If you have invested in real estate in the past, you likely have also done a 1031 exchange. As you undoubtedly learned, however, 1031s have numerous risks and disadvantages. While they defer your capital gains tax liability when you sell a piece of appreciated real estate, the rules and regulations that apply to them can make them unappealing at best and downright dangerous at worst. Why? Because they often fail, leaving you with an enormous capital gains tax to pay.
As you know, a 1031 exchange, at its heart, is a swap of one of your business or investment properties for another of equal or greater value. The immediate disadvantage is that this new property must be of “like kind” to the one you sold.
Stringent Time Frames
In addition, a 1031 comes with strict time limits with which you must comply. First, you must designate your “like kind” property within 45 days of selling your relinquished property. Second, you must complete the 1031 swap within 180 days of selling your relinquished property.
In other words, you have only about six weeks to find a suitable “like kind” property, regardless of the health of the U.S. commercial real estate market. (1031 exchanges disallow foreign real estate investments.) Then you have only about 4-1/2 additional months to complete the purchase, no matter how complicated it is or may become.
Market Conditions Risk
Depending on the market conditions at the time, you may face other challenges. Perhaps we are in a sellers market and you enjoyed several offers on your property and a high sales price as a result. For the next leg of your transaction, you are the buyer, not the seller and you should not expect the general market conditions to change in a short 45 day period. Now perhaps you are one of a number of possibly buyers vying for your identified replacement property. If you get outbid, or don’t find something you really like that also meets the 1031 requirements, you may either have pay your taxes, or settle for a sub-standard property in order to avoid the tax liability… what I call the “hold your nose and close” transaction.
Your Risk
A Qualified Intermediary (QI), also known as an accommodator, holds your sale proceeds between the time of your sale and the time you close on your new investment property, If you miss one of the deadlines, however, the entire 1031 exchange fails and the sale proceeds held by the QI immediately revert to you. The result? Not only do you face immediate payment of huge capital gains taxes, you may have to recapture depreciation as well.
Needless to say, a 1031 puts you in a disadvantaged position with respect to both the person who bought your relinquished property and the person who owns the “like kind” property you desire to purchase. Either could fail to live up to his or her end of their respective bargains. For instance, the former could refinance the loan and the latter could fail to timely complete agreed-to renovations of the property prior to closing. Either way, you wind up with constructive receipt of your entire sale proceeds, triggering a capital gains tax event.
The Risk-Free DST
Rather than doing a standard 1031 exchange and assuming all the risk yourself, you may wish to use a Deferred Sales Trust (DST) instead. What is a DST? It’s a special kind of installment sale authorized by Section 453 of the IRS Code.
The beauty of a DST is that the trust assumes ownership of the sale proceeds from your relinquished property. In exchange, you get an installment note where you set the term of the repayment plan, and your plan is secured and backed by a more diversifed selection of investments specifically approved by you. This way, if your 1031 exchange fails, your sale proceeds revert to the DST, not to you personally.
Contact Reef Point today to learn more about how the DST can work better than a 1031 exchange to help shield your profits from capital gains taxation.