Common Mistakes Investors Make With 1031 Exchange Properties

The concept of a 1031 exchange is straightforward enough: defer taxes now by rolling gains into a “like-kind” replacement property. In practice, however, 1031 exchanges are governed by strict rules, rigid timelines, and technical tax considerations that leave little room for error.

For these reasons, even experienced investors can sometimes make costly mistakes when looking at 1031 exchange properties for sale due to misunderstanding the rules and timelines. Learning about these common pitfalls can help you avoid them.

1. Misunderstanding the “Like-Kind” Requirement

Real property must be exchanged for other real property held for productive use in a trade or business or for investment. After the passage of the Tax Cuts and Jobs Act of 2017, personal property such as equipment or artwork no longer qualifies for these exchanges.

The term “like-kind” is broadly interpreted for real estate. An investor can exchange an apartment for raw land, retail property, industrial property, or a long-term leasehold interest of 30 years or more. 

However, the property must be held for investment or business purposes. Attempting to exchange a primary residence, a second home used primarily for personal enjoyment, or property acquired for resale (“fix-and-flip” inventory) does not qualify.

Failing to properly document investment intent is another common mistake. The IRS examines holding periods, rental activity, and overall facts and circumstances to determine whether the property qualifies for the exchange.

2. Missing Critical IRS Deadlines

1031 exchanges operate on strict, non-negotiable timelines:

• 45-Day Identification Period: The investor must identify potential replacement properties within 45 calendar days of selling the relinquished property.
• 180-Day Exchange Period: The replacement property must be acquired within 180 calendar days of the sale (or by the due date of the taxpayer’s return, including extensions, if earlier).

There are no extensions except for those specifically declared by the federal government as disasters. Weekends and holidays count.

Additionally, identification must comply with one of three IRS rules:

• Three-Property Rule: Identify up to three properties, regardless of value.
• 200% Rule: Identify any number of properties, as long as their aggregate value does not exceed 200% of the relinquished property’s value.
• 95% Rule: Identify any number of properties, provided that at least 95% of their total value is acquired.

Missing deadlines automatically disqualifies the exchange, resulting in immediate capital gains tax liability. Many investors underestimate how quickly 45 days can pass, especially in competitive markets.

3. Improper Use of a Qualified Intermediary (QI)

A QI is mandatory in a standard 1031 exchange. The investor cannot take actual or constructive receipt of the sale proceeds. If funds pass through the investor’s control, even briefly, the exchange fails. The QI holds the proceeds from the sale and uses them to acquire the replacement property.

Choosing the wrong intermediary can be risky. The 1031 industry is not federally regulated, and QIs are not required to be licensed in many states.

Investors should conduct rigorous due diligence on a QI’s fiduciary protections, including auditing its fidelity bonding, errors and omissions (E&O) insurance, fund segregation protocols, and financial stability.

Additionally, certain individuals are disqualified from serving as QIs, including the taxpayer’s agent, attorney, accountant, real estate broker, or employee if they have provided services within the previous two years.

4. Boot Issues

To fully defer taxes, an investor must

1. Reinvest all net proceeds, and
2. Acquire property of equal or greater value, and
3. Replace any debt paid off on the relinquished property.

Failure to meet these requirements can create “boot,” which is taxable. There are two primary forms of boot:

• Cash Boot: Occurs when the investor receives leftover cash from the exchange.
• Mortgage Boot: Occurs when the debt on the replacement property is less than the debt on the relinquished property, and the shortfall is not offset with additional cash.

Investors often overlook transaction costs. Certain closing expenses paid from exchange proceeds may inadvertently result in taxable boot if not properly structured. Therefore, it is essential to work with a certified public accountant.

5. Overlooking State Tax Implications

Not all states follow the federal 1031 treatment uniformly. Some impose specific withholding requirements, while others track deferred gains if the replacement property is located out of state.

Certain “clawback” states require tax payment when a property exchanged out of the state is ultimately sold in a taxable transaction elsewhere. Investors must evaluate compliance at both the federal and state levels to avoid surprises.

6. Miscalculating Basis and Future Tax Liability

Under a 1031 exchange, the replacement property carries a transferred basis from the relinquished property, adjusted for additional investment and depreciation.

Investors frequently underestimate the long-term implications of carryover basis and Section 1250 depreciation recapture. When the replacement property is eventually sold without another exchange, accumulated deferred gains and recaptured depreciation become taxable.

Investors should consider estate planning as part of their analysis. If held until death, heirs may receive a step-up in basis to fair market value, effectively eliminating capital gains. Without long-term planning, however, tax liabilities can compound significantly.

Final Thoughts

A 1031 exchange is one of the most powerful wealth-building tools available to real estate investors. Yet it is also unforgiving, and mistakes can trigger significant tax consequences. Investors who approach these exchanges proactively position themselves to maximize deferral benefits while minimizing risk.

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