10 Ways Your 1031 Exchange Can Go Horribly Wrong

In theory, 1031 exchanges seem simple enough: sell one investment property and, within 180 days, use the proceeds from that transaction to buy a replacement property, thereby deferring the need to pay capital gains taxes on the original sale.

But in practice…

The not-so-simple truth is that a series of intricate IRS 1031 exchange rules govern the successful completion of these transactions. As a result, deals can unravel in a costly fashion due to even innocent missteps among this network of lengthy, rigidly enforced provisions. The result can be an unforeseen tax bill that can present nightmares for even the most well-heeled investors.

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Accordingly, it’s critical for investors to enter like-kind exchanges cautiously, well-informed of the multiple risks undermining an improperly executed 1031 exchange and accompanied by a financial team that’s both knowledgeable and experienced in this nuanced area.

Let’s look at some of the multiple tripwires that can result in a tax-saving strategy’s unintended conversion into a tax nightmare for underprepared investors.

1. Blown deadlines

Two critical timelines must be adhered to in any 1031 exchange. First, the investor must identify a replacement property (or properties) within 45 days of the sale of the relinquished property. Second, and just as important, the transaction to acquire the replacement property must be completed within 180 days of the original sale. It’s important to note that the statute refers to calendar days, not business days — failure to account for weekends or holidays will not serve as an excuse.

The IRS’ inflexibility on this point is well documented. In fact, the only known extensions to 1031 deadlines have been the result of disaster relief from the IRS, and in these cases, it requires the IRS to issue a Disaster Relief Notice and post it on its website. Even a declaration of disaster from FEMA is not sufficient.

Due to personal emergencies, investors sometimes believe they deserve exceptions or waivers on deadlines, but apart from a Disaster Relief Notice, the rules forbid flexibility or deviations — even for sympathetic grounds such as medical issues or family deaths that occur during transactions.

2. Failure to identify a replacement property within 45 days or complete the exchange within 180 days

Closely related to the first failure, it’s important to know what the IRS means by “identifying” a replacement property and “completing” the transactions.

There are two accepted ways of identifying a replacement property:

• By completing the purchase of the replacement property within 45 days (at which point no written identification is needed, as the purchase itself satisfies the identification requirement)
• More commonly, by written Identification Notice through the qualified intermediary

The taxpayer should sign a qualifying Identification Notice, which should be clear, specific and unambiguous and should be delivered to the qualified intermediary (QI) or some other party representing the seller of the replacement property no later than midnight of the 45th calendar day after the sale of the relinquished property.

Similarly, completing the purchase of the replacement property means that the transaction is finalized no later than midnight on the 180th day following the sale of the original property.

In addition, the exchanger must file Form 8824 with their federal tax return for the year in which the exchange took place. Failure to close the transaction in a timely manner, or to report it to the IRS appropriately, will result in the failure of the exchange and the loss of the tax benefits.

3. Broken chain of custody

One of the principal responsibilities of the QI is to properly manage the proceeds of the sale of the relinquished property and to convey them appropriately to the seller of the replacement property. It’s critical that the funds in question are not commingled with any other funds, nor that the taxpayer ever has personal control over the funds, even temporarily. Tapping exchange proceeds for unauthorized uses, including temporary loans, negates the validity of the exchange.

In the same way, permitting the taxpayer to take personal control over the funds, by parking them in a personal checking account or otherwise accessing them, causes constructive receipt issues that negate the eligibility of the exchange.

4. Disqualified replacement assets

It’s important to remember that 1031 exchanges are also known as like-kind exchanges, and the IRS is meticulous about what constitutes an eligible asset for a like-kind exchange. IRS guidance holds, for example, that both the relinquished and replacement properties must be used in a trade or business, or for investment, which rules out any property used primarily for personal use, like a residence or a vacation or second home.

In addition, both properties need to be similar enough to qualify as “like kind,” meaning both properties need to be of the same nature, character or class — quality or grade does not matter.

The IRS notes that most real estate will be considered like kind to other real estate, but also mentions two specific exceptions:

• Real estate within the U.S. is not like kind to real estate outside the U.S.
• Improvements that are conveyed without land are not like kind to land

Most 1031 exchanges are, for all these reasons, relatively simple and straightforward, and most experienced QIs will counsel their clients not to get too creative in structuring a 1031 exchange. It’s certainly possible to tailor an exchange to meet the needs of the exchanger, but in trying to avoid faults that would disqualify a like-kind exchange, the old rule of thumb is that simplicity tends to win the day, particularly when the 180-day margin for error is so inflexible.

5. Value mismatch

Recall that a 1031 exchange needs to meet one of three criteria to fully qualify for deferral of the capital gains taxes on the original sale:

• The fair market value of the replacement property (or properties) must be equal to or greater than the sale price of the relinquished property (up to a limit of three replacement properties).
• If more than three replacement properties are involved, then the sum of the fair market value of all the replacement properties cannot exceed 200% of the sale price of the relinquished property. If it does exceed 200%, then the exchange is disqualified. Unless…
• A 1031 exchange which involves four or more replacement properties, and which violates the 200% rule above, is nevertheless permissible if the exchanger successfully acquires 95% of the properties on their list of identified replacements.

