Coronavirus and Your 45-Day 1031 Exchange Deadline

UPDATE: Since the release of this article, the IRS has extended the time period for Section 1031 Exchanges. See the IRS notice for details. Although the deadline has been extended, DSTs are still a viable alternative to a traditional 1031 exchange, especially for landlords trying to deal with the effect of the virus on their tenants’ ability to pay rent.

As I ponder various financial and business implications from my office at home, a particular situation got my attention. I own a CPA firm on lockdown less than a mile from where the first coronavirus case in the U.S. was confirmed. As we know, deadlines for tax returns were extended by three months, but deadlines for other important financial tasks — such as the 45-day period for real estate investors face with a 1031 Exchange — have not. What now?

Basically, a 1031 Exchange is a way of selling one rental property and buying another, while deferring the capital gains tax on the sale. Once a property has sold, the investor is now under a 45-day deadline to identify a replacement property. This 45-day period is a strict rule. If you are one day late, you blow your chance at a Section 1031 Exchange, and you’ll be forced to pay the income tax on depreciation recapture and the capital gains taxes on the sale. For some investors, that hit could be in the tens, hundreds or even millions of dollars.

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Quarantine Obstacles

With all the coronavirus quarantines and lockdowns going on right now, the 45-day deadline could be a problem for those currently in the middle of the 1031 Exchange process or hinder those who were considering getting started, for a couple of reasons:

1) Getting in to see properties is virtually impossible for many people. States are increasingly imposing lockdowns, closing gyms, movie theaters, restaurants and all other “non-essential” businesses. Although it is not always the case, several states — including Washington, California, New York, Illinois, Pennsylvania and Vermont — categorize real estate as a non-essential service. In these areas, real estate activities are limited to those that may be accomplished remotely.

2) Getting properties inspected could be impossible as well. Buying real estate involves many risks. One of the primary ways to mitigate a major risk factor is to have a professional inspection and property appraisal before agreeing to the purchase. So, even if a savvy real estate investor was able to use the internet and other resources to find an adequate replacement property and decided to make an offer, their deal could hit a snag: The inspector, also on lockdown, may not have the capability to visit the property and write a report in time for the 45-day requirement to be met.

Overcoming Those Obstacles with DSTs

Delaware Statutory Trusts (DSTs) could be very helpful for real estate investors facing these issues. I have written several articles regarding Section 1031 exchanges utilizing Delaware Statutory Trusts as a popular exit strategy for people who own rental properties to stay invested in real estate without actively being a landlord anymore. (See I’m a Landlord, Can I Ever Truly Retire?)

With DSTs, the real estate investment is held passively and managed by the DST sponsor. The investor is relieved of the task of finding and closing on a replacement property and can get out of the landlord business. Many people, especially retirees, have found this strategy to be a life-changing solution.

Delaware Statutory Trust investments are created through a real estate company, called a sponsor. To better explain the process, here is a hypothetical example:

• A sponsor company purchases an apartment complex in Austin, Texas. The total purchase price is $50 million. The sponsor secures $24 million of non-recourse bank financing in the form of a mortgage and writes a check for the remaining $26 million down payment. The sponsor has the property inspected, sets aside adequate reserves for the replacement, gets the property fully rented, and puts a DST wrapper around the investment so that outside investors can now come in and replace the $26 million back to the Sponsor at a cost. The sponsor then simply becomes the manager for the property for the investors.

How could DSTs help you? If you’ve sold (or are ready to sell) your investment property and are now worried that your own personal plan for identifying and approving a replacement property is in jeopardy, you have a couple of options, both involving DSTs.

1) Use a Delaware Statutory Trust as a backup investment. Given certain identification rules regarding the number of properties and purchase amounts (please consult your Qualified Intermediary for rules), the investor could potentially name a DST as a backup investment. You see, the DST has already been inspected and purchased. It is “ready to go.” You don’t need more than a day or two to review the available DSTs and select the best one for yourself. DSTs can only be purchased through a licensed financial professional, so you need to be working with someone experienced in this area.

2) Use a whole portfolio of DSTs instead. If it looks like there just isn’t much of a chance for the 1031 plan to be successful, you can abandon the idea of finding your own replacement property altogether and instead form a diversified portfolio of various DST investments. This portfolio could include investments in various regions of the country as well as in differing property types, such as apartments, self-storage, senior or student housing, industrial parks, net-lease properties or hotels.

In Conclusion …

The coronavirus has had many effects on our lives already, and many that remain to be seen. The purpose of this article is to provide a solution to a very real problem affecting sellers of real estate wanting to defer and potentially eliminate tens, hundreds or millions of dollars of income tax when they sell their property. As of March 24, 2020, the IRS has not extended the 45-day deadline for identifying a replacement property in a Section 1031 exchange.

A DST can offer a rescue plan for reinvestment even as you approach Day 45 of your deadline.

Madrona Financial Services' registration with the SEC does not imply a certain level of skill or training. Advisory services are only provided after receipt of disclosure documents and execution of an advisory agreement. The information, suggestions and recommendations included in this material are for informational purposes only and do not constitute financial, legal or accounting advice. Hypothetical returns shown illustrate mathematical principles only and are not intended to predict or project the return of any actual investment.

Insurance products are offered through Madrona Insurance Services, LLC, a licensed insurance agency and affiliate of Madrona Financial Services. Some products discussed in this article are only available to accredited investors and are offered solely through the issuer's offering documents. The issuer determines whether to accept any individual’s subscription documents. DST investments are only available to accredited investors and are offered solely through the issuer's offering documents. The DST sponsor determines whether to accept any individual’s subscription documents.