A “Like-Kind Exchange,” also known as a 1031 Exchange or a Starker Exchange, allows investors to defer paying capital gains taxes on investment properties when they are sold, as long as another “like-kind” property is purchased with the profits of the sale. Congress enacted the like-kind exchange statue nearly 100 years ago, in 1921, to help investors avoid unfair taxation of ongoing investments in property and to encourage active reinvestment (Federation of Exchange Accommodators).
Although it sounds simple enough (it’s essentially a property swap), there are a few critical ways in which investors can ruin a 1031 Exchange.
5 Ways a 1031 Exchange Can Go Off the Rails
You Miss the 45-day Deadline
A 1031 Exchange in 2017 is much like a 1031 in 1921: a great way to promote development and boost the economy. In fact, according to Scott Saunders, FEA board member and senior vice president at Asset Preservation in Colorado Springs, they’re vital to our economy. “Experts say caps or restrictions to 1031 exchanges would be chilling to the economy; airline, construction, and rental-car companies save millions annually by exchanging older assets for new ones. Should their 1031 savings be capped, the cost of everything for the consumer would go up and the real estate industry would be hit hard,” he said in a recent CNBC report.
However, as with any great deal, there’s a deadline involved. Once a property is sold, investors can purchase replacement properties for the same or greater value. To take advantage of the tax savings that a 1031 offers, investors have 45 days to identify, in writing, what they intend to purchase with the exchange.
You Miss the 180-day Deadline
The second critical 1031 deadline is the 180-day closing deadline. This rule states that investors have no more than 180 days from the sale of the old property to close on a new property or properties. So investors must be sure to have financing lined up and ready to go! The IRS isn’t in the horseshoe business: close doesn’t cut it. If a taxpayer fails to close on a replacement property within the 180-day period, they will have to pay capital gains taxes on the sale of the initial property.
You Aren’t Clear Enough
Not only must investors identify a replacement property or properties within 45 days and close on them within 180 days, but they must first identify new property clearly and in no uncertain terms. Generally, this means using a clear legal description and or street address of the identified property. Not only that, but if investors are working with another party, or buying into a condo complex, they must be extra clear!
According to First American Exchange Company “If you are going to acquire a tenancy-in-common interest in the property, you should try to identify as closely as possible the percentage interest you will be acquiring. If you are acquiring a condominium, you need to also identify the unit number. Moreover, if improvements will be constructed on the replacement property between the date you identify it and the date you acquire it, you must identify what will be constructed on the property in addition to the legal description or address. You should provide as much detail about the improvements as is ‘practicable.’”
You Jump the Starting Gun
With all the deadlines, it’s easy to feel the pressure to seal the deal and close quickly. However, if an investor closes before finalizing a like-kind exchange, they’re similarly out of luck. Property owners often (erroneously) believe that they can set up a 1031 Exchange after closing. Be intentional, methodical, and plan ahead.
You Touch the Proceeds
Once a taxpayer sells an old property under a 1031 Exchange, they are not allowed to handle the proceeds on the relinquished property. Instead, investors should work with a commercial real estate attorney to identify an escrow holder or qualified intermediary prior to the sale of the property. Once the closing has been completed, the proceeds can then be transferred to an intermediary-managed fund until the investor is ready to use them on the replacement property.
If you are in search of a commercial real estate attorney services, need help with title and closing, or simply want to learn more about a 1031 Exchange, contact Rochford Law & Real Estate Title.