Education has always been a key component of the like-kind exchange (LKE) industry and frankly, it has always been one of the more enjoyable parts of my job. Despite the fact that the 1031 exchange business focuses on a very narrow part of the tax code, there will always be significant challenges associated with anything that involves the IRS. So for this month's 1031 Tips, I'm stepping back and reexamining the most basic type of 1031 exchange, the simultaneous LKE, also known as the "swap."
The oldest form of exchange, the simultaneous LKE can take on three basic forms:
- Two-party swap format, without the use of a Qualified
A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer.
- Three-party format, without the use of a QI
- Two or three-party format, with a QI
For the purposes of this article, I'll stick to the two-party swap format.
Three-party LKEs can be structured without the use of a QI, but the accommodating party is potentially exposed to liability issues related to property they have little information about. This potential exposure makes three-party LKEs without the use of a QI, a rare (and risky) occurrence.
On the other hand, the two-party swap format represents an exchange in its most understandable and unadulterated form. Structured as a true trade, the ownership transfers must occur simultaneously with care taken in order to account for each property's respective fair market values to ensure tax liabilities are fully deferred. Furthermore, since the two properties don't usually share the same fair market values, cash or other property used as part of the purchase / sale price must be carefully delivered directly to the other party.
The two-party swap is illustrated as follows:
Two-party swaps can be a great way to keep an LKE simple and cost effective. However, what may begin as a simple swap can quickly evolve to suit the circumstances of the seller (exchanger) and / or buyer. It's these variable circumstances that can move the transaction beyond the requirements for a successful LKE. The old saying goes that the devil's in the details, and LKEs are heavily dependent on the proper transaction form. Any deviations from that form can be fatal to the exchange.
Assuming the properties qualify for LKE treatment, the primary threat to the exchange lies in delays. Delays in ownership transfers (or the delivery of cash or other considerations) can have a profoundly negative impact on the integrity of the two-party swap, so proper planning is vital. This planning is especially important if you're involved in a dealer trade-in or a pass-through transaction. In some instances, pass-throughs and trade-ins can fall outside the prescribed format, requiring the use of a QI. In other cases, where the two-party swap format doesn't require the use of a QI, exchangers may choose to involve one in the transaction. In doing so, they add some very important elements to the LKE:
In other words, simultaneous exchanges are legal and valid, but they can expose you to significant liability if they're conducted improperly. The best way to assure that your swap complies with Section 1031 is to begin the planning process by calling a QI. At Accruit, we don't charge any fees to discuss the proposed transaction, and our Exchange Operations team can provide you with an honest appraisal of the transaction's integrity, including whether or not you should use a QI.
Short version: make a call with your QI a prerequisite step in your due diligence process. You won't regret it.