Section 1031 of the Internal Revenue Code is a powerful tool that real estate investors can use to defer paying capital gains taxes when selling properties. The proceeds from the sale of an investment property won’t be taxed when they will be used to buy a like-kind piece of real estate.
Generally, 1031 exchange properties don’t include pieces of real estate that were not intended for business purposes. However, there’s a way to convert an investment property into personal use without paying any tax after holding it for some time.
With an expert team of accounting and legal professionals, you can execute a 1031 exchange flawlessly and reap its benefits. But the reality is often strange. Careful planning doesn’t eliminate all uncertainties that can cause your transaction to fall apart.
Below are some of the surprise problems that can hinder an otherwise smooth 1031 exchange:
The Value of Replacement Property Increases
When you find an attractive investment property to buy, it’s wise to close as soon as possible to minimize your expense. The longer it stays on the market, the more expensive it can become.
If you need funds to buy the replacement property, you will need to sell a relinquished one first before you can pull the trigger. In this case, your fate depends on the buyer of your property.
Without adequate liquidity, you might be doomed to wait, to allow weeks and months to slip by, and to potentially pay more than you wish to acquire the replacement property you like.
Of course, the property’s value can also decrease. But if it’s desirable enough to attract a lot of suitors, you will feel the pressure to close quickly.
The Buyer Backs Out
A fickle buyer can have a change of heart at the last minute. Since you can’t execute a 1031 exchange with yourself, your investment plan can crumble if the other party defaults.
This can be a significant concern if you have no other offer on the table. Although you won’t incur any loss yet, you may fail to maximize the profit potential of the replacement property you’re eyeing if its price goes up.
The Buyer Needs More Time to Close
Sometimes, the other party might ask for an extension to close the deal. This can be a disadvantageous development when you already committed to buying a replacement property at a particulate date.
You’ll be in luck if you’ll be allowed to adjust your scheduled closing day. The seller can begin entertaining other buyers or even worse, decide not to deal with you because you failed to deliver. Choosing a buyer with inadequate liquidity will render this predicament a high probability.
None of these surprises is pleasant, but you should anticipate all of them right from the start no matter how unlikely they seem to happen.
To ready yourself for such curveballs, strongly consider a reverse 1031 exchange. It can be trickier than the traditional 1031 trade, but it’s worth pursuing if your situation calls for it.