The Top Ten 1031 Exchange Misconceptions
Sometimes, the best intentions don’t quite get us to the finish line, but can leave us in a very painful spot. It's best to steer clear of the pitfalls that can derail an exchange or limit the tax that can be deferred. With this goal in mind, we introduce our Top Ten 1031 Exchange Misconceptions:
#1- If I sell a property, but tell the closer not to give me the money immediately, I can still decide—after the closing– to do an exchange. No matter how you slice it, if you sell property and have the ability to access the proceeds, even if you don’t, you have invalidated the exchange. Besides this error, prior to the relinquished sale, there must be an exchange agreement, assignment of the contract and notice of that assignment to the buyer. Finally, there are specific rules regarding how the funds can be held. If you contact a QI/Accommodator prior to— or even simultaneous with— the closing, they can provide what is necessary to keep you on the right track. If you leave the closing, even with an uncashed check in hand, it's too late.
#2-After I sell a property that is solely in my name, I can buy a replacement property with my spouse using both our names. Though this may be a great strategy in your personal investment planning, it can torpedo your 1031. Whoever is the seller of the relinquished property must also be the buyer of the replacement property. Going from single to joint ownership would violate the “same taxpayer” rule unless you are buying a more expensive property.
#3-1031 exchanges are only for big companies and the 1%. In reality, studies done by Deloitte reveal that the average exchange proceeds are less than $300,000. So, the 99% do the vast majority of exchanges executed each year.
#4-I plan on buying my replacement property from my dad to keep all the benefits of a 1031 “in the family”. Though this is a great sentiment, it probably won’t work. The 1031 rules stipulate that you can’t buy replacement property from a related party unless they are also doing an exchange or if they will be paying more tax than you are deferring. Usually, that’s not the case.
#5-If I am selling my own property, I can’t hold the earnest money without damaging my exchange. Actually, you can. You are allowed to accept and deposit it–as long as you are not in possession of it after the sale closes. If you are, whatever you still have becomes taxable to you. Most exchangers refund remaining earnest money to the closing where it is combined with the main proceeds that are sent to the QI.
#6-Luckily, my vacation home has really appreciated. I am going to do a 1031 exchange when I sell it. Great idea, but there may be a large problem. “Personal-use” vacation homes that are rarely– if ever—rented, do not qualify for 1031 treatment. These rules were clarified in 2008.
#7-I can’t do an exchange because I have only owned the property for 10 months. Potential good news: the exchange rules do not include a required minimum holding period. However, they do state that the properties you are exchanging must be either “held for investment or used in a trade or business”. The key is what your intention was when you bought the property. Did you plan on flipping it for a quick profit and immediately erect a for sale sign or did you receive an unexpected offer that you could not refuse? Intent matters.
#8-I can’t write a contract on a potential replacement property because I haven’t closed my relinquished sale yet. Not a problem. You can always enter into a purchase agreement on the replacement property you want to buy before the relinquished closing, as long as you don’t close on the replacement property first. (Note: If you must close on the replacement property first, than you can consider a reverse exchange strategy.)
#9-Since I reinvested all the proceeds/cash from my relinquished sale into my replacement property, I have deferred all tax, right? Not so fast. If there was a loan on the property that you sold which was repaid at closing, then you must replace the same amount of debt on the new property or put in additional cash to replace it. There are cash and debt requirements that must be met to complete a proper 1031. You must buy property for the same price or greater (than what you sold) and use all of the cash to qualify for total gain deferral.
#10-If I sell land, then I can only buy land to meet the “like-kind” requirement. Thankfully, not true. All investment real estate is considered “like-kind” with all other investment real estate. So, you can sell land and buy a rental property or sell an apartment building and buy a retail outparcel. Though there are more restrictions to meet when selling equipment and other types of qualified property, the like-kind requirement is more flexible for investment real estate.