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This article examines a single, simple, forward real estate exchange under Section 1031 and the basic issues it raises. A client, Erica, is exchanging a single real property (relinquished property) for a single real property (replacement property) in a deferred exchange. The transaction is a "deferred exchange" in the sense that she transfers the relinquished property first and acquires the replacement property later. Practically any domestic real property that is investment property potentially will qualify for a like-kind exchange -- either as relinquished property or replacement property. Before a client becomes involved in a like-kind exchange, the advisor should ask why he or she wants to do so. When selling the Bakersfield apartment house, Erica's advisors should be sure to include a like-kind exchange cooperation clause in the purchase and sale agreement. If Erica decides to dispose of the Bakersfield apartment house in a deferred like-kind exchange, she will need an exchange intermediary.

Many articles have been written-including many by this author-about the complicated problems of big, complex taxfree exchanges. The discussion below examines a single, simple, forward real estate exchange under Section 1031 and the basic issues it raises.

Properties of an exchange

Your client, Erica, is exchanging a single real property ("relinquished property") for a single real property ("replacement property") in a deferred exchange. The transaction is a "deferred exchange" in the sense that she transfers the relinquished property first and acquires the replacement property later. The relinquished property is a small apartment house in Bakersfield, California. The replacement property is a small motel in Kaanapali, Maui.

Erica needs to exchange relinquished "property held for productive use in a trade or business or for investment" for replacement "property of like-kind which is to be held either for productive use in a trade or business or for investment" if she is to avoid gain under section 1031.1 Property satisfying this test can be called "investment property." Erica likely will recognize gain in the exchange if she receives both investment property and nonqualified property as replacement property, but the transaction still can be partially nontaxable.

Practically any domestic real property that is investment property potentially will qualify for a like-kind exchange-either as relinquished property or replacement property. The most important types of real property that usually will not qualify for exchanges are "dealer property" (held for sale in the ordinary course of a trade or business) and "personal use property" (owned for a client's own personal use or for the personal use of his or her family). Section 1031 technically excludes: "(A) stock in trade or other property held primarily for sale, (B) stocks, bonds, or notes, (C) other securities or evidences of indebtedness or interest, (D) interests in a partnership, (E) certificates of trust or beneficial interests, or (F) choses in action."2

Dealer property typically involves subdivided real property or property constructed for sale.3 Dealers typically have frequent and recurrent sales of real property. Even nondealers who hold property primarily for sale will not qualify under section 1031. This might include someone who acquires real property with the intention of promptly selling the real property in an exchange.

Personal use property includes homes, vacation homes, ski lodges, lake cabins, and the like that the taxpayer or his or her relatives use. Problems can be posed by vacation homes held partially for rental and partially for personal use, and by property that may have been zoned or subdivided. These problems are difficult, and so are beyond the scope of this article.

The tax laws will not allow a partnership interest or an interest in a limited liability company (LLC) to be used either as relinquished or received property. If an exchange involves a distribution of real property from a partnership or LLC, a contribution of real property to a partnership or LLC, or a like-kind exchange of real property by a partnership or LLC, there will be additional tax issues. These partnership exchange issues are difficult, so they, too, will be left to other articles.

The like-kind exchange rules are xenophobic. A taxpayer is not allowed to exchange property in the United States for property located elsewhere in the world-not in Paris, not in Baghdad, not in Mombassa, not in Timbuktu. Real property located anywhere in the United States, though-in any of the 50 states or in the District of Columbia-may be exchanged for real property located anywhere in the United States. If a client is exchanging relinquished property in one state for replacement property in another, the advisor must make sure to check local state tax laws. A good like-kind exchange for federal income tax purposes sometimes is taxable under state tax law.4

Within the United States, the like-kind exchange rules are liberal. Improved real property (land with buildings on it) can be exchanged for undeveloped land-or the reverse.5 A taxpayer can exchange farm property for industrial property, or an office building for an apartment house. Taxpayers sometimes can exchange conservation easements, mineral interests, timber interests, air rights, leases, and more exotic real property interests for other real property interests. Such exchanges, however, are complicated.

Critical to a good exchange is that the relinquished property and replacement property constitute real property under state law and that both the relinquished property and the replacement property qualify as investment property.

