What is the best way to perform a 1031 in this market?

21 Replies

Another post about not being able to find a property with only 10 days left in a 1031 prompts this question.

In this current market, what is the best way to perform a 1031 Exchange successfully? Do you sell and hope you can find something else in the allotted time? Do you hold off listing your property until you find something first? Do you continue to hold and wait for a market change?

What steps can you take to give yourself the most chance for a successful Exchange?

@Mindy Jensen excellent question. DSTs can provide “1031 insurance” so to speak to ensure a successful exchange. Because DSTs are so modular and there are always multiple to choose from in inventory with zero closing risk they are a great tool to keep an exchange on track! 👍

Great Question @Mindy Jensen and worth a good discussion. I believe that first and foremost if the investor has flexibility, and sometimes the extra cash, the best way is to find your Replacement Property first, and then list your Relinquished Property. This can cause some headaches if you cannot manage to sell your Relinquished Property in time and you have to enter into a Reverse Exchange, so you need the cash to pony up for the Replacement Property first. However, as @Rob Pecha mentioned, a DST could be a savior for certain investors that cannot identify good properties. So while there are many ways to do a 1031, depending on each individual situation there can be different optimal strategies.

I just did the "sell and hope" method and while I did eventually locate 2 great properties and get them under contract, I found it was super stressful. 45 days is such a short period of time when you are trying to make a big investment decision. 

One key thing that I did to maximize my chances of finding a good property was to start shopping in my target area well before my sale closed. I made some key contacts, got the word out that I was looking for properties, and had several off-market deals sent to me by wholesalers and other investors. I also spent a ton of time trawling the MLS, Loopnet, and even Craigslist real estate ads. I did find a few lesser deals that would have worked out if I needed to dump the money somewhere, but I really wanted a specific mix of both forced appreciation and post-rehab cash flow.

The problem with identifying an exchange property first is that it puts you in the position of being a motivated seller and potentially needing to unload at a discount to make the deal work. It's one thing if you are sitting on a nicely rehabbed single family or duplex in a hot market and you can sell it in a weekend of open houses. It's another thing entirely if you are in a midwest class C 6-unit or own a specialty property that needs adequate marketing. It the other party in the deal wants to move quickly, this strategy has some real risk. 

I don't know enough about DSTs to comment on them, but if they are reasonably liquid they could be a nice place to stash cash while you continue to shop.

@Mindy Jensen , timely.  Here's how to make the best of things if @Jason Turgeon , sell and hope method doesn't work (BTW - jason - excellent diligent work on your part to make it happen.  You didn't just sell and hope :) 

From an email conversation today .  
1. Don't turn in your 45 day list. Your exchange dies on day 46 and you get your proceeds but the tax will be due next April.

2. Take a shot at a couple properties and list them on your 45 day list. If they end up working great. If not then your exchange will die on day 180. You get your proceeds and the tax will be due. But because you will receive the cash i 2020 you won't have to pay the tax until April 2021. Your accountant will do this for you.

3. Take a look at an opportunity zone or find a couple DSTs or TICs that could accommodate you. The returns are actually competitive with what people actually get in the market (not what they think they get :). You continue to defer your tax and still get to continue depreciating the asset as a tax break.

Note that the 2nd strategy has a timing factor built in - it will only work if your exchange starts in one calendar year and ends in another calendar year.

@Mindy Jensen but of course that was only part of your question.  the rest is what do you do when the market is against you.  Here's another snippet from an email conversation today:

...Here's the single biggest problem with the 1031 exchange. The best time to sell and start an exchange is also the worst time to have to buy to complete an exchange. And the best time to purchase properties to complete your exchange is the worst time to be selling your property to start an exchange. 

You're stuck with the market But there are some things you can do to mitigate that situation. A reverse exchange is certainly one of them. But it has it's drawbacks too...Here's some other things that our clients will do to mitigate the time crunch without doing a reverse.

