There are many rules and regulations that govern the completion of a 1031 exchange, which often make the process nerve racking for investors. Fortunately, there are many resources available to investors, including the Realized guidebook on the 1031 exchange process. Below are three common challenges of 1031 exchanges and potential solutions for each.
PROBLEM ONE: The buyer of a replacement (new) property must be the same legal entity as the seller of the relinquished (original) property.
For example, if a husband and wife own the relinquished property together, then both the husband and wife must be the owners of the replacement property. The same is true with any form of ownership including LLCs, partnerships or family trusts. This often leads to conflicts between partners when some want to complete an exchange, but others do not. For example XYZ partnership sells a property, the replacement property purchased using a 1031 exchange must also be purchased by XYZ. The same is true of a limited liability company (LLC) .
SOLUTION: For years, investors in partnerships and LLCs have used what’s known as a “drop and swap” to overcome this problem. In a drop and swap, before the sale of the relinquished property, the partnership or LLC is is converted to a tenants-in-common (TIC) structure. Each investor is now a co-owner and has a direct interest in the property, instead of an ownership stake in a partnership. The IRS views this as a collection of individual owners, thus allowing each individual investor the choice of whether to complete a 1031 exchange. For example, shortly before the sale, ownership of the relinquished property would be transferred from XYZ, LLC to each of the XYZ owners as tenants-in-common and in proportion to the amount of XYZ the each owned. It should be cautioned that drop and swaps carry considerable risk. In the event the IRS determines these violate the tax code, the 1031 exchange will not be allowed.
PROBLEM TWO: The property must be held for investment, not for resale.
So, what does this mean? Typically, a property is considered “held for investment” by the IRS when the property is owned for at least one year and it is not the owner’s primary residence (i.e. their home). If a property is owned for less than one year, the IRS typically considers it “held for resale” and does not qualified for a 1031 exchange. In addition, the profits on a property “held for resale” are typically taxed at ordinary income rates, which are higher than capital gains rates.
SOLUTION: A potential solution is simply to sit back and wait at least one year before selling a property. Investors should consider the trade-off between selling before this time period versus potential tax liabilities of doing so. Investors should consult their accountants for guidance on their specific situation as the tax impact can vary significantly based on individual circumstances.
PROBLEM THREE: You must use a Qualified Intermediary (QI).
Big picture, a Qualified Intermediary is a person, company, or entity that holds your 1031 funds from the sale of your relinquished property until you are ready to reinvest in your replacement property.
The problem is that virtually anyone can be a Qualified Intermediary. In most states QI’s are not regulated, even though they are holding your hard earned profits from selling your real estate.
SOLUTION: Choosing reputable and experienced qualified intermediary is a good start. However, the best way to protect your 1031 funds is by asking your QI to opening a “Segregated Escrow Account” where your money is set aside in a separate account. In addition, it’s smart to make sure that both your signature and the QIs are required to move the funds.