Our First Experience With A 1031 Exchange As Rental Property Owners

Recently, we decided to sell farmland in one state and exchange it for a 4-plex multifamily complex in a different state, neither state of which we resided in.  Having never done this before, we thought our readers might like to know what our first experience with a 1031 exchange as rental property owners entailed.  Where we gained insight and learned a lot, it certainly was not an easy task.  Would we do it again?  Keep reading about our experience to find out and determine if a 1031 exchange is right for you.

But First, A Little Background

My wife and I talked for some time about growing our investment portfolio for our near-term goals and, ultimately, our retirement. I owned farmland in North Dakota that had been in my family for years. While the sales of crops provided a steady supplemental income for us, it was stagnant, with no real hope that it would grow in the future.

As landlords who manage our rental properties, we are quite familiar with multi-family units. We also realize that these investments can provide us with the cash flow, appreciation, and the tax benefits that could help our income and portfolio grow. With land prices in the Midwest nearing record levels, we were ready to make the leap and move from farmland to multi-family housing.

What’s A 1031 Exchange?

Both of us were somewhat familiar with the basics of a 1031 exchange.

The term gets its name from Section 1031 of the Internal Revenue Code, which in our own word’s states:

A 1031 exchange allows you to sell a property held as an investment and swap it for a new one purchased for the same intention if the replacement property is of equal or greater value than the property you sold. This process allows you to defer capital gains tax on the sale if it is considered like-kind property by the IRS.

According to the IRS, properties are of like kind if they’re of the same nature or character, even if they differ in grade or quality. Virtually all real estate properties, whether raw land or those with substantial improvements, qualify as like-kind.

The Balanced Money has expressed this definition of Capital gains tax:

It is a government fee on your earnings from investments, like stocks or real estate property. Your earnings (or profit earned on a sale) are known as your capital gain. You’ll pay capital gains tax in the tax year you sell the asset, and the tax rate you pay depends on how long you’ve owned the asset and your income.

Examples of like-kind properties may include:

Raw Land

Multi-Family Rentals

Single-Family Rentals

Retail Shopping Centers

Office Buildings

Industrial Facilities

Storage facilities

In our case, farmland used to produce income is considered like-kind to a 4-plex apartment investment property. Be aware that REITs, real estate funds, or other securities do not qualify for a 1031 exchange. Also, real property in the United States is not like-kind to real property outside of the United States so no foreign exchanges are allowed.

You must use all net profit from the relinquished property to purchase the replacement property; otherwise, you could have taxable consequences, sometimes known as a “boot.”  For example, we pulled some funds from the sale for a few home improvements. Therefore, we will be responsible for the capital gains taxes on that amount (the boot).

The History Behind Our Farmland

Getting comps on rural farmland is not as easy as finding comparable sales for single-family homes or multi-family properties. Of course, location is important, but we learned soil type, access to water, and drainage are just some of the components you look for when evaluating farmland. With some research, which included helpful realtors in the area, we were able to get a firm understanding of what our property might sell for.

The same family leased the property from us and farmed our land for nearly 50 years. They had previously mentioned that they were interested in buying the land if I ever wanted to sell. As much as selling to them was my first choice too, as I saw it as a continuation of the land’s custodian, I also realized this had to be a business decision. Thankfully, after some negotiation, we agreed on a price and completed the transaction through a private sale.

I had traveled back to North Dakota twice, once when I was five years old, and again at the age of 21.  Both times with my grandmother, who gifted me the property many years later.  This land had been in my family for generations, and it took some time to set the emotional attachment to the property aside and finally treat it as the investment it really was.

There was no need to travel back to complete the sale. However, I jumped at the chance when my wife offered to go visit the land one more time. So, we headed back and were able to connect with the two brothers who were currently farming our land, as it was adjacent to their acreage. They spent the entire day with us, taking us out to the property and showing us how their farming operation ran. It was all very impressive. 

