Blog

Generally, real estate investors complete 1031 Exchanges to defer the capital gains tax on the disposition of their investment properties. However, there are many additional underlying reasons an investor might want to exchange one property for another. The motives often center around the standard risk/reward, cashflow, and appreciation scales.
Some of the typical non-tax motives to 1031 Exchange include:

Exchange from fully depreciated property to a higher value property that can be depreciated, potentially lowering reportable net income.
 
Exchange from property that cannot be refinanced. For example, moving from vacant land to improved property, which can support a new refinance loan, and will thereby give the client the ability to obtain cash after the acquisition of the Replacement Property.
 
Exchange from non-income producing raw land to improved property to create a positive cashflow from the rental income.
 
Exchange from a property with maximized or minimal cashflow, such as an apartment building, to a higher cashflow property, like a retail shopping center, to generate larger cashflow.
 
Exchange from a stagnant or slowly appreciating property to a property in an area with faster appreciation.
 
Exchange into a property or properties that may be easier to sell in the coming years.
 
Exchange to meet location requirements. For example, the Exchanger moves to another state and wants to have their investment property nearby for management purposes.
 
Exchange to fit the lifestyle of a client. For example, a retiree may exchange for a property requiring reduced management responsibility so they can do more traveling.
 
Exchange from several smaller properties to one larger property or visa-versa.
 
Exchange to a property the Exchanger can utilize for his or her own profession. For example, a doctor may exchange from a rental house to a medical building to use for his or her practice.
 
Exchange from a partial interest in one property to a fee interest, 100% ownership, in another property.
 
Exchange from a management intensive fee interest property to a professionally managed triple net leased property where the tenant is responsible for all of the maintenance.
 
Exchange to diversify and minimize risk to real estate portfolio. For example, exchange from residential to commercial real estate or exchange into property located in other regions of the United States.

The above is just a short list of additional reasons, unrelated to taxes, that many look to utilize a 1031 Exchange. As you can see, deferring Capital Gain tax, although compelling, is not the only reason investors utilize 1031 Exchanges in their investment strategy.
 
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

Generally, real estate investors complete 1031 Exchanges to defer the capital gains tax on the disposition of their investment properties. However, there are many additional underlying reasons an investor might want to exchange one property for another. The motives often center around the standard risk/reward, cashflow, and appreciation scales.
Some of the typical non-tax motives to 1031 Exchange include:

Exchange from fully depreciated property to a higher value property that can be depreciated, potentially lowering reportable net income.
 
Exchange from property that cannot be refinanced. For example, moving from vacant land to improved property, which can support a new refinance loan, and will thereby give the client the ability to obtain cash after the acquisition of the Replacement Property.
 
Exchange from non-income producing raw land to improved property to create a positive cashflow from the rental income.
 
Exchange from a property with maximized or minimal cashflow, such as an apartment building, to a higher cashflow property, like a retail shopping center, to generate larger cashflow.
 
Exchange from a stagnant or slowly appreciating property to a property in an area with faster appreciation.
 
Exchange into a property or properties that may be easier to sell in the coming years.
 
Exchange to meet location requirements. For example, the Exchanger moves to another state and wants to have their investment property nearby for management purposes.
 
Exchange to fit the lifestyle of a client. For example, a retiree may exchange for a property requiring reduced management responsibility so they can do more traveling.
 
Exchange from several smaller properties to one larger property or visa-versa.
 
Exchange to a property the Exchanger can utilize for his or her own profession. For example, a doctor may exchange from a rental house to a medical building to use for his or her practice.
 
Exchange from a partial interest in one property to a fee interest, 100% ownership, in another property.
 
Exchange from a management intensive fee interest property to a professionally managed triple net leased property where the tenant is responsible for all of the maintenance.
 
Exchange to diversify and minimize risk to real estate portfolio. For example, exchange from residential to commercial real estate or exchange into property located in other regions of the United States.

The above is just a short list of additional reasons, unrelated to taxes, that many look to utilize a 1031 Exchange. As you can see, deferring Capital Gain tax, although compelling, is not the only reason investors utilize 1031 Exchanges in their investment strategy.
 
