MONEY MATTERS: Tax-deferred exchanges -- pitfalls to avoid

By Stephen H. Berardi

The Daily Record Newswire

One of the best tax breaks available to real estate investors and businesses are the nonrecognition provisions outlined in section 1031 of the tax code. Generally, this code section provides that gain is not recognized when property held for investment or for productive use in a trade or business is exchanged for "like-kind" property (the replacement property).

If cash or property that is not like-kind ("boot") is received in addition to the replacement property, the amount of the gain is limited to the fair market value of the "boot". However, investors must be careful to avoid the many pitfalls that exist if a like-kind exchange is not structured properly. Some of these issues are described below.

Failure to identify property

Identifying a property for a like-kind exchange must be done properly in order for the transaction to qualify as a tax-deferred exchange. Most exchange companies (known as qualified intermediaries) provide a sample form for use in identifying potential replacement properties. Some of the common errors made in completing the identification of replacement property statement include failing to have a spouse sign the statement or failing to note the purchase is for only a percentage of the exchange property.

Limiting exchanges to one person

Initially, all exchanges were two-party exchanges. In 1979, following a court ruling, the IRS changed the regulations to allow for the utilization of qualified intermediaries. This permitted the property owner, through the intermediary, to offer the property to any interested buyer.

Different property types

For the purposes of section 1031 exchanges, all real property is considered like-kind with all other real property as long as the properties are held either for investment or business use.

Investment or business use

An important rule to be observed is that the properties in the exchange must be held either for investment or business use, but not for both. With proper planning, however, this limitation can be overcome. Another rule to observe is to avoid an immediate sale of the received property because the IRS may take the view that in such a case, the property was held primarily for sale rather than for investment.

Missing a deadline

The strict time deadlines often associated with a section 1031 exchange is the most difficult aspect of these exchanges. An investor has 45 days from the date the relinquished property closes to identify a replacement property and 100 days (or the tax filing deadline, whichever comes sooner) in which to close on the identified property. The time deadlines are not extended for weekends or holidays.

Consult with your advisors

It is always a wise decision to consult with your tax advisor during the planning stages to be sure the transaction you are considering is appropriate for your particular tax situation. For example, an investor who has incurred losses from other business transactions may not always receive the most favorable tax treatment by using a tax-deferred exchange. In addition, special rules apply to like-kind exchanges made with related parties, either directly or indirectly.

Other specific issues relating to like-kind exchanges can be resolved with the help of your tax advisor and an experienced qualified intermediary.

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Stephen H. Berardi, CPA, is a principal at Mengel, Metzger, Barr & Co. LLP and can be reached at (585) 423-1860 and SBerardi@mmb-co.com.

Published: Tue, Feb 21, 2012