Business Management

3 Common Mistakes Investors Make in a 1031 Exchange

Expertise: Real Estate Investing Basics, Real Estate Deal Analysis & Advice, Mortgages & Creative Financing, Landlording & Rental Properties, Business Management, Personal Development, Flipping Houses, Commercial Real Estate
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Something that sounds complicated that a lot of people talk about on BiggerPockets and in the real estate world in general is the 1031 exchange. Let me explain briefly what that is, and then we'll talk about mistakes that people make when doing a 1031 exchange.

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What Is a 1031 Exchange?

A 1031 exchange works like this. Let’s say I owned a piece of real estate and I decided the market’s going up. Or maybe it’s something else. But for one reason or another, I’d like to sell that piece of investment real estate.

Important to note, this is not a fix and flip. This is not a property I lived in; it’s not my primary residence. This is an investment property. It qualifies as an investment piece of real estate as long as I can show that I held it for investment intent. It could be a single family home, an apartment building, a strip center. I just have to prove that I held it for investment for a time.

So, I sell the property. If I didn't do a 1031 exchange, that sale would create a taxable event. I'd have to pay income tax on the money I made. If I made $100,000, I may have to pay short- or long-term capital gains tax on it. But if I want to avoid that tax, a 1031 exchange allows me to take the profit from that sale and roll it into something larger—let's say, I buy myself an apartment building or something else. I can sell residential property and trade it into something commercial or whatever.

Full transparency, there are a lot of rules. This post isn't about the rules. The main thing to know is as long as I hold the property in the same name, maybe it's my name or an LLC, all the proceeds from this sale need to get moved from that property to a new investment property in the same name.

Also, all the proceeds from the sale need to be reinvested. So, if I made $100K, all of that needs to be moved over. Or say I made $200K, the new property could be $201K or even $1 million. The point is the new property has to get purchased for more than the price of the old, and I have to roll all the profits over to a new property held in the same entity.

Another thing to note: it’s not tax-free, I’m deferring the tax. I may have to pay the tax when I sell the newer investment, unless I just keep doing 1031 exchanges until I pass away. Then, when your heirs inherit the property, that changes the tax structure. Talk to your CPA about that.

Related: The Ultimate Guide to Real Estate Taxes & Deductions

3 Common 1031 Exchange Mistakes to Avoid

Now, the previous information is what you should know about 1031 exchanges in general. There are a few areas where investors get tripped up when it comes to successfully doing these. Here’s what to be aware of and mistakes to avoid.

  1. Not identifying the new property within 45 days and closing on it in 180 days.

Let’s say I sell a property on January 1. OK, then I have 45 days to identify the new property. If I don’t, then I fall into violation of the 1031 exchange. So, I have to identify this property to the IRS and to the 1031 exchange custodian and have to document it, saying this could be the property I want to close. I can even identify multiple properties and only close on one of them. The bottom line is if I don’t identify in 45 days the properties that I want to trade into, then I’m in violation. I lose the tax savings, and I’ll have to pay capital gains tax on that $100,000. This identification process is called nomination.

The next timeline here is 180 days. People get this confused. This is another mistake that people make. Within 180 days, I have to close.

Some people wrongly believe that 180 days begins at the time of nomination. But it begins at the time that you sell. There are no extensions; there’s no workaround. You have to close on the new property within 180 days or you lose the 1031 exchange tax advantage.

So, what you want to do is, the second you have the thought of selling property A, start looking for property B.

  1. Not taking enough care when selecting a 1031 exchange custodian.

If you use the wrong custodian that either doesn’t understand the process or that is someone who doesn’t have a good reputation, you could be sorry.  Unfortunately, in the the United States, the custodians are not a well-regulated industry. It doesn’t take much to become a custodian of people’s 1031 exchange capital. It should be something with a lot of regulations and required licensure and insurance and things like that. But it’s not.

letters taxes on wooden blocks with calculator and pen

It’s very easy today to become a third-party custodian for people’s capital, so that enables people who are maybe not of the highest scruples or not the best decision makers or maybe straight up criminals to get into being 1031 exchange custodians. It is the biggest source of real estate capital theft. It happened to us. It turns out they were a bad actor and they were running a Ponzi scheme, so we ended up having to litigate.

So, be very careful on who you work with in that situation. What I didn't do is check to make sure they were bonded and insured, but I interviewed several people they'd worked with. I'd checked out their website. Anyway, don't make this mistake. Do all the due diligence.

