A 1031 exchange executed properly can not only defer taxes but also further investment goals.
Section 1031 of the Internal Revenue Code allows an investor to swap one form of business asset for another of a like kind — for example, selling one investment property and rolling the gains into the purchase of another property. Capital gains taxes are deferred until the property is sold with no reinvestment.
Rules surrounding 1031 exchanges are exacting, and mistakes can result in big tax consequences.
Stephen Breitstone, a partner and head of the tax practice at Meltzer Lippe, has listed eight common — and avoidable — mistakes investors tend to make when using 1031 exchanges:
1. Overpaying for replacement properties.
Alerting a seller and broker that you’re looking for a replacement property may prompt them to jack up the price because they know you’re on a tight deadline.
2. Choosing the wrong qualified intermediary.
Choosing the wrong intermediary could cause you to lose your money. Make sure you set up a separate account that can be released only with your signature and the intermediary’s at a reputable institution.
3. Improperly setting up a 1031 exchange.
A 1031 exchange is a tax transaction as much as a real estate transaction, if not more so. The tax consequences can be significant if the 1031 exchange is not done properly, so think twice about using a real estate attorney or relying on an exchange company to execute the paperwork.
4. Buying something that doesn’t make sense.
Sometimes you’re better off leasing a property rather than buying another one just to get a 1031 exchange.
5. Bungling financial statements.
The 1031 exchange is formalistic — and punishes mistakes. Take the expenses and adjustments you pay at the close. Showing the wrong figures on your closing statement can precipitate a big taxable event.
6. Believing 1031 exchanges eliminate taxes.
The 1031 defers taxes. If not done correctly, a 1031 can change income from capital gains to ordinary income, subjecting that income to a much higher tax rate as well as other taxes.
7. Running out of time.
The seller looking for an exchange has only 45 days after closing to identify a replacement property. If you haven’t done advance due diligence, or the replacement property is sold to someone else, or you don’t have a contract within that time period, you’re out of luck.
8. Lack of proper tax planning.
A 1031 exchange requires that past, present and future planning be taken into consideration to minimize tax and economic consequences.
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