SW Financial Literacy
1031 Exchange: Fortune Maker or Big Mistake?
A Big Mistake?
Marcus won the private bid to buy farm ground that was close to the headquarters of his operation. He was able to get it under contract with a closing date set for 60 days out. He didn’t have the money or financing options to buy the ground outright, so he planned to complete a 1031 exchange to buy the property that was closer to home.
Not wanting word to get out that he was going to be buying this ground, he mentioned another farm he wanted to sell for the 1031 to several ag realtors, but requested they keep the sale quiet and not market it publicly.
(This happens a lot for all types of real estate and is called a ‘pocket listing’. Realtors won’t make a listing public but will make calls to their most regular buyers to see if they can get someone to commit to buying the property. This is exactly why you should network with realtors; frequent buyers get deals no-one else knows about!)
The ground being sold was his lowest quality ground and biggest farm. Knowing his finances were tight, the asking price was at the top of the market.
Interest in the property was poor due to the outrageous asking price. After 30 days, he had no choice but to publicly list the farm and pay a higher commission to the realtor. Time was running out and he was in jeopardy of losing the farm he was going to buy.
With only 20 days left, the only offer was 30% below asking price. After trying to negotiate and meet part way, the offer wasn’t changed and Marcus had no choice but to sell the ground at a 30% discount from the original listing. The sale of his ground and purchase of the new ground were able to be completed simultaneously on the same day.
What did Marcus do wrong?
·        No flexibility with the timing of his purchase
·        With tight financials, alternative buying options weren’t available
·        Keeping his offer quiet, then keeping it quiet for too long
·        Too high of an asking price
·        Low quality properties are less desirable and can lose value faster
·        Big farms eliminate potential buyers
·        No network to help him out of the trap
·        1031 deadline worked against him; he couldn’t negotiate, and the other party knew it
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Fortune Maker
Bill is a retiring farmer who is moving on from premium farm ground that he bought in 2010. There was a large amount of equity gained from the past 14 years, but the returns (2%) weren’t sufficient based on the value of the land. He decided to put the equity to better use by buying a stable commercial property with much higher rental returns annually (9%).
Bill was able to get the commercial property under contract with a closing date that could be extended for several months if he chose. This gave him flexibility with the timing of the asset being bought, so he never had to start the 1031 exchange ‘clock’.
As mentioned, the farm Bill was looking to sell was highly improved and one of his best. This property has realized the most equity gain since he had bought it and therefore made to most sense to move on from and capture higher returns. Better assets tend to hold their value better and appreciate quicker.
After his farm was listed at the top of the market, interest was slow. This wasn’t a big concern of Bill’s, since he was 100% certain he would be able to get the farm ground sold with just a 10% discount. He began exploring other options to complete the transaction without having to accept a discount on his farm.
In his career Bill built a great network influencers and had worked with other investors on several of his projects. He struck a deal with one of them and was able assign the commercial warehouse contract to a 3rd party to complete the purchase. Once he finds a buyer willing to give him the price he wants on his farm, he will complete a 1031 exchange with his partner and own the property he originally wanted.
What did Bill do well?
·        Appreciation by owning a high-quality asset
·        Identified higher returns available
·        Diversified by switching asset classes
·        Flexible closing terms didn’t back him into a corner
·        Network of wealthy partners gave him options
·        Creative transaction through assignment of contract
·        Long runway on selling his asset to get the premium he desired
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Finally, here is what ChatGPT has to say about the pros and cons of the 1031!
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A 1031 like-kind exchange is a powerful tax strategy that allows investors to defer paying capital gains taxes on an investment property when it is sold and replaced with a similar property. However, it comes with both advantages and drawbacks. Here are some pros and cons:
Pros of a 1031 Like-Kind Exchange:
Tax Deferral:
The most significant benefit is the deferral of capital gains taxes. Investors can defer paying taxes on the profits from the sale of the property, allowing the entire amount of the sale to be reinvested into a new property, which can accelerate wealth growth.
Leverage:
By deferring taxes, you may have more capital available to invest in a higher-value property. This leverage can increase your potential return on investment.
Portfolio Diversification:
A 1031 exchange allows investors to trade properties in different locations, property types (like from residential to commercial), or even types of income-producing properties, providing opportunities to diversify their portfolio.
Estate Planning Tool:
If you hold the property until your death, the capital gains taxes can be eliminated through the step-up in basis provision. Your heirs would inherit the property at its current market value, significantly reducing their tax liability.
Preserving Cash Flow:
Instead of paying taxes on the sale, you can reinvest that capital into another property that may provide better cash flow or higher long-term returns.
Control Over Timing:
Investors can choose when and how to structure their exchanges, allowing them to time their transactions according to their financial needs or market conditions.
Cons of a 1031 Like-Kind Exchange:
Strict Deadlines:
There are strict timelines you must adhere to:
You must identify a replacement property within 45 days of selling the original property.
You must complete the exchange (buy the new property) within 180 days of selling the original property. If you miss these deadlines, you could lose the tax-deferral benefits.
Like-Kind Requirement:
The properties exchanged must be "like-kind," which, in the context of real estate, generally means they must be of the same nature or character (e.g., both must be investment properties). There are exceptions, but the requirements can limit the types of properties eligible for the exchange.
Complex Rules and Paperwork:
A 1031 exchange involves a lot of detailed paperwork and compliance with IRS regulations. This can make the process more complex and time-consuming compared to a regular sale.
Depreciation Recapture:
While capital gains taxes are deferred, depreciation recapture taxes (taxes on depreciation deductions you’ve taken during ownership) may still apply, and the deferral of this recapture could result in a higher tax burden down the road.
Potential for Reduced Flexibility:
You are required to reinvest the proceeds from the sale into a new property that meets the 1031 criteria. If you don't find an ideal replacement property, you could be forced into a less-than-optimal investment.
Limited to Investment Properties:
The 1031 exchange only applies to investment or business properties. It doesn’t work for personal-use properties, so you can’t use it to exchange a primary residence or vacation home.
Fees and Costs:
There are costs involved in a 1031 exchange, including intermediary fees (for the qualified intermediary handling the exchange), legal fees, and possibly other professional service fees. These can add up and reduce the overall benefits of the exchange.
Risk of "Swap" Tax Trap:
If the new property you acquire isn't of equal or greater value to the one you're selling, the IRS may consider it a "boot," which could trigger taxable gains.
Conclusion:
A 1031 like-kind exchange is an effective tool for investors who want to defer taxes and reinvest in new properties, but it comes with strict timelines, complex rules, and specific limitations. It works best for those with long-term investment goals who understand the technicalities of the exchange process and have suitable replacement properties lined up. It’s important to weigh the benefits against the potential drawbacks before moving forward with a 1031 exchange.
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Have a great day!
Grant
