Beware of These Pitfalls When Selling Property in a 1031 Exchange

Looking to trade in an old investment property for something new? Section 1031 of the Internal Revenue Code allows taxpayers to defer the recognition of gain on business or investment property exchanged for like-kind property. Although this seems simple on its face, below are several common pitfalls.

  • Failure to properly use a qualified intermediary (also referred to as an exchange facilitator)

The word “exchange” is applied quite literally in Section 1031. You must exchange the old property directly for the new property, without receipt of any sale proceeds. Because the odds of finding someone who is willing to swap properties is incredibly low, most people must use a qualified intermediary to comply with the “exchange” requirement of Section 1031. The funds from the sale of the relinquished property are paid directly to the qualified intermediary, who uses the funds to acquire the replacement property. The qualified intermediary also handles the exchange of title with the buyer of the relinquished property and the seller of the replacement property. You may need to come up with separate liquid funds or financing if the replacement property is more expensive than the net proceeds from the sale of the relinquished property.

  • Procrastinating Finding a Replacement Property

Sometimes, unloading an unprofitable investment may be of more immediate concern than acquiring a perfect replacement property. The IRS, however, has strict requirements for how long you can wait, giving taxpayers a 45-day window to identify potential replacement properties from the close of sale on the relinquished property. The taxpayer has 180 days from the close of sale on the relinquished property to then close on one of the three identified properties. Relief from failure to comply with these time periods is only granted in limited circumstances.

  • Reverse Exchanges

For others, acquiring an attractive new investment is of more immediate concern than unloading an existing investment; however, “reverse” like-kind exchanges should be avoided if possible. In a reverse exchange, the taxpayer closes on the replacement property and then subsequently sells the “relinquished property.” In addition to the logistical problems of coming up with a down payment and financing for the replacement property, a plain reading of Section 1031 reveals that Congress did not consider “reverse” like-kind exchanges when drafting those provisions. The IRS has provided a narrow path for relief through a Revenue Ruling, however, the requirements are strict and involve more moving pieces than a traditional “forward” exchange, resulting in much higher legal and exchange facilitator fees.

  • Drop & Swap and Other Entity Issues

Section 1031 specifically excludes partnership interests from like-kind exchange tax deferral. In the past, the IRS has aggressively re-characterized seemingly qualifying like-kind exchanges of real property as “substantive” exchanges of partnership interests in various scenarios, including distribution of the property from a partnership to a partner, followed by a 1031 exchange of the property, followed by a contribution of the property into a new partnership. The IRS also heavily scrutinizes property held in co-tenancies that the IRS deems to operate as partnerships. If either the relinquished or acquired property is held in a co-tenancy, you should engage a qualified tax attorney to carefully draft a co-tenancy agreement that will avoid IRS scrutiny.

  • Re-financings

The IRS also heavily scrutinizes pre-exchange and post-exchange re-financings, arguing that these are really an attempt to “cash out” of the property without paying taxes.

  • Failure to take non-tax factors into consideration

Clients should be careful “not to let the tail wag the dog.” Taxes are one of many considerations when engaging in a transaction, but are generally not the most important consideration. Clients should evaluate their business and personal needs, including the need for liquid funds.

  • Failure to consider other costs

1031 exchanges are subject to the same broker, escrow, and other transactional fees as any other property transaction. 1031 exchanges also incur legal and qualified intermediary expenses. A “reverse” exchange will incur additional expenses for an Exchange Accommodation Titleholder. Before engaging in a 1031 exchange, clients should carefully weigh these potential added costs against the tax savings.

  • Misunderstanding of the term “tax-deferred”

While some might be tempted to call this a tax-free transaction, the more correct term is tax-deferred. You will still be on the hook for those forgone taxes if you ever “cash out” of the replacement property, although there is no limit on how many times you can engage in like-kind exchanges for new property. Additionally, conversion of 1031 replacement property to personal use may open the original transaction to IRS scrutiny.

  • Failure to obtain tax and legal advice

A failed 1031 exchange can result in the worst kind of tax bill—a large unbudgeted tax bill that also includes penalties and interest. Engaging a qualified tax attorney to advise you on your exchange can help you to structure the transaction in a way that minimizes or avoids IRS scrutiny. 

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