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Common Exchange Problems

The procedures for doing a tax deferred exchange using a qualified intermediary are deceptively easy to follow. However, while it is easy to mechanically complete the exchange, there are substantial pitfalls, to be avoided.

The following is a list of common problems we incur in facilitating exchanges.  The list is by no means complete.  It is intended to alert taxpayers to some of the more common problems.  We strongly advise all taxpayers to consult with their tax adviser prior to entering into an exchange.

Common Exchange Problems

1.  The taxpayer who sells relinquished property must acquire replacement property.  If husband and wife exchange out of property they must both acquire the new property.

2.   Designating a property as replacement property and then acquiring less than all of the property.  For instance, if a taxpayer and another party acquire replacement property, they will each acquire an interest
in the replacement property.  If the entire property has been designated as replacement property and you only acquire a partial interest in the property, the designation may not meet IRS requirements.

3.   A failure to designate replacement property within 45 days of the date of disposition of the relinquished property.  If you fail to designate replacement property in writing within the 45 day time period, the entire exchange will fail.  It is imperative that you properly designate replacement property.  This obligation cannot be delegated unless you have had a power of attorney prepared and given someone else the authority to designate foryou. DO NOT RELY UPON ANY THIRD PARTY, INCLUDING YOUR REAL ESTATE AGENT TO DESIGNATE FOR YOU.

4.   Holding back loan funds to allow the use of all exchange funds for acquisition of replacement property. If you intend to borrow  additional funds for use in constructing improvements on the replacement property after acquisition, you should consult with your tax advisor prior to closing.  Borrowing excess funds and instructing your lender not to disburse those funds at closing to allow you to use all exchange funds in the acquisition of replacement property may result in subsequent taxation.

5.   Instructing the closing agent to escrow funds at closing to be used to pay a contractor for work on the replacement property after acquisition may result in those funds being taxable.  The IRS treats all funds expended for you at closing as though you had taken possession of those funds and paid them to the parties paid at closing.  Any funds escrowed or paid at closing will result in taxation of those funds to the taxpayer if they are used to pay any non-exchange expense such as construction expenses incurred by the taxpayer on replacement property.

6.   Exchanging out of or into a personal residence.  The exchange property must be investment property or property held for use in a trade or business to qualify under Section 1031.  A personal residence does not qualify for exchange under Section 1031.