Consider whether the relinquished property qualifies as investment property. If Erica simply operated the Bakersfield apartment house as a normal business for more than two years, it should qualify as an investment property. She may have made major improvements to the apartment house within two years of sale. Investment status then may be a bit greyer. She may regularly acquire apartment houses, improve them, and resell them within several years. Her status as an investor then is decidedly grey. Be careful to counsel a client on the status of relinquished property as investment property. The client or a family member may be living in the relinquished property, or may have done so within the past two years.

Deferral

The owner of the Maui motel might be persuaded to accept Erica's Bakersfield apartment house in a true trade-theoretically. There is, however, a limited market for true exchanges that trade deeds. (This article will consider only land and improvements and will ignore any incidental personal property.)

It might be more convenient to be able to sell Erica's Bakersfield apartment house and then to use the proceeds to acquire the Maui motel. The tax laws are not completely accommodating. They do not permit a sale of the relinquished property, receipt of the cash, and then reinvestment of those proceeds in relinquished property without recognizing taxable gain. Through a curious turn of history, however, the like-kind exchange rules permit taxpayers, through the cooperation of a "deferred exchange intermediary" (hereinafter "intermediary"), to accomplish this result, albeit with some inconvenience and appropriate payments to the intermediary.

A deferred exchange typically involves a sequence of events like this:

* Erica signs a purchase and sale agreement with the purchaser of her relinquished property-the Bakersfield apartment house. Her purchase and sale agreement includes a robust like-kind exchange cooperation clause.

* Shortly before closing the sale of her Bakersfield apartment house, she signs a deferred exchange agreement with her intermediary.

* Also shortly before closing the sale of her apartment house, she assigns her purchase and sale agreement for the sale of the Bakersfield apartment house (and any escrow, if she is using an escrow) to her intermediary, and gives her buyer notice of the assignment.

* Her sale of the apartment house closes with a deed from her to her buyer.

* All cash from the sale of her apartment house is disbursed to her intermediary. The cash (the "exchange balance") stays with her intermediary and is invested by him or her pending its use to acquire the Maui motel.

* The closing statement for the sale of her apartment house lists the intermediary as the seller.

* Within 45 days after the sale of her apartment house, she identifies up to three replacement properties. The identification is made by legal description (photocopying the legal description from a title insurance report). She signs the identification and faxes it to the intermediary. One of the three identified replacement properties is the Maui motel.

* She signs a purchase and sale agreement for the Maui motel with its seller. The agreement includes a robust like-kind exchange cooperation clause.

* Shortly before closing her purchase of the motel, she assigns the purchase and sale agreement for the motel (and any escrow, if one is used) to the intermediary and gives the seller notice of this assignment.

* Shortly before closing on the motel, the intermediary funds Erica's purchase of the motel with money from the exchange balance.

* Erica's purchase of the motel closes with a deed from the seller to her.

* The closing statement for her purchase of the motel lists her intermediary as its purchaser.

* Erica acquires fee title to the Maui motel within 180 days after her transfer of the Bakersfield apartment house or, if earlier, on the due date-with extensions-of her tax return for the year in which the like-kind exchange began (the "exchange period").

* She receives any remaining exchange balance from the exchange of the Bakersfield apartment house after the first to occur of these events: (1) receiving all the replacement property that she identified, or (2) the end of the 180-day exchange period.

All of this sounds simple enough. Several somewhat imprecise rules of thumb can be used to determine whether Erica will avoid gain in a like-kind exchange. The taxpayer usually will avoid recognizing any gain in a like-kind exchange if he or she both:

* Receives replacement property with a fair market value (ignoring any liabilities) equal to or greater than the fair market value (ignoring any liabilities) of the relinquished property.

* Reinvests the net amount of cash from the exchange balance (the net cash from the sale of the relinquished property in the first part of the exchange) in replacement property.

That all sounds simple as well. Professional exchange intermediaries are readily available to help complete deferred exchanges. They provide form paperwork that allow a taxpayer to do little more than fill in the blanks. Most of their customers no more than skim the paperwork. Intermediaries' apparent charges are surprisingly modest.

Good exchange?

