3 Things To Know To Ensure A Smooth 1031 Property Exchange

Location is paramount to any successful commercial real estate deal, as are solid financing, a great property and reliable partners. Panic and confusion, however, are not ideal ingredients to add to the mix.

But those strong emotions often rear their ugly heads near the closing of a deal if the 1031 investor hasn't taken careful steps to defer capital gains taxes on the sale of qualifying property.

“The worst call I could get is from someone who sold a property in the past few days and then decided they want to do a 1031 exchange,” said Chris Newton, executive vice president at Chicago Deferred Exchange Co., a qualified intermediary and exchange accommodation titleholder. “At that point, it’s too late, and the caller unfortunately has a taxable sale on their hands.”

Fortunately, Newton and CDEC CEO Mary Cunningham said most issues that investors might encounter while considering or executing a 1031 exchange — which allows them to defer paying taxes on a gain by reinvesting in a similar property in a qualifying like-kind exchange — are avoidable with the help of a QI. 

CDEC, a Chicago-based QI, has facilitated more than 75,000 transactions for individuals, corporations, REITs and others since 1989. Cunningham said the key to success in virtually all of those cases was simple: Someone contacted CDEC for advice. The earlier in their deal, the better, but the point is to consult with a QI rather than guessing or relying on potential misinformation about how 1031 exchanges work.

“Even if they ultimately decide not to go forward with the transaction, we're always happy to talk to people about it,” she said. “Even if it is two days from closing and they decide, ‘Let's see what our options are here,’ we're happy to talk to them. Then at least they’ve done their due diligence and exhausted their options.”

Although 1031 exchanges have been around since the 1920s, confusion persists about the nuances of how they work. Three aspects of 1031 exchanges tend to sow the most uncertainty, Newton said. These include its statutory deadlines as well as deal-specific concerns about missing a purchase opportunity.

But in most cases, help is available.

“Our most common advice to anybody is to just talk to a QI early in the process,” Newton said. “It doesn't cost you anything to have a dialog and then make a plan. But once you complete the closing of a sale, you have a taxable event and there's no way for you to go back and fix it. That's the most dire situation, but it can be avoided.”

Days And Confused

Internal Revenue Code Section 1031 gives a taxpayer 45 calendar days from the date of a commercial property sale to formally identify a limited number of potential replacement properties. It also gives them 180 calendar days to close on the replacement property from the date they closed on their relinquished property.

“That might seem like an ample window, but experience tells us that the time goes fast,” Newton said. “Anything a client can do to explore what replacement properties they are interested in purchasing early is helpful. In fact, we encourage exploring options even before the closing of a relinquished property sale.”

Some confusion might be due to the fact that the deadlines include holidays and weekends. That is important to keep in mind during the crucial last steps of closing a deal.

“All days matter, so if your 180 days conclude on a Sunday, then you need to plan to close on the Friday before, because title companies and everybody else won’t be working on Sunday,” Newton said.

A Case Of FOMO

In today’s highly competitive and unpredictable CRE market, purchasers might worry that they will miss out on an opportunity to buy a property if, for example, another interested party swoops in and closes the deal faster.

That is why CDEC advises clients to identify as many as three properties they might want to purchase, regardless of their value or location.

“People have the option to identify multiple potential replacement properties, so if property choice No. 1 doesn't work out, they have created a safety net by identifying something that they like almost as much,” Newton said. “That also highlights why understanding the deadline is important, because you might be exploring three purchase options within only 45 days.”

Some property exchangers might be unaware that they can contract to buy a new replacement property even before they close on the sale of their relinquished property.

“Some clients think that is a statutory no-no, but it's not,” Cunningham said. “It is a great way to get that replacement property locked up before you close and have to deal with the 45-day period.” 

That, she said, leads to another common concern.

Put It In Reverse

It isn't unusual for a client to need to buy a replacement property before they sell their old property or to use proceeds from a sale to both buy and improve the replacement property. A solution is to perform a reverse exchange, also called a “parking transaction” in the QI world.

“The client will engage us to ‘buy,’ in air quotes, the replacement property on their behalf with their money, and then they have 180 days to complete the sale of the property that they want,” Newton said. “They then complete the exchange by buying the property back from us with the money we borrowed from them to make the purchase. A reverse exchange has helped a lot of people out of what otherwise would be difficult situations.”

The approach is common among institutional clients, Cunningham said, but it can be a security blanket for any property purchaser who has doubts about the reliability of other parties in their deal.

“They may be concerned that they could get into a scenario where they have a contract to buy new property, but maybe the buyer falls out just prior to the closing of their relinquished property,” she said. “A parking transaction can provide them with confidence in an event like that.”

A reverse exchange can also help in situations where the sale price of the relinquished property exceeds the value of the replacement property, which might also need extensive renovations. 

In a case like that, the client might ask the QI to use the money it is holding for it to buy the replacement property. The client then uses the proceeds from its sale of the relinquished property to complete improvements to the purchased property.

In any case, it is best to talk to a QI early in the process to formulate a plan to get the most benefit from a 1031 exchange.

“The planning and documentation for an exchange are slightly more complicated than with other deals, but this is a valuable tool an investor can use to successfully execute an exchange and achieve the desired tax deferral,” Newton said.

This article was produced in collaboration between Chicago Deferred Exchange Co. and Studio B. Bisnow news staff was not involved in the production of this content.

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