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

Generally, real estate investors complete 1031 Exchanges to defer the capital gains tax on the disposition of their investment properties. However, there are many additional underlying reasons an investor might want to exchange one property for another. The motives often center around the standard risk/reward, cashflow, and appreciation scales.
Some of the typical non-tax motives to 1031 Exchange include:

Exchange from fully depreciated property to a higher value property that can be depreciated, potentially lowering reportable net income.
 
Exchange from property that cannot be refinanced. For example, moving from vacant land to improved property, which can support a new refinance loan, and will thereby give the client the ability to obtain cash after the acquisition of the Replacement Property.
 
Exchange from non-income producing raw land to improved property to create a positive cashflow from the rental income.
 
Exchange from a property with maximized or minimal cashflow, such as an apartment building, to a higher cashflow property, like a retail shopping center, to generate larger cashflow.
 
Exchange from a stagnant or slowly appreciating property to a property in an area with faster appreciation.
 
Exchange into a property or properties that may be easier to sell in the coming years.
 
Exchange to meet location requirements. For example, the Exchanger moves to another state and wants to have their investment property nearby for management purposes.
 
Exchange to fit the lifestyle of a client. For example, a retiree may exchange for a property requiring reduced management responsibility so they can do more traveling.
 
Exchange from several smaller properties to one larger property or visa-versa.
 
Exchange to a property the Exchanger can utilize for his or her own profession. For example, a doctor may exchange from a rental house to a medical building to use for his or her practice.
 
Exchange from a partial interest in one property to a fee interest, 100% ownership, in another property.
 
Exchange from a management intensive fee interest property to a professionally managed triple net leased property where the tenant is responsible for all of the maintenance.
 
Exchange to diversify and minimize risk to real estate portfolio. For example, exchange from residential to commercial real estate or exchange into property located in other regions of the United States.

The above is just a short list of additional reasons, unrelated to taxes, that many look to utilize a 1031 Exchange. As you can see, deferring Capital Gain tax, although compelling, is not the only reason investors utilize 1031 Exchanges in their investment strategy.
 