Before a client becomes involved in a like-kind exchange, the advisor should ask why he or she wants to do so. There are many bad reasons why Erica might want to exchange the Bakersfield apartment house. One of the worst reasons would be that the market has risen and she thinks she will to get a particularly good price (one that she never imagined possible). Bakersfield is not the only place in the country where property values have risen. There also can be inflation in Maui. Erica must have a good idea why she will to be better off with the Maui motel (which she may have visited once) than the Bakersfield apartment house that she has known and loved for years.

Even more caution is necessary if she does not know what replacement property she will trade for in exchange. Does it make sense to exchange the Bakersfield apartment house essentially for a black box that she does not know at all? If Erica's purchaser will be "overpaying" for the apartment house, why will she not have to "overpay" similarly for replacement property?

There is a breathless exhilaration-like the feeling of the Matterhorn ride at Disneyland-that a client feels when offered more than he or she thought possible for the property to be relinquished. That sense of exhilaration may end when he or she starts shopping for replacement property. It typically is difficult to find acceptable replacement property. Many taxpayers contract to sell their relinquished property at a time when they have barely a notion of what their replacement property might be. That is not good practice.

The advisor should consider alternatives to a like-kind exchange and investigate whether they can meet a client's objectives. Erica, for example, may simply need cash. If so, she could consider refinancing her loan on the Bakersfield apartment house, or perhaps a second mortgage. Managing the apartment house may be too much work for her, in which case she could consider hiring a property manager. Other possibilities are a long-term lease of the apartment house to a master lessee, contributing it to an up-REIT partnership, or a taxable sale. In any event, Erica's accountants should run pro forma computations of her tax liability on a taxable sale of the apartment house to provide a critical baseline for deciding how important a like-kind exchange may be.

Coming to terms

When selling the Bakersfield apartment house, Erica's advisors should be sure to include a likekind exchange cooperation clause in the purchase and sale agreement. Most exchange cooperation clauses are absurdly naïve. Some are satisfactory. A few are robust.

This is a common, nebulous clause that provides little guidance:

Buyer agrees to cooperate with Seller, at no cost or liability to Buyer, should Seller elect to sell the property as part of a like-kind exchange under Section 1031. Seller agrees to indemnify Buyer from any cost or liability on account of its cooperation.

The clause does not clarify at all what it means for buyer to "cooperate." Cooperation rarely comes at absolutely no cost or expense. The clause says nothing about a like-kind exchange intermediary. It is not clear whether buyer or seller judges whether the cooperation is adequate or what cooperation is appropriate. Cooperation under the clause could involve the buyer taking title to replacement property. Whether the clause provides enough detail to be interpreted or enforced is a matter of conjecture.

This is a simple exchange cooperation clause that provides a little more specificity concerning the obligations that it creates:

Exchange Cooperation. Buyer, at its option, may close the transfer of the Bakersfield Apartment House as a like-kind exchange of Bakersfield Apartment House qualifying under section 1031 of the Internal Revenue Code of 1986, as amended. If Buyer so elects to close the transfer of the Bakersfield Apartment House as a like-kind exchange, then (i) Buyer may delegate its obligations to pay the Purchase Price and assign its rights to receive the Bakersfield Apartment House under this Agreement to a deferred exchange intermediary ("Intermediary"); (ii) such delegation and assignment shall in no way reduce, modify or otherwise affect the obligations of Buyer pursuant to this Agreement; (iii) Buyer shall remain fully liable for its obligations under this Agreement as if such delegation and assignment shall not have taken place; and (iv) Intermediary shall have no liability to Seller, notwithstanding such delegation and assignment.

This is a somewhat more specific clause:

Tax Deferred Exchange. Buyer and Seller agree that either party (the "Exchange Party") may assign its interest in this Agreement to an exchange intermediary for the purpose of completing a like-kind exchange which will qualify for treatment as a tax deferred exchange pursuant to the provisions of Section 1031 of the Internal Revenue Code of 1986 (a"1031 Exchange"). The other party (the"Cooperating Party") shall provide reasonable cooperation requested by the Exchange Party in implementing the 1031 Exchange. This cooperation shall include the execution of any necessary documentation in connection with the 1031 Exchange and/or payment of the Purchase Price to an intermediary identified by Seller. This cooperation shall not subject Cooperating Party to any additional liability beyond its existing obligations under this Agreement. The Exchange Party shall reimburse the Cooperating Party, upon demand, for any increased expense incurred by the Cooperating Party relating to this 1031 Exchange. Cooperating Party shall not be obligated to take title to any property, other than the Bakersfield Apartment House, in the case of Buyer. A like-kind exchange shall not delay the Closing. The accomplishment of the 1031 Exchange is not a condition to the Exchanging Party's obligations under this Agreement. The Exchanging Party's failure to locate an exchange property or to consummate a like-kind exchange for any reason or for no reason at all (other than on account of Cooperating Party's material breach of this Agreement) shall in no way relieve the Exchanging Party of its obligations under this Agreement.

