A 1031 exchange is a sound way to reinvest without incurring a tax liability, but only if done correctly. These common pitfalls can leave investors paying taxes they did not anticipate – but proper steps and planning can keep everything on track.
Trading in or trading up one investment for another while deferring capital gains makes a 1031 exchange an appealing way to structure real estate transactions. However, investors must have a strong grasp of every step before getting started if they want to avoid problems along the way.
Here are several common mistakes investors make with 1031 exchanges and how to prevent them.
1. Failing to Have a Qualified Intermediary
Regulations for 1031 exchanges require the taxpayer never to have actual or constructive receipt of the exchange funds. The taxpayer cannot hold the funds in any way, even as an uncashed check. They also cannot leave the exchange funds with the title or escrow company or with their attorney. The exchange must take place through a Qualified Intermediary (QI) and an exchange agreement needs to be signed prior to close of escrow. Anything else risks violating the rule against actual or constructive receipt of the exchange proceeds and may nullify the 1031 exchange.
2. Choosing a Disqualified Party to be the Qualified Intermediary
According to the Regulations, a Qualified Intermediary is defined as a party who is not the taxpayer or a disqualified person. The Qualified Intermediary enters into an exchange agreement with the taxpayer and acts as the party responsible for completing the exchange. A disqualified person includes any individual who has served as the taxpayer's accountant, attorney, employee, investment banker or broker, or real estate agent or broker in the previous two years. Family members are also prohibited relationships, among others. If the taxpayer decides to use their attorney as the Qualified Intermediary, for example, the attorney would be disqualified, and the exchange would not be allowed.
3. Not Being Selective with Qualified Intermediaries
Just because someone can be a QI does not mean they are the right person for the job. The Federation of Exchange Accommodators (FEA) is the only national association representing QIs and tax/legal advisors who are directly involved in the 1031 exchange industry. Membership in the FEA should be a minimum requirement when choosing a QI. Investors should also look at the QI's staff. An ideal choice will have multiple Certified Exchange Specialists® (CES®) and a team of attorneys on staff. The CES® designation is the only independent, tested designation for 1031 exchange professionals, and it is always good to have legal experts reviewing complicated transactions such as a 1031 exchange.
4. Bringing in a Qualified Intermediary After the Sale
The 1031 exchange process starts before any transactions happen. Once a sale has closed, it is too late to start an exchange. The 1031 exchange must be established and in place at or before the closing of the first property in the exchange. That also means the QI needs to be vetted and selected before any properties or money exchange hands.
5. Not Documenting the Exchange Correctly
While many assume that the Qualified Intermediary simply holds onto sale proceeds during a 1031 exchange, handling the funds is not the QI's only role. The QI completes every step of the actual transaction, including selling and purchasing the property or properties involved. Consequently, a valid exchange requires an exchange agreement between the taxpayer and the QI that assigns the taxpayer's rights in the sale and purchase contracts to the QI. The taxpayer then must notify all other parties to the exchange of that assignment. The QI handles all of the paperwork involved, including preparing the documentation and ensuring the other parties receive proper notification.
6. Attempting to Exchange a Property That is Ineligible or Disqualified
Only very specific types of properties are eligible for a 1031 exchange. For instance, a vacation home cannot be part of a 1031 exchange, regardless of whether the taxpayer considers it an investment. The law requires properties in an exchange to be “held for productive use in a trade or business, or for investment.” Anything that does not meet that definition will not qualify. A vacation home, second home, or any other property used exclusively by the taxpayer for their own enjoyment, and which has no business or investment motive is not eligible for a 1031 exchange.
7. Trying to Exchange Flipped Property
There is an important distinction between an inventory property and a business or investment property; only the latter is eligible for a 1031 exchange. Any property that is purchased expressly to be rehabbed and resold is considered inventory. The key is in the phrase "productive use" from the previously cited “held for productive use in a trade or business or for investment.” Rehab and flip real estate is not being put to productive use and so does not qualify as a business or investment property.
8. Forgetting the Exchange Is Based on Fair Market Value
Many who are new to 1031 exchanges may believe they only need to reinvest the gains or profits on the sale of their relinquished properties. Alternatively, they may believe only the cash profits from the sale need to be reinvested, not including any satisfaction of loans or closing costs. However, to have a fully tax deferred exchange, the exchanger must do three things:
- Purchase replacement property or properties equal to or greater than the sales price of the relinquished property
- Replace any debt from the relinquished property with an equal or greater amount of debt
- Spend all the proceeds
9. Missing Deadlines
The deadlines involved in a 1031 exchange can confuse those new to the process. The important detail is that everything is based on the sale of the relinquished property. The law requires taxpayers to identify potential replacement properties no more than 45 calendar days after closing on relinquished properties. They have 180 days to acquire replacement properties, but that deadline also starts ticking away with the closing on relinquished properties. If an investor misses either deadline, it will invalidate the 1031 exchange.
10. Missing Out on a Reverse Exchange Opportunity
The threat of looming deadlines can make some investors worry about trying a 1031 exchange. However, the IRS approved a slight adjustment to the normal exchange process over two decades ago that can ease those concerns. Known as a "reverse exchange," this method allows the taxpayer to acquire the replacement property before the relinquished property is sold. Doing things in reverse order increases the complexity involved and adds to the need to work with a reputable and experienced QI. However, there can be additional benefits aside from ensuring deadlines are met. For instance, if both the relinquished and the replacement properties generate rental income, the taxpayer can benefit from increased cash flow during the exchange process.
11. Not Accounting for Partnerships
Investors sometimes work with partners to extend the reach of their capital, such as by pooling resources and acquiring real estate inside of a limited liability company (LLC). That LLC is a taxpayer unto itself, and any 1031 exchanges involving property held by the LLC must be performed on behalf of the LLC. The LLC's partners do not have independent rights to perform 1031 exchanges beyond the confines of the LLC. There are ways to exchange properties independent of partners, but they require advance planning. These methods, such as “drop and swap,” should always involve consultation with tax and legal advisors. Partners need to plan carefully to maximize their compliance with 1031 exchange rules, especially the concept of “held for investment.” Read a case study to learn more about “drop and swap” exchanges.
12. Not Scrutinizing the Settlement Statement
Settlement agents may not understand what is happening in a 1031 exchange, and the taxpayer and their tax or legal advisor should carefully scrutinize every line on the settlement statement. For instance, as discussed above in item 5, the assignment makes the QI both the seller and buyer in the exchange. Without that assignment, the transaction is not a 1031 exchange. As such, the settlement statement needs to identify the QI as both the seller of the relinquished property and the buyer of the replacement property with wording such as "[QI name] as Qualified Intermediary for [taxpayer's name]." Any non-qualifying expenses should be handled outside of closing and can be identified as "POC" on the closing statement to avoid a taxable event. Similarly, overfunding the purchase of the replacement property can result in cash flowing back to the taxpayer, which would also be a taxable event.
A 1031 exchange is full of opportunities for taxpayers to fall into noncompliance or trigger an unexpected tax bill. To avoid trouble, investors should ensure they are working with tax and legal advisors with 1031 exchange experience. They must also find a Qualified Intermediary with the experience and resources they can trust.
