A 1031 exchange has many moving parts. If you want to defer capital gains tax on the sale of your investment property, you must follow all the rules carefully. In addition to the requirements, such as following a strict timeline, there may be administrative and incidental costs depending on your situation. Making an error at any point during your transaction could disallow, or fail, your 1031 exchange.
The last thing you want after performing the exchange is to be hit with a tax bill. However, even the most prepared investor can make a mistake. This article looks at what happens when a 1031 exchange fails, how you can salvage it, and how to avoid this costly error.
What Are the Requirements for Completing a 1031 Exchange
The most effective way to avoid a failed 1031 exchange is to inform yourself about the requirements. Here are the fundamental rules you must know before performing a 1031 exchange.
- Timeline: A key component of a successful 1031 exchange is following the 45- and 180-day timelines. From the day you close on the sale of your relinquished property, you have 45 days to identify your replacement property and 180 days to close on the new property or properties. These periods run concurrently.
- Like-kind properties: A like-kind property refers to properties that are the same in nature and used for business or investment purposes. This rule can apply to exchanging a hotel for a retail property or a shopping center for an apartment building. The like-kind property must be equal or greater in value to the relinquished property. You must follow the replacement property identification rules and identify your replacement property in writing to your intermediary.
- Qualified intermediary: For your 1031 exchange to be considered valid, you must use a qualified intermediary (QI) to oversee the transaction. The QI manages the exchange, handles the funds from your relinquished property, and reinvests the proceeds into your replacement property. The QI acts as a neutral third party who ensures you complete the exchange correctly and do not receive cash from the sale of your investment property, which allows you to defer taxes.
How Can a 1031 Exchange Fail?
Though you can potentially disqualify your 1031 exchange in many ways, here are some of the most common mistakes investors can make that lead to a failed exchange.
1. Misunderstanding the Timeline
The 45-day and 180-day timelines start at the same time — the close date of your relinquished property. This means when you’ve hit your 45-day identification deadline, you only have 135 days left to close on the replacement property. If you lose track of the deadline and do not identify or close on a property in time, you will lose the tax-deferred benefits as the transaction will become a taxable sale.
2. Failing to Identify the Replacement Property
You must unambiguously identify the replacement property or properties, such as including a street address, in writing to your qualified intermediary.
3. Believing You Can Get an Extension
You cannot receive an extension on the 45-day or 180-day timelines. If you fail to properly identify or close on your replacement property within the required timeframes, your 1031 will not be valid.
4. Using a Non-Qualified Intermediary
The purpose of using a qualified intermediary is to have the professional restrict your access to the sale proceeds during the 1031 exchange and perform the transaction according to regulations. Some people are disqualified from acting as a QI on your behalf, including employees, investment bankers, brokers, relatives, real estate agents, and certified public accountants. Using one of these disqualified people can fail your exchange.
5. Closing Before Signing the Exchange Documents
As the exchanger, you must sign the 1031 exchange documents before closing on your relinquished property sale. Your QI will be responsible for preparing the purchase agreement. In addition, you must notify the buyer that the contract has been assigned to a QI for the purpose of a 1031 exchange.
6. Having Leftover Proceeds
Depending on your investment goals, you might find it challenging to locate the ideal replacement property that checks your boxes and allows you to reinvest all the proceeds from your relinquished property. In this case, you may still be able to perform the 1031 exchange successfully. However, the amount of funds you have left over will be taxed. These leftover funds are referred to as “boot” in a 1031 exchange.
Since your replacement property must be equal or greater in value than your replacement property, you may choose to invest in more than one property to avoid having cash left over. If you exchange down to a replacement property that’s lower in value, you may still be able to complete a partial 1031 exchange.
This type of exchange may allow investors to defer a portion of capital gain liabilities depending on how much lower the replacement property value is compared to the relinquished property.
What Happens if My 1031 Exchange Falls Through?
Depending on the case, a failed 1031 exchange will often result in you having to pay taxes on the sale of your property. However, if you want to improve your chances of a successful 1031 exchange, you can prepare a backup plan in case you run into one of the issues listed above.
In case your exchange falls through, you might consider identifying a Delaware Statutory Trust (DST) as your backup plan. A DST is a form of fractional ownership that also qualifies for a 1031 exchange, meaning it still offers the benefit of tax deferral. In a DST, investors play a passive role while a sponsor oversees property management responsibilities.
If you cannot find a suitable replacement property in time, you can invest in a DST to defer your capital gains. Instead of acquiring a replacement property, you’ll receive beneficial interests in the DST and its real estate. This can help you satisfy the 1031 exchange requirements. Down the line, you can defer capital gains again with another 1031 exchange.
Learn more about the pros and cons of a DST to determine if this might be right for you.
Strategies to Prevent a Failed 1031 Exchange
A 1031 exchange can help you access new investment opportunities and improve your purchasing power as an investor — if done correctly. Let’s look at some tips and best practices for preventing a 1031 exchange failure.
- Determine investment objectives: In addition to following all requirements closely, identifying your desired investment criteria before you begin the 1031 exchange can help streamline the identification process. Start looking for replacement properties before you close on the sale of your relinquished property.
- Identify as you go: Some investors may not know that you can change your identified properties as many times as you want before the 45-day deadline. If you’ve already identified a suitable property but a better one comes along, you can swap it.
- Use the three-property rule: There’s always a chance that a sale can fall through. This is why some investors choose to identify the maximum of three like-kind replacement properties. You don’t have to acquire all three properties, but identifying multiple properties gives you more options if one sale is unsuccessful.
- Find backup properties that are ready to close: Investors may identify as many replacement properties as they want for a 1031 exchange as long as they follow the 95% rule or the 200% rule exceptions. The 95% rule states that you can identify more than three properties if you purchase 95% of their total value. With the 200% rule, you can identify more than three properties if their combined value is not more than 200% of your relinquished property.
- Agreement contingencies: In some cases, you may be able to negotiate with the buyer and make the sale of your relinquished property contingent on your identifying a suitable replacement property. This can help lower the risk of a failed exchange.
Learn How to Complete a 1031 Exchange Successfully With 1031 Crowdfunding
If done correctly, a 1031 exchange can provide many opportunities to help you meet your investment goals. Whether you’re looking to generate more passive income to grow your wealth or diversify your portfolio, knowing the guidelines of a like-kind exchange can help you defer capital gains taxes on the sale.
At 1031 Crowdfunding, our professionals can help you complete your 1031 exchange and assist you in your due diligence. Our extensive online marketplace of properties can make it easier to identify a suitable replacement property and give you the details you need to make a well-informed decision. We invite you to register for an investor account today to view our vetted 1031 exchange properties or learn more about investing in DSTs.
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