Don’t Jeopardize Your 1031 Exchange – from First American Exchange Company – Exchange Update Newsletter

When completing a §1031 exchange there are some little-known requirements that could potentially disqualify your tax-deferred transaction.  Here are a few that could put your exchange at risk.

Qualified Intermediary Selection

 

Someone who is acting as your agent at the time of the transaction is disqualified from acting as a Qualified Intermediary.  Who is considered an agent? Someone who has acted as your employee, attorney, accountant, investment banker or broker, or real estate agent within the two-year period ending on the date of transfer of the first relinquished property. These persons are disqualified because they are presumed to be under the Taxpayer‘­s control.  Thus, the Taxpayer is deemed to have control of the exchange funds, otherwise known as “constructive receipt”. Constructive receipt by the Taxpayer invalidates the §1031 exchange. See here for exceptions to this rule.

 

If exchange funds are set aside or otherwise made available to you, it is also considered to be constructive receipt. Of course, if you actually receive the exchange funds you will invalidate your exchange.

 

Identification Deadlines

 

The most common reason an exchange fails is missed deadlines.  Potential replacement property(ies) must be identified by midnight of the 45th day after the relinquished property transfer.  Therefore, it is advisable to begin searching for the replacement property as soon as possible. In addition, the replacement property must be received by the taxpayer within the exchange period which ends on the earlier of 180 days from the date on which the taxpayer transfers the first relinquished property, or the due date for the taxpayer’s federal income tax return for the taxable year in which the transfer of the relinquished property occurs.  Extensions may be available for Taxpayers within a Presidentially Declared Disaster Area, or in active service in a combat zone. See here for exceptions to these deadlines.

 

Same Taxpayer Rule

 

Another mistake someone could inadvertently make would be to change the manner of holding title from the relinquished property to the replacement property. As a general rule, the same Taxpayer that transferred the relinquished property should be the same Taxpayer that acquires the replacement property. There are a variety of reasons you might want to change how title is held in an exchange and some changes are allowed, but you must be sure to talk it over with your tax advisor first. You can read further details on vesting title in a §1031 exchange, here.

 

Related Party Exchanges

 

You must also give serious consideration to any relationship you might have with the seller of the replacement property. Acquiring replacement property from a related party is potentially problematic, so the facts of the transaction should be reviewed by your tax advisor before proceeding.  The IRS could view the transaction as an abusive shift of basis between related parties resulting in tax avoidance and disallow the exchange.  Exchanges involving related parties are allowed, but both parties must hold their newly acquired properties for at least two years or both exchanges will fail.  For more information on exchanging with related parties, click here.

 

First American Exchange has helped thousands of taxpayers successfully complete even the most difficult transactions. While we don’t provide tax or legal advice, we make it our business to keep you informed of your exchange deadlines and other potential pitfalls that could jeopardize your exchange.

– See more at: http://firstexchange.com/June2013Newsletter#sthash.7dRJR7Vh.dpuf

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Top Ten 1031 Exchange Misconceptions

1.  Like-kind means I must exchange the same type of property, such as apartment building for apartment building.

 

All real property is like-kind to other real property, but personal property

like-kind requirements do have some restrictions. Real property and personal property are not like-kind to one another.  To read more about like-kind real estate, go here.

 

2.  My attorney can handle this for me.

 

Not if your attorney has provided you any non-exchange related legal services within the two-year period prior to the exchange. To read more about qualified and disqualified parties, go here.

 

3.  I must literally “swap” my property with another investor.

 

No. A 1031 exchange allows you to sell your relinquished property and purchase replacement property from a third party. Watch a short video on the basic process of a 1031 exchange.

 

4.  1031 exchanges are too complicated.

 

They don’t have to be. An experienced Qualified Intermediary will work with you and your tax and/or legal advisors to make sure the process is as seamless as possible.  Go here to read frequently asked questions and answers about doing a 1031 exchange.

 

5.  The sale and purchase must take place simultaneously.

 

No. The taxpayer has 45 days to identify the new replacement property and 180 days to close.

If you would like more information on the identification time period, go here.

