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.

Keep up with oth­er top­ics on

https://dstnews.org/

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.