Tax-Deferred Exchanges: Pitfalls to Avoid

By Robert Klein

One of the few tax breaks available to real estate investors and businesses is the nonrecognition provision in Section 1031 of the tax code. Generally, this section provides that gain is not recognized when property held for investment or for productive use in a trade or business is exchanged for "like-kind" property (the replacement property). If cash or property that is not like-kind ("boot") is received in addition to the replacement property, the amount of the gain is limited to the fair market value of the boot. However, investors must be careful to avoid the many pitfalls that exist if an exchange is not structured properly. Some of these are described below.

Replacement Debt

While investors understand the net proceeds received from a sale of their relinquished property must be invested in like-kind replacement property, many fail to realize they must also replace any discharged debt. For example, if an investor exchanges a property for $100,000, subject to debt of $75,000, the investor must not only reinvest the $25,000 of equity but also the debt of $75,000. The investor can take on more debt to acquire a higher-valued property as long as all of the net equity is reinvested. If the investor invests only the net equity, the IRS will impose a tax on the "debt release" experienced in the exchange.

Failure to Identify Property

Identifying a property for exchange may be done improperly. Most exchange companies (known as Qualified Intermediaries) provide a sample form for use in identifying potential replacement properties. Some of the common errors made in completing an identification statement include failing to have a spouse sign the statement, entering the wrong street address or lot number or failing to note the purchase is for only a percentage of the exchange property.

Limiting Exchanges to One Person

Initially, all exchanges were two-party exchanges. In 1979, following a court ruling, the IRS changed the regulations to utilize Qualified Intermediaries. This permitted the property owner, through the intermediary, to offer the property to any interested buyer.

Different Property Types

For the purposes of 1031 exchanges, all real property is considered like-kind with all other real property as long as the properties are held either for investment or business use. Thus, rental properties are like-kind to commercial buildings and improved properties are like-kind to raw land. Fractional interests (held as tenants in common) are like-kind to owning a fee simple interest. Long-term ground leases with 30 years or more remaining on the lease can be like-kind to other real property interest.

Investment or Business Use

An important rule to be observed is that the properties in the exchange must be held either for investment or business use, but not for both. With proper planning, however, this limitation can be overcome. For example, holding a condo for investment purposes for at least two years and then converting it to personal use is permitted. Another rule to observe is to avoid an immediate sale of the received property because the IRS takes the view that in such a case, the property was held primarily for sale rather than for investment.

Consult With Advisors

It is always a wise step to consult a tax or legal advisor to be sure the transaction you are considering makes sense. For example, an investor who has incurred losses from other business transactions has no need for an exchange. Other such issues can be resolved with the expertise of an experienced Qualified Intermediary.

Missing a Deadline

The strict time deadlines often associated with a 1031 exchange is the most difficult aspect of these exchanges. An investor has 45 days from the date the relinquished property closes to identify a replacement property and 180 days (or the tax filing deadline, whichever comes sooner) in which to close on the identified property. The time deadlines are not extended for weekends or holidays.

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