Even though 1031 exchanges are shrouded in technical lingo and bright line rules, they still leave some room for creative thinking and reasoning. No matter how rigid they appear, there is some flexibility in the requirements of 1031 exchanges.
One bright line rule that actually has some flexibility is the time requirement for acquiring replacement property. Many investors don’t know that there are ways to extend the time requirements, known as option agreements. An option agreement?specifically an “option to purchase” or “option to buy” agreement?can allow you to line up a potential buyer for your relinquished property but delay the actual release of the relinquished property until a suitable replacement property is identified.
The time requirements for acquiring replacement property are triggered by the disposal of your relinquished property. An option to purchase can extend the point at which these requirements take effect. Let’s take a closer look at the specifics of how you can use an option to purchase agreement to create a 1031 exchange that better suits your needs.
Option to Purchase Agreements Can Extend 1031 Exchange Time Requirements
As you’re no doubt aware, time has a great deal of value when you’re making investments. Property can appreciate greatly in a relatively short span of time, and it can also decline in value rapidly as well. Given this reality, as an investor, you should be keenly interested in any sort of tool that can be used to give you more time.
This is precisely what an option to purchase can do. Under current law, you have 45 days to formally identify a replacement property following the sale of your relinquished property, and 180 days to acquire this replacement property. An option to purchase can extend this indefinitely and grant you a much longer period to identify and acquire a suitable replacement property.
An option to purchase means that the potential buyer pays for an opportunity to purchase your relinquished property during a specified timeframe. This option can be paired with a lease agreement as well, so your potential buyer has the capacity to take physical possession of the property prior to its disposal. As long as certain rules are followed, this arrangement should not bar 1031 treatment once the relinquished property has been sold and the replacement property has eventually been acquired.
On first glance, this may seem like a loophole you’re just cleverly exploiting, but the truth is that an option agreement of this sort carries its own complications. In a sense, you are making a trade to receive the extra time.
If you develop such an option agreement, be sure that the option payments are reasonable. If your option payment is excessive, this may raise issues about the legitimacy of the arrangement. Also, if you receive large sums in the form of option payments, this may trigger a transfer of ownership and initiate the time requirements.
Option Agreements May Present Issues Concerning Taxpayer’s Intent
As we’ve seen, your intent plays a large role in your 1031 exchange. And the issue of intent definitely relates to the use of option agreements as time-creating mechanisms. If you decide to create an option to purchase agreement, this agreement could undermine a future 1031 exchange depending on your actions.
Unfortunately, there is not too much guidance in this area, as case law and IRS guidelines are sparse. The key point is that you do not want your option agreement to stand as evidence against your intent to hold the property for purposes covered under section 1031. Remember, if your property is held “primarily for sale” then it is disqualified from receiving section 1031 treatment.
Overall, option agreements present a unique opportunity to extend time requirements, though investors who choose to execute such agreements do take on a measure of risk in the process. With the additional time, you can find a truly desirable replacement property, or you can obtain the best possible financing for a replacement property that has already been identified.
Still, you need to be careful, otherwise you risk losing 1031 treatment. At CWS Capital Partners, our staff members can provide you with in-depth counsel on option agreements.
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