Savvy property investors have been using 1031 exchanges to defer capital gains taxes for over a century. Despite its long history, there are still several common myths surrounding 1031 exchanges. While some of these myths may deter investors from reaping the potential benefits of engaging in a 1031 exchange, others can cause an exchange to fail, leading to potentially significant financial losses. Here is a look at five common misconceptions and the facts you need to know.

1. 1031 Exchanges Are “Not Legal”

While it may sound too good to be true, 1031 exchange transactions are completely legal. They have been established through Section 1031 of the U.S. Tax code and have been successfully used by investors since 1921.  The legality of 1031 exchanges and the rules surrounding them can be found in recent IRS Fact Sheet 2008-18. 

2. Only “Commercial” Properties are Eligible for a 1031 Exchange

While “commercial” properties, such as buildings used for stores and retail are often used in 1031 exchanges, other types of properties are allowed as well. This includes residential rental properties, undeveloped land, and other types of business and rental properties.

3. Your Accountant, Attorney, or Real Estate Broker May Act as Your Qualified Intermediary (QI)

Not only is this not true, falling for this myth could cause your exchange to fail. It is true that you can choose virtually any person or business as your QI so long as they meet the requirements. However, IRS rules require the investor and the QI to have an independent relationship. This means that when selecting your QI, you must ensure you have not chosen an individual who is a disqualified person; They must be a disinterested third party. 

Examples of disqualified people include the investor themselves, relatives of the investor, or anyone who has “acted as an agent” for the investor within the two years prior to the sale of the relinquished property – including your attorney, accountant, or real estate broker. So, while you may choose a professional such as an attorney or accountant to act as your QI, you cannot choose your attorney, accountant, or anyone else who you have worked with during the specified time frame, nor anyone who is currently acting in any other capacity for your transaction.

Some states also have regulations regarding QIs, such as required licensing and insurance, so be sure to check your state’s rules as well. 

4. The Property Received Must be the Same Exact Type of Property as You Are Selling

IRS rules state that a replacement property must be “like kind” to the relinquished property. However, the definition of “like-kind” is broader than you may think. The IRS actually deems any type of real estate in the U.S. to be like-kind to any other type of real estate in the U.S. 

This means that you can exchange a commercial building for vacant land, a storage facility for a hotel, industrial property for a ranch, an apartment building for a Delaware Statutory Trust (DST), and so on. One requirement, however, is that both properties must be “held for productive use in a trade or business or for investment.”

5. A Property Must Be Held for a Certain Amount of Time Before Exchanging It

It is a common belief that you must hold your replacement property for two years before selling it to ensure your 1031 exchange is not disqualified. This belief is based on the IRS “safe harbor” provision stated in Revenue Procedure 2008-16, but technically, the IRS has never stated an exact required holding time.

Holding your replacement property for two years may qualify you for safe harbor and helps ensure your exchange won’t be questioned. However, if an excellent offer comes up before then, the two-year time frame should not drive your exchange and investment decisions.

If you sell in less than two years, the IRS may question you to confirm that you intended to hold the property for productive use in business or trade or for an investment. If you can prove your intent, your exchange may not be disqualified.

Since there are many variables, it is always important to consult with your tax and legal professionals regarding your property holding periods. 

Learn More About the 1031 Exchange Process 

Now that we’ve debunked some of the most common 1031 exchange myths, you may feel a bit more comfortable about exploring your options. To learn more about the 1031 exchange process and whether it might be right for you, schedule a consultation with our team today!