How Chunking can save a 1031 exchange

Big Picture

Luke Spitzer sold his family’s ranch outside Weatherford for $6 million net of closing costs and established a 1031 exchange. His qualified intermediary (QI) held the money, and the clock started ticking. His main target replacement property was a retail center in Fort Worth priced at $5 million. Needing only $1M more replacement property to achieve full deferral, on Day 45 he identified the retail center plus a $500K interest in a Delaware Statutory Trust (DST) and a $500K package of oil and gas royalties. Three properties. Clean list. Well inside the rules.

Then came the environmental report on the retail center. The cost to remediate contamination was a deal-killer. Luke walked away from the retail center.

Why It Matters

Now Luke owes $1,375,000 in taxes. When you identify replacement property, you must acquire property that is substantially the same as what you identified. If you identify a $500K interest in a DST and a $500K interest in minerals, that is all you can buy. You may not acquire a $6 million interest instead. It is not substantially the same property. It is six times the amount of DST’s and minerals identified.

So Luke was boxed in. His three-property list let him buy any one, two, or all three of the properties he named. But all three together came to $6 million. The first $5 million had nowhere to go when the retail center failed. It went back to Luke at the end of the exchange, and the day it did, it became taxable boot. The exchange he had built to defer tax on a $6 million ranch deferred tax on less than $1 million of it. The $5 million allocated exclusively to the retail center was fully exposed. And on the $1M that was invested, he only deferred the amount of the $1M that exceeded his basis in the property he sold. In most cases like this, the taxpayer would lose all benefits of doing a 1031. If his basis had been $1M or more he would have not deferred any gain.

How to avoid this? Chunking with the 200% Rule. It costs nothing but a few extra lines on the identification form. Rather than identifying his backup as a single $500K DST interest and a single $500K royalty package, Luke should have added several increments. If he had listed five separate $500K chunks of DSTs and five separate $500K chunks of mineral interests, each as its own line item on the form, he could have bought more than just the initial single increments of each. He could have bought the number of such increments that he wanted to. The option to defer more – and potentially all – capital gain would have remained. The tax stays deferred and Luke owns passive income instead of a troubled asset.

Note what chunking does not do: it does not let you exceed the identification rules. You still have to satisfy the three-property rule or the 200% rule. Chunking works because DSTs and mineral interests are typically available at small enough and flexible enough amounts that a properly structured set of increments fits within 200% of your relinquished value. Getting that arithmetic right is the whole job, and it happens before Day 45 or it does not happen at all.

Note also that DSTs and mineral interests are identified as percentages of the properties they are buying. To the exchanger and for the 200% Rule what is relevant is the value of each investment they are identifying and buying.

Takeaway

Your identification is not a shopping list. It is a fence. You may buy inside it, and you may buy somewhat less than you named. You may not buy outside it, and you may not buy more.

Most exchangers identify their backup properties as single line items because that is how they think about them — one DST, one royalty package. That framing is fine until the primary property fails. Then the single line item becomes a ceiling, and the ceiling is far below what the exchanger needs.

Build the flexibility in on or before Day 45, when it costs you nothing but a few extra lines on a form. After Day 45, no one can build it for you.

(For more information on DSTs and royalties, see Turning Land and Buildings into Mailbox Money) :