 

6.  I just need to file a form with the IRS with my tax return and “roll over” the proceeds into a new investment.

 

No.  A valid exchange requires much more than just reporting the transaction on Form 8824.  One of the biggest traps when not structured properly is the taxpayer having actual or constructive rights to the exchange proceeds and triggering a taxable event.  For more information on tax filing requirements, go here.

 

7.  1031 exchanges are only for real estate.

 

No. Almost any property, whether real or personal, which is held for productive use in a trade or business, or for investment, may qualify for tax-deferred treatment under Section 1031. For more information on personal property exchanges, go here.

 

8.  All of the funds from the sale of the relinquished property must be reinvested.

 

No. A taxpayer can choose to withhold funds or receive other property in an exchange, but it is considered boot and will be subject to federal and state taxes.  To understand more about boot, go here.

 

9.  1031 exchanges are just for big investors.

 

No. Anyone owning investment property with a market value greater than its adjusted basis should consider a 1031 exchange. To find out how to use 1031 exchanges as a retirement planning tool, go here.

 

10.  I must hold property longer than a year before exchanging it.

 

The 1031 regulations do not list a time requirement on how long you must hold property, but it does say that property must be “held for productive use in a trade or business or for investment”.

To learn more about holding period requirements, go here.

from First American Exchange Company “The Exchange Update”

 

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FHA will keep funding flips

For the second year in a row, the Federal Housing Administration is extending a temporary waiver of its “anti-flipping” rule, meaning homebuyers relying on FHA-insured financing will continue to be able to buy homes that have changed hands in the last 90 days.

The waiver is a boon for investors seeking to rehab and flip properties, because it expands the pool of eligible borrowers to include those relying on FHA-backed loans, popular with first-time homebuyers and others who lack the cash to make large down payments.

In extending the waiver through 2012, FHA said all transactions must continue to be arms-length. In cases in which the sales price of the property is 20 percent or more above the seller’s acquisition cost, the waiver will apply only if the lender can document the justification for the increase in value, FHA said.

FHA instituted the anti-flipping rule in 2003 to protect its mutual mortgage insurance program from losses on homes that were merely flipped, rather than rehabbed. Homes repossessed by Fannie Mae, Freddie Mac, and state- and federally chartered financial institutions were exempt from the rule.

In February 2010, the Obama administration waived the waiting period for resales — including homes purchased and rehabbed by private investors — in the hopes of stabilizing home prices and revitalizing communities hit by foreclosures.

It often takes less than 90 days to acquire, rehabilitate and sell properties, the Department of Housing and Urban Development said at the time. Some sellers of rehabbed properties had been reluctant to enter into contracts with FHA buyers because of the cost of holding a property for 90 days, HUD said.

In extending the waiver through 2011, FHA said it insured 21,000 90-day property flip loans worth more than $3.6 billion in 2010 that would otherwise not have qualified for financing.

That number has since grown to nearly 42,000 mortgages worth more than $7 billion on properties resold within 90 days of acquisition.

By Inman News, Wednesday, December 28, 2011.

Inman News®

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Know risks when forgoing inspection contingency

Think again if you’re considering buying a home without having it inspected. This particularly applies to first-time buyers who have little, if any, experience with home defects and repairs. Even professionals can make mistakes when buying homes without having them thoroughly inspected.

In one example, an experienced contractor bought a home to fix up and resell. The contractor looked over the property carefully before he bought it, but he did not have it inspected by an impartial home inspector.

After the contractor took possession of the property, he discovered that the furnace was shot and required replacement. The cost of a new furnace was not included in his renovation budget.

Homebuying is an emotional experience no matter how hard you try to keep it strictly business. You have high hopes that nothing will go wrong and the transaction will close. The appeal of a home could cloud your objectivity about the real purchase price when you consider the work that needs to be done to repair defects and deferred maintenance.

<a href="http://www.shutterstock.com/gallery-478396p1.html" mce_href="http://www.shutterstock.com/gallery-478396p1.html" target=blank>Home and magnifying glass image</a> via Shutterstock.com.Home and magnifying glass image via Shutterstock.com.

Think again if you’re considering buying a home without having it inspected. This particularly applies to first-time buyers who have little, if any, experience with home defects and repairs. Even professionals can make mistakes when buying homes without having them thoroughly inspected.

In one example, an experienced contractor bought a home to fix up and resell. The contractor looked over the property carefully before he bought it, but he did not have it inspected by an impartial home inspector.

