Understanding your options if you are considering selling your investment real estate utilizing a 1031 Exchange is critical. You may have a few options to consider depending on your specific situation and the condition of your replacement property.
By Al DiNicola, AIF®, CEPA ™
August 24, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
IRC §1031 has been in existence for over 100 years. There have been some changes over that period of time but 1031 has enabled investors to build wealth by deferring capital gains. The other advantage of the 1031 exchange is the deferral of the recapture of depreciation. These two elements have enabled the investor to utilize all the proceeds from the sale to acquire a replacement property. There are rules on timing, identification, and other very specific regulations that are outside the scope of this article. This writing will provide an overview of the various types of exchanges enabling you to defer taxes.
Four Flavors of 1031 exchanges.
New investors may be surprised to discover there is more than one plain vanilla exchange that enables an investor to defer capital gains and defer taxes.
- The Delayed Exchange
The plain vanilla exchange may be the Delayed Exchange. However, this was not the first to be permitted but currently most often used. Real estate investors may prefer this type of exchange because of the timing afforded to the investor. The investor can arrange to close on the property they are selling and then identify and close on a replacement property. This is most preferred method of doing a 1031 exchange by real estate investors. This type of exchange allows you to close on the sale of your relinquished property before closing on the purchase of your replacement property at a later date usually within 180 days. In the delayed exchange, you need the service of a qualified intermediary to handle the exchange on your behalf.
2. The Simultaneous Exchange is where it all started.
While this type has been around for the longest period of time it is not used very often because of the timing requirements. You may hear the word “Forward Exchange” associated with this exchange. The timing requires you to sell your property (relinquished property) and purchase a replacement property immediately. Imagine all the details required to sell one property and acquire another on the same day. Especially if there is a mortgage being paid off and another being close on the replacement property. (Debt replacement is one of the requirements of the 1031 exchange).
3. Tight Market may use Reverse 1031 Exchange
The U.S. real estate market operates typically in cycles. The cycles may be a sellers’ market or a buyers’ market. The seller’s market is when the seller holds the upper hand on inventory (available homes to buy) or firm price appreciation (could be multiple offers). These conditions make acquiring a replacement property an issue. The strategy behind a reverse exchange may be beneficial in this situation.
The 1031 exchange is carried out in reverse order. You would acquire the replacement property prior to selling the relinquished property. As with all exchanges there is a QI involved and required. The QI is required to hold the title to the replacement property until the investor sells the relinquished property. Not all QI feel totally comfortable with a reverse exchange.
Is there are risk with a reverse exchange? The QI will be holding the title of the replacement property. The investor has 180 days to sell the relinquished property and close. If you are successful, the QI will transfer the title of the replacement property to you. Caution- you need to have the funds to purchase the replacement property and you will be reimbursed from the proceeds the QI is holding of the relinquished property. What if you don’t sell your relinquished property? You may need to drop your price or cancel your exchange.
4. Construction / Improvement Exchange
At first glance this exchange may resemble the reverse exchange. You may want to purchase a new property that is under construction or purchase a property that needs improvements. The construction (does not need to be new) or improvement exchange may provide a few advantages. You sell your relinquished property and use part of the proceeds to acquire the replacement property. In all cases the QI is holding the proceeds of the relinquished property. For example, you sell a property for $500,000 (all cash) and purchase a property that is $350,000 but needs a lot of repair work or capital improvements. If the improvements are $150,000 or more the exchange is successful.
The QI will take title to the property during the construction or improvement that are made to the property. You still have the strict time period of 180 days from the closing of the relinquished property to complete all the construction. Once you complete the construction the QI transfers title to you. Please consult the QI on the additional cost of holding funds and disbursing proceeds to a contractor who may be doing the construction on the property.
There is always a word of caution if you are buying a new home (that qualifies for a 1031) from a builder. Construction schedules have a tendency of dragging out and if you go past the 180 days your entire exchange could be in jeopardy. There is also the potential to value the improvements that have been made up until the 180th days and if the total value is equal to or greater than the relinquished market value this may keep your exchange intact.
All of the types of exchanges could involve traditional investment real estate as well as Delaware Statutory Trust (DST). Investors seeking to become more passive in management may find the solution in a DST. The main advantage of the DSTs would be not needing the reverse exchange or the construction/improvement exchanges. The main reason would be DST are offered for a specific time period and once a subscription agreement is in place closing happens within a matter of days. This relieves the investor from buying something first and then attempting to sell their property. Although in some cases there may be an exception where a reverse exchange may be executed for a DST. By design DST are completed, constructed, and typically cash flowing. In addition, DST are prepackaged prior to being offered to any accredited investor completed with financing in place in the case of leveraged DSTs.
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 email@example.com.
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