CAN I USE THE PROCEEDS FROM THE SALE TOWARDS A PURCHASE AND IMPROVEMENT OF THE PROPERTY I BUY AS MY REPLACEMENT PROPERTY?

Yes you can!!  This type of transaction is called a "Build to Suit" or "Construction Exchange" or an "Improvement Exchange".  For those bloggers that are familiar with a "reverse exchange", you might be aware of all of the issues in this type of transaction as they are very similar.    Should you want to do a Section 1031 exchange, the taxpayer is not allowed to build on property it already owns.  So---we form an unrelated party to the transaction, also known as a "parking entity".     The correct term for educational purposes is an EAT (Exchange Accommodation Titleholder).  The EAT will then take title to the property, work on the improvements, and then finally convey title to the taxpayer before the expiration of the exchange period.  Sounds complicated?   Well it is, but we try to make it as easy as possible.   

HOW DOES ONE IDENTIFY A PROPERTY IN A SECTION 1031 TAX DEFERRED EXCHANGE?

That is an important question.  The FEA, our trade organization, confirms the statute when they say:  "Potential replacement property must be identified in a writing, signed by the taxpayer, and delivered to a party to the exchange who is not considered a "disqualified person".  A "disqualified person" is anyone who has a relationship with the taxpayer that is so close that the person is presume to be under the control of the taxpayer.  Examples include blood relatives, and any person who is or has been the taxpayer's attorney, accountant, investment banker or real estate agent within the two years prior to the closing of the relinquished property.  The identification cannot be made orally."  At BFES (Bayview Financial Exchange Services) we prepare a form for you to fill out.  Takes all of about 30 seconds to fill it out and either mail it , fax it or e-mail it  to us.  We try to keep the process simple

DOES THE QUALIFIED INTERMEDIARY (QI) ACTUALLY TAKE TITLE TO THE PROPERTY?

Good question.   The Internal Revenue Code says that the taxpayer is supposed to transfer title to the Qualified Intermediary(QI) and then the QI transfers the relinquished property to its Buyer.  When the taxpayer purchases their replacement property, they are supposed to have received it from the QI, who purchased it from the Seller. 

This created a problem in many states, as most states have a transfer tax every time a piece of property is sold.  In the above example, there would be two transfer fees on each side.  That's 4 sets  of transfer fees rather than 2.   That would be very unfair to the Section 1031 Exchange taxpayer.  So-----IRS in its infinite wisdom, when interpreting the Code (fyi--the interpretation of the Code by IRS is called the IRS Regulations), allows the properties to be directly deeded to the appropriate parties.  In other words, it's just like a normal purchase and sale transaction.  The Deed gets transferred from or to the taxpayer directly. No additional transfer taxes necessary.  BUT, and that's a big word, all of the proceeds from the sale must still go directly to the Qualified Intermediary, who must remain completely independent. 

I hope that answers the question.  That's what I do for a living--I run one of the larger QI companies in the world.  For more information on 1031's or similar types of questions, go to the 1031 exchange FAQ's at www.Bayview1031.com.

I SIGNED A CONTRACT OF SALE, BUT HAVEN'T CLOSED YET--IS IT TOO LATE TO DO A TAX-DEFERRED EXCHANGE?

I am happy to report that it is not too late.   As long as the taxpayer has not had a closing and transferred the benefits and burdens of the property that was sold (the relinquished property), a tax deferred exchange (Section 1031 Exchange) can still occur.  If a closing has occurred, it will be too late and that answer still stands even if the taxpayer didn't cash the check they received at closing.

WHAT HAPPENS IF THE TAXPAYER CAN'T IDENTIFY A REPLACEMENT PROPERTY OR CLOSE ON THE REPLACEMENT PROPERTY WITHIN THE PRESCRIBED TIME LIMITS?

You readers are coming up with wonderful questions.   As most of you are aware the taxpayer must identify the replacement property(ies) within 45 days after the sale of the relinquished property and must close on the purchase of the replacement property(ies) within 180 days of the sale of the relinquished property. 

But what happens if the taxpayer is unable to accomplish these requirements in a timely fashion?  The answer is that there are no extensions of time*.  Should the taxpayer fail to identify the replacement property in a timely fashion or not close on the replacement in a timely fashion, the exchange will fail.   

This will result in the taxpayer having to pay their taxes rather than deferring the tax in a completed Section 1031 exchange.   Did you see that *?   O.K. here is the additional statement.  * An extension of time is sometimes given when the President of the United States signs a Presidential Order giving an extenstion--this is sometimes given to areas of the country that were hit by a hurricane or experience an earthquake, etc.  These extensions are rarely given--so don't presume you are going to get an extension. 

You can see a list of current IRS 1031 extensions and alerts here.

