The 1031 Trap

March 5, 2023

Real Estate, Taxes

The manager of the apartment deal Boruch Sherhoffer had invested in had notified him that a sale was imminent. B’ezras Hashem, he stood to make a nice profit, but a good chunk of it would be taxed if he didn’t roll all the proceeds into a new property via a tax-deferred 1031 exchange. The GP who had arranged this deal said he would likely have another one lined up, but Boruch was skeptical about reinvesting in the current environment. On the other hand, paying a bunch of taxes seemed like bal tashchis.

Is doing a 1031 exchange always the best choice?

1031 Powerful Premise

Here’s the powerful premise of the 1031 exchange in a simplified nutshell: If an investor pays $1 million for a building and then sells it for $2 million, he would normally owe a bunch of tax on his gains. But if he doesn’t take control of the money generated from the sale, and instead parks it in a trust account and quickly uses it to buy another building, the tax bite is delayed. When he sells this second building, he’ll owe tax on all the accumulated profit unless he does a 1031 exchange again, rolling all the accumulated equity into a third building.

Ticking Tax Time Bomb

Tax perks help make real estate investing especially lucrative, and 1031 exchanges can perform money magic. But this powerful tax loophole also has a time bomb quality to it which blows up in many investors’ faces. In order to qualify as an exchange rather than a sale, the property to be purchased has to be identified within 45 days of the sale of the prior one, and closing has to occur within the next 135 days after that 1^st deadline. No excuses or extensions. The pressure of these deadlines often leads investors to grab dumb deals—anything to avoid a huge tax bill.

Desperate 1031 Buyers

Real estate brokers and sellers dealing with 1031 buyers, meaning someone who has already sold their property and is now facing the exchange deadlines, know they are dealing with a desperate buyer—not a good place for the buyer to be. Often, these investors parted with their original property due to an astronomical price offered in a booming real estate market. They took the money, and now what? The seller has immediately become a buyer and faces the same booming environment. There’s nothing attractive to buy, but the 1031 tax time bomb is ticking.

Greener Pastures

If not for the 1031 pressure, sellers could capture high prices and patiently wait until they find an attractive new deal. But 1031 rules require them to find something now, and often, the same boom that allowed them to sell high will prevent them from buying at a fair price. Sometimes, the seller decides that the grass is greener on the other side and decides to cash out of one property type that in their view is priced to the max and buy another type that in their view has more upside potential. For example, they may switch from apartments to offices or from retail to student housing.

Unknown Pitfalls Abound

In theory, this could work. But some major players who tried this asset class-shift approach had it blow up on them. I’m thinking of three groups in particular who built up major portfolios and expertise in a specific category over many years. Then, they cashed everything out for top dollar, rolled their cash to a new real estate type, and fell on hard times almost immediately. Not only had they grossly overpaid for the new property type, they had missed other pitfalls they weren’t equipped to handle. Because of 1031 pressures, these players jumped in and lost.

Don’t Sell. Refi

It took those investors years to extricate themselves, at great cost in time, money, and reputation. One eventually got busy trying to buy back some of the same properties they had sold years ago, now at astronomically higher prices. All were much worse off than if they had simply held onto their portfolios and refinanced as valuation rose. This is why many successful real estate investors rarely sell properties, despite a high price environment and the ability to do a 1031 exchange. If there’s nothing better to buy, they don’t sell.

LPs are Really Stuck

Limited partners in a deal usually have little say or control over these decisions. The other partners, who may have abundant losses to cancel their gains or access to other deals for 1031 purposes, may be very happy to cash out, leaving the LPs with no options except to pay the tax or accept the best 1031 solution they can get their hands on. Note that not all deals welcome 1031 money since it can raise the cost and complexity for other partners, so their options may be even narrower.

Placeholders

One possibility is to find a 1031 exchange placeholder, that is, a property that may not be a great investment but offers reasonable confidence that it will hold its value over time. Rolling gains into a well-priced single-family home or a single-tenant property with a very strong lease (NNN) may offer an investor a temporary 1031 solution. When they find a better deal, they can exchange the placeholder for it. I’ve seen this work, though it’s not foolproof. Investors can also research Delaware statutory trusts, which may work as placeholders, too.

Bite the Bullet?

Paying 20 cents on the dollar to the IRS is definitely better than jeopardizing 100 cents on the dollar exchanging into a dumb deal. Sometimes the bite isn’t too bad, especially if the investor has losses carried over from another deal. On the other hand, it’s possible the tax bite for selling without an exchange can be very harsh, equaling most of the equity available upon the sale. If someone successfully deferred tax on gains while depreciating the building basis to zero, the case and pressure to do a 1031 can be severe. Then, you do the best you can.