Andrew Gustafson, CES®
Thanks to Don V. in Lubbock, Texas for pointing out many of the links were inoperative. Your patience is appreciated.
A tough lesson to learn is that ignorance is no excuse especially with the Internal Revenue Service. 1031 exchanges are riddled with rules supported by IRS memorandums and revenue procedures.
The featured article summarizes seven mistakes 1031 exchange mistakes to avoid. When reviewing consider the impact of not being informed.
The 1031 market is once again active with strong commercial activity including sale of land and buildings. Many owners are selling and using the exchange proceeds to improve the replacement property. Land already owned can be improved in a leasehold improvement exchange.
|Seven 1031 Exchange Mistakes to Avoid
1. Lack of knowledge about the process and its requirements.
The sooner you understand and take ownership of the many requirements of a 1031 exchange, the smoother your transaction will be.
a. The net equity and mortgage of the new property must be equal to or greater than the old property. The difference is called equity or mortgage boot and is taxable.
b. The first dollar received at the old property closing is taxable. That means you can receive your deposit back or dollars used to refurbish the property, but they are taxable.
When you are considering selling real or personal property held for investment or in a business and have intentions of replacing the asset, contact your accountant and a qualified intermediary. If you don't have either, place it on your to do list and get some names from your circle of professionals.
2. Selecting an unqualified qualified intermediary.
Would you ask a medical doctor to perform a surgical procedure without the proper credentials and experience? Three key characteristics of a good qualified intermediary include: expertise, security and transparency.
a. Expertise with a type of exchange is one element while another is the Certified Exchange Specialist® (CES®) designation. The CES reflects a minimum of three years of 1031 consultations and a thorough knowledge of the 1031 procedures.
b. Security of the exchange proceeds is critical. Is the accommodator following prudent investment standards by holding the funds in non-commingled accounts? Are the funds held in liquid money market accounts that are FDIC insured? Is your signature required or personal identification number required to authorize the disbursement of the exchange proceeds?
c. Transparency is verification of the security. Can you view your funds online 24 x 7 x 365? Can you speak with the custodial bank to confirm your funds are in an account under your social security or employee identification number?
3. Missing critical deadlines.
a. Know your 45th and 180th calendar days. Mark them on your calendar. The IRS is not forgiving except under specific guidelines set forth by the IRS such as a Presidential Disaster declared in the county where the old or new property is located. There are additional exceptions, but don't miss your identification and completion end dates.
b. The letter identifying your replacement property candidates must be received by the qualified intermediary no later than 11:59 PM on the 45th calendar day post closing. Fax is acceptable but email is not. The letter can also be delivered to your escrow agent, but ideally it is faxed to the accommodator.
c. The letter must specifically identify by address or map and cannot be generally stated.
d. Be sure to identify at least two, if not three, properties as a contingency. There is no going back to update or post date the identification letter.
4. I want my money back.
A common misconception is once the exchange documents are signed, HUD settlement statement reflects a 1031 exchange and the proceeds are deposited being held by the qualified intermediary. The funds cannot be returned until the 46th calendar day post closing. This is one of those unpleasant conversations when I explain that it is the IRS requirement that prevents the return of the funds because of the decision not to purchase a replacement property.
a. If the decision is not to identify replacement property, then the exchange terminates on the 46th calendar day at 12:00 AM.
b. Once property is identified and the replacement property is not purchased, the funds must be held until the 180th calendar day post closing.
5. Using a disqualified person as your accommodator.
The accommodator or qualified intermediary must be a party who is independent of the Exchangor.
a. The accommodator cannot be the Exchangor or of lineal descent.
b. May not be an agent of the Exchangor (Realtor, Attorney, Accountant, or Employee) two years prior to the sale unless they have provided only title closing or 1031 services in the past.
i. Attorney is disqualified if the law firm provided other than title closing or 1031 services.
6. Wanting different titleholder on the old and new properties.
The tax return that sells is the tax return that purchases, according to the same taxpayer requirement. If the wife is on title to the old property, the wife should purchase the new property and then quit claim the husband to the new property is that is the desired outcome on the title.
7. You want to sell your old property to a related party or purchase the new property from a related party.
There are specific requirements to understand when selling or buying from a blood relative, not in-law or entity that is a 51% owner where the Exchangor owns the minority.
a. If selling or buying from a related party, the buyer/seller must hold the property for two years; otherwise the sale will trigger the tax on the deferred gain.
b. If buying from a related party, the seller must also be exchanging into another property.
In summary, don't make the mistake of not being informed. Planning is critical supported by selecting an accommodator who asks probing questions to uncover issues that are typically misunderstood. Ignorance is no excuse.