After the contractor took possession of the property, he discovered that the furnace was shot and required replacement. The cost of a new furnace was not included in his renovation budget.

Homebuying is an emotional experience no matter how hard you try to keep it strictly business. You have high hopes that nothing will go wrong and the transaction will close. The appeal of a home could cloud your objectivity about the real purchase price when you consider the work that needs to be done to repair defects and deferred maintenance.

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In some areas, the home-sale market has picked up. One example is California’s Silicon Valley, where job growth is strong. There is far more demand than there are homes for sale, which tends to drive prices up.

In some cases, buyers will waive contingencies in order to outbid the competition. Buying without including an inspection contingency in the purchase contract can be an expensive strategy if you later find defects that are expensive to repair.

The risk is minimized if the sellers provide the buyers with copies of recent presale home inspections done by reputable local home inspectors before they write an offer. However, most home inspection reports recommend further inspections. Diligent sellers take the extra step and have further inspections done, like a roof or furnace inspection. Many do not.

HOUSE HUNTING TIP: A second opinion from a highly regarded home inspector can’t hurt. The reason to have inspections at all is to find out as much as possible about the property’s condition before you go through with the sale. Don’t skip an inspection to save money.

Sometimes, buyers who are satisfied with the report they received from the seller’s home inspector will hire that inspector to do a walk-through inspection based on the seller’s report. This means a second home inspector isn’t involved. But at least the buyers have an opportunity to spend time at the property with the seller’s inspector, ask questions, and find out more about what works and what doesn’t.

Inspection contingencies protect the buyers and, depending on how the clause is written, can allow the buyers to withdraw from the contract without losing their deposit. This is why sellers are often drawn to an offer that doesn’t have an inspection contingency. However, accepting such an offer can create problems.

Inspection contingencies also protect sellers from future legal entanglements with the buyers over items that weren’t discovered before closing. It’s much easier to resolve inspection defect issues before, than after, closing.

Inspection contingencies can create an opportunity for buyers to ask sellers to fix defects, lower the price, or credit money at closing to cover the cost of repair work.

When buyers ask sellers to make concessions after they bought the house “as is” with respect to certain disclosed defects, it can be a deal-breaker. However, reasonable sellers will often attempt to negotiate an acceptable solution regarding newly discovered defects rather than put the house back on the market.

If you’re buying in a competitive market and find you’re losing out because you won’t waive an inspection contingency and others are willing to take the risk, consider having inspections done before making an offer.

THE CLOSING: Make sure to ask permission from the seller through the listing agent.

By Dian Hymer, Monday, January 2, 2012.

Inman News®

Dian Hymer, a real estate broker with more than 30 years’ experience, is a nationally syndicated real estate columnist and author of “House Hunting: The Take-Along Workbook for Home Buyers” and “Starting Out, The Complete Home Buyer’s Guide.”

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Check home’s permit history before buying

Now more than ever, it’s important to protect yourself from unexpected surprises when you buy a home. The goal is to find out as much about the house as possible before closing.

Your offer should include an inspection contingency even if you’re making an offer in competition. The contingency wording should be broad enough for you to inspect whatever you deem necessary so that you are confident the home will satisfy your housing needs within a budget you can afford.

If the inspections reveal defects that can’t be corrected, or ones that can but the sellers won’t participate in the solution, you should have the option to withdraw from the contract and have your deposit returned.

Most buyers have a home inspected by a home and structural pest control (“termite”) inspector. Additional inspections recommended, such as for roof or drainage, should also be done.

Now more than ever, it’s important to protect yourself from unexpected surprises when you buy a home. The goal is to find out as much about the house as possible before closing.

Your offer should include an inspection contingency even if you’re making an offer in competition. The contingency wording should be broad enough for you to inspect whatever you deem necessary so that you are confident the home will satisfy your housing needs within a budget you can afford.

If the inspections reveal defects that can’t be corrected, or ones that can but the sellers won’t participate in the solution, you should have the option to withdraw from the contract and have your deposit returned.

Most buyers have a home inspected by a home and structural pest control (“termite”) inspector. Additional inspections recommended, such as for roof or drainage, should also be done.

