§1031 Exchanges- The Old and the New

Matthew J. Howard, J.D., LL.M.

Brian D. Smith, J.D.

MOORE INGRAM JOHNSON & STEELE, LLP

192 Anderson Street

Marietta, Georgia 30060

 

TABLE OF CONTENTS

I. Sales or Exchanges Generally
A. Internal Revenue Code Sections on Exchanges
1. IRC §1031
2. IRC §1033
3. IRC §121

II. Requirements for a §1031 Exchange
A. General Requirements
B. Holding Purpose Requirement
C. Exchange Requirement
D. Like Kind Requirement
E. Property Ineligible for Like Kind Treatment
1. Stock in Trade or Other Property Held Primarily for Sale
2. Stocks, Bonds, Notes, Etc.
3. Partnership Interests
4. Certificates and Trusts for Beneficial Ownership
5. Choses in Action

III. Multiple Party Exchanges
A. Two Party Exchanges
B. Three Party Exchanges
C. Four Party Exchanges

IV. Delayed Exchanges
A. Identification and Receipt Requirements
1. Identification
2. Receipt
B. Safe Harbors
1. Security or Guarantee Arrangement
2. Qualified Escrow or Qualified Trust
3. Qualified Intermediary
4. Allowable Payments from Escrow, Trust or Intermediary
5. Growth Factors and Interest

V. Realized Gain/ Recognized Gain/Boot/Liability/Basis
A. Realized Gain and Recognized Gain
B. Boot
1. Boot Offset Rules
2. Transfer of Property Other than Cash or Other Property
3. Financing Expenses
4. Allocation of Boot
C. Determining Basis of Property Received
D. Carry Over Holding Period
E. Example of Gain/Basis Allocation
F. Multiple Property Exchanges

VI. Mechanics/Documentation of Exchanges
A. Beginning the Exchange- Sale of Relinquished Property
1. Exchange Cooperation Clause
2. Exchange Agreement
3. Contract Assignment
4. Direct Deeding
5. Handling Earnest Money
6. Transfer of Relinquished Property- A Summary
B. Acquiring the Replacement Property
C. Closing Statements
D. Reporting the §1031 Exchange

VII. Special Issues
A. Related Party Rules
B. Reverse Exchanges
1. Introduction
2. Pre-Rev. Proc. 2000-37
3. Post Rev. Proc. 2000-37
4. DeCleene
C. Exchange Property to be Produced
D. Early Distribution from Escrow Account

APPENDICES:

Appendix A Agreement for the Deferred Exchange of Properties

Appendix B Qualified Exchange Accommodation Agreement

Appendix C Assignment of Purchase and Sale Agreement and Notice of Assignment

Appendix D Exchange Cooperation Clauses

§1031 Exchanges- The Old and the New

Matthew J. Howard, J.D., LL.M

Brian D. Smith, J.D.

MOORE INGRAM JOHNSON & STEELE, LLP

192 Anderson Street

Marietta, Georgia 30060

II.SALES OR EXCHANGES GENERALLY

INTERNAL REVENUE CODE ("I.R.C.") SECTIONS ON EXCHANGES

5.I.R.C. §1031

 

Section 1031 of the Internal Revenue Code of 1986, as amended (hereinafter referred to as the "I.R.C.") provides for the non-recognition of gain or loss on the exchange of certain types of property. The property exchanged and received in the exchange must be of like-kind and must be held for productive use in a trade or business or for investment. I.R.C. §1031(a)(1).

Section 1031 does not provide for the non-recognition of gain or loss on the exchange of stock in trade or other property held primarily for sale, partnership interests, stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest. I.R.C. §1031(a)(2).

 

Section 1031 only provides an exception from the current recognition of gain or loss. Upon the ultimate sale of property in a taxable transaction, all gain or loss is recognized.

6.I.R.C. §1033

 

I.R.C. § 1033 provides for the non-recognition of gain or loss on the theft, destruction, seizure, requisition or condemnation of property, or the threat or imminence of condemnation as long as the property is converted into property that is similar or related in service or use. I.R.C. §1033(a)(1).

 

In order for non-recognition treatment under §1033 to apply, the taxpayer must invest the conversion proceeds in similar property and the taxpayer must make an election to not recognize the gain. I.R.C. §1033(a)(2).

