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.
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.
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.
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.
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.
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.
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.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.