Very few exchangers or tax advisors think about what happens when replacement property is identified more broadly than necessary. A common example is an exchanger using the three-property rule, identifying three properties, buying one, and then discovering that a small amount of exchange proceeds remains in the account.
If the exchanger has no intention of buying the other identified properties, it can be frustrating to watch those residual funds sit in the exchange account earning little or no interest while everyone waits for the exchange period to end.
Why the funds stay trapped
The exchange does not end simply because one replacement property was acquired. It generally remains open until all identified property is acquired, the 180-day exchange period expires, or the taxpayer's return due date arrives for the year in which the exchange began.
That means leftover funds may linger for months even when the exchanger is already resigned to recognizing a small amount of boot.
How identification wording can avoid the problem
The article explains that the issue can often be avoided with more careful drafting in the identification notice. If the exchanger truly intends to acquire only one property, the notice can identify only that property. If the exchanger intends to buy either one property or an alternative combination, the notice can say so specifically.
That distinction matters because the default assumption in an identification notice is that all listed properties will be acquired. If the exchanger wants alternatives, the notice must clearly use an 'or' designation rather than leaving the document to imply 'and.'
Use 'or' carefully
The piece also warns that an 'or' designation can have side effects. The exchanger may later decide to buy more identified property after all, or an alternative designation may unintentionally cause the exchange to end in the current tax year rather than the next one when the transaction begins late in the year.
That timing difference can matter if the taxpayer was counting on deferring recognition of boot into the following year.
Reimbursements during a pending exchange
A related issue arises when the exchanger wants reimbursement for out-of-pocket expenses while the exchange is still open. The conservative response is for the qualified intermediary to refuse, since the IRS could treat the reimbursement as giving the exchanger actual receipt of exchange funds.
The regulations do allow exchange funds to be used for transactional items that ordinarily appear on closing statements, such as commissions, prorated taxes, recording charges, transfer taxes, and title fees. But the article notes that it is still not perfectly clear whether reimbursing the exchanger is equivalent to the intermediary paying the expense directly.
The author's preferred approach is to have the qualified intermediary pay the expense directly and then have the third-party payee refund the exchanger if needed. That structure better fits both the language and the spirit of the regulatory exception.
