Let’s answer this question by first reviewing several important rules that must be followed to successfully complete a 100% deferral of tax liabilities by utilizing the 1031 Exchange process.
Rule #1: You must purchase a qualifying “like-kind” investment property having same or greater value than the sold or relinquished property.
Let’s break this down into two parts. First, you must purchase a “like-kind” investment property. Fortunately, the IRS allows a broad interpretation of what is a “like-kind” property. For example, if the investor sells a single-family rental property, they can reinvest the proceeds into an apartment, a retail property, a storage facility, an office building, raw land, or other qualifying real property. “Like-kind” also include some less common property types such as manufactured homes, billboards, parking lots, and cell phone towers, among others.
Secondly, the replacement property must have a value that is the same or greater than the value of the property that was sold. The property value referenced in this rule is the net sales price after subtracting closing costs e.g., commissions and other sales expenses.
Rule #2: You must reinvest all net proceeds from the sale.
This is straightforward and needs little interpretation. The funds that remain after all sales related costs have been paid and any loan obligations have been discharged are the net proceeds. At the close of escrow, the net proceeds need to be transferred directly to the account of a 1031 Exchange Qualified Intermediary (QI) who will hold the funds on your behalf until you provide written instructions on how the funds are to be reinvested or returned to you.
It is critical that an Exchange Account be opened with the Qualified Intermediary (QI) firm prior to the close of your escrow and that all parties related to the sale are aware of your intent to potentially complete a 1031 Exchange. If an Exchange Account is not opened prior to close of escrow – or if someone at closing inadvertently sends the funds to you instead of to the QI, you will be ineligible to complete a 1031 Exchange and possibly be subject to significant tax liability.
Rule #3: You must replace any debt with same or greater new debt or with cash from outside the exchange.
This third rule is arguably the least understood and most often overlooked rule for investors who are new to the 1031 Exchange process. It can also create some unexpected headaches – so it is worth taking a deeper dive on options to satisfy this requirement.
If the property that you sold had no loan, you could complete a successful 1031 Exchange by following only the first two rules summarized above and not be concerned about Rule #3. You could also acquire a property and add or assume debt on the replacement property. Often investors who have sold a debt free property will want to use a loan to buy a more valuable property so that can avoid investing extra cash to acquire the property. If a higher valued replacement property is purchased, you may be able to claim added income tax deductions for depreciation and interest expenses which could provide added tax shelter on any income received from the new property.
If the property that you sold has a loan on it, the IRS requires that your replacement property must either have a new loan with the same amount or higher than the loan on your sold property or you may reduce the loan requirement by adding cash from outside the exchange. For example if you sell a property valued at $1M with loan of $400K, rather than obtaining a new loan of $400 or greater, you could take $400K in cash from other sources not related to your sale e.g., your bank account or sell some stock or other assets and then acquire a property with no debt.
We occasionally see older retired investors who may be wealthy based on their assets – but who do not have sufficient income to qualify for a new loan. So, a possible solution for them might be to sell some of their assets and purchase their replacement properties with all cash.
However there is another option that has become very popular that help investors who want to acquire higher valued real estate for added tax deductions or for investors who cannot qualify for a loan – and that is to consider investing in properties structured as a Delaware Statutory Trust (DST).
DSTs offer investors potential benefits for satisfying 1031 Exchange loan requirements.
First, DSTs are generally available with already in-place debt ranging from no-debt to approximately 80% debt. By combining DSTs with different debt ratios, a portfolio could potentially be tailored that would meet the needs of an investor to satisfy his/her debt requirement.
Secondly, DST investors are not required to qualify for any of the loans that may be in place. The DST sponsor firm (or a related party) has already qualified for the loan and is the sole loan guarantor. The investor does not need to submit any financials or otherwise prove that they are qualified for the loan. Better yet, they are still able to deduct their portion of the interest expenses of the loan to reduce their income tax liabilities.
For more information on real estate tax deferral strategies including 1031 Exchanges and replacement property options, please feel free to contact us at info@firstguardiangroup.com or you can also schedule some time on Paul Getty’s calendar for a personal consultation.
Disclosure: DSTs, like all real estate, have risks, including illiquidity, potential for loss of property value, costs and expenses that could offset the benefits associated with tax deferral, and reduction or elimination of monthly cash flow.
Disclaimer: There is no guarantee that any strategy will be successful or achieve investment objectives. All real estate investments have the potential to lose value during the life of the investments. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please be aware that this material cannot and does not replace the Memorandum and is qualified in its entirety by the Memorandum.
This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal.
Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits.
IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation.
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