Last week we looked at the basic elements of a tax-deferred exchange as a way of saving tax dollars when we sell investment real estate. We saw that there are identification requirements, and that the entire exchange transaction must be completed within 180 days of the start date.

The purpose of an exchange is to defer payment of taxes to the government, and to use that money to grow your investments. The tax deferred exchange allows the investor to sell one investment and replace it with a more attractive opportunity. Structured properly, this can be accomplished with no tax consequences whatsoever.

This week, we will look at some common pitfalls in an exchange transaction, and see how a recent IRS ruling regarding principal residences may impact future exchange opportunities.

There are a number of issues that are important to the successful completion of a 1031 exchange:

* The selection of your intermediary is one of the most important parts of the exchange.

The IRS doesn’t tell us whom we must use, but the Service is clear in whom we cannot use as the intermediary. Specifically forbidden are past business partners and anyone who has ever served the taxpayer as an agent or in a fiduciary capacity.

Thus, the most logical person, your real estate closing attorney, is forbidden from serving as your intermediary. While many closing attorneys separately offer exchange intermediary services, it is a violation of Section 1031 rules for the intermediary to also close any portion of the exchange transaction.

Likewise, neither your accountant nor your real estate agent can be your intermediary. All are considered non-qualified by the IRS.

Instead, it is best to use a totally independent third party as your intermediary. Certain firms have spring up around the nation to offer services to investors wishing to complete an exchange, and they are known as "qualified" intermediaries. Because they have expertise in this specialty and only serve this particular function, the IRS has said that these firms can offer a "safe harbor" for your transaction. In other words, if you use a qualified intermediary and follow all their instructions, the government guarantees that your exchange transaction will meet their standards.

That’s why I always recommend that you use a Qualified Intermediary instead of someone who is simply willing to act as a third party in exchange for a fee. Because they perform exchanges in high volume, the fee of a qualified intermediary is often quite reasonable. Simple one-for-one exchanges often can be performed for less than one thousand dollars.

* Meeting the 45-day identification rule can also present a problem. While there are several different approaches to this procedure, most investors use the "three property" rule. The IRS says you can identify up to three properties that you will purchase as a replacement for the property being relinquished. The problem comes in finding the right property in only 45 days, and getting it under contract before you place it on your ID letter. Once the 45-day limit has passed, no changes can be made to the identified properties. And if a problem should arise such as a seller refusing to sell or a serious termite problem appear, you have no choice. You must either purchase one or more of the properties you identified at 45 days, or you must abandon hope of having a successful exchange. There are no exceptions to this rule.

* Likewise, the 180-day closing rule is considered a "bright line" test, meaning if you cross it, your exchange will fail. From the day that you give up (or close) the relinquished property, you have 180 calendar days to close on the replacement property. Due to a quirk in the law, if your relinquished property closing is on or after October 17, you only have until the due date for your tax return, including all extensions, so you may need to file an automatic extension (Form 4868) to get the full 180-day period.

Recently, the IRS ruled that if you exchange into a house that later is converted into your principal residence, you must own that house for a period of not less than five years before you can exclude capital gains under the principal residence rules. It seems smart landlords were selling ten little rental houses with large profits in them, then exchanging into one big nice rental house at the beach. They would rent the beach house for one year to establish intent as an investment, then move in and convert the house to principal residence status. After two years, the house could be sold, and a married couple could exclude up to half a million dollars of gain from tax.

This new ruling still allows that activity to proceed, just at a slightly slower pace. As you can see, the smart landlord can shift a lot of capital gains into excluded residence profits if he plans things right.

I simplified a lot of the rules and regulations surrounding exchanges for this column, so please consult with your CPA to see how this information applies to your situation. For an expanded discussion of 1031 exchanges along with answers to frequently asked questions, visit my website at www.money99.com and click on "topic of the week."