A 1031 exchange mistake is a planning, eligibility, documentation, timing, or reinvestment error that makes some or all of an investor’s deferred gain currently taxable. Depending on the error, the exchange can fail completely or produce taxable boot on only part of the transaction. The most damaging 1031 exchange mistakes are made before the relinquished property closes, several of them cannot be corrected afterward, and the list starts with closing the sale before a Qualified Intermediary (QI) is engaged.
This article covers the ten mistakes that most often cost investors their deferral, in the order they tend to happen, from assembling the team through the 180-day closing deadline. Each one names what goes wrong, what it costs, and how to prevent it.
Why 1031 exchange mistakes can’t be fixed after closing
The irreversible 1031 exchange errors are created at or before the closing of the relinquished property, because the transaction has to already be structured as an exchange rather than as a sale followed by a purchase. Once the relinquished property transfers, the identification and acquisition deadlines begin running immediately and the structure can no longer be rebuilt. That is why the expensive errors are rarely math errors. They are sequencing errors.
Alan Fruitman devotes a section of The NNN Triple Net Property Book to nine warnings for buyers of single-tenant NNN property. The list below applies that same warning discipline to the stage of a 1031 exchange where investors have the most control and use it the least: the weeks before the sale closes.
1. Closing your sale before hiring a qualified intermediary
Hiring a QI after the relinquished property closes cannot rescue a delayed exchange, because the exchange agreement has to be signed and in place before the sale closes.
What it costs. A sale that closes with no exchange structure in place is a taxable sale, and the deferral is gone on day one.
How to prevent it. Engage your QI while the property is still under contract, and work with your QI to get the exchange documents into the closing file before settlement. The QI arrangement described in Treasury Regulation 1.1031(k)-1 is the standard structure for a delayed exchange, and it protects only an investor who puts it in place beforehand.
2. Choosing a qualified intermediary without vetting how exchange funds are held
No federal agency licenses, examines, or insures QIs, so the safety of your exchange funds depends entirely on which QI you choose.
What it costs. The IRS warns that intermediaries have declared bankruptcy or otherwise failed to meet their obligations to taxpayers, and that investors caught in those failures missed exchange deadlines and owed tax on the gain in the current year.
How to prevent it. Before you sign, ask whether exchange funds are held in a segregated qualified escrow account under your taxpayer identification number, what fidelity bond and errors and omissions coverage the firm carries, and whether it belongs to the Federation of Exchange Accommodators.
3. Selling before defining your replacement property criteria
Selling first and shopping second compresses the entire replacement property search into a 45-day identification window that runs on calendar days.
What it costs. Investors who start looking after closing tend to identify what is available rather than what fits, which leads to overpaying, accepting weaker tenant fundamentals, or ending up with limited near-term exit options.
How to prevent it. Write down your replacement criteria before you list, including property type, price range, remaining lease term, tenant credit quality, and geography, so your buyer’s broker will already be working a pipeline the day your 45 days begin.
4. Taking actual or constructive receipt of 1031 exchange proceeds
Taking control of the sale proceeds before the exchange is complete can disqualify the entire transaction and make all of the gain immediately taxable.
What it costs. Constructive receipt does not require the money to reach your account, because the right to draw on the funds is enough to break the exchange.
How to prevent it. Route the proceeds from settlement directly to your QI, and have your CPA model any cash you want to take out of the deal before closing rather than after.
5. Assuming every property qualifies for a 1031 exchange
Section 1031 applies only to real property held for productive use in a trade or business or for investment, so a primary residence, a vacation home used primarily for personal purposes, and property held primarily for sale do not qualify. Real property inside the United States is also not like-kind to real property outside the United States.
What it costs. Learning that the relinquished or replacement property never qualified is a full disqualification, and it usually surfaces at filing, long after every deadline has passed.
How to prevent it. Have your attorney review title and use history before you list, and have your CPA confirm how the property has been reported, since a dwelling unit with genuine rental use can still qualify under the safe harbor in IRS Revenue Procedure 2008-16.
6. Missing the 45-day identification deadline (which cannot be extended)
The 45-day identification period begins the day the relinquished property transfers and ends at midnight on the 45th day, counting weekends and holidays.
What it costs. Missing the identification deadline makes the entire gain taxable, and the deadline cannot be extended for hardship or for a replacement deal that fell apart. The only exception is a postponement the IRS grants following a presidentially declared disaster.
How to prevent it. Calendar day 45 and day 180 the moment your sale closes, and work with your QI to submit the signed written identification several days early rather than on the deadline itself.
7. Delivering your 45-day identification notice to the wrong party
A replacement property identification counts only when it is delivered in writing to a party involved in the exchange, such as your QI or the seller of the replacement property, and notice to your own attorney, real estate agent, or accountant is not sufficient.
What it costs. An identification that goes only to your own agent is no identification at all, which produces the same outcome as missing the 45-day deadline entirely.
How to prevent it. Send the signed identification to your QI, keep the timestamped delivery confirmation, and do not treat an email to your own broker as the official notice.
8. Breaking the three-property rule, 200 percent rule, or 95 percent rule
Replacement property must be unambiguously described by legal description, street address, or distinguishable name, and the number you identify must satisfy one of three rules: the three-property rule, the 200 percent rule, or the 95 percent rule.
What it costs. An investor who identifies more properties than the applicable rule allows is treated as if no replacement property had been identified, which ends the exchange.
How to prevent it. Have your QI review the identification letter for both the property descriptions and the count before you sign it.
9. Missing the 180-day closing deadline
The replacement property must be received no later than 180 days after the relinquished property transfers, or the due date including extensions of your tax return for the year of the sale, whichever is earlier.
What it costs. An investor who sells late in the year and files on the original due date can lose weeks off the 180 days without realizing the exchange period ever shortened.
How to prevent it. Have your CPA model your return due date against day 180 before you close, and file an extension where that is what preserves the full exchange period.
10. Failing to replace debt and creating taxable mortgage boot
Debt relief counts as value received in a 1031 exchange, so retiring a mortgage on the relinquished property and not covering it on the replacement side creates taxable mortgage boot.
What it costs. Retire $300,000 of debt, take on only $200,000 of new debt, and add no cash of your own, and the $100,000 difference is boot.
How to prevent it. Debt relief is netted against the liabilities you assume on the replacement property and against cash you bring into the exchange under the rules in Treasury Regulation 1.1031(d)-2 and IRS Publication 544, so have your CPA model both the equity and the debt you need to replace before you list.
Alan’s Rule
If you are not sure, ask before you act. A five minute phone call to your QI costs nothing. A sequencing error costs the deferral, and by the time it surfaces on a tax return, there is nothing left to fix.
About the Author
Alan Fruitman is the founder of 1031tax.com and President & Managing Broker of Real Estate Foundation, Inc. Alan began his real estate career in 1993 and has closed more than 1,000 properties valued at several billion dollars. He is the author of The NNN Triple Net Property Book and is a nationally recognized authority on single tenant net leased property and IRC Section 1031 exchanges. With more than 30 years of experience, Alan advises investors on identifying, underwriting, and acquiring absolute NNN leased assets with corporate guarantees, including banks, quick service restaurants, pharmacies, dollar stores, convenience stores, and auto related retailers. Alan holds Colorado real estate license ER1322889 and helps buyers and sellers nationwide.
This article is for general informational purposes only and does not constitute legal, tax, financial, or real estate advice. Every exchange and tax situation is unique. We strongly encourage you to work with qualified professionals, including a qualified intermediary, CPA, and real estate attorney, before making any decisions related to a 1031 exchange. 1031tax.com is a service of Real Estate Foundation, Inc.