What Investors Need to Know About Exchange Funds

Posted on: June 22, 2007

Misunderstanding the restrictions on exchange funds can be a costly learning experience. We want you to have familiarity with IRS restrictions to help you avoid frustration and get the most out of your property exchange. While much exchange law is “gray,” there are some very rigid rules about the care and handling of exchange funds.

Exchange funds can be used to pay for all typical and ordinary closing costs, only.

This includes commissions, title insurance, recording fees, closing fees, etc. The funds can be used to make earnest money deposits for the replacement property.

Exchangers can pull cash from their sale.

If they elect to do so they must receive the cash before the exchange begins. This money will be taxable to the Exchanger, thus reducing the benefit of an exchange, but it does not eliminate the opportunity to do an exchange. The Exchanger is essentially doing a “partial” exchange, which must be discussed with their tax advisor. An alternative approach might be to leave all the cash in the exchange, sink it into the replacement property and then refinance the replacement property after the exchange to pull the cash out. While the IRS has taxed a refinance that occurred before the exchange, refinancing after the exchange should be a non-taxable event.

Exchangers cannot pull cash out during the exchange.

In a recent case the entire exchange failed due to mishandling of the exchange funds – checks cut to the exchanger, escrow refunds delivered to the Exchanger instead of the exchange company, etc. There were multiple purchases in the exchange and the court disallowed even the one good purchase that took place before the misbehavior began.

Funds cannot be delivered to the Exchanger until there is a technical termination event.

This was reiterated in a private letter ruling issued in 2000. The earliest termination event is on the 45th day when the Exchanger fails to identify replacement property. The latest termination event is on the 180th day. There are a few other possible termination events in between those dates but it is clear from the private letter ruling and treasury regulations that termination does not occur when your client decides they want to be done with the exchange. Nor does a termination event occur when your client experiences a financial setback and needs the funds to live on.

Funds can be used to make improvements to replacement property.

It is important to know that the work must take place within the 180 days of the exchange and before the Exchanger becomes the owner of the property.

Learn what security the exchange company offers to protect your client’s exchange funds.

Exchange companies are an unregulated industry. While the funds are in their accounts the funds belong to the exchange company, not your client. Working with a company that offers security will bring your client peace of mind. Ask about the level of bonding, errors and omissions coverage and whether there is a deep-pocket parent company.

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 investor, please call our Portland Office (503) 223-3911 or (888) 310-1031.