A 1031 exchange can be effective for deferring taxes on the sale of property used for business or investment purposes. However, the approach requires strict adherence to IRS regulations.
Failure to observe the following regulations can void a 1031 exchange, leading to unexpected capital gains and depreciation recapture taxes.
Working Without a Qualified Intermediary
The IRS is adamant that you do not have access to or control over the exchange's proceeds, from when you sell the relinquished property to when you close on that replacement property or properties. This is where the Qualified Intermediary is necessary.
In addition to helping with documentation, the QI, as a neutral third party, facilitates the 1031 exchange by preparing the necessary documentation and holding the proceeds from the sale of the relinquished property in escrow to close on the replacement property. The exchange is not allowed if you receive any of the proceeds directly from the sale of the relinquished property during escrow.
Finding a reputable, experienced QI is an important step in pursuing a 1031 exchange.
Missing the Deadlines
The IRS has two mandatory deadlines that must be observed for a valid like-kind exchange:
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45-Day Identification Period: You must identify potential replacement property or properties within 45 days of selling your relinquished property.
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180-Day Completion Period: You must close on the purchase of your replacement property or properties within 180 days of selling your relinquished property.
The above are calendar deadlines. They're still in force if the end dates fall on a weekend or holiday. Failure to meet either deadline voids the exchange.
Launching your replacement property search early in the process can help you stay within the required time limits. Also, communicate often with your real estate team and Qualified Intermediary throughout the process.
Failing to Identify Replacement Assets Properly
The replacement properties you’re considering (or that you select) must adhere to one of these rules:
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The three-property rule: Identify up to three replacement properties, regardless of value.
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The 200% rule: Identification of multiple properties, as long as their combined fair market value doesn’t exceed 200% of your relinquished property’s value.
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The 95% rule: The acquired properties must total at least 95% of the fair market value of all identified properties.
Failure to follow the above can void the exchange. To avoid this pitfall, ensure proper documentation and partner with an experienced and reputable Qualified Intermediary.
Changing the Ownership Structure
You’re not allowed to change your ownership structure in the middle of a 1031 exchange. Whatever structure you set up for selling relinquished property must stay in place when you close on the replacement property or properties. However, certain strategies, such as the use of disregarded entities or pre-planned adjustments before or after the exchange, may provide flexibility. Consult a qualified tax advisor or attorney for guidance.
For example, if you sell your relinquished property under an LLC set-up, that same LLC must find, identify and close on the replacement property.
Changing ownership entities can void the exchange, so keep the same entity in place throughout the process.
Take Steps to Avoid the Void
A 1031 exchange can be a helpful tax-advantaged strategy to grow your investment portfolio. However, multiple regulations exist for a successful exchange; failure to follow even one can void the process. Hiring a QI, adhering to deadlines, and proper documentation are steps for a successful exchange process.
Additionally, adding a tax advisor who is well-versed in the like-kind exchange can be beneficial. With guidance from your QI, tax advisor, and other professionals, you can defer taxes, avoid mistakes, and continue potential wealth-building efforts through sound real estate investment strategies.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
