The fourth key to success in 1031 exchanges is to make sure an actual exchange takes place. Tax-deferred exchanges differ from a sale and a purchase in several important ways. Listed below are the distinguishing characteristics of an exchange and how they differ from separate purchase and sale transactions.
- The first difference is the way in which the property value is transferred. If the property is temporarily converted to cash that is available to the taxpayer, the IRS considers the transaction indistinguishable from a sale and disqualifies the transaction from being an exchange. The funds must be held by a third party (such as a Qualified Intermediary) under strict conditions. The taxpayer cannot have constructive use of or access to the funds at any time during the exchange.
- The sale and purchase transactions must be interrelated. Merely having two transactions occur simultaneously or at nearly the same time is not sufficient. The Purchase and Sale Agreement, escrow instructions, and other documentation must be specific in stating that one property is to be exchanged for another like-kind property. When using a third party Qualified Intermediary (QI), the documentation on both the sale side and purchase side of the exchange should reference a common QI. In a direct swap with another party, the exchange must be reflected in the title transfer.
- The taxpayer must sell property that is owned for property that is not owned. While this sounds simple enough, situations can occur where a taxpayer might want to exchange property for other property held through a business or entity in which the taxpayer has an interest or other disqualifying relationship. Proceeds from a sale usually cannot be used to improve a separate property (i.e. a piece of raw land) also owned by the exchanger. Simply put, a taxpayer may not trade with him/herself.