1. Go into contract for their purchase before the sale occurs. The statutory order of the 1031 is that the sale must happen before the purchase. But you can go into contract on your purchase at any time. So you can go into contract before your old property closes. Or even before your old property contacts if you want. You can always try to get the sale of your old property to go though before your purchase. But a few weeks before you have to take title you can decide to switch to a reverse exchange with no problem . Just leave enough time to get your financing in place.

2. Use contingencies. Sell your old place with a floating closing date contingent on finding a new property. Or buy the new property contingent on selling your old property (I know it's a sellers market but that doesn't mean this wont' ever happen). Maybe try to increase your earnest money. Or release some earnest money. There's all kinds of ways to entice a seller to wait for you.

3. You could negotiate a lease on the new property with an option to purchase it. Then you exercise the option once your old property closes.

4. Have a pocket listing in your back pocket as a fall back. Or use a commercial fractional product like a TIC or a DST as a fall back.

5. Or just let your exchange die. There is no penalty for starting and not completing a 1031 exchange. All it costs you is the exchange fee. But the IRS doesn't ding you at all. So start the exchange and go for 45 days. If you can't find a good property then dont' turn in a 45 day list and your exchange dies on day 46. You get your proceeds back and the profit is taxable. But you haven't been forced to buy a sub par property. And you're no worse off than if you simply sold and paid the tax.

@Mindy Jensen I'm surprised how often people run into this issue when they could have controlled the closing date on the sale. A great example is selling to a tenant. If doing that, I think nearly all of them would happily give you a delayed close until you opened escrow on the replacement. Similar to what @Dave Foster said on floating close. 

The Opportunity Zone is an interesting idea but has some major differences from a 1031. 

1. If you have a lot of depreciation recapture, the OZ won't do anything to help you
2. Remember you will eventually owe 90% or 85% of the cap gains taxes in 5 or 7 years and you will need to have that money available at that time
3. For estate planning, you (your heirs) won't be able to take advantage of the step up in cost basis available for 1031's

On the huge positive side for OZ, if the Opportunity Zone investment performs, you can avoid (not defer, AVOID) any cap gain taxes for the new appreciation if you hold at least 10 years. The other big positive is you can have immediate access to your cost basis so you can make a smaller investment in the OZ vs. having to go bigger than the existing sale with a 1031. Of course, be careful what you do with that released capital because you will need to pay the taxes in 2026 ...

@Mindy Jensen Sorry, much better answer. Use your status as a Biggerpockets (one word @Joshua Dorkin ) celebrity and do what @Brandon Turner does and tell everyone you meet, podcast to, etc. what you are looking to purchase. Given the reach of your platform, you should get plenty of opportunities coming to you and just pick the best one. If that doesn't work, tell Brandon he has 45 days to find a TIC for you to trade into with him or you will shave his beard. Two full proof options.

You guys are amazing and it is so great to see how many investors the BP platform helps. Thank you, thank you, thank you!

@Mindy Jensen

A lot of great answers here so I’ll just throw in a couple more that have not yet come up.

1. Shop for your upleg(s) as soon as you know that your downleg will close. If there are 45 days after contingency removal and you have 45 days to identify then you’ve really got 90 days.

2. Have a great relationship with the person buying your downleg. See if they will let you push close if you are really concerned about finding the upleg. I’m buying a property right now off market from a seller I have a great relationship with. He’s worried about replacement property and I said I’ll be flexible on close to accommodate.

3. Have friends/contacts who will let you TIC into their deals. This can be a great Hail Mary. In example 2 above I told me seller that he can TIC into one of my deals if he gets in a bind with his exchange. Knowing people who have active deals is critical for this.

4. Go into an opportunity zone instead of exchanging. The benefits coming out are great because there is no tax on the gains from the money put into the opportunity zone fund. Opp zones are also great for exchange boot that isn’t enough to buy a property with.