Related: How a 1031 Exchange Can Make You Millions

  1. Not ensuring that you fully understand all the rules.

The third mistake that people make is just in general misunderstanding the rules. There are two common ways this occurs. The first was the timeline that I mentioned. But also, I’ve seen people try and do 1031 exchanges and try to find a way to take a few of those dollars out for themselves. They want to take a few thousand out to put in their pocket or to use as a down payment on the new property. But no. This money needs to live with the custodian and you can’t use it for anything except for the actual closing activity when this property changes hands.

The other misunderstanding occurs when buying property with other investors. Say two other investors and I go in on a property together and eventually decide to sell it. Then, only two of the three of us want to get into the new property—or maybe only one does. Whatever it may be, those profits cannot be transferred into a new investment and avoid taxes via a 1031 exchange. The only way you can do this is if the LLC who owns the property transfers its ownership into the new investment.

The Bottom Line

The bottom line for a 1031 is yes, they are complex, but they’re extremely lucrative. And all these mistakes can be avoided by doing the research ahead of time.

If you’ve got a lucrative sale and you don’t want to pay tax on it and all the other owners of the property are on board, 1031 exchanges can be phenomenal wealth-builders by allowing you to transfer the property proceeds tax-free into the larger piece of real estate. I highly recommend you look into it, but make sure you do your homework and don’t trigger one of these mistakes.

Have a great and profitable day!

I’d love to talk more with you about 1031s. If you have any questions or comments, please ask.

Leave a comment below.

