A 1031 exchange allows real estate investors to legally defer capital gains and depreciation recapture taxes on the sale of investment property by reinvesting the net proceeds of a sale according to certain rules. If these rules are not strictly followed, some or all of the capital gain can become immediately and irrevocably taxable. The tax consequences of a failed 1031 exchange depend on whether you or your Qualified Intermediary is at fault, what your overall tax position is, and other factors. This article provides three tactics for guarding against failure when completing a 1031 exchange.
Tactic #1: Assemble Your 1031 Exchange Team Prior to Closing Escrow on Your Relinquished Property
It is important to establish your team of 1031 experts prior to closing escrow on your relinquished property, starting with your escrow officer and Qualified Intermediary (QI). You must engage the escrow company and QI in advance so that the escrow company can forward the net proceeds from the sale to the proper QI account. If this is not done properly and you take constructive receipt of the proceeds from the sale, the event will be taxed as a traditional sale rather than an exchange (i.e. capital gains and depreciation recapture taxes will be owed).
In addition to the escrow officer and QI, it is helpful to establish working relationships with a tax attorney, CPA, real estate broker or investment advisor, and, if applicable, a loan officer. Assembling this team in advance gives you the opportunity to involve these experts in the planning process and benefit from each of their unique perspectives on the exchange process. Stay in touch with your team throughout the exchange period, and speak up immediately if any concerns arise. They may be able to help save your exchange if you encounter unexpected challenges.
Tactic #2: Write Contingencies Into Your Agreements
You and your real estate advisor may be able to negotiate with the buyer of your relinquished property to make the sale contingent on your finding suitable replacement property in order to lower the risk of fumbling your 1031 exchange. Depending on your timing within the market cycle, you may be in a stronger position to do this on the other end: if you are able to identify a suitable replacement property in advance, you may be able to negotiate with the seller to make the purchase contingent on a successful sale of your relinquished property.
Tactic #3: Identify Backup Replacement Property Options that Are Ready to Close
According to 26 C.F.R. 1031 you must identify potential replacement property by the 45th day after the close of escrow according to one of three rules:
3-Property Rule: You may identify up to three potential replacement properties and purchase any (or all) of them, regardless of their total value.
200% Rule: You may identify more than three potential replacement properties and purchase any (or all) of them, so long as their total value does not exceed 200% of the value of your relinquished property.
95% Rule: You may identify more than three potential replacement properties, regardless of their total value, so long as you purchase at least 95% of the total value of all of the properties you identify.
Utilizing these identification rules can work to your advantage. Even if you plan to acquire just one specific property, you can identify backup properties in case your first choice does not work out. Some investors identify multiple properties that they would be similarly satisfied with acquiring if their initial selection falls through. Other investors target net-leased properties that have fewer moving parts to serve as their back up option if their first option falls out and leaves them with less time for due diligence. Additionally, many investors will identify one or two Delaware Statutory Trust (DST) and Tenant-in-Common (TIC) investment properties since they provide a lot of prepackaged due diligence upfront and are structured to allow each investor to quickly close escrow (typically within 1-3 business days) on his own interest to complete the 1031 exchange. Even if your primary replacement property identification is not a DST or TIC, identifying suitable DSTs or TIC backups just might save your exchange if and when your first choice(s) fall through. Learn more about the pros and cons of Delaware Statutory Trusts.
If you follow the rules, you can successfully defer your capital gains and depreciation recapture taxes utilizing a 1031 exchange. Assembling your team of professionals in advance, negotiating contingencies, and identifying backup replacement properties can bolster the likelihood of your success.