Top 10 Mistakes 1031 Investors Make
IRC 1031 has been a proven tax planning strategy for nearly 100 years. It is estimated that 1031 exchanges account for more than $100 billion in transaction volume annually. While a 1031 exchange is a proven tax strategy, tax deferral should never be a substitute for solid investment fundamentals.
1. Misplaced focus on tax deferral versus capital preservation
A 1031 exchange is an investment strategy first and a tax strategy second. Whatever you do, do not get these out of order. Tax deferral and capital preservation are not mutually exclusive. Because of the short 45-day identification window, too many investors focus on the tax benefits of an exchange rather than the quality of the property.
Do not compromise the quality of your exchange property at the expense of paying some or all of your taxes. Many investors depend on their investment property to fund a substantial portion of retirement income. Your 1031 exchange should start with a two-fold mandate: Preserve Capital and Protect Cash Flow.
Remember: the investment that promises you everything you want will risk everything you have.
2. Lack of focus on real estate fundamentals
As the old saying goes, you make money when you buy, not when you sell. Low investment returns on bonds and fixed income alternatives have contributed to escalating real estate prices. Future upside appreciation may be limited, meaning most of the investment return will be generated from income rather than growth.
Petra uses the 3Q test to analyze the quality of the property, the quality of the income, and the quality of the property manager. Key performance indicators include location, market dynamics, tenant credit quality, lease structure, comparative lease rates, rent escalations, and exit strategy.
You do not have a return on capital until you have a return of capital.
3. Failing to achieve risk-adjusted returns
In a low interest rate market, it is tempting to chase yield while underestimating risk. In the financial world, this is known as asymmetrical or incongruent risk. Now is the time for a flight to quality. Safety first through managed risk should be the battle cry of investors.
At its core, a 1031 exchange should be a store of capital with risk-adjusted income and multi-generational tax benefits. Do not confuse investing with speculating. Always look for a positive risk-return correlation.
There is no such thing as zero risk. There is only mispriced risk.
4. Insufficient planning
Competition for quality properties is fierce. Immediate access and certainty of closing are among the two biggest challenges facing 1031 investors. The rules require investors to identify replacement property within 45 days of closing the relinquished property, and complete the exchange within 180 days.
Forty-five days is generally not enough time to properly identify, negotiate, underwrite, secure financing, and complete third-party reports for a specified exchange property. To mitigate this risk, investors might want to consider a 1031 fractional ownership program. DSTs feature institutional quality properties with low investment minimums, pre-structured identification, and certainty of closing.
Invest time and due diligence in knowing what you want to buy before you sell.
5. Lack of diversification
Diversification is the number one factor in determining investment outcomes, as the late Jack Bogle of Vanguard consistently argued. History has proven that it is difficult to consistently time the market when buying or selling. Pre-structured 1031 programs such as Delaware Statutory Trusts allow investors to pool their exchange capital to buy a diversified portfolio of properties.
You worked a lifetime to create your real estate wealth. It only takes one bad investment to destroy it. Diversify, diversify, diversify.
6. Not working with a professional 1031 specialist
Many real estate and tax professionals do not fully understand 1031 exchange rules as they relate to the definition of like-kind property, tax boot, recapture taxes, and the overall investment process. Make sure you work with an experienced 1031 specialist who can navigate your replacement property options and help construct a personalized real estate investment portfolio.
Some key planning questions: What is my primary purpose for this investment? How much income do I need? How much risk am I willing to take? How does this property fit into my overall estate plan?
If you think hiring a professional is expensive, try hiring an amateur.
7. Not planning for future liquidity needs
Directly-owned and managed real estate is illiquid. Depending on the overall financial situation and future liquidity needs, a partial exchange might be the right combination of tax deferral and necessary liquidity. Of course, investing less than 100% of exchange proceeds results in a taxable event on uninvested proceeds.
DSTs, because of their low investment minimums, are diversified building blocks designed to reduce risk and create laddered liquidity. While the ultimate sale of DST properties is up to the sponsor and manager, most programs have an exit strategy of 5 to 7 years.
8. Not fully aligning risk with return
A famous money manager once said that when too many people want to buy too much of a good thing, everyone is sorry they bought it at all. The seeds of destruction are usually sown in good times. It is important to work with a 1031 specialist who can manage value at risk of the replacement property.
Ideally, investors should have full transparency in all matters of capital pricing, operating assumptions, projected cash flow, and targeted liquidity events.
Always evaluate future projections in light of realistic assumptions.
9. Misaligned financing structure and debt terms
An estimated 60% of all multifamily and single-family rental property in the United States is owned by individual investors or family partnerships. An estimated 50 to 60% of all 1031 investors need to replace debt to satisfy their exchange. If debt is required to complete your exchange, it is important that the debt does not require your personal guarantee.
DSTs are structured so that the DST itself is the borrower, eliminating personal recourse for individual investors. This is one of the most practically valuable features of the DST structure for investors who need debt replacement.
Not all debt is bad, but personal guarantees can end badly.
10. Failure to align quality management with optimal performance
Warren Buffett says that when you buy the stock of a company, you are not buying a piece of paper. You are investing in the integrity and expertise of management. Lenders say it differently: bricks and sticks do not pay loans back. People do.
Investors who are tired of direct property management might want to consider the turn-key advantages of a professionally managed DST. As the quality of management declines, so does the value of your property.
Make sure you achieve a 360-degree alignment between the quality of your property and the quality of your property management.
Ready to apply these principles?
Book a Portfolio Design Session with Petra.
Petra will review your property sale, exchange equity, income needs, and risk tolerance, then build a custom POPP around your situation.