Ten Stupid Things Smart People Do To Mess Up Their Tax-Deferred Exchange Part 1

Posted on: June 21, 2007

Toija J. Beutler, Esq., Sr. Vice President/NW Regional Manager of Investment Property Exchange Services, Inc. (IPX1031), shares with us ten ways exchanges fail to produce the tax savings investors desire. This list has been posted as a two-part series with points 10 through 6 explained in this blog post.

10. Investors fail to get “replacement” debt. Good news for the IRS! All Exchangers understand they are supposed to reinvest the cash from the sale into the replacement property. Few Exchangers (or their tax advisors) know that they also have to “reinvest” their debt. For example, if they sell a property and pay off a mortgage of $75,000, they must acquire replacement property also encumbered by a mortgage of at least $75,000. If the Exchanger only reinvests the cash into a free and clear property the IRS will tax them on the “debt relief” they experienced when they paid off the mortgage on the relinquished property. This is not a happy outcome for an Exchanger who thinks they have a perfect exchange because they spent all their cash. (There is one small exception to this rule relating to cash “added in” to the exchange.)

9. Investors fail to meet the identification requirements. Let me count the ways… there are so-o-o many ways to mess up the identification requirement. The requirements are quite simple. Most exchange companies provide a one-page form with three lines on it. The Exchanger simply fills in the lines with street addresses (including city and state) of three target properties and signs the form. Seems pretty easy.

Just a short list of common mistakes: they fail to have their vacationing spouse sign; they copy the wrong street number; they leave off the city and state; they fail to note that they are buying only a percentage of the property; they fail to provide floor plans for projects currently under construction; they squeeze six properties onto the three lines; etc.

Unfortunately, what would appear to be a minor procedural requirement has major implications for the exchange. After midnight of the 45th day there is no way to correct these errors. The IRS does not play nice with taxpayers who pull the old identification out of the file and slip in a new one. A small, small mistake can result in complete failure of the exchange.

8. Investors think they cannot do an exchange if they are buying a smaller property. There will be a tax bill, but… For example, the investor is selling a rental house in the city for $200,000 and has found a rental house in a resort location valued at $175,000. Sometimes “partial” exchanges can be beneficial. Yes, they will pay tax on the $25,000 differential. Still, depending on the gain in the relinquished property there may still be some tax-deferral (the whole point of §1031 exchanges) from the reinvestment into a smaller property. Investors must consult with tax advisors to determine if a partial exchange makes sense for them. (See Number 4, below)

7. Investors think exchanges only work if they are swapping properties with someone else. Not since the Starker case. Historically this is the way all exchanges were structured. Ivan Investor owned a property in the city. Fred Farmer owned a property in the country. Ivan wanted Fred’s property. Fred wanted Ivan’s property. The two swapped deeds and each deferred payment of their capital gain taxes.

The Starker case changed history. In that case the Supreme Court ruled that there could be a delay between the time of the sale and the time the replacement property is acquired. Subsequent to Starker, Treasury Regulations were issued creating other acceptable exchange structures – including the use of Qualified Intermediaries (QI).

Now Ivan and Fred do not have to swap with one another. Using a QI, Ivan can sell his property at the best price to Betty Buyer and purchase from Fred. Fred using the same, or a different, QI will sell to Ivan and buy a better-priced property from Reasonable Ron. Tax deferral for everyone!

6. Investors think if they sell a duplex they have to buy a duplex. Not true! This is the best news! In exchanges of real property, all real property is considered like kind with all other real property. Exchangers can sell the duplex and buy any other real property that they intend to hold for investment purposes or for productive use in their trade or business. So, residential rental is like kind with commercial. Improved properties are like kind with bare land. Non-income producing is like kind with income producing. This flexibility allows investors to dramatically reconfigure their real estate portfolio and still get the tax deferral.

Click here to read Part 2 of this post.

Article written by Toija J. Beutler, Esq., Sr. Vice President/NW Regional Manager for IPX1031. IPX1031 is a national leader in 1031 tax-deferred exchange transactions and is a wholly-owned subsidiary of the nation’s largest title insurance underwriter. For more information on our services and the value we bring to your real estate investment, please call our Portland Office (503) 223-3911 or (888) 310-1031.