Failure to meet these standards will not invalidate the entire exchange but will subject the difference in the values (also known as “boot”) to a tax that, depending on variables, could be at the taxpayer’s ordinary income tax rate. Granted, even in this scenario, a partial deferral of capital gains tax is better than none at all, but since the goal of a 1031 exchange is to defer the maximum amount, it’s important to follow IRS guidance to the letter.

6. Debt mismatch

In many (if not most) 1031 exchanges, one or more of the properties involved in the exchange come with debt, usually in the form of an existing mortgage. There’s nothing wrong with that, of course, but while properties with debt are eligible for participation in a 1031 exchange, the value of the debt does have to be accounted for.

Many investors, and more than a small number of inexperienced tax advisers, believe (incorrectly) that the debt of a replacement property needs to be equal to or greater than the debt on the relinquished property. That’s certainly one way to address the value of the debt on the relinquished property, but not the only one! In fact, the value of the debt can be replaced:

• By a new loan on the replacement property
• By an infusion of cash that the exchanger has available (separate from the proceeds of the original sale)
• By a seller carryback note, in which the replacement property’s seller agrees to help finance the purchase through a note that the exchanger pays back on an agreed-upon schedule
• Some combination of the three

In these cases, as in all 1031 exchanges, the assistance of an experienced, capable QI is essential to minimize the possibility of “mortgage boot,” which would weaken the tax benefits inherent to the exchange.

7. Undiscovered title or use defects

As discussed, like-kind exchanges require the eligibility of all assets involved, and its incumbent on the exchanger and their team to do effective due diligence on the replacement assets in a timely manner. If previously unknown property defects are unearthed on identified replacement assets past the 45-day deadline, it would certainly threaten the validity of the exchange. Finding current or recent-past owner usage of the identified replacement property as a vacation residence or for other personal uses also sabotages eligibility.

The limitations on an asset’s personal use are strict, and by and large, properties must adhere to being used only for investment purposes. Impermissible prior tenant usage or prohibited conditions uncovered in inspections can also undermine closing qualification.

Finding alternative qualifying properties with remaining funds typically proves impossible this late in the process and can easily doom the transaction and trigger large tax bills.

8. Utilizing exchange funds for other purchases

If any part of intermediary-held exchange funds gets diverted toward an unauthorized purchase unrelated to completing the specific exchange transaction, immediate disqualification of the exchange results. Unexpected shortfalls might tempt inexperienced intermediaries to indulge in such impermissible diversions, sabotaging the validity of the exchange.

Along the same lines, it sometimes happens that final proceeds from the sale of the relinquished property leave inadequate funds for acquiring the previously identified replacement, and the exchange can implode, with immediate tax payments often unexpectedly due.

An experienced and knowledgeable financial team is able to foresee circumstances such as these and can be counted on to ensure the availability of adequate funds for legitimate exchange needs throughout the process.

9. Simplification is your friend

It can’t be stated enough: Even with an experienced intermediary at the helm, the simpler and more straightforward a proposed 1031 exchange is, the higher the odds of its success. Savvy intermediaries and their teams know how to avoid some of the more common examples of “overengineering” an exchange.

Some examples are:

• Trying to include additional replacement properties separately from the initial exchange without the proper identification process (or outside of the 45-day window)
• Excessively changing the parameters on an already-identified replacement property, such as the number of units in a housing development, square footage of the property in question or acreage of the identified lot
• Closing processes that are overly encumbered with contingencies, triggers or other significant strings attached that can jeopardize the timing of the transaction

10. Don’t forget your friends at the state level

While federal 1031 exchange rules may govern these transactions, some state tax authorities impose added limitations, procedural hurdles or other such requirements at local levels. (A handful of states have clawback rules that govern the eventual sale of the replacement property, for example, and the state of Pennsylvania didn’t even recognize 1031 exchanges for state tax purposes until 2023.)

These additional state-level factors are constantly evolving and may trip up unwary investors and intermediaries whose focus is exclusively on federal compliance. Significant liability arises if state-specific policies get ignored, and it’s imperative that investors and their advisers are fully aware of these pitfalls.

The bottom line

None of the above risk factors is grounds to simply roll your eyes and pay Uncle Sam a capital gains tax that can be deferred with the right process, of course. They are simply some of the more common traps to be aware of as you undertake the process, and especially as you consider who you want to work with on your financial team.

Be sure that your advisers are experienced, knowledgeable and focused on every detail of the transaction, and all of the horror stories we've reviewed here will be nothing more than cautionary tales.

Done correctly, a 1031 exchange is a smart and safe way to put more money in your pocket and effectively assist in the substantial growth of your assets.

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• What Is Capital Gains Tax Deferral?
• 1031 Exchanges vs Opportunity Zones: Which Has the Edge?
• 1031 Exchanges: A Matter of Life and Death?
• 11 Reasons to Consider a 1031 Exchange
• Are Capital Gains Taxes Keeping You From Selling Property?