Matt Faircloth, co-founder and president of the DeRosa Group, is a seasoned real estate investor. The DeRosa Group, based in historic Trenton, New Jersey, i...
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    David Krulac from Mechanicsburg, Pennsylvania
    Replied about 1 year ago
    Matt, my friend, Great article on a much misunderstood topic. I did my first of many Section 1031 exchanges when you were 11 years old, I was a couple years older. I talked about 1031 exchange in my Bigger Pocket Podcast #82, and also talked about how capital gains should be indexed for infaltion, as much of the capital gain tax is a tax on inflation beyond the control of the investor. The rules are the rules and you can't deviate in the slightest, as you corrected noted the settlement of the acquired property must occur within 180 days from the settlement of the relinquished property. I've seen many times when other have expressed the time from as "SIX months" That is NOT correct because sometimes "SIX months" is more than 180 day, when the string of months includes a lot of 31 day months! Also the period can be shorter if the six month goes into another calender year, the the time period becomes April 15, since that's the date of the income tax filing where you identify the Section 1031 to the IRS. But the biggest mistake that I have seen, other than not following the IRS rules, is that the short 45 day time frome for identification FLIES BY extremely quickly and the savy investor is looking for the the bargain replacement property that fits multiple requirement, like certain location, certain price range, and certain use or structure. The ticking clock often means that the investor buys an less than ideal replacement property just to satisfy the IRS ticking time bomb, I mean clock. Best wishes, David Krulac
    Tom Phelan Real Estate Investor from Key West, FL
    Replied about 1 year ago
    Thank you for making real estate Investors aware of the 1031 Exchange. The #1 Mistake for people selling an investment property or considering buying an investment property is using a Realtor that doesn't have a clue how 1031 Exchanges work. Most Realtors when confronted with a 1031 Exchange either shirks from the duty of providing correct 1031 Exchange information or, worse, provide incorrect informatiion like telling the client someday he/she/it will have to pay taxes so why not bite the tax bullet now. With a 1031 Exchange you never ever have to pay taxes as long as you meet one requirement, you die. Don't fret over your Heirs, they will inherit on a "Stepped-Up Basis". Voila, Uncle Sam is left holding an empty cup. I have taught Realtors CE Credit Classes for 25-years and today Realtors are no better informed about the advantages of 1031 Exchaning than 25-years ago. Much of this ignorance I blame on their Employing Brokers and or NAR. Only one other catagory of ignorance competes with the 1031 Exchange for the prize of being uninfotmed and or misinformed; "How To Buy Investment Real Estate With An IRA". I also teach this CE Credit Class to Realtors and routinely encounter the vast majority of Realtors placing their retirement funds in ... nope, not real estate, rather Wall Street like Mutual Funds.
    Dave Foster Qualified Intermediary for 1031 Exchanges from St. Petersburg, FL
    Replied about 1 year ago
    Timely Topic Matt. The 1031 exchange can be a powerful tool for investors at any time but it is used best strategically. And strategy comes with counsel, guidance, and a deep grasp of the possibilities within the rules. Of the three mistakes you mention I'd pay special attention to mistake #2. Of them all that's the only one that can't be recovered from. And included in that mistake is the overlooked fact that the Qualified Intermediary must be in place prior to the closing of the sale - or it's game over! The QI has three roles - document the exchange, manage the proceeds in between sale and purchase, and guiding the client through the maze of 1031 rules. Of those three roles, guiding the client is the one that ensures success of your 1031. And as others have pointed out, successful 1031 exchanges lead to a lifetime of tax free investing!
    Denise Brown-Puryear from Julian, North Carolina
    Replied about 1 year ago
    Timely article and mistakes well pointed out. I agree that a 1031 can be extremely stressful if the rules are not fully understood or made clear. I've been through one myself in 2014. Great and timely article!
    Kris Patel Investor from Arroyo Grande, California
    Replied about 1 year ago
    Two comments, use reputable title company for QI. Also, 180 days may be wrong, if tax filing comes before.
    Nicholas Varanelli from Grants Pass, or
    Replied about 1 year ago
    Thanks for the great article. In it you mention that the 1031 must be used to purchase a single property that is more expensive than the one you sold. I know your article isn't focused on all the rules (other than making sure you follow them), so hopefully I'm not derailing the conversation with this. I was told by a real estate agent that in the past they had helped clients use a 1031 to move the sale cash from one single property to buy *multiple* properties they had identified within the 45 day window. If that's true, it seems like that opens up a whole bunch of possibilities, and I can imagine many situations where that could be beneficial to purchasing one property that is more expensive than the first. Clearly I havent tried this maneuver myself and my info on it is second hand, and so I'm wondering if you have heard of anyone who has actually pulled this off and/or if you know if that is doable when doing a 1031. Thanks!
    Sri Ram Rental Property Investor from West Palm Beach, FL
    Replied about 1 year ago
    Hi Nicholas Your information is correct. You can identify upto 3 properties whose total purchase price should be greater than the price of the property you sold. I hope it clarifies. I have done multiple 1031 exchanges. Good luck thanks
    Denise Parent from NH
    Replied about 1 year ago
    So, to is not necessary to buy only one property. You are allowed to buy multiple properties as long as all the money is used. Is this correct? Does the total net worth of the property or properties have to be more than the sold property? And if yes, why does it need to be more?
    Nica Robins
    Replied about 1 year ago
    Can you explain a “partial 1031” exchange? We bought a property for 30k 10 years ago. Decided to sell and put 70k to rehab property this year. This money was taken out of personal savings, not a home loan. The house is selling for 150k. The capital gain is 50k. We would like to put the 50k profit in to a new investment property (through a 1031 exchange) and put the 70k we used to rehab it back into our savings. Thoughts?
    Felicia Lucco Rental Property Investor from 07105
    Replied about 1 year ago
    Matt, I came across your article just as I am in the midst of selling my first investment property. And I had every intention of doing an exchange until I read that I had to reinvest ALL of it AND that I had to do it in my name, instead of the intended LLC. There goes that plan! I was also dismayed to hear that the very important job of the intermediary is not regulated. Ouch. However... I do have a second property to sell. And I can potentially reinvest all of it and was happy to see that Sri confirmed I can buy multiple properties. Is there a way around the name thing? My current props are in my name (I didn't know any better 15 years ago) and I would like to invest with a partner or at least with an LLC.
    Andrea P. Rental Property Investor from Roma, Italy
    Replied about 1 year ago
    I am foreign investor who spent 3 years in the USA. At the time I bought a SFH in Alabama which was primary residence when I worked there, the it became investment property when I left the US. I could come back in the US for work, I could sell in Alabama and buy somewhere else (filing 1031). I could use the new House as investment property for a while then I could use it for living. Can I convert an investment property in primary residence? If yes, can I reset the 1031?
    Alecia Breeggemann
    Replied about 1 year ago
    I am thinking of selling a single family investment property and purchasing a duplex at roughly twice the cost of the original property. If I move into one side of the duplex would it still qualify for a 1031 exchange? If not, could I rent out both sides for a certain amount of time and move in later?
    Katia May Rental Property Investor from Philadelphia, PA
    Replied 11 months ago
    Hi, can anybody recommend a good intermediary in PA ( preferably in Philadelphia area). I have a rental property in PA and would like to buy a house in FL, which I will rent. How long after I buy the house in FL I will have to rent it? What if it takes couple months to find somebody to rent it to? Thanks.