In March 2020, shortly after the United States issued a national state of emergency in response to the COVID-19 pandemic, the IRS provided relief from tax deadlines to all Americans. Among the extensions were several date changes for real estate investors in 1031 exchanges. The new deadline has been extended to July 15 for investors who previously faced deadlines between April 1 and July 15. By that time, investors must identify or complete the purchase of a replacement investment property.
While the deadline extension has provided real estate investors with much-needed time to complete a 1031 exchange, there are some negative implications potentially associated with the deadline as well. I had the chance to connect with a leading expert on 1031 exchanges, Alex Madden, Vice President of Kay Properties & Investments. We discussed some of the repercussions of the extension and what investors in a 1031 exchange can do to prepare for the upcoming July 15 deadline.
What are the potential negative impacts of the July 15 deadline?
There has rarely been a time in real estate history where countless investors across the United States had the exact same deadline. If an investor waits until too close to the July 15 deadline to purchase a replacement property, they may not have enough time to complete the transaction.
Additionally, over the past few months, Madden said he has seen a considerable number of properties either taken off the market due to COVID-19 or not listed for sale at all. Thus, for buyers who must identify or purchase property by July 15, demand is extremely high while supply is considerably low.
"We have seen several properties taken off the market due to COVID-19, but there are also a lot of buyers in the market," Madden explained. "There's a potential scarcity of assets as we've seen supply go down, which potentially could inflate asset prices for buyers investing in replacement properties."
For those less familiar with the 1031 exchange process, an investor can defer taxes on the gain from the sale of a property by doing a "like-kind" exchange, meaning they sell one investment property and purchase a different income-producing property (or properties) in its place. Replacement properties can range from apartment buildings, warehouses, retail centers, and office space to any other property type that produces income.
After selling a property, a real estate investor has 45 days to identify the new property they plan to buy and 180 days to close on the property. If they don't close within that time frame, they'll pay hefty taxes on the sale.
What taxes will I pay if I'm unable to complete a 1031 exchange by July 15?
If an investor in this situation sells a property and has a gain on the sale, Madden explains, they will be subject to the following taxes:
- Depreciation recapture tax: Taxpayers are taxed 25% on all depreciation recapture.
- Federal capital gains tax: 15% to 20% (depending on income tax bracket).
- State capital gains tax: 0% to 13.3% (depending on the investor's home state).
- Medicare surtax: 3.8% (whether the investor will owe this depends on their income).
- Alternative minimum tax (whether and how much the investor will owe depends on their situation).
These taxes can be incredibly burdensome on a real estate investor. Knowing that they can be deferred by completing a 1031 exchange, investors will be all the more incentivized to complete an exchange on time.
What does the July 15 deadline mean for property owners?
Despite the economic crisis, Madden has not seen a drop in real estate prices over the past few months. With the upcoming July 15 deadline, there may be an influx of buyers seeking to purchase property and complete their 1031 exchanges before the deadline.
"There aren't as many properties listed as we would have if we weren't in a pandemic," Madden explained. "A lot of investors might be afraid of selling right now because they think they're going to get a lower price, but the market hasn't followed that. With the advent of prices holding up over the last few months, it is potentially a really good time to sell. During the 2008 recession, the epicenter of that crisis was in real estate. But this crisis is not real estate related, and prices seem to be staying high."
What does the deadline mean for investors in a 1031 exchange?
With the limited amount of inventory currently on the market, investors in a 1031 exchange may find it difficult to find a property to purchase when completing their exchange. It is in investors' best interest to have a backup option, should the property they hope to purchase fall through due to financing, due diligence issues, etc. Delaware Statutory Trusts (DSTs) are a great backup option for investors in 1031 exchanges, as they are considered a like-kind investment.
A Delaware Statutory Trust (DST) is a legally recognized trust used to hold title to a piece of real estate. Similar to an LLC or family trust, a typical DST is owned by accredited investors who pool their funds into the trust. There are typically several properties within the trust, ranging from retail space to multifamily buildings to any other income-producing property.
"DSTs are incredibly well-tailored to investors in a 1031 exchange because the real estate has already been purchased by the sponsor company," Madden explained. "As a result, investors can purchase their beneficial interest in a DST, build out a diversified portfolio, and have a high level of confidence that they're going to close."
Madden also explained that investors who are completing a traditional 1031 exchange face the challenge of financing, due diligence, and all the other details involved in closing on a property after an offer is accepted. With DSTs, that process has already been completed, making the closing process significantly shorter.
"We usually have our DST clients close in three to five business days, which is pretty unheard of in the greater real estate industry," Madden said. "DSTs could be an excellent replacement property option because they allow investors with a lower price point to invest in a potentially higher asset class on their own while having a far more diversified portfolio."
With the July 15 deadline quickly approaching, landlords who took their properties off the market may find it worthwhile to re-list their assets in preparation for an increase in buyers leading up to the deadline. Those who are currently on track to invest in a 1031 replacement property may find it beneficial to consider a DST as a backup option should their identified property fail to close.
Accredited investors with a net worth of $1 million or more (excluding their primary residence) who are interested in viewing available 1031 replacement properties, including DSTs, are welcome to sign up for an account on Kay Properties' website and review the offerings on their platform.