Top Ten Common Exchange Misconceptions
1. If I don’t get a wire, a check or cash at my relinquished closing, but let my attorney hold the proceeds for me, I can still decide---even at the last minute-- to do an exchange. No matter how you slice it, letting your attorney hold the money for you is a non-starter. First, your attorney is a disqualified party and cannot serve as a qualified intermediary in your exchange. Secondly, prior to the relinquished sale, there must be an exchange agreement, assignment of the contract and notice of that assignment. 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.
2. 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.
3. If I sell a property that is solely in my name, then I can buy a replacement property with my wife using both our names. Though this may be a great move 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.
4. 1031 exchanges are only for big companies and the 1%. In reality, studies done by Deloitte revealed that the average exchange proceeds are less than $300,000. So, the 99% do the vast majority of exchanges executed each year.
5. 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. Most times in practice, that’s not the case.
6. 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 other proceeds that are sent to the QI.
7. Luckily, my vacation home has really appreciated. I am going to do a 1031 exchange when I sell it. Great idea, but it may not work in practice. “Personal-use” vacation homes that are rarely-- if ever—rented, do not qualify for 1031 treatment.
8. 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”.
9. 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 it first. (Note: If you must close on the replacement property first, than you can consider a reverse exchange strategy.)
10. 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 you sold that was repaid at closing, then you must replace the same amount of debt on the new property or put in additional cash to balance. There are cash and debt requirements that must be met to complete a proper 1031. You must buy property for the same price or great (than what you sold) and use all of the cash to qualify for total gain deferral.