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Ideally, you want to know not only the severity of a defect, but how much it will cost to repair. It’s a good idea to ask for written reports and repair estimates, despite the additional cost. Written reports can be effective in negotiations with the sellers over inspection issues.

Even if you don’t intend to negotiate, written reports provide a record that will help you complete the needed repair work. It will also serve to inform the future buyers about the condition of the property when you bought it.

HOUSE HUNTING TIP: An item that is often overlooked during buyers’ inspections is the permit history on the house. It can be a hassle dealing with the city bureaucracy, and few buyers have time to go to the city planning department. Some even pay others to take care of this task. One way or the other, it should be done. Ignoring this detail can result in problems.

Several years ago, a buyer in the hills of Oakland, Calif., didn’t check the permit history when she bought. When she applied for a permit to do work on her house, she was denied because of outstanding permits taken out by the previous owner that hadn’t received final approval.

In order to obtain a permit, she had to have the property inspected by the city and do any work necessary to receive the final approval — all at her expense. This can cost thousands of dollars.

Recently a homebuyer in Oakland’s trendy Rockridge neighborhood obtained the permit history on the home she was buying. Two items became apparent that required further investigation.

One involved a remodel done by a past owner, not the current owner, for which a variance was granted. The permit received final approval. However, final permit approval was conditioned on the seller agreeing to record a notice of property use limitation on the title to the property. The preliminary title report on the property didn’t show a notice of property use limitation.

The title company searched the title record again, aware of the dates around which the notice should have been recorded, and found it. The title company issued an amended report correcting its mistake.

The permit search also indicated that there were fees owed against the property. The buyer was concerned because she planned to do work after closing and didn’t want to be stuck paying fees that she hadn’t incurred, especially having no idea how much was owed.

It turned out that the fees would not be charged to the new owner. One was for an application made by a past owner that had expired. The city had not performed any services. The other was from 1997, which was deemed to be too old to collect.

THE CLOSING: While you’re checking the permits, be sure to ask if any fees are owed. You may need to check directly with the cashier.

By Dian Hymer – from Inman News Weekly Headlines

Dian Hymer, a real estate broker with more than 30 years’ experience, is a nationally syndicated real estate columnist and author of “House Hunting: The Take-Along Workbook for Home Buyers” and “Starting Out, The Complete Home Buyer’s Guide.”

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Refinancing Before or After a 1031 Exchange

A common question that we are asked when working with investors contemplating a 1031 tax deferred exchange is:  Can I refinance the property and pull out cash before or after I complete my exchange?  Unfortunately there is no clear cut answer to this question, but hopefully the information in this article will provide you with some clarity. 

 In order to completely defer all tax in a 1031 exchange, you need to acquire property equal to or greater in value than the property you have sold, and you need to reinvest all of the net cash you receive from the sale of the relinquished property.  Because of the rule which requires you to reinvest all of the equity, when you refinance right before or after a 1031 exchange, the IRS may question whether you refinanced to avoid complying with the 1031 rules or whether you did it for a legitimate business purpose. 

Under the step transaction doctrine, the IRS may argue that what you did in several steps (close your exchange as step one and refinance your property as step two) was really all a part of one transaction.  Under that theory, the IRS could take the position that you may be considered to have taken cash boot in your exchange.  If that happens, an exchange that you thought was completely tax-deferred would be at least partially taxable.  It is important to consult with your tax advisor when deciding whether and how to refinance properties that are involved in an exchange. 

Here are a few suggestions that you may want to consider:

  • The loan should have a clear business purpose which should be well documented in your files.  For example, the maturity date of the loan may be approaching and you may want to set up a refinance prior to the exchange in case the exchange does not go through.  Other potential business purposes may be to get a lower interest rate or to buy property that is not a part of the exchange. 
  • If you schedule your refinance and exchange so that there is as much time in between them as possible, it should make it less likely that you are audited concerning this issue.  It should also strengthen your argument that the refinance was not set up to avoid the 1031 exchange rules.  If you intend to refinance your relinquished property, you may want to refinance it before you list it for sale.  
  • Some tax advisors believe that it is better to refinance the replacement property after an exchange rather than to refinance the relinquished property before an exchange.