MENTAL ACCOUNTING

    A recent article about "Mental Accounting" said that we keep separate running tabs in our minds that help us justify what we spend.  Let me explain:  "Let's say you are headed to a movie.  As you are about to enter the theater, you reach into your pocket and find to your dismay that you have lost your ticket.  You don't have a receipt, so if you still want to see the movie, you have to pay another $10 for a new ticket.  If you are like most people, you would probably think twice.  You may still plonk down the money, but you will now feel that you paid $20 for a $10 movie.  But let's reconstruct the secanrio differently.  You are going to a movie.  As you stand in line at the box office to buy your ticket, you discover that you have dropped a $10 bill on the Metro.  You are disappointed, of course, but would this affect your decision to buy the move ticket?  Again, if you are like most people, you may feel sore about the lost money, but it won't affect your decision to buy the ticket.

Psychologists once conducted an experiment along these lines.  They found that only 46% of those who lost a ticket were willing to buy a replacement ticket, whereas 88 % of those who lost an equivalent amount of cash were willing to buy a ticket.  Since the lost ticket had the same value, their loss should have been experienced in the same way--so why were nearly twice as many people willing to ignore the lost cash but not the lost ticket?"   

OK--Here it comes--"The difference is because of a psychological phenomenon known as mental accounting--and it has enormous consequences in everyday life.  It affects how people spend money and how they save.  It influences how people deal with losses and windfall gains. "    Want the simple definition of mental accounting?  According to the article:  "...People carry around different running tabs in their heads.  You have, for example, an "entertainment account".  Losing a movie ticket and having to buy a second one takes $20 out of your entertainment account when you planned to take only $10. 

Lost cash, on the other  hand, is not charged to the entertainment account--which is why most people don't hesitate to buy a movie ticket after they lose some cash.   This is an interesting subject--I know I personally have thought about not spending X dollars to purchase something, when at the same time, I have over tipped because I thought it was the right thing to do--different tabs--but the same money.

CAN THE REPLACEMENT PROPERTY BE IMPROVED PRIOR TO THE TAXPAYER TAKING TITLE?

This is a complicated subject and is known in many circles as an "improvement exchange" or a "construction exchange".   Title to the property that would become the Replacement Property is taken by someone other than the taxpayer (the investor or business owner who is doing the exchange).  The titleholder taking title in a "construction/improvement exchange" is called an EAT--that stands for Exchange Accommodation Titleholder and they should be completely independent from the taxpayer.  FYI--the QI usually owns the EAT.   

I don't want to get too technical here--suffice it to say that this property would be identified by the taxpayer, as the property they want to purchase as part of the exchange, within 45 days of the purchase by the EAT and must be transferred to the taxpayer within 180 days of the purchase by the EAT.  Meanwhile, during that time period, improvements can be completed and the Relinquished Property sold in order to purchase, the now "improved" replacement property. 

Whew!! I hope I explained this in a satisfactory manner--it is a very complicated subject and transaction.

OBSCURE LAW SCHOOL PLACES GRADS AT TOP FIRMS

The Wall Street Journal had an interesting article on law students trying to find summer law clerking jobs.  This was a very interesting article to me, because I can distinctly remember when I was in law school and went through that excruciating process.  I was very fortunate, in that I obtained a law clerking job at the top law firm in Miami--but I was one of the lucky ones. 

Have you ever heard of the University of Detroit Mercy School of Law ?---Well even if you were a lawyer, you probably would not have heard of that law school.  It seems this particular law school has a wonderful Dean who has set up a system which helps his better students obtain "good clerking jobs".  Let me quote from the WSJ article:  "In the stratified world of law, educational pedigree largely dictates where (law)students will get a look.  Firms want to signal to clients and colleagues that they only hire the best...Nonetheless, a student from a school like Detroit Mercy--firmly in the cellar of U.S.News & World Report's rankings of 184 accredited law schools--hasn't stood a chance at the fancy firms."  Yet the Dean has put his school on the radar screen of some of the better law firms.  How did he accomplish this feat you ask?  He improved the third year curriculum by creating a required set of courses that simulate real-life practice.  "The idea of focusing the curriculum on practice resonated with the lawyers.  In fact, many have long complained that law school devotes too much attention to theory and leaves students unprepared to practice, even as the market demands that firms pay new hires high salaries from day one."  I can only say I think the Dean of this particular law school is on the correct path.  Kudo's to him.

CAN EXCHANGE FUNDS BE USED TO PAY DEPOSITS?

Funds received from the sale of the Relinquished Property CAN be used for a deposit toward the purchase of the Replacement Property.  Usually, you will assign the contract to the Qualified Intermediary (QI) such as Bayview Financial Exchange Services.  The QI, may directly wire transfer the funds they were holding on your behalf to the agent for the party that is selling you the Replacement Property or in the alternative, the taxpayer could pay the deposit out of other funds that they have and then they would be reimbursed from the exchange proceeds.