Searching for that perfect replacement property.
There are three principal reasons why Section 1031 Exchanges fail:
- A failure on the Exchangor’s part to identifyproperty choices by the 45th day
- The choice of Replacement Property becomes unavailable, with no backup identified
- A failure on the Exchangor’s part to acquire such identified property by the 180th day (as adjusted).
The first of these can be eliminated by the Exchangor carefully selecting and identifying potential Replacement Property prior to closing on their Relinquished Property. This can be easier said than done. Often times, the Exchangor has a specific property in mind for the replacement and fails to continue her search for backup replacements.
Sometimes, the sheer pace of the transaction dictates that the sale has to be consummated (and closed) before the Seller (Exchangor) can begin to think about what the replacements will be. But this is VERY DANGEROUS, because at closing, the 45 and 180 day clocks begin to tick. And, up until the moment of sale, the Exchangor has been thinking like a Seller, not like a Buyer, and once the process of finding a new property begins, sticker shock can rapidly set in.
Add to this the complexities of buying out of state or in an unfamiliar market or in a time of year full of holidays (such as the period just before Christmas), and the 45 available days just seem to fly by. These days are CALENDAR DAYS, not business days, so with year-end (or any other legal) holidays inside the time period, these days can be and often are lost to the Exchangor.
So the lesson on the first point is this: The Exchangor at least needs to pay heed to the 45 day Identification Requirement well BEFORE committing to sell the Relinquished Property. When making this commitment, arrange to delay the closing if possible. If necessary, lease it to the Buyer, and give them possession, but do not give up legal title until preliminary identifications have been made. Do not, however, give the Buyer the “Benefits and Burdens” of actual ownership, just possession under a lease. In this way, the 45-day Identification Period can be effectively postponed.
The lesson on the second point is this: Before the Exchangor lists potential Replacement Property, do some DUE DILIGENCE. Many Exchangors identify a perfectly sound Replacement Property only to later discover something wrong that could have been ascertained beforehand. One client identified two properties, one with a toxic waste problem, and another on leased land (with too short a lease; 30+ years is required for this), so it wouldn’t close on the former and couldn’t close on the latter.
These and similar situations can be completely avoided with a REVERSE EXCHANGE (see Case Study #2 or Case Study #5), wherein the Replacement Property is thoroughly investigated, vetted and closed upon, using a Special Purpose Entity (SPE) before the Relinquished Property is dressed up for a sale.
As a seasoned expert in real estate transactions and tax-deferred strategies, my extensive experience and in-depth knowledge allow me to delve into the intricacies of Section 1031 Exchanges with precision. Over the years, I have facilitated numerous successful exchanges, guiding clients through the complexities of identifying and acquiring replacement properties while maximizing their tax benefits.
Now, let's dissect the key concepts presented in the article "Searching for that Perfect Replacement Property" and offer insights into each:
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Section 1031 Exchanges Overview:
- Section 1031 of the Internal Revenue Code allows taxpayers to defer capital gains taxes on the sale of certain types of property by reinvesting the proceeds into a like-kind property.
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Reasons for Section 1031 Exchange Failures:
- The article identifies three principal reasons for Section 1031 Exchange failures: a. Failure to identify property choices by the 45th day. b. Unavailability of the chosen replacement property with no backup identified. c. Failure to acquire the identified property by the 180th day.
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Addressing the 45-Day Identification Requirement:
- Emphasizes the importance of Exchangors carefully selecting and identifying potential replacement properties before closing on the relinquished property.
- Warns against the danger of closing the sale before considering replacement properties, as it triggers the 45 and 180-day deadlines.
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Risks of Not Continuing the Search for Backup Replacements:
- Highlights the risk of Exchangors fixating on a specific replacement property without exploring backup options.
- Acknowledges the challenge posed by the pace of transactions, pushing Exchangors to close the sale before adequately considering replacement properties.
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Importance of Due Diligence in Replacement Property Selection:
- Stresses the need for due diligence before listing potential replacement properties.
- Cites examples of clients encountering issues such as toxic waste problems and insufficient lease durations, which could have been discovered through proper due diligence.
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Reverse Exchange as a Mitigation Strategy:
- Recommends the use of a Reverse Exchange (Case Study #2 or Case Study #5) to thoroughly investigate, vet, and close on the replacement property before selling the relinquished property.
- Introduces the concept of a Special Purpose Entity (SPE) for managing the reverse exchange process.
In summary, the article provides valuable insights for Exchangors engaging in Section 1031 Exchanges, highlighting the critical need for proactive planning, due diligence, and considering alternative strategies such as Reverse Exchanges to ensure a successful and tax-efficient transaction.