In any event, it is important to consider the risks and discuss your plans with your tax advisor. 

from the First American Exchange Company October Newsletter “The Exchange Update”

 

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Improvement Exchanges for Commercial and Residential Property

In the current real estate market there are many opportunities to acquire distressed property at a fraction of the price. Investors can take advantage of this market by selling their relinquished property in a 1031 tax deferred “improvement” exchange and purchasing replacement property that might need construction work or improvements.    

The improvement exchange, also known as a build-to-suit or construction exchange, allows an investor to use the proceeds from the sale of the relinquished property not only to acquire replacement property, but also to make improvements to the property.  For example:

If an investor sells relinquished property with a fair market value of $1 million, debt of $200,000 and equity of $800,000, he must acquire a property equal to at least $1 million and must invest at least $800,000 into that property in order to completely defer his tax in a 1031 exchange.  In an improvement exchange, however, the investor could acquire property worth only $300,000, borrow an additional $200,000 and spend the remaining $500,000 of exchange proceeds plus the $200,000 in loan funds on improvements to the property.  This would use up the remaining cash and increase the fair market value of the replacement property to $1 million, resulting in a fully tax deferred exchange.

Structuring an Improvement Exchange

An improvement exchange is accomplished by having a separate entity called an “exchange accommodation titleholder” or “EAT” temporarily take title to the replacement property while the improvements are being made.  The EAT is necessary because any work done to the property after the investor takes title to it is not considered like kind property and therefore will not increase the value of the property for exchange purposes. First American Exchange creates and owns this entity which holds title to the property for up to 180 days.  During that time frame the investor controls the construction, not First American Exchange.  The costs of construction are paid for either by the investor, a loan, or by using the funds from the sale of the relinquished property.

Benefits and Drawbacks of Doing an Improvement Exchange

The benefits of doing an improvement exchange include the ability to buy property that is lower in value compared to the relinquished property while still having a completely tax-deferred exchange, and to use exchange funds rather than loan proceeds to fund construction. 

The principal drawback of doing an improvement exchange is that the work must be done within the 180 day period in order to have any effect on the exchange.  In addition, improvement exchanges can be more costly due to fees and costs of an additional closing and formation of the EAT. 

Planning for an Improvement Exchange

For those intending to do an improvement exchange, planning ahead is essential. 

  • First, include a provision in the purchase contract that it is assignable in connection with a 1031 exchange.  This is necessary because the EAT, rather than the investor, will be taking title to the replacement property.  
  • Contact First American Exchange and your lender early in the process.  Typically the EAT signs the loan documents and the loan must be completely non-recourse to the EAT.    
  • Get an accurate estimate of the amount of time it will take to complete the construction project.   Although the construction does not have to be complete at the expiration of the 180 day period, the only improvements that will affect the value of the replacement property for exchange purposes are the improvements that are done as of the date that the EAT transfers the replacement property to the exchangor.  
  • Finally, always consult with your tax advisor before doing any exchange, including an improvement exchange. 

By properly structuring an improvement exchange, the investor should have much more flexibility in finding appropriate properties and at the same time completely defer all capital gains tax. 

from First American Exchange Company “The Exchange Update”

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Property Boundaries

Fences should not be considered an indication of property boundaries. Legal property boundaries are demarcated by surveyor pins or stakes. These are typically 1/2″ to 3/4″ round iron pipes flush or buried slightly below land surface. Newer pins might have yellow or orange caps that indicate the surveyor’s license number.

Locating property lines can be challenging. Older surveyor pins tend to erode. Older property markers could be metal posts, rebar, pipes or car axles. Those having difficulty locating their surveyor pins, also called corner pins, should contact their city or county government and get a copy of their plat map.

A plat map will identify each specific lot located in a subdivision — as well as the shape and dimension of the lot — and where the surveyor pins are located.

If a plat map is not available, or no pins are found, the next step is to contact a registered land surveyor to locate the property lines and set new surveyor pins. The boundary surveyor will thoroughly research city and county records relating to the land and all adjacent property. After research, the field work begins, reconciling the research with the onsite analysis on the property to determine the final boundary lines.

Boundary surveys might also include property improvements, fences, power lines and any encroachments crossing the property lines. Costs of a boundary survey can vary depending on property size, terrain, vegetation, location and season.

