The 1031 Exchange can be one of the most important tools in an investor’s investing career. One of the main benefits is to defer taxable gains. When you own a property over time you can typically take a certain amount of depreciation on the property depending on the asset type. Different asset types have different depreciation schedules. There is also bonus depreciation available currently (tax laws are ever changing so consult your CPA for the latest information).
To maximize wealth over time the 1031 can help roll depreciation recapture & capital gains into another property. If a property owner just sold and did not 1031 exchange the taxes in some states combined with Federal could be over 50% of your profit (gain)!! Talk about hampering wealth! That is why investors love the 1031 exchange as you can keep rolling into larger and larger properties with more NOI (net operating income) and cash flow and then leave to heirs at a stepped-up basis. This basically means all that depreciation recapture and many millions of capital gains taxes or more goes away and the heirs get the property at today’s value instead of the price when it was bought with the person that passed away.
So making sure a 1031 exchange is successfully executed is a very important component to real estate investing success.
During the process for a 1031 exchange, the main error I see with sellers is improper planning. They wait until their property is almost sold before taking any action. They do not often engage 1031 exchange companies so do not know how far in advance they need to reach out. When they finally reach out the sellers have already made mistakes with the timing of the sale of their property and many 1031 companies cannot take them on because of the back log of 1031 clients that reached out to them earlier in the process.
When potential 1031 clients contact me I tell them they need to plan in advance. I get them with one of our 1031 companies that are experienced right away. The seller needs to ask entity formation questions, if multiple partners are involved, or if it’s a trust, etc. There are literally hundreds of scenarios that can play out and one misstep can be critical in success or failure. Most 1031 buyers use the 3 property rule. That is where from the time of the sale of their property closing they have 45 days (ID period) to locate potential properties to buy. They could buy 1, 2, or 3 properties selected if they have they cash and they qualify with lenders. Typically my clients buy one because adding a second and third can be more difficult to coordinate. At NNN INVEST we have pulled it off before so it is possible if you start early in the process.
In today’s market the good STNL and MTNL properties go fast. About 4% of the United States population (around 14 million) are millionaires. That is a lot of money and a lot of buyers out there wanting to invest! So to have a chance at winning the game you need to have a great plan of action and execute it early. It’s just like a family reunion… if you do not get there early all the good food is gone and left with the less desirable food (properties) nobody wants….LOL!
TIP: When you put your property under contract to sell a good idea is to add a clause where YOU the seller can extend closing another 3 to 4 weeks at your discretion from the original closing date. The reason is you may not have found the optimal property to purchase yet and you want to have more time before your 45 day ID period starts.
When the buyer goes to place a Letter of Intent (LOI) on a property the seller is going to want to know a bunch of questions about the buyer and ask the buyers broker:Is the buyer in a 1031 exchange?
- Have they put their property up for sale?
- Is the property under contract?
- If under contract has due diligence period expired and buyer gone non-refundable with their earnest money?
- Has 1031 – 45 day ID period started?
The seller for the 1031 buyer wants to ask these questions before considering their offer. The seller usually only wants to engage a buyer to go under agreement if the property they are selling that buyer to has gone non-refundable with the earnest money OR the 1031 buyer is in the 45 day ID period. In those 2 cases the seller knows the chances of success and getting the funds to purchase are high.
With the 1031 buyer just putting their property on the market for sale, or just under contract, the seller knows they might not get the 1031 exchange proceeds money to purchase their property.
There is part art and science to having a successful 1031. A big mistake I see is buyers selling their property and then going on vacation with 45 day ID period started. They come back and then have 2 to 3 weeks left to ID a property. That is where mistakes can happen because now the 1031 buyer at all costs doesn’t want a failed exchange and owe a HUGE tax bill so they are willing to accept much less yield. Had they started the process earlier they might not be in that situation and then get a property with good returns AND keep the 1031 exchange intact.
It takes more time than people think to locate a good property, put in the LOI for agreement, negotiate purchase and sale agreement with attorneys, and conduct pre-due diligence in the LOI period to make sure the property looks good for financing and cash flow before locking in as a 1031 selection. Our goal at NNN INVEST is by the time the 45 day ID period is coming to an end the buyer is already in purchase and sale agreement with the property they want and we have already reviewed the lease and financing looks good. At that point the other 2 properties selected are just back ups.
- Locate a property – quickest 1 week but can take months
- Place LOI (letter of Intent)- Accepted Agreement – 1+ weeks
- Purchase and sale agreement – 2 to 3 weeks
- Under contract and due diligence – 45 days
- Closing on the property – 15 to 21 days after due diligence expires.So conservatively it could be 3 to 4 months to close on your 1031 replacement property. This is why with a lender it’s not about what the initial quote is but WILL they lock the rate where it will stay fixed until you close?
There are so many steps involved in purchasing a STNL or MTNL property but once you own it the investment is mainly passive unlike other type of real estate asset classes. The no headache factor is often very appealing to investors because they can live their life happy and stress free without being bothered by problems all the time.