1031 Exchange Strategies for High-Rate Environments

To navigate a higher-for-longer climate where 1031 exchange strategies become more complex, the right approach depends on your timeline, capital position, and risk tolerance. To pull off a successful exchange, you’ll need the right help.

When examining the current real estate landscape, it’s obvious that things are not as promising as they once were for those looking to perform 1031 exchanges: transaction volume is down from the post-pandemic period, and interest rates remain higher than they were a decade ago. At a recent JTC webinar, our panel of industry experts talked about what this means for property owners.

What is the current market for 1031 exchange strategies?

“We’re in a higher interest rate environment, and with that comes reduced borrowing power,” said JTC Senior National Sales Manager Justin Amos. “Investor behavior has shifted, so today’s focus is a lot more on stable cash flow, long-term fundamental investments, rather than short-term appreciation. So, when people are looking to buy, it’s with an understanding that they’re going to be holding this property for a longer period of time.”

Knowing that properties will be held longer at a higher interest rate affects how buyers will look at them, but as Amos pointed out, sellers are not necessarily willing to meet them halfway on price.

“Sellers have a fixed price in mind, and until this point, have been unwilling to adjust to the current economic setting,” he said. High prices, fewer available 1031 exchange replacement properties, and elevated interest rates can make it harder for deals to pencil out. It might not be possible to find a single replacement property that allows for full tax deferral and offers the long-term growth and income the taxpayer desires.

There’s also the possibility that one won’t find a property in time, and the exchange could fail. With limited availability and a ticking clock, a like-kind exchange can be risky, but that doesn’t mean it’s impossible. At the webinar, the panel discussed lesser-known alternative 1031 exchange strategies for acquiring the right properties and deferring taxes even in a tough market.

How a partial 1031 exchange works

Many exchangers are looking for a replacement property valued the same or higher than their relinquished property so they can completely defer taxes on their property sale. But it’s also possible to perform a partial 1031 exchange, in which the exchanger defers taxes on the portion the proceeds used to acquire a lesser-value replacement property, receiving the rest as  boot.

“We’ve seen quite a few people do the partial received exchange when they can’t find a replacement property that meets or exceeds the value that they sold for, or they just want to take some cash out at closing,” said Certified Exchange Specialist® Nicole Vella, who explained that while this is a viable option, it does mean paying taxes on any cash received, and doesn’t allow the exchanger to take cash out and replace it with debt.

“To do the full deferral, you do need to meet or exceed the value that you sold the relinquished property for,” she said. “You can replace debt with cash, but you cannot replace cash with debt, so you always need to use that equity piece towards the purchase in order to not raise a red flag.”

A partial 1031 exchange could also be coupled with a DST to make up the difference and ensure the exchanger can fully defer taxes, while also allowing them to take advantage of the benefits of a Delaware Statutory Trust.

Reverse 1031 exchange: an alternative strategy

In a traditional forward exchange, the property owner finds a buyer for their relinquished property and completes the sale. The sales proceeds are held by the qualified intermediary 1031 exchange facilitator, known as the Qualified Intermediary (QI), until they can be deployed to acquire the 1031 exchange replacement property.

But in a tight market, it may be easier to find a buyer than it is to find a quality property. And if you can’t identify a replacement property within 45 days, your exchange could fail. Wouldn’t it be safer to find the replacement property first, and then worry about selling the relinquished property?

That’s exactly what happens with a reverse 1031 exchange, in which the replacement property is acquired at the start of the exchange, and the exchanger then has 45 days to identify and 180 days to sell the relinquished property.

In many cases, “you’re not going to have any problem selling your relinquished property, but you need to buy the replacement property immediately because of competition concerns in your line of business,” said Nicholas Scarfone of Barclay Damon LLP. However, because the acquisition is being made before the sale, sourcing the funds to purchase the replacement property becomes more complex.

“Where am I getting the money to buy that replacement property?” said Scarfone. “Because I would normally use my relinquished property proceeds.” The answer is in the creation of an Exchange Accommodation Titleholder (EAT), an entity that purchases the property from the seller and parks it until the relinquished property is sold.

“You could loan money to the EAT to acquire the replacement property, or you could arrange to have a third-party lender come in and fund the purchase of the replacement property,” explained Scarfone. “When the relinquished property gets sold, eventually, those proceeds are just used to pay off that debt.”

“If someone’s in a fortunate situation where they have the capital to provide to the EAT to acquire the replacement property, they essentially could be paying themselves back,” said Amos.

Scarfone said that in the current environment, he’s “definitely seeing it a lot more with our clients who are feeling confident that, hey, I can sell properties within six months. But, you know, I really want to secure this. I don’t know about this replacement property being there.”

To learn more about reverse 1031 exchanges, read the JTC Reverse Exchange Guide.

1031 improvement exchanges: using exchange funds when the replacement property is worth less

As mentioned, you don’t always have to find a property valued at or above your relinquished property. You could exchange into a lower-value property. You could receive the leftover proceeds as a taxable boot, or you could exchange them into a DST. A third option is a 1031 improvement exchange, in which some sales proceeds are used to make improvements to the replacement property.

As Scarfone explained at the webinar, as long as the improvements are made during the exchange window, you can employ those funds to increase the value of the 1031 exchange replacement property without facing capital gains taxes.

“The safe harbor is key,” he said. “You’ve got to expend all of the cash proceeds that you received on sale, and the value has to be equivalent.”

“You could potentially buy it lower and improve an asset to get to where you need to meet that equal-to-or-greater-than value,” said Amos.

“These can be done in the context of a forward, deferred exchange, as well as a reverse exchange. I see them more in a reverse exchange,” said Scarfone. “You have the Qualified Intermediary hold the proceeds, and then the Qualified Intermediary takes title to the replacement property, and then pays the contractors and subcontractors, pays their invoices out of the exchange proceeds to improve the replacement property, to increase its value.”

While a 1031 improvement exchange can allow taxpayers to increase the value of their replacement properties and put exchange funds to good use, all repairs and improvements need to be completed during the exchange, meaning there is some risk involved. For more information, read our guide to improvement exchanges.

Is now a good time to use 1031 exchange strategies?

All of these 1031 exchange strategies can make it possible to perform an exchange even when conditions are not favorable. But they require a lot of planning, and they require additional help. Talking to your tax and legal advisors ahead of time and engaging a qualified intermediary 1031 exchange specialist well in advance of your exchange can make a world of difference.

“We’re definitely starting to see a lot longer of a runway, which is good. People are planning sooner and having more options available to them,” said Amos. “You’re doing yourself right by doing the due diligence now.”

“We do encourage you to look for replacement properties even prior to selling your relinquished property, because that will inevitably help you in your timeline,” said Vella.

While you have a lot of options for who can act as your QI during a traditional forward exchange, working with the wrong third party during a reverse exchange, improvement exchange, or partial exchange could end up costing you if funds are mismanaged or returned to you too early. That’s where JTC can help: our team has experience with even the most complex exchanges, and we can work with you to provide the right institutional-grade solutions for your situation.

“We utilize JTC as much as we can,” said Scarfone. “Our clients are always happy.”

Learn more about JTC’s 1031 services

Frequently Asked Questions