5. Have a large network with people who might be willing to sell so you get your exchange done.

Great topic right now! Great time to sell but not a great time to buy! So 1031s are tricky right now but entirely possible!

While I am a fan of 1031 exchanges in general and find them to be very strategically useful at times, I agree that the stress component isn't always going to be worth it.  It depends on your ability to find replacement deals and the amount of gain/recapture being deferred.  
Many investors, high W-2 earners who are in the suspended passive loss territory for their portfolio for example, will have suspended losses freed up to be deducted in the year that they report a capital gain from the sale of a rental property.  In these cases, it can be nice to finally start deducting some of those net rental losses that have been stacking up for years.  
So just because you have a large capital gain, it doesn't always mean that a 1031 exchange is needed to not pay new tax dollars to the government for the year of sale.  

Originally posted by @Lee Ripma :

3. Have friends/contacts who will let you TIC into their deals. This can be a great Hail Mary. In example 2 above I told me seller that he can TIC into one of my deals if he gets in a bind with his exchange. Knowing people who have active deals is critical for this.

Tell me more about this option 3, the TIC.

@Mindy Jensen The TIC (Tenants in Common) is a common strategy used by 1031 investors. It is where each purchaser owns a TIC interest in the property such as a 25% TIC interest. The TIC's then enter into a TIC Agreement on how to run the property. The IRS has issued a Ruling regarding what can and cannot be in a TIC Agreement. However, IT IS NOT A PARTNERSHIP! It should not be treated like a partnership or file a partnership tax return. There are downsides to TIC's - such as every TIC needs to agree to a sale of the whole property. So if your friend lets you in on a TIC you have the ability to torpedo his whole business plan (or vice versa).

They are a great way to use 1031 funds. 

@Mindy Jensen

@Michael Skoczylas explained it pretty well but I'll just add on my personal experience doing this. A Tenants in Common (TIC) is a way to hold title on a property. Let's say that you and I @Mindy Jensen decided we wanted to do a deal together but you wanted to 1031 exchange and I had regular money. We couldn't form an LLC to hold that property because it would invalidate your exchange. However, we could hold the property TIC. I'd own half and you'd own half (you can split any way you want, so it could be 70/30). Your exchange would only go into the part you own. We both own half of the property. I have to keep my own books for my half and you do that with your side as well. I've personally done this. I allow people to do this into my development deals in LA if they want to. I won't put the details here but it allows them to go into a deal with their exchange money when deals are hard to find.

@Mindy Jensen , There's quite a bit of confusion in the investing community over the acronym TIC. At it's simplest tic (tenants in common) is a way to own property. That's it!. If you own a property you are the tenant (you own 100%). If a married couple own a property they are probably "Joint tenants" (each deemed to own 50%). if two or more unrelated people own property they are "tenants in common" (their% of ownership is specified). A tenant in common owns actual real estate it just happens to be an undivided % of a larger property. You get a deed etc - you own property. This is why it qualifies for 1031 treatment. And is very common.

As a matter of fact it's the best way to own property from a 1031 perspective because when the property sells each tenant is free to do what they want with their % of the sale.  They can each do their own 1031.  Or they can stay together and 1031 the entirety.  Or one could do a 1031 and another take the cash and pay the tax.  Ultimate flexibility. 

Where there ends up being a lot of confusion is that there is an IRS blessed structure in Rev proc 2002-22 that lays out a safe harbor tenant in common ownership structure that is very syndication like. It restricts the number of investors, and creates other requirements like the unanimity of consent and management structure. This is a different animal although the ownership structure is exactly the same. A TIC structured to meet 2002-22 is much more "security like" and designed to meet the safe harbor of 2002-22.

But there are many ways to structure a tic like @Lee Ripma is doing. Or like me and my buddy Joe. Or three friends from church. As one judge said - "tenants is tenants". And you bet, TIC ownership can be a Godsend. Since this thread is about the best way to complete a 1031 in today's market let's go back once again to how to beat the 45 day clock. If you're running out of time you probably know a person or a group of people who would sell a % of their property to you to complete your exchange. It's not on the market but because you can take title as a tenant in common you can make your exchange work!

