The 1031 exchange is a tax-deferred strategy that allows investors to reinvest proceeds from the sale of investment properties into like-kind properties. When structured properly, it can enable investors to defer capital gains and depreciation recapture taxes, offering a pathway to refine or expand their investment portfolio.
However, if you start the exchange process and change your mind, can you undo it? The short answer is that you can technically halt an exchange at any point during the process. However, once a 1031 exchange process begins and the Qualified Intermediary (QI) holds proceeds from the sale of your relinquished property, the question becomes how long that money could be unavailable to you. The QI could hold those proceeds for up to 180 days.
Stopping a 1031 Exchange
If you must backtrack from an in-progress exchange, the best way to do so is by asking your QI to return exchange funds within the 45-day replacement property identification period. This effectively stops the exchange, even though you’ll have to pay taxes on capital gains and depreciation recapture. Furthermore, it’s effective only if you haven’t identified or purchased any replacement properties.
Halting the exchange process becomes more difficult and costly if you're further into it. The following could be used to do so, but each method brings its own challenges.
Invoking the “Material and Substantial” Contingency
Under the Treasury Regulation §1.1031(k)-1(g)(6) limitations, a 1031 exchange can fail without disqualification if a “material and substantial contingency” occurs that is beyond the taxpayer’s control. This applies when:
- You cannot close on a replacement property due to circumstances outside of your control (e.g., title defects, natural disasters, or regulatory obstacles).
- The contingency cannot be invoked due to economic conditions, failed negotiations, or other conditions outside of your control.
Qualifying events in which you can evoke this contingency include:
- Destruction of the identified property in a fire or natural disaster
- Legal or regulator delays that prevent closing on the replacement property
- The replacement property’s seller withdrawing the property due to situations beyond your control
Other issues to consider are that:
- The contingency applies only after funds are held by the QI, and generally impacts the period following the 45-day identification window.
- Invoking the contingency means you must have identified replacement properties within the 45-day window.
- If the contingency applies and the exchange fails (because you haven’t identified a replacement property), you’ll owe capital gains and depreciation recapture taxes on proceeds from the relinquished property.
Missing the IRS Deadlines
In a 1031 exchange, the following deadlines must be followed to maintain tax-deferral benefits:
- 45 days from the sale of your relinquished property to identify replacement properties.
- 180 days from the sale of your relinquished property to close on the replacement property.
Missing these deadlines will automatically terminate the 1031 exchange process. However:
- Missing the deadlines deliberately is not a recommended method for stopping an exchange. Doing so delays access to your funds until the process formally concludes. This can take as long as 180 days.
- If you miss the deadline and the exchange fails, you’ll be responsible for paying your relinquished property’s capital gains taxes and depreciation recapture.
Staying the Course
Your best bet to stop a 1031 exchange is to ask your QI to return proceeds from the sale of your relinquished property within 45 days after closing. The further you move into the process, the more complex and costly it could be if you change your mind. In some cases, you might be better off completing the exchange, holding the replacement asset for two years, then selling it.
A better method is carefully considering your investment strategy and long-term plans before embarking on a 1031 exchange. Get advice from a QI or tax professional; these experts can guide you and help you make the best decisions for your real estate investment goals.
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.
