A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property (the relinquished property) as long as they reinvest the sales proceeds into another “like kind property” – the “replacement property.” When executed correctly, a 1031 Exchange can provide tremendous tax benefits for investors, but they are complicated transactions with a lot of rules.
In this article, discuss one specific aspect of 1031 Exchange rules – identifying and closing on a replacement property. We will describe what the rule is, how it works, and how it is involved in determining if a 1031 Exchange can be completed after closing. By the end, readers will have a greater understanding of the 1031 Exchange process and will be able to determine if this type of transaction is a good fit for their own needs.
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How Does a 1031 Exchange Work?
To understand how a 1031 Exchange works, an example scenario is helpful.
Suppose an individual investor purchased a small retail center 15 years ago for $1,000,000. In the present day, the market has grown significantly and the investor has received an offer to buy their center for $2,000,000. The difference between the purchase price and the sales price ($1,000,000) is known as a long term capital gain and it is taxable – at rates up to 25% at the time of writing. Clearly, this is a very large tax bill and investors could potentially save a lot of money by deferring it. This is where a 1031 Exchange comes in.
In a 1031 Exchange transaction, the investor could sell the property for $2,000,000 as normal. Then, within 45 days of the sale of the relinquished property, they would identify a replacement property in writing and then would have 180 days to close on the purchase of it.
Throughout the process, the investor would work with a Qualified Intermediary to help facilitate the exchange and make sure all rules are followed for tax deferral.
When thinking about how the exchange process works, the key point is that a real estaten investor has to decide before the sale of the relinquished property that they would like to do a 1031 Exchange – so they can plan for it. But, this doesn’t always happen.
Can An Investor Do A 1031 Exchange After Closing?
To answer this question, consider the same example above, where a real estate investor buys a property for $1,000,000 and sells it for $2,000,000. In this case, suppose the investor had no plans for a 1031 Exchange at the time of sale, but once the sale closes, they learn they face a tax liability of up to $250,000 and they start to have second thoughts about not doing a 1031 Exchange. Can they do it? The answer lies in a concept known as “rescission.”
The word “rescission” is derived from “rescind” which means to take back. So, in a real estate context, it means an investor could “take back” the transaction, in which case the Internal Revenue Service (IRS) would treat it as if it never happened.
As a general rule, an investor can rescind their sale transaction as long as it occurs in the same tax period in which the property is sold. Doing so would allow them to re-do the sale and complete a 1031 Exchange the second time around. But, there is a huge caveat to this idea. The buyer of the relinquished property has to agree to it. Further, if the buyer got a loan to purchase the relinquished property, it is also necessary to get their lender to participate in the rescission – both of these could prove to be incredibly difficult. But, for the purposes of this article, assume they both agree.
How Does The Rescission Process Work?
If both the buyer and lender agree to rescind the transaction, there is some paperwork and logistics that must be managed to transfer the sale proceeds and property title from the buyer back to the seller/taxpayer. If it is just a few days after the sale, this may not be a major undertaking. But, the longer after sale it happens, the more complex this task may be.
Once the property is returned, the IRS treats the transaction as if it never happened as long as a few criteria are met:
- Rescission has to happen within the same tax year the property was sold. For example, if the transaction happened in 2022, the rescission also has to happen by the end of 2022.
- The seller/taxpayer must receive the property back from the buyer
- The buyer must receive the full purchase price back from the seller within the same tax year. Again, if the rescission occurs in 2022, the buyer must receive the money back by the end of 2022.
There are additional legal and potential regulatory steps that must be taken to complete a rescission. So, it is always a good idea for real estate investors to consult a CPA and/or tax advisor with a has strong familiarity on the internal revenue code (IRC) to make sure there are no issues around the constructive receipt of funds from the deal or depreciation recapture from the sale.
1031 Exchange Rescission as it Relates to Commercial Real Estate Investing
So, if the concepts of a 1031 Tax Deferred Exchange and rescission are combined, here is how it could relate to a commercial real estate investment.
In theory, an investor could sell a property (normally) and realize a big gain and the tax bill that goes with it. Then, they could get the tax bill and retroactively realize they want to do a 1031 Exchange. In this case, they could attempt to rescind the transaction, get the buyer to give the property back and then give the sale proceeds back to the buyer within the same tax year.
Once the transaction is rescinded, they could again attempt to sell the property at the then current market value with the idea they would do a 1031 Exchange the second time around. When the sale of the relinquished property closes, they would use the exchange proceeds to find a replacement property within the required timelines and purchase it. The net proceeds from the sale must be used to purchase a replacement property with equal or greater value.
Drawbacks to Rescission
There are two major drawbacks to the strategy of trying to rescind a deal.
The first is the complexity. The fact that both the buyer and their lender have to agree to it makes the likelihood of it actually happening very low. In addition, the legal process for giving a property back and the potential tax code issues can add an extra layer of complexity.
The other major drawback is the market risk that can come with selling, taking back, and then trying to sell a property again. In some cases, it could work in the taxpayers favor if they were able to sell the property for more the second time around. But, it could also work against them if market conditions deteriorate. Unfortunately for them, they have to complete rescission within the same tax year so they do not have the luxury of waiting out a market downturn.
Deadlines to Remember
When considering a transaction rescission, there are several key deadlines real estate investors must remember:
- Same Tax Year: Rescission must happen within the same year the property was sold. So, a property sold in December 2021 could not be rescinded in January 2022. It must be the same year.
- 45 Days: If the property is taken back and it is decided a 1031 Exchange is the right way to go, investors have 45 days from the sale date of the relinquished property to identify a new property to purchase. In a 1031 Exchange, this is known as the “identification period.” The identification must be made, in writing, and often includes the address of the property and/or the legal description.
- 180 Days: If the property is taken back and a 1031 Exchange is started, investors have 180 days from the date of sale to close on the purchase of the replacement property. So, this would be an additional 135 days past the identification period.
There may be other contractual obligations on a transaction specific basis, but these time frames are the most important dates to keep in mind when trying to rescind a sale and complete a 1031 Exchange.
Investing Through a Real Estate Syndication
A real estate syndication is a commercial real estate transaction structure that allows individual investors to purchase a fractional share of an institutional grade commercial property. At first look, this transaction structure does not appear to be related to a 1031 Exchange, but a fractional share in a syndication could be used as a potential replacement property. In this scenario, the syndication deal leader does the hard work of finding and managing the property and can help with some of the logistics of the transaction.
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