Want to execute a successful 1031 exchange? Here’s what not to do.
JTC has been in the 1031 exchange business for a long time, and from the countless exchanges we’ve helped facilitate, we’ve seen what can go right and what can go wrong. First-time exchangers can be caught-off guard when an unexpected error leaves them subject to tax payments they’d hoped to defer. That’s why we’ve compiled this handy guide to some of the 1031 mistakes we see most often and how you can steer clear of them with proper planning.
Mistake #1: trying to exchange properties that don’t qualify
A like-kind exchange allows taxpayers to defer capital gains taxes, depreciation recapture, and certain other taxes when exchanging one property for another “of like kind.” The definition of “like kind” is very broad, encompassing most types of real estate, including single-family rentals, industrial commercial property, bare land, and Tenant-in-Common (TIC) or Delaware Statutory Trust (DST) structures.
A mistake property owners often make is thinking that because a type of property can qualify, that means a certain property will qualify. There are some properties that are excluded from IRC Section 1031. An important aspect of Section 1031 is that it only applies to properties “held either for productive use in a trade or business or for investment.”
Your primary residence cannot qualify under Section 1031 because it is not held for business or investment. For your main home, there is another part of the tax code, Section 121. It’s possible to convert your main home into a business property or vice-versa, but this cannot be done overnight. To better understand the differences between 1031 and 121 and scenarios where they can work in tandem, read our blog on the subject.
You also can’t perform an exchange with property acquired strictly for resale purposes or dealer property, as Section 1031 states that it “shall not apply to any exchange of real property held primarily for sale.” Because of this provision, if you own land you’ve recently developed, it may not qualify. You could hold it for a period of time as a rental property and subsequently qualify for 1031, but again, this cannot be done overnight.
If you try to perform an exchange with a disqualified property, it may be deemed ineligible and subject to taxation, which could greatly upset your investing strategy. It’s important to work with your tax and legal advisors to plan your exchange in advance and be sure you are complying with the rules.
Mistake #2: not understanding the 1031 timeline
Whether you’re contemplating a forward exchange, reverse exchange, or any other type of 1031 exchange, you must adhere to the 1031 exchange timeline. There are two main dates to keep in mind, because if you don’t complete the required tasks by those dates, your exchange will fail.
In a forward exchange, within 45 days of the date the relinquished property sale closes, you must identify your replacement property or properties. If you do not identify properties by this day, your exchange will fail.
The replacement property must be acquired within 180 days of the date the relinquished property is sold. If not, the exchange will fail. There are some important exceptions that exchangers need to be aware of, including a shortened timeline when your tax filing date comes before Day 180.
When pursuing a reverse exchange, the timeline involves the same 45-day and 180-day deadlines, but with different procedures. To learn more, read the JTC Reverse Exchange Guide.
Mistake #3: failing to identify enough replacement properties
There is always the chance that your chosen replacement property will become unavailable. When that happens, you’ll need to purchase another property to complete your exchange. But if you’ve only identified one property, you won’t have a backup option and won’t be able to complete your exchange.
That’s why the “three property rule” exists, allowing exchangers to identify up to three replacement properties (or more in certain scenarios) without requiring the exchanger to eventually acquire all three. If your first choice falls through, you can acquire one of your other identified properties to complete the exchange.
It’s a good idea to use all three identification slots just in case. Many exchangers use an interest in a Delaware Statutory Trust as one of their identified properties as a way to hedge against exchange failure. But as our next mistake shows, having a backup plan won’t matter if you don’t identify your replacement properties correctly.
Mistake #4: not keeping proper records and documentation
During the property identification process, it isn’t enough to simply select the properties you want. There are specific rules for how to identify those properties and inform the affected parties that you are performing a 1031 exchange. You’ll also need a proper exchange agreement with your Qualified Intermediary (QI), and a Qualified Exchange Accommodation Agreement if you’re performing a reverse exchange.
It’s critical not only to execute these documents correctly, but to have thorough records for your tax return and in the event of an audit. Working with experienced professionals who understand the proper procedures and how to perform them is the best way to set yourself up for success.
Mistake #5: miscalculating the taxable boot
It’s likely that your replacement property will not be of the exact same value as your relinquished property. If the replacement property is of higher value, you may need to contribute additional cash or mortgage debt in order to make the purchase. And if the replacement property is of lower value, there will be leftover cash returned to you at the end of the exchange. This is known as the “boot,” and it will be treated as taxable income.
If your goal is to maximize 1031 benefits by achieving full tax deferral, you need to understand that there are multiple types of boot. To avoid a boot, the taxpayer must purchase replacement property of the same or greater value to the net sales price of the relinquished property, but must also assume debt on the replacement property equal to or greater than that on the relinquished property (or add cash to the transaction to make up the debt amount). If the taxpayer does not incur equal or greater debt on the replacement property, they can incur what is known as a mortgage boot, which will be subject to taxation.