 

Under §1033(g), in order for non-recognition treatment to apply to the involuntary or compulsory conversion of real property held for productive use in a trade or business or for investment, the replacement property must also be real property held for productive use in a trade or business or for investment.

 

For §1033 to apply, the replacement property must be acquired by the taxpayer within a specified time period. The time period commences on the date of the disposition of the property, or the earliest date of the threat or imminence of condemnation , whichever is earlier, and ends on the date which is two years after the close of the first taxable year in which any part of the gain is realized or later, upon application to and acceptance by the Secretary. I.R.C. §1033(a)(2)(B).

 

7.I.R.C. §121

Under I.R.C. §121, an individual may exclude up to $250,000, and a married couple can exclude up to $500,000 from gain realized on the sale or exchange of a principal residence. To qualify for such non-recognition, the taxpayer must have owned and occupied the residence as a principal residence for an aggregate of at least two of the previous five years. I.R.C. §121(a). The exclusion of gain under §121 cannot be used more than one time in any two year period.

 

I.R.C. §121(b)(3).

 

II. REQUIREMENTS FOR A §1031 EXCHANGE

A. GENERAL REQUIREMENTS

§1031 provides that no gain or loss is recognized when property held for productive use in a trade or business or for investment is exchanged for like-kind property held for productive use in a trade or business or for investment. I.R.C. §1031(a)(1). Qualifying property under §1031(a)(2) does not include:

1. Stock in trade or property held primarily for sale (inventory);

2. Stocks, bonds, or notes;

3. Other securities or evidences of indebtedness or interest;

4. Partnership interests;

5. Certificates of trusts or other beneficial interests; or

6. Choses in action.

B. HOLDING PURPOSE REQUIREMENT

 

Qualifying property under §1031 must be held by the taxpayer for productive use in a trade or business or for investment. I.R.C. §1031(a)(1). The determination of whether property is held for productive use in a trade or business or for investment is made as of the time of the exchange.

A minimal amount of personal use may not disqualify the property from being trade or business or investment property. Additionally, the holding purpose may change while the taxpayer owns the property. Rev. Rul. 57-244, 1957-1 C.B. 247. For example, property held as a principal residence that later becomes rental property may qualify as investment property. The longer the property is held by the taxpayer as trade or business or investment property, however, the better. The more evidence showing the property is investment property, the better.

 

There is not a requirement that the property actually be used in a trade or business, or for investment. As long as the taxpayer intends to hold the property for use in a trade or business or for investment at the time of the exchange, then the holding purpose requirement is satisfied. Wagensen v. Commr, 74 T.C. 653 (1980).

 

The replacement property does not have to be held for the same purpose as the property transferred. Reg §1.1031(a)-1(a). For example, property held by a taxpayer for productive use in a trade or business can be exchanged for investment property.

 

The length of time that a taxpayer holds the property prior to or following the exchange is also an important factor. The longer the taxpayer holds the property before or after the exchange, the more likely it is that the property was held by the taxpayer for productive use in a trade or business or for investment. Unfortunately, the Service has not issued a clear rule in this area. Griffin v. Commr, 49 T.C. 253 (1967). It appears, however, that the shorter the holding period, the more important it is to have additional evidence indicating the existence of the requisite holding period. A sale or other disposition of the replacement property immediately after the exchange is evidence that the taxpayer did not have the requisite intent at the time of the exchange.

 

If, at the time of the exchange, the taxpayer intends to make a gift of the replacement property, the exchange may not qualify under §1031 because the taxpayer does not intend to hold the property for use in a trade or business or for investment. Click v. Commr, 78 T.C. 225 (1982), appeal dismissed 4th Cir. 1983.

 

As stated above, however, if at the time of the exchange, the taxpayer intends to hold the property for use in a trade or business or for investment but subsequently decides to give away the property, the exchange should qualified under §1031. Wagensen v. Commr, 74 T.C. 653 (1980).

 

It is not clear whether a taxpayer who acquires property from a related party succeeds to the rights of the taxpayer to qualify the subject property for §1031 non-recognition treatment. It is also unclear whether a person who acquires property from another taxpayer by gift or inheritance succeeds to the rights of the other taxpayer.

