As we look back over the past few years, it is very clear that the #1 challenge with 1031 exchanges is not being able to identify appropriate replacement property within the 45 day time deadline.

Clients enter into an exchange with the expectation of completing it and deferring their capital gain taxes, but ended up receiving all their exchange proceeds back on the 46th day with the prospects of paying full taxes for the year. It is not uncommon to see exchange credits returned of $100,000 to $10 million dollars due to not meeting this requirement.

(A) What identification deadline did they miss? (B) What does identification mean? (C) What caused the difficulty? (D) What can you control? (E) What can’t you control? (F) What can you do about this? These are the 6 questions we’d like to respond to in this special article for M5 attendees with special emphasis on the last one.

A) What Deadline Did They Miss?

Internal Revenue Code section 1031 and the accompanying regulations specify that your replacement property must be identified within 45 days from closing on the property that you sold.

B) What Does Proper Identification Mean?

Identification is most frequently accomplished by faxing a simple one page document signed by the taxpayer with the specific addresses of up to three targeted replacement properties. There is nothing difficult about it other than what addresses or legal descriptions to write down. Here is the kicker, if not received by midnight on the 45th day your exchange has ended.

C) What Caused the Difficulty?

We have looked at identification difficulties and observed three primary causes:

1. Finding something of value in a changing market
2. Obtaining the desired property before others do
3. Finding property that would “pencil out” into a profit

D) What Can You Control?

We have observed that the first two causes for not identifying replacement property can be brought within your control. We see enough client’s each year that we know it is possible to overcome these two causes. You just have to start the search process earlier and tie some things up.

E) What Can’t You Control?

We believe that the third cause could be a valid reason to not complete an exchange. In those cases, you should maybe take your proceeds back, pay taxes, and go on with life. From our experience it is usually best to make a good real estate investment decision first, then save taxes, because what you save in taxes can be overshadowed by what you stand to lose in a changing real estate market. Also exchangers that make hurried decisions based solely on saving taxes can end up with properties they regret owning. We’ve seen several of these instances in the past few years. However to some extent you can control this cause also by looking in the right places for properties and not necessarily in the same hot market that you sold in.