1031 exchanges for investors are incredibly beneficial for a number of reasons. However, while some may be aware of how these exchanges work, others may venture into them without all the necessary information. As a result, there are a number of common mistakes that investors are making and can ultimately be avoided.
In this guide, we’ll take a look at what 1031 exchanges are, the benefits, and the key mistakes investors make when it comes to these exchanges.
Definition of 1031 exchange
A 1031 exchange helps real estate investors to defer capital gains by selling an investment property and then reinvesting the proceeds of the sale into another like-kind property.
As a result, this allows for portfolio growth without any immediate tax hits. There are strict IRS timelines and rules, though, that are important to be aware of to swap one/business investment real estate with another similar one.
What are the benefits of 1031 exchanges for investors?
There are some wonderful benefits of 1031 exchanges for investors, and these should hopefully inspire you to explore the option of such processes to help you save on taxes. These benefits include:
Tax deferrals
Tax deferrals mean you can avoid paying capital gains tax and depreciation on the property.
Portfolio growth
Portfolio growth is important because it provides more potential for new opportunities. Reinvesting the full sale proceeds into another property, it can help with enabling expansion of the portfolio or upgrading to larger properties.
Portfolio diversification
1031 exchanges are a portfolio diversification where you can switch from one type of property to another. Whether that be a single-family rental to commercial building.
Management relief
These exchange opportunities can help when you want to go from a high-maintenance property to one that’s easier to manage, like a triple-net lease property instead.
Key mistakes investors make with 1031 exchanges
Investors can often make several critical mistakes when it comes to 1031 exchanges. This is primarily relates to strict deadlines, handling funds, or proper identification. These are some of the key mistakes investors will often make.
Missing strict deadlines
The most common and frequent mistake that’s made when it comes to 1031 exchanges is failing to adhere to the absolute deadlines in place by the IRS.
Investors have 45 calendar days from the sale of the original property to identify any potential replacement properties in writing. They have 180 calendar days to close on the new property.
It’s good to know that these deadlines include weekends and holidays and are therefore rarely extended, except in the case of a federally declared disaster.
Taking personal receipt of funds
The exchange proceeds should be held by a neutral third party known as a Qualified Intermediary (QI for short).
If an investor were to touch the money, even for a moment, then the entire exchange becomes a taxable event, thus making the whole process obsolete.
Failing to use a qualified intermediary
Talking of the QI, a QI is essential for a valid exchange to occur. Using a disqualified person, whether that’s a family member, a real estate agent, or persona attorney within the last two years, will also invalidate the exchange you put in place.
Incorrect property identification
Identified properties must be clearly and specifically described in writing. For example, the full address must be noted and then submitted to the QI within the 45-day window provided.
For some investors, incorrect property details can be troublesome and cause problems within the process. Identifying one property is risky, so it’s important to use the three-property rule, in which you identify up to three properties regardless of value.
This offers a necessary safety net, should the deal fall through at any point.
Not reinvesting all proceeds
To achieve the full tax deferral required, the replacement property will need to be equal to or of greater value than the relinquished property. All equity and debt must also be replaced. Receiving cash or acquiring a property with less debt results in a boot, which is then immediately taxable.
Ignoring the ‘same taxpayer’ rule
The individual or legal entity who sells the relinquished property must be the same person who acquires the replacement property.
Changing the title or ownership structure, whether you’re adding a spouse or transferring it into an LLC, will disqualify the exchange.
Exchanging ineligible properties
The properties that are involved must be like-kind and held strictly for investment or for business purposes.
Personal residences or properties that are intended for quick resale do not qualify for the 1031 exchange. These are otherwise referred to as ‘flips.
Using a Delaware Statutory Trust
So what about a Delaware Statutory Trust? This is a legally recognized trust structure that’s commonly used for real estate investment purposes.
DSTs are often used and popular for 1031 exchanges, allowing customers to defer their capital gains taxes when selling investment properties.
How to invest in a DST
To invest in a DST, you’ll first need to identify your investment goals. DSTs are often offered by real estate investment firms that acquire and manage the properties. Delaware Statutory Trusts investing news is worth keeping up to date with, should any rules and regulations change regarding these trusts or taxes.
You’ll want to review available DST offerings. These may include office buildings, retail centers, or multifamily apartments.
From this, you’ll want to review the private placement memorandum, which provides details about the investment, including property details, risk factors, expected returns, and financials.
It’s important to ensure the trust aligns with your risk tolerance and investment horizon. DSTs typically will have holding periods of 5-10 years. You’ll also need to fund your investment, so when doing a 1031 exchange, funds must be transferred from the sale of the relinquished property into the DST via a qualified intermediary.
Investors are able to receive monthly or quarterly distributions from rental income. There are no active management responsibilities as the DST sponsor handles operations, maintenance, and leasing.
An exit strategy is also important to have, which is when, upon the requirement of such, the DST will liquidate the properties at the end of the holding period and distribute proceeds to investors. As an investor, you can either take cash or roll over into another 1031 to continue deferring taxes.
