A 1031 exchange has a stringent timeline and set of rules to follow. This leaves little room for error. Even the best-prepared investor can get caught off guard. When that happens, what will you do for a backup?
For the unprepared investor, it may simply be to pay taxes on the relinquished property due to a failed 1031. While that is one option, it doesn’t have to be your only option. Depending on the situation, you may be able to salvage the 1031 by investing in a Delaware Statutory Trust or DST for short.
In this article, we’ll look at some common 1031 mistakes that you can avoid. Knowing about these mistakes will help you to be better prepared to successfully execute a 1031 exchange. You’ll also see how to consider a DST as your 1031 backup plan.
Common Mistakes
To qualify for a 1031 exchange, the investor will need to set up an account with a qualified intermediary. The replacement property must be identified (nominated) within 45 days of closing on the relinquished property. If using the three property rule, up to three properties can be identified. Once identified, you have 180 days from the close date of the relinquished property to close on the new/replacement property. This timeline of events is where some investors go wrong with their 1031.
Misunderstanding The Timelines
The 180-day time frame includes the 45 days for identification. Start (from the close date of the relinquished property) to finish (closing on the replacement property) is 180 days. Thinking that you have 45 days plus another 180 days will lead to a failed 1031.
Believing There Is An Extension
Sorry, but there isn’t one. Some investors go into a 1031 believing they can file for an extension if time runs out. Unfortunately, this is not a feature of the 1031.
Changing Entities
Due to the IRS same taxpayer rule, whatever entity relinquished the old property must be the same entity that acquires the replacement property. For example, if ABC LLC is the entity that owned the relinquished property, you, as an individual that owns ABC LLC, can’t acquire the new property. ABC LLC must acquire the new property.
There are some exceptions for "disregarded entities", which is a good question for an experienced Qualified intermediary or attorney. Additionally, with proper planning, in most cases, it's possible to restructure the entities to allow the investors individual exit options.
Not Using The Right Intermediary
All 1031s must use a qualified 1031 intermediary. Unfortunately, not all 1031 intermediaries are created equal. This is a result of the industry not being well-regulated. Just because an intermediary is qualified and has a license doesn’t mean they have the experience and can execute a 1031 successfully. The truth is that anyone can become a 1031 custodian. You want someone who is able to get the job done smoothly and can handle any hiccups that might come up.
A 1031 intermediary with a proven track record is a great first step to verifying that the intermediary will be able to follow through and provide you with the right guidance. The intermediary should also be bonded and insured. Funds should be held in a special account called a Qualified Trust Account or Qualified Escrow Account. This not only separates and protects the funds from the seller but the Qualified Intermediary as well.
DST Backup Plan
DSTs can be a great option in case your primary deal falls through, or you have some leftover funds that need a home. Keep DSTs in mind as a backup. Think of your DST backup plan as, "if things don't work out, I'll just use a DST." At the least, it allows you to take advantage of tax deferment.
Identifying DST Properties
For some investors, DST's can feel overwhelming and difficult to understand. Reaching out to the right DST specialist with ample resources to perform DST specific due diligence is an important first step. DST's can hold multiple properties, giving investors the option to diversify across asset classes, industries, and locations. When doing a 1031 exchange into a DST, your tax advisor may have a specific method for identifying your ownership. It might be fractional interest in a specific property, percentage of the DST as a whole, or a dollar amount of equity. Different 1031 exchange rules can come into play, depending on how the property is identified.
Being prepared by identifying a replacement property before selling your relinquished property gives you a headstart with 1031 exchange timelines. However, unforeseen problems can still crop up. That’s where a DST backup plan can help you with real estate tax deferment.
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. It should also not be construed as advice meeting the particular investment needs of any investor.
IRC Section 1031 is a complex tax concept; Realized does not offer legal or tax advice, consult your legal or tax professional regarding the specifics of your particular situation.
