§1031 Exchange, Top 5 Best Practices

1031 Like Kind Exchange

By Kenneth Millar, Designated Broker/Partner, Peak Realty Advisors LLC.:  Five “best practices” to ensure a successful Section 1031 like-kind exchange for real estate.

Section 1031 Exchanges can be very beneficial to the owner of a particular real estate property.  This is especially true when the subject property has accumulated substantial net equity gains over a period of time.  The 1031 Exchange process however can also be very stressful due to strict IRS requirements including fixed deadlines that must be met.  The following best practices will help the investor avoid creating an unintended taxable event in the process of selling one property “in exchange” for another.

  1. Understand the 1031 Exchange Timing.  The Internal Revenue Code 1031 Exchange rules are very specific and should be considered rigid.  The investor, also known as the Exchanger, is ultimately the party that is subject to taxes and penalties should the transaction violate any of the provisions of the tax code.  The first issue that needs to be addressed is that you must start the process prior to the close of escrow of the first sale.  It is too late to initiate an exchange once ownership has changed.  Other dates of significant importance are identifying the replacement property within 45 days of the sale of the first property, thereafter you must complete the purchase of the replacement property no later than the 180th day after the sale of the first property, or before the end of the current tax reporting period, whichever occurs first.
  2. Choose the Right Advisor(s).  Before listing the relinquished property, the potential Exchanger should consider hiring a real estate broker team experienced with 1031 exchanges to manage the exchange process.  The fees charged are typically only those normal to a sale or purchase transaction where the seller normally pays a commission on the value of the sold property.  Without the help of the experienced broker team, an Exchanger will likely be at a disadvantage because they will not be able to anticipate potential fail points throughout the process.  It should be noted that the IRS does not make exceptions for missed dates or other violations even if the fault is with parties other than the Exchanger.  A missed date represents a failed exchange and therefore a taxable event that may include additional penalties and interest.   Properly structured Purchase Contracts are but one important tool used by the broker to ensure an on time enforcement of time line events.
  3. Research and Choose the Right Property.  A well thought-out acquisition strategy is another key to success.  With the help of your broker, you’ll determined your minimum purchase price and debt that you need to carry over from the relinquished property; it will then be time to identify the replacement property(ies).  When selecting the property, it is important to determine the region, price, returns after cost and taxes, asset type, level of management, length of tenancy, escalations and other lease terms.  A good broker can help a buyer determine the acquisition criteria in advance, enabling better sourcing and earlier review.  Remember, the process needs to fit within the time requirements of the Internal Revenue Code.  Property inspections, appraisals, and lender underwriting all take time leaving little margin within the exchange period for indecision or failed property selection.
  4. Negotiate for the Best Terms.  When negotiating the purchase or sale of real estate, it is important to know what the current market norms are so that you benefit from the inclusion of those items into a transaction or conversely, you exclude terms that are not necessary.  An experienced broker brings the knowledge of what is acceptable and what’s not into the discussion.  It is easy to appreciate that contingencies can be anticipated and are best served when those contingencies are negotiated into the original purchase contract.  Within the exchange process, the exchanger’s bargaining position weakens when the other party knows that a failed transaction can represent an unanticipated taxable event.
  5. Deploy a Solid Communication System.  A successful 1031 exchange is all about communication.  While essentially only two or more real estate transactions executed back to back, the 1031 exchange is far more difficult to manage from a communication perspective.  Everyone involved needs to be focused on their tasks and contingencies executed on a timely basis.  Effective communication between all parties to the transactions in an exchange is a necessity; including brokers, accountants, attorneys, and escrow officers – any of whom can all make or break a deal.

The benefits of a “like-kind” exchange to a real estate investor can’t be overstated.  They represent a tax management strategy that can defer the payment of taxes to a future date or in some cases, a complete legal avoidance of taxes.  To ensure success, Investors are best served by working with real estate brokers that are experienced with 1031 exchanges.  These select brokers’ often are assisted by a deep field of experienced affiliates including attorneys, accountants, qualified intermediaries, inspectors, and closing officers that mitigate much of the exchanger’s stress and uncertainty throughout the process.

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