Delayed 1031 exchange is a popular choice for investors, since they allow them to find a new property with better returns than the first one, and avoid capital tax gains almost indefinitely.
They work by allowing investors to sell a property and buy another like-kind property with the proceeds. It’s a great way to diversify your portfolio or consolidate your real estate holdings if you know how to do it right.
However, there are strict rules governing delayed 1031 exchanges, and in order to make one work for you, you’ll need to make sure to avoid these common investor mistakes.
1. Not Making The Deadline
In a delayed 1031 exchange, you have 180 days from start to finish to complete the transaction. That means from the time you sell the first property (called the relinquished property) until you close on the new property (termed the replacement property), you have exactly six months or 180 days.
Here’s where some investors mess up.
The IRS states that you have 45 days to find a replacement property, in writing. You need to add a specific clause to the purchase contract for both the relinquished property and the replacement property that you will be using them in a 1031 exchange.
You also need to identify three different properties, and once the 45 days pass, you can’t add any new properties.
Some investors also don’t realize that the 45 day period is included in the 180 day time period so that you really have just 135 days from the time you close on the relinquished property to complete the transaction.
2. Not Making Sure Your Intermediary Uses A Separate, FDIC-Insured Account To Store Your Money
A qualified intermediary is an essential part of doing a 1031 exchange.
That’s because the IRS states that you are not allowed to be in a position of either the relinquished property or the replacement property until the transaction is completed.
And while most investors are careful to find a qualified intermediary, many don’t realize that your money should not be held together in one account with other investors’ money.
Instead, the intermediary must hold your money in a separate, FDIC-insured account, one ensured for that specific amount of money.
3. Filing After The Tax Return Deadline
Although the IRS specifies 180 days as the time period for a delayed 1031 exchange, many investors don’t realize that a replacement property must be purchased before the tax return filing deadline.
This holds true no matter when the relinquished property was sold, and even if the investor is still within the 180 day time period.
4. The Replacement Property Must Be Equal To Or Higher In Cost Than The Relinquished Property
Not all delayed 1031 exchanges are free of capital gains taxes.
If you purchase a replacement property that costs less than the relinquished property, you will be forced to pay capital taxes on the difference. This difference is called boot, and it can add up to hefty sums.
Keep in mind that this calculation also includes your debt service. So if the mortgage on the new property is less than that of the old property (taking into account the amount of cash you put down as down payment as well), then you could still find yourself owing capital gains taxes.
This isn’t a problem if this is a conscious choice; sometimes it’s the only way to get at least a portion of your proceeds free of capital gains taxes.
On the other hand, many investors don’t know that they can put extra money into improvements on the replacement property, and this will be counted towards the final net worth of the property.
5. Overpaying For A Replacement Property
Although you want to make sure to find a replacement property before the deadline is up, avoid broadcasting the fact that the property is for a 1031 exchange.
It’s actually not uncommon for sellers to jack up the prices of a property when they hear it’s for a delayed 1031 exchange.
At the same time, don’t choose the wrong property simply because your back is up against the wall. Take the time to carefully examine each property before you start the clock. In fact, some investors are choosing to find a replacement property before they sell their relinquished property.
It’s called a reverse exchange, and though more complicated and costly than a standard exchange, it can still be worth it for the right type of situation.
6. Making A Mistake At The Close
The IRS, as you might guess, is super picky about crossing your t’s and dotting your i’s when it comes to a delayed 1031 exchange. Something as simple as putting the wrong numbers on a closing statement can cause you to be liable for tens or hundreds of thousands of dollars.
Likewise, if 1031 isn’t processed properly, it could end up changing your income from capital gains to regular income – which is taxed at a much higher rate. You could even end up being held accountable for other taxes on top of those.
In short, choosing an experienced intermediary is one of the most important parts of a 1031 delayed exchange. Get it wrong, and you make regret it for a long, long, time. Get it right, on the other hand, and you can sit back and enjoy the rewards of a high-performing investment property.