Important Pitfalls to Avoid When Preparing for a 1031 Exchange

Conducting a 1031 exchange can afford significant and long-term tax benefits. However, mistakes during the exchange process can disqualify transactions from eligibility for indefinite tax deferral. As a result, an informed approach is key, and this means knowing both the steps you need to take and the mistakes you need to avoid.

In this article, our 1031 exchange specialists are focusing on the mistakes you need to avoid. For an overview of the steps involved in the 1031 exchange process, you can read: 7 Steps to Successfully Completing a 1031 Exchange.

5 Mistakes that Can Invalidate a 1031 Exchange

There are several pitfalls you need to avoid when going through the 1031 exchange process. Here are five examples of mistakes that can invalidate a 1031 exchange and trigger immediate tax liability under the Internal Revenue Code (IRC):

1. Using a Non-Qualifying Property

While the definition of “like-kind” property under Section 1031 is broad, there are still limits to the properties that qualify for a 1031 exchange. In particular, when conducting a 1031 exchange, both the relinquished property and the replacement property must be “held either for productive use in a trade or business or for investment.”

This means that the relinquished property must qualify based on its current use, and you must be able to demonstrate that the replacement property will be used for a qualifying purpose as well. If either property is non-qualifying, then the exchange is not eligible for like-kind exchange treatment under Section 1031.

2. Failing to Meet the Deadlines that Apply

Two critical deadlines apply to like-kind exchanges under Section 1031. If a taxpayer fails to meet either of these deadlines, the taxpayer’s exchange will be ineligible for indefinite tax deferral. The deadlines for conducting a 1031 exchange are:

• 45 Days – The taxpayer must identify a replacement property within 45 days of closing on the sale of the relinquished property.
• 180 Days – The taxpayer must close on the acquisition of the replacement property within 180 days.

As discussed below, when closing on the purchase of a replacement property after selling a relinquished property (which is referred to as a delayed exchange), the taxpayer cannot take possession of the proceeds of the sale. This makes it essential to work with a qualified intermediary.

3. Taking Possession of Sale Proceeds

The rules for conducting a 1031 exchange prohibit taxpayers from taking possession of the proceeds of the sale of a relinquished property. Similar to missing either the 45-day or 180-day deadline, this can also immediately disqualify an exchange from eligibility for indefinite tax deferral.

To avoid taking possession of the sale proceeds, taxpayers who are seeking to conduct a 1031 exchange must work with a qualified intermediary. The qualified intermediary will manage the funds involved in the transaction in order to maintain compliance with Section 1031 and will be able to assist with documenting all phases of the transaction so that the taxpayer is prepared to withstand IRS scrutiny if necessary.   

4. Overlooking Taxable Boot

When conducting a 1031 exchange, it is possible for only part of the exchange to qualify for indefinite tax deferral. If a taxpayer receives any property (or anything else of value) in an exchange that does not qualify as like-kind property, it will be classified as “boot.” Boot is subject to immediate taxation under Section 1031.

With this in mind, when preparing to conduct a 1031 exchange, it is important not to overlook anything that will qualify as boot in the transaction. Cash, debt relief, installment notes, and personal property are all examples of possible boot in a 1031 exchange.

5. Failing to Comply with the “Same Taxpayer” Rule

Under Section 1031, the party that sells a relinquished property and the party that acquires a replacement property must generally be the same individual or entity. This is commonly referred to as the “same taxpayer” rule. While there are exceptions for qualifying disregarded entities (i.e., single-member LLCs and revocable trusts), in all cases, taxpayers must be careful to ensure that they correctly identify the owner of each property involved in a 1031 exchange.

Contact the 1031 Exchange Specialists at 1031 National Services

If you need to know more about how to make sure you receive an indefinite tax deferral in a 1031 exchange, we invite you to get in touch. To schedule a free consultation with one of our 1031 exchange specialists, give us a call at 888-872-1031 or tell us how we can get in touch online today.