To keep the like-kind exchange simple, no deposits or payments on the Bakersfield apartment house should be received outside of escrow. If deposits outside of escrow are received, they should be replaced before closing. They may be assigned to the intermediary.8

Intermediary matters

If Erica decides to dispose of the Bakersfield apartment house in a deferred like-kind exchange, she will need a exchange intermediary. There are basic issues to consider in selecting an intermediary:

* Will the intermediary steal the client's money?

* Will the intermediary lose the client's money?

* Will the intermediary charge too muchparticularly through hidden charges?

* Does the intermediary demand unreasonable indemnifications and indemnities?

* Do the intermediary's documents fail to comply with tax requirements?

Not surprisingly, intermediaries universally will answer "no" to all of these inquiries. Experience proves that there often is reason for skepticism.

Few intermediaries have much in the way of net assets. The typical intermediary has practically no assets other than customer exchange balances. Some intermediaries are owned by large financial institutions, but they normally are shell subsidiaries. If the intermediary subsidiary became bankrupt, the parent corporation might or might not make good on the intermediary's obligations to customers. Only occasionally do intermediaries have substantial balance sheets.

There are real economic risks in selecting an intermediary. Some have stolen exchange balances. Some have misinvested exchange balances, and those balances have disappeared. Some have become bankrupt. Some have disappeared. No one seems to know precisely how many intermediaries have become bankrupt or otherwise have lost exchange balances. In fairness to the industry, the level of disappearing exchange balances appears to have been surprisingly low-thus far. There is no assurance that this will continue.

It is hard to imagine an industry that could prove more attractive to aspiring criminal talent than the intermediary business. Organized crime thus far appears diverted by prostitution, drugs, pornography, gambling, and more traditional criminal endeavors, and appears not yet to have diversified into the intermediary business. Some organized crime members perhaps already have diversified into the business and are merely cultivating customers. They may be waiting for exchange balances to build up before they spirit the funds off-shore to a hundred numbered bank accounts of as many shell corporations. The compromise of even a moderate-sized intermediary could produce an incredible bonanza for organized crime-enough to finance a regal retirement in a country that does not have an extradition treaty with the United States. The intermediary industry is such fertile ground for criminal activity that it is difficult to imagine its remaining unplowed by organized crime-or perhaps not-so-organized crime. When shopping for an intermediary, be wary of finding one who takes a cue from "Pirates of the Caribbean" ("We extort, we pilfer, we filch, and sack.... Maraud and embezzle, and even highjack").

Recent history shows that even some large corporations can be subject to pillaging and imprudent investments by owners, executives, and employees. Even large banking institutions have suffered embarrassment from an inability to meet their liabilities. One could imagine what would have happened if Enron had had an intermediary affiliate. In retrospect, it may be remarkable that Enron did not have an intermediary affiliate. No intermediary is completely immune to the possibility of loss of funds.

If a client undertakes a small exchange and does not much mind losing his or her exchange balance, there may be no need to worry much about which intermediary to use. Otherwise, the most important aspect of selecting an intermediary involves investigating its financial reliability. For large exchanges, consider an institutional intermediary with a strong guarantee by the group parent (or an asset-rich affiliate), plus using either cash in an exchange escrow or an exchange trust. For smaller exchanges, be sure to use a strong intermediary, ideally with cash in an exchange escrow or an exchange trust. Use an unknown, small intermediary only if the client does not care much whether the exchange balance is lost (and then: "Drink up, me 'earties, yo ho").

Other security issues. The regulations permit the use of standby letters of credit and mortgages of property as security for exchanges.7 These devices rarely are practical, and rarely are used in like-kind exchanges.

