A 1031 exchange is often used by investors to defer capital gains taxes when exchanging one business or investment property for another. While these tax savings can potentially create a significant financial benefit, it’s essential to follow all IRS rules pertaining to the exchange. Otherwise, your exchange could fail, creating some costly consequences.
Prior to engaging in a 1031 exchange, it’s important to understand the common issues that may lead to failure and the financial consequences of a failed exchange.
In many cases, a 1031 exchange failure is caused by a simple error or the inability to meet specific deadlines. Here’s a look at some of the most common problems you may encounter.
When engaging in a 1031 exchange, IRS rules require you to identify one or more replacement properties in writing by the end of the 45th calendar day following the date you close on your relinquished property. The only exception to this rule applies if you close on your replacement property before the 45-day time period has passed.
It’s common for investors to miss this deadline either because they’ve procrastinated, forgotten to account for weekends or holidays, or were unable to find an attractive property before the deadline arrived.
Not only do you need to identify one or more replacement properties within 45 days, but you must also identify them unambiguously. This typically means that the identification must include the property’s street address, legal description, and other important details, such as the percentage of ownership interest you are acquiring.
If the space you are acquiring has a unit number, you must include this as well. In addition, if construction or improvements will occur on the property before you acquire it, the details must be clearly described in your identification documents.
When completing a 1031 exchange, you must close on one or more of the identified replacement properties by the end of the 180th calendar day from the date you closed on the relinquished property.
Failure to procure financing or issues with the seller can sometimes result in missing this deadline. It’s also important to remember that if the 180th day falls on a weekend or holiday, the previous business day would be your last day to close on the property.
Late-year exchanges can also complicate matters. If the 180th day falls in the next year and is after your tax filing deadline, you’ll need to either close on the property before you file your income tax return or request an extension.
During a 1031 exchange, taxpayers are expressly prohibited from taking possession or control of the proceeds of the property sale. When the relinquished property is sold, the escrow holder must transfer the funds directly to a qualified intermediary (QI).
The QI is a third-party entity that holds the funds in an escrow account until it’s time to close on the replacement property. The QI then uses the funds to purchase the property before ultimately transferring ownership to the taxpayer.
If you fail to use a QI or take receipt of the funds before turning them over to a QI, this will cause your exchange to fail.
Whether you make one of the previously mentioned mistakes or run into another issue that causes your exchange to fail, there will be financial consequences. Unfortunately, the IRS rarely grants extensions or exceptions for taxpayers attempting to complete a 1031 exchange.
When an exchange fails, the taxpayer is subject to tax on all of the capital gains from the sale of the relinquished property as well as depreciation recapture taxes.
While there may be some strategies that could help you defer a portion of your capital gains taxes or push the tax liability into the following year, the ability to take advantage of them will depend on your circumstances and the situation that caused your exchange to fail. In most cases, it’s very unlikely that you will be able to achieve the full tax deferral as originally intended.
Successfully completing a 1031 exchange isn’t necessarily difficult, but as you can see, there are many moving parts. Since a mistake that causes an exchange to fail can occur at any stage of the process, it’s helpful to assemble a team of experienced professionals before you begin.
In addition to your tax and legal advisors and your qualified intermediary, you may also consider consulting with a real estate professional and an investment professional. Together, your team can help guide you through the 1031 exchange process and may be able to help you avoid making a costly mistake.
Accredited investors may also consider identifying a Delaware Statutory Trust (DST) as a backup replacement property. This may help you avoid missing critical deadlines by ensuring you have a viable option if your exchange doesn’t go as planned.
To learn more about 1031 exchanges and whether this strategy may be appropriate for you, contact us to schedule a free consultation with a member of our team.