Pivoting out of a 1031 exchange

[Olga Nadal]

Here is the situation, we identified 3 properties for our 1031 with the idea of buying two and having a back up. We ended up buying one house to turn into a vacation rental and the two other options were one- a stand alone commercial building and two- a ground floor unit (currently occupied with a tenant for another 3 years) of a building that is in the process of being turned into condos. 

The first commercial option was sold to someone else and we are in escrow for the condo one but ready to fold that deal due to several reasons that have made us lose faith that this is a good investment. Now, we are out of the identification window so we are left with either trying to save the current deal (which involves accepting terms that weren't initially part of the deal or call it quits and pay the capital tax gains on half of the proceeds from the sale.

Are there any other options that would be worth considering? And if it were you, what would you do? Happy to answer more questions if the scenario is not clear. Thanks in advance ;) 

[Chris Seveney]

Quote from @Olga Nadal:

Here is the situation, we identified 3 properties for our 1031 with the idea of buying two and having a back up. We ended up buying one house to turn into a vacation rental and the two other options were one- a stand alone commercial building and two- a ground floor unit (currently occupied with a tenant for another 3 years) of a building that is in the process of being turned into condos. 

The first commercial option was sold to someone else and we are in escrow for the condo one but ready to fold that deal due to several reasons that have made us lose faith that this is a good investment. Now, we are out of the identification window so we are left with either trying to save the current deal (which involves accepting terms that weren't initially part of the deal or call it quits and pay the capital tax gains on half of the proceeds from the sale.

Are there any other options that would be worth considering? And if it were you, what would you do? Happy to answer more questions if the scenario is not clear. Thanks in advance ;) 

 pay the tax. eventually will have to pay it anyways - rather pay tax now vs. buying a bad deal

[Olga Nadal]

Thank you Chris! 

[Sean O'Keefe]

@Olga Nadal next time you might consider doing a Reverse 1031 Exchange to avoid this situation. 

There is an alternative that involves doing cost segregation on property you purchase and using this to help offset cap gains resulting from failed 1031 Exchange. However, there are specific requirements that you and the property need to meet to make this a viable option.  

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*This post does not create a CPA-client relationship. The information contained in this post is not to be relied upon. Readers are advised to seek professional advice.

[Mohammed Rahman]

@Olga Nadal

This is a tough situation, but here's my direct take: If you're losing faith in the investment, paying capital gains tax might be better than being stuck in a problematic deal for years.

Remember, a bad investment can cost you way more than the tax bill you're trying to avoid. In my experience, when investors force themselves into deals just to complete a 1031, they often regret it.

Unfortunately, since you're outside the identification period, your only options are to either close on the identified property or terminate the 1031 and pay the taxes. 

Before making your final decision, I'd suggest running the numbers both ways - calculate your tax liability versus the potential long-term impact of accepting those unfavorable terms you mentioned. Sometimes paying taxes is actually the more profitable path!

[Jackson Hanssen]

As many have said here, back out and take the tax hit. DO NOT let the tax tail wag the dog.

Tax considerations are an important part of real estate, but the actual investment is way more important. As a silver lining, when you buy the next property you'll have full basis for depreciation. 

[Olga Nadal]

Thank you everyone! Really good information and appreciate all the input.

[Olga Nadal]

Update: 

We ended up backing out of the commercial deal, way too many issues going on and shady practices that we were not comfortable engaging with.

Now the question is what to do with the chunk of money left after we pay taxes. Where do you suggest that we look for ideas on where to invest it? 

Thank you!

[Ashish Acharya]

@Olga Nadal Your options after the 1031 identification window closes:

1. Close the Condo Deal: Renegotiate the terms if you can address your concerns, allowing you to defer taxes on the full amount.

2. Partial 1031 Exchange: If you back out of the condo deal, you can still defer taxes on the portion already reinvested (the vacation rental) and pay capital gains tax only on the unused portion ("boot").

3. Pay Capital Gains Tax: If the investment isn’t sound, paying the tax (15-20% + state taxes) might be the better option.

4. Delaware Statutory Trust (DST): A DST could allow reinvestment into a professionally managed property to complete the exchange. Check with a tax professional.

You can manage your taxes if you do cost seg on the vacation rental and use the losses. Make sure your losses are not limited under PAL.

