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Six Ways to Prevent a 1031 Exchange from Blowing Up


Do you have a client considering selling their investment or business property? Unless they are willing to pay the IRS a crushing tax bill that could exceed 40%, they are probably considering a 1031 exchange … or they should be.

Section 1031 of the federal tax code dictates that no gain or loss shall be recognized upon the sale of a real estate property held for business or investment purposes, as long as the seller purchases a replacement property of equal or greater value. This can be a solid opportunity, potentially, to preserve the gain and accrue additional wealth. However, the 1031 exchange can be a tricky process; your client should be prepared.

Here are six steps to consider as you advise a client on undertaking and entering into a 1031 exchange:

Step 1: Know the applicable deadlines. The IRS requires an investor to identify a replacement property within 45 days, and to close on the target property within 180 days of selling the relinquished property. That doesn’t leave much time to hunt for the right deal, but it’s enough time.

Step 2: Get educated about acceptable types of replacement properties. The IRS requires an exchanger to reinvest in a “like kind” property. However, “like kind” does not necessarily mean the same type of property. There are a variety of options available. If your client is selling a duplex in San Diego, they don’t need to replace it with another duplex. They can replace it with a variety of asset types. It can be a medical building, single-family home, multifamily apartment building, raw land, self-storage facility or any other investment real estate. The type doesn’t matter as long as it is held for investment or business purposes. Ideally, your client should know what they are looking for in a replacement property well before going into escrow on the property they are selling.

Step 3: Narrow down the options while in escrow. I cannot tell you how many times I have seen 1031 exchange investors in a desperate panic once they hit day 30 of their 45-day window with not a single replacement option identified for their exchange. This is an extremely stressful position; help spare your client the anguish.

Help your client locate five to 10 potential replacement properties as they get close to the closing date of the property they are selling. As your client moves through escrow, many of the new properties you’ve helped them identify will be acquired by other buyers or will prove unsatisfactory for one reason or another upon conducting due diligence. Help your client enhance the odds of identifying and closing on their ideal investment by developing a short list of potentials prior to closing on the relinquished property.

Step 4: Help your client line up financing. Investors will often call me in a panic because they’ve located their replacement property, but they cannot access the financing necessary to purchase the asset. It is important to make sure that they have the financing lined up before closing on the property being sold to spare themselves from a stressful and potentially expensive predicament. If financing is impossible for whatever reason, another option to consider is a fractional ownership real estate investment. For accredited investors, a Delaware Statutory Trust (DST) or Tenants In Common (TIC) investment may be a suitable option. Some of these investments provide built-in financing that is nonrecourse to the investor and does not require them to sign for a loan. A DST may be an ideal opportunity for an investor looking to a 1031 exchange to be a passive, turn-key solution with required financing already established.

Step 5: Have a backup property identified just in case. The IRS code allows investors to identify replacement properties using different rules. The most common rules used are to either identify three properties for their 1031 exchange or identify real estate valued at up to 200% of the property that’s being (or been) sold. This means there is room for back-ups. Take advantage of the opportunity. An exchanger should never leave an empty space on their ID form, which is submitted and filed with a qualified intermediary. More often than not, the exchanger’s primary option doesn’t work out … even if it looks like a sure thing! I have often seen sellers exploit the buyer’s 45-day time clock in order to press their back against the wall, forcing them into an inferior negotiating position. Backup IDs can strengthen the exchanger’s negotiating power by providing additional options.

For accredited investors, a DST can be an excellent option for a backup strategy. DST properties are already purchased, stabilized, and providing monthly distributions to investors. There is no negotiating and the due diligence is already complete. Additionally, an exchanger can often close on a DST in three to five business days. I often recommend my clients use a DST as a backup ID if there is room in their exchange and it is appropriate for their situation.

Step 6: Help your client negotiate a 1031 contingency in their purchase and sale agreement. Many buyers are willing to allow a 1031 contingency that will permit the seller to extend escrow on the property being sold if the seller can’t find a replacement property. For example, try to negotiate a clause that extends escrow for the seller by an additional 30 days if they are unable to identify a suitable replacement property. This can be a quick and easy way to buy additional time if your client is having difficulty locating the right 1031 exchange investment.

Net-net: a 1031 exchange can be a potentially great tool for building and preserving wealth, but it can be a daunting process if not properly prepared. If your client decides to do a 1031 exchange, encourage them to start early, get educated, narrow down their options, line up financing, have a backup ID, and negotiate for more time in case they need it. When appropriate and if they qualify as an accredited investor, use a DST as part of their 1031 exchange strategy. There are no guarantees in real estate, so it is always best to plan ahead when considering a 1031 exchange.

Steve Haskell

Steve Haskell

Steve Haskell is Vice President of Kay Properties and Investments, LLC, which operates a 1031 exchange property marketplace at Steve works with 1031 exchange and direct investment clients throughout the U.S. He is based in San Diego.