Four Complications That Can Arise During A 1031 Exchange
Are you about to complete a 1031 exchange? A 1031 exchange is the ideal way to exchange properties of one type -- such as a residential home for another residential home -- without having to pay capital gains tax on the proceeds of the first sale. But it's also a fairly complicated financial transaction that you need to work out ahead of time. It involves selling the first property, having the funds transferred to escrow and then purchasing another property at the same time.
Not Notifying Escrow of Your Intentions
Your escrow company -- and your real estate agent -- must be aware of the 1031 exchange from the very start. If they are not, you could run into significant problems. In order to qualify for a 1031 exchange, you can't ever be in possession of the funds. If the 1031 exchange transfers the money to you or sends a check to you -- which they may do if they don't know that you're completing an exchange -- you will no longer qualify.
Having the Purchase Fall Through
What happens if the purchase of your new home falls through? You need to find another property. The escrow company will hold the funds for you for some time, but you will only have six months to complete escrow -- and escrow generally takes 45 days. For that reason, it's usually a good idea to make an offer on multiple properties, on the contingency that one must fall through before the other becomes valid. (In this situation, you'll often be a backup offer rather than a primary offer, but it can still be useful.)
Having the Sale Fall Through
If the sale of your first home falls through, you will often have to delay the process of purchasing the second home. In fact, you may need to cancel it entirely if the seller does not want to wait. Sometimes you can offer the seller money in good faith to hold the home for you, but other times you're going to have to start back at the beginning of the process. For that reason, you should always accept at least two backup offers when selling your home.
Not Exchanging Like Kind Properties
To qualify for a 1031 exchange, the two properties need to be "like kind." You can't exchange a rental property for a residential property, nor can you do the opposite. This will not cause you to encounter issues during escrow but instead during your later tax payments, when you will be required to pay tax in full for the transfer.
Many of the complications which arise during a 1031 exchange occur because the timing is so tight. To properly qualify, you generally have to close on the second house within 180 days. But that's not always true. You can apply for an extension if the process runs longer than it should. Your escrow agency can help.
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