Though the exact count isn’t known, I’ve done a lot of ’em. I know a ton about ’em too. I could tell stories, big time. But first, I’d make dang sure Bill Exeter wasn’t in the room, cuz no matter how many stories I can tell, he has 100 times more. Also, I’d never tell the first story if he was in the room, never. Yeah, I’ve done multi-state exchanges with a buncha properties and multiple exchangers. Big whoop. Bill? I’m guessin’ he’s presided as Qualified Intermediary (you may know this as Accommodator) in thousands of exchanges. Oh, and he does ’em in all 50 states. I get questions about 1031s pretty frequently. 95% of the time I not only have the answer, I know the exceptions to the answer. Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free Yet, when it comes to this subject, he is the man, period. Don’t know how to make it any plainer than that. Here are the interview questions I recently posed to him. The observations from the PeanutGallery are from me. Jeff: Bill, in your experience, what has been the most common mistake made during exchanges by investors? Bill: There are a many common mistakes, so I’ll just list a few of the most common. I know you asked for the most common, but I could not help myself. (1) You would be surprised how many calls we still get from investors that have already closed on the sale of their relinquished property and now want to structure a 1031 Exchange in order to defer their taxable gain, but it’s too late after they close. The 1031 Exchange must be set-up before the investor’s sale of their relinquished property closes. (2) There are still many investors who incorrectly think they only have to reinvest the equity or the gain from the sale of their relinquished property, but that’s not true. Investors must acquire one or more replacement properties that are valued equal to or greater than the value of their relinquished properties sold. (3) Investors often think they can legally change or alter their identification of replacement properties after the 45 day identification period, but they can’t. It’s the law – they must identify during the 45 calendar day ID period and can’t change it afterward (unless they want to commit tax fraud). Jeff: Would you please explain when the 180 day period is shortened — why it’s shortened — and the solution to work around it? Bill: The rule is that you have 180 calendar days — or — up until the due date to file your income tax return (with extensions), to acquire and close on the purchase of your replacement property. This is only an issue if the sale of your relinquished property closes between October 17th and December 31st of any given tax year. Let’s assume that you sell and close on the sale of your relinquished property on December 1st, 2012. The 180th day falls after April 15, 2013, which is when most taxpayer’s income tax returns are due. The rule then means that you must complete the purchase of your replacement property no later than April 15th. You therefore have less than 180 calendar days to complete your 1031 Exchange. However, you can extend the 1031 Exchange deadline so that you have the full 180 calendar days to complete your 1031 Exchange if you file an extension for your tax return, complete your 1031 Exchange, and then file your tax return after you have completed your 1031 Exchange. You will never have more than 180 calendar days if you file an extension, but at least you will have the full 180 days. It’s not a big deal, unless you forget about it. Jeff: In these days of so much lost value, tell BiggerPockets readers what a ‘zero equity’ exchange is. Bill: We all know that the market value of most real estate has fallen dramatically over the past five years. In many cases, investor’s investment properties are worth less than what they owe the bank – they have negative equity in the property. The misunderstanding that many investors have is that if they have no equity they have no taxable gain. This may or may not be true. It all depends on the investor’s cost basis in the property. For example, let's assume that an investor bought a property for $100,000.00 (original cost basis) ten years ago. The property increases in value each year up to 2007. They refinanced the property every 12 months or so and pulled their equity (appreciated value or profit) out of the property. The property reaches a value of $500,000.00 by 2007 and they refinance again so that their total outstanding loan balance is now $400,000.00. The property then drops in value to $300,000.00 during the recession. For whatever reason, they lose the property through a foreclosure or must sell it as a short-sale for $300,000.00. Investors often think that they are selling for $300,000.00 with a loan value of $400,000.00, so they have no equity and therefore no gain. However, they bought the property for $100,000.00, so they still do have a taxable gain of $200,000.00 ($300,000 less $100,000.00). So, even when they are selling property with no equity or negative equity , they may still have a taxable gain. It’s what we have trademarked a Zero Equity 1031 Exchange™. You can still 1031 Exchange the property when there is no equity, but it takes more effort and creativity to acquire replacement property. Jeff: Bill, what the heck is a reverse exchange?! Bill: Most investors use what we call a Forward or Delayed 1031 Exchange. The forward 1031 Exchange means they are selling their relinquished property first and buying their replacement property later (delayed purchase). However, there are times when an investor must acquire his or her replacement property before they are able to list and/or sell (close on) their relinquished property. The Reverse 1031 Exchange allows an investor to do just this – buy first and sell later. It can be a very powerful tool, but it is also more complex and more expensive. It also significantly reduces an investor’s risk with a 1031 Exchange because they can take all the time they need to look for suitable replacement property without stressing out over the 45 day identification deadline. Once they locate and acquire the replacement property they have 180 days to list, sell and close on their relinquished property. If they are unable to sell their relinquished property within the 180 day exchange period, they have a failed Reverse 1031 Exchange. However, since they have not sold any property there is no taxable gain. They end up owning both properties with no tax