#3 of 5: Am I prepared if my replacement property falls through before deadlines?
Don’t get caught in a panic if things aren’t going as planned with your 1031.
#3 of 5 Critical Questions to Answer Before Engaging a 1031 Exchange
In the first two articles of this series we discussed the importance of coming to terms with if a 1031 truly makes sense in the first place. For those with substantial gains problems, the idea of deferring taxes is almost always appealing. But letting taxes be the sole factor determining the process is potentially letting the tail wag the dog, so I cover how you might improve your confidence with using a 1031 through prioritization.
We also peeled back the layers of potential planning flexibility 1031s may provide (either in part or in whole), including in conjunction with possible enhancements provided by various types of potential replacement properties, sometimes in combination.
This week we’re going to presume a 1031 is already moving forward, which lets us move onto questions that might be asked to help protect the Exchange from either becoming derailed, resulting in an unwanted taxable event, or simply going down the wrong path. If you haven’t read Questions #1 and Question #2, we recommend you go back and read those first as a foundation for the series.
With that in mind…
Question #3. Am I prepared if my replacement property falls through before deadlines?
Sometimes replacement properties come together very efficiently. In fact, it’s not uncommon for a 1031 Exchange to be driven by the Exchanger’s desire to acquire a specific property. Called a Reverse Exchange, the property is discovered, and the deal closed using 1031 structures for acquisition and holding ownership pending the full exchange being completed. With a Reverse 1031, the exchange is completed upon the sale of the buyer’s unwanted property. In simplest form, those proceeds go directly from the buyer to the Qualified Intermediary (QI), who releases the property and settles acquisition costs and reimbursements. There are a variety of designs and additional complexities, but the replacement property is known and completed from the start.
Timing can also work out very neatly where closings are simultaneous. Appropriately called “Simultaneous Exchanges”, closings are functionally simultaneous for both properties, making for a comparatively streamlined 1031. Although, sellers should be careful to still use a QI and have proper structures in place.
However, it’s not always so tidy. With “Deferred Exchanges”, the seller will relinquish property first, knowing they’ll have a full 180-calendar-days from that date to complete the 1031 and the first 45-days to formally identify replacement property. Unexpected offers commonly catch sellers off-balance, putting them in a scramble to find a replacement property within the 45-day identification period, as required by law. Even when a longer glidepath is available before closing, replacement property isn’t always easy to find, a task made more complicated with COVID-19. Once that deadline passes, there’s no legal remedy for retroactively adding properties.
Optimally, a closing on replacement property would be completed before the identification period expires. That’s simply for helping maintain control over the outcome of the 1031. But, again, that’s not always possible, especially with COVID. It’s common for many outstanding issues to be unresolved by 45-days, with many details to be sorted out during the 135 remaining days of 180.
That raises a critical question: How positive are you the deal will be completed before the 180-day deadline expires? When there are still lots of outstanding questions or issues to negotiate, deals can plainly and painfully, taxwise, fall through.
When there’s debt involved, that presents additional pressures: The COVID-19 Economy has made lenders far more cautious about lending to investment real estate. Hence, those inclined towards 1031s may find they can’t get credit for the replacement property on attractive terms, if at all. That forces them to come out-of-pocket to make up the difference or suffer terms that negatively affect their investment’s cash flow. It’s that, or tie-up other assets as collateral, or face taxation.
As well, pushing beyond 45-days for a closing can place you in a more vulnerable negotiating position. When the seller of your property knows your 1031 is in motion, they will also probably know a bit about your capital gains exposure: They’ll understand that you’re facing taxes of up to 30% or higher on your prior transaction (capital gains, depreciation recapture, etc.) unless you consummate a deal by 180-days. In other words, a seller could play hardball if you don’t meet their terms, essentially absorbing some of your tax advantages with their pricing leverage!
Backup Plans Are Just Good Practice
One way to abate the potential for suffering any of those pressures, let alone being left empty-handed at day-180, is to have a backup plan in place. That’s because an Exchange permits you to list more than one prospective replacement property, so long as you follow the related rules. While you could rush around and try to find another directly-held, active property to co-list, that’s generally unrealistic. Instead, you can keep your 1031 safe by having 1031-eligible, passive investment property, such as Delaware Statutory Trusts (DSTs), ready to list as an emergency backup.
