Monday, March 2, 2009

1031 Tax Free Exchange - The IRS Guidelines

As my Papa would tell me, there are no guarantees in life. Same is true for 1031 Exchanges. You "do" an exchange, declare it on your tax return and hope you don't get audited. And in the unfortunate event that you do get audited, you hope that it passes the auditor's muster.

When you read Section 1031 of the IRS Code (and you should) it will raise your blood pressure, because you'll find that there is very little in there that will help guide you in completing a successful 1031 exchange. It does however do a good job of telling you what doesn't work, which is only mildly helpful.

When the 1031 exchange law was first created, it was interpreted that you needed to acquire the "replacement property" at the exact moment you sold your original property. Yes, that's what I said. You executed the sale documents as you executed the purchasing documents. Yes, lets call that as a practical matter, hummmm, impossible.

Then the IRS auditors backed off their interpretation of simultaneous closings interpretation to mean that the transactions could occur during the same business day. That gave us the ability to drive across town to facilitate the closing, but it wasn't really much help. After a few showdowns at the federal courthouse, we have now some general guidelines, that if followed, the IRS has agreed in principal to not challenge.

That means declaring a 1031 Tax Free Exchange on your returns by some other method than the guidelines could be permissible, but also subject to challenge by the IRS. You win some, you lose some.

So these are the guidelines the IRS wants us to follow;

1) Close your original property and place your proceeds with a Qualified Intermediary (or QI). I'll explain who is a QI later, but the key here is that YOU or someone you can influence can not hold the funds. Many of my clients take issue with not being able to personally hold their proceeds and I don't blame them, but I didn't write the guidelines.

2) Now the fun begins. You have 45 calender days from the date of closing your original property to identify up to three (3) properties as potential "replacement" properties and I want you to know from experience, the 45 days will feel more like 45 seconds. I call this the Identification Period.

3) Lastly, we need to finish the exchange. You have 180 calender days from the date of closing your original property [not 180 after the Identification Period] to purchase one (or more) of the three (3) potential "replacement properties" you identified. You'll do this with the original property proceeds the QI is holding for you. You're done.

Now in the effort of full disclosure, there are a few other options that may fit your needs [such as increasing the number of identified replacement properties] but most exchanges are completed by following these guidelines.

You've undoubtedly noticed that I just introduced a new character into the plot, the Qualified Intermediary (QI). QIs are interesting people who have chosen this narrow alley of tax law in which to reside. I don't think QIs get many Christmas Card, I know I've never sent one.

A QI can be anyone who isn't disqualified. Who is disqualified is someone you could exercise control over, like your banker, your brother-in-law or me, your commercial broker/attorney, the IRS considers us disqualified. And since you're not going to turn your money over to just anyone to hold, there are professional QIs. But be careful. One more time with emphasis; but be careful.

QIs are not regulated. There is no test, no license, nada. They can be ANYONE and that can be a problem. There are QI professional organizations, but they're not mandatory and they don't regulate, but they are nice to list on letterhead.

And while rare, QIs have run-off with their client's money, declared bankruptcy and committed fraud. Are they liable to their clients? Of course, but you can't get blood from a turnip. The QI may go to jail but if the money is gone, it usually says gone.

So what do you do? Ask many, many questions of your QI, including references. The ones affiliated with title companies generally feel the safest. And lastly ask if they are insured or bonded, and then ask for documentation.

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