Savvy investors know that a 1031 exchange can help boost potential cash flow and manage investor’s tax liability by deferring capital gains and other taxes on the sale of investment real estate and acquisition of replacement assets.
The exchange process isn’t without risk to investors, however. Knowing which pitfalls to avoid and the key rules you must follow can help ensure your 1031 exchange goes smoothly. Below we’ve outlined the three primary risks to avoid so you can successfully complete your 1031 exchange.
Execution Risk #1: Identifying Like-Kind Replacements Within 45 days
Under Section 1031 of the IRS Code, you can defer paying capital gains on the sale of your investment property when you exchange it for a like-kind replacement. This process allows you to shift the focus of your investment strategies, diversify, or upgrade investment properties without incurring stiff tax obligations.
Your replacement property must be similar (like-kind) in nature, character, or investment-grade quality as the relinquished asset. The catch here is that you must identify replacement properties within 45 days of closing on your relinquished asset using one of three identification strategies:
- Three-property rule. You can identify up to three like-kind replacements. This is the most common approach.
- 200 percent rule. You can identify unlimited replacement assets so long as their cumulative value does not exceed 200 percent of the relinquished asset.
- 95 percent rule. You can identify more than three properties whose value exceeds 200 percent so long as you acquire 95 percent of the value of the replacement properties.
Finding suitable replacement properties can be challenging in hot real estate markets where good deals are snapped up quickly. The 45-day identification window can close fast-- and it’s calculated in calendar days, not business days.
Beginning the process of identifying like-kind replacement assets prior to closing on your original property can reduce stress, provide more time to complete due diligence, and better position your planned exchange to remain compliant with IRS rules.
Execution Risk #2: The 180-Day Exchange Completion Window
Section 1031 of the IRS Code stipulates that you have 180 days after the sale of your relinquished asset to close on one of your previously identified replacement properties and thereby complete the exchange.
While the IRS did release new guidance this year on how COVID-19 impacted pending like-kind exchanges for these 45- and 180-day deadlines (if they occurred prior to April 1), you’d do well to consider these safe harbor deadlines set in stone. They are concrete, and failure to complete the exchange process within the allotted time frame can result in an unsuccessful exchange -- and capital gains income.
Lastly, the 180-day window runs concurrent to the 45-day identification window, and the IRS counts each day from closing on the original asset, including weekends and holidays.
Execution Risk #3: Your Qualified Intermediary
There are a few areas in a 1031 exchange over which investors have complete control -- jump on the paperwork early, and the 45- and 180-day deadlines won’t sneak up on you.
Few things can make the process more difficult, however, than choosing the wrong Qualified Intermediary (QI). These professionals, also known as 1031 Exchange Accommodators, facilitate the exchange by acquiring the relinquished property from the exchangor and transferring title to the buyer. They also acquire the replacement property from the seller and transfer title to the exchangor to complete the 1031 exchange process.
Experienced QIs can take much pressure off investors by properly executing all necessary documentation, including the exchange and assignment agreements, notice of assignment exchange account forms, and other important paperwork.
More importantly, however, QIs also hold all exchange proceeds until the funds are needed to purchase the replacement asset. While some states have passed legislation to oversee QIs, the industry as a whole is not regulated by the Federal Government. This lack of oversight leaves the door open to malfeasance. Select carefully when choosing a QI to facilitate the exchange.
Advance Planning Pays Off
Planning ahead is perhaps the easiest way to ensure a successful 1031 exchange. Identify like-kind replacement assets well in advance to avoid being rushed into a poor deal by the mandatory 45- and 180-day deadlines. And don’t be hesitant to do a bit of due diligence on your choice of Qualified Intermediary as well.
Putting these pieces in play well before the exchange process begins can help you reap the most benefit from this important tax-deferment strategy with fewer hassles.
This material is for general information and educational purposes only. 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.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.