Common §1031 Mistakes and Misconceptions

Learn­ing from His­to­ry and Expe­ri­ence.

Over my 40-year career as a real estate bro­ker and an invest­ment advi­sor I have seen count­less 1031 exchanges. The IRC §1031 exchange is a tool that has been used by investors for over 100 years in the US to defer cap­i­tal gains, realign assets, cre­ate gen­er­a­tional wealth and accom­plish oth­er goals.

By Al DiNi­co­la, AIF®, CEPA ™
adinicola@namcoa.com
June 4, 2023
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC

We have been for­tu­nate to work with many investors who stayed on track with all the IRC §1031 require­ments to suc­cess­ful­ly com­plete the exchange and defer cap­i­tal gain tax­es.  We have also been able to guide investors into Delaware Statu­to­ry Trust (DSTs) that qual­i­fy for the 1031 exchange pro­gram and pro­vide pas­sive tax favored income. Along the way we have wit­nessed suc­cess­ful exchanges.  Suc­cess­ful exchanges may get more atten­tion than the exchanges that do not go well.  We study his­to­ry to learn from other’s mis­takes. Albeit occa­sion­al­ly some investors may repeat the mis­takes of oth­ers.   We will attempt to review the biggest faux pas that will sink or blow up an exchange.

There are about ten sit­u­a­tions that may turn into mis­takes that we will out­line and briefly com­ment on in this arti­cle. 

