Behavioral Finance and the 45-Day Clock

DSTNEWS.ORG EXECUTIVE REFERENCE GUIDE

By Al DiNi­co­la, AIF®
Pri­vate Fund Advi­sor
DST §1031 Spe­cial­ist

When psy­chol­o­gy becomes more pow­er­ful than the tax code

Most dis­cus­sions sur­round­ing Sec­tion §1031 exchanges focus on the tech­ni­cal require­ments of the Inter­nal Rev­enue Code. Advi­sors care­ful­ly review the 45-day iden­ti­fi­ca­tion peri­od, the 180-day exchange dead­line, debt replace­ment require­ments, tax­able boot, and the role of the Qual­i­fied Inter­me­di­ary. These are all essen­tial ele­ments of a suc­cess­ful exchange. How­ev­er, one of the most influ­en­tial fac­tors affect­ing the out­come of a §1031 exchange is not found any­where in the Inter­nal Rev­enue Code. It is found in human behav­ior. (Tver­sky & Kah­ne­man, 1974; Kah­ne­man & Tver­sky, 1979).

Behav­ioral economics—the study of how psy­cho­log­i­cal fac­tors influ­ence finan­cial decision-making—has demon­strat­ed that investors do not always make per­fect­ly ratio­nal deci­sions, par­tic­u­lar­ly when faced with uncer­tain­ty, time con­straints, and the fear of loss. Nobel Prize-win­ning econ­o­mists Daniel Kah­ne­man and Richard Thaler, along with Amos Tver­sky, trans­formed mod­ern finance by show­ing that emo­tions, cog­ni­tive short­cuts, and bias­es fre­quent­ly shape invest­ment deci­sions.

A Sec­tion §1031 exchange cre­ates a unique envi­ron­ment where many of these behav­ioral bias­es con­verge. Investors often face com­pressed time­lines, com­pet­i­tive bid­ding, large sums of cap­i­tal, and the prospect of sig­nif­i­cant tax con­se­quences if the exchange is not com­plet­ed suc­cess­ful­ly. These con­di­tions can sub­tly alter deci­sion-mak­ing and influ­ence pur­chase nego­ti­a­tions in ways that may not serve the investor’s long-term inter­ests. Under­stand­ing these bias­es allows investors and their advi­sors to rec­og­nize when emo­tion may be replac­ing dis­ci­plined invest­ment analy­sis.

Loss Aversion: The Fear of Paying Taxes

One of the strongest behav­ioral forces affect­ing §1031 investors is loss aver­sion. Behav­ioral research sug­gests that indi­vid­u­als gen­er­al­ly expe­ri­ence the pain of a finan­cial loss more intense­ly than the sat­is­fac­tion of an equiv­a­lent gain. In the con­text of a §1031 exchange, many investors view the pay­ment of cap­i­tal gains tax­es as a loss that must be avoid­ed at almost any cost. As a result, the investor’s mind­set may shift from: (Kah­ne­man & Tver­sky, 1979).

How do I make the best invest­ment?

to:

How do I avoid writ­ing a check to the IRS?

While these objec­tives are relat­ed, they are not iden­ti­cal. An investor who is will­ing to pay $300,000 more for a replace­ment prop­er­ty sim­ply to avoid rec­og­niz­ing tax­able gain may ulti­mate­ly reduce future returns by more than the tax­es they deferred. The desire to avoid an imme­di­ate tax lia­bil­i­ty can unin­ten­tion­al­ly over­shad­ow care­ful eval­u­a­tion of val­u­a­tion, pro­ject­ed cash flow, mar­ket fun­da­men­tals, and over­all port­fo­lio fit. Tax defer­ral remains an impor­tant objec­tive, but it should nev­er become the sole cri­te­ri­on for eval­u­at­ing an invest­ment oppor­tu­ni­ty.

