Note: To follow is an excerpt of an interview with Brenden C. Faber, President of First American Exchange Company in Salt Lake City www.firstexchange.com. To listen to, or download the show archive MP3, go to IncomePropertyInvestmentTalk.com.

Mosca: Named after the IRS tax code that permits such transactions, 1031 exchanges allow investors to defer paying taxes on property they buy and sell as long as the transactions meet certain criteria. What defines a 'QI' or qualified intermediary?

Faber: If you're going to be entrusting your exchange funds, it's important to know what type of knowledge and experience the exchange company has. Are they qualified under the 1031 regulations and do they strictly adhere to the financial reporting and disclosure requirements of the Sarbanes-Oxley Act of 2002? What type of fidelity coverage and security do they have while they're holding or safeguarding your exchange funds? What kind of control do they have internally when they're holding your exchange funds?

Mosca: Is there a layer of reporting 'QIs' deal with internally that most customers won't see?

Faber: We have a daily reconciliation of accounting for all of our exchange transactions throughout the country. We also have a treasury management team that will take those exchange funds and place those funds with a group of money-centered banks throughout the country, but that control is removed from our exchange offices. That way, our exchange officer can focus on servicing the client as opposed to trying to determine which bank they should use to hold those funds.

Mosca: What is the 'napkin test?'

Faber: If you want to have a tax-deferred exchange, you trade across or up in value and across or up in equity. That is what we call the basic rule or the 'napkin test.' Here is an example. A taxpayer sells a property worth $100,000. They want to buy a replacement property at least $100,000 or exchange into that. Now if they had debt or if they pay off a debt of $50,000, they have $50,000 left over. They are going to use that $50,000 to buy that replacement property at a $100,000, effectively trading across or up in value and across or up in equity. The whole idea is the IRS wants you to have a continuation of your investment. At the end of the exchange, you don't want to be holding any cash in your hands or you don't want to have any debt relief

Mosca: What else does the IRS require?

Faber: Once you sell a relinquished property, you have a 45-day time frame to identify potential replacement properties from the original sale date and a full 180 days to acquire that replacement property. It's one of the hard and fast rules in 1031. There's no way to extend that. The 45 days goes by very quickly.

Mosca: Let's say there's 10 investors, all 10 are going into a tenant in common property, and each one has his own individual LLC. Three years later they sell the property. Can each one of those 10 investors do an individual 1031?

Faber: Partnership interest cannot be exchanged under section 1031. Each investor or tenant in common owner, provided that they're not construed as a partnership, can then do an exchange if they are selling the property and they take their portion that's attributable to them and trade across or up in value and across or up in equity.

Mosca: At what point should a 'QI' be called in the 1031 exchange process?

Faber: We want as much time as possible to cover all the issues. We have a schedule of questions to go through when someone sets up an exchange transaction. We can do it the same day that they're transferring the relinquished property although we recommend more time.

Mosca: Are there different types of exchanges?

Faber: So far, we have talked about the deferred exchange, where you're disposing of an old or relinquished property and trading into a replacement property. We also get involved in reverse exchanges where replacement property is identified that you want to acquire but you have not yet sold the relinquished property.

In that case, there's what they call a revenue procedure in which the IRS spells out the process to do that reverse exchange. It's much more costly than a deferred exchange and the reason for that is the exchange company will typically form a single-member pass-through entity that's sole purpose is to hold that replacement property. The QI will go through the due diligence process with the client and acquire that replacement property in an entity that's separate and apart from everything else. We hold that property until the taxpayer is ready to sell their relinquished property. It's important to remember you still have the 180 day time frame.