Case Study: When a 1031 Exchange fails and the client wants these funds to remain in Real Estate - the next best option.
A client sold a highly appreciated commercial property with intent of completing a 1031 Exchange. He had one particular property in mind and thought it would easily close within the allotted 180 days. Early on in the exchange it appeared there may be some issues in closing by the 180th day. His Qualified Intermediary had them call Brook Hollow Financial to discuss a backup plan. At this point the client knew he had another option if the 1031 Exchange should fail. At Day 45 he ID’d the main property to cover most of the proceeds, along with 2 other smaller properties that fell well short of covering their exchange proceeds.
Day 175 – An urgent call came from the client that one of the small deals closed, but the main property which would cover the bulk of the exchange proceeds fell through. Both parties were interested in completing the transaction, but unforeseen issues delayed the close past the 180th day. This client had very little basis, was in the highest tax bracket, and located in NY (which behind California carries the highest state tax in the country). So a tax deferral strategy was in this client’s best interest.
Brook Hollow Financial designed the following strategy:
The client’s sole purpose with these appreciated proceeds was to buy more real estate, so he needed a strategy that would mirror the benefits of a 1031 Exchange. This strategy was a 1031 Exchange Parking Lot (click to read Chris Princis’ blog on this topic). The entire lump sum amount of the remaining proceeds was deferred with a 15 year maturity date in a conservative investment portfolio (a “structure”). At the same time, Brook Hollow Capital, a loan company that works directly with Brook Hollow Financial, was able to provide a 15 year loan of approximately 80% of the structure. The loan is interest only and provides an attractive interest rate. This means the client was able to access 80% of their pre-tax lump sum within 5 days of their 1031 Exchange failure date. The remaining 20% of the structure is used as an “escrow hold back” to automatically pay the monthly interest. In effect, the client may end up with no out of pocket expenses on the loan while it is automatically paid within the tax deferred strategy.
In 15 years the loan will be due, but the structure and “hold back” will also be paid to the client. Depending on market conditions, there could be sufficient funds to cover the outstanding tax obligation.
A 1031 Exchange remains one of the most effective tax deferral and wealth building strategies available. However, at a 20% failure rate many exchangers are left with a large tax consequence if they are not able to follow the strict IRC 1031 rules. Those looking for a “parking lot” solution like the client discussed in this study will benefit from using a structured sale coupled with a loan based on the structure.