The 1031 Trap

March 5, 2023

Real Estate, Taxes

During the recent commercial real estate bust, it’s become apparent that many investors had jumped in over their heads. In addition to shrinking distributions, cash calls, and foreclosures, many Limited Partners (LP) in real estate “deals” are learning belated lessons in tax complexity. Tax benefits are a great perk of real estate investing, but they are never as simple as many imply. As I keep saying, real estate is fantastic, but you need a solid basic understanding of what’s happening under the hood. In this article, we’ll break down the pitch and perils of tax-free 1031 exchanges, a cornerstone of real estate’s tax magic.

1031’s Powerful Premise

In a simplified nutshell, here’s the powerful premise of the 1031 exchange: 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 yet a third building.

Ticking Tax Time Bomb

Tax perks help make real estate investing especially lucrative, and 1031 exchanges can indeed perform money magic. But this powerful tax loophole also has a time bomb quality, which blows up in many investors’ faces. To qualify as an exchange rather than a sale, the new 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 1st 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. Often, these tax-desperate 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? To avoid a huge tax bill, the seller must immediately become a buyer and face the same booming price environment. The market offers 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 a well-priced new deal. But 1031 rules require them to find something now. Usually, 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 significant 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 valuations 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. Instead, they refinance, which is tax-free, to expand their portfolios.

LPs are Really Stuck

Limited partners in a deal usually have little say or control over these decisions. The primary controlling 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 options for LPs 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, 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 tax bill and pressure to do a 1031 can be severe. Then, you do the best you can.

Double Whammy!!

If an investor has shrewdly used depreciation, refinances, and 1031 exchanges to the maximum, they also have a huge deferred tax bill riding on the property. If that property then falls on hard times and is foreclosed upon, investors may get hit with a double whammy! Not only have they lost all their anticipated accumulated equity, but they face a huge tax bill upon the foreclosure!!

Investors must pay the IRS a huge sum for the deferred taxes and the privilege of losing their failed real estate investment! We will explore this nightmare scenario in more detail at some point. But for now, recognize that any time you’re pitched money magic of any sort, you need to ask about and understand the potential downside if things don’t proceed as planned.