Specific Rules Apply to 1031 Deferred Exchanges
Posted March 15, 2006

Dear Joan:

 My wife and I are planning to sell an apartment building we have owned for the past ten years in Idaho, which has had a substantial appreciation. We have visited Maui a number of times and we would like to purchase a condominium in Kaanapali for investment, and one to live in. We are considering doing a tax-deferred exchange under Section 1031 of the Internal Revenue Code. We understand the basic mechanics of these exchanges and want to know if there are any tips you can give us.

 Signed,

Goodbye Winter—Hello Sunshine

 Dear Sunshine:

 It sounds like you’re doing your homework, which is wise when making any financial decision. Here are you a few things to add to your checklist.

 In doing a 1031 tax-deferred exchange the IRS allows you to sell your appreciated investment property (your apartment house in Idaho) and replace it with property of “like-kind” (the Maui condo you want to purchase as an investment), which will need to have a fair market value that is equal to or greater than the fair market value of the relinquished property. If the IRS believes you followed all of their rules on this exchange, you will defer having to pay capital gains tax on the sale of your apartment house.

 Now for some more homework: the first thing is consult with your attorney, accountant and/or tax or legal advisors. Give them the details of your plan and ask for their advice concerning the risks inherent in a deferred exchange and their opinion on the amount of money the exchange may help you defer. If you decide to go forward with the exchange, have them review all documents before you sign them. This step comes under my personal “Better Safe than Sorry” theory of real estate transactions.

 You will need to select another independent third party, besides your escrow officer, who will be operating on your behalf to ensure that the exchange is handled correctly. This person is commonly referred to as an Exchange Accommodator, Facilitator or Qualified Intermediary. This Accommodator will work closely with your escrow officer to make sure all documents are properly signed and completed on the dates required.

 Before selecting an Accommodator I would get some information from them. Ask if they are bonded, their fees, and if the money from the sale of your apartment building will earn interest while you are looking for your replacement property. The fees and/or the lack of interest are sometimes surprises to people doing exchanges and none of us like surprises when it comes to money (“No Surprises” comes right after “Better Safe than Sorry”).

 Although it is a rare occurrence, there have been incidents where an Accommodator has taken off with millions of dollars that had been given to them to hold for exchanges. Make sure you are working with a reputable firm. If your Accommodator begins asking what you think of Brazil in the summer, choose someone else.

 As a side note, if you do a reverse exchange—which is buying the replacement property before you actually close on selling the apartment house—the fees can be substantially higher than on a regular exchange. Again, doing your homework up front is best.

 There are some specific rules for 1031 Tax Deferred Exchanges that I want to mention. You have 45 days from the day the property you are selling records to the date you need to give your accommodator a written list of possible replacement properties you have identified. You have 180 days from the same recordation date to close on your new property. If you don’t meet these dates, you no longer have an exchange and the Accommodator is required to return the money they are holding on your behalf.

 Maui is fortunate in that it has many experienced real estate agents that are familiar with 1031 Exchanges and understand the critical timing involved with doing an exchange. You’re not the first couple who want to hang up their skis for a surfboard. If you take your time, and prepare carefully, everything should work out fine and you’ll be on the beach this winter instead of shoveling snow in Idaho. Hawaii has a withholding requirement for all sellers who do not live in the state but are residents of the United States. This withholding requirement, known as the Hawaii Real Property Tax Act or HARPTA, is designed to enforce the payment of Hawaii state income taxes on the sale of Hawaii real estate by nonresidents. It is a five percent withholding. There are exceptions for totally tax deferred and partially tax deferred 1031 exchanges. This is another question to ask your financial advisors.