UNLUCKY THIRTEEN

(THE COMMON 1031 PITFALLS)

Tax laws continually change.
Check with your tax professional for any updates before you decide to exchange real property.

Pitfall No. 1 ? Failure to use an accommodator in a delayed exchange.

Taxpayer Inquiry: "Escrow sent me the check. Now what do I do with it?"

In a delayed exchange an accommodator must be in place prior to closing on the relinquished property. The accommodator is necessary to prevent the exchanger from having actual or constructive receipt of funds. Treas. Reg 1.1031(k)-1(g)(4). Anyone may be an accommodator unless disqualified by the regulations. Treas. Reg. 1.1031(k)-1(k). The following are disqualified:

1. The exchangers realtor, broker, banker, employee, attorney and accountant may not serve if they have provided services within the last two years.
2. A related party as defined in I.R.C. 267(b) or I.R.C. 707(b), and substituting "10 percent" for "50 percent".

Pitfall No. 2 ? Missing a deadline.

Taxpayer Statement: "Ill start looking for my replacement property after I return from my vacation in New Zealand".

The deadlines begin to run on the date the exchanger transfers the relinquished property to the buyer. The date of transfer will be the date of recording or the date of possession, whichever occurs first.

1. Exchange period ? the exchange period is 180 days or the date the exchanger must file their return (including extensions), whichever occurs first. The exchanger must acquire the replacement property within this period of time. I.R.C. 1031 (a)(3)(B).
2. Identification period ? the exchanger must identify the potential replacement property within the first 45 days. I.R.C. 1031 (a)(3)(B).
3. There is no extension for Saturdays, Sundays, or holidays.
4. If there is more than one relinquished property in the exchange and the sales of the properties occur on different dates, the deadlines area calculated from the date the first sale transaction closes. Treas. Reg. 1.1031(k)-1(b)(2)(iii).

Pitfall No. 3 ? Failure to understand basic rules of reinvestment.

Taxpayer Statement: "Im paying off a mortgage and getting $35,000 cash. I just want to buy a lot for $35,000".

In order to obtain a deferral of the entire capital gain tax the exchanger must:

1. Use all the cash in the exchange account to acquire replacement property, Treas. Reg.1.1031(k)-1(f)(1), and
2. Have equal or greater debt on the replacement property, Treas. Reg.1031(d)-2, and
3. Receive nothing but like-kind property. Treas. Reg. 1.1031(k)-1(f)(1).

Pitfall No. 4 ? Failure to have the appropriate intent.

Taxpayer Inquiry: "How soon can I move into my ($400,000) rental house?

The exchanger must hold the relinquished and replacement properties for:

1. Investment, or
2. For productive use in a trade or business.

Exchange treatment is not available for property held for:

1. Personal use, or
2. Primarily for sale (i.e., builder/developer properties).

With proper intent the following are like-kind:

Residential for commercial

Commercial for residential

Single family for multi-family

Non-income producing for income producing

Bank building for swamp land

Pitfall No. 5 ? Belief that they do not have to buy from the list of identified properties.

Taxpayer Statement: "But this condo is exactly like the one on the list!"

Property will not be treated as like-kind unless properly identified. Treas. Reg. 1.1031(k)-1(b).

The identification must be:

1. In writing,
2. Unambiguous,
3. Signed by the exchanger,
4. Sent to a party to the exchange,
5. Within the 45 days. Treas. Reg. 1.1031(k)-2

The exchanger must comply with the following additional rules:

1. 3 property rule ? the exchanger may identify up to three (3) properties of any value, Treas. Reg. 1.1031(1)-1(c)(4)(i)(A); or
2. 200% rule ? the exchanger may identify more than three (3) properties if the total fair market value of what is identified does not exceed 200% of the sale price of the relinquished property, Treas. Reg. 1.1031(k)-1(c)(4)(i)(B); or
3. 95% rule ? if the exchanger exceeds the 3 property rule and the 200% rule the exchange will not fail if they purchase 95% of the aggregate fair market value of all identified properties. Treas. Reg. 1.1031(k)-1(c)(4)(ii).

Pitfall No. 6 ? Wanting cash out during the exchange.

Taxpayer Statement: "But I have to have some cash to pay off my VISA bill!"

The exchanger can receive funds either before the exchange or after termination of the exchange, but never during an exchange. Exchangers who want money for non-exchange purposes may receive funds directly from the relinquished property escrow. These funds are always taxable, but receipt in this way should not jeopardize the rest of the exchange. Once the accommodator received the proceeds, they may only be used for purchase of replacement property and customary closing costs. If there are "excess" funds I the account, those funds can only be released after termination of the exchange. Treas.Reg. 1.1031(k)-1(g)(6) (i.e. the "g6 restrictions) states the four termination events:

1. The exchanger does not identify replacement property within the 45 days deadline;
2. After the identification period, receipt by the Exchanger of all the identified property to which they are entitled;
3. After the identification period, upon the occurrence of a material and substantial contingency provided for in writing, related to the exchange and beyond the control of the exchanger;
4. Upon the expiration of the 180 day exchange period.

It will jeopardize the entire exchange to release funds during the exchange directly to the exchanger, or for benefit of the exchanger, for something other than replacement property or customary closing costs. Accommodators will not release funds contrary to their exchange agreement and the Treasury Regulations.

Pitfall No. 7 ? Receiving Earnest Money

Taxpayer Statement: "But I havent cashed the earnest money check yet."

