The goal of every Section 1031 exchange is to defer capital gains taxes. However, not every 1031 exchange is carried out correctly. A large percentage of these exchanges fail for one reason or another. Determining precisely the percentage of exchanges which fail would be difficult, but the phenomenon is not at all uncommon. As we’ve seen, Section 1031 is full of rules, and sometimes taxpayers fail to comply with one or more of these rules.
In this post, we will discuss some of the more common reasons why exchanges fail and how you can avoid these mistakes.
- Miss the 45-Day Identification Deadline
Once you close on your relinquished property, you have 45 days to identify in writing what you intend to acquire in the exchange. The only exception to this rule is that no identification is needed if you acquire the replacement property before the end of the 45-day period.
The rule states that property that is not identified will not be “like kind” to the relinquished property; therefore, you are only able to acquire replacement property that you identified. If you do not identify or acquire the replacement property within the 45 days, you are not able to complete a valid exchange.
At Sera Capital we see this type of failure often. There is a saying on Wall Street, “Pigs make money, but Hogs get slaughtered.” The saying is appropriate in this situation. What we see day in and day out is two cases. In the first case, the selling agent of the relinquished property wants to identify the replacement property so that they can earn a double commission. The result, is they don’t utilize any of the tried and true methods to complete a successful 1031 exchange and their client ends up with a large and unnecessary tax bill. In the second case, we see active real estate investors that sell but then end up disappointed that they could not find something attractive. Its difficult to find an attractive replacement property in 45 days. We always advise our clients to start looking before they sell and present them with multiple opportunities that range from DSTs to Opportunity Zone Funds to listed NNN to off market properties.
- Close Without a Contract with a Facilitator
Another common reason for failure is due to closing property without a facilitator. To qualify for tax deferral, a taxpayer must have a contract with a facilitator in place before closing on the relinquished property. Closing without such a contract will result in the taxpayer having constructive receipt of exchange proceeds. A facilitator is actually a Qualified Intermediary, but they go by various names depending on what part of the country you are from. Synonyms for Qualified Intermediary include facilitator and accommodator.
- Take Possession of Your Exchange Funds
Another important rule for a successful 1031 Exchange states that the taxpayer cannot have possession, or control, of the proceeds from the sale of the relinquished property. Upon closing of the relinquished property, the escrow holder will transfer the funds directly to the Exchange Company, thus keeping the taxpayer from having receipt of the funds. One of the reasons it is so important to choose an intermediary wisely is that they hold the proceeds of your sale until you are ready to acquire the replacement property.
- Fail to Clearly Identify What You Are Going to Buy
In addition to making sure you identify replacement property within 45 days, you must identify it unambiguously. That generally means using a legal description or street address. If you are going to acquire a tenancy-in-common interest in the property, you should try to identify as closely as possible the percentage interest you will be acquiring. If you are acquiring a condominium, you need to also identify the unit number.
Moreover, if improvements will be constructed on the replacement property between the date you identify it and the date you acquire it, you must identify what will be constructed on the property in addition to the legal description or address. You should provide as much detail about the improvements as is “practicable.”
- Exchanging A Piece of Personal Property
As of 2017, personal property no longer qualifies for like-kind exchange. Previously, property such as vehicle fleets, construction equipment, or even airplanes were eligible to exchange, as long as they were like in kind (i.e., a plane for a plane, or a tractor for a tractor). According to the IRS:
“Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.”
With the elimination of personal property, only real estate is eligible for 1031 exchange. However, all real estate is like-kind to other real estate, which means you can exchange your mausoleum (commercial building) for a cemetery (raw land).
Our 1031 Exchange Experts Can Help
Again, the best way to avoid pitfalls is to procure competent counsel before an exchange occurs. At Sera Capital, our tax experts have mastered the rules guiding the 1031 exchange and are able to help. Navigating the rules of the 1031 exchange is something which no taxpayer should do independently. You need someone who can guide you and alert you whenever a tricky area comes up. If you need assistance with an exchange or another tax matter you should consider reaching out to us at Sera Capital.
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