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

Many investors decide that they want to structure their real estate transactions as a 1031 Exchange, without knowing all of the steps and hurdles they can encounter along the way. But being well-informed before the sale of the first property is critical to the success of a 1031 Exchange.
Here we will discuss some common obstacles people face in a 1031 Exchange, all of which can be avoided by planning early.
1. Not Using a Qualified Intermediary
Some taxpayers believe, mistakenly, that leaving the exchange funds at the title or escrow company is sufficient to establish a successful 1031 Exchange. However, the 1031 Exchange Regulations prohibit the taxpayer from having actual, or even constructive receipt of the exchange funds. This means that leaving the exchange funds with the title or escrow company, with the taxpayer’s attorney, or just simply not cashing the check, all violate the rule against having actual or constructive receipt of the exchange proceeds which nullifies the 1031 Exchange.
2. Using a Disqualified Party as Your Qualified Intermediary
The Regulations define a Qualified Intermediary as a party who is not the taxpayer or a disqualified person, who by a series of assignments enters into an exchange agreement with the taxpayer and acts as the party to complete the exchange. A disqualified person includes anyone “who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker” within the preceding two years, as well as family members and other prohibited relationships. When the taxpayer utilizes the services of his attorney to be his Qualified Intermediary, for example, the attorney is disqualified from serving as the Qualified Intermediary, and the exchange would be disallowed.
3. Selecting the Wrong Qualified Intermediary
As in most other business settings, not all Qualified Intermediaries are created equal. At a minimum, we recommend selecting a Qualified Intermediary that is a member of the Federation of Exchange Accommodators (FEA), the only national association representing Qualified Intermediaries, and tax/legal advisors who are directly involved in the 1031 exchange industry. We also highly recommend selecting a Qualified Intermediary that has multiple Certified Exchange Specialists® (CES®) on staff. The CES® designation is the only independent, tested designation for 1031 exchange professionals. A Qualified Intermediary that has a team of attorneys on staff is also recommended, as not all exchanges are as routine as they may seem up front. Learn more about selecting the right Qualified Intermediary.
4. Not Hiring the Qualified Intermediary Before the Sale
As mentioned previously, the taxpayer may not have actual or constructive receipt of the exchange funds. Phrased another way, the 1031 exchange must be established and in place at or before the closing of the first property in the exchange. Vetting and selecting the Qualified Intermediary in advance of the closing is integral to a successful 1031 exchange.
5. Failing to Properly Document the Exchange
Some people believe that the sole purpose of the Qualified Intermediary (QI) is to hold the exchange funds. While this is certainly an important function of the Qualified Intermediary, it is not the main function of a QI. For a 1031 exchange to be valid, there must be an Exchange Agreement between the taxpayer and the Qualified Intermediary; the taxpayer must assign their rights in the sale and purchase contracts to the Qualified Intermediary; and the taxpayer must notify all other parties to the exchange of that assignment. The Qualified Intermediary prepares these documents and ensures proper notification to the other parties to the exchange.
6. Trying to Exchange Ineligible or Disqualified Property
Virtually every day we receive a phone call from someone who wishes to participate in a 1031 exchange involving vacation homes. Yet the statute is clear that the properties in the exchange must be “held for productive use in a trade or business, or for investment.” Under the Regulations, ‘disqualified property’ is property that was not held for productive use in a trade or business or for investment. Second homes, vacation homes, or other property that is used exclusively by the taxpayer for their own enjoyment, with no business or investment motive, are therefore not qualified property and not eligible for a 1031 Exchange.
7. Fix-and-Flip Properties
As noted above, the properties being exchanged must be “held for productive use in a trade or business or for investment.” Property that was acquired to be improved or rehabbed, and then immediately resold is viewed as inventory, rather than investment property. These so-called ‘fix-and-flip’ properties do not qualify as business or investment property, and are not allowed with a 1031 Exchange.
8. Not Exchanging Equal or Up in Value, and Equity
There is a common misconception that taxpayers only need to reinvest the gains or profits on the sale of their Relinquished Properties. Others are of the mistaken belief that they only need to reinvest the cash that was generated at the sale, after satisfying loans and paying closing costs. Both situations will result in the taxpayer being exposed to potential tax liabilities. Rather, taxpayers should endeavor to exchange equal or up in fair market value, and equal or up in equity, and to replace any debt from the Relinquished Property with either new debt or cash to avoid a taxable event at the time of the 1031 Exchange.
9. Failing to Understand or Comply with the Deadlines
Every day we hear from taxpayers who completely misunderstand the deadlines. “I have 60 days to find my replacement property and 6 months to complete the purchase.” No. The statute clearly states that taxpayers must identify their potential replacement properties within 45 calendar days after closing and complete the acquisition of identified Replacement Property or properties within 180 calendar days after the closing on the Relinquished Property. Failure to comply with the identification rules effectively invalidates the 1031 Exchange.
10. Failing to Consider a Reverse Exchange
The IRS approved the concept of so-called “reverse exchanges” over twenty years ago. Yet many advisors and even more taxpayers are unaware of the concept, and the incredible power that they provide. When real estate markets are incredibly hot, many taxpayers are fearful that they will not be able to find quality Replacement Property within the identification period, or to complete the purchase within the exchange period. Enter the reverse exchange. With a reverse exchange, the taxpayer acquires the Replacement Property before the sale of the Relinquished Property. The process is a little more complicated, but in a situation where both the Relinquished and Replacement properties are rental properties generating cash, the taxpayer has the potential to double their cash flow during the exchange period. Gain a better understanding of the Reverse Exchange.
11. Partnership Issues
Taxpayers often acquire properties together with other investors. When multiple investors pool their resources and acquire real estate inside of a limited liability company (LLC), that LLC is a entity – a taxpayer unto itself. The individual taxpayers do not have independent rights to perform 1031 exchanges, or not, beyond the confines of the LLC. If they wish to exchange independently of one another, they should plan for that well in advance of the sale of the property. Concepts to accomplish this include “drop and swap” and “swap and drop” are discussed in more detail here.They should consult with their tax and legal advisors, and plan carefully to maximize their compliance with 1031 Exchange rules, especially the concept of “held for investment.”
12. Settlement Statement Issues
Some settlement agents do not fully comprehend the significance of the Assignment (discussed in number 5, above) on the 1031 Exchange. The Assignment effectively inserts the Qualified Intermediary as the seller of the Relinquished Property and the buyer of the Replacement Property. It is by virtue of these assignments that the taxpayer ‘exchanges’ the Relinquished Property for the Replacement Property. Because the taxpayer has assigned their interests in the underlying real estate contract, the settlement statement should identify the seller of the Relinquished Property and the buyer of the Replacement Property as ‘Accruit as Qualified Intermediary’ for [taxpayer’ name]. Further, non-qualifying expenses would ideally be handled outside of closing and can be identified as ‘POC’ on the closing statement. Additionally, overfunding the purchase of the Replacement Property, resulting in cash flowing back to the taxpayer, could result in a taxable event for the taxpayer. Each line item on the Settlement Statement should be scrutinized by the taxpayer and their tax/legal advisors to ensure compliance with the 1031 Exchange rules.
As you can see, there are many opportunities for taxpayers to create headaches for themselves, or foot fault into non-compliance issues with a 1031 Exchange. As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before the first closing that will effectively start their 1031 Exchange.
 
