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Navigating Exchange Pitfalls: 6 Mistakes to Avoid in Your 1031 Exchange

If you invest in real estate or work with those who do, it’s not an exaggeration to say that understanding how the government supports (or inhibits) real estate investments is crucial. You will never have a more powerful ally or adversary than the IRS, the US Treasury Department, and state Departments of Revenue.

The most well-known and useful carveout for real estate investors is the 1031 exchange. Through a 1031 exchange, you can instantaneously increase your buying power, enjoy greater flexibility and adaptability, significantly improve your tax efficiency, and even boost your estate planning. On the flip side, exchanges can be tricky to navigate. Certain mistakes can be the difference between making a great investment and paying tens of thousands ㅡ or even hundreds of thousands ㅡ of dollars in unwanted taxes.

With that in mind,  I want to highlight the most common and damaging mistakes we see investors make.

1. Delaying the Involvement of a Qualified Intermediary (QI)

Our first mistake is often the worst mistake you can make, and that is waiting to bring in a Qualified Intermediary (QI) until after you’ve completed your property sale. 

The IRS mandates that investors looking to defer taxes involve a QI before their sale concludes. This is because your intermediary must set up a separate escrow account to receive your sale proceeds and properly structure the transaction as an exchange in advance of closing. If you bank the proceeds from your sale, you are no longer eligible for an exchange. 

Most qualified intermediaries require at least two weeks of advance notice before your sale closes. And even for companies that can accommodate a faster turnaround time, involving them too late in the process will mean paying additional fees.  

Part of what separates 1031X is our ability to handle closings on very late notice ㅡ even as late as an hour before closing ㅡ without causing delays or charging additional fees to our clients. 

2. Mismanaging the 45-Day Identification Window

The strict 45-day window investors have to identify potential replacement properties is a common stumbling block investors face. Misunderstanding or neglecting this deadline can render your exchange invalid.  Proper planning and a clear understanding of the requirements are crucial to navigate this critical phase successfully.

From the date your sale closes and your 1031 exchange begins, the IRS gives you 45 calendar days to present (signed and in writing)  a list of properties you may want to buy as your replacement. Only properties on this list are considered valid replacements for your Exchange. After 45 days, your list cannot be modified. The IRS makes this even more difficult by effectively limiting* your number of replacement options to three or fewer.

(*We cover exceptions to the “Three-Property Rule” in this explainer). 

You cannot complete your 1031 exchange without first undergoing proper identification unless you complete your exchange and close on your replacement property(ies) within the first 45 days.

It gets even more tricky. If you acquire replacement property in your 1031 but still have funds left over, the IRS prohibits you from receiving any leftover funds from your escrow account unless all identified replacement properties have been acquired or the 180-day window has expired. As the potential for a valid 1031 exchange transaction still exists, IRS regulations prohibit investors from accessing leftover funds.

3. Choosing the Wrong Qualified Intermediary

Not all QIs are created equal. Some companies take risks with the funds they hold on deposit. Some  companies are either too small or lacking in sophistication to effectively mitigate against cyber theft and wire fraud. While not as drastic, some companies simply are unimaginative or unresponsive and difficult to work with. 

For example: In the aftermath of the 2008 financial crisis, several now infamous 1031 qualified intermediaries either suddenly failed or tried running away with their clients’ funds. When some 1031 companies declared bankruptcy and closed their doors, the Office of Chief Counsel at the IRS granted no relief, stating that taxpayers in the middle of an exchange were not to receive any special treatment – even if they lost their money – because their intermediary went bankrupt.

Opting for a QI based solely on cost or convenience is a mistake. Without evaluating their experience, reliability, and the protections they offer, you can quickly jeopardize your exchange (or worse). Work with a QI with a solid track record, robust security measures for your funds, and a proven track record of sustained success.

4. Disregarding Advanced Exchange Strategies

Many investors are unaware of, or are too daunted by, advanced exchange strategies such as reverse and construction/improvement exchanges. This limits their strategic options. 

One common experience we have is speaking with an investor who thinks a 1031 exchange is outside their reach or feels they have to abandon their exchange plans because of an unforeseen challenge, only for one of our officers to walk them through a slightly different strategy that produces the result they’re looking for.

The IRS did not create reverse or construction exchanges; in fact, the IRS was late to the game in terms of recognizing and acknowledging them. Instead, these more advanced strategies were the innovations of motivated attorneys, accountants, and investors who found creative ways to navigate the thicket of regulations surrounding Section 1031. The same is true for so-called “drop and swap” strategies. 

A creative investor with access to a knowledgeable intermediary can successfully navigate…

  • Converting investment properties to and from a primary residence
  • Tactically refinancing for extra liquidity
  • Conducting exchange transactions with related parties
  • Handling seller carry notes

…all within the confines of a legitimate 1031 exchange structure.

Understanding the full range of options available can significantly enhance the benefits of your exchange.

5. Overlooking Partnership Complications

It is impossible to complete and report a 1031 exchange where the taxpayer(s) who sold the relinquished property differs from the taxpayer(s) who purchased the replacement property. So when a partnership owns your property, and not all partners wish to participate in the exchange, there isn’t always a clean solution. These situations rank high in complexity and potential for disruption, making them a stubborn thorn in the side of investors and the 1031 exchange profession. 

However, these situations can be navigated by experienced investors and intermediaries.

Traditionally speaking, there are three solutions:

  1.  Drop and Swap.  Here, all the partners agree to dissolve the partnership and distribute the property pro rata, whereafter, each former partner now owns a tenant in common interest in the underlying real estate.
  2. Swap and Drop.  Different partners can designate different replacement properties for the partnership to acquire as part of the exchange. After the exchange, the partnership can dissolve, and distribute the replacement properties to the respective partners.
  3. Partnership Division. If there are four or more partners and at least two partners exist in each of the “exchange” vs. “don’t exchange” camps, then the partnership can be divided into separate, smaller partnerships.

You should address these complexities early to keep your options open and avoid unintended tax consequences.

6. Narrowing Your Reinvestment Options Prematurely

A less obvious yet impactful mistake an investor can make is thinking too narrowly about what you could choose as a valid replacement property in your 1031 exchange.

Many investors limit their search to similar properties or familiar markets, potentially overlooking better returns or diversification benefits elsewhere. Expanding your horizon to include various property types and locations can unveil valuable opportunities that align more closely with your long-term investment objectives.

Remember that the IRS only requires that your replacement property is “like-kind”  to the property you sold. In this instance, “like-kind”  can be a little misleading; many mistakenly assume it needs to be the same type of property or engage in the same type of investment activity. In reality, virtually any real estate asset you can think of is “like-kind” to virtually any other real estate asset you can think of —  so long as both what you sold and bought are held for business or investment purposes.

For example, if the math worked out, you could sell a patch of desert in Arizona and 1031 exchange into the Empire State Building. Alternatively, you could exchange out of one single-family rental and into 100 solar and wind farms.

An entire industry of deal sponsors, developers, and management companies exists to offer creative replacement properties to real estate investors in a 1031 exchange. 

If you want to move on from one investment asset but aren’t sure that you’ll be able to find a similar replacement property that you like, it would be a good idea to think outside of the box and look at some other alternatives so you aren’t stuck in neutral.

By understanding and avoiding these common mistakes, you can navigate the process more confidently and successfully, ensuring your investments continue to grow and adapt to your evolving financial landscape.