A 1031 exchange is a great way to defer taxes when exchanging properties. But the tight deadlines on this process means that a 1031 exchange can go wrong fairly swiftly and in a few important ways. Failure can come in the form of unmet deadlines, incorrect use of the exchange, or misunderstanding of the regulations.
1. No Replacement Property
The most common reason a 1031 exchange fails is that the replacement property cannot be purchased, and the purchaser did not identify a backup property (or up to three). Without a secondary property identified, a 1031 will fail if the first prospective property falls through. It’s important to note that there is no middle ground in the eyes of the IRS—either a replacement property was purchased or it was not. If the property is pending or in progress, it will not satisfy the requirements.
2. New Property Purchased Too Soon
Alternately, if a replacement property is purchased before the old property is sold and the time taken to sell the old property exceeds 180 days, the exchange will fail. Therefore it’s important to ensure that both the selling and purchasing of properties during this exchange are closely managed and expedited wherever possible to ensure a successful transfer under deadline.
3. Exchanging Personal Properties
An additional reason that 1031 exchanges often fail is that they are not truly investment properties. 1031 exchange real estate properties can’t be used for personal reasons. A purchaser must be careful not to use a property in a manner that categorizes it as a personal property. Certain restrictions and guidelines apply. Specifically, for a minimum of two years prior to and after the exchange, the property must be rented for a minimum of two weeks to a non-relative. The property can’t be used personally for more than two weeks or 10% of the time rented. The property must be placed on Schedule E of your tax return and reported as income property.
The following steps outline how to perform a successful 1031 exchange process:
1. Identify whether or not to conduct a 1031 exchange based on the classification of the property as an income property or a personal property.
2. Inform your real estate agent and include a clause in the contract to require the buyer to cooperate with the exchange.
3. Ensure the escrow company is aware you are performing a 1031 exchange.
4. Identify and employ a Qualified Intermediary to open the exchange.
5. Identify a replacement property.
6. Deliver a signed description of the two properties to the Qualified Intermediary within 45 calendar days of the transfer of title of the property you intend to exchange.
7. Identify up to three replacement properties.
8. Acquire the replacement property within 180 days of the transfer of title.
9. Purchase a property equal to or of greater value than the relinquish property and reinvest the equity into the replacement property.
10. Close on the replacement property and provide the Qualified Intermediary with information on your closing.
It’s important to keep in close contact with all parties to ensure there is no delay in processing that could hold up the sale of the old property or closing on the new property. Contact a trusted financial and real estate advisor to ensure that your 1031 exchanges goes off without a hitch. Good luck!