When it comes to conducting a safe-harbor Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange , there's a set process that must be followed in order to stay clear of the grim reaper. The regulations impose a set of rules ensuring you can’t ‘trick” your way into an exchange. The safe-harbor guidelines provided by the Internal Revenue Code reward you with a “treat” by allowing a deferral of taxes on the gain of your investment and allowing you to properly reinvest into a like-kind property. This allows small and medium sized businesses to move, grow and diversify.
In honor of 10/31, the best date on the calendar in our opinion, we decided to have a little fun and play around with the top ten reasons an exchange might fail—with an added Halloween twist.
Number 10: Identify after midnight on the 46th day
The period of time allotted for identifying replacement properties is 45 days from the sale of the relinquished property. This period of time is known as the identification period. In general, this deadline cannot be extended.
Number 9: Allow a vampire to exchange his personal coffin for a vacation coffin
1031 exchanges are limited to real estate that is intended for business use or investment. In the case of most personal and vacation homes, a 1031 exchange would not be permissible. There are, however, some circumstances in which a personal residence or vacation property could be eligible.
Number 8: Claiming that real property in Pennsylvania is like-kind to real property in Transylvania
1031 exchanges are limited to properties that are both located within the United States. This includes some, but not all US Territories.
Number 7: Pushing 1031 as simply an avoidance of a “DEATH TAX”
1031s are never an avoidance of a tax. It is a deferral of gain recognition allowing for continuity of investment. In fact, studies have shown that 88% of properties involved in a 1031 exchange are sold in a taxable transaction, and about a third of transactions have some taxable boot received at the time of sale (Reference recent FEA post).
Number 6: Selling to or buying property from Deceased family members
An informed Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary , like Accruit, can guide you through the rules when it comes to exchanging your property. Exchanging with a family member MAY jeopardize your entire exchange. When it comes to related parties, Congress added an amendment to Section 1031 in 1989 to stop abuse that was happening whereby investors were exchanging with related parties as an effort to skirt the rules. (link to: https://www.accruit.com/blog/1031-tax-deferred-exchanges-between-related-parties) There are very few exceptions to this rule, so it’s important to be aware or your exchange could end up in a graveyard.
Number 5: Exchanging your mausoleum for a hearse
As of 2017, personal property no longer qualifies for like-kind exchange. Previously, property such as vehicle fleets, construction equipment, or even airplanes were eligible to exchange, as long as they were like in kind (i.e. a plane for a plane, or a tractor for a tractor). With the elimination of personal property, only real estate is eligible for 1031 exchange. However, all real estate is like-kind to other real estate, which means you can exchange your mausoleum (commercial building) for a cemetery (raw land).
Number 4: Thinking your abnormal deranged brother with a cue ball as an eye is your QI
A 1031 exchange requires the use of a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary (QI), such as Accruit. If the taxpayer is in receipt of funds following the sale of their relinquished property, this becomes a taxable event, and the exchange fails. The QI must not be related to the taxpayer, and they may not use their Realtor®, attorney, or accountant to hold funds either.
Number 3: After identifying a property, claim it is haunted to get your exchange funds returned early
Once an exchange has started, the regulations are very strict as to when funds are allowed to be released to the taxpayer. Barring the occurrence of a limited and specific set of circumstances, funds are held by the QI until the completion of the 180-day exchange period (link to https://www.accruit.com/blog/early-release-exchange-funds-possible-under-1031-exchange-rules)
Number 2: Insisting the form you file with the IRS to claim your LKE is Form-666, not 8824
Following the completion of an exchange, the taxpayer will receive a 1099 for the amount of interest that was accrued on the exchange deposit. This should be reported as income, and the exchange transaction is reported to the IRS on form 8824.
And the number 1 way to KILL a 1031 exchange: Comingle your exchange funds with your Halloween candy (we're officially terrified)
When selecting a QI, not only should the right QI adhere to industry standards of segregated accounts, but your QI should also inform you that there are some states that mandate how exchange funds should be held. Don’t be fooled by a low-cost QI wearing a trusting mask. Not for your 1031. If the offer just sounds too good to be true, BE SCARED—be very, very SCARED.
Have a happy and successful 1031 day!