 

C. EXCHANGE REQUIREMENT

 

To qualify for non-recognition treatment under §1031, a transaction must constitute an exchange. Typically, a transaction constitutes an exchange if there is a reciprocal transfer of property, as opposed to a sale or transfer of property followed by a receipt of money or other like-kind property. Treas. Reg. §1.1002(d). Merely intending to effectuate an exchange is not sufficient. Bezdjian v. Commr, T.C. Memo 1987-140, aff'd. 88-1 USTC Para. 9306 (9th Cir. 1988). There must actually be an exchange of qualifying property. A sale and subsequent reinvestment is not a like-kind exchange under §1031 unless the substance of the transaction shows each step to be interdependent. Allen v. Commr, T.C. Memo 1982-188, 43 T.C.M. 1045.

As discussed above, in order for a transaction to qualify under §1031, there must be a reciprocal transfer of property. A transfer of property rather than cash does not automatically ensure non-recognition treatment.

 

A sale of property for money followed by a reinvestment of the money in like-kind property does not constitute an exchange under §1031. Treas. Reg. 1.1002(d); D'Onofrio v. Commr, T.C. Memo 1983-632, 47 T.C.M. 29.

 

Even if the sale of the relinquished property and the acquisition of the replacement property occur simultaneously, non-recognition treatment under §1031 will not be allowed if the two transactions are independent of one another. Allen v. Commr, T.C. Memo 1982-188, 43 T.C.M. 1045. To qualify for non-recognition treatment, the sale and subsequent reinvestment must be mutually dependent transactions. The sale of the relinquished property must be dependent upon the acquisition of the like-kind replacement property, and vice-versa. Even if the proceeds from the sale of the relinquished property are placed beyond the taxpayer's control, such as an escrow account for the purpose of completing the acquisition of the replacement property, the transaction will not qualify for non-recognition treatment under §1031 if the transactions are independent. Meadows v. Commr, T.C. Memo 1981-417, 42 TCM 611.

 

The taxpayer must never receive cash for the relinquished property, either actually or constructively. If the taxpayer does receive cash proceeds, like-kind exchange treatment will be denied to the extent of the cash proceeds received, even if the taxpayer holds like-kind property at the end of the transaction.

 

If a sale and subsequent reinvestment are dependent upon one another, the step transaction doctrine may be applied to cast the transaction as an exchange rather than a sale and reinvestment. Under the step transaction doctrine, the separate steps of a transaction could be viewed as interdependent transactions. Century Elec. Co. V. Commr, 15 T.C. 581 (1950), aff'd. 192 F 2d 155 (8th Cir 1951), cert denied 342 U.S. 954.

 

It is important in a §1031 exchange to fill the exchange agreement with intent language. It should be clear that the taxpayer intends to effect an exchange rather than a sale and reinvestment.

 

D. LIKE-KIND REQUIREMENT

 

To qualify for non-recognition treatment under §1031, the relinquished property must be of like-kind to the replacement property. I.R.C. §1031(a). "Like-kind" refers to the nature or character of a piece of property rather than the quality of the property. Treas. Reg. §1.1031(a)-1(b).

One piece of real property is like-kind with another piece of real property regardless of how dissimilar the properties may be. For example, an apartment complex could be of like-kind to a golf course.

 

Foreign real property is not like-kind with United States real property. I.R.C. §1031(h)(1).

 

Certain lease-hold interests can be of like-kind to fee simple interests. Although a lease-hold interest represents less than a fee interest in real estate, a lease-hold interest for a sufficiently long period of time vests in a taxpayer certain attributes which make the lease-hold interest and the fee simple interest like-kind. A lease-hold interest with 30 years or more to run on the lease and a fee simple interest are of like-kind. Treas. Reg. §1.1031(a)-1(c). In determining the length of a lease-hold, optional renewal periods may be included. Rev. Rul. 78-72, 1987-2 C.B. 258. Additionally, the Internal Revenue Service has ruled that a lease-hold for a period of less than 30 years is like-kind with another lease-hold of less than 30 years. Rev. Rul. 76-301, 1976-2 C.B. 241.

 

It is important to note that while properties may be of like-kind for federal tax purposes, they may not be of like-kind for state tax purposes. For example, relinquished property in Georgia is not like-kind to replacement property outside of Georgia. O.C.G.A. § § 48-7-21(b)(5) and 48-7-27(b)(6). In such transactions, non-recognition treatment is available for federal tax purposes, but gain must be recognized for state tax purposes.

