What has changed in 1031 exchanges and four ways to combine seller financing with an exchange in three common structures.
By Aaron Kirk Douglas
The 1031 exchange has been in the tax code since 1921. The rules have not changed much lately, but how owners use them has.
Mark Adams, managing director of Accruit, walked through the current landscape with HFO partner Greg Frick on Multifamily Marketwatch. Accruit is a Denver-based qualified intermediary that Adams said is the third largest in the country and the largest not affiliated with a title company. It licenses its software to more than 30 other intermediaries, giving it an unusual view of national data.
Repeal talk has quieted, but the lobbying has not
Concern about capping or eliminating 1031 ran high in 2021 and has quieted, though Adams, a member of the Federation of Exchange Accommodators, said the industry still meets with the Ways and Means and Senate Finance committees. Most opposition, he argues, misreads who uses the tool.
The average exchange rate is about $775,000, and roughly 60% to 65% involve single-family rentals, duplexes or smaller properties. These are often people who do not have a 401(k) and built retirement equity in a few rental houses instead.
Reverse exchanges have become a plan, not a fallback
Owners once used reverse exchanges only when they could not sell first. Adams said clients now ask about them up front.
The advantages are straightforward. There is no property to identify inside a 45-day window, and no gap in operating income because the owner holds both properties until ready to sell. The tradeoff is cost. In a reverse or improvement exchange the intermediary takes title, which is more expensive to administer.
Cost segregation as an alternative to an improvement exchange
One of the more useful ideas involves boot. Suppose a seller ends up with $100,000 or $200,000 of taxable boot after buying the replacement property. The traditional fix is an improvement exchange, which is complex and costly.
The alternative grew out of last year’s tax law and its treatment of bonus depreciation. Take the boot in cash at closing, buy the replacement property and use a cost segregation study to offset the gain. Adams called it a way to supercharge an ordinary exchange without paying for a structured one.
Two misconceptions worth flagging
The first shows up with newer investors. They assume they only need to reinvest their gain or equity. The rule requires reinvesting all proceeds and either replacing the debt or bringing in outside cash. Skip that and there is tax.
The second is more interesting. Adams said clients increasingly arrive with answers pulled from AI tools, and those answers are often directionally right and procedurally wrong. The common example is whether exchange proceeds can build on land the taxpayer already owns. There is a narrow path, a related-party leasehold improvement exchange, but the steps AI tools describe usually do not satisfy the rules.
DSTs and the 721 one-way door
Adams said Delaware statutory trusts have proliferated over the past five years, accelerated by the large brokerages moving into the 721 UPREIT space.
An exchange goes into a DST, which qualifies as replacement property. After two years the interest converts into operating partnership units, essentially shares in a REIT, with distributions treated as a return of basis.
There is also a door that closes behind you. Once the interest converts, the exchanging is over. A traditional DST is different. When that asset sells, the owner can still exchange.
The transaction data
Drawing on data from intermediaries using Accruit’s platform, Adams said multifamily exchange counts are down about 10% year over year while prices per unit are up about 5%.
Frick offered a possible explanation. Some longtime owners are simply exiting, not exchanging at all, and some are using seller contracts instead, often because they do not intend to pass the property to heirs.
Four ways to combine seller financing with an exchange
Adams laid out three common structures:
- Run the down payment through the exchange and take the note outside it. This only produces a benefit if the down payment exceeds your basis. On a $1 million sale with $500,000 down and a $200,000 basis, the exchange shelters $300,000.
- Loan the buyer the cash yourself. The buyer gives you a promissory note and deed of trust, the full price goes into the exchange and you collect on the note outside it.
- Put both the down payment and the note into the exchange, then arrange for someone to buy the note out during the 180-day period so the exchange holds cash.
Each takes time to structure. Adams’ advice was the same on every topic. Sort out entity structure, partner intentions and debt well before closing, especially when an LLC has members who want different outcomes.
“You really can never ask too many questions as part of the process,” he said. “Where you get in trouble is if you’re asking too few.”
About the author:
HFO Research (Aaron Kirk Douglas) from HFO Investment Real Estate’s Multifamily Marketwatch YouTube podcast, hosted by partner Greg Frick. Aaron Kirk Douglas is director of market intelligence for HFO Investment Real Estate In Portland.
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