What Is Not Allowed in a 1031 Exchange and How to Avoid It

A 1031 exchange can be a powerful tool for real estate investors, allowing them to defer taxes on the sale of a property and reinvest the proceeds into a new one. However, there are strict rules that govern what is and isn't allowed in a 1031 exchange.

You can't use a 1031 exchange to avoid paying taxes on personal property. This includes items like art, jewelry, and collectibles. Personal property is not considered a like-kind exchange for real estate.

To avoid any issues, it's essential to understand what is eligible for a 1031 exchange. This includes investment properties, such as rental properties, raw land, and even some types of business property.

Stock in trade or other property held primarily for sale is not eligible for 1031 treatment. This includes property held for sale to customers in the ordinary course of a taxpayer's trade or business.

Stocks, bonds, or notes are also excluded from 1031 treatment. Although certain transactions involving these assets may qualify for tax deferral under other sections of the Internal Revenue Code, none of them qualify for 1031 treatment.

Interests in a partnership are not eligible for 1031 treatment. This exclusion was added to the Internal Revenue Code in 1984.

Certificates of trust or beneficial interests are not considered real property and therefore do not qualify for 1031 treatment.

Choses in action, which are rights to recover or receive money or other consideration, are also excluded from 1031 treatment.

One of the biggest challenges in a 1031 exchange is dealing with personal use property, which is not allowed. This includes vacation homes, personal residences, and even timeshares.

You can't use a 1031 exchange to buy a vacation home, even if you plan to rent it out. For example, if you own a rental property that you also use as a vacation home, you may be considered to be using it for personal purposes, which would disqualify it from a 1031 exchange.

The IRS has strict rules about what types of property can be exchanged, and personal use property is not allowed. This includes property that is used for personal entertainment, such as a beach house or a ski lodge.

Some countries' banking systems don't utilize an escrow structure, making it impossible to use Qualified Escrow accounts to hold exchange funds.

This can be a major issue, especially if you're trying to navigate a 1031 exchange with foreign property. Different QIs have different procedures when it comes to holding funds during a foreign exchange.

Financing an acquisition through a foreign lender can present difficulties and may take time. Several nations now have their own versions of the U.S. Patriot Act, which grants the power to restrict or prohibit the transfer of money into or out of the country.

Currency conversion rates can affect the value of the funds as they are moved back and forth. Exit taxes or limits on currency remittance can also be a problem in some countries.

If the exchange is taking place entirely in one country, it's possible for exchange funds to be held in that country during the exchange. However, this requires careful planning and compliance with both local and U.S. 1031 rules.

In countries without the types of accounts typically used for 1031, it's still possible to hold funds in an account that abides by local rules and U.S. 1031 rules. But it needs to be done right, and an experienced QI is crucial in these situations.

Missing deadlines can be a major challenge in a 1031 exchange. You have 45 days from your closing to identify the replacement property, and if there is more than one property in your exchange, the 45 days begin from the date of the first closing.

You must have properly identified any replacement property in the 45-day identification window to meet the 180-day deadline to complete the acquisition. This is a crucial rule that many investors overlook.

A Qualified Intermediary (QI) is essential in ensuring your compliance with the IRS rules on 1031 exchanges. They call the play, and their role is to ensure your compliance with the complicated rules.

Working with a professional QI is vital, especially if they are owned by a large national title company like Fidelity Title or Chicago Title. This ensures their expertise and dedication to 1031 exchanges.

Don't rely on attorneys who offer QI services as a "sidebar" - it's not worth the risk.

One invalid exchange method is selling the relinquished property to a related party, such as a family member or business partner, as this is considered a disallowed transaction.

You can't sell the relinquished property to a related party, as this can lead to tax consequences and potentially disqualify the entire exchange.

The IRS defines a related party as anyone with a direct or indirect interest in the property, including family members, business partners, and certain entities.

Related parties can include family members, such as spouses, parents, children, and siblings, as well as business partners and entities with a shared interest in the property.

Any sale to a related party is considered a disallowed transaction and can't be used as part of a 1031 exchange.

Cash transactions are not allowed in a 1031 exchange, which means you can't use cash to buy a replacement property.

You can't use a 1031 exchange to buy a primary residence, only investment properties qualify.

Personal property, such as art or collectibles, is not eligible for a 1031 exchange.

You can't use a 1031 exchange to buy a vacation home or a second home that you plan to occupy.

A 1031 exchange can't be used to buy a property that's been held for personal use or enjoyment, such as a family home or a vacation home.

The replacement property must be a like-kind property, which means it must be a business or investment property.

You can't use a 1031 exchange to buy a property that's not used for business or investment purposes, such as a personal residence or a property held for personal use.