14 Possible Problems with a 1031 Exchange

1031 Exchange Problems
Issues and problems with a 1031 Exchange
1. Exchange rules are complicated.

There are many legal issues that can come up during a 1031 exchange, and even more that can slow down the process of the deal. For example, if an investor’s tax return is audited by IRS, he may have to explain source of funds used for the purchase the replacement property. This could lead to further scrutiny from them on all other income or losses reported within his tax returns also. Even though there is no requirement to report these exchanges to IRS officially , investors need to make sure their books are in order before filing any additional exchanges after first one mistake . It is better safe than sorry.

2. Sometimes finding a broker who understands the process enough makes it worse situation worse.

It is not hard to find a broker who knows the process of 1031 exchange. But, if they do not understand how it works or are just inexperienced in this field, they can make mistakes that could cost you money. It is better to interview them before hiring them rather than regretting later.

3. Time delays on closing the sale on your old property and purchase of new one can delay your tax savings.

Although there are several different procedures for completing 1031 exchanges, many investors choose delayed boot method to avoid having too much money tied up in their old property while waiting for replacement property to be acquired . However, by waiting more time between purchase of your old property and acquisition of replacement, IRS allows more depreciation on your old property and therefore, increasing your tax savings.

4. Difficulty of finding a replacement property that is suitable for the needs.

If you are unable to find a new investment property with matching cash flow as your old one, you may need to look at different properties with higher rents or lower expenses. For example, those who had rental homes as their investments might not be able to find something similar now as now most people rent apartments rather than single family homes. Thus they will either need to spend more money on buying an apartment and lose some monthly income or buy a smaller house and loose some value when they decide to sell it later on the future after improving it. However, these deals can take time and there can be issues such as financing which could delay the closing.

5. You need to use cash for your investment or you will be taxed as if you sold the property and received cash instead of exchanging it for replacement property.

Collectibles such as art, antiques, precious metals and stones are not allowed during 1031 exchanges. Also, coins are not acceptable because they are considered collectibles. For example, gold coins which used to be considered “currency” in US are now recognized as collectible items by IRS, therefore subject to capital gains tax when bought or sold after holding period is over. If an investor has these types of properties in his portfolio, he needs to sell them before doing exchange or pay taxes on them at that time.

6. Time needed for finding replacement property can increase your overall tax liability.

It is important to find replacement property in a timely manner in order not to have it considered taxable gain by IRS when you sell your old investment faster than you acquired the new one which will cause time gap between these two transactions. Although there are 3 different procedures for completing 1031 exchanges, investors who choose delayed boot method do so because they are afraid that if they spend too much time, IRS may consider taxable gain when they sell their old property before acquiring replacement. However, this usually takes longer amount of time which could cause its own set of problems, such as difficulty or increased costs associated with financing the sale and purchase simultaneously.

7. Difficulty in finding private money lender qualified to be part of exchange.

There are a few banks and private lenders who understand 1031 exchanges and they will lend money to a qualified investor for replacement property, but typically most investors don’t qualify. Private money lender is not required to follow 1031 exchange rules which means there is no guarantee that the investor will be able to acquire new property with help of this source of financing. Also, since these loans are unsecured by any assets of the borrowers, they usually carry high interest rates which could cause long-term debt. It is important for an investor to find right private money lender in order not to get himself into too much debt when acquiring investment property during 1031 exchange.

8. Needing to re-qualify your existing tenants on your new property may cause vacancy and loss in rent.

Even though your tenants can move with you to new property, if they are receiving low rental rates, there is a chance that when putting them on the new contract, they could reject it and choose not to follow their old home and go for other options in the market. For example, even though you paid $1,400 per month for 10-year lease agreement when you owned one house and moved into another house which was paying $1,200 per month after closing tenant out of old place and into replacement property before closing purchase deal but your tenant did not sign new contract because he was getting only 1 year’s worth of free rent from you at this rate ($1400-$1200=$200), plus, he was saving money with security deposit, you have now locked yourself into a complicated situation where your tenant wasn’t going to pay the same rent as before and you had no option but to find a new tenant or reduce rent.

