Exchanging properties is a good way to invest in real estate, while deferring capital gains taxes way into the future. It’s called a 1031 exchange. But the rules are that substituting one property for another has to happen within a tight timeframe. What if something goes wrong with landing that second, replacement property? Are you stuck? For an answer, we turn to Stephen Nelson,a wealth manager at Aldrich Wealth in Carlsbad, Calif.
Larry Light: Should that second leg of the swap deal go wrong, and the plan to bag the replacement property collapses, you’re screwed. So you might have to snap up a building you don’t want, simply to avoid paying taxes on the place you just sold. Tell us what you can do.
Stephen Nelson: First, let’s look at how these swap deals are done. The 1031 exchange is a great tax savings maneuver.You sell one appreciated property and purchase another “like-kind property” without realizing the capital gain, which is deferred. This is done for a multitude of reasons, such as if the owner wants to move their investment property from one location to another or exchanging a single property in an expensive area to multiple properties that offer a higher cash flow.
The problem is that the replacement property can only be purchased after the original property is sold. Furthermore, this second property must be identified within 45 days and the acquisition completed no later than 180 days after the sale. What if you found a great new property, but then by the time you are able to sell your original property, the new property isn’t available anymore? You may then be forced to take a less than desirable property just to stay within the 180-day window.
Light: So what can you do?
Nelson: Go for what’s called a reverse 1031 exchange. It’s more technical, but with the right partners, it can be done.Today In: Money
Light: How exactly is this accomplished?
Nelson: The initial step is finding the property or properties that you would like to exchange into. To stay within the 1031 exchange rules, you can’t own both properties at the same time. To solve this, you’ll have to work with a bank or trust company. A new limited liability corporation, or LLC, will be opened, and owned by the bank or trust company for the 180 days. The LLC purchases the new property, allowing you to list your old property for sale. Once sold, you then buy the new property from the LLC.
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In summary, the “reverse process” is like a normal 1031 exchange but with an intermediary first purchasing the replacement property.
Any expenses the LLC incurs during this process can be grossed and then capitalized. Keep in mind that, like a normal 1031 exchange, the full proceeds from old property need to be invested including equity and debt, otherwise you’ll be exposed. The 1031 exchange is based on the total fair market value of property, not the value of your equity. So you have to have the same equity and same amount of debt.
Light: Are there any hurdles one would have to be prepared for?
Nelson: Since timing is everything and sometimes you have to act quickly to take advantage of the right property, you’ll want to make sure you understand that it can take a bit of time to set up the LLC. Typically this can take up to two weeks but the process can be accelerated usually within 24 hours for an added fee of a couple of hundred dollars.
The second hurdle has to do with financing. If the investor will be buying the new property with cash, then the process is straightforward. If the investor will be utilizing some debt on the exchange, then it’s important to work with the loan officer early. Some banks won’t finance a reverse exchange be sure to work with a trusted partner who will.
You likely will have to pay more than you would for a straight swap. A normal 1031 exchange could run you around $800 to $1,000, but due to the added complexity of a reverse exchange, expect costs to be in the $5,000 to $6,000 range.
