7 Dos and Don'ts for Legal 1031 Exchanges

April 1, 2008

Rochelle Stone and John Mangham of Starker Services Inc. in Los Gatos, Calif., share these tips on how to avoid common legal mistakes in 1031 exchanges.

1. Do know how to count. Like-kind exchange rules allow 180 days to complete the transaction, which includes the 45 days for the identification of a replacement property. Weekends and holidays count, and no extensions are granted, so don’t get it wrong.

2. Don’t assume a second home qualifies for an exchange. Vacation property must be an investment (which means you don’t live there for more than 14 days a year or 10 percent of the time it’s rented) or used in a trade or business to qualify for a 1031 exchange.

3. Do exchange for a property equal or greater in value. If your client exchanges for a property of lesser value, the unspent money will be taxable as capital gains.

4. Do replace your debt. Taking out a mortgage at a lower level during an exchange creates a taxable event. If your clients want a lower mortgage payment, they have to bring cash to the transactions.

5. Don’t ignore recapture. Any depreciation an investor has previously taken must be deducted from the basis of the property before calculating any gain.

6. Don’t forget to set up the exchange before the transaction closes. You need to include a stipulation in the purchase agreement so that the funds from a property’s sale transfer to a qualified intermediary instead of to the sellers during the closing.

7. Do give the buyers and exchangers a refund on any earnest money advanced from their own cash for a property that is later transferred through a 1031 exchange. This refund will come from the intermediary, who will replace the amount with exchange funds.