investment options for exchange investors, the opportunities are often widely marketed. What this means is that a DST or TIC project is unlikely to present the sorts of mispriced investment opportunities that may be optimal. Furthermore, the yield that these investments produce is often low relative to more active, or conventional LP, investment opportunities.
A 1031 exchange can be a powerful tool for commercial real estate investors looking to defer taxes on the sale of a property and increase their potential return on investment. However, it’s important to understand the rules and regulations surrounding 1031 exchanges and to consult with a professional before pursuing one. With the right approach, a 1031 exchange can be a valuable strategy for growing your real estate portfolio and maximizing your returns.
Disclaimer: This article is for educational purposes only and is not to be construed as legal, financial, or tax advice. It is important to always seek appropriate legal and financial counsel. Valencia Realty Capital, LLC does not provide any legal, tax, or financial advice. This information is for educational purposes only. You should confer with a tax or real estate lawyer and CPA for any advice on these matters.