The Key To a Successful 1031 Exchange? (Advanced Planning)

As an experienced Financial Advisor, I constantly get asked: “What is the most important aspect of facilitating a successful 1031 Exchange?” And my answer always is “Advanced Planning.” If you are looking to make a successful 1031 Exchange, advanced planning goes a long way. And in my professional opinion is the most crucial aspect that people often overlook. And I can tell you that with 23 years of experience in the industry, it is not uncommon for me to receive a call from an investor (anxious and scared) who is late in the exchange or property sale process. And it breaks my heart to see. That is why I stress the importance of not only working with an experienced Advisor but making sure to plan your exchange. That is why I have created this post, so you can educate yourself on critical aspects of the 1031 Exchange process and avoid a costly mistake.

A Qualified Intermediary Is Essential:

One of the biggest mistakes I see is the client has not set-up an account with an experienced Qualified Intermediary (also known as an Exchange Accommodator) well in advance of selling their relinquished property. The Qualified Intermediary essentially sells the relinquished property on the seller’s behalf and buys the replacement property, assigning the deed to the seller, who is now the buyer. The Qualified Intermediary must receive the sale proceeds at the closing. If the sale proceeds are in possession of the seller, there is no exchange. I have seen quite a few exchanges come to a screeching halt when a client is not aware of this rule. Once you have made arrangements with the Qualified Intermediary, you can start focusing on finding a suitable replacement property.

Only 180 Days To Close:

From the day the relinquished property is closed on, the seller has 180 days to close on a replacement property. The challenging part is that the seller must identify the replacement property choices within the first 45 days of the 180-day period, which is a short window. Having a firm grasp of crucial timelines can save you a headache in the future.

The Three Property Rule Is Your Friend:

The first is the three-property rule. You can identify up to three properties. You can invest in any one, two or all three of the properties. The idea is that you would have a primary option with the others being secondary or “back-up” options. You need back-up because, as many real estate investors know, you can’t always make a deal. If your primary deal falls apart and you have no back-up, you have no exchange.

The 200% and 95% Rule:

You can identify as many properties as you like if the aggregate value of those properties does not exceed 200% of the value of the property sold. You can close on any or all the properties. Then there is the 95% rule. You may identify as many properties as you wish if you close on 95% of them by the end of the 180-day period. There is a great risk associated with this rule. And there are specific replacement property options that can provide the surety of closing. That’s why it’s important to work with an experienced advisor who can educate you on potential risk so that you can make the most informed decision. Once suitable replacement property options have been identified, the seller can begin making an offer, go to contract, performing due diligence and finally close on the deal.

Plan For Surprises:

At this point, you may have as little as 135 days. From my experience, that time goes by very quickly. Certain discoveries made during the due diligence process may require remediation or possibly renegotiating the purchase price. These things take time and add stress to the process. Advanced planning can give you enough time to think through this process and reduce the stress typically associated with a 1031 exchange.

Don’t Let Panic Prompt Bad Decisions:

And finally, the best advice that I can give a potential client is not to allow the stress of the process or amount of the Capital Gains Tax to affect your judgment. Do not make a hasty purchase on a replacement property just to avoid the tax. You can lose more money on a bad real estate investment than you would have paid in taxes. I tell everyone if you have a tax bill, you’re making money. You’re doing something right. Don’t let the complexities of the exchange ruin that. Plan ahead and always work with experienced advisors.