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

Many investors decide that they want to structure their real estate transactions as a 1031 Exchange, without knowing all of the steps and hurdles they can encounter along the way. But being well-informed before the sale of the first property is critical to the success of a 1031 Exchange.
Here we will discuss some common obstacles people face in a 1031 Exchange, all of which can be avoided by planning early.
1. Not Using a Qualified Intermediary
Some taxpayers believe, mistakenly, that leaving the exchange funds at the title or escrow company is sufficient to establish a successful 1031 Exchange. However, the 1031 Exchange Regulations prohibit the taxpayer from having actual, or even constructive receipt of the exchange funds. This means that leaving the exchange funds with the title or escrow company, with the taxpayer’s attorney, or just simply not cashing the check, all violate the rule against having actual or constructive receipt of the exchange proceeds which nullifies the 1031 Exchange.
2. Using a Disqualified Party as Your Qualified Intermediary
The Regulations define a Qualified Intermediary as a party who is not the taxpayer or a disqualified person, who by a series of assignments enters into an exchange agreement with the taxpayer and acts as the party to complete the exchange. A disqualified person includes anyone “who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker” within the preceding two years, as well as family members and other prohibited relationships. When the taxpayer utilizes the services of his attorney to be his Qualified Intermediary, for example, the attorney is disqualified from serving as the Qualified Intermediary, and the exchange would be disallowed.
3. Selecting the Wrong Qualified Intermediary
As in most other business settings, not all Qualified Intermediaries are created equal. At a minimum, we recommend selecting a Qualified Intermediary that is a member of the Federation of Exchange Accommodators (FEA), the only national association representing Qualified Intermediaries, and tax/legal advisors who are directly involved in the 1031 exchange industry. We also highly recommend selecting a Qualified Intermediary that has multiple Certified Exchange Specialists® (CES®) on staff. The CES® designation is the only independent, tested designation for 1031 exchange professionals. A Qualified Intermediary that has a team of attorneys on staff is also recommended, as not all exchanges are as routine as they may seem up front. Learn more about selecting the right Qualified Intermediary.
4. Not Hiring the Qualified Intermediary Before the Sale
As mentioned previously, the taxpayer may not have actual or constructive receipt of the exchange funds. Phrased another way, the 1031 exchange must be established and in place at or before the closing of the first property in the exchange. Vetting and selecting the Qualified Intermediary in advance of the closing is integral to a successful 1031 exchange.
5. Failing to Properly Document the Exchange
Some people believe that the sole purpose of the Qualified Intermediary (QI) is to hold the exchange funds. While this is certainly an important function of the Qualified Intermediary, it is not the main function of a QI. For a 1031 exchange to be valid, there must be an Exchange Agreement between the taxpayer and the Qualified Intermediary; the taxpayer must assign their rights in the sale and purchase contracts to the Qualified Intermediary; and the taxpayer must notify all other parties to the exchange of that assignment. The Qualified Intermediary prepares these documents and ensures proper notification to the other parties to the exchange.
6. Trying to Exchange Ineligible or Disqualified Property
Virtually every day we receive a phone call from someone who wishes to participate in a 1031 exchange involving vacation homes. Yet the statute is clear that the properties in the exchange must be “held for productive use in a trade or business, or for investment.” Under the Regulations, ‘disqualified property’ is property that was not held for productive use in a trade or business or for investment. Second homes, vacation homes, or other property that is used exclusively by the taxpayer for their own enjoyment, with no business or investment motive, are therefore not qualified property and not eligible for a 1031 Exchange.
7. Fix-and-Flip Properties
