5 Critical Questions to Answer Before Engaging a 1031 Exchange
Don't let the "tax-tail" wag your dog!
1031 Exchanges can be a very attractive strategy given they offer the potential to defer taxes on the sales of highly appreciated investment property. But if you’re new to 1031s, or even familiar -- but experiencing life-changing events or major mileposts, there can be uncertainty about how they might be best used -- or if they should be used at all.
With that in mind, I’ve put together a five-article series that will cover 5-Questions you should probably be considering before engaging in a 1031 Exchange. With each, there are related tips, insights, and ideas.
So, without further ado, let’s get started with our first question!
Question 1: Do I really have a handle on my mid- and long-term goals?
I believe this broader question should serve as a starting point for any major financial transaction or planning decision. Whether a business, family, or individual, it’s just good form to understand one’s goals related to cashflow and set budgets, and to be guided by a formal plan to achieve results. Yet it’s not uncommon for investment real estate owners to not be so formal or organized.
Optimally, a 1031 Exchange doesn’t occur in an isolated planning silo, as a lone transaction hurried along in a rush to meet deadlines for minimizing a tax bill. Such detachment from an exchanger’s broader goals runs the risk of, as is sometimes said, allowing the “tax tail” to wag the dog.
I won’t go into the details, but 1031s involve many potential considerations and carry several deadlines that can make an Exchange seem like a lot to complete in a relatively short time. Facing a large tax-bill, sellers sometimes feel pressured into securing a 1031’s tax advantages without having a high level of confidence if that’s the best approach. That uncertainty is potentially elevated if the seller thinks they might want to exit the burdens of active real estate ownership and is considering a lifestyle change.
With uncertainty, it’s not uncommon for owners to walk away from great offers, sticking instead to the adage, “better the devil you know.” In some cases, 1031s go forward that maybe shouldn’t, while others are less effectively structured than they might be. Often because the exchanger just didn’t know options existed that are probably in better alignment with their goals.
Which returns us to the purpose of this article: 1031s are not always the answer, but when they are, they can be very helpful in unexpected ways. Sellers should, and can, have confidence in the potential and purpose of a 1031, and in context of their specific situation. Learning how is far from an insurmountable task to sort out.
Organizing Your Options
I spent much of my career assisting clients through such processes, functioning as a thought-partner to help them efficiently organize actions that are likely to improve odds of achieving objectives. What follows are some goal-oriented questions and observations I often use for this process. While they may seem basic or even open-ended, they are intended to foster quality insights and help clients constructively evaluate potential goals, options, and actions.
That in context, consider organizing thoughts around the following:
Where do you want to see yourself in 10 years? What do you envision for yourself and family later in life? What, then, do you want to achieve the next 5 years? How about the next 12-mos? Chart it out!
Are there any plans or routines you intend for yourself or your family, like group vacations? Reunions? Weddings? Summer vs. Winter homes? Write it down!
How much savings will these goals require? Have you considered broader wellness results outside of purely financial outcomes? (This is where it may get complex. Balance sheet, cashflow studies, assets, liabilities… Tax-efficiency -- they all play a part.) Quantify it. Know your numbers.
Which goals are realistic? What (and how much) will it take to reach them? What risks are there to such goals? Prioritize them!
What do you intend to happen, to protect, or carry on after you die? Get it down.
Self-author a realistic, meaningful, and priority-driven plan for your goals. Move on it.
Digging through what that list unearths may reveal planning gaps, shortfalls, and opportunities. It has the potential to provide context on how a 1031 might be prioritized. It may confirm how a 1031 might (or might not) contribute to your goals, and just as importantly, how a 1031 might be best structured.
If you’ve been through such a process for other purposes, you’ll probably have a foundation to work from. Although if you’re reading this article series for guidance, you might need to review or update what you have.
If not, that list may come across as ambitious for a short period of time. If it seems like more than you’re up to, or even if it may seem like the 1031 tax-advantages are too much of a no-brainer to bother delaying, keep in mind: A blueprint for where you are and where you want to be -- and with viable options for getting there -- can help avoid big mistakes, even if it means a more suitably structured 1031 than you might have rushed into.
1031s also Buys You Time to Decide
Of course, if we had all the time in the world, that’d be nice! But the real world isn’t perfect! What if you’re sitting on an offer and don’t have a ton of time to dwell? It may be helpful, then, to know that starting a 1031 doesn’t mean you have to go through with it.
Of course, you’d be committing to sell your property, so let’s table any uncertainty about that for a moment. Assuming a sale is on, though -- properly initiating a 1031 locks-in the potential for your deferral, granting you up to 180-days (in addition to the time you have before your closing date) to engage the goal-evaluation process. You can do prudent analysis, like cash-flow projections and broader risk analysis, and gain confidence with your choices and actions.
If you’re still not sure as the 45-day replacement property listing deadline nears, you have the option to list any that’s eligible as a placeholder, including, when suitable, passive options like Delaware Statutory Trusts (DSTs), that can be secured relatively quickly. If you conclude a 1031 makes sense before the 180-day deadline, just proceed. If the 1031 doesn’t fit, simply let the deadlines pass as you take all the time you need to finalize your new plans.
You can also choose to do a “partial 1031” for a proportional tax deferral, where whatever amounts that don’t go to like-kind property become what’s called “taxable boot” and are taxed according to the 1031 rules.
Just be advised, any sales-proceeds that enter the 1031 process are committed to the process. What that means is, if you later decide you’d rather not 1031 some or all of the proceeds, those amounts are required to be held aside for the remainder of 180-day 1031 window before they can be released. Hence, if there’s a high probability you’ll need some of those proceeds for other purposes before 180-days, you’d want to consider not committing that amount to a 1031 where whatever is not specifically used to acquire like-kind/eligible property will be held aside the full duration.
Of course, knowing those numbers is an argument for starting this process as early as possible, well ahead of the closing date, and ideally, even before the property is on the market!
Expedience from Guidance
Getting one’s head around all of this is understandably a tall order without prior experience and assistance. Professional guidance can contribute to efficiently expediting the process, especially if rushed. Consideration should go to specialists who understand 1031s and multiple forms of replacement property, but, ideally, specifically those with experience helping clients with meaningful goal and strategy development! Don’t end up with the “cart pulling the horse” and situations like having proceeds you actually needed being locked in illiquid property, or replacement property that might have been more suitable if different.
I’ll wrap this first article of the series asking question to frame what I believe is Best Practice: What would be my ideal for those contemplating a 1031?
I would like them to find this article well before a 1031 is even on the table. Preferably, they find it when reaching the point of wondering what they might ultimately want to do with their real estate holdings. They might be asking questions like, “How do I retire as an owner-landlord?” or “Should I sell within the next few years? What are my options?” This article would encourage them to organize and goal-orient their thoughts and actions. The results would help them be more confident in executing purposeful strategy, and be more prepared to capitalize on opportunities, like an unexpected, general purchase offer.
Of course, there’s the “ideal” and then there’s “reality”. We are, as they say, stuck playing the hand we’re dealt. Make the most of it and do the best you can. Contact our team of 1031 professionals for a no-obligation consultation to gain insights and answers to your questions and learn how we efficiently help clients distill if and how 1031s might help them achieve their goals.
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 taking on the role of being our client’s thought-partners. He specializes in 1031 Exchanges and potential replacement property strategies.
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