Potential Pitfalls in a 1031 Exchange


Make sure your Qualified Intermediary is qualified

 Your Qualified Intermediary must be an "unbiased" third party, as such your QI cannot be a family member.  Also, you must not have had a financial relationship with the qualified intermediary within the last two years which would disqualify your accountant, attorney, and real estate agent.  Using a non-qualified QI could invalidate your exchange, and your property sale will become a taxable event.

It is also recommended that besides using a bonded and insured QI, also make sure that the QI is a national, reputable and financially stable entity.  If your QI were to go bankrupt, not only would your funds be at risk, you would also have to pay taxes on your invalidated exchange.


Make sure your Qualified Intermediary receives sales proceeds from escrow

In addition to your QI being listed as the principal in the sale of your property, the QI must receive all proceeds from the sale directly from escrow.  Any funds that are held by you, no matter how briefly, will be invalidated for the exchange and become susceptible to taxation.


Make sure you don't miss your 45 or 180 day timelines

Any properties that are not identified within the first 45 days of your exchange (with close of escrow being day 0) will not eligible for your tax free exchange.  Also, if the property or properties named in your first 45 days are not purchased within the 180 day timeline your exchange will not be valid.  The IRS is very strict about the timelines, and will not make exceptions if the 45th or 180th day falls on a weekend or holiday.  Because you have the option of naming three properties, even if you only need to close on one, it is advisable that you list three properties.  That way, if you are unable to close the purchase on your first property after the 45th day, you still have choices #2 and #3 to fall back on.


Make sure you purchase "like-kind" property

For the purposes of a 1031 exchange a like-kind property is one that is used "in a trade or business or for investment."  The key is the purpose of the property.  You may trade from a residential property to raw land, a mobile home park for an industrial property, etc.  However, you may not purchase a property for personal use such as a home or vacation property.  Purchase of a non like-kind property will invalidate your exchange.


Make sure your QI receives and verifies receipt of your written notification of property selection by day 45

Don't go through all of the trouble of searching for acceptable properties for your exchange and have it invalidated by not following through on the proper notification.  Find out the best way to notify your QI early in the process rather than at the last minute.  And make sure to get proof of receipt.  Even if it is the QI that drops the ball on your exchange, you will be the one liable for the taxes.


Make sure you don't violate the 3 property or 200% rule

If you decide that you want to name more than 3 properties in your exchange, make sure you can close on at least 95% of the properties.  For the math challenged, that means if your named 19 or less properties, you must close on them all!  Also, make sure to do the math and make sure that the value of the acquired properties do not exceed 200% of the value of the relinquished properties.  Violation of the 3 property or 200% rule will invalidate your exchange.


Make sure you look out for unscrupulous sellers

Remember, there are so many rules involved in performing a 1031 exchange, and you will be notifying your seller of your 1031 exchage via the Collaboration Clause.  Therefore, it would be wise to get as much of the terms of your purchase contract nailed down as soon as possible.  Many unscrupulous sellers will use the possibility of an invalidateed exchange as a bargaining chip in your deal.





1031 Exchanges

Possible Pitfalls