Exchanging in a Down Market

A few years ago, many were seeing their real estate investments appreciate at incredible rates, and in turn, were doing 1031 tax-deferred exchanges to defer their capital gains liabilities into new investment properties. But in today's market, many investors see limited or no appreciation in their investment property. In times like this, does it make sense for an investor to sell their property and do a 1031 exchange? In many cases, the answer is "yes."

With almost all real estate sales involving improved property, there is the recapture of depreciation. Section 1250 of the Internal Revenue Code requires that depreciation be recaptured at the current rate of 25%, which is higher than the current long-term capital gains rate. For this reason, the ability to defer the recapture of depreciation may make a 1031 exchange very attractive.

There are even more reasons to consider doing a 1031 tax-deferred exchange in a down market:

The value of a 1031 exchange is considerable, even in a down market. Leveraging the cash that would otherwise be forfeited in capital gains taxes and/or depreciation recapture makes sense in any market, and a 1031 exchange is the vehicle to get it done. Contact a qualified intermediary prior to selling to set up your next exchange.

1031 Exchanges with Short Sales, Auctions and Foreclosures

Short Sales
You can acquire property in a short sale through a 1031 exchange; however, you may find it difficult to do so while complying with the exchange deadlines. Section 1031 of the Internal Revenue Code requires taxpayers to identify replacement property within a 45-day Identification Period and to close on the identified properties within the Exchange Period, which is a maximum of 180 days. In a short sale, a bid package must be sent to the asset manager at the bank. Included in this package is information regarding the seller's financial situation as well as a settlement statement showing the amount of money the bank will receive on the payoff of their loan at the current bid price. The review of this package can (and regularly does) take up to 60 days. By this time, your Identification Period may have already expired leaving you unable to identify an alternate property for your 1031 exchange, or your Exchange Period may have expired. Please be aware of the time constraints and coordinate with your REAL TOR® and your tax advisor before attempting this type of transaction.

Auctions
It is an extremely difficult to purchase replacement property at an auction. When property is sold at an auction, there is no contract between the buyer and the seller. This is an issue because, when buying a property in a 1031 exchange, the taxpayer must assign its rights to buy the property under the contract to the qualified intermediary and the seller must be given notice of this assignment. Additionally, one of the fundamental requirements of a 1031 exchange is that the taxpayer cannot have control or "constructive receipt" of the exchange funds during the transaction. Many times, auction property is sold on the county courthouse steps or in a meeting hall where the seller is expecting the funds immediately after the auction. Because of the rules regarding constructive receipt, First American Exchange is unable to provide you with a check on the chance that you may purchase a property that day. Therefore, if you purchase a property through an auction, there must be time after the auction when First American Exchange can prepare the necessary exchange documents and coordinate the delivery of the exchange funds for the closing. In some instances, the seller will not delay the sale of the property to help facilitate a 1031 exchange. Speak with the seller or auctioneer of the property about this before you make any bids on auction properties.

Foreclosures
You can acquire property in foreclosure through a 1031 exchange so long as there is a contract between the buyer and seller and there is a time period after the offer is accepted for First American Exchange to provide the exchange funds to close. Remember that the 45-day Identification Period still applies, so do your inspection of the property within the 45 days to make sure that the condition of the property is acceptable to you. If there are repairs that need to be made on the property after closing, you cannot fund these repairs through a standard delayed exchange. If the property needs substantial repair, a more complex structure known as an Improvement Exchange may be appropriate. Please speak with your tax advisor and exchange manager before identifying or purchasing foreclosure property and ask about the Improvement Exchange process.