When it comes to executing a successful 1031 exchange, many investors focus on the property they’re selling. However, the real complexity often lies on the other end of the transaction: the replacement property.
Identifying and acquiring the right replacement property is essential to preserving the tax-deferred status of your 1031 exchange. There are several nuanced issues that can cause delays, trigger taxes, or even disqualify your like-kind exchange altogether.
Here are five key considerations to help you navigate potential replacement property challenges with confidence.
Start the Search for Replacement Property Early. In Some Cases, Really Early.
One of the biggest mistakes taxpayers make during the 1031 exchange process is waiting too long to begin looking for replacement property. Under IRS rules, you have just 45 calendar days from the closing of your relinquished property to identify potential replacements and 180 days to close.
In a tight or competitive real estate market, this window can close fast. Savvy investors often begin scouting for replacement property well before closing on the relinquished property. In some cases, it may even make sense to acquire the replacement property first through a reverse exchange, which requires careful structuring and experienced qualified intermediaries.
Confirm It’s Like-Kind Property
To qualify for tax deferral, the replacement property must be like-kind when compared to the relinquished property. In the context of real estate, “like-kind” is interpreted broadly. For example, you can exchange a retail building for farmland, or a warehouse for an apartment complex.
However, issues can arise when:
Personal property (e.g., equipment, furnishings, or other personal property) is involved
The property is a personal use property (e.g., a vacation home or a second home)
These scenarios may disqualify the transaction. Be sure the replacement property is held primarily for investment or business use, as opposed to personal use.
Hoping to Make Improvements? Plan Accordingly.
Some investors see an opportunity to upgrade or build on their replacement property as part of an exchange. That can work but only if it is structured properly as an improvement exchange.
Improvement exchanges require the qualified intermediary (or an exchange accommodation titleholder) to hold title during construction, and any improvements must be completed (or at least built into the property’s value) within the 180-day exchange window. These are complex transactions that require advanced planning and coordination with all parties involved.
Be Cautious with Related Parties
Buying replacement property from a related party can be a red flag for the IRS. Even if the property is like-kind and all other requirements are met, the IRS may challenge the transaction if it believes the exchange was structured to inappropriately avoid taxes.
If a related-party transaction is planned, you should consult your tax advisor early. There are strict limitations and documentation requirements and in some cases, alternative options may be safer.
Co-Ownership? Understand the Structure First
Co-owning replacement property, whether with a spouse, business partner, or investment group, can be done, but it needs to be structured correctly. The IRS is concerned about who the taxpayer is, so the entity that sells must be the same entity that buys.
Common co-ownership structures include:
Tenants-in-common (TIC) arrangements
Delaware Statutory Trusts (DSTs)
Properly structured partnerships
Each has different implications for control, liability, and IRS compliance.
Assemble an Experienced 1031 Exchange Team
The replacement property is not just the second half of your 1031 exchange, it is where many of the risks and opportunities reside. From timeline pressures to title structure, due diligence concerns, and related-party rules, what you do next can determine whether your exchange stays on track or runs into trouble.
The best way to navigate these complexities? Start early, stay informed, and rely on a team of experienced professionals including your qualified intermediary, CPA, attorney, and real estate advisor.
Thinking about a 1031 exchange? Feel free to call me, Jeff Peterson, at 612-643-1031, or email me at jeffp@CPEC1031.com.
Defer the tax. Maximize your gain.
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