Why Should Investors Seek Counsel for Real Estate Exchanges?

Deferred real estate exchanges under Section 1031 of the Internal Revenue Code are as common as traffic jams in Southern California.

Your neighbor, your real estate broker or just about anyone you meet on the street, it seems, can advise you about them. They won’t hesitate to tell you how easily deferred exchanges can be done.

You sell your property to an intermediary, “the accommodator,” who will then resell it to your buyer and use the cash to buy replacement property, which he will transfer to you.

So why pay extra for an attorney they ask. Just buy a deferred exchange package off the shelf.

Few investors realize that deferred exchanges are probably the most complicated transactions they will enter into during their lives.

But still, most deferred exchanges are undertaken by investors who have little knowledge of the tax laws, who are advised by neighbors, brokers or accommodators with only a limited knowledge of the tax laws.

The result is that deferred exchanges often are defective from a tax or real estate standpoint--or both.

Almost any deferred exchange should be structured to take advantage of, and to qualify under, Treasury regulations on deferred exchanges. Like most tax regulations, they are extremely complex and filled with traps.

The two clearest requirements in the regulations are that you must designate replacement property within 45 days and acquire the replacement property within 180 days. Hardly anyone forgets these simple requirements. Still, they often are difficult to satisfy.

The tax regulations specify a set of very detailed additional rules that should be met to qualify for non-taxable treatment.

These rules--which are often missed--include detailed requirements on designating replacement property, designating alternative replacement property, revoking designations, securing an exchange agreement, structuring an exchange with an accommodator and receiving cash when an attempted exchange fails to close.

The rules most easily misunderstood concern structuring an exchange with an accommodator. Agreements must be drafted carefully to qualify under the regulations and to give you protection that the accommodator will do what he is supposed to do.

Before you worry about the tax implications, however, you should think about making sure you get paid.

Anyone can be an accommodator. They are not licensed, bonded, insured or regulated in any way. Most accommodators are shell corporations with liabilities almost equal to their assets.

Even though accommodators thus far have an excellent record for performing as expected, there is a substantial economic risk in relying on the unsecured promise of a corporation with small net worth.

When an exchange involves hundreds of thousands or millions of dollars, you should think about how to get your accommodator’s promise properly secured. Several Southern California accommodators already have gone bankrupt or have just disappeared with their clients’ money.

The proposed regulations permit security in the form of specially drafted letters of credit, escrows, trusts, guarantees and pledges of non-cash property. Although some of these arrangements may provide imperfect security that may be set aside on the bankruptcy of an accommodator, they could turn out to be much better than an unsecured promise.

Besides worrying about security, you need to properly structure your contract with your accommodator. A frequently missed point is that your contract with your accommodator must restrict the property that you can receive in the exchange.

Only real property that you will use in your business or will hold for investment will qualify as replacement property for tax deferral under Section 1031. Cash, personal property or real property that you will not hold for business use or investment (called “boot”) is taxable.

Your contract with the accommodator can permit you to receive boot only after any of four events:

--The first is the end of the 45-day designation period if you fail to designate replacement property.

--The second is after you have received all the replacement property that you designated.

--The third is the end of the 180-day replacement period where you have a remaining exchange balance.

--The fourth is after the 45-day designation period upon the occurrence of a written condition that is outside your control (or the control of a related party) and relevant to the exchange transaction.

Many deferred exchange contracts fail to satisfy the regulations. For example, your contract with your accommodator perhaps gives you the right to designate any real property you choose as replacement property. This fails the regulations’ test.

The contract must limit you to acquiring only replacement property that you will hold for a qualifying business or investment use.

Another issue in deferred exchanges is interest.

The tax regulations clarify that it is permissible for you to receive interest on your exchange balance.

There are tight restrictions on when you can receive interest.

Interest can be paid to you on or after the first of any of the four dates on which you can receive boot. If your contract permits you to receive interest prior to that date, you will fall outside the regulations’ safe harbor, and your transaction may be taxable.

You should also be careful in structuring how interest is paid. When your accommodator invests the exchange balance, he should invest in his name and not in your name. Interest payments by the bank first should be made to your accommodator.

At a permitted time, he should pay to you the interest that is provided for under your exchange contract. You should not receive interest payments directly from his bank.

If your property is owned by a partnership, there are an entirely different set of considerations that should be taken in account in structuring the exchange. Special care must be taken if either the property you are exchanging or the replacement property is being contributed to or distributed from a partnership immediately before or after the exchange transaction.

Any partnership undertaking a deferred exchange should seek expert real estate tax counsel.

You may ask yourself: How big should an exchange be before you hire a real estate tax expert to help you with it?

A good test is to ask yourself: Do you want to make sure you are paid in the transaction and is it important for the transaction to be non-taxable?

If the answers to both questions are yes, you should seriously consider seeking representation by a competent real estate tax professional.

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