1. Fail­ing to cre­ate a plan.  Over the recur­ring cycles of real estate, investors will watch the val­ue of their invest­ment rise and decide to sell their invest­ment. Excit­ed real estate bro­kers & agents are ready, will­ing, and able to list the prop­er­ty, espe­cial­ly in a flu­id mar­ket. Occa­sion­al­ly the invest­ment prop­er­ty sells quick­ly, and the investor has not prop­er­ly planned what the exit strat­e­gy is for the pro­ceeds.  Is the plan to pay the cap­i­tal gains and move on or uti­lize the 1031 tax deferred exchange alter­na­tive. Exit plan­ning is sim­ply good busi­ness.
2. The par­ties who assist you in set­ting up your exchange are crit­i­cal.  Sim­ply using a real estate attor­ney does not guar­an­tee suc­cess espe­cial­ly if the real estate attor­ney is not pro­fi­cient in 1031 exchange process.   Although you’re exchang­ing real estate, a 1031 exchange is a tax trans­ac­tion as much as a real estate trans­ac­tion, if not more so. If a 1031 exchange is not done prop­er­ly, the tax con­se­quences can be sig­nif­i­cant. The exchange com­pa­ny (ref­er­enced as a qual­i­fied inter­me­di­ary or QI)  should under­stand how  to com­ply with the IRC 1031 exchange rules.  Occa­sion­al­ly an investor will deposit their sales pro­ceeds with an escrow agent or take con­struc­tive receipt of the pro­ceeds rather than hav­ing the pro­ceeds from the relin­quished prop­er­ty placed with a QI.  This will void the 1031 exchange. Pro­ceeds must be held by a QI. Attor­neys must also be set up as a QI if they are han­dling the exchange.
3. There are many rep­utable QIs. Every day QIs effec­tive­ly com­plete the exchanges for investors.  There are no licens­ing require­ments to be a QI.  This is an unreg­u­lat­ed pro­fes­sion if com­pared to a real estate license or invest­ment advi­sors licens­ing require­ments.  There are pro­fes­sion­al orga­ni­za­tions of QI who spon­sor best prac­tices and pro­fes­sion­al stan­dards.  How­ev­er, if you use a QI with­out ask­ing the right ques­tions there may be a poten­tial of the exchange not going well or worse yet los­ing your funds.  Your due dili­gence ques­tions may  include how your funds will be deposit­ed and if a sep­a­rate account is used for your funds. Also check out the process for the release of your funds.
4. Over­pay­ing for the replace­ment prop­er­ty. Once you enter a 1031 exchange (with a QI) a big  mis­take is tar­get­ing your replace­ment prop­er­ty with spend­ing all the pro­ceeds being held by the QI. There are three ele­ments when decid­ing on the replace­ment prop­er­ty. How to locate, how to nego­ti­ate and how not to over­pay. Typ­i­cal­ly, sell­ers will know the investor is a 1031 investor based on con­tract lan­guage as well as real estate agent feed­back. The list­ing bro­ker on the replace­ment prop­er­ty as well as the sell­er may be reluc­tant to nego­ti­ate. The 1031 investor may sim­ply want to spend all the cash. There have been stud­ies that have shown 1031 investors may be pay­ing 15% more for the replace­ment prop­er­ties sim­ply because to avoid cap­i­tal gain tax­es, the investor needs to spend all the cash.
5. Buy­ing any­thing that comes along.  An investor may pull the trig­ger and sell their invest­ment prop­er­ty and turn around and buy some­thing that may not make sense.  A hasty pur­chase with addi­tion­al cap­i­tal improve­ments may cre­ate investor remorse and wish­ing they had not sold their prop­er­ty in the first place.
6. Under­stand­ing the num­bers. You don’t need to be a rock­et sci­en­tist to exe­cute a 1031 exchange, but you do need to watch the details. Under­stand­ing the num­bers on the cost of sell­ing the prop­er­ty and acquir­ing the replace­ment prop­er­ty is crit­i­cal to under­stand.  Under­stand­ing the debt that may need to be replaced is also an impor­tant com­po­nent.  Tax­able events can be avoid­ed by ensur­ing the total under­stand­ing of all required cost items.
7. 1031 exchanges are Defer­ral not Elim­i­na­tion of tax­es. Cap­i­tal gains tax­es can be deferred to a lat­er time but are not elim­i­nat­ed for the investor. Cap­i­tal gains tax­es are typ­i­cal­ly less than ordi­nary income tax. There would be the elim­i­na­tion of tax­es would hap­pen if the investors retained the prop­er­ty and pass the prop­er­ty to their heirs. This is known as a step up in basis upon the death of the investor.
8. The clock is tick­ing. The 45-day clock starts tick­ing when the investor is clos­ing on the relin­quished prop­er­ty. Many times, 45-days seems like a long time. How­ev­er, when you add in con­tract nego­ti­a­tion, inspec­tions, loan approval (if need­ed) and oth­er poten­tial issues all com­pound the chal­lenge. At the end of the 45-day peri­od an investor may sim­ply pur­chase some­thing, any­thing, just to com­plete the 1031 exchange.
9. This is tax plan­ning. Tax plan­ning for invest­ment real estate is very impor­tant to pro­vide the most effi­cient uti­liza­tion of the tax codes.  Investors need to under­stand depre­ci­a­tion, car­ry for­ward depre­ci­a­tion as well as oth­er poten­tial real estate write offs.  
10. Cash boot and mort­gage boot. There is a dou­ble-edged sword with nego­ti­at­ing a bet­ter price and not using all the cash. You paid less for the prop­er­ty but need to pay cap­i­tal gains on the cash you did not use.  Like­wise, if you paid off a loan and you can­not arrange non-recourse financ­ing this would be mort­gage boot and tax­able. This may result in your total replace­ment price falling short.

There is a poten­tial DST solu­tion for many of the issues. Accred­it­ed investors seek­ing replace­ment prop­er­ties with a pas­sive invest­ment will seek Delaware Statu­to­ry Trust (DST). The advan­tage with the DST struc­ture affords the investor with non-recourse debt on the prepack­age invest­ment alter­na­tives. 

Left­over pro­ceeds from  strong nego­ti­a­tions may be invest­ed into a DST. Pro­ceeds as lit­tle as $100,000 may be placed in a DST avoid­ing cap­i­tal gains.

Con­tact us for addi­tion­al infor­ma­tion on the DST struc­ture and func­tion for your poten­tial invest­ment solu­tions.

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. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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