Selling investment or business real estate can be costly, but a 1031 exchange can help preserve gains and generate wealth. Under Section 1031 of the federal tax code, no gain or loss is recognized on the sale of a real estate property held for business or investment purposes if a replacement property of equal or greater value is purchased. However, the 1031 exchange process can be complex. To help guide your clients through a successful exchange, consider these steps:
Be aware of the deadlines set by the IRS. Investors have 45 days to identify a replacement property and 180 days to close on it after selling the relinquished property. It may seem like a short time frame, but it is manageable with the help of a professional 1031 exchange investment firm such as Perch Wealth.
The IRS requires that an exchanger reinvest in a “like-kind” property, but this does not necessarily mean the same type of property. There are various options available. For example, if you are selling a duplex, you don't have to replace it with another duplex.
The 1031 exchange allows investors to replace relinquished real estate with different types of assets such as a medical building, single-family home, multifamily apartment building, raw land, self-storage facility or any other investment real estate as long as it is held for investment or business purposes.
It is best to know what you are looking for in a replacement property before going into escrow on the property you are selling. Working with a 1031 exchange investment firm like Perch Wealth can greatly reduce the stress and confusion surrounding 1031 exchanges.
It is not uncommon for 1031 exchange investors to feel overwhelmed and stressed when they reach the 30-day mark of their 45-day window without a replacement property identified for their exchange. However, with some planning and preparation, you can avoid this situation.
A good strategy is to identify five to ten potential replacement properties as the closing date of the property you are selling approaches. Keep in mind that some of these properties may be acquired by other buyers or may not be suitable after further evaluation, which is why it is important to have a short list of potential replacement properties before relinquishing the original asset. This can help prevent your 1031 exchange from falling apart.
It is not uncommon for investors to call in a panic because they have found a replacement property, but they are unable to secure financing to purchase it. To avoid this stressful and potentially costly situation, it is important to ensure that financing is in place before closing on the property being sold.
One solution is to consider fractional ownership structures for 1031 exchanges, such as a Delaware Statutory Trust (DST) investment for accredited investors. DSTs have a non-recourse financing component built-in, so the investor does not need to sign for a loan. This can make a DST an ideal opportunity for an investor looking for a passive, turn-key solution with pre-established financing for their 1031 exchange.
According to the IRS code, investors have options for identifying replacement properties for their 1031 exchange. The most common methods are identifying three properties at any value or identifying real estate valued at up to 200% of the property being sold.
This allows for back-up options. It is important to take advantage of this opportunity and not leave any empty spaces on the ID form submitted to the qualified intermediary. Often, the primary option may not work out, and having back-up options can strengthen the investor's negotiating power by providing additional choices.
For accredited investors, a Delaware Statutory Trust (DST) can be an excellent back-up strategy. DST properties are already purchased, stabilized, and may provide monthly distributions to investors. There is no need for negotiation and due diligence is already complete.
Additionally, closing on a DST can often be done in three to five business days. It is a good idea to consider using a DST as a back-up ID if there is room in the exchange and it is appropriate for the investor's situation.
When entering into a purchase and sale agreement, it is important to include a 1031 contingency clause. Many buyers are willing to allow a 1031 contingency that allows the seller to extend escrow on the property being sold if the seller is unable to find a replacement property. For example, try to negotiate a clause that extends escrow by an additional 30 days in case you are unable to identify a suitable replacement property. This can provide extra time if needed when locating the right 1031 exchange investment.
In summary, a 1031 exchange can be a valuable tool for building and preserving wealth, but it can also be a challenging process if not properly prepared. To ensure a successful exchange, start early, educate yourself, narrow down options, secure financing, have a back-up plan, and negotiate for more time if needed.
For accredited investors, consider using a Delaware Statutory Trust (DST) as part of your 1031 exchange strategy. Keep in mind that there are no guarantees in real estate, so it is always best to plan ahead when considering a 1031 exchange.
Perch Financial LLC and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA/SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein. 1031 Risk Disclosure:
No offer to buy or sell securities is being made. Such offers may only be made to qualified accredited investors via private placement memorandum. Risks detailed in a private placement memorandum should be carefully reviewed, understood, and considered before making such an investment. Prospective strategies and products used in any tax advantaged investment planning should be reviewed independently with your tax and legal advisors. Changes to the tax code and other regulatory revisions could have a negative impact upon strategies developed and recommendations made. Past performance and/or forward-looking statements are never an assurance of future results.
Many of the investments offered will be only available to those investors meeting the definition of an Accredited Investor under SEC Rule 501(A) and offered as Regulation D private placement securities via a Private Placement Memorandum (“PPM”). Prospective investors must receive, read, and understand all the risks associated with buying private placement securities. Investments are not guaranteed or FDIC insured and risks may include but are not limited to illiquidity, no guarantee of income or guarantee that all tax advantages or objectives will be met and complete loss of principal investment could occur.
Risk Disclosure: Alternative investment products, including real estate investments, notes & debentures, hedge funds and private equity, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-U.S. exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in U.S. markets. Additionally, alternative investments often entail commodity trading, which involves substantial risk of loss.
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