Mistake #6: not understanding the same taxpayer rule
in order to qualify under Section 1031, the taxpayer surrendering the relinquished property must be the same taxpayer acquiring the replacement property. This means that if the property is owned by a partnership, corporation, or tenant-in-common structure, the replacement property must be purchased by the same entity that sells the relinquished property.
In some instances, a taxpayer may wish to relinquish a property owned by one entity, like a multi-member LLC or partnership, with the intent of acquiring a replacement property under a different taxpaying entity. It’s important to assess the following:
• Who holds title to the relinquished property?
• Who is the property’s “tax owner” when it is surrendered?
• Who will hold title to the replacement property?
There is a method for dissolving partnerships or separating members in an LLC, but it must be initiated before the exchange. This is known as a “drop and swap,” and you can learn more about it in our guide to 1031 ownership structures.
It may not always be possible for the same party to sell the relinquished property and acquire the replacement property due to various reasons, such as the need for a loan or a business need requiring different entities for holding properties. Taxpayers can overcome this by using “disregarded” entities for their replacement property acquisition, such as individual names, revocable grantor trusts, or single-member LLCs owned by the taxpayer. Disregarded entities, although legally recognized, are completely ignored under tax law.
Mistake #7: taking receipt of funds during the exchange – why you need a QI
An important component of a successful 1031 exchange is that “the taxpayer is not in actual or constructive receipt of money or other property” received from the sale of the relinquished property.
In a pure exchange, the seller and buyer want one another’s properties and merely “swap” properties, with cash only changing hands if there is a difference in the value of the two properties. In this case, the relinquished property is sold and the replacement property acquired at the same time, so there is no need to worry about taking receipt of proceeds from the relinquished property sale.
But in a deferred exchange, the taxpayer sells one property and then uses the sales proceeds to purchase a replacement property at a later date. Section 1031 allows this to qualify as an “exchange,” but only if the taxpayer does not take receipt of the sales proceeds from the sale of the relinquished property before they are used to purchase the replacement property.
The taxpayer must retain a Qualified Intermediary take receipt of those sales proceeds and control funds during the exchange process. You enter into an agreement with your QI to act as the third party in the exchange so you only receive title to the replacement property and any leftover cash at the completion of the exchange.
The exchange agreement with your QI (along with the QEAA in a reverse exchange) must contain certain provisions – and must be signed before you begin your exchange.
Mistake #8: waiting too long to contact a QI
In a forward exchange, you have 180 days from the date of sale of your relinquished property to acquire your replacement property. Many people think this means they can sell their relinquished property and decide later on if they want to perform a 1031 exchange, but this isn’t the case. If you take receipt of the sales proceeds, your opportunity to perform an exchange can be lost.
That’s why you need to get in touch with a QI to enter into an exchange agreement and set up a qualified escrow account at a secure bank to hold the sales proceeds before you sell your relinquished property. The earlier you contact your QI, the better – especially if you’re performing a reverse exchange that involves more steps than a forward exchange.
Don’t make the error of thinking you can wait until the last minute – find a QI today, and work with one that understands your exchange needs.
Common mistakes when selecting a QI
The QI is necessary for the success of an exchange, and picking the right QI is important. Many exchangers go with the first QI they find because they don’t realize what to look for, but mistakes made by careless or inexperienced Qualified Intermediaries can result in a failed exchange or worse.
One major mistake exchangers sometimes make is working with a QI that doesn’t keep their funds secure. JTC is committed to best practices in fund security, which include:
• Any fund movement requires dual approval by the exchanger and the QI
• Exchange funds are only held:
• In FDIC-insured, fully liquid accounts at highly-rated banks
• In individual qualified escrow accounts, never commingled in operating accounts
• Errors and omissions and cyber insurance and a fidelity bond should be provided for added protection.
Another big mistake is working with a QI that doesn’t understand your type of exchange. Unlike many QIs, JTC’s 1031 exchange team has specific expertise in reverse exchanges and those involving Delaware Statutory Trusts. If you have a complicated situation, don’t just assume an off-the-shelf solution will provide what you need. Instead, go with a QI that will work with you to understand your unique scenario and meet the challenges it presents.
In addition to our experienced team and commitment to best practices, JTC also provides our 1031 exchange clients with 24/7 access to exchange information through a secure online portal, along with customized reports and document storage with a full audit trail. Every year, we subject our processes to SOC 1 Type 2 certification to ensure we’re offering the utmost in fund and information security.
The best way to ensure a successful exchange is to work with the right partners. In addition to your tax and legal advisors, JTC can provide QI services for all types of like-kind exchanges, and will work with your team to help you achieve your investment goals.
Learn more about JTC’s 1031 exchange services.