Some intermediaries offer fidelity bonds underwritten by insurance companies. The coverage of these fidelity bonds usually is limited to employee theft of funds. An advisor must understand the fidelity bond's limitations if he or she is relying on a fidelity bond for a client.

Coming to terms with intermediaries. Security should predominate in selecting an intermediary. Interest on an exchange balance also is important. The advisor may need to discuss interest with a number of intermediaries. Try to find an intermediary willing to quote a fixed fee and to let a client keep all of the interest. Try to find an acceptable rate of interest, but in all events find an intermediary willing to specify high-reliability investments as the only permissible investments of exchange balance. There is an extraordinary reluctance among many intermediaries to set forth in one number what a client is being charged for their services. The advisor needs to overcome that reluctance-or figure out for him or herself how much the intermediary is charging.

Common myths too often control in reviewing exchange agreements. One is that large, experienced intermediaries have good documentation that has stood the test of thousands of transactions. Another is that an intermediary's documentation meets all tax requirements. Intermediaries' form documentation is often replete with faults. Read it skeptically. Do not accept the faults.

Intermediary documentation tends to be as protective of the rights of exchangers as the printed contracts in tiny type on parking lot parking receipts are protective of the interests of those parking their cars.6 Intermediary-drafted exchange agreements tend to go overboard on indemnifications of intermediaries and are less expansive in defining the intermediary's duties and responsibilities. The poor quality of many intermediary agreements-even the form agreements of some large institutional intermediaries-is disappointing. Never accept an intermediary's form exchange agreement (or other documents) without careful review.

Things to look for in reviewing an exchange agreement include:

* What does the exchange agreement require the intermediary to do?

* What is the intermediary's nominal fee?

* How is interest computed?

* How much money is the intermediary making on the interest spread between what the intermediary receives and what the intermediary pays the client?

* Does the exchange agreement specify how the exchange balance will be invested?

* Does the intermediary have the power to resign?

* Does the exchange agreement limit rights "to receive, pledge, borrow, or otherwise obtain the benefits of" the exchange balance as required by Reg. 1.1031(k)1(g)(6)."9

* What are permitted charges against the exchange balance?

* Is the arrangement guaranteed? By whom? Precisely what is guaranteed and what is not? Are there conventional waivers of guarantor defenses? Are guarantee payments made on an after-tax basis?

* Is the like-kind exchange secured by escrowing the exchange balance or placing the exchange balance in a trust? Has the intermediary pledged its interest in an escrow or trust to secure its obligations under the exchange agreement?

* Does the exchange agreement provide that if the client has not identified replacement property by the end of the 45-day identification period, the client may receive the exchange balance after the end of that period (ending on the 45th day after transfer of the relinquished property to its purchaser)?10

* Does the exchange agreement provide that the client may receive any remaining exchange balance after the end of the 180-day exchange period?11

* Does the exchange agreement provide that the client may receive any remaining exchange balance upon receipt of all of the replacement property to which he or she are entitled under the exchange agreement?12

* Does the exchange agreement provide that the client may receive any remaining exchange balance on "[t]he occurrence after the end of the identification period of a material and substantial contingency that... (1) Relates to the deferred exchange, (2) Is provided for in writing, and (3) Is beyond the control of the taxpayer and of any disqualified person (as defined in paragraph (k) of this section), other than the person obligated to transfer the replacement property to the taxpayer"?13

* What are the indemnifications and waivers of liability? Does the intermediary accept full responsibility for acts of its employees? For failures of its internal custody procedures? For failing to follow the exchange agreement? For failure to follow investment instructions?

* Do other parties (e.g., sellers of replacement property) have to agree to indemnify or hold harmless the intermediary?

* Is there a liquidated damages provision? If the intermediary loses or purloins the exchange balance, are the client's damages limited to a nominal liquidated damages amount?

* Does the exchange agreement describe the intermediary as the client's agent?

In short, what does the agreement ask the intermediary to do? The agreement should clearly set forth the intermediary's responsibilities and duties, requiring the use of reasonable care in the exercise of its duties. The obligations of the intermediary should not be eliminated through an indemnification agreement or a hold harmless agreement.

