Common 1031 Exchange Misconceptions
As a Qualified Intermediary (QI), we spend much of our time each day on calls with investors, real estate professionals, and closing agents answering questions about the 1031 Exchange process. We're here to address the FIVE most common misconceptions of 1031 Exchanges:
1.) I do not need a Qualified Intermediary for a 1031 Exchange.
Per Treas. Reg. §1.1031(k)-1(g)(4)(iii)-(vi), a Qualified Intermediary (QI) must be assigned the seller’s rights to proceeds under the contract and transfer the relinquished property on behalf of the seller, pursuant to an exchange agreement. To meet these requirements, a taxpayer wishing to do a 1031 Exchange with the sale of property must hire a QI before the transfer of their property to the buyer to avoid “actual” or “constructive” receipt.
Unfortunately, it is a common call that we receive that a taxpayer closed on a property a few days (or a few weeks) ago and now they have decided to do a 1031 Exchange. Since the transfer of ownership of the property has already occurred, we cannot set up the exchange per the code.
But there are parties that CANNOT be your QI:
Your Agent/Broker
Your Attorney
Your Accountant
Your Investment Banker
Your Employee
Or anyone who has represented you within the last 2 years (other than a Qualified Intermediary).
2.) An Exchange must be one property for one property.
It is common for taxpayers to want to grow their portfolio through the 1031 process. This is allowed through the 1031 process as long as the taxpayer meets the financial requirements of the 1031. This allows a taxpayer the ability to sell multiple properties and acquire, or sell one to acquire multiple.
But, we must always take into consideration the timeframes of the 1031. Refer to the infographic below.
3.) An Exchange must acquire the same type of property that they sold.
Another common call that we receive from many real estate professionals is that they assume (incorrectly) that since their client sold farmland, that they must acquire farmland through the 1031.
The Section 1031 says the following:
“No gain or loss shall be recognized on the exchange of real 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 either for productive use in a trade or business or for investment.”
To summarize, this means that you can sell any type of real property and acquire any type of real property to qualify for 1031 treatment - just as long as that property is held for investment purposes.
4.) The 1031 Exchange is just a tax loophole.
Section 1031 of the tax code was part of the Revenue Act of 1921. It’s been around for over 100 years!
5.) A taxpayer will be penalized if they start an exchange but do not complete it.
If a taxpayer sets up a 1031 Exchange before the closing of their sale, the proceeds will come to us as QI at closing. The taxpayer has 45 calendar days to identify the replacement property and 180 calendar days to close on the replacement property.
If a taxpayer is unable to identify replacement property within the 45 days, we will release the funds to the taxpayer on Day 46 (or the next business day after) and the funds are taxable. There is no penalty to a failed exchange; the taxpayer pays whatever tax was being deferred through the 1031 process.
If the taxpayer does identify replacement property within the 45 days, then the funds must remain in the 1031 account until they purchase their replacement property, or the 180 days of the exchange expires. Any funds remaining in the 1031 account after the 180 days will be taxable.
For more information about these topics, or if you have other questions, please contact the specialists here at Security 1st Exchange for assistance.