Steps to ensure a successful "safe harbor" 1031 exchange

The adage "the devil is in the details" could never be more true than when an investor is performing a 1031 exchange. As the details cover a wide range of issues, the investor as well as his or her counsel and CPA all need to be knowledgeable about the steps involved and active in the process to ensure the exchange will be properly executed. Listed below is a summary of significant steps that should be addressed in any exchange. The summary pertains to a delayed or forward exchange though many of the steps also apply to reverse and improvement exchanges, albeit in a different order. Select a Qualified Intermediary (QI). Investors seeking to take advantage of the "safe harbor" provisions of the code must engage a QI or similar entity to facilitate the exchange. An investor should always conduct due diligence on a QI before engaging one to facilitate an exchange. The investor should verify that the selected QI has financial backing, years of experience facilitating 1031 exchanges and solid expertise concentrated in 1031 exchanges. Investors must be especially diligent in their evaluation as QI are not regulated at the Federal level and only by a few states. Qualify the relinquished property. In 1031 exchanges, both the relinquished and the replacement properties must qualify as having been "held for productive use in a trade or business or for investment." Many practitioners forget to qualify the transaction. Whether property is "held for investment" as defined by the IRS is dependent on many factors. The fact that property is being sold at a profit is insufficient in and of itself to establish investment intent. Include cooperation clause in 1031 contracts. IRC 1031 requires that notice of the fact that a contract for purchase or sale is to be assigned to a QI be provided to the other party to the contract in writing before closing. Many advisors recommended that language be inserted in the contract for sale of the relinquished property and purchase of the replacement property indicating that an exchange is to be performed and that the contract is to be assigned to a QI. Identify the tax owner. In most cases, the tax and legal owner of the relinquished property are the same person or entity. However, this may not always be the case. Where for instance the deed to the relinquished property is in the names of three individuals but where the tax returns for the property have been filed for years in the name of the partnership and all actions with respect to the property have been carried on in the partnership name. In the case where inconsistency exists between the legal owner and the tax owner, it is up to the investor's legal advisors to determine which person or entity is the tax owner of the property as the tax owner is the owner with the legal standing to perform an exchange. Special issues for entity exchangers. One of the most common issues in performing a 1031 exchange in today's market concerns the issue of what to do when investors who own property in a multi-member LLC wish to independently exchange their membership interests. One cannot purchase or sell a membership or partnership interest in a tax deferred exchange as such interests are specifically excluded from what is considered qualifying property under the code. If an exchange involves this potential issue, identifying it as an issue as early as possible is important. There are a number of legal and tax issues that arise in connection with converting to TIC ownership and converting to TIC form of ownership does not in itself result in each investor being qualified to independently exchange his or her interest. Especially where the conversion occurs soon before a sale, there may be a risk that the IRS could question whether the tenant in common ownership interest was held with investment intent as required under 1031. To be continued in the April 22nd edition of the New York Real Estate Journal. Pamela Michaels, Esq., is VP of Asset Preservation, Inc., New York, N.Y.