Time Pressure: The Psychology of the 45-Day Identification Period

Sec­tion §1031 impos­es strict statu­to­ry dead­lines. Investors gen­er­al­ly have only 45 days to iden­ti­fy poten­tial replace­ment prop­er­ties and 180 days to com­plete the acqui­si­tion. While these dead­lines are intend­ed to pre­serve the integri­ty of the exchange process, they also cre­ate a psy­cho­log­i­cal phe­nom­e­non known as deci­sion com­pres­sion. Ear­ly in the iden­ti­fi­ca­tion peri­od, investors often eval­u­ate mul­ti­ple oppor­tu­ni­ties care­ful­ly, nego­ti­ate aggres­sive­ly, and com­pare alter­na­tives. As Day 45 approach­es, how­ev­er, pri­or­i­ties may change.

Instead of ask­ing:

• Is this prop­er­ty fair­ly priced?
• Does it meet my long-term objec­tives?
• Are there bet­ter oppor­tu­ni­ties avail­able?
• the investor may begin ask­ing:
• Can I iden­ti­fy some­thing before the dead­line?
• Will this trans­ac­tion pre­serve my tax defer­ral?
• What hap­pens if I miss the exchange win­dow?
• The clos­er the dead­line, the greater the pres­sure to act

Time pres­sure often reduces patience, short­ens due dili­gence, and weak­ens nego­ti­at­ing lever­age.

Anchoring: When the Asking Price Becomes the Reference Point

Anoth­er com­mon behav­ioral bias is anchor­ing. Anchor­ing occurs when investors rely too heav­i­ly on the first piece of infor­ma­tion pre­sent­ed, even when bet­ter infor­ma­tion lat­er becomes avail­able. In com­mer­cial real estate trans­ac­tions, the sell­er’s ask­ing price often becomes the anchor. Sup­pose a replace­ment prop­er­ty is list­ed for $5 mil­lion. Even if inde­pen­dent val­u­a­tion, cap­i­tal­iza­tion rates, or com­pa­ra­ble sales sug­gest a mar­ket val­ue clos­er to $4.6 mil­lion, investors may sub­con­scious­ly nego­ti­ate around the orig­i­nal ask­ing price rather than around objec­tive mar­ket data. Exchange dead­lines can inten­si­fy this effect. (Tver­sky & Kah­ne­man, 1974).

Rather than walk­ing away from an over­priced oppor­tu­ni­ty, the investor begins nego­ti­at­ing with­in the sell­er’s pric­ing frame­work because the need to com­plete the exchange becomes increas­ing­ly impor­tant. Suc­cess­ful investors rec­og­nize that ask­ing prices are invi­ta­tions to nego­ti­ate, not objec­tive mea­sures of val­ue. Suc­cess­ful investors con­struct a back­up plan that includes alter­na­tives such as DSTs that are prepack­ages (sone with non-recourse debt) that can sat­is­fy replace­ment needs.

Confirmation Bias: Seeing What We Want to See

Con­fir­ma­tion bias occurs when indi­vid­u­als seek infor­ma­tion that sup­ports their exist­ing beliefs while dis­count­ing evi­dence that con­tra­dicts them. Once an investor iden­ti­fies a replace­ment prop­er­ty, it is nat­ur­al to become emo­tion­al­ly invest­ed in mak­ing the trans­ac­tion suc­ceed. Pos­i­tive infor­ma­tion receives greater atten­tion. Neg­a­tive infor­ma­tion is min­i­mized. For exam­ple, an investor may focus on:

• Pro­ject­ed rental growth
• Favor­able demo­graph­ic trends
• Planned infra­struc­ture improve­ments
• while giv­ing less con­sid­er­a­tion to:
• Deferred main­te­nance
• Lease rollover risk
• Ten­ant con­cen­tra­tion
• Mar­ket over­sup­ply
• Chang­ing financ­ing con­di­tions

The exchange dead­line can ampli­fy con­fir­ma­tion bias because aban­don­ing the prop­er­ty means restart­ing the search process under sig­nif­i­cant time pres­sure. A dis­ci­plined due dili­gence process should encour­age advi­sors to active­ly search for rea­sons not to com­plete the acqui­si­tion before con­clud­ing that it is the right invest­ment.

