How to tackle more complicated 1031 exchanges
A Section 1031 exchange is a valuable tool for real estate investors who want to defer capital gains taxes on the sale of a property. The exchange involves an investor selling one property and then using the proceeds to quickly buy another.
You do have to meet certain specific requirements, such as only exchanging real property, not taking cash out of the deal and acquiring a new property within 180 days of selling your original property. Often, however, a 1031 is fairly straightforward, provided you or your tax advisor knows the steps involved.
But what about a situation that’s more complicated? Keep reading for three examples of how you might navigate a 1031 that requires a less conventional approach.
Scenario 1: You own a property in partnership. But you want to do a 1031 while one of your partners wants to exit.
Here’s a fairly common scenario: You own an investment property through a partnership. Some of the partners want to stay in and roll their cash into a new investment via a 1031, while others want to cash out and move on.
In this situation, you typically can’t just do a straightforward 1031, since one person wants out. Instead, you’d have to structure the deal carefully to make it work. From a tax perspective, you have a couple of different options, including:
Drop and swap
A drop and swap is a strategy used in the context of a 1031 exchange. This strategy is particularly relevant when co-owners of a property (often in a partnership or LLC) want to go their separate ways — with some looking to do a 1031 exchange and others ready to cash out. It is carried out as follows:
- The drop: The entity (e.g., an LLC) distributes ownership of the property to individual members as tenants-in-common (TIC).
- The swap: Each individual then sells their TIC interest and can choose to either do a 1031 exchange into a new property, or cash out and pay taxes.
The drop and swap strategy carries several risks that require careful planning. The IRS may challenge the exchange if it appears the ownership change — from an entity to individuals — was done solely to avoid taxes.
A key issue here is the holdings period as it relates to held for considerations. If individuals sell their interests too soon after the drop, it may suggest the property wasn’t held for investment or trade or business purposes, violating 1031 rules.
Additionally, the change in ownership can trigger legal and logistical complications, such as transfer taxes, title issues or lender objections. To reduce risk, the drop should occur well in advance of the sale — ideally a year or more — and be supported by clear documentation of investment intent.
Section 708 partnership split
Under IRC §708(b)(2), a partnership can be divided into two or more new partnerships. If one of the resulting partnerships includes partners who collectively owned more than 50% of the original partnership, it is treated as a continuation of the original partnership.
This allows the new partnership to maintain its tax attributes and potentially complete a 1031 exchange. The other resulting partnerships are considered new entities for tax purposes.
This structure can be useful when partners have differing goals — some wanting to continue with a 1031 exchange, others wanting to cash out. By dividing the partnership in advance of a sale, each new entity can pursue its own strategy. However, timing, documentation and intent are critical to ensure compliance and avoid IRS challenges
Buy your partner out
The simplest option in a situation where some partners want to do a 1031 but one partner does not is to buy that partner out before you sell the original property. However, you need to be able to finance the transaction to ensure it occurs and is not dependent upon the sale.
Scenario 2: You want to use a 1031 exchange to acquire property you plan to develop or improve.
In a standard 1031, you’re essentially swapping one property for another, similar property of equal or greater value. For example, you might sell a multifamily building for $4 million and use the proceeds to buy another multifamily building for $4.5 million.
But what if you want to sell that original $4 million building to acquire a more run-down $2 million building you plan to upgrade later?
Typically, when you do a 1031, you have 180 days from the sale of your original property to acquire a new property. With an improvement exchange, you’re still bound by that 180-day day window — but you also have to finish making your improvements in the new property within that same time frame.
In other words, if you want to successfully defer capital gains, you can’t just sell a property for $4 million, buy another one for $2 million, and then invest in the construction materials you need to make $2 million worth of improvements without actually building anything. You have to do the work too.
Two more noteworthy nuances here:
- For an improvement exchange, during the 180-day window, the title of the property has to be held by an exchange accommodation titleholder (EAT). You can’t take possession of the property until construction is complete or after the 180-day period.
- As with any 1031, all funds from the sale of your previous property must be held by a qualified intermediary (QI), similar to an escrow, during the 180-day window. The QI distributes funds for construction as needed to the EAT.
Scenario 3: You want to acquire a new property before you sell your existing property.
Let’s say you’ve found a property you want to acquire via a 1031. But the clock is ticking, and you need to close the deal now — before you’ve had time to sell your current property.
You can solve this by doing what’s called a reverse 1031 exchange. In this situation, you’ll need to acquire the new property and then sell your existing property within 180 days, while abiding by all the other standard 1031 rules.
The main complication here is whether you can sell your existing property within the 180-day timeline. If you’re not able to find a buyer or complete a deal until after that window closes, that sale likely becomes a taxable event.
Additional notes to consider:
- An EAT must hold the title for the new property until the exchange is complete.
- If you have multiple existing properties in your portfolio, you have 45 days from your purchase of the new property to identify which of your existing properties you plan to sell as part of the exchange.
- Lenders may be more uncomfortable with the structure.
- Generally, this exchange variant may be more expensive to finalize due to the EAT.
What do all these complicated 1031 scenarios have in common?
These are three different scenarios. But they’re united by two common elements.
First, with any complex variation on a 1031, you need a certain amount of preparation and planning to structure the deal properly (even with a time-sensitive reverse exchange). This isn’t something you should try to pull off overnight, because you will frequently make a mistake that ends up creating a tax liability.
And second, each is likely too complicated to tackle entirely on your own. Your tax advisor can help you plan and structure a 1031 to meet your specific deal requirements while preserving your ability to defer capital gains.
How Wipfli can help
We help real estate investors navigate taxes and transactions. Ask our team to strengthen your tax strategy and advise you on how to structure deals like 1031s to your financial advantage. Learn more here.
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