One of the most common reasons a 1031 exchange fails an audit is a violation of the "Same Taxpayer Rule." The IRS requires that the entity selling the relinquished property must be the exact same entity that acquires the replacement property . This sounds simple, but it becomes complicated when investors use Limited Liability Companies (LLCs) or trusts.

Common Title Mistakes

Individual to LLC: Selling a property held in your personal name and trying to buy the new property in a newly formed LLC.
Spousal Issues: Selling a property owned only by the husband and trying to buy the new property as "Husband and Wife."
Partnership Breakups: If a partnership owns a building, the partnership must do the exchange. Individual partners cannot usually "split off" and do their own 1031 exchanges unless the partnership is restructured well in advance .

The "Disregarded Entity" Exception

There is a silver lining: if an LLC is a "single-member LLC" that does not file its own tax return (a disregarded entity), the IRS generally views the owner and the LLC as the same taxpayer . However, this requires careful verification with a tax professional before closing.

Closing Costs: The "Allowable" vs. "Non-Allowable" List

Not all expenses on a closing statement are created equal in the eyes of the IRS. Using exchange funds to pay for "non-allowable" expenses creates boot.

Allowable Exchange Expenses (No Boot)	Non-Allowable Expenses (Triggers Boot)
Real Estate Commissions	Prorated Property Taxes
Title Insurance Premiums	Utility Deposits
Qualified Intermediary Fees	Loan Application Fees
Legal Fees for the Exchange	Prorated Rent Credits to Buyer
Transfer Taxes	Homeowner Association (HOA) Fees

The Proration Trap

At closing, there are always "prorations"—adjustments for taxes or rents that the seller has already collected or owes. If you give the buyer a credit for $2,000 in security deposits you collected from tenants, that $2,000 is coming out of your exchange equity. The IRS may view this as you "receiving" that cash to satisfy a debt, thus triggering boot .

Qualified Intermediary (QI) Selection: The Safety Net

As emphasized in , the QI is the linchpin of the entire transaction. Because you cannot touch the money, you are essentially handing your entire net worth to a third party for up to 180 days.

Risks of a Poor QI Choice

Bankruptcy: If the QI goes bankrupt while holding your funds, you could lose your money and your tax deferral .
Disqualification: If your QI is someone you have a "disqualified relationship" with—such as your attorney, CPA, or real estate agent who has worked for you in the last two years—the IRS will invalidate the exchange .
Missed Deadlines: A QI who "flakes" or fails to provide documents on time can cause you to miss the 45-day or 180-day windows, which are non-negotiable .

The Identification Pitfall: Rules of Three and Two Hundred

While previously covered in terms of deadlines, the method of identification is a common pitfall. You must identify your replacement properties in writing within 45 days . But you can't just list every building in the city. You must follow specific rules:

The Three-Property Rule: You can identify up to three properties of any value .
The 200% Rule: You can identify any number of properties, as long as their combined fair market value doesn't exceed 200% of the property you sold .
The 95% Rule: If you exceed both of the above, the exchange only works if you actually acquire 95% of the value of everything you identified .

The Pitfall: If you identify four properties and their total value is 210% of your sale price, and you only buy one of them, your entire exchange is disqualified because you violated the identification limits.

Practical Compliance Checklist

To ensure a smooth, boot-free exchange, investors should follow this step-by-step guide:

Pre-Sale: Consult a tax advisor to calculate potential depreciation recapture .
Contract Phase: Ensure the sales contract includes "1031 exchange cooperation" language.
Selection: Hire a QI who is not a "disqualified person" (not your current CPA or lawyer) .
Closing (Relinquished): Ensure the settlement agent sends all funds directly to the QI. Do not touch the money .
Day 45: Submit a formal, written identification letter to the QI listing specific addresses .
Closing (Replacement): Ensure the new property is of equal or greater value and has equal or greater debt .
Title Check: Confirm the name on the new deed matches the name on the old deed exactly .
Tax Season: File Form 8824 with your federal tax return .

Summary of the "Boot" Concept

The 1031 exchange is a game of precision. While the "Starker Loophole" provides immense wealth-building power, it requires the investor to remain "economically unchanged" except for the nature of the real estate they hold . Any deviation—whether it's taking a little cash for a vacation, reducing a mortgage to save on interest, or buying a property in a different LLC name—breaks the "like-kind" chain and invites the taxman back into the deal. By focusing on the "Equal or Greater" rule and maintaining a strict firewall through a Qualified Intermediary, investors can successfully navigate these pitfalls and keep their equity growing compounding, tax-deferred, for decades.