Every year, hundreds of thousands of investors subject themselves to the anxiety that comes with the challenge of completing a 1031 exchange. That anxiety, however, is avoidable.
In this post, I’ll lay out the two major exchange challenges investors often face, and how to overcome them. The key to avoiding anxiety is to plan ahead, before you sell a property.
The two major challenges of the 1031 exchanges rules are:
The IRS imposed timeframes
Finding a “Goldilocks Property”
Challenge #1: IRS Imposed Timeframes
When it comes to completing an exchange, there are two critical deadlines. If you miss either one, you will owe taxes. This is important to note because 1031 exchange rules (also known as "like-kind exchange rules") are not flexible. The IRS does not grant extensions on these deadlines.
The 45-Day Identification Period: You have 45 days from the date you sell your property to identify potentialreplacement properties (note that you typically can identify up to three).
The 180-Day Closing Period: You have 180 days from the date you sell your property to purchase a replacement property (note you can exchange into more than one).
The most challenging requirement, without question, is the 45-day identification deadline. Finding a suitable property within 45 days is an ominous task. The mistake many investors make is waiting to look for a replacement property after they’ve sold their current property.
Even under perfect circumstances, looking at property and performing a reasonable level of preliminary due diligence, including negotiating the sales price, is incredibly challenging. Moreover, there is the pressure to act fast or owe 30 to 40 percent of your sales profits in taxes. It can be very overwhelming!
Challenge: Finding a “Goldilocks Property”
In order to defer all of your capital gains taxes, the replacement property for your exchange must have a purchase price and a mortgage balance equal to or greater than that of the replacement property being sold.
The price of a Goldilocks Property is ideal—not too big and not too small. To insure that you defer all of your taxes, you need to find a replacement property that requires at least as much equity as you have in 1031 proceeds from the sale. Here’s the rub: if the replacement property requires more equity than you have in 1031 proceeds, you will be able to defer all your taxes, but you will also have to come up with the difference out-of-pocket.
Let’s look at a few simple examples. Assume your property is being sold for $1,000,000. The mortgage balance on the sale date will be $600,000, which means the 1031 proceeds to exchange are $400,000. For simplicity, we won’t worry about closing costs.
If the purchase price of the replacement property is also $1,000,000, the new mortgage should be exactly $600,000. This way, the equity requirement will be exactly equal to the 1031 proceeds: $400,000.
Now assume that the purchase price of the replacement price turns out to be $1,250,000. Your equity available is still $400,000. To defer all your taxes, and avoid paying anything out-of-pocket, the mortgage needs to be $850,000 ($1,250,000, less $400,000).
An exchange is straightforward conceptually, but in reality, finding a Goldilocks property in 45 days is next to impossible. Particularly if you are trying to buy a property in a “hot market,” where there are a lot more buyers, and therefore a greater degree of competition.
The importance of planning in advance is the greatest insurance you can have to avoid missing the 45-day deadline and finding a Goldilocks Property. It’s not uncommon for investors to call us on day 30, day 35, or even day 43 in an absolute panic. Most of the time, we’ve been able to help investors solve their problem, and alleviate their angst. Even so, it always pains me to see the worry and anxiety they go through, especially when it is avoidable.
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Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.
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