While we have not been able to find a recent study to give an exact ratio of 1031 Exchanges that end up failing or “falling through.” We’ve been able to conservatively estimate, based on our personal experience and a survey of a dozen other industry experts, that about 30% of 1031 exchanges end up falling through, creating a taxable event for the investor.
If the chances of failure are so high, and if the result of that failure is a (potentially large) tax liability, then creating contingency plans and adding flexibility to a 1031 Exchange seems like an invaluable capability. So, how exactly do you do so? Well, luckily for those you that are running low on sleeping pills, we have a previously recorded webinar you can watch (below) that covers the rules and guidelines of 1031 exchanges, how you can create a contingency plan and add flexibility to the process.
For those of you who prefer to read over listen, I have included the key highlights over the rules, timing, and guidelines below. I have also included the highlights over the resource we use to create a contingency plan and add flexibility to the process.
What exactly is a 1031 Exchange?
1031 just referrers to the IRS code that allows the tax advantageous strategy. When you sell an investment property and you have a profit or “realized gain,” you normally are required to pay capital gains tax. A 1031 Exchange allows you to sell your real estate investment and reinvest the proceeds into a “like-kind” investment, which defers any capital gains taxes. You also defer the 3.8% net investment income tax (if applicable) and the 25% depreciation recapture tax. It is important to highlight that this process does not eliminate any taxes due, just defers them.
Timing, equity, and debt requirements:
- Entire process must be completed within 180 days
- Day 1 – Sell your (relinquished) property; proceeds are escrowed with a Qualified Intermediary (QI)
- Day 45 – Identify a property(s); you must notify your QI of the identified property(s)
- Day 180 – Close on new property; you must close within 180 days after the first sale
- Maintain equal or greater amount of equity
- Maintain equal or greater amount of debt
Identified Property Rules:
- 3-Property Rule: You may identify up to three potential replacement properties and purchase any (or all) of them, regardless of their total value.
- 200% Rule: You may identify more than three potential replacement properties and purchase any (or all) of them, so long as their total value does not exceed 200% of the value of your relinquished property.
- 95% Rule: You may identify more than three potential replacement properties, regardless of their total value, so long as you purchase at least 95% of the total value of all of the properties you identify.
The above guidelines are strict and must be adhered to in order to avoid a taxable event. So how exactly do we put in place contingency plans and add flexibility to the process? Well, we incorporate something called a Delaware Statutory Trust or DST.
What is a DST?
A Delaware statutory trust is a legally recognized trust that is set up for the purpose of business, but not necessarily in the U.S. state of Delaware. It may also be referred to as an Unincorporated Business Trust or UBO and is recognized by the IRS as “like kind” property for the purposes of a 1031 Exchange.
DSTs are normally sold as, or like a security and require the investor to be an accredited investor.
Key Highlights and Benefits of DSTs
- Access to institutional-quality real estate
- Professional asset and property management
- Passive ownership
- Non-recourse institutional financing (Investors are not on the hook for any of the debt)
- Lower minimum investment
- Portfolio Diversification
How Does a DST Create a Contingency Plan and Add Flexibility?
- Ability to close quickly (if listed as an Identified Property with the Qualified Intermediary)
- Once listed as an “identified property” it can be a contingency plan for any real estate sales that fall through
- Any excess profit or “boot” can be rolled into a DST
- You can put a portion of equity into a highly leveraged DST to facilitate any debt you may be required to maintain, leaving any remaining equity to purchase any other identified properties with CASH.
1031 Exchanges can be a complex process, if you have any outstanding questions or would like to inquire any further information of the topic or over DSTs you can schedule a quick call or Zoom meeting with one of our partners, or reach out to our office at the contact information below.
Dan Nuwash, MBA
Founder, Managing Partner
Finance For Thought
675 Third Ave, 9th Floor
New York, NY 10017