Understanding the Importance of Planning for a 1031 Exchange
A 1031 Exchange, in short, is a way for investors to sell an income property and defer the capital gains taxes by buying a new income property (replacement property). A common question from investors is, “When should I start working on my exchange if I know what I am going to sell?” When it comes to planning, there is no such thing as “too early” for an exchange. The more you understand the investment market and process, the more likely you are to make a solid investment decision.
Over the last few years, upwards of 50% of our company’s transactions have involved an investor with a 1031 exchange. With the amount of sale activity in the real estate investment market due to the increased values, investors have been and are continuing to utilize the 1031 exchange to protect their capital. If done correctly, with a plan, investors can achieve their financial objectives. If done without a plan, investors can find themselves rushing into the purchase of a bad property due to the short time frame and may have been better off paying taxes.
Successful exchanges start with a strong plan. This includes understanding the components of the exchange, the timing, and involving the right team early on. Investors should understand the property type they will be looking for, expectations of return, debt needed (if applicable), price point, team (attorney, accountant, broker, intermediary), and timing of the process – starting the exchange process before an investor is closing the sale of a property is key. Taking these steps before an exchange better prepares an investor and allows them to find a good property matching their investment criteria. Like anything, not having a plan is planning to fail. In the world of real estate exchanges, it could cost hundreds of thousands of dollars – maybe millions if the wrong property is purchased, or worse, the exchange doesn’t go through and you pay the taxes.
Investors, per the tax code, have 45 days from the date of the sale of their property to choose the property they will buy. When people wait until after they close on the sale of their property to start planning, they often struggle to understand what they are looking for. Today, many of the best deals are done off market. That means if an investor is only looking at properties on the market, they will have a difficult time finding the best opportunities. Trying to learn which property type you want, where you want to invest, and figuring out the investment market while simultaneously looking for a replacement property can be a recipe for disaster.
Key Components for a Successful Exchange
The best advice I can give investors who are considering selling an income property and interested in an exchange is the following:
— Meet with your accountant to understand your tax consequences and how an exchange could work for you. This will help you with your plan and understand if an exchange makes sense
— Meet with an investment broker who can put a plan in place based on the amount you will exchange and your investment criteria for the exchange property. This will allow you to understand the market, what your options are, and ensure the property type, return, and location meet your expectations.
— Once you feel comfortable with the options and still want to proceed with the exchange, then put your property on the market for sale. Having the exchange plan in place eliminates any concern of what to do after your property sells.
— During the time you are in escrow you will want to make sure you have an intermediary in place. This is an integral part of the exchange process. The intermediary is a company that will hold your funds after close of escrow of the sold property until close of escrow on the exchange property.
— If debt is needed, meet with lenders to discuss your financing options and submit all personal documents to make sure you have your loan lined up. Financing is important to get in front of. Understand the terms and what you qualify for based on the property type you will be purchasing.
— Start making offers on properties the last week in escrow (of the property you are selling). Not waiting for the escrow to close buys you more time as offers can take a week or two to finalize to purchase contract. Doing it the week before you close allows you to start the exchange process before your 45-day clock to find the replacement property.
An exchange can be a great way to get out of an asset that doesn’t fit future investment goals and into an asset that make sense for years to come. Reduce your risk of making a mistake and talk to professionals before you make any decisions to sell a property. Create a plan for the exchange. Knowing your expectations of return, property type, and location are all the key factors to understand before starting the exchange process.
Brett Visintainer, CCIM is a Commercial Investment Advisor and the Principal of Visintainer Group in Fresno, CA. Formed in 2018 and built on a foundation of investment real estate, the Visintainer Group is a client-first commercial real estate firm. The Group has executed over $575 million in transactions across the United States. Brett specializes in commercial property acquisitions and dispositions and 1031 exchanges for owners in the Central Valley, Sacramento, and Central Coast markets. He can be reached at 559.890.0320 or firstname.lastname@example.org.