Avoiding Rookie Mistakes in a 1031 Tax Deferred Exchange

By Al DiNicola, AIF®
December 8, 2022
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC

What could Possibly Go Wrong with the 1031 Tax Deferred Exchange?

For over 100 years the internal revenue service has a consistent position on the 1031 tax deferred exchange process. The deferral of capital gains to some point in the future is the underlying goal by using the exchange.  It is amazing the number of call and inquiries we receive that attempts to clarify the process.  Unfortunately, some of the calls are received after the mistake or improper action was taken.  There is no reporting service that tracks the numbers of exchanges that are unsuccessful. Exchanges that fail may fall apart for a number of reasons.  The failed exchanges may be a common occurrence and we would never know.  From our perspective we receive calls from potential investors with a host of questions and comments. When we answer and evaluate the investors’ questions regarding to completing their exchange the investor anxiety level increases.  Who do you blame?

We will attempt to review the top list of reasons for potential rookie mistakes.

Qualifying your exchange

Prior to closing on the property, you are selling (relinquished property or “down leg”) you should have already entered into an agreement with the Qualified Intermediary (QI). There are a few potentially interchangeable references to a QI.  Occasionally  QI may be called the accommodator and/or facilitator. The QI cannot be associated with the investor.  This means a relative, attorney, real estate professional or financial advisor of the exchanger. Some of the tasks handled by the QI may be:

Preparing exchange documentation that are required with the Exchange Agreement and any Assignments of the Agreements of Sales and ensuring Acknowledgements among others.

There will be a closing agent on the relinquished property the QI will Coordinate details with the closing agent to ensure the transaction is documented as a 1031 exchange. This is important to do and avoid any resemblance of a taxable sale. The QI will provide written instructions to the closing agent. The closing statements on the replacement property will be reviewed by your Exchange Officer in advance of the closing.

One of the major items is the receipt and holding of the exchange funds. Ideally these funds should be held in a segregated, interest-bearing exchange account until the replacement property is acquired. There should be numerous safeguards in place to protect your funds during the Exchange Period. One caveat is Qis are an unregulated profession and does not have any licensing laws or qualification.

The investor needs to enter into a contract with the QI.  As stated previously the QI needs to accept the proceeds from the relinquished property. A taxpayer cannot accept any funds from the sale. If you close without a contract with the QI prior to closing the exchange cannot take place and this will be a taxable event. Investors receiving funds is called having constructive receipt of the funds.

Deadlines are DEADLINES!

If you have closed with a QI in your corner, you next need to be cautious with time frames.  Many of the Qis we have worked with for the benefit of the investor are well aware of the deadlines.  Most QI will immediately upon receipt of the closing proceeds on the relinquished property send a detailed form with dates, replacement property rules and reminders. One of the first deadlines is the 45-day replacement notification list.  There is no extension to the 45 days.  If the 45th day falls on a weekend, holiday or any other special occasion there is no extension.  You can alter your list during the 45-day period but on the last day whatever the list the QI has becomes the final list. Some of our investors may locate a replacement property prior to the 45 days and close on the property. In this case there is an exception that there does not need to be a 45-day list.   Be advised that if you are closing on multiple properties all properties need to be identified. One other caution- if you acquire a property that is not on your list that property does not qualify as a 1031 exchange. We will cover rules for identification later in this article.

Real Estate Broker Involvement.

Being a Florida Real Estate broker for 4 decades I have participated in and seen hundreds of exchanges.  There are incidents  where the real estate agent or broker may have created a situation that led to the failure of the investor exchange.  Occasionally when a real estate agent starts working with an investor selling a property and wishing to enter into a 1031 the agent develops a strategy.  This strategy may include the real estate agent anticipating and thinking about making two sales.  The two sales would be selling the investor’s current property and then arranging for the acquisition of the replacement property.    We have received several calls from investors stating the real estate agent encouraged the investor to sell their property with the real estate agent almost guaranteeing the real estate agent will locate replacement properties. In defense of real estate agents some are well skilled to handle the critical timing of the 1031.  Ideally, the investor has insight on the replacement property the investor wants to acquire prior to listing and selling the relinquished property.  There are three potential negative outcomes that we have witnessed firsthand.  Those would be finding an acceptable property, Understanding the 1031 details,  and contract contingencies.

Finding acceptable property.

On more than one occasion, the selling agent convinces the investor to list and sell an income producing property. Once the income producing property closes the investor starts to review the replacement properties being suggested by the selling agent (who would earn a second commission). The clock is ticking on the 45-day identification period. At times there are so many details to review on the replacement properties with inspection, potential mortgage approval, and a host of other items that need to be verified.   Depending on the current real estate market the available inventory may not be acceptable to the investor for a variety of reason. Unfortunately, the investor is on the short end of the stick. 

