1031 Exchange Pitfalls to Avoid: expert tips for real estate investors
1031 Exchange Pitfalls to Avoid: Expert Tips for Real Estate Investors
Real estate investors find a 1031 exchange very powerful. It is convenient for meeting their property-related needs without facing capital gains taxes.
Under this scheme, a property held for sale can be exchanged for a property of a similar nature within a specified timeline.
Even though this strategy has great tax benefits, it can sometimes be tedious. Therefore, knowledge of the 1031 exchange rules and efforts to avoid common mistakes are important in ensuring seamless transactions and maximizing advantages.
To help solve that, let’s explore the more common problems that might be faced in a 1031 exchange and how one may go about them with the help of experts.
1. Failing to Meet the 1031 Exchange Time Limit
Probably the most common error in a 1031 exchange is failing to meet deadlines. As per 1031 exchange rules, investors are required to indicate a replacement property with a 45-day period from the date of sale of the original property.
In addition to the 45-day rule, there is a total of 180 days from the time of sale of the relinquished property within which one must close the deal for a new property.
If any of these deadlines is missed, it means the 1031 exchange is null and the capital gains tax becomes chargeable forthwith.
Tip: Begin to think of a property property exchange strategy even before you sell the original property. Working with a real estate advisory firm, like 317 Advisory, can assist to ensure that these vital timelines do not get missed.
2. Misidentifying Replacement Properties
Another common mistake is the failure to distinguish the ownership of new properties. According to the 1031 exchange rules, investors have 45 days within which they are allowed to select up to three "like kind" replacement properties.
On the other hand, more properties may be identified, but their value should be at most 200% of the value of the sold property. Failure to comprehend these options or the wrong property identification can create problems.
If any of the selected properties are unagreeable and the investor is unable to transact on the properties, the 1031 exchange would be ineffective and would call for immediate tax obligations.
3. Not Using a Qualified Intermediary
A direct transfer of two properties cannot be done in a 1031 exchange. This is because a qualified intermediary must facilitate any exchange.
One of the most significant investment mistakes is the lousy selection of the trusted intermediary, which can cause a failed exchange or lead to only partial tax deferral.
The intermediary will collect the proceeds from the sale of the original property, which will be used to purchase the replacement property.
If you control the sale proceeds at any point, the exchange may be disqualified, and you would have to pay capital taxes on gains.
4. Underestimating the Complexity of "Like-Kind" Properties
There is a popular misconception about 1031 exchanges that both the relinquished property and the replacement property have to be very similar to each other.
This level of flexibility does not, however, imply that all types of real estate can be placed in a 1031 exchange. For instance, personal property, such as a primary or secondary residence, cannot be exchanged for real estate intended for investment.
5. Overlooking Tax Implications and Other Costs
Although 1031 exchanges do help you to postpone the tax on any capital gains, you should keep in mind that the tax is deferred, not eliminated. It is still applicable when the replacement property is sold unless 1031 exchanges are employed again.
In addition, there are other expenses involved, for instance, closing expenses, fees paid to the qualified intermediary, and those for advisory services.
Not taking these costs into account and thinking that all taxes are evaded puts you at the risk of unforeseen complications later in time.
6. Ignoring Market Trends and Property Values
One key mistake that is frequently ignored is the aspect of commercial real estate trends and their effects on the underlying value of real estate.
In this circumstance, exchanging property in a steady market for one in a declining or unstable region may involve financial risks that outweigh the tax deferral's benefits.
Additionally, there are investors who are in such a rush to close a 1031 exchange within the time frame limits that they need to study the replacement property's worth functionally quite well.
The Final Word
A 1031 exchange is an effective way of obtaining a capital gains tax deferral and increasing wealth in real estate. However, the process definitely has some drawbacks.
By understanding what are the complications of 1031 exchange in real estate and how to avoid common investment mistakes, you can make sure you go through a successful exchange process.
Whether it's keeping track of the 1031 exchange time limit, finding appropriate properties, or working with a qualified intermediary, everyone needs good advice.
To obtain individualized recommendations and create a compelling property exchange strategy, reach out to 317 Advisory's professionals.
We assist our clients in understanding all aspects of the 1031 exchange and strengthening their investment thoroughly.