 

Although this outline focuses primarily on exchanges of real property, it is important to note here that exchanges of personal property can also be conducted under §1031. Depreciable tangible personal property held for productive use in a trade or business or for an investment can be exchanged for other property of either like-kind or like class. Treas. Reg. §1.1031(a)-2(b).

 

Whether personal property is of like class under §1031 is determined by classifying the property among general asset classes and product classes as of the date of the exchange. Depreciable tangible personal property is of like-kind if the exchanged properties are either within the same general asset class or within the same product class. A single property may not be classified within more than one general asset class or within more than one product class. Treas. Reg. §1.1031(a)-2(b)(1).

 

Regulation §1.1031(a)-1(b)(2) provides a list of 13 general asset classes. These asset classes are based on asset classes listed in Rev. Proc. 87-56. These asset classes are as follows:

 

1. Office furniture, fixtures, and equipment (asset class 00.11);

2. Information systems (computers and peripheral equipment)(asset class 00.12);

3. Data handling equipment, except computers (asset class 00.13);

4. Airplanes (airframes and engines), except those used on commercial or contract-carrying of passengers and freight, and all helicopters (asset class 00.21);

5. Automobiles and taxis (asset class 00.22)

6. Buses (asset class 00.23);

7. Light general purpose trucks (asset class 00.241)

8. Heavy general purpose trucks (asset class 00.242);

9. Railroad cars and locomotives, except those owned by railroad transportation companies (asset class 00.25);

10. Tractor units for use over the road (asset class 00.26);

11. Trailers and trailer mounted containers (asset class 00.27);

12. Vessels, barges, tugs, and similar water transportation equipment, except those used on marine construction (asset class 00.28);

13. Industrial steam and electrical generation and/or distribution systems (asset class 00.4).

 

A product class consists of depreciable personal tangible property listed in a product class in the North American Industrial Classification System (NAICS) which has replaced the Standard Industrial Classification Codes. The NAICS is prepared by the Office of Management and Budget. The manual can be obtained at www.ntis.gov.

 

Even if depreciable tangible personal property is not of like class, it may still qualify for non-recognition treatment for §1031 if it is of like-kind. Treas. Reg. §1.1031(a)-2(a). To determine whether property is of like-kind, all facts and circumstances must be considered.

 

E. PROPERTY INELIGIBLE FOR LIKE-KIND TREATMENT.

 

As discussed above, certain types of property are ineligible for like-kind treatment under §1031. §1031(a)(2) provides that non-recognition treatment under §1031 does not apply to any exchange of the following assets:

 

1. Stock in trade or other property held primarily for sale;

2. Stocks, bonds, notes;

3. Other securities or evidences of indebtedness or interest;

4. Interests in a partnership;

5. Certificates of trust or beneficial interests; or

6. Choses in action.

 

1. STOCK IN TRADE OR OTHER PROPERTY HELD FOR SALE

The exclusion for stock in trade refers primarily to property that is included in the taxpayer's inventory. See I.R.C. §1221(a)(1).

 

Aside from inventory, other property held by the taxpayer primarily for sale is also excluded. I.R.C. §1031(a)(2)(A). Such property has always been outside the scope of §1031. The determination of whether property is "held primarily for sale" is a question of fact. The taxpayer's purpose for holding the property is to be determined at the time of the exchange. Brauer v. Commr, 74 T.C. 1134 (1980). The taxpayer has the burden of proving that the exchange property is held for productive use in a trade or business or for investment rather than primarily for sale.

 

2. STOCKS, BONDS, NOTES, SECURITIES, EVIDENCES OF INDEBTEDNESS, OR INTEREST

§1031(a)(2)(B) and (C) specifically exclude the exchange of stocks, bonds, notes, other securities and evidences of indebtedness or interest from non-recognition treatment under §1031.

 

3. PARTNERSHIP INTERESTS

§1031(a)(2)(D) specifically excludes the exchange of partnership interests from non-recognition treatment under §1031. This rule applies to all interests in partnerships regardless of whether the interests are general or limited partnership interests. Treas. Reg. 1.1031(a)-1(a)(1).

 

§1031(a)(2) does provide, however, that an interest in a partnership which has elected under §761(a) to not be treated as a partnership for federal tax purposes shall be treated as an interest in each of the assets of the partnership rather than as an interest in the partnership itself.

