Understanding the Types of 1031 Exchanges

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 ™
adinicola@namcoa.com
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.

1. 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 180^th days and if the total val­ue is equal to or greater than the relin­quished mar­ket val­ue this may keep your exchange intact.

Mov­ing For­ward

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 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.

SOCIAL MEDIA

Social Media plat­forms are sole­ly for infor­ma­tion­al pur­pos­es. Advi­so­ry ser­vices are only offered to clients or prospec­tive clients where the advi­so­ry firm and its rep­re­sen­ta­tives are prop­er­ly licensed or exempt from licen­sure. Past per­for­mance is no guar­an­tee of future returns. Invest­ing involves risk and pos­si­ble loss of prin­ci­pal cap­i­tal. No advice may be ren­dered by NAMCOA unless a client ser­vice agree­ment is in place.

Thank you.