When a 1031 Deadline Drives the Deal, What Will You Not Compromise On?

Question

A 1031 exchange can solve a tax-timing problem, but the deadline can also create an underwriting problem.

Consider this hypothetical situation:

An investor sells a rental property and has approximately $300,000 of equity to reinvest. On day 38 of the identification period, the best available replacement property has:

• A 5.75% cap rate

• 65% leverage

• A significant lease rollover within 18 months

• Less operating reserves than the investor would normally require

• A projected return that depends on optimistic rent growth

The pressure to identify something is real. Nobody wants to lose a potential tax deferral after beginning the exchange.

But I think the most important question is this:

Would you buy this property if there were no 1031 deadline?

When evaluating a replacement property, I would be careful about relaxing standards in these areas:

1. Current cash flow, based on actual income and realistic expenses

2. Debt terms, maturity risk, and sensitivity to refinancing conditions

3. Tenant, lease, or occupancy concentration

4. Capital expenditure needs and operating reserves

5. The assumptions required to make the projected return work

6. The ability to hold through a slower market or unexpected disruption

The tax consequences matter, but they should be compared with the potential cost of owning the wrong property. A disappointing investment can be far more expensive than the taxes an investor was trying to defer.

Every situation is different, so investors should involve their qualified intermediary and tax adviser early. From an investment perspective, however, I believe the property still needs to stand on its own.

For those who have completed a 1031 exchange, what underwriting standard did you refuse to compromise on? Have you ever decided that paying the tax was preferable to forcing a replacement-property purchase?

Dave Foster · Answer

@Dan Handford  I completely agree; investors should never 1031 into a poor property for the sake of deferring the tax. I also think that what one investor would call non-negotiable to walk away from a deal, another will call an opportunity. I think it's relative to the investor and their circumstances.

1031 exchanges can feel restricting because of the time frame requirement, but there is no penalty for not completing a 1031. Seasoned investors will keep the 1031 option available by starting it. But if the market doesn't look good,  dont put anything on your identification list and let your exchange die on day 46. You would just pay the tax like you would normally, but it prevents you from making bad investment decisions and feeling the stress of buying the property you shouldn't have

Identifying properties before your relinquished property is even sold will relieve some pressure of looking within you 45 day identification period. And if you find a property you really like, you could even get it under contract before the sale of your old property; you just can't take title to it until your relinquished property is sold. This is just one of the many things investors can do to make the process smooth and successful.

Dan Handford · Answer

Alex, I agree that location and asset quality can justify accepting less immediate cash flow, provided the investor has adequate liquidity and realistic operating assumptions. Dave, your point about allowing an exchange to expire is important. Tax deferral should remain an option, not become a reason to accept a replacement property that fails the investor's normal standards. Starting the property search before closing also creates more room for disciplined underwriting.

Alex Olson · Answer

I would not compromise on location. Breaking even today on a class a or b location in the suburbs in a place like KC is acceptable. I have never heard anyone complain about investing in these locations.