With qualified intermediary costs ranging from $500 to $1,500 for standard 1031 exchanges, transactions don’t necessarily have to be for large dollar amounts in order to make sense. However, there are 10 crucial points to consider before participating in a 1031 exchange:
1. How much has my existing investment property increased in value?
Investors whose properties experienced good growth and who are seeking future growth should consider 1031 exchanges, Jeff Brown, owner and president of Brown & Brown Investment Properties, said. “To the extent that your equity has become a huge part as a percentage of the value of your property in total, your rate of capital growth slows down….It’s just a result of leverage.”
Investors who grew from 10 to 20 percent equity positions up to 35 to 40 percent equity positions may want to consider a tax deferred exchange to increase the amount of real estate their equity controls, thereby increasing their capital growth, Brown said.
“If somebody puts 20 percent down on a piece of property for $1 million and then [its value] goes up 10 percent, his capital…just improved…by 50 percent,” Brown said. In contrast, if the same investor “put 50 percent down, and it went up 10 percent, his capital only grew at a 20 percent rate, and so he’s not making as much money…in terms of capital growth.”
2. Does “like kind” property offer attractive opportunities?
“I think you have to ask yourself the question, if you’re selling investment property, do you want more investment property?” Bob Schardt, vice president of operations at Asset Preservation, Inc., said.
Because a 1031 exchange can only be made into property that qualifies as “like kind,” the investor must consider whether the properties in that category offer attractive enough opportunity to warrant an exchange. A 1031 exchange will eliminate opportunities in other markets such as equities, lending, commodities, etc.
“What’s nice is that the IRS has said that real estate, U.S. real estate, is ‘like kind’ to almost every other [U.S.] real estate interest,” Karin Church, vice president of Investment Property Exchange Services, Inc., said. “So if you have an office building, you can exchange that office building into a vacant piece of land.”
The range of opportunities available for exchanging U.S. real estate may be large, but there are still cases when it doesn’t make sense. The key is “making sure that what you trade into is actually an improvement on your prior position,” Brown said.
3. How much will the 1031 timelines limit my opportunities?
In a standard exchange, the investor usually identifies between one and three potential replacement properties within 45 days of closing on the relinquished property. An incredible deal that comes on the market on day 46 is not an option for an exchange.
Once the specific replacement properties have been identified, the investor must close on at least one of those properties within 180 days of closing on the relinquished property. This creates challenges in fast-selling, competitive markets because there is no guarantee that the investor will be able to successfully purchase the properties that were identified, Anthony James, regional manager with TransUnion Exchange Corporation, said.
In addition, if the other party knows that the investor is doing a 1031 exchange, the investor is in a bad negotiating situation.
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4. What are closing costs and tax liability on this property?
Closing costs will apply to a 1031 exchange just as they would to a regular sale, and they should be taken into account when considering an exchange, James said.
In addition, the investor should consider the tax liability on the property if it were sold without doing an exchange. Investors need to sit down with a CPA to determine the gain they would recognize for “an outright sale on this property,” Church said.
“If the tax liability on the property they’re selling…is less than the [qualified intermediary] fee…that’s where it doesn’t make sense to do the exchange,” Schardt said.
5. Would partial tax deferral make more sense than full?
The IRS allows investors to use 1031 exchanges for partial tax deferral, Church said. Investors can take out some of the money for other uses, but whatever is taken out will be taxed.
“There is a point in a partial exchange where you lose the benefit of doing the tax deferred exchange,” so involving a CPA or tax attorney at an early stage of the process is essential, Church said. “Obviously, people wouldn’t want to do a partial exchange only to find out that they ended up recognizing all of their tax consequence anyway.”
An investor can do a partial exchange into a replacement property of lower value than the relinquished property, as long as the replacement property is of greater value than the original purchase price of the relinquished property, Schardt said.
6. How long do I plan to defer my taxes?
Since this is a tax deferral strategy rather than a tax free strategy, investors should consider their long-term, big picture goals, Church said. How long does the investor plan to hold the property? Is the intention to later pass on the property and its gains to heirs? Will the investor need additional money for retirement or for another reason at some point in the future? Can the property be refinanced if the investor needs access to cash? What does the investor’s overall cash flow picture look like?
Many investors continue using 1031 exchanges to defer taxes until their death, when the IRS allows their heirs to receive the property without paying the capital gains taxes that were deferred during the investor’s lifetime, Church said.
Although investors may not 1031 exchange into property with the intention of living there during retirement, after holding the property as an investment for what is deemed a sufficient amount of time to establish intent of the 1031, they may be permitted to move into the property and change its nature from investment to personal property.
7. What else is going on in my portfolio?
A decision to make a 1031 exchange should also take into consideration the investor’s overall portfolio, Church said.
“You have to consider what’s happening with the rest of [your] portfolio because you might have a gain that you could defer on the sale of one particular piece of property, but if you have a loss that you’re taking on another piece of property, maybe this is the time to go ahead, recognize that gain, in which case you would not want to do a 1031 exchange,” she said. If the loss is less than the gain, it may make sense to consider a partial exchange.
Diversification of the overall portfolio is another factor to consider. If the investor’s portfolio is 90 percent real estate, it may make sense to cash out some of the gains and invest them into a different asset class.
8. What opportunities could I miss out on by NOT setting up a 1031 exchange?
The low cost of standard 1031 exchanges make it worthwhile for some investors to start an exchange just to keep the opportunity for exchanging available for the 45-day period, Church said.
“We will frequently find investors who might not even have any replacement property lined up, but just to hold open their options for 45 days, will start a 1031 exchange, and see if something comes along that they’re interested in. If not, on day 46 they collapse the transaction,” she said.
9. What are my market conditions?
The challenges of 1031 exchanging depend on the market, Brown said. In a normal market, finding properties is not usually a problem, but it sometimes can be, he said.
Competitive markets sometimes cause investors to vary their strategy. “This is why a lot of people will not allow their [relinquished] property to close escrow until they find something they want to trade into. Some people even go into a reverse exchange, which means they acquire the property they’re going to trade into first and then sell their property,” Brown said.
10. Do I have a trustworthy qualified intermediary?
Recent media attention has highlighted qualified intermediary bankruptcies, and “it is important to know that the qualified intermediary…industry is not regulated,” Church said.
Unlike funds held in standard real estate escrow accounts, money held with qualified intermediaries may be invested in any way the intermediary chooses. There are no regulations stating how the intermediary must manage the money while holding it.
Some qualified intermediaries have stronger backings than others, Church said. Those backed by banks and title companies are easier to pursue if something goes wrong, and their fees are comparable to other qualified intermediary companies.
Investors who feel that 1031 exchanges may make sense after considering these questions will then need to sit down with professionals for an in depth analysis of their particular situations. “It really comes down to a case by case scenario,” James said.