Real estate investors looking to defer their capital gains taxes often turn to 1031 exchanges. Essentially, a 1031 exchange allows investors to sell a property and reinvest the proceeds into a like-kind property without paying capital gains taxes. However, investors can make several common mistakes during a 1031 exchange, leading to unexpected taxes and penalties.
Let’s dive into some of the most frequently encountered 1031 exchange mistakes and discuss how to avoid them so that you can capitalize on your 1031 investment.
Mistake #1: Missing Critical Deadlines
One of the most critical missteps an investor can make during a 1031 exchange is failing to meet the tight deadlines set by the IRS. Investors have 45 days to identify a potential replacement property and another 180 days to close on that property. If investors miss these deadlines, they will be subject to capital gains taxes on selling their original property. To stay on track and meet these deadlines, investors should work with a qualified intermediary who can help keep them on schedule.
Mistake #2: Choosing the Wrong Replacement Property
Another common mistake is identifying the wrong replacement property. While the IRS allows investors to identify up to three potential replacement properties, they must all be like-kind. The replacement property’s value must meet or exceed the value of the original property sold. Choosing the wrong property could mean paying taxes on the sale of the original property. To avoid this pitfall, investors should work with a knowledgeable real estate professional who can help them identify the best replacement property for their needs. If you have questions about 1031 and this premise, please get in touch with us.
Mistake #3: Failing to Follow IRS Rules
The IRS has specific rules and requirements for completing a 1031 exchange. Not following these rules will result in taxes and penalties. To avoid costly mistakes, investors should take time to understand all the rules before jumping into this powerful investment vehicle.
Mistake #4: Using Exchange Proceeds for Personal Use
Investors who use proceeds from selling their original property for personal use will be subject to capital gains taxes. For instance, an investor who sells a rental property and uses the funds to purchase a vacation home will be subject to capital gains taxes on the sale of the rental property. To sidestep this mistake, investors should work with a qualified intermediary to hold the funds until the new property is purchased.
Mistake #5: Failing to Understand Tax Implications
Investors who don’t fully comprehend the tax implications of a 1031 exchange may eventually owe more taxes than anticipated. For example, if an investor sells a property and reinvests the proceeds into a new property, they may not realize that the deferred gain reduces the basis for the new property. As a result, if the investor sells the new property later on, they will have to pay capital gains taxes on the deferred gain. To avoid this problem, investors should consult with a tax professional who can provide guidance on the tax implications of a 1031 exchange.
Mistake #6: Trying to DIY the 1031 Exchange
Investors who attempt to complete a 1031 exchange without professional assistance risk making costly mistakes. A seasoned, qualified intermediary, real estate, and tax professional can provide valuable expertise to ensure a successful exchange. Without professional guidance, investors could miss crucial deadlines, identify the wrong property, or fail to complete the exchange correctly. Investors should work with a team of professionals experienced in completing 1031 exchanges to avoid this mistake. Such a team can guide investors through the process and ensure they follow all rules and regulations.
In conclusion, a 1031 exchange can be brilliant for real estate investors who want to defer their capital gains taxes. But to ensure a successful exchange, avoiding common mistakes is essential. Investors can avoid these pitfalls by working with qualified intermediaries, real estate professionals, and tax professionals, making the most of their 1031 exchange.
A Final Word
One final note of importance: another mistake you could make with your 1031 exchange is not taking advantage of the over 50 years of experience that Cortes & Hay brings to every property transaction in the New Jersey area. If you are on the hunt for a qualified intermediary or want additional information regarding 1031 exchanges, give us a call today!