As noted above, the properties being exchanged must be “held for productive use in a trade or business or for investment.” Property that was acquired to be improved or rehabbed, and then immediately resold is viewed as inventory, rather than investment property. These so-called ‘fix-and-flip’ properties do not qualify as business or investment property, and are not allowed with a 1031 Exchange.
8. Not Exchanging Equal or Up in Value, and Equity
There is a common misconception that taxpayers only need to reinvest the gains or profits on the sale of their Relinquished Properties. Others are of the mistaken belief that they only need to reinvest the cash that was generated at the sale, after satisfying loans and paying closing costs. Both situations will result in the taxpayer being exposed to potential tax liabilities. Rather, taxpayers should endeavor to exchange equal or up in fair market value, and equal or up in equity, and to replace any debt from the Relinquished Property with either new debt or cash to avoid a taxable event at the time of the 1031 Exchange.
9. Failing to Understand or Comply with the Deadlines
Every day we hear from taxpayers who completely misunderstand the deadlines. “I have 60 days to find my replacement property and 6 months to complete the purchase.” No. The statute clearly states that taxpayers must identify their potential replacement properties within 45 calendar days after closing and complete the acquisition of identified Replacement Property or properties within 180 calendar days after the closing on the Relinquished Property. Failure to comply with the identification rules effectively invalidates the 1031 Exchange.
10. Failing to Consider a Reverse Exchange
The IRS approved the concept of so-called “reverse exchanges” over twenty years ago. Yet many advisors and even more taxpayers are unaware of the concept, and the incredible power that they provide. When real estate markets are incredibly hot, many taxpayers are fearful that they will not be able to find quality Replacement Property within the identification period, or to complete the purchase within the exchange period. Enter the reverse exchange. With a reverse exchange, the taxpayer acquires the Replacement Property before the sale of the Relinquished Property. The process is a little more complicated, but in a situation where both the Relinquished and Replacement properties are rental properties generating cash, the taxpayer has the potential to double their cash flow during the exchange period. Gain a better understanding of the Reverse Exchange.
11. Partnership Issues
Taxpayers often acquire properties together with other investors. When multiple investors pool their resources and acquire real estate inside of a limited liability company (LLC), that LLC is a entity – a taxpayer unto itself. The individual taxpayers do not have independent rights to perform 1031 exchanges, or not, beyond the confines of the LLC. If they wish to exchange independently of one another, they should plan for that well in advance of the sale of the property. Concepts to accomplish this include “drop and swap” and “swap and drop” are discussed in more detail here.They should consult with their tax and legal advisors, and plan carefully to maximize their compliance with 1031 Exchange rules, especially the concept of “held for investment.”
12. Settlement Statement Issues
Some settlement agents do not fully comprehend the significance of the Assignment (discussed in number 5, above) on the 1031 Exchange. The Assignment effectively inserts the Qualified Intermediary as the seller of the Relinquished Property and the buyer of the Replacement Property. It is by virtue of these assignments that the taxpayer ‘exchanges’ the Relinquished Property for the Replacement Property. Because the taxpayer has assigned their interests in the underlying real estate contract, the settlement statement should identify the seller of the Relinquished Property and the buyer of the Replacement Property as ‘Accruit as Qualified Intermediary’ for [taxpayer’ name]. Further, non-qualifying expenses would ideally be handled outside of closing and can be identified as ‘POC’ on the closing statement. Additionally, overfunding the purchase of the Replacement Property, resulting in cash flowing back to the taxpayer, could result in a taxable event for the taxpayer. Each line item on the Settlement Statement should be scrutinized by the taxpayer and their tax/legal advisors to ensure compliance with the 1031 Exchange rules.
As you can see, there are many opportunities for taxpayers to create headaches for themselves, or foot fault into non-compliance issues with a 1031 Exchange. As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before the first closing that will effectively start their 1031 Exchange.
 