The Endowment Effect: Becoming Emotionally Attached

Behav­ioral econ­o­mists describe the endow­ment effect as the ten­den­cy to place greater val­ue on some­thing sim­ply because we believe it is,or soon will be,ours. This phe­nom­e­non fre­quent­ly appears dur­ing real estate nego­ti­a­tions. After weeks of review­ing finan­cial state­ments, con­duct­ing inspec­tions, dis­cussing financ­ing, and imag­in­ing future own­er­ship, investors begin to men­tal­ly “own” the prop­er­ty before clos­ing. Walk­ing away becomes emo­tion­al­ly dif­fi­cult. Instead of objec­tive­ly eval­u­at­ing whether the pur­chase price remains jus­ti­fied, the investor begins focus­ing on pre­serv­ing the trans­ac­tion. (Kah­ne­man, Knetsch, & Thaler, 1990).

This emo­tion­al attach­ment may weak­en nego­ti­at­ing dis­ci­pline and increase the will­ing­ness to accept unfa­vor­able terms. Expe­ri­enced advi­sors often pro­vide sig­nif­i­cant val­ue by remain­ing emo­tion­al­ly detached and help­ing clients eval­u­ate trans­ac­tions objec­tive­ly.

Deadline-Induced Decision Making

Per­haps the most dis­tinc­tive behav­ioral chal­lenge unique to Sec­tion §1031 exchanges is dead­line-induced deci­sion mak­ing. Unlike most com­mer­cial real estate acqui­si­tions, exchange investors can­not sim­ply wait indef­i­nite­ly for a bet­ter oppor­tu­ni­ty. The tax code estab­lish­es a firm timetable. As dead­lines approach, investors fre­quent­ly expe­ri­ence increas­ing lev­els of stress. Stress affects deci­sion qual­i­ty. Research con­sis­tent­ly demon­strates that indi­vid­u­als oper­at­ing under pres­sure often:

• Sim­pli­fy com­plex deci­sions
• Accept greater risk
• Reduce infor­ma­tion gath­er­ing
• Place greater empha­sis on imme­di­ate out­comes
• Become more will­ing to com­pro­mise
• In a §1031 exchange, this may man­i­fest as:
• Accept­ing high­er pur­chase prices
• Waiv­ing nego­ti­a­tion oppor­tu­ni­ties
• Short­en­ing due dili­gence
• Over­look­ing alter­na­tive invest­ment struc­tures
• Con­cen­trat­ing exces­sive cap­i­tal into a sin­gle prop­er­ty

These deci­sions may sat­is­fy the tax require­ments of Sec­tion §1031 while simul­ta­ne­ous­ly reduc­ing long-term invest­ment per­for­mance.

The Advisor’s Role: Managing Bias Rather Than Eliminating It

Behav­ioral bias­es are not signs of poor judg­ment or inex­pe­ri­ence. They are part of nor­mal human deci­sion-mak­ing. Even high­ly sophis­ti­cat­ed investors expe­ri­ence them. The pur­pose of under­stand­ing behav­ioral eco­nom­ics is not to elim­i­nate emotion—it is to rec­og­nize when emo­tion may be influ­enc­ing impor­tant finan­cial deci­sions. Every mem­ber of the advi­so­ry team plays a role in main­tain­ing invest­ment dis­ci­pline. A com­mer­cial real estate bro­ker can encour­age con­tin­ued nego­ti­a­tion even when dead­lines cre­ate pres­sure. A CPA can help clients eval­u­ate whether pre­serv­ing long-term wealth is more impor­tant than avoid­ing every dol­lar of tax­able gain.

A Reg­is­tered Invest­ment Advi­sor can assess how a pro­posed acqui­si­tion fits with­in the clien­t’s over­all port­fo­lio rather than eval­u­at­ing it in iso­la­tion. An attor­ney and Qual­i­fied Inter­me­di­ary can ensure tech­ni­cal com­pli­ance while allow­ing the investor to focus on invest­ment qual­i­ty. When advi­sors under­stand behav­ioral finance, they become more than trans­ac­tion spe­cial­ists. They become deci­sion archi­tects.