 

One possible way around this exclusion is to dissolve the Partnership and distribute its assets as tenants-in-common prior to the exchange of the property. Special care should be taken, however, to prevent the tenancy-in-common from being treated as a partnership. In such a transaction, the IRS may argue that the individual receiving the property from the dissolved partnership does not succeed to the partnership's holding purpose. See I.R.C. §1031(a). As with all exchange transactions, it must be the taxpayer's intent to hold the property for a productive use in a trade or business or for investment. I.R.C. §1031(a). The taxpayer cannot hold the property primarily for sale.

 

4. CERTIFICATES OF TRUSTS OR BENEFICIAL INTERESTS.

§1031(a)(2)(D) specifically excludes the exchange of certificates of trust or beneficial interest from non-recognition treatment under §1031.

 

5. CHOSES IN ACTION

§1031(a)(2)(F) specifically excludes the exchange of choses in action from non-recognition treatment under §1031. A chose in action represents the right to receive or recover some consideration or property from another.

 

III. MULTIPLE PARTY EXCHANGES

Exchanges of property under §1031 can be conducted with two parties, three parties, or even four parties.

 

A. TWO PARTY EXCHANGES

Two party exchanges are often very difficult to accomplish. In order to complete a two party exchange of property under §1031, the taxpayer would not only have to find a person who wanted to buy the taxpayer's property, but also owned property that the taxpayer wanted to purchase. Such exchanges occur simultaneously and involve a straight swap of property. These exchanges very rarely take place.

 

B. THREE PARTY EXCHANGES

Three party exchanges consist of a taxpayer who desires to exchange his property, a prospective purchaser of the taxpayer's property and a prospective seller of the replacement property. Typically, such exchanges involve two contracts and an exchange agreement. In structuring a three party exchange, special care must be taken to prevent the transaction from being viewed by the Internal Revenue Service as a sale and subsequent reinvestment rather than an exchange.

 

Three party exchanges do not involve an intermediary. These exchanges are either buyer facilitated or seller facilitated. In a buyer facilitated three-party exchange, the buyer of the taxpayer's property purchases the replacement property and then swaps with the taxpayer. In a seller facilitated three-party exchange, the taxpayer swaps properties with the seller of the replacement property and the seller then sells the relinquished property to the buyer of the relinquished property.

 

C. FOUR PARTY EXCHANGES

Multi-party exchanges under §1031 typically involve four parties. Four party exchanges usually involve an intermediary as the fourth party. There are usually two real estate contracts. One contract is for the sale of the relinquished property by the taxpayer. The other contract is for the acquisition of the replacement property by the taxpayer. There should also be an exchange agreement between the taxpayer and the intermediary. Both real estate contracts should be assigned to the intermediary. For reasons unrelated to §1031, direct deeding from the taxpayer to the buyer or from the taxpayer to the seller is allowed.

 

In a standard four party exchange, the taxpayer sells the relinquished property to the purchaser and the proceeds are paid directly to the intermediary. Pursuant the exchange agreement, the intermediary then acquires the replacement property. Since direct deeding is allowed, title to the replacement property passes directly from the seller to the taxpayer.

 

Four party exchanges can be accomplished either simultaneously or as delayed exchanges.

 

IV. DELAYED EXCHANGES

Although many exchanges can be conducted simultaneously, there are numerous reasons why a delayed exchange works better than a simultaneous exchange. For example, the taxpayer may not be able to find a suitable replacement property prior to the sale of the relinquished property. In such a situation, a simultaneous exchange is not possible.

 

Before the 1984 Act, the IRS took the position that a taxpayer could not achieve a delayed exchange. The IRS reasoned that either no exchange took place, or that the property received was a promise to acquire suitable replacement property, which is not like-kind to the relinquished property.

 

Starker v. U.S., 602 F2d. 1341 (9th Cir. 1979) was the first Circuit Court decision which considered the use of a delayed exchange under §1031. Prior to Starker, there was very little guidance in the area of delayed exchanges.

 

In Starker, A transferred property to B pursuant to a contract under which B agreed to acquire other real property in the future and convey it to A. B agreed to provide suitable replacement property to A within five years or pay any outstanding balance in cash. B also agreed to pay a growth factor of 6% per year on any outstanding balance. The 9th Circuit in Starker held that the transaction did, in fact, constitute an exchange under §1031 since the taxpayer intended to receive qualifying property and did not simply cash out his real estate investment.

