A 1031 exchange can be a game-changer for real estate investors. By allowing you to defer capital gains taxes when you sell one investment property and purchase another, it preserves more capital to reinvest and potentially compound your portfolio over time. But here’s the catch: the IRS plays by a strict rulebook. One wrong move, and the tax deferral you counted on could disappear—replaced by an unexpected tax bill.
The good news? Most 1031 exchange missteps are entirely avoidable. Below, we outline eight of the most common—and costly—mistakes investors make, along with practical guidance to keep your exchange compliant and on track.
1. Missing the Strict Deadlines
The Rule: Investors have 45 days to identify replacement properties and 180 days to close the exchange. Generally, no exceptions except for Federally Declared Disasters under Revenue Procedure 2018-58.
The Mistake: Procrastination. Some investors wait too long to engage a Qualified Intermediary (QI) or begin searching for replacement properties. The result? A time crunch that leaves little room for due diligence or negotiations.
How to Avoid It: Treat the timeline like a fuse—it starts burning the moment your relinquished property sells. Line up your team early, build a short list of potential properties in advance, and partner with a responsive, experienced real estate advisor and Qualified Intermediary (QI). Begin your search for replacement properties BEFORE your property sells.
2. Taking Cash (a.k.a. “Boot”) Too Soon
The Rule: Any cash or non-like-kind property received during the exchange is considered “boot”—and it’s taxable.
The Mistake: Some investors, either through miscommunication or poor structuring, end up taking partial cash from the sale before the exchange is finalized. Even small amounts can create a taxable event.
How to Avoid It: Direct all proceeds in writing from the sale into a QI-managed escrow account. Don’t touch the funds yourself. If you’re tempted to “hold a portion back,” know that you will likely be exposed to tax liabilities.
3. Choosing an Ineligible Property
The Rule: Both the relinquished and replacement properties must be “like-kind” under IRS guidelines—real property held for investment or business purposes. The replacement properties do not need to be identical to the type of property sold, however they must qualify as an investment property and not a personal use property. For example, you exchange the proceeds from a single family rental property into an apartment, commercial, retail, even raw land and mineral rights.
The Mistake: Assuming that any real estate qualifies. For example, a personal use residence, second home, or fix-and-flip project usually doesn’t meet the standard.
How to Avoid It: When in doubt, consult a tax advisor or a 1031 specialist. Stick to investment-grade properties—rental units, commercial buildings, raw land, and certain Delaware Statutory Trusts (DSTs) are typically eligible.
4. Not Following the Identification Rules
The Rule: Replacement properties must be identified in writing within 45 days, and investors must comply with one of the IRS-approved methods: the Three-Property Rule, the 200% Rule, or the 95% Rule.
The Mistake: Misunderstanding the rules—or worse, failing to document them properly. Some investors exceed the property count or miss critical paperwork deadlines, invalidating their exchange.
How to Avoid It: Familiarize yourself with the identification methods or work with a QI who can walk you through them. Ensure that your list contains all required identification information and is submitted in writing and received on time.
5. Selling Before Holding the Property Long Enough
The Rule: The IRS expects that properties involved in a 1031 exchange are held for long-term investment purposes.
The Mistake: Trying to exchange a property you’ve held for only a few months. That may raise red flags with the IRS, which could reclassify the property as inventory rather than an investment, nullifying the deferral.
How to Avoid It: While there’s no hard-and-fast minimum holding period, a general guideline is at least two calendar years, preferably 24 months. At a minimum, aim to hold the replacement property long enough to file two Schedule E tax returns which are required for investment properties. The longer the hold, the stronger the case that the property was for investment, not resale.
6. Failing to Reinvest All Proceeds
The Rule: To fully defer taxes, you must reinvest all proceeds into a replacement property of equal or greater value.
The Mistake: Buying a less expensive replacement property or holding back part of the proceeds. The difference is considered boot—and it’s taxable.
How to Avoid It: Match or exceed the value of the relinquished property. A qualified exchange partner can help ensure the structure meets IRS expectations while aligning with your investment goals.
7. Failing to Replace Debt
The Rule: To fully defer taxes, you must replace the amount of any loan on the sold property with a new loan of equal to or greater value. You may also reduce this debt replacement requirement by adding funds from outside the exchange to purchase the replacement properties.
The Mistake: Buying a replacement property with insufficient debt to equal the debt of the sold property. The difference is considered boot—and it’s taxable.
How to Avoid It: Match or exceed the debt of the relinquished property. Replacement properties structured as a Delaware Statutory Trust (DST) can be an option to consider since many DSTs already have debt in place. A qualified exchange partner or a DST specialist can help ensure the structure meets IRS expectations while aligning with your investment goals.
8. Not Working with the Right Professionals
The Rule: A Qualified Intermediary is required to facilitate the exchange and hold proceeds during the process. An experienced DST specialist or a realtor who specializes in qualifying 1031 investment properties can help you locate suitable replacement properties.
The Mistake: Trying to manage the exchange yourself or relying on an intermediary or advisor who doesn’t specialize in 1031s. This is a compliance-heavy process, and small missteps can have big tax consequences.
How to Avoid It: Partner with professionals who live and breathe 1031 exchanges. At FGG1031, our team has helped countless investors navigate the rules, deadlines, and documentation requirements with confidence.
Final Thoughts: Expertise Makes All the Difference
Even seasoned investors can get tripped up by the nuances of a 1031 exchange. With the IRS watching closely, there’s little margin for error—but there’s also no reason to go it alone.
If you’re considering a 1031 exchange, your best move is to bring in the right professionals early. At FGG1031, we help investors structure compliant, tax-efficient exchanges that potentially preserve capital and keep your investment strategy moving forward.
Schedule a free consultation with our team today to learn how to avoid these costly missteps—and make your exchange a success.
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