5 More Mistakes to Avoid When Conducting a 1031 Exchange
While conducting a 1031 exchange can have significant tax benefits, businesses and real estate investors must be careful to avoid mistakes that could result in the loss of indefinite tax deferral. Mistakes during the 1031 exchange process can lead to audits and other risks as well. By working with a 1031 exchange expert, businesses and investors can avoid making mistakes that have the potential to lead to adverse consequences.
Last year, we published an article discussing important pitfalls to avoid when preparing for a 1031 exchange. In that article, we highlighted the importance of meeting the “like-kind” property requirement and the strict deadlines imposed by Section 1031, and we noted a few other common oversights that can result in loss of tax deferral eligibility.
What Not to Do When Conducting a 1031 Exchange
While these are serious mistakes to avoid, they are not the only ones that can lead to adverse consequences for businesses and real estate investors. When conducting 1031 exchanges, businesses and real estate investors must be careful to avoid various other mistakes as well. Here are some additional examples:
1. Improperly Conducting a 1031 Exchange with a Related Party
The Internal Revenue Code (IRC) allows taxpayers to conduct 1031 exchanges with related parties (i.e., family members and closely-held business entities). However, strict rules apply. For example, when conducting a 1031 exchange with a related party, both parties must hold the exchanged properties for at least two years. Improperly conducting a 1031 exchange with a related party can result in loss of indefinite tax deferral.
2. Not Engaging a Qualified Intermediary
In the vast majority of circumstances, conducting a 1031 exchange requires working with a qualified intermediary. Engaging a qualified intermediary is necessary to avoid taking direct possession of the sale proceeds from the relinquished property (or taking direct possession of the replacement property in a reverse exchange), which triggers immediate tax liability.
3. Failing to Properly “Identify” a Replacement Property
As discussed in our previous article, when conducting a delayed exchange, a taxpayer has 45 days to “identify” a replacement property after selling their relinquished property. There are technical requirements for “identifying” a replacement property—and failure to meet these requirements can also result in loss of tax deferral eligibility.
4. Ignoring the Restrictions on Use of a Replacement Property
Under Section 1031, both the relinquished property and the replacement property involved in a 1031 exchange must be “held for productive use in a trade or business or for investment.” If a taxpayer ignores the restrictions on the use of their replacement property, this can result in retroactive liability for capital gains tax resulting from a “failed” exchange.
5. Overlooking Options for Maximizing the Benefits of the Process
Delayed, reverse, and improvement exchanges all offer different opportunities for businesses and real estate investors to maximize the benefits of conducting a like-kind exchange. By working closely with a 1031 exchange expert, business owners and investors can ensure that they are not overlooking desirable options they have available.
FAQs: Ensuring Eligibility for Indefinite Tax Deferral Under Section 1031
What qualifies as a “like-kind” exchange under Section 1031?
Section 1031 applies exclusively to real estate held for business or investment purposes. While most types of real estate are considered to be of “like kind” with one another, there are a couple of key exceptions. A 1031 exchange expert can advise you based on the specifics of your proposed exchange.
What are the consequences of failing to comply with Section 1031?
Failing to comply with Section 1031 results in loss of indefinite tax deferral eligibility. Taxpayers that improperly claim tax deferral can face liability for back taxes, interest, and penalties. In this scenario, facing an audit is a very real risk, and taxpayers accused of intentionally violating the Internal Revenue Code can potentially face a criminal investigation.
How can I make sure I comply with Section 1031 when conducting a like-kind exchange?
Ensuring compliance with Section 1031 when conducting a like-kind exchange involves working closely with a 1031 exchange expert throughout the process. If you are preparing to pursue a like-kind exchange, we encourage you to contact us to discuss how we can help.
Schedule a Free Initial Consultation with a 1031 Exchange Expert Today
To speak with a 1031 exchange expert at 1031 National Services, contact us today. Call us at 888-872-1031 or tell us how we can reach you online to schedule a free initial consultation.