If the strict timeline and procedural rules are not followed, the 1031 exchange may be disqualified. Also, there is no guarantee that the IRS will approve each individual exchange, nor that tax law will not be altered in the future, nor that the IRS will not change their application of present law to future cases. Finally, the full scope of tax related risks can only be determined in counsel with the client’s personal tax advisor, taking into account all the facts and circumstances of that client’s tax situation and the specific laws of the state where they reside.

What Are the Main Risks of a 1031 Exchange?

A 1031 exchange can defer recognition of some gain only when the transaction satisfies applicable requirements; it does not remove investment, financing, market, sponsor, liquidity, fee, or tax risks. The checklist below highlights questions to review with your qualified intermediary, tax advisor, lender, and investment professionals before proceeding.

Can missed deadlines or identification errors disqualify an exchange?

Yes. In a deferred exchange, the IRS generally requires replacement property to be identified within 45 days and received within 180 days, subject to applicable rules. Missing a deadline or using an invalid identification can jeopardize the intended tax treatment.

  • Confirm the transfer date of the relinquished property and calculate both deadlines with your qualified intermediary.
  • Document the identification in the manner and by the deadline required for the exchange.
  • Ask your tax advisor how the identification and acquisition rules apply to your facts and circumstances.

Source: Internal Revenue Service, Like-kind exchanges; Cornerstone, 1031 Exchange Identification Rules.

What can go wrong after replacement property is identified?

Identification does not guarantee that a replacement property will close or that it will remain suitable. Availability, property-level due diligence, financing, tenant or operating conditions, and offering documents can change before closing.

  • Review the property, leases, debt terms, sponsor information, and offering documents before committing funds.
  • Confirm the transaction schedule, funding requirements, and contingency process with the appropriate professionals.
  • Keep a backup strategy in mind without assuming another property will be available or qualify.

Source: Cornerstone, DST Due Diligence Checklist; SEC, Private Placements under Regulation D.

What financing and sponsor risks should investors review?

Financing and sponsor performance can affect an investment’s operations and outcome. Review leverage, interest-rate exposure, repayment terms, reserves, property cash flow, sponsor experience, conflicts, and the disclosures describing what happens if assumptions change.

  • Read the debt, guaranty, reserve, and fee sections of the offering materials.
  • Ask how changes in rates, occupancy, rents, expenses, or refinancing conditions could affect the property and investors.
  • Review sponsor duties, conflicts of interest, and the process for communicating material developments.

Source: Cornerstone, DST Due Diligence Checklist; FINRA, Private Placements.

Why do illiquidity and fees matter in a DST investment?

A DST investment may be difficult to sell before the sponsor’s planned exit, and there may be no active secondary market. Fees and expenses can reduce the amount available for the property or investor, while distributions and appreciation are not guaranteed.

  • Ask whether transfers are restricted, whether a secondary market exists, and what approval process applies.
  • Review acquisition, financing, asset-management, disposition, administrative, and other disclosed fees.
  • Consider whether the investment horizon and liquidity limits fit your circumstances.

Source: SEC, Private Placements under Regulation D; FINRA, Private Placements.

Can an investor lose principal?

Yes. A 1031 exchange does not protect an investor from a decline in property value, tenant or operating problems, financing losses, sponsor failure, fees, market conditions, or other investment risks. Investors should review the offering documents and consider whether they can tolerate a possible loss of principal.

  • Identify the risks that could reduce cash flow, property value, or proceeds at sale.
  • Review the stated assumptions, material risks, and limitations rather than relying on a projected outcome.
  • Discuss tax, legal, and investment questions with the appropriate qualified professionals.

Source: SEC, Private Placements under Regulation D; FINRA, Private Placements.

Educational note: This checklist is general information, not tax, legal, or investment advice. A qualified tax advisor should evaluate the tax consequences of a specific transaction, and investors should review the complete offering documents and applicable disclosures before making an investment decision. No outcome, distribution, appreciation, or qualification for intended tax treatment is guaranteed.