 

Following Starker, there was widespread confusion regarding the use of delayed exchanges under §1031. In the 1984 Act, Congress took the 9th Circuit's lead and amended §1031(a) to permit delayed exchanges under certain circumstances.

 

§1031(a)(3) provides that the property received by a taxpayer will not be considered like-kind property if it is not properly identified by the taxpayer within 45 days of the closing of the sale of the relinquished property, or received by the taxpayer within 180 days of the closing of the sale of the relinquished property, or by the due date for the taxpayer's Federal Income Tax Return for the year in which the transfer of the relinquished property occurs, whichever is earlier.

 

The new rules promulgated by Congress in the 1984 Act were effective for all exchanges after July 18, and 1984. On April 25, 1991, Regulations were issued providing guidance on deferred exchanges. These Regulations begin with Treas. Reg. §1.1031(k)-1.

 

Treas. Reg. §1.1013(k)-1(a) defines a deferred exchange as,

"An exchange in which, pursuant to an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (the "relinquished property") and subsequently receives property to be held either for productive use in a trade or business or for investment (the "replacement property").

 

A. IDENTIFICATION AND RECEIPT REQUIREMENTS

As discussed above, property acquired in the exchange will not qualify as like-kind property if the property to be acquired is not identified, and the exchange is not completed, within certain specified time periods.

 

The time periods for both identification and acquisition of the replacement property begin on the date the taxpayer transfers the relinquished property. Treas. Reg. §1.1031(k)-1(b)(2). If the taxpayer transfers multiple relinquished properties as part of the same deferred exchange, and the relinquished properties are transferred on different dates, the periods begin on the date of the earliest transfer of relinquished property. Treas. Reg. §1.1031(k)-1(b)(2)(iii).

1. IDENTIFICATION

In order to comply with §1031, the taxpayer must identify the replacement property on or before the date which is 45 days after the transfer of the relinquished property. Treas. Reg. §1.1031(k)-1(b)(2)(i).

 

A taxpayer may identify up to three replacement properties without regard to the fair market values of the replacement properties. Treas. Reg. §1.1031(k)-1(c)(4)(A). If more than three properties are identified, the aggregate values of all identified replacement properties cannot exceed 200% of the fair market value of the relinquished properties in the transaction. Treas. Reg. §1.1031(k)-1(c)(4)(B).

 

A replacement property is properly identified only if it is unambiguously designated as replacement property in a written document signed by the taxpayer and delivered, mailed, telecopied, or otherwise sent before the end of the identification period to either the person obligated to transfer the replacement property to the taxpayer, or to any other person involved in the exchange other than the taxpayer or a disqualified person Treas. Reg. §1.1031(k)-1(c)(2).

 

Any property that is actually received by the taxpayer prior to the conclusion of the identification period is treated as properly identified. Treas. Reg. §1.1031(k)-1(c)(4)(ii)(A).

 

As mentioned above, the replacement property must be unambiguously identified in the identification document. This requirement can be satisfied with a legal description of the property, street address of the property, or by a distinguishable name. Treas. Reg. §1.1031(k)-1(c)(3). It is best to include as much information about the replacement property on the identification document as possible.

 

As discussed above, the maximum number of replacement properties that can be identified by the taxpayer is (a) three, without regard to fair market value, or (b) as many as the taxpayer wishes as long as the aggregate fair market value of all replacement properties does not exceed 200% of the aggregate fair market value of all relinquished properties as of the date the relinquished properties were transferred. Treas. Reg. §1.1031(k)-1(c)(4)(i). For purposes of the identification requirements, fair market value is the fair market value without regard to liabilities. Treas. Reg. §1.1031(k)-1(m).

 

If, as of the conclusion of the identification period, a taxpayer has identified more properties than are allowed, the taxpayer is deemed not to have made a valid identification of replacement property. Treas. Reg. §1.1031(k)-1(c)(4)(ii). This rule does not apply to any replacement properties actually received by the taxpayer prior to the end of the identification period or to any replacement properties identified by the taxpayer prior to the conclusion of the identification period and received before the end of the acquisition period, if the taxpayer actually receives replacement property constituting at least 95% of the aggregate fair market value of all identified replacement properties. Treas. Reg. §1.1031(k)-1(c)(4)(ii).

