1031 Exchange - Commercial Real Estate Perils to Look Out For

Ah.... The joys of successfully completing the 1031 down leg (successful sale of your relinquished property).

You breathe a sigh of relief and go on a vacation. You think " I have earned this! " While this may or may not be true the joy of your property being sold quickly wears off when you have the 45 day clock winding down to select 3 replacement properties.

Now selecting 3 properties is not the only way you can do an exchange but it is the most common and generally the choice most 1031 investors use so for purposes of this article I will focus on that.

As a commercial principal broker and investor I get contacted often from potential clients wanting me to find their 1031 commercial real estate replacement property. 

The 2 biggest issues that come up again and again are:

1. Poor planning. The investor has no idea or game plan for what to do with the 1031 funds sitting with a 1031 exchange company in an escrow account.

2. Procrastination. The investors think "I have 45 days to find something. That is plenty of time!". Those 45 days will go by so fast it will seem like a week. You see when I do a purchase and sale we try for business days in a contract. This way holidays, weekend days are not generally counted. With the IRS the 45 days are calendar days and there are NO EXCEPTIONS.  

To fix the the 2 main issues above you need a STRATEGY.

Before even selling your property to buy another for a 1031 you need to be thinking of what kind of replacement property or properties you are searching for. Then you need to look at the positives and negatives of each asset class to determine which ones you believe you like and have merit.

At this point you also need to be thinking about what conditions if any you will be placing on the sale of your property. You could put in a clause saying that you will only sell your property once you have found a suitable replacement property or properties to purchase. The downsides to this is that it may turn off a buyer knowing if they put time and money into performing due diligence to buy your property it may go nowhere. The other negative is generally when you find a replacement property then the first question asked by the seller or listing broker is " Has your property sold yet and are the funds sitting with a QI in a 1031 escrow account? "

This question is asked to see if you have already sold your property and also to hopefully make sure that since the money is sitting with a 1031 company you have not messed up the 1031 protections for your tax liability. A seller knows if you have not sold your property yet then your sale of your property could fall out which means you likely cannot purchase their property under contract and also that if you touched the money instead of giving to a 1031 company your tax liability shield is now likely gone.

With 1031 funds you ARE NOT at any time to touch the money. It should directly go to the 1031 company designated escrow account. If you are even pondering the sale of your property and doing a 1031 you need to be contacting 1031 companies and asking questions ahead of time. You also need to be talking to your tax accountant and your attorney. Remember that attorneys are NOT generally tax professionals.  

I saw one instance before where an attorney was contemplating telling their client to possibly not do an exchange because they believed the return should be higher. In a perfect world and situation we all would but sometimes life isn't that easy! The attorney was looking at only a 20% base capital gains rate. They were not thinking and didn't even know about the almost 4% medicare tax, a state 11% imposed tax, and depreciation recapture which was substantial. This person would have lost most of their 1031 exchange money over 7 figures due to bad advice from an attorney. This all goes back to people that do not have an understanding of certain things should not be giving bad advice/suggestions to their clients! 

Now that you have determined how you want to sell your property and performed some preliminary research it is time for the next steps. While focusing on the sale of your property you need to find a competent commercial broker for the purchase of your replacement property. You seek out specialists in your chosen asset class to 1031 into       ( retail, office, large multifamily, industrial, warehouse, etc.).  You are checking for example if you want a certain quality and cap rate how often does that come up? For instance if you want retail strip centers at a 7.5 to 8 cap in Georgia in the 5 million range and you are asking the broker does this come up 1,2,4 times a week or once a month? That lets you know supply and demand of the market you are choosing to invest in.  If product is more scarce you cannot wait around to act when a great property is found especially with a 45 day selection window for your 1031.

Some investors like to diversify risk by purchasing 2 properties out of the 3 selections. So if they are exchanging say 2 million and they want to buy a 3 million and a 4 million dollar property instead of one 7 million then the 1031 gets more complex.

You have 3 properties to select. A common mistake is thinking this property looks good with the flyer I will select it as a choice and move on to the next selection. What could go wrong after I have made it my selection and the 45 day ID period has closed? EVERYTHING!

You see when I work with a client my strategy is to use an LOI with a confidentiality agreement built in. I want to see all the reports from the owner of a property. Financing kills deals and I am looking for any major issues before selecting the property as a choice to lock in. Minor issues can be handled while under purchase and sale agreement to get to closing. Common issues are the numbers presented are not accurate by the seller and they are not counting proper underwriting items against verified incomes for the property. You do not want to do minimal up front diligence and choose as a selection and go to purchase and sale to find out massive issues. Now you either have to take a whopper of a tax hit not doing a 1031, purchase one of the other selections ( they could be just as bad with not conducting proper due diligence in the beginning ), or purchase the property with diminished returns.

If that situation happens likely more down will be needed and required by the lender to get a loan as the numbers were worse then they thought. If you are unable or unwilling to put in more money to add to the 1031 funds sitting in escrow to buy the property you are in trouble.

When you make your 3 selections you want to feel really good about your chances of a successful 1031 outcome buying your replacement property or properties.

I hope this article has helped shed some light on the 1031 process buying a commercial replacement property.

This article is not meant as legal advice of any kind and the information is general in nature. 

All the best.

Joel Owens