Do not focus solely on the intermediary's nominal fee. Consider how much the intermediary is making on retained interest. The ready availability of exchange intermediaries, their friendliness, and their apparent prosperity says something about the intermediary business. Intermediaries make money on exchanges. In fact, they can make lots of money on exchanges. Most intermediaries take a cut of the interest on the investment of the exchange balance. Some take half of the interest earned; others take all of it. Some intermediaries keep all of the interest for a specified number of days and let the client keep the interest earned after that. Some pay interest at a contractual interest rate and are entitled to invest the exchange balance however they will-letting the intermediary speculate with the money and earn the interest arbitrage. Some intermediaries deposit exchange balances with bank affiliates, which make money on relending the money at higher rates than they pay on their deposits.

Depending on the size of the like-kind exchange, intermediaries can make enormous amounts on interest arbitrage. In one recent exchange, an intermediary stood to make hundreds of thousands of dollars on the interest spread between what it received in interest on investment of the exchange balance and the amount that it paid to its customer. That is a high exchange fee. The advisor will want to maximize the client's interest return, not the intermediary's return, with the minimum risk on investment.

If the intermediary retains interest, determine how much. This effectively is an additional fee that the intermediary receives and the client does not. Shop around for an acceptable rate of return, adjusted by the investment risk. The intermediary should be limited to investing in a small class of specified high-reliability investments. He or she should not have the legal right to speculate with a client's exchange balance in kumquat futures or Iranian war bonds. He or she ought not lend the exchange balance to nonbank affiliates for speculative adventures-perhaps a wildcat drilling project in the Amazon. The client should not be entitled under the exchange agreement to receive actual payment of any interest until the end of the likekind exchange.14

The intermediary should have no power to resign as intermediary. If he or she insists on a power to resign, insist on getting a new intermediary. Resignation of an intermediary should invalidate the like-kind exchange.

The intermediary exchange agreement should provide that the client cannot receive, pledge, borrow, or otherwise obtain the benefits of the exchange balance as provided in Reg 1.1031(k)-1(g)(6). This means that, if the client decides to receive cash rather than replacement property, or if there is a remaining exchange balance, the client cannot receive the exchange balance until the like-kind exchange is over. As a practical matter, the exchange agreement should not permit the client to receive remaining exchange balance until after the end of the 45-day identification period if the client does not identify replacement property, until after he or she receives all property identified, or until after the expiration of the 180-day exchange period.

The intermediary exchange agreement also should clearly set forth permitted charges against the exchange balance. This should include reasonable out-of-pocket costs of acquiring replacement property and the intermediary's permitted fee. The agreement should not unreasonably burden the exchange balance with the intermediary's incidental costs.

The advisor may be using the unusual intermediary that has hundreds of millions or billions of dollars of its own assets. If so, he or she should not have to worry about a parent or affiliate guarantee. If not, get a guarantee if an asset-laden affiliate or parent is available. If that parent or affiliate is unwilling or unavailable, consider providing for the exchange balance to be held in a qualified escrow or a qualified trust. If the intermediary refuses to cooperate with guarantees, trusts, or escrows, consider the client's willingness to lose the exchange balance. If that creates no problems, it may be fine. If not, a different intermediary should be considered.

Many intermediaries offer all sorts of bonds. These bonds usually offer protection for only a limited class of calamities.

The regulations permit an exchange balance held by an intermediary to be secured in an exchange escrow or an exchange trust.18 A good exchange escrow or exchange trust might make a small intermediary competitive with an institutional intermediary. Do not simply accept the intermediary's form exchange escrow language or its exchange trust language. Also, consider whether it is possible to perfect a security interest in the intermediary's rights to any distributions or reversions from the trust or escrow.

If a parent or affiliate guarantee is relied on, the financial condition of the guaranteeing affiliate or parent must be investigated. Some institutional intermediaries have prepared guarantees that they make available as part of their exchange document packages. These guarantees are sometimes referred to as "Swiss cheese guarantees." Most guarantee something, but are filled with holes. Compare one of these guarantees to a typical bank form guarantee. The flaws should be readily apparent. "Swiss cheese guarantees" make a pleasing sound when run through an office paper shredder. The author has had good luck in finding large intermediaries willing to negotiate more reasonable guarantees that will stand up to standards of normal commercial transactions and to bankruptcy laws. Make sure to have the parent's guarantee reviewed both as to commercial law and bankruptcy law. It is hazardous practice to undertake a large exchange transaction-even with a large exchange subsidiary-without a strong, commercially reasonable guarantee (by an asset-laden parent or affiliate) if the intermediary does not have sufficient credit to justify trusting him or her with the exchange balance. Intermediaries' form guarantees rarely meet the "commercially reasonable" standard.

