How to Avoid a Failed Exchange Due to Replacement Property Issues
Why Tics & Dsts Are Great Backups
One of the most common reasons 1031 exchanges fail is because of issues relating to the acquisition of suitable replacement property. What if I can’t find suitable replacement property for my 1031 exchange in time? What if my selections fall through after the 45 days? Can I change my identification? We get questions like this all the time. With the proper precautions, these risks are easily avoidable and TIC properties and Delaware Statutory Trusts can be useful tools to help protect from the risk of paying the tax. If you’re not sure what a TIC or DST is there’s an overview of each at the bottom of this article. When exchanges fail (about 15% of them do), it’s often due to issues with finding/acquiring the replacement property. In this article, we review some of the most common and how to avoid them.
Steps For A Successful Exchange (The Earlier In The Process The Better):
- Clarify your investment objectives
- Determine which types of investments best accomplish your objectives
- Establish at least general investment criteria (lease duration, tenant profile, geographical restrictions, etc.)
- Find specific properties that meet investment criteria
- Perform due diligence
- Tie up properties early
- Close within the allotted time period
MISTAKE: Failure To Identify More Than One Property By The 45Th Day
Why Does This Happen?
- Exchangors sometimes place too much confidence in their primary selection. There are many unforeseeable circumstances that can put exchangors at risk of paying the tax: financing issues, fickle sellers, boundary issues, or an inspection that turns up some unexpected complication.
- Exchangors treat the 1031 process like purchasing a house….looking for ages until they find the perfect property. This may work if you’re early in the process and your 45-day period hasn’t started yet.
- 45 days isn’t a lot of time! Sometimes it’s simply the short timeline that puts exchangors in a pinch
- Hot market or limited supply of suitable options
- Too restrictive or unrealistic investment criteria
- Not establishing investment objectives and desired investment criteria prior to the sale can waste valuable time.
How Can It Be Avoided?
- If you’re using the 3 property rule, then always use all three selections. Even a “sure thing” can fall through and it’s not putting your hard-earned equity at risk.
- Determine investment objectives and desired investment criteria as early in the process as possible. If you’re not sure how to approach this, talk to one of our 1031 advisors!
- Begin looking at replacement property before you close on your sale
- Identify as you go along. Many exchangors don’t know you can change your identification selection as many times as you’d like up until midnight on your 45th day.
- Use a TIC or DST as a backup! They’re “inventory off the shelf” with a simple acquisition process and, regardless of your investment objectives, acquiring a property that provides passive monthly cashflow is much better than paying unnecessary taxes.
MISTAKE: The Property (Or Properties) Identified Becomes Unavailable
Why Does It Happen?
- Exchangors identify properties they don’t have under contract.
- Exchangors overestimate how quickly the 45 days go by and wait too long to begin narrowing the selection
How Can It Be Avoided?
- Once you have found a solid option, get it under contract! Many exchangors are nervous to be this aggressive but we strongly suggest tying up legitimate options before your ID period is over. It’s harder to lose the property if you have it under contract!
- Use a TIC or DST as a backup! Broken record here, but as long as it’s communicated with the sponsor to ensure there’s enough ownership interest still available left in the property, it’s a reliable backup. With certain stipulations, many sponsors will allow exchangors to reserve a stake in their deals. Again, regardless of your investment objectives, acquiring a property that provides passive monthly cash flow is much better than paying unnecessary taxes.
MISTAKE: Failure To Acquire Identified Property By The 180Th Day
Why does this happen?
- Exchangors haven’t done enough due diligence on their selection before the 45-day period is over. Even if a property is under contract during the 45-day period, the due diligence process may uncover something that makes it the acquisition undesirable, for example, a title or boundary dispute, or an environmental issue.
- Another reason a post-identification property may not close is the failure to obtain suitable financing.
How Can This Be Avoided?
- Do everything earlier in the process. The suggestions already provided will help avoid the pitfalls of not acquiring property within the allotted timeframes.
- Leveraged TIC/DST properties already have the financing in place allowing even those needing debt replacement to benefit from their“plug-and-play” nature.
- Hopefully, by now it is clear why TICs and DSTs are such valuable tools so commonly used to protect from a failed exchange. In the event of unforeseen obstacles that prevent exchangors from acquiring their primary selections, it can be a major relief to have a surefire option that can bail a taxpayer out from having to pay what can be a significant tax liability.
No one wants to pay capital gains tax on a failed exchange. The safest course of action is to actually close in the 45 days following the closing of the relinquished property, thereby eliminating the chance of a failed exchange. The IRS does not even require identification of replacement properties if closed within 45 days. TIC/DST properties can be closed within a matter of days. If you are approaching the end of the 45-day identification period without a suitable replacement property, it certainly makes sense to identify a DST/TIC property.
Regardless of where you are in the process if you’d like assistance with finding suitable replacement property, please talk with one of our 1031 advisors.
More Information About TIC Properties
A TIC (Tenant in Common) property is deeded, fractional ownership interest in real estate. The basis of TICs popularity is the low minimum investments of most TIC properties. They can be as low as $50,000 thus providing exchangors in smaller (<$1M) exchanges access to investment-grade real estate. Typical TIC properties feature net leases with Fortune 500 tenants with the advantages of longer-term leases (often as long as 10-15 years) and strong corporate tenants that are responsible for the property's taxes, insurance, utilities, maintenance, and upkeep. This leaves investors with a very passive role. Returns are predictable as they are based on the lease and are guaranteed by the tenant. This provides consistent, steady monthly income that is simply direct-deposited in exchangors' bank accounts each month. TIC properties are available through 'sponsors' (such as our sister company Realtynet Advisors) and because of their inventory-like nature, they have the ability to acquire and close on demand.
More Information About DST Properties
As the name Delaware Statutory Trust or DST suggests, a trust under the state laws of Delaware owns the property and in turn, each exchangor/investor owns a fractional interest in the trust. Similarly to TICs, DSTs give exchangors access to institutional-grade real estate they wouldn't otherwise have access to. One of the primary benefits to a DST is that they are completely managed by the 'sponsor' and thus completely passive investments for exchangors. The other primary benefit is that multiple properties can be held in the trust which can provide security through diversification in a single investment. Also like TIC properties, DSTs are available through sponsors and can be acquired close very quickly and easily. Many DSTs have built-in financing so for exchangors with debt-replacement requirements in their exchange can satisfy their debt needs by simply acquiring their pro rata share of the debt without the hassles of having to procure financing on their own. All-in-all they're another great on-demand exchange solution.
We'd love to guide you through the 1031 process, let us know how we can help!