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Pitfall 1
Failure to obtain
“replacement” debt.
Most investors
understand they need to reinvest the net proceeds realized from the
sale of their relinquished property into like-kind replacement
property. Many fail to realize that they must also replace the debt
they were relieved of when the relinquished property was sold. For
example, if an investor sells a property for $100,000 with debt in
the amount of $75,000, they must not only reinvest the $25,000 of
equity; they must also acquire replacement property with at least
$75,000 of debt. They can take on more debt if necessary to acquire
a higher value property as long as all of the equity is reinvested.
Additionally, an investor can always add cash out of pocket towards
the purchase of replacement property. On the other hand, if an
investor only reinvests the net equity without replacing their debt,
the IRS will tax them on their “debt relief”.
Pitfall 2
Failure to properly
identify replacement property.
There
are many ways an identification can be done improperly. The id
requirements are actually quite simple, most Qualified
Intermediaries provide an identification form to use. The investor
needs to complete the form by unambiguously describing the potential
properties to be acquired.
Some common mistakes made by
investors are: putting down the wrong street address; leaving off
the city and state; failing to note they are buying only a
percentage interest; failing to include improvements that will be
constructed on the property before it will be acquired; etc.
Unfortunately, what would appear to be a minor procedural
requirement has major implications for the exchange. After midnight
of the 45th day there is no way to correct these errors. Taxpayers
can be charged with tax fraud for backdating identification
statements or otherwise trying to make it appear as if they properly
identified their properties in a timely manner.
Pitfall 3
Investors believe that an
exchange is an “all-or-nothing” tax
benefit.
Assume an investor is selling
a rental house for $200,000 and has found another property valued at
$175,000. Sometimes “partial” exchanges can be beneficial. This can
be a partially tax deferred exchange. They will owe capital gain
taxes on the $25,000 differential. Depending on the gain realized
from the transfer of the relinquished property, there may still be
some tax-deferral from the reinvestment.
Pitfall 4
Investors don’t hold their
properties for investment or business
use.
Although all real property is
like kind with all other real property, the properties in the
exchange must be held either for investment or business use;
excluding properties held primarily for sale or personal use. If an
investor sells a rental house, buys a condo in Palm Springs
and quickly begins to use the condo for personal use the IRS might
disallow the exchange for failure to have the appropriate
“investment” intent. With proper planning, however, an investor can
initially hold the Palm
Springs condo for investment purposes by
renting it out for a period of at least one to two years, and then
later “convert” the condo to a property used for personal
purposes.
Pitfall 5
Investors don’t understand
the need for a Qualified
Intermediary.
One of the most basic
requirements under Section 1031 of the Code is that you must have an
“exchange” of properties, a reciprocal trade. The IRS established
the concept of a Qualified Intermediary (QI) in 1991 to simplify the
process. The QI trades properties with the investor by acquiring the
relinquished property from the investor and transferring it to a
buyer for cash, and then acquiring the replacement property with the
cash from a different seller and transferring it to the investor.
The QI typically produces the necessary documentation that must meet
some very specific requirements under the Tax Code and IRS
Regulations. Additionally, it is imperative that the Qualified
Intermediary holds the cash or controls the cash. A QI is necessary
even for simultaneous exchanges wherein the investor is closing on
their relinquished and replacement properties at the same time
because the investor must still create a trade of properties between
two parties.
Investors should be careful in their selection of a
QI. Not all QI’s are alike. QI’s can vary greatly in their level of
expertise and security (or lack thereof) of exchange funds. Unlike
most service providers in the real estate community, QI’s are
completely unregulated. The IRS only prohibits agents (real estate
agents, accountants, attorneys, etc) and parties that are related to
the taxpayer from acting as a Qualified Intermediary. There is no
requirement for QI’s to have a license, a bond, insurance,
conservative banking/investment procedures or any continuing
education or training. Investors should inquire into the level of
expertise and security offered. Unfortunately, there have been
several recent incidents wherein Qualified Intermediaries lost
significant sums of exchange clients’ funds.
In conclusion, there are many
ways an investor can get tripped up in the tangles of complicated
IRS rules and regulations and the tax code requirements of a 1031
exchange. With careful planning and an experienced team of
professionals a tax deferred exchange can be properly structured and
successfully closed.
Marie C. Flavin, Esq., Vice President
& Northeast Regional Manager for Investment Property Exchange
Services, Inc., (877)
230-1031.
Circular
230 Notice: This communication, including any attachments, is not
intended or written to be used, and cannot be used, for the purpose
of (i) avoiding tax-related penalties or (ii) promoting, marketing
or recommending to another person any tax-related matters addressed
herein.
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