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.

Many investors decide that they want to structure their real estate transactions as a 1031 Exchange, without knowing all of the steps and hurdles they can encounter along the way. But being well-informed before the sale of the first property is critical to the success of a 1031 Exchange.
Here we will discuss some common obstacles people face in a 1031 Exchange, all of which can be avoided by planning early.
1. Not Using a Qualified Intermediary
Some taxpayers believe, mistakenly, that leaving the exchange funds at the title or escrow company is sufficient to establish a successful 1031 Exchange. However, the 1031 Exchange Regulations prohibit the taxpayer from having actual, or even constructive receipt of the exchange funds. This means that leaving the exchange funds with the title or escrow company, with the taxpayer’s attorney, or just simply not cashing the check, all violate the rule against having actual or constructive receipt of the exchange proceeds which nullifies the 1031 Exchange.
2. Using a Disqualified Party as Your Qualified Intermediary
The Regulations define a Qualified Intermediary as a party who is not the taxpayer or a disqualified person, who by a series of assignments enters into an exchange agreement with the taxpayer and acts as the party to complete the exchange. A disqualified person includes anyone “who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker” within the preceding two years, as well as family members and other prohibited relationships. When the taxpayer utilizes the services of his attorney to be his Qualified Intermediary, for example, the attorney is disqualified from serving as the Qualified Intermediary, and the exchange would be disallowed.
3. Selecting the Wrong Qualified Intermediary
As in most other business settings, not all Qualified Intermediaries are created equal. At a minimum, we recommend selecting a Qualified Intermediary that is a member of the Federation of Exchange Accommodators (FEA), the only national association representing Qualified Intermediaries, and tax/legal advisors who are directly involved in the 1031 exchange industry. We also highly recommend selecting a Qualified Intermediary that has multiple Certified Exchange Specialists® (CES®) on staff. The CES® designation is the only independent, tested designation for 1031 exchange professionals. A Qualified Intermediary that has a team of attorneys on staff is also recommended, as not all exchanges are as routine as they may seem up front. Learn more about selecting the right Qualified Intermediary.
4. Not Hiring the Qualified Intermediary Before the Sale
As mentioned previously, the taxpayer may not have actual or constructive receipt of the exchange funds. Phrased another way, the 1031 exchange must be established and in place at or before the closing of the first property in the exchange. Vetting and selecting the Qualified Intermediary in advance of the closing is integral to a successful 1031 exchange.
5. Failing to Properly Document the Exchange
Some people believe that the sole purpose of the Qualified Intermediary (QI) is to hold the exchange funds. While this is certainly an important function of the Qualified Intermediary, it is not the main function of a QI. For a 1031 exchange to be valid, there must be an Exchange Agreement between the taxpayer and the Qualified Intermediary; the taxpayer must assign their rights in the sale and purchase contracts to the Qualified Intermediary; and the taxpayer must notify all other parties to the exchange of that assignment. The Qualified Intermediary prepares these documents and ensures proper notification to the other parties to the exchange.
6. Trying to Exchange Ineligible or Disqualified Property
Virtually every day we receive a phone call from someone who wishes to participate in a 1031 exchange involving vacation homes. Yet the statute is clear that the properties in the exchange must be “held for productive use in a trade or business, or for investment.” Under the Regulations, ‘disqualified property’ is property that was not held for productive use in a trade or business or for investment. Second homes, vacation homes, or other property that is used exclusively by the taxpayer for their own enjoyment, with no business or investment motive, are therefore not qualified property and not eligible for a 1031 Exchange.
7. Fix-and-Flip Properties
As noted above, the properties being exchanged must be “held for productive use in a trade or business or for investment.” Property that was acquired to be improved or rehabbed, and then immediately resold is viewed as inventory, rather than investment property. These so-called ‘fix-and-flip’ properties do not qualify as business or investment property, and are not allowed with a 1031 Exchange.