The gain in value from the time my grandmother transferred me the property till now was substantial enough that if we elected to keep the funds from the sale and pay the capital gains tax, we would potentially lose somewhere in the range of $100K. By using a 1031 exchange, we were able to take that $100K and add it to the down payment, now affording a much higher valued property when purchasing our new multi-family property.

Moving Into The 1031 Exchange

As this was our first experience with a 1031 exchange, we quickly learned that timelines are very important. Once a relinquished property closes, you have 45 days to identify the replacement property in writing, specifying the property you want to acquire. The IRS says you can designate three properties as long as you eventually close on one of them. You must close on one of those designated properties within 180 days. These two deadlines run concurrently, and every day counts, including weekends and holidays.

The buyers of the land were doing a 1031 exchange as well. Being a private sale, we worked our closing day to give us each time to research and identify replacement properties.

Finding A “Qualified Intermediary”

An IRS requirement for a 1031 exchange is that the proceeds from the sale of your investment property must be held in escrow by a third party, known as a Qualified Intermediary.  Basically, a 1031 exchange Qualified Intermediary sells a property for you, holds the proceeds from the sale in a trust or escrow account to ensure the taxpayer never has actual or constructive receipt of the sale proceeds, then buys the replacement property and transfers the ownership to you.

Before you sell your property, you must coordinate with your QI for the proper paperwork that outlines their role in the process. That will help preserve the tax deferral benefit, which is ultimately the whole point of a 1031 exchange. Additionally, a 1031 exchange intermediary is responsible for coordinating and drafting all the paperwork and organizing documentation for the sale and purchase of both properties. During escrow, they’ll also work with the title company and receive the funds after the sale of the first property.

Get Referrals

With this being our first experience with a 1031 exchange, it was important to find the right Qualified Intermediary. Recommendations are always helpful, especially from someone you trust and who has firsthand experience. Fortunately for us, the attorney facilitating my land property sale had worked with a company named Asset Preservation Inc. (API), a national 1031 exchange company, and referred me to them as he had had a good experience. After interviewing them and a couple of other firms, I decided to use their services.

When researching for a Qualified Intermediary, look closely at the following:

• Experience: Find out how many exchanges they have done, how long they have been in service, and how much exchange funds they currently hold.

• Fidelity Bond: Because the QI will be holding your funds, it is crucial that you obtain a copy of their fidelity bonds. All QIs should hold fidelity bonds of at least $1 million. These are insurance that protects businesses from theft or dishonest behavior, such as if an employee of the QI’s company steals from your account while in escrow.

• Errors and Omissions Coverage: All Qualified Intermediaries must have errors and omissions coverage, which protects you if a QI’s paperwork mistake causes your exchange to fail. This coverage allows you to collect damages from the insurance company rather than the Qualified Intermediary.

• Funds Management: Always insist that the funds are held in a segregated escrow account. Verify that your funds will not get commingled with funds from other clients. This prevents your money from seizure if the QI declares bankruptcy during the exchange process. All qualified intermediaries should hold funds in a separate trust or escrow accounts in FDIC-insured banks.

• Costs and Fees: For typically delayed exchanges, most QIs charge around $700 to $1,500 per transaction. However, if you are doing a more complex exchange, prices will likely increase.

Finding A Replacement Property

Now it was time to move on and find a replacement property. Living in California as rental property owners managing our own buildings, it would be ideal to invest close to home. However, the reality of the market conditions led us to consider investing out of state.

It is essential to have the right real estate agent, even more so in a case like ours.  Being our first experience with a 1031 exchange along with investing out of state for the first time, it is key to work with an agent who is very familiar with investment properties and who ideally owns rental property themselves. We looked for agents online. Additionally, we used the Bigger Pockets forums to connect with and interview Realtors in various areas of the country. 

