We often receive calls from taxpayers who are seeking information on their first 1031 exchange. In some cases, the conversation is rather short as the facts of their potential exchange do not permit them to proceed. We’ve compiled our top seven most common reasons when a 1031 exchange does not work.
1. The Property Has Already Closed
This is one of the most frustrating scenarios for a taxpayer and is by far the most common. In this scenario, a taxpayer has closed prior to discovering that a 1031 exchange could benefit them. If the taxpayer has receipt of the exchange proceeds or if the proceeds are being held in a manner that the taxpayer can pledge, direct or borrow, the taxpayer cannot move forward with a 1031 exchange. As a 1031 educator who primarily teaches courses to Realtors, I often share the cliff notes of angry calls where the taxpayer directs their angst at their agent. Whether that is fair or not, I encourage Realtors to ask their clients two simple questions at the beginning of their listing. First, “Is the property you’re selling an investment or business property?” and if the answer is yes, then, “Is it your intent to acquire an investment or business property with the proceeds of your aforementioned sale?”. If the answer is yes, I would encourage them to speak with a Qualified Intermediary to see if their transaction qualifies for 1031 exchange treatment, as well as their CPA to determine if it is in their best interest.
2. The Property Being Sold is a Primary Residence
As previously mentioned, the usage of the property matters in a 1031 exchange. If the property is the primary residence of the potential Exchangor, it will not qualify. Additionally, if the property that is being sold is an investment, but the intent of the taxpayer is to immediately move into the replacement property as their primary residence, this also does not qualify. One exception to this could be a multi-unit residential property like a duplex. It is possible to live in one section of the property and still utilize section 1031 towards deferring the taxable obligation of the portion that is utilized as an investment or business property. If the property is a primary residence, we often encourage the taxpayer to confer with their CPA to see if they qualify for IRC § 121, which provides an exclusion of gain if certain criteria are met.
3. The Relinquished Property is in the US and the Replacement Property is Abroad
“Like-Kind” is defined as “Domestic to Domestic” and “International to International.” In the case that a taxpayer wants to sell a residential building in Montana, they could not then buy a replacement property in Canada. They could, however, purchase a property in any of the 50 states, including the US Virgin Islands, The Marianas Island and Guam, so long as they can substantiate that they have business interests in those territories. International properties are considered like-kind with other international properties; therefore, you could sell a property in Portugal and purchase replacement property in Japan.
4. The Taxpayer is Selling as an Individual but Wants to Acquire in Another Taxable Entity
IRC § 1031 is very clear that the “same taxpayer who sells, must be the same taxpayer who acquires”. Ultimately, this is distilled down to the tax ID of the exchangor. If an individual is selling, they have options to acquire as a disregarded entity, such as a single-member LLC, land trust or revocable trust. They could not, however, acquire in a Multi Member LLC (MMLLC) with another member. This MMLLC would have a separate tax identification number and therefore would be ineligible. It is possible to transition the property to another entity after the exchange is complete but we encourage the involvement of the taxpayer’s CPA to provide guidance regarding the potential tax consequences.
5. The Taxpayer Wants to Acquire Personal Property as Replacement Property
In some unique cases, a taxpayer has an interest in selling their real property to replace with personal property, such as a boat, RV or airplane. Real property must be exchanged for real property. Real property provides many options beyond commercial and residential real estate; however, it does not allow for the acquisition of personal property.
6. The Real Property Does Not Satisfy Revenue Procedure 2008-16
Given the property to be sold has a dwelling unit consisting of a bedroom, kitchen, and bathroom, Rev. Proc. 2008-16 requires the property is held for at least two years. In each of the two years, no more than fourteen personal overnights are allowed, including when friends and family stay without paying fair market rent and the property has been rented at least fourteen overnights in each of the two years. Property such as single-family residential and condominiums cannot be flipped for profit and must be held for at least two years to show proper intent. Itemizing on Schedule E of the taxpayer’s return is another fact supporting a 1031 exchange.
7. Not Reinvesting at Least 50 Percent of the Net Sale Price
Those taxpayers looking to replace a portion of the net sales price should seek the input of their CPA to understand the tax consequences. More often than not, taxpayers reinvesting less than 50 percent of the net sales price will find the tax on the difference is close to or the same as the tax on the sale if a 1031 exchange was not initiated. You can do an exchange, but why?
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
