Six Strategies For A Smooth 1031 Exchange

In a previous blog, we noted that 1031 Exchange rules can be challenging. That article focused on three Internal Revenue Service (IRS) rules when it came to identifying the replacement property or properties for a successful exchange.

In this article, we’re identifying six additional approaches that, when implemented, may help ensure your exchange is completed within the IRS timeframes with as little stress – and as few mistakes – as possible.

1. Strategize Before Relinquishing

You might wake up one day, decide you’re tired of your rental property, and decide to exchange into another one to defer any kind of tax burden on proceeds or profit. We don’t have a problem with this – our business revolves around 1031 exchanges, after all. However, before you plot how to sell that asset, be sure you know what type of property you’re looking for to take its place – and if that type of property is even available to you. In fact, it’s a better idea if you can find that ideal replacement property BEFORE you relinquish yours. “Winging it” when it comes to your replacement property could play havoc with your portfolio and/or investment tactics.

2. Solidify Your Exchange Team

This is another check on your “things-to-do-before-putting-your-property-on-the-market” list. Ensure your exchange team is in place. And, that team MUST include a third-party Qualified Intermediary (QI). We’ve pointed out in previous articles that you absolutely are not allowed to touch any of the proceeds from your 1031 Exchange, at least, not if you want to reap the tax savings.  That is your QI’s job.

3. Target Backup Replacement Properties

At Realized Holdings, we frequently hear this: An exchange investor sells his/her asset, then almost immediately finds a like-kind replacement property (or has it in place beforehand, per the above). Then things fall apart. The seller gets cold feet. Or gets a better offer. Or dies, and the heirs decide not to sell. Deals frequently fall out of escrow, leaving you with a ticking clock and no replacement property. This is why it’s essential to find at least one backup replacement property. You don’t have to buy it. But it’s your safety net in the event that your original replacement choice doesn’t make it to the closing table.

4. Launch Immediate Due Diligence

It’s vitally important to immediately schedule inspections for the replacement property. Don’t wait until that 45-day identification period is completed. Doing so might mean the seller has the upper hand. Another thing to do at once? Negotiate repair agreements with the seller in that 45-day window. Certainly, you can threaten to pull out of the sale on day 46 – but it may leave you subject to the taxes you had hoped to defer on the property you’ve relinquished.

5. Forget About Size

One idea behind a 1031 Exchange is that you can trade into something with a higher value. But perhaps a smaller size/smaller value property better fits your investment strategy. If this is your situation, you can decide to pay taxes on the remaining proceeds (referred to as “boot”). Or, you could invest those “leftover” proceeds in a Delaware Statutory Trust, providing you with another tax deferred investment.

6. Ensure Acquisition Financing

In order to fully defer capital gains, requirements of an exchange are that you a) reinvest all equity from the relinquished property and b) acquire equal or greater property value - for investors who paid off a mortgage on the relinquished property, this typically means seeking to replace at least the same amount of debt. This could be a problem if 1) your targeted replacement property doesn’t qualify for financing, or 2) you can’t get a loan because of poor credit or lack of steady income. While you’re mulling over relinquishing your property and targeting a replacement, make sure you can find the necessary debt or equity for the exchange.

The final, important piece of a successful exchange is to mark your calendar. We’ve stressed this before: the IRS is adamant that you

• Find a replacement property within 45 days after selling yours
• Close on that replacement asset within 180 days after selling yours

There are plenty of pitfalls that can occur during the 1031 Exchange process. Following the IRS rules, and taking the above suggestions to heart, can help minimize the problems and risks, while maximizing your chances of a successful exchange.