You might want to read this article first: The 1031 Exchange - "Swap till you drop", The Basics
The Ninja's Arsenal – Advanced 1031 Exchange Strategies
A confession: my first 1031 exchange had me so stressed out I almost gave up. I was a wreck touring property after property feeling like I had a gun at my head (or wallet). I was hustling to process paperwork and at every turn sweating that I was going to make a mistake. It was a tough 45 days.
Fast forward through dozens of successful exchanges, and I now look forward to every exchange as an opportunity. I’ve got a process, that I’m about to explain.
You, the savvy investor, are about to become a like-kind ninja.
Disclaimer: This article is for educational purposes only. Consult qualified tax and legal professionals before implementing any strategy.
A: Time Is Your Ally: Start Early, Plan Smart
More time is like a head start on a treasure hunt. Get going early to find more gold.
Specifically,
Begin identifying new properties while your original property is under contract. "All cash, quick close", usually great for a seller, can often be a disadvantage since it shortens the time during which you can look for replacements. The earlier you begin your search, the better.
Negotiate an option for an extension on your original property to give yourself more flexibility.
Include specific 1031 cooperation clauses in your purchase and sale contracts, so that all parties know and agree to the process. That language is shown here.
Assemble your team before you need it. Include: brokers, banks, inspectors, surveyors, contractors, lawyers.
B: Property Selection: Think Differently
To get the best fish, cast a wider net.
Think bigger. Search for properties up to 5x the size of your available equity, more than you can afford using just your exchange money. Why? That might be where that once in a generation real estate asset is priced.
Look at alternatives. For example, oil and gas royalties qualify as like-kind real estate. With these high yield assets, you never get a late-night tenant phone call – just fat checks straight to your mailbox every month.
Cautiously consider “net leased investments”. These are properties typically rented by popular retailers like Starbucks or Walgreens. Because these companies have their own property management, they pay all the expenses including maintenance, taxes and insurance. They are consistent profit makers and extremely low hassle, but as a result, are often overpriced.
C: Navigate The Financial Landscape
Consider how much debt you can put on your replacement property – not just at close, but in the following tax year. Let's say you owned your original property all cash and get $1,000,000. You can buy an apartment building for $1,000,000 cash, and take out $700,000 in debt the next year, tax free. Or you can buy land all cash and get…no debt.
Pay your legal fees through your escrow agent rather than directly to the law firm. This ensures you can deduct them from your exchange.
Understand boot: If you spend less than your replacement amount, that leftover is called the "boot". You'll pay taxes on this amount. Depending on what you list on your ID form and what you close, you’ll usually get this money at either 45 days or 180 days.
D: Embrace Flexibility on your 45 Day Identification Letter
Always list three properties on your identification form. While it might delay receiving any boot, I’m constantly reminded that anything can happen in real estate. A few years ago, I discovered an old strip-mining dump pit next to my replacement property – 3 days before close.
If you don’t have 3 properties at the deadline, list a DST on your form, which can be closed quickly and easily as a backup.
Consider listing more than 3 properties. Note: a) the combined value of the listed properties must be less than 200% of the value of your original property, or b) you must acquire 95% of the value of the listed properties. The first option works if you are still narrowing your options on day 45, the second almost never applies.
E: Advanced Exchange Techniques
Consolidate multiple gains into single investments. To do this, you will designate a percentage ownership on your replacement property ID form. For example, your first $300,000 sale lists 33% ownership in an apartment building, and your $600,000 sale a month later designates the remaining 67%.
Or: Break one large 1031 and into smaller properties to diversify.
Understand your options beyond a vanilla 1031 exchange.
Found a property that needs some work? Use an improvement exchange.
Found the perfect property but haven't closed yet your first? Use a reverse exchange, where you can flip the timeline.
Don’t want to be involved in day-to-day management? Understand DSTs, Delaware Statutory Trusts. Note: returns might be lower.
Want diversity and potential liquidity? Look into UPREITs, Umbrella Partnership Real Estate Investment Trusts. Note: returns might be lower.
All options are still subject to 1031 timelines.
The Ninja’s Wisdom: Key Considerations
State Tax Implications: Understand the state tax implications of exchanges. California has claw back provisions for some sales. Pennsylvania used to ignore exchanges completely. Know your state's quirks.
Allowed Property: Remember to buy and sell actual US investment property! That means – no primary or vacation homes, no quick fix and flips, no REITs, no related party transactions, no foreign real estate.
Gain to Investment Ratio: If your gain is less than 30%, you should consider Opportunity Zones (OZs) or simply paying the tax. The bar for your replacement property should go higher as your gain is smaller, since you must tie up a greater amount to protect the same gain vs OZs.
Gain vs. Investment Ratio: You might have a taxable gain even if you are selling for less than you paid, due to depreciation.
Paperwork matters: Submit your identification letter early and replace later if needed. Weekends count towards your days. Your qualified intermediary can be extremely helpful if you have any questions.
Understand these principles, and you’ll soon find yourself looking forward to your next exchange.
1031 exchanges can often be combined with other tax strategies. In our next article, we will introduce 10 more tax concepts that, once you learn how to use them, will multiply your tax savings. Think of it like strategies to get a hyper efficient engine, so you can get even more mileage out of every bit of your resources.