Deferring capital gains is a topic that will always turn heads and ignite discussions. To be clear, it’s not a simple process, but it is attainable. Once you have trodden down the 1031 pathway — checking off every painstaking step to execute the exchange — how can you be certain you can hang onto those gains? No road we travel is without pitfalls. And it’s the wise traveler — or investor, in this case — who recognizes that they cannot afford any missteps.
Connect The Dots Before You Cash Out
If you have initiated a 1031 specialized real estate transaction, you will want to ensure you maximize your capital gains by delaying the tax liability for a few years. It’s a loophole by which the IRS will allow you to push the tax ‘due date’ into the future, thus allowing you to reinvest your profits elsewhere – as long as the purchased property falls within the prescribed framework.
While it’s a way to preserve and build wealth, the 1031 provision comes with many strings attached. Investors must adhere to strict rules and inflexible deadlines. Those who fail to connect all the dots can expect to receive a tax due notice from the IRS, stating that capital gains taxes must be paid – immediately.
So what are the most common pitfalls that investors overlook – the ones that invalidate the deferral, requiring them to end up paying their tax bill ASAP? Worse than that, the gains will be taxed as ordinary income. In this piece, we will focus on 1031 exchanges and QOZs, as they are the most common ways investors' deferred gains may be triggered.
Failure To Adhere To 1031 Regulations
45-day and 180-day deadlines. While the IRS may sit on the sideline, they always keep a vigilant eye on the calendar. Many investors, however, aren’t as disciplined, and inadvertently let the mandatory dates slip past them.
This timeline is carved in stone; the time clock starts ticking the day the relinquished property closes. Within the next 45 days, the seller must identify the replacement property. The next item of business: the investor has 180 days to close on and acquire the specified replacement property.
A few additional rules apply to a 1031 exchange. Remember that for the exchange to qualify, only one of these rules has to be met:
Three Property Rule. Under IRC Section 1031, the exchanger may identify up to three properties, regardless of value, as long as the individual closes on two or all three as the replacement property.
200% Rule. Under this rule, the exchanger may identify more than three properties provided their combined value does not exceed 200% of the fair market value of the relinquished property.
95% Rule. This rule allows an investor to identify an unlimited number of potential replacement properties, without regard for valuation, provided they actually acquire 95% of the aggregate identified value within the exchange period.
DST Converts To Springing LLC And Does Not Convert Back Before Sale Of Assets
In cases when structural restrictions throw a wrench into the Delaware Statutory Trust (DST), all is not lost; the DST may be converted to an LLC. It’s important to note that when this happens, it will be treated as a partnership for federal income tax purposes. Translation: investors will not be able to execute a 1031 exchange if the LLC sells the asset.
Neglecting To Complete Another 1031 Exchange In The Required Timeframe
Investors are not limited in the number of times they can execute a 1031 exchange. The difficult part is completing the transaction within the fixed window of time. The exchange defers the tax bill as long as you continue to complete exchanges each time the asset is sold. Once you stop the cycle, you will be required to pay the capital gains tax.
Qualified Opportunity Zones (QOZs)
Numerous benefits have been injected into QOZs to incentivize investors. However, prospective investors should be aware of four areas that can trigger capital gains:
- Fund does not comply with the program’s guidelines and regulations
- Sold all or a portion of your investment prior to December 31, 2026
- Distribution exceeds the investors’ basis in the fund
- The QOZ fund is dissolved prior to 12/31/26
At Realized, we understand and can assist with many of the complications that may arise while executing a 1031 exchange. If you have any questions, our professionals are ready to help. Reach out to us at (877) 797-1031.
Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not offer legal or tax advice. The application and impact of tax laws can vary widely based on the specific facts involved. As such, this information should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers. Before making any decision or taking any action, you should consult with a qualified professional.
What is a 1031 Exchange
The Investor's Guidebook