What Options Are There for 1031 Exchanges When Inventory is Tight?

Real estate inventory is very scarce right now, which has caused a lot of frustration among investors engaging in 1031 exchanges. This scarcity has caused many people to try and get creative with their replacement properties. However, you need to be very careful in how you approach this as the IRS has very strict rules on what does and does not qualify for 1031 treatment.

Buyer Beware

Here’s an example of a potential “solution” to the scarcity problem that does NOT work for 1031 exchange purposes.

Let’s say you are looking to sell your investment property in a 1031 exchange transaction and you want to buy a gorgeous single-family home as your replacement property. Then you want to move into that new single-family home and rent out your old home.

Here’s the issue with that – your 1031 replacement property has to be used for investment or business purposes. If you move into that home, that will likely be considered personal use by the IRS.

Some may try and argue that in this scenario you’re just substituting the old home as the new rental property, but I don't think the IRS is going to look at it that way.

This is just one example of a creative “solution” to a 1031 problem that will likely not work out in the taxpayer’s favor. It’s important to be very mindful that when you're doing an exchange, you want to bring your accountant, your tax preparer, your tax attorney, and your qualified intermediary to ensure that your exchange is going to be successful.

Like-Kind

The like-kind provision in section 1031 is very broad. Most real estate in the United States can be considered like-kind to most other real estate in the United States. So an unimproved farm is considered like kind with the IDS Center in downtown Minneapolis. They're both real estate. The character of the farm and the character of the IDS Center are both real estate so you can do an exchange of real estate that may not be similar but you can still exchange within the United States real property for real property.

That it gives investors a lot of options for potential replacement properties when considering a 1031 exchange.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

Who Should you Identify Your Property To in a 1031 Exchange?

Typically, taxpayers conducting 1031 exchanges will send their completed and signed 1031 replacement property identification form to their qualified intermediary. That is the norm in the industry, however, under the Treasury Regulations, a taxpayer can technically identify to:

1. The person that is obligated to transfer the replacement property to the taxpayer (such as the seller of the Replacement Property if you have signed a purchase agreement to buy the replacement property);

2. Any other person involved in the exchange other than the taxpayer or a disqualified person.

A Word of Warning

Your real estate agent, attorney or accountant may be involved in your exchange, but these people are probably disqualified because they are acting as your agent or employee. Also people that you are “related” to you by familial relation or business relationships [set out in IRC Section 267(b) or 707(b)] such as business partners are also disqualified.

If there is a title company or escrow company involved in your exchange, that title company or escrow company could theoretically be sent your 1031 replacement property identification form, and they likely would not be considered to be your agent, so that could be sufficient.  However, the better practice is to send the identification to your qualified intermediary. 

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

5 Required Elements for a Valid 1031 Exchange Property Identification

As we’ve discussed many times before, there are numerous rules you have to abide by in order to execute a successful 1031 exchange and defer your capital gains taxes. One of the most important areas to be aware of in this realm is property identification. In this article, we are going to discuss five required elements for a valid property identification in a 1031 exchange of real estate.

1031 Exchange Property Identification

In a 1031 exchange, your replacement properties should be:

1. Clearly and specifically (unambiguously) designated

2. In writing

3. To the qualified intermediary (or other person involved in the exchange who is not disqualified)

4. Using the postal address(es) of the property (including House/Building Number, Street Name, City, County, State, and Zip Code), and/or the complete legal description (including the Metes and Bounds description, or Lot and Block or Other Subdivisions, or Condominium Unit Number and Name) and/or the County Tax Assessor's Parcel Number (APN, PID or Property Tax Identification Number) or you can use the property’s distinctive name, such as “The Empire State Building”

5. Sent before Midnight of the 45th day after the closing of the sale of your relinquished property

Generally, the more specific the identification the better. The more general or less specific, the more risk that the 1031 exchange could be disallowed during a federal or state audit.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

How Exactly do Build-to-Suit Construction Exchanges Work?

In a normal real estate transaction, if John Doe sells a property worth $500,000 and purchases a new piece of land with nothing on it for $100,000, the IRS takes the position that once John Doe owns that land. His exchange is complete and any improvements that he makes on top of that land that he now already owns won't count towards his 1031 exchange.

A Work-Around

A work-around for this type of situation is a mechanism under rev proc 2037 that allows the qualified intermediary to form an LLC and buy the new land using $100,000 of John Doe's exchange funds and holds title to that dirt during the remainder of the 180 day exchange period.

During this time, improvements can be constructed on that new land and still count towards the 1031 exchange. So if you can build up quickly, you can potentially construct another $400,000 property value on top of that dirt so that you receive replacement property of equivalent or greater value. Remember, in a 1031 exchange, you want to buy property of equal or greater value so you continue your investment. You want to reinvest all of your equity, your proceeds, and to the extent that you pay off debt on the old property you want to offset that debt either with the replacement property itself or cash from your own pocket.

Constructing Improvements

A build-to-suit exchange is a great way to construct the improvements to your specifications and get new property that qualifies for 1031 exchange treatment, but you only have 180 days total so make sure you have all of your ducks in a row and ready to go before you begin the process.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved

How 1031 Exchange Restrictions Would Slow Down Velocity in the Marketplace

Even before he took office, President Biden had proposed a cap on 1031 exchanges that would cap the deferral at $500,000 per year. There was a very strong pushback on that from people who do conservation easements, people in the banking sector, developers, and a whole spectrum of real estate related trade associations. The bottom line is that restricting 1031 exchanges would really hurt the economy and the expected increased revenue is a fallacy because people will simply choose not to sell their real estate if this 1031 incentive is taken away.

Incentivizing Investment

Essentially, this added tax would act as a disincentive for velocity in the real estate marketplace. It wouldn't be a very good Revenue raiser and it would have a really adverse effect on real estate values and redeployment of cash in the marketplace.

There is also a compelling argument that real estate owners, unlike owners of stocks and bonds, are paying taxes the entire time they're owning a piece of real estate, because at the state and county levels they're paying property taxes. They may also have to pay mortgage registration tax and other assessments that may be applied.

So unlike other vehicles of investment, an investor in real estate is being taxed while they're owning the property - just not by the federal government.

100 Years of 1031 Exchanges

This year marks the 100-year anniversary of the 1031 exchange. This provision has been in the tax code for a long time to facilitate the transfer of capital to those segments in the marketplace where we need infrastructure.

1031 exchanges provide private infrastructure, whether it is housing, warehouse, retail stores, etc. We need to encourage this type of private infrastructure just as much as we need public infrastructure like roads and bridges.

• Start Your 1031 Exchange: If you have questions about 1031 exchanges, feel free to call me at 612-643-1031.

Defer the tax. Maximize your gain.

© 2021 Copyright Jeffrey R. Peterson All Rights Reserved