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1031 Like-Kind Exchange Pitfalls to Avoid - Part II

Previously, we looked at ways that a 1031 exchange can fail due to a taxpayer receiving funds prior to the completion of an exchange. In this post, we examine other common mistakes that can invalidate an exchange.

In 1031 Like-Kind Exchange Pitfalls to Avoid, we examined 1031 exchange practices that could inadvertently cause an exchange to go awry.  Most of those examples pertained to the taxpayer coming into constructive receipt of funds.  Here, we’ll look at a variety of other practices where problems sometimes occur.

1031 Exchange Pitfall No. 7 – Execution of the Exchange Agreement and Identification Forms

Often relinquished property in a tax deferred exchange can be held by co-owners, including spouses.  This is documented differently than an LLC where the spouses are sole members.  In the event of co-ownership, either spouse can make decisions on behalf of the couple and even sign the other spouse’s name.   In other co-ownership arrangements, one co-owner may sign for the group of co-owners.  However in an exchange transaction, it is important to stick to the formalities of each person with an ownership signing all applicable documentation.  Failure to do so will invalidate the exchange.

1031 Exchange Pitfall No. 8 – Identification of a Group of Replacement Properties

Most replacement properties are identified according to the three property rule, meaning that a taxpayer may identify up to three replacement properties, regardless of their value. It doesn’t matter how many of the three properties are purchased, however problems arise when one party doing an exchange wishes to acquire a group of properties that are owned by one seller and sold under one contract.  While there is a temptation to consider the group as one property, there does not appear to be any foundation for identifying them as one property. 

A similar issue arises when a taxpayer wishes to identify a small percentage in a group of properties in which that interest is being sold as a Delaware Statutory Trust (DST).  These are popular with taxpayers who want a good-yielding, secure investment that involves no management headaches.  However, the number of different properties underlying the individual investment are considered separate properties for exchange purposes.  The 200% rule may be helpful in these instances.

1031 Exchange Pitfall No. 9 – Diminution of Exchange Proceeds Due to Prorations

In the case of a non-exchange sale of property, it is customary to give the buyer a credit for partial month’s rent held by the taxpayer as well as the security deposits.  Most practitioners prepare an exchange-related closing statement the same way.  While it makes no difference if the transaction is not part of an exchange, it does make a difference when an exchange is taking place.  More specifically, the taxpayer is retaining the value of the rent and security deposits and thereby reducing the cash received for the exchange account.  In other words, a taxpayer cannot retain these items of income and offset the amount of money going into the replacement property.  The best solution is to pay to the buyer directly for the rent and security deposits and not give a credit on the closing statement.

1031 Exchange Pitfall No. 10 – Notice to All Parties to the Agreements

In a 1031 exchange, the taxpayer assigns his rights for both the sale of the old property and purchase of the new property to the qualified intermediary. Under safe harbor exchange procedures, the taxpayer must give notice in writing to all parties to each contract of the assignment of rights to the qualified intermediary.  In most cases when a taxpayer is dealing with one buyer and one seller, this notification is easily done.  However sometimes there are many buying or selling entities as well as third parties.  I recently reviewed a contract in which the title insurance company was included as a party under the contract.  Care must be taken to ensure that all parties receive such notice, not just the counterparty.  Note, however, that although it is customary to request the counterparty’s signature on this notice of assignment in order to prove compliance should the transaction be audited, the counter-signature is not a requirement.