Common Challenges of a 1031 Exchange and How to Overcome Them

Most 1031 exchanges go smoothly. When they don't, it's usually for one of a handful of reasons, and nearly all of them can be avoided with a little planning before the sale closes.

1. Not having the exchange in place before closing

The exchange has to be set up before your relinquished property closes, with the proceeds going directly to your Qualified Intermediary. If the sale closes and the funds come to you first, the exchange is off the table. There's no fix after the fact.

How to avoid it: Connect us with your closing agent as soon as you're under contract. We'll coordinate the exchange documents with them so everything is in place before closing.

2. Running out of time to identify

You have 45 calendar days from the closing of your sale to identify replacement property in writing. Weekends and holidays count, and the deadline doesn't move. In a tight market, 45 days goes quickly.

How to avoid it: Start looking before your sale closes. Use your 45 days to narrow down properties you've already considered, and identify backups within the identification rules. Depending on which identification rule you select, you can identify up to three properties of any value, or more than three as long as their total value doesn't exceed 200% of what you sold.

3. Financing delays

Your replacement purchase has to close by day 180, or earlier if your tax return is due first and you haven't filed an extension. Lender delays are one of the most common reasons buyers get pushed up against that date.

How to avoid it: Get your lender involved before your sale closes, and make sure they know the purchase is part of an exchange with a hard deadline.

4. Unexpected boot

Boot is anything you receive in the exchange that isn't like-kind property, and it's taxable. It usually shows up in one of three ways:

• Cash you keep. Any exchange proceeds you take out are taxable.

• Buying down. If your replacement property costs less than what you sold, the difference is generally taxable.

• Reduced debt. If the loan on your new property is smaller than the one you paid off, the difference can be taxable unless you make it up with additional cash.

To defer all of your gain, buy property worth at least as much as you sold and reinvest all of your net equity. Additional cash can offset a smaller loan, but it doesn't work the other way: a bigger loan won't offset cash you take out.

How to avoid it: Have your CPA run the numbers before you go under contract on the replacement property, and review your closing statements before both closings.

5. Choosing the wrong intermediary

Certain people can't serve as your Qualified Intermediary, including anyone who has acted as your agent in the past two years, such as your real estate agent, attorney, accountant or employee, and close relatives. Beyond that, your intermediary holds your sale proceeds for up to six months, so how those funds are protected matters.

How to avoid it: Ask any intermediary how client funds are held, whether accounts are segregated, and what bonding and insurance they carry.

6. State tax surprises

A 1031 exchange defers federal tax, and most states follow along. California adds a step. If you exchange California property for property in another state, California keeps track of the deferred gain. You'll file an annual report (FTB 3840), and California taxes the deferred gain when you eventually sell without exchanging, even if you no longer live here.

How to avoid it: If you're selling in California and buying elsewhere, plan for the annual filing with your CPA.

7. Partners who want different things

When property is owned by a partnership or LLC, the entity is the taxpayer. If one partner wants to exchange and another wants cash, it gets complicated. Restructuring ownership before a sale, sometimes called a "drop and swap," can work but carries real risk if it isn't done carefully and early.

How to avoid it: Have the conversation with your partners well before you list, and bring in your CPA and attorney to structure it.

The common thread

Almost every one of these comes down to timing. The earlier your QI, lender and CPA are involved, the more options you have. If you're thinking about selling, reach out and we'll help you plan the exchange side.

APX 1031 is a Qualified Intermediary. We don't provide tax or legal advice; talk with your CPA or attorney about your situation.