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Obstacles to Avoid for a Successful 1031 Exchange

Understanding the common obstacles Exchangers may encounter in a 1031 Exchange if proper planning and steps are not taken, can allow you to ensure you avoid these obstacles in your own 1031 Exchange.
Obstacles to Avoid for a Successful 1031 Exchange

Many investors decide that they want to structure their real estate transactions as a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange , without knowing all of the steps and hurdles they can encounter along the way. But being well-informed before the sale of the first property is critical to the success of a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

Here we will discuss some common obstacles people face in a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange , all of which can be avoided by planning early.

1. Not Using a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary

Some taxpayers believe, mistakenly, that leaving the exchange funds at the title or escrow company is sufficient to establish a successful Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange . However, the Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange Regulations prohibit the taxpayer from having actual, or even constructive receipt of the exchange funds. This means that leaving the exchange funds with the title or escrow company, with the taxpayer’s attorney, or just simply not cashing the check, all violate the rule against having actual or constructive receipt of the exchange proceeds which nullifies the Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

2. Using a Disqualified Party as Your Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary

The Regulations define a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary as a party who is not the taxpayer or a disqualified person, who by a series of assignments enters into an exchange agreement with the taxpayer and acts as the party to complete the exchange. A disqualified person includes anyone “who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker” within the preceding two years, as well as family members and other prohibited relationships. When the taxpayer utilizes the services of his attorney to be his Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary , for example, the attorney is disqualified from serving as the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary , and the exchange would be disallowed.

3. Selecting the Wrong Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary

As in most other business settings, not all Qualified Intermediaries are created equal. At a minimum, we recommend selecting a Qualified Intermediary that is a member of the Federation of Exchange Same as intermediary, facilitator, or Qualified Intermediary. The party who facilitates a tax-deferred exchange by acquiring and selling property in an exchange to aid the taxpayer in complying with Section 1031 and all applicable rules. Accommodator s (FEA), the only national association representing Qualified Intermediaries, and tax/legal advisors who are directly involved in the 1031 exchange industry. We also highly recommend selecting a Qualified Intermediary that has multiple Certified Exchange Specialists® (CES®) on staff. The CES® designation is the only independent, tested designation for 1031 exchange professionals. A Qualified Intermediary that has a team of attorneys on staff is also recommended, as not all exchanges are as routine as they may seem up front. Learn more about selecting the right Qualified Intermediary.

4. Not Hiring the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary Before the Sale

As mentioned previously, the taxpayer may not have actual or constructive receipt of the exchange funds. Phrased another way, the 1031 exchange must be established and in place at or before the closing of the first property in the exchange. Vetting and selecting the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary in advance of the closing is integral to a successful 1031 exchange.

5. Failing to Properly Document the Exchange

Some people believe that the sole purpose of the Qualified Intermediary (QI) is to hold the exchange funds. While this is certainly an important function of the Qualified Intermediary, it is not the main function of a QI. For a 1031 exchange to be valid, there must be an Agreement between the Exchanger and the Qualified Intermediary, establishing the Exchanger’s intent to complete a Like-Kind Exchange and detailing each party’s roles and responsibilities. The Exchange Agreement must detail the exchange in accordance with the deferred exchange regulations. Exchange Agreement between the taxpayer and the Qualified Intermediary; the taxpayer must assign their rights in the sale and purchase contracts to the Qualified Intermediary; and the taxpayer must notify all other parties to the exchange of that assignment. The Qualified Intermediary prepares these documents and ensures proper notification to the other parties to the exchange.

6. Trying to Exchange Ineligible or Disqualified Property

Virtually every day we receive a phone call from someone who wishes to participate in a 1031 exchange involving vacation homes. Yet the statute is clear that the properties in the exchange must be “held for productive use in a trade or business, or for investment.” Under the Regulations, ‘disqualified property’ is property that was not held for productive use in a trade or business or for investment. Second homes, vacation homes, or other property that is used exclusively by the taxpayer for their own enjoyment, with no business or investment motive, are therefore not qualified property and not eligible for a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

7. Fix-and-Flip Properties

As noted above, the properties being exchanged must be “held for productive use in a trade or business or for investment.” Property that was acquired to be improved or rehabbed, and then immediately resold is viewed as inventory, rather than investment property. These so-called ‘fix-and-flip’ properties do not qualify as business or investment property, and are not allowed with a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

8. Not Exchanging Equal or Up in Value, and Equity

There is a common misconception that taxpayers only need to reinvest the gains or profits on the sale of their Relinquished Properties. Others are of the mistaken belief that they only need to reinvest the cash that was generated at the sale, after satisfying loans and paying closing costs. Both situations will result in the taxpayer being exposed to potential tax liabilities. Rather, taxpayers should endeavor to exchange equal or up in fair market value, and equal or up in equity, and to replace any debt from the Those certain items of real and/or personal property described in the relinquished property contract and qualifying as “relinquished property” within the meaning of Treasury Regulations Section 1.1031(k)-1(a); The "Old Asset”, property or properties given up or conveyed by a taxpayer as part of a 1031 exchange. Relinquished Property with either new debt or cash to avoid a taxable event at the time of the Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

