1031 Exchanges - Avoid These Common Mistakes
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1031 Exchanges - Avoid These Common Mistakes
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By:
Anthony Seruga and Yolly Bishop |
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A 1031 exchange sounds like a great deal - trade properties of equal value and avoid all the tax and fee issues - and it is a great deal, provided you carry it through properly. Unfortunately, because it is such a complex transaction, it is common for real estate investors to make mistakes during the exchange.
That is disastrous. If you don't do a 1031 exchange properly, you could find yourself liable for back taxes as well as penalties and other fees.
To qualify for a 1031 exchange, the properties to be exchanged must meet the following criteria:
* They must be held for productive use in a business or a trade, or they must be held as an investment. Homes are not eligible.
* Properties must be of the same nature or quality - so all real estate that otherwise qualifies would work.
* Properties must be held within the United States
* Equipment with total value of not more than 15% of the fair market worth of the more valuable property may be traded as part of the 1031 exchange.
Provided these criteria are met, capital gains and losses upon transfer of the properties can be deferred. If cash is part of the transaction - for instance, if cash must be exchanged to make the trade of equal value - its capital gain/loss is not deferred and capital gains tax must be paid on it. There are a few other 1031 exchange rules, but this is the core.
Most people who are participating in a 1031 exchange with their properties make an error based on a misapprehension of some part of the criteria. Some of the most common errors include the following:
1. Attempting to do a 1031 exchange on a home or personal residence. 1031 exchanges only apply to business properties: rentals, business property, land held as an investment, and similar properties.
2. Selling a property, then trying to convert it to a 1031 exchange. If you don't have the 1031 paperwork set up when your property closes at escrow, you can't do it, and the exchange needs to be set up with an uninvolved third party, not the current real estate agent or attorney or other interested party of either property owner. An easy rule of thumb is that the property must be a 1031 exchange before any money touches you or your bank accounts.
3. Because intermediaries do not need to be licensed, an unaware real estate investor may inadvertently select one who is not reputable. Before doing a 1031 exchange, make certain you have chosen an intermediary who is experienced in your sort of 1031 exchange and has proven his knowledge and trustworthiness.
4. Holding a property for less than two tax years before using it as part of a 1031 exchange may indicate to the IRS that you did not intend to use it as an investment property, one of the key requirements for a property to be eligible for a 1031 exchange. There is no specific length of time the IRS requires you to hold properties, though, so if you're in doubt ask your intermediary or a tax attorney.
5. Doing too little research on the rules and not understanding what you're doing. The rules above are a portion of the tax code controlling a 1031 exchange, but there's a little more to it. If you aren't doing a simultaneous exchange, for instance, there are time limitations governing your 1031 exchange: you must identify up to 3 properties you could purchase as the second half of your 1031 exchange by midnight on the 45th day after selling your first property and tell the intermediary in writing. At least one of the three identified properties must be purchased and closed on by 180 days following the sale of your first property; there is no grace period if the last day falls on a weekend. Failing to follow these time limitations will negate your 1031 exchange and force you to pay significant capital gains.
6. Giving yourself inadequate time for property research. Some investors jump into a 1031 because the market is good for the first property and they think that they'll surely be able to find a second party they're interested in within the 45-day limit. If you have not done any preliminary research on other properties, this can be a disastrous error; leaving you with capital gains to pay or with a property you didn't really want.
7. Assuming that boot - the cash difference between the first and second property price - does not accrue capital gains penalty. It does. It's better to pay a little more for the second property than pay the penalty for the profit you make on the first one. This is something to plan ahead for. If you don't have cash on hand to pay the difference, you may have to purchase a lower-valued property, and it may be a property you don't want as much.
8. Assuming that trading down when the first property has a mortgage will leave you free of liability. If you have a mortgage on the first property and trade down for a second property, getting rid of the mortgage, you are then liable to pay the taxes on the amount of mortgage eliminated in the trade. So if you have a $100,000 mortgage and your trade reduces your mortgage to $70,000, you owe capital gains on the $30,000 difference, even if money never changed hands. This is called mortgage boot.
As you can see, a 1031 exchange for your properties can bring up some complicated issues you may not anticipate when you take the first step into one. To avoid making errors with this useful but confusing transaction, think your entire exchange through before entering into it, and seek out the advice of a knowledgeable intermediary.
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