Where We Looked For Our Next Investment Property

After researching various areas, including Tennessee, Indiana, Ohio, and Texas, we finally decided on the greater Boise, Idaho area. The Realtor we had connected with on Bigger Pockets specialized in multi-family investment properties. He also had investments himself, and had been through a 1031 exchange. He was able to refer us to a lender whom had experience with lending on investment properties and 1031 Exchanges.  Additionally, we have immediate family living in the area giving us peace of mind that they could assist us with the property if needed.  Our team was forming quickly!

We chose three properties in the Boise area, made an offer on our first choice, and sighed with relief when they chose to accept it.  However, issues in the inspection report led us to drop out of that property, and suddenly tensions began to grow. We successfully had our offer accepted on the second property. But we knew that if for some reason that didn’t work out, we would be down to our final option.  It turned out this property we now had in escrow was a better investment . It was located in an area that was preferable to the first property’s location. However, if this sale fell through for some reason, we weren’t as confident in our third and final choice.

Tighten Your Seatbelt, This Is Where It Gets Bumpy

Our realtor, loan officer, qualified intermediary, and the title company worked in unison throughout the entire process. The biggest concern, as it turned out, was that my wife (who did not hold any title in the land) needed to go on the loan for the new/replacement property.  Another regulation of a 1031 exchange is that you cannot change how title is held during the exchange. Changing how title to your property is being held or dissolving partnerships during the exchange may cause the exchange to be dishonored due to holding-period issues.

So, we had the sale of land in my name only. However, in order to quality for the new loan, I needed my wife to join title for the replacement property. This was a cause for concern as I had already had my offer accepted.  Because time is of the essence, we sought advice on this right away.  And of course, we were literally driving to our family’s summer vacation spot when all of this went down!

The Importance of a Good CPA

Having our CPA on our team is invaluable. It is important to note that a Qualified Intermediary cannot give tax or legal advice to exchangers. Therefore, it is vital to have a tax and/or legal advisor provide you with the advice you may need. Although not mandatory, we recommend retaining an attorney or accountant to complete an exchange.

We found from our CPA who, after some research, found that you can indeed add a person on title. But only if the value of the property being purchased is 50% more than the property being exchanged.  So, let’s keep the math simple. If exchanging a $250,000 property with one of value $500,000 or more, you can add a person to title.  It’s assumed the exchangers 50% value is still the full amount exchanged with the new person adding the other 50%.

We were grateful to have a knowledgeable CPA on our team. He provided expert advice and guidance to keep the process on track.  Our concern was that any delays in the current lending approval process could allow the replacement property owners to back out.  This would leave us with very little time to start the loan process over again. As we only had the third and final property listed on our replacement selections.  We had no idea if it was still on the market as we had selected it over 60 days prior.

We Made It!

After picking up our stomachs off the ground and getting the lender the additional information needed to keep the loan process going, we were able to enjoy our much-needed family vacation time.

We closed on our replacement investment property and made the trip north soon thereafter to inspect our new property. We also wanted to introduce ourselves and meet our tenants. This property had a property manager in place, so we took time to meet with them. We wanted to explain how we run our properties and express how communication is of utmost importance to us.

Final Thoughts

We learned so much throughout our first experience of a 1031 exchange.  Mostly that all the moments of concern, trepidation, and worry are heightened by the ever-present time constraints along with the finite property choices available.  While stressful at times, this journey will allow us to grow our investment portfolio and better plan for our future.

Would we do it again? You bet!  We are already strategizing on the next exchange.  I hope this blog encourages you to investigate how a 1031 exchange might benefit your future investment goals. 

Check out our other blogs to guide you on your self-management journey as a landlord:

Buying Rental A Rental Property? Make Sure You Evaluate These Structural Items

The Exit Strategy: A Landlords Guide To Tenant Move Outs

How and Why Landlords Want to Create Standard Operating Procedures In Their Rental Property Business

How The California Deck & Balcony Law Affects Your Property

Landlording Is A Team Sport

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_{^{*Disclaimer: Keep in mind that this blog post is intended as a general resource only. It does constitute legal advice.  We are not lawyers. We do not claim to have expertise in this area. This blog post is based on personal opinions, experience, and research.}}