Warning: 1031 tax-free exchanges

There is a new law in California,Washington, Colorado and several other states requiring a Qualified Trust or a Qualified Escrow. Recently a client/friend called and asked if I would intervene in a problem exchange. The exchange had been started and when the taxpayer inquired about his funds they were not with the intermediary, they had been sent to the seller of the replacement property prematurely. There seemed to be some involvement between the intermediary and the sellers of the replacement property. They had interconnected businesses.

The intermediary said he was qualified to do exchanges but did not know of the California law. I declined to get involved. The transaction was illegal. The taxpayer hired attorneys and his funds were finally returned. The exchange failed and the taxes had to be paid. There is a provision for changing intermediaries in the case of their bankruptcy but otherwise it is very difficult.

These laws were put in place to protect taxpayers since a few exchange companies misappropriated large amounts of 1031 funds. We use a Qualified Trust which requires the taxpayer signature before any funds can be withdrawn. The caution for investors is to hire only qualified intermediaries that should be Certified Exchange Specialists as designated by the Federation of Exchange Accommodators.

Some CPAs or attorneys do occasional 1031 exchanges but probably are not aware of the latest laws, IRS rulings and weather extensions which are granted after most hurricanes, fires, tornadoes, floods and other disasters. Typically these four-month extensions can be of great value to taxpayers. Part-time facilitators rarely do all the documents correctly, they are not aware of the flexibility and legal loopholes that exist in Code Section 1031 that can be of benefit to investors.

There has been a resurgence of 1031 exchanges in the past six months due to buyers being able to get loans for homes and commercial properties. Prices have stabilized and are rising in several markets, giving investors a profit which they can move into replacement properties. The capital gains rate may go up in the new near future. The rate had been 25% for many years. It was lowered to 20% and then to 15%. It will probably go to at least 20% and there is talk of eliminating the capital gains rate altogether but most experts don’t believe that will happen. The exchange can be more important for investors in the future if the rates rise. At the 15% level some taxpayers elected to pay the tax but fewer will choose that course in the future if rates increase.

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