The exchanger may receive earnest money from their buyer but it will be taxable. However, receipt of earnest money does not preclude an exchange with the balance of the sales proceeds. Treas. Reg. 1.1031(k)-1(f)(1).

Pitfall No. 8 ? Agreeing to accept a carry-back.

Taxpayer Statement: "Im getting $10,000 down with the balance on contract".

It is always best for the exchanger to have a cash buyer for the relinquished property. A carry-back to the exchanger greatly complicates the exchange. Some of the exchangers options are:

1. Take the note outside the exchange. The note will be taxed on an installment sale basis.
2. Pass the note through the exchange. The note must be prepared showing the accommodator as the beneficiary. The accommodator can use the note in several ways:

a) Assign the note to the seller of the replacement property. This is ideal for the exchanger, resulting in a complete tax deferral. However, the seller does not get installment sale treatment on their receipt of the note.

b) Sell the note for cash and use the cash to purchase replacement property. The exchanger must consider whether a discount, if applicable, exceeds the capital gain tax they would have paid.

c) Sell the note for cash to the exchanger or a friendly party. This arrangement, while not recommended, may be attempted.

d) If Options A, B and C fail the accommodator will assign the note back to the exchanger at the termination of the exchange. The exchanger still receives installment sale treatment.

Pitfall No. 9 ? Buying from (or selling to) a related party.

(Potential) Taxpayer Statement: "I want to buy from my own construction company".

Exchanges may take place between related parties. Mother and Daughter, owning separate properties, may swap those properties with one another. The only requirement is that neither may dispose of their replacement properties within two (2) years of the exchange. I.R.C. 1031(f).

The more typical scenario, however, has Mother, with the use of an accommodator, "selling" to a third party buyer and "buying" from Daughter. It is uncertain whether this can be an exchange for Mother.

Some authorities suggest that the later scenario will fail. I.R.C. 1031(f)(4) disallows related party treatment to "any exchange which is a part of a transaction (or series of transactions) structured to avoid the purposes (of the related party provisions)". Others dispute the applicability of this provision to exchanges where a qualified intermediary is facilitating the exchange. Exchangers should know that related party transactions do present some issues.

Pitfall No. 10 ? Wanting a separate LLC for each investment property.

Taxpayer Statement: "I plan to have a new LLC for my new apartment complex."

Using a new LLC for each investment property does not fit into the exchange format. Exchange rules anticipate that the entity beginning the exchange will be the entity concluding the exchange. The exchangers legal relationship to the relinquished property must be the same as the exchangers legal relationship to the replacement property. The accommodator will generally prepare exchange documentation reflecting the vesting information as shown on the title commitment or title report for the relinquished property.

Pitfall No. 11 ? Dissolving a partnership.

(Potential) Taxpayer Statement: "My partner and I want to sell and go our separate ways".

If a partnership holds real property the partnership may do an exchange. However, partners hold a partnership interest, not an interest in real property, and partnership interests are not exchangeable. Treas. Reg. 1.1031(a)-1(a)(1)(iv). The partners must consider a multitude of issues if they plan to dissolve the partnership and complete an exchange.

Typically the partnership deeds to the individuals as tenants in common. The individuals then execute a deed to the ultimate buyer. The specific issue for the exchange is whether the individuals ever held the property with the proper intent, as an investment or for productive use in a trade or business. The argument an be made that the individuals held the property primarily for sale, which does not qualify for exchange treatment. In Magneson v.C.I.R., 753 F2d 1490 (9^th Cir. 1985) the tax court did allow an exchanger to transfer replacement to a partnership immediately after an exchange.

Pitfall No. 12 ? Wanting to build on property they already own.

Taxpayer Statement: ?I am selling my rental will use the funds to build on my lot at the coast."

Any improvement work on property to which the exchanger holds title will be "goods and services" and not like-kind real property. Treas. Reg. 1.1031(k)-1(e)(4). In order for the construction to qualify for the tax deferral, the regulations require that the work be done before the exchanger takes title. Some Private Letter Rules provide hope for exchangers who must build on such properties. Priv. Ltr. Rul.7823035 (March 9, 1978). Priv. Ltr. Rul. 8304022 (October 22, 1982). Priv.Ltr. Rul 923038, (July 27, 1992).

Pitfall No. 13 ? Purchasing Property, without an accommodator, before selling property.

Taxpayer Statement: "I Just got a buyer for my Washington property and I bought a condo in Hawaii two months ago."

Reverse exchanges, buying before selling, are fraught with legal and practical issues. This taxpayer is hoping for a reverse exchange. Unfortunately they never intended an exchange at the time they purchased in Hawaii, they purchased without an accommodator and they have held both the relinquished property and replacement property at the same time.

There are no Treasury Regulations in support of reverse exchanges and most cases disallow the structure employed by the various taxpayers. Bezdjian V. C.I.R., 845 F.2d 217 (9^th Cir. 1988). One case offers some support. Biggs V. C.I.R., 69 T.C. 905 (1978), affd 632 F.2d 1171 (5^th Cir. 1980). The cases do suggest that:

1. The exchanger must intend to exchange at the time of acquisition;
2. The exchanger may not hold title to both the relinquished property and the replacement property at the same time.

In order to meet these requirements, an accommodator should be engaged at the time of the acquisition. The accommodator will document the exchange intent and hold title to one of the properties. The practical issues are numerous:

1. Additional expense to the exchanger.
2. Security for the exchanger.
3. Liability to the accommodator.
4. Lender concerns.
5. Management of the property held by the accommodator.
6. Timing of the transactions.
7. Meeting the basic exchange requirements. (see Pitfall No 3)