The Two Party Swap and The Simultaneous Exchange
When two parties have properties of equal value and want to trade or swap properties, they can proceed with the transfer without the use of a Qualified Intermediary. The tax risk is low as long as an experience escrow officer sets up the settlement statement correctly. If the properties are of unequal value, or in different counties and/or states, the use of a Qualified Intermediary is recommended and can even be set up as a simultaneous exchange.
In a Simultaneous Exchange, the old (“relinquished”) property and the new (“replacement”) property are transferred concurrently. Exchangers involved in such an exchange without the benefit of a Qualified Intermediary may risk losing the tax deferred status of the transaction if not handled properly. The key here is the numbers of parties involved. If there are three or more parties involved the use of a Qualified Intermediary to facilitate the transaction is extremely valuable. (If done between only two parties, it is considered a Swap.)
The escrow closer cannot hold the funds from a seller and expect to receive the tax-deferred treatment. The Tax Court in Keith K. Klein v. Commissioner, 66 T.C.M. 1115 (1993), has determined one simultaneous three party exchange as a fully taxable sale. Mr. Klein's closing escrow instructions simply assigned his rights to the proceeds from the sale of his property directly to the second closing for the purchase of his Replacement Property. The Tax Court stated that Mr. Klein had unrestricted control over, and thus the receipt of the funds in his transaction. Klein argued that the provision in his earnest money agreement stated that the buyer would cooperate in structuring a tax-deferred exchange. He felt that the funds in escrow were already assigned to the seller of the Replacement Property and thus he had no control over the funds. The Court indicated that the cooperation clause would not control the constructive receipt issue. Unwary investors who do not utilize a Qualified Intermediary may be surprised to discover their transaction does not qualify for tax deferral.
Using a Qualified Intermediary involves the insertion of a fourth party that coordinates the transfer of ownership to the proper entities and insulates the Exchanger from constructive receipt issues on the sale proceeds. The Qualified Intermediary becomes the accommodating party, thus protecting the Exchanger, buyer and seller. Although the Qualified Intermediary does not hold any proceeds in a simultaneous exchange, they are in control of the flow of the exchange funds thus removing the constructive receipt of the funds from the Exchanger, which is essential to creating the safe harbor, required by the IRS. |
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