When suitable, DSTs permit Exchangers to quickly access professionally-managed, institutional-quality real estate before the 45-day deadline. Moreover, correctly structured DSTs can alleviate the need for the buyer to secure replacement debt, keeping in mind that any debt amounts settled from the relinquished property become part of your 1031’s potential tax calculation. If your active property appears too flawed or the seller refuses to be reasonable, the DSTs can normally be acquired in 72-hours or less. The investor becomes a proportional, passive owner of each related DST property, all of which retain eligibility for future 1031 Exchanges as needed.
With that in mind, unless you’re lucky enough to have a property set and ready to close before day-45, listing DSTs that you trust and are suitable is one way to help preserve 1031s after the listing deadline passes. We believe, it’s arguably a best-practice strategy as a matter of precaution.
It’s important to note that DSTs are not open-ended investment pools. They are specific real estate projects, and when they reach their investment limits, they are closed to new investors. That means exchangers should be careful to list DSTs with a sufficient liquidity-window to accommodate their Exchange timeline. Unfortunately, that also means if negotiations over a “Plan-A” active property are taking longer than expected and remain uncertain, the Exchanger may not have the full 180-day window to use “Plan-B” DSTs as a backup as listed DST’s reach capacity. Facing such uncertainty, an Exchanger may decide to use Plan-B well before 180-days rather than waste more time sorting out Plan-A, if it’s most sensible. Moreover, having a suitable Plan-B gives the Exchanger leverage in gaining good faith negotiations over the Plan-A property, potentially increasing timeliness.
COVID Notice and Urgency
At the time of publication of this article, COVID19 has severely affected the investment real estate market, and that includes DSTs and related demand for quality DSTs. At present, it’s common for DSTs to reach their limits within days of being opened, and for some to even be “fully reserved” before formally coming onto market. While the reasons are too many to list here, suffice it to say that 1) supply of quality programs is severely limited vs. demand; and 2) the DST marketplace is expected to be very much in flux and restricted over the coming months.
Hence, for the time being, Exchangers should plan accordingly. That includes aligning with a reliable DST partner well in advance of deadlines so that you are fully prepared to do what’s determined to be most suitable when the time comes. Such a DST partner will advise you of where the market is, give you estimates on DST availability, and will have good relationships with DST sponsors that will help you reserve spots for DSTs expected to have very short availability windows. Most importantly, Exchangers should understand the critical nature of the 45-day deadline re: flexibility, and, when possible, therefore do their utmost to start aligning a potential 1031 well in advance of their property sale. That includes moving forward on understanding replacement property types and the related market for finding what is goal-oriented and sensible for the Exchanger.
It’s the subject for another article, DSTs are also complex investment instruments that require very specific due diligence. Aligning with those who specialize in Due Diligence can play an important role in helping to achieve goals.
Client Purpose-Driven 1031s
As a last observation: There is plenty of enthusiasm for 1031s because of the deferral potential. Often that excitement comes with lots of energy from those whose self-interest is to sell replacement property, many of whom are very effective at encouraging the proceeds through an Exchange and into a commissionable replacement property.
While this could be the most suitable approach, is there enough certainty that the client’s best interests are being served first and foremost? Might the 1031 have been better structured, perhaps with a different combination of replacement property or proportional taxation? Is that something an investor wants to realize with regret after the fact?
Consequently, having a broadly-experienced DST professional on the team will provide additional perspective. With experience beyond just DSTs and 1031s, they can help investors assure their 1031s make sense and improve the chances that they’re structured to best meet their needs, leading to more satisfied clients. Ideally, such advisors have experience helping clients organize towards self-authored strategy and healthier outcomes. We’ll get into team-building later in this series, but for now -- Letting a “replacement property acquisition” lead the charge for a 1031 is risking having the proverbial “cart before the horse”.
With that in mind, I’ll also reiterate that readers seek the guidance offered in the first two articles of this series that encourage prospective exchangers to be certain of their goals, be familiar with potential options, and have a song idea of desired outcomes.
Best of luck with your 1031!
Johannes Ernharth, AIFA® is Mid-Atlantic Regional Director of Asset Strategy, a Private Wealth Management firm whose advisors take a fiduciary-driven, goal-oriented approach to become thought partners with their clients. He specializes in 1031 Exchanges and potential replacement property strategies.
Asset Strategy offers DST guidance backed by thorough due diligence that strives to make available a diversified array of Delaware Statutory Trusts that may be closed on in as little as 72-hours. Contact our team of 1031 professionals for a no-obligation consultation to gain insight to any questions you have!
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