The Unlucky Thirteen: The Common 1031 Pitfalls
by Steven G. Rosansky, IPX Investment Property Exchange Services, Inc.
Note: This is an abbreviated form of a more extensive paper. To obtain a complete copy, please contact us.
Sec. 1031 real estate exchanges are carefully scrutinized by the Internal Revenue Service and, where the rules are not carefully followed, the tax-free exchange is nullified and capital gains taxes become payable. Consequently, it is important that the rules be followed with great care and that knowledgeable professionals be retained to insure the integrity of the transaction. What follows is an abbreviated summary of common mistakes in the transaction that can render it invalid as a tax-free exchange.
- Failure to use an accommodator in a delayed exchange.
In a delayed exchange, an accommodator must be in place prior to closing on the relinquished property. Treas. Reg. Sec. 1.1031 (k)-1l(g)(4).
The deadline begins to run on the date the exchanger transfers the relinquished property to the buyer. The date of transfer will be the date of recording or the date of possession, whichever occurs first. IRC Sec. 103(a)(3)(B).
- Failure to understand
the basic rules of reinvestment. Treas. Reg. Sec.
1.1031(k)-1(f)(1) and 1.1031(d)-2.
In order to obtain a deferral of the entire capital gain tax, the exchanger must
- Use all of the cash in the exchange account to acquire replacement property,
- Have equal or greater debt on the replacement property, and
- Receive nothing but the like-kind property.
- Failure to have the appropriate intent.
The exchanger must hold the relinquished and replacement properties for the appropriate intent:
- Investment or
- Use in a trade or business, and
- Not for personal
they do not have to buy from the list of identified properties. Treas.
Reg. Sec. 1.1031(k)-1(b).
Property will not be treated as like-kind unless properly identified. The identification must be in writing, unambiguous, signed by the exchanger, sent to a party to the exchange, and sent within the 45 days. The exchanger must also comply with additional rules:
- The three property rule,
- The 200% rule, and
- The 95% rule.
- Wanting cash out
during the exchange.
The exchanger can receive funds either before the exchange or after termination of the exchange, but never during an exchange. Releasing funds during the exchange—either directly to the exchanger or for the benefit of the Exchanger for something other than replacement property or customary closing costs—jeopardizes the entire exchange.
- Receiving earnest money.
The exchanger may receive earnest money from the buyer, but it will be taxable. However, receipt of earnest money does not preclude an exchange with the balance of the sale proceeds. Treas. Reg. Sec. 1.1031(k)-1(f)(1).
to accept a carry-back.
It is always best for the exchanger to have a cash buyer for the relinquished property. A carry-back to the exchanger greatly complicates the exchange.
- Buying from (or selling to) a related party.
Exchanges may take place between related parties, but, in such a case, the parties may not dispose of their replacement properties within two years of the exchange. IRC Sec. 1031(f).
- Wanting a separate LLC for each
Using a new LLC for each investment property does not fit into the exchange format. Exchange rules anticipate that the entity beginning the exchange will be the entity concluding the exchange.
- Dissolving a partnership.
If the partnership holds real property, the partnership may do an exchange. However, partners hold a partnership interest, not an interest in real property, and partnership interests are not exchangeable. Treas. Reg. Sec. 1.1031(a)-1(a)(1)(iv).
- Wanting to build on property one already owns.
Any improvement work on property to which the exchanger holds title will be “goods and services” and not like-kind real property. In order for the construction to qualify for the tax deferral, the regulations require that the work be done before the exchange takes title. Treas. Reg. Sec. 1.1031(k)-1(e)(4)).
- Purchasing property without an accommodator,
before selling property.
Reverse exchanges, buying before selling, are fraught with legal and practical issues. There are no Treasury Regulations in support of reverse exchanges and most cases disallow the structure employed by various taxpayers.