Risks in 1031 exchanges

Risks in 1031 Exchanges

Real estate prices are strong. However, when people decide to sell, the risks in 1031 exchanges will pop up all over again.

With the strong rally in real estate since the crash in 2007-08, colliding with the millions of baby boomers that are likely downsizing their assets, we are likely to see increasing sales volume in real estate markets. We will also likely observe baby boomer-aged real estate investors increasingly unload their investment properties.

This economic trend of boomers selling may bring us back – at least in part – to some of the headlines from prior booms. One of those headlines could be the layman’s increasing use of 1031 exchange laws (not to be confused with tax-deferred transfers of annuities under Section 1035). For those of you unfamiliar with Section 1031 of the Internal Revenue Code, A Section 1031 exchange is part of the tax code which allows the owner of investment real estate to sell and buy another property while deferring capital gains taxes.

This tax law offers huge benefits. You can potentially:

  • Upgrade your real estate portfolio,
  • Switch to different kinds of commercial property
  • Buy 1 large property with the equity from 2+ properties

Or for any number of reasons, sell while deferring what can be a massive tax bill. Simply avoiding the recapture tax on the depreciation can be enough to make this a consideration. And for experienced, active real estate investors, this is a gift in the tax code. For less experienced and less active real estate investors, this can be a risk trap.

Why Do Smaller Investors Get Attracted to S1031 Exchanges?

No one likes to pay taxes. Especially when the tax bill exceeds your annual salary. For many retiring real estate owners, their appreciation on their investment property has been immense over the past 20-30 years. Therefore, when they see a six figure tax bill coming, they become very open to alternative suggestions.

Enter the Retail 1031 Exchange Offers

Prior to the 2008 financial crash, there were dozens of real estate firms who offered not only REIT share offerings (Real Estate Investment Trusts) but also 1031 exchange opportunities for the smaller investor.

How these plans work was that these firms would buy a building or group of buildings, then sometimes sell tranches to direct investors and and sometimes sell them exclusively to 1031 investors. If these investment firms bought a $20 million building for example, they would then offer ~40 slots of ~$500,000 apiece to potential 1031 investors.

These investors were sometimes, small real estate investors. People who, lets for argument say, owned a 3 apartment property, which they bought years ago. Now the desire to dump the headaches of property ownership. But they also wanted to avoid the tax. That eagerness to avoid taxes – the last time real estate was frothy – subsequently opened them up to the pitches of the sectional 1031 offerings.

These deals were structured typically with leverage. Often not too much leverage – maybe 50% – but buying at the peak of the market, it added to the risk. A further risk to the investor was that now, he was not in control of the funds. The real estate firm decides what service firms to use, where to spend excess cash flow etc.

The Crash and the Danger in 1031s

50% leverage is not bad – having a house half paid off is a good thing. But in shaky commercial real estate, it’s a whole other story. This is where the risks in 1031 exchanges really start to show. Remember that quote from Warren Buffett about how you can see who’s swimming naked when the tide goes out?

By 2008, there were increasing numbers of vacant commercial properties. Paying mortgages grew difficult as cash flow dried up. Some 1031 sectional owners were receiving “cash calls” as the managers ran out of funds to pay the debt and the maintenance. This never happened to these investors back when they owned their little 3 unit house. They could always lower the rent in hard times and there was no mortgage.

When the 1031 investment property value fell in half, there was no more equity. The manager had levered to 50% – meaning 50% equity and 50% debt. Now 50% was gone and it was just debt. These investments folded (foreclosed etc) and the small investor was out 100%.

Note: we didn’t even cover the risks with choosing a “qualified intermediary.” That may be a topic for another article or a video. For now you can read about that at Inman News.

Risks in 1031 Exchanges – Will This Happen Again?

This is a real risk. Humans are remarkably consistent. The same motivators that caused an owner of investment property to sell and to find a hands off way to earn real estate income without getting hit with taxes on the sale are still there.

But now that group may be larger. Boomers are turning 70 to the tune of 10,000 a day. They don’t like taxes either. They may want to “stay” in real estate since it’s been so good to them. So if someone comes pitching them a sectional 1031 exchange, they may go for it. The appeal to be “hands off,” defer the taxes and let “professional management” handle the real estate will be strong.

Why I think the Small Investor May Be Better Off Keeping Their Property or Simply Selling Outright

As I outlined above, by keeping your property, you control the cash flow and where it goes. You decide if you should leverage the property or not. You know your property, the location and the local market better than you and maybe even the manager know the market dynamics around a proposed 1031 target property.

And if you don’t want the headaches, sell and pay the tax. It will beat putting all of your eggs in one basket and help you avoid all of the risks in 1031 exchanges (with the manager, tax laws, economy etc).

Creative Ways to Sell Real Estate

If you really don’t want to own the property anymore, there are some interesting ways to move it along. Here are some points that I want you to know as you work through this decision process:

  • Understand that passing the real estate on to the next generation could qualify the property for a step up in basis meaning your heirs may pay no tax.
  • You could sell the property to family using either a private mortgage or an annuity sale. Understand that both of these methods need to follow strict tax rules to be effective and valid sales.
  • You could donate the house to charity using a charitable trust and still collect income while you’re alive, in lieu of the rent you previously collected. You also may qualify for a large tax deduction. Interesting programs may be offered by your alma mater, museum or other endowed non profit organizations.
  • You could consider selling your primary residence, taking advantage of the $250/500k capital gains exemption, then move into the investment property, live there for 2 years and get 250/500k of that gain exempted too.
  • Many more creative ideas exist.

If you are in this position and would like some creative solutions for your investment real estate, and want to do it while keeping smart overall planning in mind (something I’d highly suggest), consider talking with me, Chris Grande. Consider filling out my intake form HERE, and we can follow up with a discussion.

Thanks for reading!

Helpful Links:

IRS Q&A

Dangers of poorly chosen qualified intermediaries

Cover photo: Source

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