When the IRS announced various deadline extensions in April 2020, a large bulk of the U.S. population breathed a collective sigh of relief. The extension of quarterly tax payments and filing deadlines from April 15 to mid-July provided wiggle room for taxpayers dealing with COVID-19’s economic fallout.
Also breathing a sigh of relief are investors in the middle of 1031 exchange agreements. Thanks to IRS Notice 2020-23, “in-flight” investors have until July 15, 2020, to identify exchange properties, as long as the original 45-day identification period start date fell between April 1 and July 15.
If, however, you are in the midst of a 1031 exchange, this is not the time to sit back and relax, especially if you don’t want to be stuck with a capital gains tax bill. You need to keep in mind that the 45-day countdown to identify your replacement property/properties began on May 31. You also need to keep in mind that the coronavirus pandemic has thrown the economy and real estate market into turmoil, leading to serious issues for exchange buyers.
The 1031 Exchange — a Brief Review
With help from Section 1031 of the U.S. tax code, you can defer paying capital gains taxes from the sale of a property, as long as you re-invest, or “exchange” the value of the original property into that of a replacement property or properties. The IRS also has certain requirements for this exchange:
- You have 45 days from the sale of your original property to find a like-kind replacement property or properties for exchange.
- You must close on that replacement property or properties within 180 days after selling your original property.
- The replacement property or properties must be worth at least as much — if not more than — your original property.
Due to the IRS’ stringent requirements, targeting and closing on a replacement property can be a challenge. In the current economic situation, even with deadline extensions, those challenges are magnified, for the following reasons.
Increased Demand, Decreased Supply
You are not the only investor out there who is trying to find a replacement property. You’re competing against others, who have that same July 15 deadline.
Depending on when the original properties sold, the 1031 exchange deadline extension provided qualified investors with up to a total of 105 days to identify replacement properties — far more than the usual 45 days. As a result, the number of “exchangers” with the mid-July deadline in their sights has more than doubled from what it normally might be. The exponential increase in demand, which is already driving competition, will be made much worse with the decrease in property supply.
Sellers are removing their properties from the market, at least until the economy stabilizes. This has led to a dwindling supply. In one scenario, investors attempting to exchange into rental homes and duplexes have found available supply decreased by 20%. Similar numbers are reported among net-lease properties and other commercial real estate.
Even if you can find a viable replacement property, the spread between what you are willing to pay and what the seller is willing to accept might be far apart. The seller will probably want a pre-pandemic price, whereas you might be basing your bid on current economic uncertainties, such as double-digit unemployment and tenant uncertainty. If your bid is too low, and the seller doesn’t like it, he or she can move on to another buyer who might be more amenable. And, as mentioned above, there are plenty of buyers looking for properties.
This supply shortage impacts more than just the investors interested in direct ownership of potentially revenue-producing single-family or similar properties. Passive real estate investment vehicles, such as Delaware Statutory Trusts (DSTs) are also likely to feel the supply pinch. DSTs allow investors partial ownership of portfolios containing institutional-grade commercial real estate assets. However, such real estate is also anticipated to be in short supply, meaning potential challenges.
And, once you find that property, you could run into some troubles sourcing debt.
The likelihood is pretty good that, even with an exchange, you’ll need a loan. In our experience, approximately 80% of 1031 exchange transactions require a mortgage to meet the necessary requirements. But, obtaining mortgage financing these days is hard.
Banks and lenders are extremely busy, dealing with loan forbearance and refinancing applications, especially in light of very low interest rates. These institutions are also working with COVID-19-related programs, such as the Payback Protection Program, meaning less time available to underwrite and issue original mortgages.
Even if you are fortunate enough to have a good relationship with your banker, more stringent lending practices could mean the following.
- You will need a credit score of at least 700.
- You might have to accept a lower loan-to-value agreement, meaning higher equity requirements.
- Your lender could either re-trade, or pull, your loan, up until closing.
- It could take longer to get the loan approved.
This is the case, even if you are trying to exchange into residential real estate. Fannie Mae and Freddie Mac — which guarantee half of U.S. residential mortgages — aren’t loosening lending standards.
Avoiding Problems on July 15
The above is not to deter you from moving forward on a 1031 exchange, but rather, to outline the issues you can expect as you move forward through the process. So, to avoid potential capital gains taxes on July 15 from the sale of your property, you should consider the following steps.
Start your replacement property search now. Just because there is still time until the July 15 deadline doesn’t mean you should wait to begin looking. Timing is of the essence when it comes to an exchange, especially during these times.
Talk to your banker. As mentioned above, financing is more difficult to obtain, at this time. Given this, it’s a good idea to know if you will have financing for the replacement property, once you find it. Set up some time to talk with your banker for a realistic assessment as to what loan products are available, and how long it will take to obtain them.
Deliver realistic bids. If you are exchanging into direct ownership of another property, you still need to consider proformas and the current economy when making your bid. Do keep in mind, however, that this is a seller’s market, complete with scarce supply. Your offer should reflect this.
Consider exchanging into a passive investment vehicle. DSTs can be an ideal replacement target, as the trust already owns the property/properties, and financing is in place. This gives you a respite from searching for properties and nailing down financing. Furthermore, the set-up means you can exchange into as few, or as many, fractional ownership shares as necessary to satisfy the IRS’ requirements. However, as mentioned above, DSTs could also face a shortage of viable properties, meaning you should take steps now to find a suitable trust for your investment needs.
While the IRS extension provides some breathing room, it’s important not to waste time when it comes to targeting a replacement property as part of your exchange. Failure to move now could mean a hefty tax bill when the July 15 deadline rolls around.
For assistance in finding feasible exchange properties, or to access advice from our experts, contact Realized Holdings by calling 877.797.1031 or logging on to www.realized1031.com.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation. This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.