9. There can be issues with financing which could delay closing.

Although there are many ways of financing 1031 exchanges such as using private money lenders who is qualified for this type of deal, IRA for example for retirement funds exchange, investors usually prefer to use cash from their sale because it saves time and they don’t need to go through another loan qualification process which might take months regardless if they have good credit score or not! Also, most banks require personal guarantees from you on any loans which will increase your risk profile, while private money lenders are unsecured loans. This can easily be avoided if you ask for 1031 Exchange Fund Assistance from our knowledgeable staff.  This is super high liquidity, fast transaction, and returns are great with this exchange fund!

10. There can be tax advantages in short term transactions between family members.

As stated earlier, 1031 exchange is intended to postpone the capital gains taxes for qualified investors when they buy rental property or sell it even if replacement property has already been purchased. It doesn’t matter how long investor will hold the investment property or whether he will do 1031 exchanges more than once, his profit after selling investment property must be equalized with the costs of acquiring new one by using like-kind exchange procedure which allows him to defer paying capital gain taxes until either taxpayer dies or sells his first replacement property made during 1031 exchange.

11. You could need professional help with transfer on death deed, living trust and “Starker” Trust.

When a seller dies, he can leave property to a beneficiary or to a group of beneficiaries by using transfer on death deed which will allow them to avoid probate process since the property is already titled in their name as the new owners! In order for this plan to work, there must be no liens against the property and everything must be paid for including any back taxes if applicable. The biggest benefit of doing it this way is that you don’t need professional help from attorney or tax advisor because all procedures are easy and straightforward but paperwork might take some time depending on state’s laws which you should check with local office before going forward with this type of option. On the other hand, one of the biggest cons is that if beneficiary dies unexpectedly for example, there would be no time to process transfer on death deed and his property will link back to the original owner with all related expenses of 1031 exchange which means high capital gain taxes. Thus, this plan is not suggested by most financial advisors because even though it’s hassle free; it might cost more than what investor expects.

12. There are some cases when you have to repay any depreciation taken.

Depreciation allows taxpayers or investors to deduct parts of an asset or investment over its useful lifespan before selling it in order to reduce their taxable income during the sale but there are many exceptions when taxpayer can’t do so including rental real estate properties! If you use Section 1250 depreciation method for rental real estate property, you can’t deduct depreciation from your investment/property value if the building was built after 1987. In this case, taxpayer is “forced” to repay any depreciation taken as a deduction from their capital gain tax which means higher capital gains taxes as a result!

13. Most 1031 exchanges are done by using qualified intermediary or QI.

One of the most important requirements for successful 1031 exchange is that all profit and expenses must be documented and reported on every transaction according to IRS rules and regulations which requires professional help from tax advisor and attorney in order to avoid penalties and fines! Financial advisors usually use private money lenders who qualified for 1031 exchanges to keep everything clean during transfer their clients don’t have to worry about that because all transactions are done by qualified intermediary or QI who works with investors to document, report and file proper paperwork according to IRS rules.

14. You can change your mind before closing escrow since you are not limited to specific property you can find one according to your needs.

When you use qualified intermediary or QI, he will work with you to find “suitable” property for 1031 exchange but not limited to it! The goal is to exchange your money into new property as soon as possible and one of the biggest cons of working with intermediary is that you are limited to their choices which means that there might be better properties than ones they choose according to their listing rules! On the other hand, since intermediary works on behalf of exchanger; all paperwork is done by them which means no additional fees added after closing escrow for document processing.  To make it even better, a 1031 Exchange Fund will provide the liquidity, return on investment, and most of all, time to do your homework on where to transfer funds in the future.  Give yourself room to breathe and grow your portfolio the right way.

There are some issues that should be taken into consideration before you can successfully complete a 1031 exchange, which is why it’s important to contact an accountant or tax professional in order to understand how they work and what all of this entails.

This article provides only general information about possible issues with the 1031 exchange program. It is not exhaustive nor should it be considered advice on any particular matter. The author explicitly disclaims liability for damages incurred by relying on these contents or related materials from third parties. Always seek the help of a qualified legal, accounting, real estate professional and/or such related professionals when dealing with specific legal or financial issues.