Guest blog by 1031 Specialists
The inimitable Keith Wasserman of Gelt Ventures is fond of saying, “The 1031 exchange is the 8th wonder of the world.”
This is a statement chock full of wisdom, anchored in the mathematical purity of tax-deferred compounding.
But like any great financial tool, a 1031 can be misused. And in the world of 1031 exchanges, an ugly side does exist.
What’s a 1031 exchange?
A 1031 exchange is the swap of one investment property for another like-kind property without paying tax. It’s a tax deferral tool that’s existed in the US for more than 100 years. And while the Tax Cuts and Jobs Act of 2017 eliminated 1031 exchanges for personal property (e.g., off-lease assets, aircraft, railcars, vehicles, equipment, collectibles, franchises), it reinforced the existing treatment for real estate held for investment or business use. In this author’s opinion, real estate exchanges will continue to exist long after our children inherit the estate.
There are 4 types of 1031 exchanges: the forward exchange, the reverse exchange, the simultaneous exchange and the improvement or construction exchange. The vast majority of 1031 exchanges done today are forward exchanges, which involve hiring a Qualified Intermediary like 1031 Specialists (here), selling a property, and purchasing a replacement property within six months. There are rules to follow and deadlines to hit, but these are the broad strokes.
How big is the 1031 exchange market?
For more than a century, 1031 exchanges have been a material component of US real estate transactions. It is estimated that 1031s account for ~15% of all US commercial real estate transactions annually – that’s $185 billion of 1031 exchange volume per year!
The ugly side of 1031 exchanges
Despite their history and prevalence, not everything is roses in the world of 1031 exchanges. Investors considering 1031s voice two primary concerns:
1. “It feels like I have a gun to my head as far as the timelines are concerned.”
2. “1031s cause you to overpay for your properties.”
The main challenge with 1031 exchanges is the limited amount of time you have to find and close on a replacement property. There are 2 deadlines you must meet to successfully execute a 1031 exchange: the 45-day identification period and the 180-day exchange period. These deadlines are firm, regardless of whether the 45th or 180th day falls on a Saturday, Sunday or Holiday.
But there’s something all investors should appreciate: even before the 45-day clock starts to tick, there are things you can do to plan ahead and eliminate the time pressure of a 1031 exchange. You can:
* Have your broker shortlist 10 properties for you
* Identify your replacement property or properties
* Enter into an option contract to buy your replacement property
* Put your target property or properties under contract (assuming you are not going “hard”)
* Do a Reverse Exchange
There's absolutely no reason why you can't have your target property lined up long before you sell your relinquished property. People do this all the time when they buy and sell their primary home. They know what they're buying before the sale closes and they line-up financing beforehand. The exact same thing is true here: you have the entire duration of the sales cycle to prepare.
If you heed the wise words of my mother, you’ll be just fine: “Proper planning prevents poor performance.”
There is another big misconception to dispel – one that needs to be shouted from the rooftop of every commercial building in this great country:
Tell no one.
The truth is, almost no one needs to know you’re exchanging. There is no provision in the 1031 code that requires you to publicly disclose you're doing a 1031 exchange. Other than your QI and your tax advisors, you don't need to tell anyone. And you certainly don't have to advertise yourself as a 1031 buyer.
People think that because you’re a 1031 buyer, you will overpay. But why would anyone know you’re a 1031 buyer in the first place? Logic demands you follow the “Need to Know” principle – only tell those that absolutely must know. And for clarity: the “must know” list definitely doesn’t include the seller!
In reality, some investors who utilize 1031 exchanges overpay – but they overpay because they are sloppy, disorganized and undisciplined. 1031 exchanges aren't structured in a way that inherently makes you overpay. If you follow best practices, your 1031 exchange will be a walk in the park:
* Plan ahead, smartly
* Have a process to identify opportunities
* Never let the tax tail wag the dog – if you’re overpaying a ton to save on taxes, you’ll be inflicting significant financial damage to your portfolio… it’s probably best to opt out and pay the tax.
Investors mustn’t allow the concerns swirling around 1031s prevent them from exploring a 1031 exchange. After all, the 1031 exchange truly is the 8th wonder of the world.
About 1031 Specialists
We are the 1031 Specialists trusted by sophisticated investors and family offices to facilitate fast, transparent, and error-free 1031 exchange transactions. From our years of experience at Goldman Sachs and Ernst & Young, we know and appreciate what good execution, institutional processes, and time sensitive situations with large dollars at risk look like. More importantly, we know how to navigate them to successful outcomes. Find us online at www.1031Specialists.com and contact us anytime at: info@1031specialists.com / (631) 438-1031.