Choosing between these depends on your financial goals and risk tolerance.

This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.

[Dave Foster]

@Olga Nadal Fortunately, there is no penalty for an incomplete exchange. If you do not close on enough of your properties to defer all tax you will simply pay the same tax you would have at the same time you would have. It is possible as@Ashish Acharya said that you might still have some tax savings from the one purchase as a partial exchange.

It's important to be as proactive as possible when it comes to the 45 day identification period. You can even be under contract to buy within or before your 45 day period even starts. And you can go into contract for your new property at any time you want - even before the sale of your old property has happened. Naturally your old property must sell before you can take title to the new one, but it gives you a much better head start on the negotiation process of your replacement property. It sounds like most of your issues came to light during your due diligence. But the due diligence period exceeded the 45 day period. There's ways to tighten that up next time.

The other option is what's known as a reverse exchange. This is where your intermediary takes title of the replacement property before you sell your relinquished property. This would eliminate the stress of managing the 45 day identification period. Just be mindful the reverse exchanges tend to be more expensive than a traditional 1031 exchange.

There is one more option for you that might be very beneficial. And it comes out of what might feel like a disadvantage. Because you are past your 45 day period and have a valid list in place your QI has to hold your proceeds until either you have purchased all of the properties on your list, or day 180. That's not a good thing. But what is a good thing is that your 180 days will probably end in 2025. This means that your accountant can report your exchange as a partial exchange and partial installment sale with proceeds received in 2025. This will mean that you won't have to pay the tax until April of 2026. So you'll get another year or 18 months to plan for the tax before having to pay it.

[Olga Nadal]

Quote from @Ashish Acharya:

@Olga Nadal Your options after the 1031 identification window closes:

1. Close the Condo Deal: Renegotiate the terms if you can address your concerns, allowing you to defer taxes on the full amount.

2. Partial 1031 Exchange: If you back out of the condo deal, you can still defer taxes on the portion already reinvested (the vacation rental) and pay capital gains tax only on the unused portion ("boot").

3. Pay Capital Gains Tax: If the investment isn’t sound, paying the tax (15-20% + state taxes) might be the better option.

4. Delaware Statutory Trust (DST): A DST could allow reinvestment into a professionally managed property to complete the exchange. Check with a tax professional.

You can manage your taxes if you do cost seg on the vacation rental and use the losses. Make sure your losses are not limited under PAL.

Choosing between these depends on your financial goals and risk tolerance.

This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.

 Thanks so much for this detailed answer. I just sent you an email, thanks!

[Olga Nadal]

Quote from @Dave Foster:

@Olga Nadal Fortunately, there is no penalty for an incomplete exchange. If you do not close on enough of your properties to defer all tax you will simply pay the same tax you would have at the same time you would have. It is possible as@Ashish Acharya said that you might still have some tax savings from the one purchase as a partial exchange.

It's important to be as proactive as possible when it comes to the 45 day identification period. You can even be under contract to buy within or before your 45 day period even starts. And you can go into contract for your new property at any time you want - even before the sale of your old property has happened. Naturally your old property must sell before you can take title to the new one, but it gives you a much better head start on the negotiation process of your replacement property. It sounds like most of your issues came to light during your due diligence. But the due diligence period exceeded the 45 day period. There's ways to tighten that up next time.

The other option is what's known as a reverse exchange. This is where your intermediary takes title of the replacement property before you sell your relinquished property. This would eliminate the stress of managing the 45 day identification period. Just be mindful the reverse exchanges tend to be more expensive than a traditional 1031 exchange.

There is one more option for you that might be very beneficial. And it comes out of what might feel like a disadvantage. Because you are past your 45 day period and have a valid list in place your QI has to hold your proceeds until either you have purchased all of the properties on your list, or day 180. That's not a good thing. But what is a good thing is that your 180 days will probably end in 2025. This means that your accountant can report your exchange as a partial exchange and partial installment sale with proceeds received in 2025. This will mean that you won't have to pay the tax until April of 2026. So you'll get another year or 18 months to plan for the tax before having to pay it.

 Thanks so much for your answer. Yes, we just found out about the 180 days and were initially not happy about it but after your explanation on partial installment sale, it makes it less irritating. Do you have any suggestions for a great CPA that can help us with this? Our CPA is not very well versed on 1031 exchanges. Thanks!