Common Pitfalls to Avoid in 1031 Exchanges

Section 1031 of the U.S. tax code allows investors to defer federal capital gains when selling a piece of investment property. It is a powerful strategy that many take advantage of if their plans are to replace one property with another like-kind property. 

However, there are complexities to navigate — and even the most experienced investors can make small mistakes that lead to huge problems. 

Avoiding these pitfalls can ensure your 1031 exchange is a success. 

Failing to Stick to the Required Timelines

The IRS is very clear that there is a timeline that must be followed in order to maintain a qualifying transaction. Failing to stick to the deadlines can jeopardize the tax-deferred status of the exchange. 

You have 45 days from the date of the sale to identify a replacement property. Then, you have 180 days to acquire that property. No exceptions. 

Have a plan in place and work with a team that can help you stick to the timeline. 

Not Working with a Qualified Intermediary

Experienced investors often find themselves in hot water when they try to do things on their own. They may underestimate the intricacies involved, including the planning and execution. Not only could this result in missteps, but it also violates the IRS requirements for a 1031 exchange. 

It is required that you work with a qualified intermediary (QI). This is an uninterested third party that is hired to facilitate each part of the exchange, including the financial aspects. After all, the proceeds from the sale must be held by someone other than the seller. 

Choosing the Wrong Replacement Property

The IRS is very specific when referring to what type of property can be used for the exchange. They refer to it as a like-kind property, one that is similar to the one that is sold. 

Factors that need to be similar include the nature of the property, its use, and its location. If you are unsure whether your replacement property meets the criteria, discuss it with your QI.

Failing to Keep the Same Entities Throughout the Transaction

When it comes to a 1031 exchange, it is important to view it as one continuous transaction rather than two separate transactions. More specifically, the exchange must be a continuation of the first sale or investment. Because of this, the individuals or entities who are purchasing the new replacement property must be the same individuals or entities who sold the first property. 

There may be exceptions in certain situations. This is something to discuss with your QI. 

Improperly Documenting the Exchange

All of the details of your 1031 exchange need to be documented properly and reported to the IRS. This should be done using IRS Form 8824 — and filed for the tax year in which your original property was sold. If the sale and purchase of the second property is spread out over two years, then you will file the completed form with the previous year's tax return. 

Not completing these documents and getting them turned in at the right time can be problematic and may lead to tax penalties. Consider it just one more reason to work with an experienced QI. 

Avoid 1031 Exchange Pitfalls With Blue Note Title, LLC

Blue Note Title, LLC has extensive experience handling 1031 exchanges. We understand that there are so many specific details that need to be followed in order to successfully fulfill all requirements.

When you are ready, give us a call.