Understanding the 1031 details.

There may also be confusion on the part of the investor totally understanding the requirement of the 1031 exchange.  One stipulation is the debt being paid off on the relinquished property must be replace when acquiring a replacement property. I can remember vividly hearing the spouse of the exchange investor stating that she did not want to have a mortgage because  the loan “will be a noose around their neck”. The reference to the noose was based on the requirement for the investor to sign the loan documents and be liable for the loan on the new replacement property.

Contract Contingencies.

Contingencies in contracts work for both the seller as well as the buyers.  Even though there is 45 days to identify time goes by quickly. Once you engage in an offer, negotiations, and final acceptance of the purchase contact there are many items to clarify.  Typically, there may be contingencies in the contract. From the buyer’s perspective they want to purchase the property free of any existing liens, with the proper representation and warrants from the seller.  We have seen situation where the person signing the purchase contract not having the legal right to sell the property. This may come up in the title search and there were additional people on the title. Title searches need to be ordered immediately.  We have seen in the case of income properties rent rolls overstated effecting the NOI of the property.  NOI may be used to establish an acceptable purchase price.  Even if the price of the property is reduced after discovery of rental discrepancies the total value of the exchange may be affected. The drop in the purchase price may create a capital gains event for the exchanger. You frankly may run out of time.  We have been successful in assisting an investor who was at the end of the 45-day identification period (4 days remaining) and needed to place $3.2M in cash and needed $2.8M in debt.

Tested Solution.

Commercial real estate agents who fully understand the replacement solutions that a DST may provide to the investor that agent can add a tremendous value to the investor. DSTs have provided potential both  a primary replacement solution and a backup solution for 1031 exchanges. One scenario that may assist the investor would be to immediately identify a variety of DSTs as replacement properties at the start of the 45-day period. (Investors may use the three-property rule or the 200% Rule). During the 45-day period the investor may find an acceptable replacement property. This may replace some or all of the properties on the list based on the overall market value of the replacement property.  There is evidence that suggests 1031 exchange investors may overpay for the replacement property because of the requirements to use all the cash proceeds and also meet or exceed the relinquished property value. This may indicate the investor lacks motivation to negotiate the best acquisition price for the replacement property.  The DST back up solution may provide the investor the ability to negotiate a great acquisition price and then select a DST for the balance of the proceeds to avoid any boot on remaining cash proceeds.  In the example above of the investor with 4 days remaining we were successful because of our knowledge of available inventory and DST are prepackaged with non-recourse debt meaning no “noose” around anyone’s neck.

The Devil is in the Details!

We understand the details on clearly identifying the potential properties an exchange investor may wish to purchase. There can be no mistake with the property identification on the 45-day identification list.  This list may be altered during the 45 days. However, at the end of the time period the list is locked so to speak.  To avoid any confusion, you may include the address as well as the legal description. Condominiums may have additional descriptions as well as adjacent property usage such as garages, etc.  If you are listing a fractional interest in a property (Tenants in Common or DST) you need to identify the percentage of ownership as closely as possible.  There is some room on the fractional interest where you may acquire less than the stated amount. In the past an acquisition of 20%-25% less than listed may be considered acceptable.

Construction Cost Accepted.

There may be exchanges where a property is acquired and will have some improvements.  This is allowable but there is a caution with regards to improvements.  Improvements need to be well documented. In addition, this is considered a construction exchange and the QI may suggest to establish a new entity called an Exchange Accommodation Titleholder (EAT) to hold title in your place. This may also be used with a reverse exchange.

Elimination of Exchange of Personal Property.

The Tax and Jobs Act of 2017 (TCJA) had major changes to the IRS code. The elimination of personal property qualifying for like kind exchanges was one major change. Planes, vehicles and construction equipment and other personal property can no longer be exchanged. As an additional note personal residences and second homes do not qualify for a 1031 exchange.  However, you can still exchange raw land for an apartment building which means all real estate is like kind to other real estate.

Start a Conversation with an Expert.

The best advice we can offer anyone contemplating utilizing the benefits of the 1031 tax deferred exchange section of the IRS code is to start a conversation with an expert.  A call prior to even listing your property may provide details you will need to achieve outstanding results.  We would be happy to assist you in the 1031educational process.  We also can shed light on the DST alternative and help determine if this may be included in your success of your exchange.

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DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.

This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 1719 NW Edgar Street, McMinnville, OR 97128 MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.

Thank you.

About the author

Al DiNicola, AIF, CEPA, specializes in 1031 Exchanges utilizing DST as a viable alternative for accredited investors. He also is well versed in Opportunity Zones and Alternative Real Estate Investments. Mr. DiNicola has more than 40 years of experience in commercial & residential sales and development. Al has extensive experience in real estate land acquisitions, development, investment and real estate securities.

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