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Consequences of Failed Like-Kind Exchanges

Also known as a 1031 exchange, a like-kind exchange is a transaction that allows for the disposal of an asset such as a business, rental property, vehicle, among others, and the acquisition of another replacement asset without generating a current tax liability from the sale of the first asset.   This transaction gets reported on IRS Form 8824.  It is important to note, exchanges involving personal-use property, securities, and inventory cannot qualify as like-kind exchanges.  Although this concept of “swapping” can be easy to understand, there are many parameters that must be followed in order to receive this tax treatment, and the consequences of failed like-kind exchanges can put you in a terrible jam.

When exchanging real property, the tax on your capital gain can be excessive as it could fall between 20-30% of the purchase price minus selling price.  That is why taking advantage when possible on a like-kind exchange, where you can avoid paying taxes on the sale of property, is not something you want to miss out on.   As you can imagine, there are many IRS rules that govern this exchange, and they are never static.  In order to take full advantage of a 1031 exchange your best bet is to hire a tax attorney so you can fully understand what your optimal options are.  In addition, only a lawyer will be able to represent you in tax court in case you fall into trouble with the transaction.

Among the biggest ways a like-kind exchange could go wrong involve not adhering to the timing rules.   First, you must be aware that from the sale of the initial asset the clock starts running for you to designate in writing what replacement asset you intend to purchase with the exchange.  The deadline for that is 45 days.  The second timing restraint is the 180 day deadline.  This rule states that people have only 180 days from the day of sale of the old property to close on a new replacement property.   There are no exceptions to either deadline; therefore, it is important to move fast and in particular have financing firmed up, if needed.  Finally, be aware that many investors get stumped by these two deadlines because they think that the 180 day rule applies after the 45 day deadline, which is not the case.  The clock starts ticking the day of closing, and if for example you happen to designate replacement property at day 25, you only have 160 days to close on the replacement property.

Another tricky area is the handling of the proceeds on the sold property.  Namely, you are not allowed to handle the funds in any manner, rather they should be deposited with an intermediary such as an escrow holder until the replacement property is ready for purchase.  If you deposit the funds from sale – even the full amount – into a personal account, you may trigger tax consequences.  Therefore, if you plan on doing a 1031 exchange some forethought and planning is absolutely necessary, which highlights the next important point:  this exchange cannot be set up after closing on the property.

Other areas that can cause troubles in these transactions include the considerations of mortgages or other debts on the properties being exchanged.  In some instances gains can be recognized which trigger tax consequences.  Another tricky area is doing a like-kind exchange on vacation homes.  Furthermore, the various parameters governing these IRS statutes, including the fact that every so often the rules do fluctuate, is reason enough for you to have a trusted tax attorney on your team if you plan on taking full advantage of a like-kind exchange.

At Dallo Law Group, we have extensive experience in 1031 exchanges.  We can help you avoid all the pitfalls and fully explain your options.  We can also clarify your tax liability under different scenarios and clarify what portion of your tax could be deferred.  More importantly, our professionals have the background to represent you in front of the IRS in case you are placed in the collection process due to a failed like-kind exchange.  Finally, you can reap the benefits of leveraging and increasing your cash flow for reinvestment purposes through this tax area, and Dallo Law Group can lead you through the steps.  Give us a call at our main Downtown San Diego office (619) 795-8000 to discuss your tax benefits when considering this exchange.