9. Failing to Understand or Comply with the Deadlines

Every day we hear from taxpayers who completely misunderstand the deadlines. “I have 60 days to find my replacement property and 6 months to complete the purchase.” No. The statute clearly states that taxpayers must identify their potential replacement properties within 45 calendar days after closing and complete the acquisition of identified Replacement Property or properties within 180 calendar days after the closing on the Relinquished Property. Failure to comply with the identification rules effectively invalidates the Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

10. Failing to Consider a A Reverse Exchange is typically conducted under the safe harbor established in Rev Proc 2000-37. These are "parking arrangements" where either: (i) a property is purchased and "parked" as a potential replacement property for the benefit of a specific taxpayer by an exchange accommodation title holder until such time as the taxpayer arranges for the transfer of the relinquished property to the ultimate transferee in a simultaneous or deferred exchange; or (ii) a taxpayer transfers the relinquished property to be "parked" by an exchange accommodation title holder in exchange for immediately receiving the replacement property, and the exchange accommodation title holder later transfers the relinquished property to the ultimate transferee Reverse Exchange

The IRS approved the concept of so-called “reverse exchanges” over twenty years ago. Yet many advisors and even more taxpayers are unaware of the concept, and the incredible power that they provide. When real estate markets are incredibly hot, many taxpayers are fearful that they will not be able to find quality Replacement Property within the identification period, or to complete the purchase within the exchange period. Enter the reverse exchange. With a reverse exchange, the taxpayer acquires the Replacement Property before the sale of the Relinquished Property. The process is a little more complicated, but in a situation where both the Relinquished and Replacement properties are rental properties generating cash, the taxpayer has the potential to double their cash flow during the exchange period. The amount received for a property, minus the property’s adjusted basis and transaction costs. Regardless of the adjusted basis of a property, there is no gain until the property is transferred. There are two types of gain: “realized gain” and “recognized gain.” Realized gain is the difference between the total consideration (cash and anything else of value) received for a piece of property and the adjusted basis. Realized gain is not taxable until it is recognized. Gain is usually, but not always, recognized in the year in which it is realized. If gain is not recognized in the year it is realized, it is said to be deferred. In an exchange under Section 1031, realized gain is recognized in part or in full to the extent that boot is received. See Boot. Where only like kind property is received, no gain is recognized at the time of the exchange. Gain a better understanding of the Reverse Exchange.

11. Partnership Issues

(“Exchangor" or "Exchanger") Individual or entity desiring an exchange. Taxpayer s often acquire properties together with other investors. When multiple investors pool their resources and acquire real estate inside of a limited liability company (LLC), that LLC is a entity – a taxpayer unto itself. The individual taxpayers do not have independent rights to perform 1031 exchanges, or not, beyond the confines of the LLC. If they wish to exchange independently of one another, they should plan for that well in advance of the sale of the property. Concepts to accomplish this include “drop and swap” and “swap and drop” are discussed in more detail here.They should consult with their tax and legal advisors, and plan carefully to maximize their compliance with Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange rules, especially the concept of “held for investment.”

12. Settlement Statement Issues

Some settlement agents do not fully comprehend the significance of the Assignment (discussed in number 5, above) on the Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange . The Assignment effectively inserts the Qualified Intermediary as the seller of the Relinquished Property and the buyer of the Replacement Property. It is by virtue of these assignments that the taxpayer ‘exchanges’ the Relinquished Property for the Replacement Property. Because the taxpayer has assigned their interests in the underlying real estate contract, the settlement statement should identify the seller of the Relinquished Property and the buyer of the Replacement Property as ‘Accruit as Qualified Intermediary’ for [taxpayer’ name]. Further, non-qualifying expenses would ideally be handled outside of closing and can be identified as ‘POC’ on the closing statement. Additionally, overfunding the purchase of the Replacement Property, resulting in cash flowing back to the taxpayer, could result in a taxable event for the taxpayer. Each line item on the Settlement Statement should be scrutinized by the taxpayer and their tax/legal advisors to ensure compliance with the Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange rules.

As you can see, there are many opportunities for taxpayers to create headaches for themselves, or foot fault into non-compliance issues with a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange . As always, taxpayers are encouraged to discuss their plans with their tax and legal advisors before they embark on the path toward the sale of an investment or business use property, and to engage the services of a Qualified Intermediary, such as Accruit, before the first closing that will effectively start their Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange .

 

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.