Mistakes to Avoid in Your First-Ever 1031 Exchange

Did you know that most Americans prefer investing in real estate to most other things? That’s right; stocks, gold, savings accounts, and bonds – they are not what Americans are after when it comes to long-term investments. 

Now, a 1031 exchange? That might be more to their liking.

If you're diving into the world of real estate investing, you've probably heard about the benefits of a 1031 exchange. But just because it’s a great tax-saving strategy doesn’t mean it’s simple. A lot of first-timers make mistakes that can turn their tax-deferral dream into a costly headache. 

Let’s go over some of the most common mistakes you need to steer clear of when executing your first 1031 exchange.

Missing the Strict 1031 Exchange Deadlines

Here’s the deal: the IRS is not your friend. That means no matter what, they are not going to be flexible when it comes to 1031 exchange rules. So, missing a deadline – even by a day – could mean losing your tax-deferral benefits. 

The moment you sell your current investment property, the clock starts ticking. You have 45 days to identify your replacement property and 180 days to close on it. Those dates aren’t suggestions; they’re non-negotiable.

Many investors make the mistake of waiting too long to start searching for like-kind property. They assume 45 days is plenty of time, only to realize that the real estate market doesn’t always cooperate. 

As 1031 Crowdfunding points out, the best way to avoid this mistake is to start looking for replacement properties well in advance. Exactly how early should you start? Before you even sell your existing one. That way, when the 45-day deadline comes up, you already have strong options lined up.

Choosing a Property That’s Ineligible 

Selling real estate, buying real estate: Is a 1031 exchange as simple as that? Absolutely not. The IRS has clear guidelines on what qualifies as like-kind property. A common mistake new investors make is thinking they can swap any property for another and still qualify for tax deferral. 

The key is that both the property you sell and the property you buy must be held for business or investment purposes.

For example, you can’t sell a rental property and use the proceeds to buy a vacation home you plan to use personally. You also can’t sell an investment property and use the proceeds to buy a primary residence. These are personal-use properties, not like-kind investment properties. 

Touching the Proceeds from the Sale

It might be tempting to access the funds from the sale of your investment property. However, that’s a surefire way to get your 1031 exchange disqualified. The IRS is very clear on this: you are not allowed to receive or control the proceeds from the sale. 

Instead, the money must go to a qualified intermediary – a neutral third party who holds the funds until you purchase your replacement property.

A common mistake is assuming you can briefly hold the funds and then reinvest them in a new property later. The moment you take possession of the money, the IRS considers the sale complete, and you’ll owe capital gains tax. 

The safest way to avoid this issue is to work with an experienced intermediary from the start. That way, you won’t accidentally violate the exchange rules and trigger an unnecessary tax liability.

Underestimating the Financial Details

First-time real estate investors sometimes think a 1031 exchange is a simple swap – sell one property, buy another, and defer taxes. But the financial details matter, and overlooking them can lead to unpleasant surprises. 

The general rule is that to defer all of your capital gains tax, you must reinvest all of the proceeds into your replacement property. If you purchase a lower-priced property or fail to reinvest all the proceeds, the difference – known as “boot” – will be taxed.

Another issue is debt. If your original investment property had a mortgage, your replacement property must have equal or greater debt. Or, you must invest additional cash to make up the difference. 

The best way to avoid these missteps is to work closely with a tax professional who understands 1031 exchange rules. They can guide you through the financial side of the process.

A 1031 exchange is one of the best tools real estate investors have for building wealth while deferring capital gains tax. But as with any investment strategy, there’s a right way and a wrong way to do it. 

If you want your first 1031 exchange to go smoothly, plan ahead. Work with the right professionals, and make sure you fully understand the 1031 exchange rules before jumping in.