OK @Dave Foster , @Lee Ripma and @Michael Skoczylas .

I have a 1031, my 45 days are nearing their end. Can I "buy" into someone's TIC to park my money, then get out of it again when I find something I like better?

Could my other TIC's "buy me out"? Can I sell my portion to someone else to get out?

I'm not looking for anything illegal, just looking for clarification. Thanks!

@Mindy Jensen

You can always TIC into my deals Mindy! But seriously, here are some options if you can't find a property:

1. Find a partner who has something under contract that you can take your exchange into using a TIC. Then you'd identify that property as 1 of your 3. This can be a small piece of a big deal or a big piece of a small deal. The great thing is you get to set the %. Commercial lenders won't care that the property is TIC.

2. Find someone who will partner with you and your exchange using the TIC structure. Based on property value you will determine the TIC split. Identify this property.

3. Talk to your friends and see if they have a property they might be willing to sell you a portion of. Remember, this can be any portion, 21%, 50%, 63%, etc. So if they have a property they would sell a portion of then you can work out the right percentage and TIC into that percentage. I've actually never done this but I think it will work based on @Dave Foster comments. 

4. Buy into a Delaware Statutory Trust (DST). You go on title in these which is why it works for an exchange. I've never done this either but I know it's a common Hail Mary when you can't find an exchange property.

The DST option does the thing you are talking about with an exit where you can get out when you want to. The others I'm not sure how much you can mess around with the selling and such. Would depend on your partners. But you can go in fractional and come out fractional (TIC is fractional ownership). For those questions I'll defer to @Dave Foster

@Mindy Jensen Excellent Questions- and its getting us to talk about this - on 10/31 of all days. 

As far as TIC's go- if you want out, and use a TIC just to "park" your money to extend the 45/180 day deadlines the IRS might get you. One of the paramount rules of 1031 is that the property must be held for trade or business or investment purposes- this rule is dictated by intent. If your intent is just to extend the deadlines and save your 1031, you will have a problem. But if you can prove you intended to hold it for ToB or investment purposes, but something better came up, you are fine.

To exit a TIC you can always "unify title" and buy out the other TIC's OR you can be bought out by the other TIC's.

There are lots of ways to use TIC's to help with a 1031. @Lee Ripma I love your ideas- I would only caution in using the word "partner" when you are referring to the arrangements because it is one of the only limitations the IRS places on the TIC structure - it cannot be a partnership. I wish more investors offered TIC opportunities, it would make 1031's for the smaller seller much more viable. 

@Lee Ripma just to be clear the IRS only allows you to fractionally own real estate within the context of a 1031 in 2 ways — TICs and DSTs. Both had revenue rulings issued that make them qualify for the exchange. I prefer to work with DSTs because they are more user friendly in certain respects and they are non-recourse to the investor. Whether someone is tired of active property mgmt, in need of a Hail Mary backup or simply looking to fill in any boot left over, these can be a home run.

@Mindy Jensen , It's a fall back position.  But you don't want to use it simply as a work around for the time constraints.  Make sure that you're going into that purchase with the "intent" of holding for productive use.  If your intent is not to hold then 1031 is not available to you.  There is no statutory holding period.  Most folks feel comfortable with anything more than a year (there's some case law and revenue rules that come into play).  But there could always be reasons why a shorter or longer period might be justified.  Bottom line is it is your intent that matters.

And if your friends or the other TIC owners are willing to let you come in with an eye to possibly exit in a year or so then all the better.

Hello Mindy!  I don’t know if I can add to your answers but I’ll try.  This might be a common thought but I would try to buy at the optimum time that gives you the maximum time to get a 1031 done.  The hotter your targeted area is doing will effect your ability to do that.  Just try to locate in a hot/high demand/growth area.

Good luck to you!

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