Consolidation & Diversification Through 1031 Exchanges

by F. Moore McLaughlin, IV, Esq., CPA, CES®, Owner of All States 1031 Exchange Facilitator, LLC, and Partner at McLaughlin & Quinn, LLC


In order for investors to take full advantage of the power of Section 1031 exchanges, they must understand that Section 1031 specifically allows a single property to be sold and replaced by multiple properties. Additionally, Section 1031 provides that multiple properties can be sold and replaced with a single property. As usual, with flexibility comes complexity. Regardless, many investors take advantage of these rules when desiring to consolidate or expand their real estate holdings.

Consolidation

A common situation that we encounter is an older client who has accumulated several properties over the years. He or she has managed them very successfully, taking care of the repairs, finding tenants, and dealing with the normal tasks. The client has now reached a point in life where he or she is either unable or unwilling to continue performing such management functions. Hiring a professional management company is typically not cost-effective, i.e. the fees will strip out all of the profits.

To solve this problem, the client wants to sell all of the properties, either to a single buyer or multiple buyers. The investor then desires to either buy a single property as the sole owner or purchase a Tenants-In-Common interest as a co-owner with other passive investors. The idea is that by combining the proceeds from the sale of all of the properties, the investor can purchase a property more suitable to being professionally managed, while at the same time achieving an acceptable rate of return. Since no capital gains taxes will be paid on the exchange, the client is able to reinvest all of the sales proceeds. In most of these cases, the properties being sold are encumbered by little or no debt. So, if the investor is willing, he or she can leverage the equity into a property of much greater value than the aggregate of the properties being sold.

When selling multiple properties, timing is often critical. If selling to a single buyer, then the process is relatively easy because the 45-day identification period and the 180-day replacement period begin at the same time for all properties. If the properties will be sold to multiple buyers, which is likely the case, then the 45-day identification period and the 180-day replacement period begin on the sale of the first relinquished property. If the other properties are not sold soon after the first relinquished property, then inevitable timing concerns arise. Some of these concerns are eased if the replacement property will not be acquired until well into the 180-day replacement period. In any event, special care must be taken in complying with the strict identification rules.

One type of replacement property that is extremely well suited to this type of planning is the TIC or Tenant-In-Common arrangement. Following the issuance of IRS guidance in 2002, this type of investment has blossomed. While treated as a security for some purposes, a property designed arrangement will be treated as real property for section 1031 purposes. These investments are designed for the passive investor who wants to acquire a professionally managed property. To learn more about these types of investments, click here.

Diversification

Another common situation we face on a daily basis is where a younger investor has built-up significant equity in a single property and wants to grow their real estate holdings. The plan is to sell the single relinquished property and use the equity with additional debt to acquire multiple replacement properties. The properties that will be acquired will be managed by the investor, who has the energy and desire to perform the management duties.

Compliance with the identification rules may result in some difficulties because multiple properties will be identified. However, if three or fewer properties are identified, then compliance is straight-forward. If more than three properties will be identified, then either the 200% rule or the 95% rule must be used. To learn more about these rules, click here.

The other key to this plan is to properly allocate the cash from the sale of the relinquished property so that the replacement properties can be appropriately financed. Section 1031 does not mandate how to allocate cash and debt among multiple replacement properties. Therefore, the investor may choose the optimal allocation.

Conclusion

These opportunities allow investors to fully utilize the power of Section 1031 exchanges. To learn more about these and other ideas, please contact the professionals at All States 1031 at Exchange@AllStates1031.com or call toll-free at 877-395-1031.