Cash back. The regulations are explicit about when the client can cash out of the likekind exchange if the exchange is not completed. These rules apply when cash is left over. The intermediary exchange agreement should "provide that if the taxpayer has not identified replacement property by the end of the identification period, the taxpayer" may receive the exchange balance after the end of the 45-day identification period, but no earlier. The agreement also should permit the client to receive any remaining exchange balance in cash after receiving all exchange property identified, and to receive any remaining exchange balance after the end of the 180-day exchange period.

As spelled out above, Reg. 1.1031(k)1(g) (6)(iii)(B) allows receipt of any remaining exchange balance on the occurrence (after the end of the identification period) of a "material and substantial" contingency that "(1) relates to the deferred exchange, (2) is provided for in writing, and (3) is beyond the control of the taxpayer and of any disqualified person other than the person obligated to transfer the replacement property to the taxpayer." Some exchange agreements mirror this language without specifying any material and substantial contingency. There is a danger in doing so. Good practice requires that the exchange agreement or a simultaneous writing set forth an objective, material, and substantial contingency. Although this is not expressly required by the regulations, it may be implicitly required. Using the substantial contingency language without specifying the contingency at the time the exchange agreement is executed creates the possibility that a contingency might be specified at a later date-perhaps even after the expiration of the identification period. This ability might cause the client to be in constructive receipt of the exchange balance at the beginning of the likekind exchange.

Indemnity. The intermediary's indemnifications should be reviewed skeptically. Some indemnifications are drawn so broadly that it is not clear whether the intermediary has much liability to perform under the agreement. The intermediary should have absolute responsibility for its own breaches and for the misadventures of its employees or agents. The intermediary should have absolute responsibility for its internal custody procedures and absolute liability for thefts by its employees. It should not have liability for the performance of investments if it puts money in investments selected from an approved list. It should be indemnified from liabilities and claims arising from the relinquished or the replacement property, except where those liabilities and claims proximately relate to its breach of the agreement.

Some intermediary exchange agreements limit the intermediary's liability to the amount of its stated fee. This is absurd and should be unacceptable. Read literally, these agreements would permit the intermediary to run off with a client's exchange balance and then have liability only for its intermediary fee. Intermediaries also should have liability for any damages resulting from their breach of the exchange agreement. Liquidated damages provisions should be unacceptable.

Some exchange agreements describe the intermediary as the taxpayer's agent. It is not clear that this description serves any good purpose. This language could create nebulous authority for the intermediary to act on a client's behalf.

Other matters

The exchange agreement, the exchange escrow agreement, and the exchange trust agreement are the key pieces of exchange documentation. If they are acceptable, the advisor is a good way toward documenting a client's forward exchange.

The advisor must identify the correct "taxpayer" who owns the Bakersfield apartment house. Erica may own it directly, in which case she is the "taxpayer." She also will be the taxpayer if she owns it through a single-member limited liability company that is treated as a disregarded entity for tax purposes. She will not be the taxpayer if she owns it through a partnership, and may not be the taxpayer if she owns it through an irrevocable trust. The exchange agreement should be signed by the correct taxpayer, as should identification notices.

The client's interest as seller in the purchase and sale agreement (and also the escrow, if any) for the relinquished property should be assigned to the intermediary prior to closing. The assignment should be a simple document. Be careful that the intermediary does not insert new indemnification obligations into this document. Also be careful that it does not require the buyer of the relinquished property to indemnify or to hold harmless the intermediary. At most, the buyer should give a covenant not to sue the intermediary. There is no good reason for the assignment to contain any indemnifications. Indemnifications should be limited to those in the exchange agreement. The intermediary should rely exclusively on those.

When the like-kind exchange of the relinquished property closes, all of the cash to the seller should go to the intermediary or to an exchange trust or exchange escrow serving as security for the intermediary's exchange obligations. The exchange balance should not be disbursed to the taxpayer. The intermediary should be shown as the seller on the escrow closing statement. The taxpayer will directly convey title to the relinquished property to the buyer without the intermediary taking title to the relinquished property.