A survey is strongly recommended before subdividing, improving or building on land. Building beyond property lines could result in being forced to alter or remove a structure, fines and lawsuits.

from Prospect Mortgage Knowledge Builder

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Top Ten Identification Rules for 1031 Exchanges

For a successful 1031 exchange, it is important to understand and comply with the 1031 exchange identification rules.  These rules are not that complicated, but a failure to follow the rules may ruin your exchange.  Here are the top ten things to remember when identifying replacement property in an exchange:

  1. Deadline and General Rules.  The taxpayer has 45 days from the date that the relinquished property closes to identify the replacement property that he intends to acquire in the exchange.  If there is more than one relinquished property in one exchange, the 45 days are measured from the date the first relinquished property closes.  The property identified does not have to be under contract, and the taxpayer does not have to acquire everything that he identifies.  It is important to note, however, that the taxpayer is not allowed to acquire anything other than the property that he has identified, and a failure to comply with the identification rules can ruin the whole exchange.  
  2. 3 Property Rule.  There are rules that limit how many properties the taxpayer may identify.  In most cases taxpayers use the three property rule.  The taxpayer may identify up to three replacement properties and may acquire one, two or all three of those.    
  3. 200% Rule.  If the taxpayer wants to identify more than three properties, he can use the 200% rule.  This rule says that the taxpayer can identify any number of replacement properties, as long as the total fair market value of what he identifies is not greater than 200% of the fair market value of what was sold as relinquished property.  First American Exchange recommends that taxpayers build in a “cushion” by identifying properties that are worth less than what is permitted, in case some properties are later determined to have a higher value than what was originally estimated. 
  4. 95% Rule.  There is another rule that is not commonly used by investors.  The 95% rule says that a taxpayer can identify more than three properties with a total value that is more than 200% of the value of the relinquished property, but only if the taxpayer acquires at least 95% of the value of the properties that he identifies.  Essentially, the taxpayer will need to acquire everything that he has identified to make this work, and that is why it is not relied on too often. 
  5. Property Acquired in 45 Day Period.  Any property that is actually acquired during the 45 day identification period is deemed to be properly identified.  It’s important to note that if some property is acquired during this period and some property is acquired later using another one of the identification rules, the property acquired during the first 45 days needs to be counted as one identified property.  For example, if you acquire one property during the first 45 days and you plan to use the 3 property rule and buy more properties after the 45 days, you only have two more properties to identify because you have already used up one. 
  6. Manner of Identification.  The identification must be in writing and signed by the taxpayer, and the property must be unambiguously described.  This generally means that the taxpayer identifies either the address of the property or its legal description.  A condo should have a unit number, and if the taxpayer is buying less than a 100% interest, the percentage share of what is being acquired should be noted. 
  7. Who Must Receive the Identification.  The taxpayer must send the identification notice either to:
     
    1)  The person obligated to transfer the replacement property to the taxpayer (such as the seller of the replacement property) or;
    2)  To any other person “involved” in the exchange (such as the qualified intermediary, escrow agent or title company), other than a “disqualified person,” such as an agent or family member of the taxpayer.  Most identification notices are sent to the qualified intermediary.
     
  8. Replacement Property Must be Same as What Was Identified.  The taxpayer must receive “substantially the same” property as he identified.  The regulations contain four examples to illustrate what “substantially the same” means.  In one example, the taxpayer identifies two acres of unimproved land and then acquires 1.5 acres of that land.  The property acquired is substantially the same because what the taxpayer received was not different in nature or character from what was identified, and the taxpayer acquired 75% of the fair market value of the property identified.  In another example, the taxpayer identifies a barn and two acres of land, and then acquires the barn with the land underlying the barn only.  The IRS says that the property acquired was not substantially the same as the property identified because it differed in its basic nature or character.  
  9. Property to be Constructed.  If the replacement property is under construction at the time of identification, the taxpayer must include not only the address or legal description of the property, but also must include a description of what is to be constructed on the property.  
  10. Reverse Exchanges.  If the taxpayer is doing a reverse exchange where the accommodator acquires the replacement property before the taxpayer closes on the sale of the relinquished property, the taxpayer must identify in writing what he intends to sell and that identification must be sent no later than 45 days after the accommodator closes on the replacement property. 

from The Exchange Update Newsletter by First American Exchange Company

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