For the past 23 years, I’ve been helping Real Estate Investors successfully complete their 1031 Exchanges. Along the way, I’ve seen a lot of common 1031 mistakes that can easily derail an exchange. Many of these mistakes come from not understanding the strict guidelines of IRC Section 1031. But with a bit of knowledge, it’s easy to avoid common 1031 mistakes and have a successful exchange today.
Get ready to explore – this contents page will guide you through the important stuff.
- Not Using a Qualified Intermediary (QI)
- Missing Deadlines
- Failing to Identify Enough Properties
- Confusing a 1031 Exchange With Section 121
- Not Replacing Debt Properly
- Disregarding Due Diligence
- Overlooking Reverse Exchange Options
- Not Working With Experienced Professionals
- Conclusion
Not Using a Qualified Intermediary (QI)
This is the biggest mistake you can make in a 1031 exchange because it can completely disqualify your exchange. This is why I work alongside clients to help select a qualified intermediary early in the process. You want someone who will safeguard the exchange process, making sure you avoid common 1031 mistakes along the way.
Why is a QI necessary? To meet IRS requirements, the taxpayer must never take actual or constructive possession of the funds during the exchange. Actual or constructive receipt is when the taxpayer has control of the money, even if it’s just a check. That’s why a QI must handle the funds throughout the exchange.
Missing Deadlines
Another common 1031 mistake that can get you into hot water is not following the 1031 timeline. This is especially true because most people aren’t aware of these timelines and don’t leave themselves adequate time. The moment you sell your relinquished property, the clock starts ticking.
You only have 45 calendar days to identify a replacement property. Don’t wait. You can start looking even before your relinquished property closes to get a head start. But changing your identification needs to be completed before this 45-day deadline. Make sure to solidify this before day 45.
To further understand these timeframes, you can review this helpful video on 1031 Exchange Identification Requirements . After the 45-day deadline has passed, you have 180 days to acquire your identified replacement property. Failing to meet these strict timelines will invalidate your exchange. This results in unexpected capital gains taxes, depreciation recapture, and even net investment income taxes. Review this video detailing the importance of 1031 exchange time constraints .
Failing to Identify Enough Properties
It’s critical that you identify more than one property during the 45-day identification window. You’re allowed to identify up to three under the three-property rule. With this rule, exchangers get to handpick up to three properties that catch their eye, no strings attached.
But, sometimes life happens. Maybe an agreement can’t be met, or there is an unforeseen issue that halts the deal. What do you do then if you only identified one replacement property? If your top choice becomes unavailable and you only selected one, your 1031 exchange will likely fail. This can be a common mistake when people rush, especially during a busy market when you feel pressured to get an offer accepted.
But by identifying all three allowed properties, you avoid unnecessary stress in the event your top choice falls through. Imagine you want to utilize exchange funds to purchase a property held in an exchange fund, but your identified property falls through. Without backup options, your exchange could fail, making it crucial to have those additional identified properties.
Confusing a 1031 Exchange With Section 121
One of the biggest common 1031 mistakes I see is investors misunderstanding which properties qualify. You cannot just use any property for a 1031 exchange. For example, while many rental property owners consider their properties an investment, if it’s their primary residence it doesn’t qualify.
This is where IRC Section 1031 and Section 121 differ, as Section 121 deals with the sale or exchange of a primary residence. For an investor who rents properties, their primary residence isn’t considered an investment. However, some use both a 1031 exchange and Section 121 in tandem to potentially defer capital gains.
Not Replacing Debt Properly
To maximize the tax benefits and defer all taxes in a 1031 Exchange, investors must purchase a replacement property of equal or greater value than their relinquished property. They must also have an equal or greater amount of debt on the replacement property.
But one of the most common mistakes is overlooking this critical component of debt replacement. It is easy to miscalculate when determining if debt is being replaced correctly. This can trigger something called “boot” – a tax liability that negates some or all the tax advantages of the exchange.
Disregarding Due Diligence
Investors often overlook a critical step: carefully vetting the replacement properties. Just like you carefully reviewed every aspect of your relinquished property before purchase, so too should you do this with your replacement property. Common 1031 mistakes happen when this crucial step gets overlooked.
Location, market conditions, and room for growth – these three fundamentals form the bedrock of sound investment decisions, helping cautious investors steer clear of risky ventures. You’ll want to carefully consider the cash flow projections, especially if the new property has higher operating expenses than what you’re used to.
Thinking long-term, create short and long-term investment goals based on this new purchase. It’s not merely about deferring taxes but making smart financial moves. What might seem like a smart bet today could be a money pit tomorrow; evaluating the future rewards sharpens your investment instincts.
Overlooking Reverse Exchange Options
While the standard delayed exchange involves selling the relinquished property and then identifying and acquiring the replacement, there’s another method available: a reverse exchange. By taking the reins and acquiring the replacement property upfront, investors can sidestep some of the typical restrictions that come with delayed decision-making.
A reverse exchange, however, is much more complex which is why working with a knowledgeable QI and legal team is critical to your success. So what are the advantages? First, if both properties generate rental income, you’ll be in a better cash flow position during the 180-day window.
Deadlines are already stressful enough; this helps alleviate some of that tension. By swapping into a new property quickly, investors can sidestep the rat race in competitive markets and snag a better deal.
Not Working With Experienced Professionals
To prevent costly common 1031 mistakes, it’s paramount to work with experienced professionals. Before the Tax Cuts and Jobs Act, investors were able to do 1031 exchanges with real and personal property. However, that all changed in 2017 when personal property like art, planes, and collectibles became ineligible.
For many, this is confusing. Surrounding yourself with experienced CPAs, real estate attorneys, and Qualified Intermediaries who are up-to-date on the latest tax codes and regulations will go a long way in making your 1031 exchange a resounding success. What separates the trailblazers from the rest is a Single sharp tool: knowledge. Consulting with legal advisors early on can provide clarity on specific rules and help you navigate the complexities of a 1031 exchange.
Conclusion
Navigating a 1031 exchange is best done with help from experienced professionals and careful consideration of the intricacies of Section 1031. Keep learning, be proactive and you can sidestep some of the biggest Common 1031 MIstakes.
Don’t leave your investments to chance – get the insights you need to make informed choices and start building the financial future you’ve always wanted. Feel free to schedule a free consultation so I can answer any questions you may have. Let’s tackle this together – I’m committed to providing assistance.