A like-kind exchange is a great idea, but when mistakes occur, a failed exchange places the seller in double trouble.
One of the most tax-favored transactions is the like-kind exchange (also commonly called a 1031 Exchange). In a like-kind exchange, the sellers of real property may defer the gain of the sale of real estate if they reinvest the sale proceeds in a similar property that can be exchanged without incurring any tax liability.
Like-Kind Exchange Basics:
In a like-kind exchange, the seller usually hires a “qualified intermediary” who acts a middleman to facilitate the real-estate exchange. The process usually starts when the seller sells a piece of property. The qualified intermediary receives and holds the proceeds of the sale.
Within an identification period of 45 days after the sale of the first property, the seller must identify a replacement property. Once a replacement property is found, the seller instructs the qualified intermediary to acquire the replacement property within the replacement period of 180 days after the sale. This may be sooner if the tax return date is due.
The purpose of a qualified intermediary is to avoid the seller having receipt of the sale proceeds. If the seller receives the sale proceeds of the first property, the benefits of a like-kind exchange are lost. Here are 8 common mistakes in a like-kind exchange.
1 – Too Late for an Exchange
It takes advance planning to benefit from a like-kind exchange. Sellers may miss the opportunity to make a like-kind exchange by not realizing the opportunities until they arrive to close the deal. In some cases, it may be too late when a seller walks into closing and realizes only then that the gain on the sale could have been protected by purchasing a like-kind property.
2 – Incorrectly and Untimely Identification of Replacement Property
There is only a short amount of time to identify, negotiate, underwrite, finance, and complete due diligence for the purpose of property acquisition. Sellers usually lose track of time and are unaware when the 45-day period ends. The identification period begins on the date that the seller sells the property and ends at midnight on the 45th day after the property is sold. It would be wise for sellers to mark specific deadlines on a calendar to benefit from a like-kind exchange.
Another common mistake is to identify only one replacement property. This gives the seller the possibility to revoke the identification near the end of the identification period and miss the deadline. There should be ample time to select another potential replacement property before the end of the 45-day period. When identifying multiple replacement properties, the seller is subject to two rules:
- The three-property rule where the seller can identify up to three properties as potential properties without any concern over the values of the properties, and
- The 200 percent rule is where the seller may name more than three potential replacement properties, but the combined value of those properties cannot exceed 200 percent of the value of the sold property.
By naming multiple potential replacement properties, the seller gives an allowance for the likelihood that he will change his mind over the 45-day period.
3 – Incorrectly Computing the Exchange Period
The 180-day exchange period begins on the date the seller transfers the sold property and ends at midnight on the 180th day. The 180-day exchange period is ample time to close but the 180th day could land on a holiday or a weekend. This can prevent the closing from happening.
Another potential problem is that the 180-day period could end early if the tax return for the year is due. An exchange that started late in the tax year could pose a risk if the seller files a tax return on March 15 or April 15.
4 – Getting a Less-Than-Qualified Intermediary
A qualified intermediary holds large amounts of money so it is not surprising that there are publicized stories of less-than-scrupulous qualified intermediaries mismanaging or even losing exchange funds. If a seller fails to complete an exchange, he or she faces a lawsuit for potential breach of contract aside from losing the funds for the replacement purchase, so sellers should use only a reputable and experienced qualified intermediary.
A qualified intermediary should be formal and precise and should be able to take action when the seller is exposed to the risk of a botched like-kind exchange. Most reputable title companies or banks maintain a qualified intermediary business staffed with competent personnel. There are also many capable private qualified intermediaries not affiliated with a title company or bank. Some real estate lawyers serve as qualified intermediaries too.
5 – Believing Flawed Tax Advice
It is often tempting to follow advice from staff of the intermediary or from other financial institutions but receiving flawed tax advice from amateur intermediaries or financial institutions is another common mistake.
The tax requirements of a like-kind exchange have a technical nature, and taxpayers should only rely on experienced and knowledgeable advisers for guidance.
6 – Exchanging Property Not Held for Investment nor Used in Trade or Business
One of the rules of a like-kind exchange is that the property sold and the exchange property must both be investment properties or trade or business properties. This is another mistake sellers make when they lose sight of the rules.
A residential property will most probably fail as a replacement property. By offering it as a rental prior to an exchange, some sellers try to convert residential or vacation property into investment or trade, or business property.
The IRS provides a safe harbor for exchanging a second home or residential property in an exchange. It requires ownership for 24 months before or after the exchange, minimizing personal use to 14 days or 10 percent of the number of days the property is rented at fair market value during the year. It is because of this that sellers should proceed with caution if they want to include personal-use property in an exchange.
7 – Exchanging Property Not Held for Investment nor Used in Trade or Business
Another common mistake is when sellers try to exchange property held by a partnership or LLC. Like-kind exchanges involve the exchange of real property, not partnership or LLC interests. The seller might be in a partnership or LLC where other partners may not want to undertake a like-kind exchange.
A seller should arrange for the transfer of the property from the partnership or LLC and undertake the exchange as an individual owner if the property is still held in the partnership or LLC.
It is generally ill-advised to attempt a like-kind exchange with a related party. Like-kind exchange rules permit an exchange with a related party when holding period rules are considered. A time requirement of 24 months is imposed, which means both the seller and the related party must hold title to the property acquired in the exchange for a minimum of 24 months.
If either party sells the acquired property prematurely, both parties lose the favorable tax treatment of an exchange. The parties are relieved of the 24-month rule if a related party dies, and if either experiences an involuntary conversion like the destruction of the property because of a storm.
The seller should also proceed with caution because the definition of who is related is not straightforward. For individuals, related parties include a spouse, brothers, sisters, ancestors, and lineal descendants. If an individual owns more than 50 percent interest in a corporation or partnership, then the corporation or partnership is the related party.