3 Common Mistakes Investors Make When Using a 1031 Exchange

If you're looking for a way to defer capital gains taxes when selling your income properties, a 1031 exchange will help you do just that. However, there are a few considerations to remember if you want to take full advantage of the tax benefits.

To help you get the most out of your 1031 exchange, we compiled a list of three common mistakes real estate investors make regarding the 1031 exchange and how you can avoid them.

Important Note: In addition to avoiding the mistakes we mention below, we recommend working with a tax professional or accountant to ensure you cover your bases.

1. Ignoring the Timeline

To secure the tax deferment of a 1031 exchange, there are two time periods you must operate within:

1. You must identify your "replacement property” (new property) within 45 days of closing on your “relinquished property” (old property). The IRS allows you to list three possible replacement properties. Once you list three options, you are limited to those properties. You must close on one of them to complete the exchange.
2. You must close on your replacement property within 180 days of closing on the sale of your relinquished property.

Following these guidelines, you will want to start searching for replacement properties when you decide to list your property for sale. An innovative real estate investment software like PropStream can speed up this process by helping you narrow your search results, find off-market properties, and access new data before the competition!

2. Choosing the Wrong Custodian

Your custodian (also known as a “qualified intermediary”) is the party responsible for holding your funds and ensuring that your exchange meets the strict rules outlined by the IRS. 1031 exchange custodians are not as highly-regulated as you might think. So it’s important to do your due diligence in reviewing and selecting your custodian. Invest some time in:

• Reading reviews from property owners who have used custodial services.
• Reviewing the custodian’s Better Business Bureau profile.
• Interviewing multiple custodians to find one you’re comfortable working with.

3. Failing To Understand the Rules

Many rules apply to 1031 exchanges. Failing to understand these rules could nullify your exchange and eliminate your tax deferment.

Here are some basic rules to be aware of when deciding if a 1031 exchange is right for you:

1. 1031 exchanges do not eliminate capital gains taxes; they only defer taxes to some future date.
2. 1031 exchanges apply to property held for business or investment purposes, not for personal-use properties.
3. Only "real property" qualifies for a 1031 exchange. Before 2018, personal property like aircrafts, boats, and equipment qualified, but the Tax Cuts and Jobs Act (TCJA) eliminated those options.
4. Properties must be “like-kind.” Even this basic rule is a bit ambiguous. According to the IRS, “Most real estate will be like-kind to other real estate.” However, improvements that convey without land rights are not like-kind to vacant or improved land.
5. The value of the new property must be greater than the value of the old property.
6. You must maintain equal or greater debt in the new property to what you had in the old (or face taxes on the difference).
7. Property outside the United States does not qualify for a 1031 exchange.
8. The replacement property must be purchased with the intention of holding it for investment or business purposes. This means you should expect to hold the new property for several years.
9. You cannot access any cash from the transaction. All proceeds from the sale of the relinquished property must roll into the purchase of the replacement property.
10. If you exchange an improved property for vacant land, you may be subject to depreciation recapture. If so, you'll owe back the depreciation claimed on the old property.

Before taking advantage of the benefits of a 1031 exchange, ensure you understand the rules, adhere to the timeline, and have a custodian you can trust.

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