4 Mistakes to Avoid with 1031 Exchanges of Real Estate by Yovanny Hernandez, CPA
For more than a century, Section 1031 of the U.S. tax code has carved out a unique opportunity for qualifying individuals and businesses to defer federal capital gains tax on the sale of highly appreciated real estate held for investment or business use when they reinvest the sales proceeds into a similar, like-kind property. These so-called 1031 exchanges are not only a savvy tax-planning tool, but they also help investors keep their capital working for them in the market, investing in additional properties and yielding higher cash flow and property appreciation. However, the rules for completing a successful 1031 like-kind exchange are extensive and making one mistake – whether it be a missed deadline or failing to work with a qualified intermediary – can nullify all the intended benefits.
Failing to Follow the Required Timelines
Investors considering a 1031 exchange must abide by stringent time constraints or risk exposure to capital gains tax and the Net Investment Income Tax (NIIT) on the original property sale.
- You have 45 days from the sale of the original property to identify a replacement property of equal or greater value than the sold property
- You have 180 days from the sale of the relinquished property to close on the acquisition of the replacement property.
You must report the 1031 exchange on IRS Form 8824 for the tax year in which you relinquish the original property. However, given the time limits for completing the exchange, the original property sale and the purchase of the replacement property may extend over two tax years. Under these circumstances, you will have to wait until you close on the replacement property to complete your tax return for the prior year.
Failing to Work with a Qualified Intermediary
The IRS requires that you work with and pay for an independent third party to facilitate the exchange and manage the financial aspects of those transactions. This qualified intermediary (QI) acts as the seller, receiving and holding the net proceeds from the original property sale and later transfers those funds to acquire the replacement property. In this sense, the QI serves as your representative to sell the original property, buy the replacement property and ensure proper transfers of funds to the rightful persons.
Using Different Taxpayers/Entities for the Exchange
Because the IRS considers a 1031 exchange to be a continuation of the taxpayer’s original investment, it requires that the person or entity purchasing replacement property be the same person or entity with the same tax ID number that sold the original property. Therefore, a husband and wife who relinquish property titled in both their names must also purchase replacement property in both their names. The replacement property cannot be titled solely in the husband’s name.
However, there is an exception to this rule for single-member LLCs, which are permitted to sell property in the member’s name and replace it with property held in the LLC’s name. The same is true for grantor trusts, in which a taxpayer sells a property and then buys the replacement property, putting the title in the trust’s name.
Failing to Recognize State Taxes on Relinquished Property Sales
While you may execute a 1031 exchange across state lines, it is important to recognize that not all jurisdictions follow federal law.
For example, California, Massachusetts, Montana and Oregon have clawback provisions that impose capital gains tax on the sale of replacement property outside their state lines. Therefore, a taxpayer who sells an original property in one of these states may defer federal and state taxes on the gain until they eventually sell the replacement property outside of a 1031 exchange. At that point, they will be subject to capital gains tax on the federal level, in the state where the replacement property is located (if that jurisdiction has state income taxes) and in the state with the clawback provisions.
About the Author: Yovanny Hernandez, CPA, is a senior manager of Tax Services with Berkowitz Pollack Brant Advisors and CPAs, where he provides tax, business and compliance services to real estate businesses and individual investors. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or info@bpbcpa.com.
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