Replacement property must be identified (or acquired) within 45 days after closing the transfer of the relinquished property. (The Service's apparent position is that the 45-day period is not extended for weekends and holidays. This period will not be extended by the IRS on application for relief. The period can be extended for Presidentially-declared disasters.) The most common identification rule permits the taxpayer to identify up to three replacement properties and acquire one, two, or all three.16 Other identification rules permit taxpayers to identify an unlimited number of replacement properties. One such rule allows identification of an unlimited number of replacement properties so long as the fair market value of the identified replacement properties is no greater than 200% of the fair market value of the relinquished property. Another rule permits an unlimited number of identifications so long as the fair market values of the replacement properties acquired are at least 95% of the value of those identified.

Identify only a percentage interest in the replacement property if the plan is to acquire a tenancy-in-common interest in a replacement property.

Identify replacement property in a signed identification notice that clearly identifies property as replacement property. Unambiguously describe the replacement properties. Use either street address or legal description. Be careful that the identification has no typographical errors. Be particularly careful that the street address is correct and complete. Many owners do not know the correct street addresses of their properties. This is particularly a problem with multifamily housing projects. It is possible to identify replacement property by name, but that is a more dangerous technique. Sign the identification notice. Hand deliver, mail, telecopy, or otherwise send it before the end of the identification period (the 45th day after transferring the relinquished property). Be careful not to miscount the number of days and send the identification the day after the identification period expires. There are other alternatives, but the best practice is to send the identification notice to the intermediary. Keep a record that proves when the identification notice was sent. Do not backdate a late identification.

For a simple exchange, do not ask the intermediary to fund option payments or deposits for the replacement property out of the exchange balance. Have the client pay option payments or deposits from his or her own funds. It may be possible to use the exchange balance for this purpose, but using exchange balances for replacement property deposits makes the like-kind exchange more complicated, and so beyond the scope of this article.

Include a robust exchange cooperation clause in the purchase and sale agreement for the replacement property that clarifies the duties of the parties and permits the client to close the acquisition of the replacement property as a like-kind exchange.

Assign the purchase and sale agreement for the replacement property to the intermediary prior to closing. Make sure that the assignment does not create unreasonable indemnifications of the intermediary. There is no particular reason for the assignment to contain any indemnifications, and the intermediary should rely on the indemnifications contained in the exchange agreement. Make sure the assignment does not require the seller of the replacement property to indemnify or to hold harmless the intermediary.

The intermediary should fund the escrow for closing the replacement property prior to closing. Instructions should provide that the funds (or any excess funds) will be returned to the intermediary if not needed for closing. The escrow should show the intermediary as the purchaser of the replacement property.

The purchase of the replacement property closes with a deed from the seller to the client. No deed goes to the intermediary. The closing statement for the purchase of the replacement property should list the intermediary as its purchaser. There may be remaining funds from the exchange balance. These funds should be returned to the intermediary if the client has identified more than one replacement property.

Acquire title to the replacement property within 180 days after the transfer of the relinquished property. If the due date of the client's tax return (with extensions) falls before then, the 180-day period is cut short. Seek an extension of the return filing date. The apparent position of the IRS is that the 180-day period is not extended for weekends and holidays. Nor will the IRS extend it on application for relief, though it can be extended for Presidentially-declared disasters.

The client may receive any remaining exchange balance and any interest that the intermediary has agreed to pay as provided in the exchange agreement. This should happen after the completion of the like-kind exchange-after the client has received all identified replacement properties or after the end of the 180-day exchange period.

If possible, make sure the client knows what he or she is trading for before contracting to sell the relinquished property. Many taxpayers expose themselves to tortures reminiscent of the medieval rack when they first sell their relinquished property and then start looking for replacement property. It can be desperately difficult to find and acquire acceptable replacement property. That replacement property must be identified within 45 days of selling the relinquished property. That is a short time. The taxpayer who first sells relinquished property and then looks for replacement property is living dangerously.

Conclusion

With that, the exchange should be successfully completed. Erica should be ready to recline on the beach at Kaanapali sipping guava juice in an iced glass with a parasol.