Have you done a 1031 Exchange?

Question

Hi BP community!

We just closed on the sale of a rental property and are doing a 1031 Exchange to finance the purchase of 3 rentals. The process is fairly simple, there are some rules on the minimum debt and price of your new investments and the time frame.

I'm wondering, is this something common to do among investors?

Is the process simple when closing on the properties? If there is some money that is not used, can you gain access to it right after closing?

Thanks!

Bill Haley · Answer

@Alain Labrada

Hi!

1031 exchanges are quite common. The benefit, as I am guessing you have learned, is the tax advantage in that you do not have to pay capital gains if you exchange like-asset for like-asset, meaning real estate for real estate or stocks for stocks, not one for the other.

In December of 2017, I helped an investor who had a multi-million dollar rental in Paradise Valley sell that one and purchase several single-family homes and condos in the Greater Phoenix Area. There was a little trick in the completion of the sale, which, I am not sure why, can be a common occurrence with 1031 exchanges. I know this because many of the agents who were selling the homes we were going to buy would ask if the sale had been completed.

Escrow was a little different in that we had both a title company and another company that specialized in 1031 exchanges to work with. They did great work and collaborated well together, but it was one more person in the conversation — just something to be aware of.

That other company who oversaw the 1031 exchange needed all the properties we identified listed, and tied up in escrow. We identified properties that were up to 180% of the sales price, and I think we could have identified up to 200%, but we wanted to be conservative.

We put 12 homes under contract and backed out of 5 to close on 7. The offers were very attractive, as it was cash, and the process from the seller's end was simple overall. The most challenging part was waiting for the proof of funds, which, again, I forget exactly what caused that delay.

I believe the money that is not used is available right after closing, but I may be wrong on that one.

Dave Foster · Answer

@Alain Labrada, Your experience should be just as @Henry Lazerow described.  For you it should be no different than normal - market/sell, shop/buy using all the same professionals you normally use.  The required qualified intermediary is simply an added component in the middle and has to be used to perform 3 functions

Document the transactions and process to provide a clear trail for your accountant and the IRS.

Take custody of the proceeds from the sale and transfer to the purchase as you cannot have actual or constructive receipt.

Consult with you to keep you straight of all the little regs and nuance.

It's this third one that is so critical if you want to harness the full power of the 1031 exchange.  and yet too often the QI function becomes simply one of generic paper documentation without crafting a scenario specific to the clients needs/goals.  @Bill Haleys story is a great example of how an involved QI can make a complicated scenario work for a client!.  Selling one and buying 7 is not an easy feat.  There are some restrictions and requirements with the identification and purchase of the replacement properties.  And it looks like their transaction was a great success because the QI was staying close to his client throughout.

A couple things that you may not know but could help you.

1. You do not have to replace the debt in your old property.  If you want to defer all tax you must purchase at least as much as your net sale.  And you must use all of your net proceeds.  But you can either purchase less than you sold (reducing the debt).   You will pay tax on the difference but not jeopardize the rest of your exchange.

You can also replace debt with cash from the outside.  You do not have to maintain the same debt levels on your replacement.  In fact it is a very strategic practice for investors to use cash from other sources including refinances of other properties in order to complete a 1031 and have a debt free property.  Late in a market when it is time to white knuckle your gains some debt free properties can be a great risk mitigator.

2. You can also take cash out if you want.  Again you will pay tax on this as the irs views it as a way of taking profit. But you can do so and not jeopardize the remainder of your exchange.  Folks will frequently have needs for which they're willing to pay a little tax for in order to access some of the money.  A client with pent up passive losses will also sometimes strategically take cash enough to offset some passive losses.

There are two times you can receive cash - At the closing of the sale your intermediary can identify the amount you want on the settlement statement and you get it at the closing - taxable of course.  Or you can wait until the exchange is complete.  Whatever cash is left over comes to you at the end - again taxable.

There will probably be around 400,000 - 500,000 exchanges performed this year.  So it is not uncommon.  But compared to the number of transactions that could potentially qualify it's still pretty small.  Congratulations on finding the greatest tool for tax mitigation and portfolio growth that is available (grudgingly) from our government!

Henry Lazerow · Answer

I have been broker for two 1031 exchanges both times representing sellers when buyer doing the exchange. The process at least from our end was very similar to a normal deal and everything went smoothly. Close was same old.

Alain Labrada · Answer

Yes, some of the rules are that the total debt of the new properties have to be equal or greater that the debt on the property sold. Also, the combined purchase price have to equal or higher than the sell price.

There are more rules, like the 200% rule.

Anthony Bellesbach · Answer

some rules i believe are you have to close in short period of time  It has to be a similar deal usually more debt the governent wants. Should have 3 deals Lined up incase a deal or 2  falls thou or your paying the capital gains if not. As far as if you got money you want out of that you would be paying capital gains tax on that amount. I believe

Have you done a 1031 Exchange?

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