8. Not Exchanging Equal or Up in Value, and Equity
There is a common misconception that taxpayers only need to reinvest the gains or profits on the sale of their Relinquished Properties. Others are of the mistaken belief that they only need to reinvest the cash that was generated at the sale, after satisfying loans and paying closing costs. Both situations will result in the taxpayer being exposed to potential tax liabilities. Rather, taxpayers should endeavor to exchange equal or up in fair market value, and equal or up in equity, and to replace any debt from the Relinquished Property with either new debt or cash to avoid a taxable event at the time of the 1031 Exchange.
9. Failing to Understand or Comply with the Deadlines
Every day we hear from taxpayers who completely misunderstand the deadlines. “I have 60 days to find my replacement property and 6 months to complete the purchase.” No. The statute clearly states that taxpayers must identify their potential replacement properties within 45 calendar days after closing and complete the acquisition of identified Replacement Property or properties within 180 calendar days after the closing on the Relinquished Property. Failure to comply with the identification rules effectively invalidates the 1031 Exchange.
10. Failing to Consider a Reverse Exchange
The IRS approved the concept of so-called “reverse exchanges” over twenty years ago. Yet many advisors and even more taxpayers are unaware of the concept, and the incredible power that they provide. When real estate markets are incredibly hot, many taxpayers are fearful that they will not be able to find quality Replacement Property within the identification period, or to complete the purchase within the exchange period. Enter the reverse exchange. With a reverse exchange, the taxpayer acquires the Replacement Property before the sale of the Relinquished Property. The process is a little more complicated, but in a situation where both the Relinquished and Replacement properties are rental properties generating cash, the taxpayer has the potential to double their cash flow during the exchange period. Gain a better understanding of the Reverse Exchange.
11. Partnership Issues
Taxpayers often acquire properties together with other investors. When multiple investors pool their resources and acquire real estate inside of a limited liability company (LLC), that LLC is a entity – a taxpayer unto itself. The individual taxpayers do not have independent rights to perform 1031 exchanges, or not, beyond the confines of the LLC. If they wish to exchange independently of one another, they should plan for that well in advance of the sale of the property. Concepts to accomplish this include “drop and swap” and “swap and drop” are discussed in more detail here.They should consult with their tax and legal advisors, and plan carefully to maximize their compliance with 1031 Exchange rules, especially the concept of “held for investment.”
12. Settlement Statement Issues
Some settlement agents do not fully comprehend the significance of the Assignment (discussed in number 5, above) on the 1031 Exchange. The Assignment effectively inserts the Qualified Intermediary as the seller of the Relinquished Property and the buyer of the Replacement Property. It is by virtue of these assignments that the taxpayer ‘exchanges’ the Relinquished Property for the Replacement Property. Because the taxpayer has assigned their interests in the underlying real estate contract, the settlement statement should identify the seller of the Relinquished Property and the buyer of the Replacement Property as ‘Accruit as Qualified Intermediary’ for [taxpayer’ name]. Further, non-qualifying expenses would ideally be handled outside of closing and can be identified as ‘POC’ on the closing statement. Additionally, overfunding the purchase of the Replacement Property, resulting in cash flowing back to the taxpayer, could result in a taxable event for the taxpayer. Each line item on the Settlement Statement should be scrutinized by the taxpayer and their tax/legal advisors to ensure compliance with the 1031 Exchange rules.
As you can see, there are many opportunities for taxpayers to create headaches for themselves, or foot fault into non-compliance issues with a 1031 Exchange. As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before the first closing that will effectively start their 1031 Exchange.
 
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.