REAL ESTATE DOLLARS AND SENSE

Like-Kind Exchanges Under IRC Section 1031 offer real estate investors with a valuable tool in creating generational wealth. In a 1031 exchange, real estate investors can sell their non-owner occupied property (i.e. the “relinquished” or "downleg" property) and reinvest the net sales proceeds into another non-owner occupied property (i.e. the “replacement” or "upleg" property) while deferring the taxes owed from capital gains to a future date. The benefit is that the full before-tax net sales proceeds can be reinvested as opposed to having to pay the taxes owed upon sale of the downleg and only reinvesting the remaining after-tax funds. Generally speaking, tax strategies that involve delaying tax payments to a later date benefits investors looking to maximize the time value of money with their real estate portfolio.

1031 tax deferred exchanges come in two flavors - forward exchanges and reverse exchanges. In a forward 1031 exchange, an investor (or exchanger) first sells the downleg property and subsequently purchases the upleg property of equal to or higher value. The upleg property must be identified within 45 days of closing on the downleg property and fully purchased within 180 days of closing on the downleg property. Furthermore, the net sales proceeds from the downleg are held by a qualified 1031 Exchange Accommodator in a separate account on behalf of the exchanger to ensure that all funds are fully reinvested into the upleg property. In a reverse 1031 exchange, the exchanger first purchases the upleg property and subsequently sells the downleg property within 180 days of closing on the upleg property. On the surface, these two transactions might seem similar, but there is one key difference between the two. Specifically, the IRS requires the exchanger to NOT hold title to both properties at the same time pursuant to IRS Rev. Proc. 2000-37, released on Sept. 15, 2000 (later amended by Rev. Proc. 2004-51). To meet this IRS requirement, the Exchange Accommodator must create a pass-through entity (i.e. an LLC) to temporarily take title to (or “park”) either the downleg or the upleg property, at the discretion of the exchanger, until the downleg property is sold.

The main consideration to be aware of when deciding whether to park the upleg vs. the downleg property in a reverse exchange revolves around the lender guidelines. For example, many lenders will not loan on properties where the borrower is not on or is not taking title to the subject property. This can be an issue when parking the upleg because the Exchange Accommodator’s LLC will take title to the upleg, precluding the exchanger/borrower from qualifying for a loan to complete the purchase the upleg. No problem – just park the downleg property, right? Not so fast! If the downleg property has debt on it, it is quite likely that the lender servicing that debt has a “due on sale” clause in their loan terms and conditions. This means that if title to the downleg property is transferred to the Exchange Accommodator’s LLC to park the downleg, the lender could theoretically call the loan (i.e. require the balance to be paid in full!). To navigate around these obstacles, the exchanger would either need to park the upleg and use a lender that allows the Exchange Accommodator’s LLC to be on title to the property or the exchanger would need to own the downleg property outright (i.e. without any debt) to ensure that parking the downleg could not trigger any type of loan “due on sale” clause.

While only ~20% of all exchanges are reverse (and only ~5% of those park the downleg), reverse exchanges can be helpful under certain circumstances even with the additional hoops required. For example, if while in escrow on both properties during a forward exchange, an exchanger’s downleg escrow falls through, a reverse exchange may allow the exchanger to salvage the 1031 and continue to close on the upleg and subsequently sell the downleg to another buyer. Another situation where reverse exchanges are useful is during seller’s markets. In a seller’s market, the assumption is that the downleg property will sell easily, however purchasing a suitable upleg property in the face of reduced inventories and bidding wars may not be so easy. In this case, it may be prudent to first purchase the upleg and subsequently sell the downleg via a reverse exchange. Lastly, a reverse exchange may offer benefit when the exchanger secures a unique property or gets an exceptionally great deal on their upleg before their downleg has sold. One drawback with reverse 1031 exchanges is their cost. A typical reverse 1031 exchange costs around $8-10K. Contrast that with a typical forward exchange that costs around $1-2K. The higher cost of a reverse 1031 exchange can be attributed to several factors - the creation of the temporary LLC, the separate title insurance policy required for the LLC, the preparation/filing of the tax return for the temporary LLC, the large number of documents required in a reverse exchange, and the limited supply of exchange accommodators with reverse 1031 expertise. For the above reasons, reverse 1031 exchanges should only be pursued when the benefits clearly outweigh the costs. To take things one step further, combining 1031 exchanges (forward or reverse) with the "step-up in basis" provision of the tax code can maximize the creation of generational wealth when your next of kin ultimately inherits your property. Simply put, 1031 exchanges allow investors to grow the value of their real estate portfolio tax-free by trading up and deferring the capital gains taxes owed. Eventually, when the real estate asset is passed on to your heirs, they will receive a “step up” in cost basis all the way up to the market value at the time of inheritance, effectively zeroing out their capital gains tax liability that you deferred via your 1031 exchanges! Voila! If you’re thinking like me and looking to take advantage of the current shift in the real estate market to trade up into another property via a tax-deferred 1031 exchange, give me a call – I’ll put my firsthand experience with both types of exchanges to work for you!