The Behavioral Economics Checklist

Before com­mit­ting to a replace­ment prop­er­ty, investors should pause and ask them­selves:

• Am I eval­u­at­ing this prop­er­ty objec­tive­ly, or am I react­ing to the exchange dead­line?
• Would I pay this price if no §1031 exchange were involved?
• Have I nego­ti­at­ed as aggres­sive­ly as I nor­mal­ly would?
• Have I active­ly searched for rea­sons not to buy this prop­er­ty?
• Is my desire to avoid tax­es influ­enc­ing my invest­ment judg­ment?
• Have I con­sid­ered alter­na­tive replace­ment prop­er­ty struc­tures, includ­ing mul­ti­ple acqui­si­tions or Delaware Statu­to­ry Trusts, where appro­pri­ate?
• Does this acqui­si­tion improve my long-term after-tax wealth, or does it mere­ly com­plete the exchange?
• These ques­tions may appear sim­ple

Sunk-Cost Thinking

After an investor has spent time and mon­ey on inspec­tions, legal review, financ­ing, trav­el, and due dili­gence, aban­don­ing a trans­ac­tion may feel like wast­ing the effort already invest­ed. Those pri­or costs can­not be recov­ered and should not deter­mine whether the prop­er­ty remains attrac­tive at the cur­rent price and terms. The rel­e­vant ques­tion is whether the expect­ed future ben­e­fits jus­ti­fy the remain­ing costs and risks—not how much has already been spent. (Arkes & Blumer, 1985).

Transaction Momentum

Once a prop­er­ty has been iden­ti­fied and the advi­so­ry team begins mov­ing toward clos­ing, each com­plet­ed step can make the trans­ac­tion feel increas­ing­ly inevitable. A for­mal pre-clos­ing “stop deci­sion” can help. At that point, the team should re-under­write the prop­er­ty, iden­ti­fy the strongest rea­son to walk away, com­pare back­up alter­na­tives, and con­firm that the invest­ment would still be accept­able with­out the exchange dead­line.

Advi­sors who reg­u­lar­ly engage with DSTs have access to due dili­gence mate­ri­als ahead of the needs of the indi­vid­ual investors. If DST have been iden­ti­fied on the 45-day iden­ti­fied list clos­ing may be an easy process with the Qual­i­fied Inter­me­di­ary.

Check back for Chap­ter 5- Why Investors Lose Nego­ti­at­ing Lever­age

• Al DiNi­co­la adnicola@fiduciarycm.com  
• Direct: 239 691 8098
• Sched­ule Appoint­ment

Advi­so­ry ser­vices are offered through Fidu­cia­ry CM, an SEC-reg­is­tered advis­er. Invest­ments involve risk and are not guar­an­teed. Always refer to offer­ing doc­u­ments for full risk dis­clo­sures. Delaware Statu­to­ry Trust (DST) invest­ments involve risks asso­ci­at­ed with com­mer­cial real estate own­er­ship and are not suit­able for all investors. These risks may include, but are not lim­it­ed to, loss of prin­ci­pal, illiq­uid­i­ty, ten­ant vacan­cy, financ­ing risk, inter­est rate fluc­tu­a­tions, prop­er­ty val­ue declines, eco­nom­ic and mar­ket con­di­tions, and risks asso­ci­at­ed with spon­sor and prop­er­ty man­age­ment deci­sions. Please refer to the applic­a­ble Prop­er­ty Pri­vate Place­ment Mem­o­ran­dum (PPM) for a com­plete dis­cus­sion of the risks and con­sid­er­a­tions spe­cif­ic to that offer­ing. For addi­tion­al infor­ma­tion regard­ing gen­er­al DST invest­ment risks, please click here. Past per­for­mance is not indica­tive of future results. Nei­ther the Reg­is­tered Rep­re­sen­ta­tive nor the Bro­ker-Deal­er can con­trol or guar­an­tee future deci­sions made by the DST spon­sor, asset man­ag­er, prop­er­ty man­ag­er, ten­ants, lenders, or oth­er third par­ties involved in the oper­a­tion of the prop­er­ty. Past per­for­mance is not indica­tive of future results. Secu­ri­ties may be offered through MSC-BD, LLC, a mem­ber of FINRA/ SIPC.