consequences. PeanutGallery: This approach tends to virtually eliminate the fantasy that the investor exchanger’s property is worth more than everything else on the market. That tickin’ clock turns into Big Ben as those 180 days begin to grow short. When opting to execute a reverse exchange, the investor must be brutally objective about the real market value of their property. Jeff: The phrase ‘like kind’ is thrown around easily by investors. Would you please define it for us? For instance, can an investor trade a vacant lot, held for investment, for a 10 unit apartment building? Bill: You are so right, Jeff. This is one term that is vastly misunderstood in the 1031 Exchange world. First, it is important for investors to know that 1031 Exchanges can be structured on real property as well as personal property (i.e. non-real estate such as a 1031 Exchange of aircraft for aircraft). Second, the definition of like-kind is very different for real estate than it is for personal property. In the real estate context, like-kind property means ANY kind of real estate that is exchanged for ANY other kind of real estate as long as the real estate sold and the real estate bought are held for rental, investment or use in a business. Real estate held for personal use such as a primary residence, second home or personal vacation home do not qualify. Real property acquired solely with the intent to sell, such as fixers/flippers, do not qualify because they are held for sale (i.e. inventory in a real estate business) and not held for investment. In the personal property context, like-kind property is very specific. If you are selling a convenience store, for example, you would have to exchange refrigerators for other refrigerators, computers for other computers, and so on. Jeff: How are the 45 day ID and 180 closing periods calculated? Bill: The 45 day Identification and 180 day exchange deadlines both start at the close of the sale of the investor’s relinquished properties. If the investor’s sale closes today, tomorrow would be day number one (1) for the two time periods. The investor has exactly 45 calendar days from the close of their sale transaction to identify their replacement properties followed by an additional 135 calendar days after the 45 days (for a total of 180 calendar days) to acquire (take title) to their replacement properties and complete their 1031 Exchange. The 45 day ID period is part of the total 180 day exchange period. PeanutGallery: Notice Bill didn’t say ‘business days’. ID period (45 days) and total exchange period (180 days) don’t get weekends off. Jeff: What is boot? Bill: The term boot refers to the amount of cash received or mortgage balance paid off (not replaced) through a 1031 Exchange that is now taxable. The example in my next response shows that a taxpayer can trade down in value by buying a lesser valued replacement property with less debt. The $100,000.00 would be considered mortgage boot. An example of cash boot would be an investor that sells property for $500,000.00 with no outstanding loan balance and acquires a replacement property worth $400,000.00. They end up with $100,000.00 left over after they complete their 1031 Exchange, which is considered to be “cash boot” and is taxable. Jeff: What about debt relief (investor exchanges into lower debt than was on relinquished property) — isn’t that taxable as ‘boot’? Are there exceptions? Bill: It does not apply if the debt is replaced by new out-of-pocket cash. If the debt is not replaced with out of pocket cash, then it would be mortgage boot. PeanutGallery: Another example is personal property. Back in previous down economies it wasn’t uncommon to see an exchanger take a car or gems, or other types of personal property as part of their transaction. That’s the same as takin’ cash if you keep it. Jeff: Is it possible to execute a partial exchange? Bill: Yes, absolutely, Jeff. Advisors too often forget to counsel investors about this option. We call it trading down in value. In fact, many investors have done just this over the last few years during the recession with the goal of lowering their debt service requirement. For example, the investor may be selling relinquished property for $500,000.00 with an outstanding loan balance of $400,000.00. They might want to consider buying replacement property for $400,000.00 with a new loan of only $300,000.00. They have traded down in value by $100,000.00 and reduced their total outstanding loan balance by $100,000.00. The amount they traded down — $100,000 — is considered mortgage boot (i.e. it’s taxable), but they may have put themselves in a better or more manageable position and have still deferred most of their taxable gain. PeanutGallery: This opens up an opportunity for a post on partial exchanges and how they can be structured to lower the investor’s tax bill. Jeff: What’s the biggest gripe you’d like to get off your chest as it relates to exchanges? Bill:Oh, that would be the 45 day identification requirement. And, I know that I'm not alone in this gripe. The requirement that investors have to identify their replacement property within 45 calendar days after they close on the sale of their relinquished property makes absolutely no sense. It serves no business, legal, tax or economic purpose what-so-ever. Unfortunately, it just is what it is. It presents risk to investors that use the 1031 Exchange. Investors should always begin working with their real estate agent well before they close on the sale of their relinquished property in order to minimize this risk. PeanutGallery: First off, Bill’s on target with his criticism of the ID time limit. It’s without any merit I can discern, other than to make the investor’s life more difficult. Second, his advice to begin working with your real estate investment agent/expert is critical to say the least. Can’t tell ya how many calls I’ve had with agents and/or their clients, asking me to ‘fix’ their tax deferred exchange. Far too often their exchange has already been ruined. When it comes to Section 1031 of the IRC, there is precious little forgiveness to be found. 1031s are not for the DIY crowd, at least in my professional experience. Jeff: Thanks so much, Bill. You’ll probably never know how many investor’s you’ve helped here with your answers. Bill: Your welcome, Jeff. It was my pleasure and a lot of fun. Connect Bill via his BiggerPockets profile or through his company, Exeter 1031 Exchange Services.