 

Under Treas. Reg. §1.1031(k)-1(c)(6), an identification of replacement property can be revoked at any time before the conclusion of the replacement period. A revocation of an identified property is only valid if it is made by a written document signed by the taxpayer and hand-delivered, mailed, telecopied, or otherwise sent before the end of the identification period to the person to whom the identification of replacement property was sent. Treas. Reg. §1.1031(k)-1(c)(6). If the identification of replacement property is made in the exchange agreement, then revocation can only be made by amending the exchange agreement or in a written document hand-delivered, mailed, telecopied, or otherwise sent to all parties to the exchange agreement. Treas. Reg. §1.1031(k)-1(c)(6).

 

One interesting issue regarding the identification and receipt of replacement property involves the identification of multiple legal parcels of property for purposes of the three property rule. Is legal title relevant for purposes of determining what constitutes "property" under the three property rule?

 

Example:

Taxpayer sells a warehouse and identifies as replacement property an office complex consisting of four (4) separate, but contiguous, lots. The four lots have one owner, but for reasons unrelated to the exchange, are each separate lots. Taxpayer acquires three (3) of the four lots, the cumulative value of which exceeds Two Hundred percent of the fair market value of the relinquished property as of the date of its sale. It is clear that the taxpayer has violated both the Two Hundred Percent Rule and the alternative Ninety-Five Percent Rule, but has taxpayer's §1031 Exchange failed?

 

The answer to the question presented in the above example depends on the definition of "property" under §1031. The taxpayer has a legitimate argument that the separate legal titles to the parcels should be irrelevant, and that the three property rule was satisfied. The following example may help clarify the issue.

 

Example:

Taxpayer sells a golf course and identifies as replacement property an entire city block. If one person owns the entire city block, it is clear that §1031 is satisfied. But what if the city block is actually owned by a number of different people?

 

In this example, §1031 treatment should apply because taxpayer has acquired substantially all of the property that he identified. Additionally, despite the fact that §1031 requires multiple relinquished property under the same exchange to be treated as one property, there is not a similar rule for replacement properties. Thus, by implication, it appears that separate legal title should not matter for purposes of the three property rule. The fact that taxpayer acquires substantially all of the identified replacement property should be the dispositive factor.

The above examples each deal with contiguous properties. It is clear that non-contiguous properties should be treated as separate properties for purposes of the identification rules under §1031.

 

2. RECEIPT

The property identified by the taxpayer must not only be identified within 45 days of the transfer of the relinquished property, but must be received by the taxpayer on or before the earlier of 180 days after the date of the transfer of the relinquished, or the due date, including extensions, of the taxpayer's tax return for the tax year in which the transfer of the relinquished property occurred. I.R.C. §1031(a)(3)(B). Additionally, the property acquired must be substantially the same as the identified property. Treas. Reg. §1.1031(k)-1(d)(1).

 

Strict adherence to the identification and receipt timing requirements must be followed. As stated above, the periods begin on the date the relinquished property is transferred. If multiple relinquished properties are transferred, the time periods begin on the date on which the first relinquished property is transferred. Treas. Reg. §1.1031(k)-1(b)(2).

 

In calculating the time period, the taxpayer should use a starting date that is the earlier of the date on which the deed to the relinquished property is delivered to the buyer, or the date on which the buyer releases the funds for the purchase.

 

Identification and receipt must be performed before midnight on the 45th and 180th days without regard to weekends or holidays. Treas. Reg. §1.1031(k)-1(b)(2)(i) and (ii). If the 45th day falls on a Sunday, identification must be made by midnight that Sunday.

 

The receipt time period may be cut short if the taxpayer's federal income tax return for the year in which the relinquished property is transferred falls before the conclusion of the 180 day period. Treas. Reg. §1.1031(k)-1(b)(2)(ii). In exchanges in which the due date for the taxpayer's tax return falls before the conclusion of the 180 day period, it might be wise to extend the due date for the taxpayer's tax return. The possibility of extending the due date for the filing of the federal tax return might be an issue for calendar year corporations which close the sale of the relinquished property on or after September 16 or 17 or for individuals who close the sale of the relinquished property on or after October 16 or 17.

 

B. SAFE HARBORS

When a taxpayer transfers relinquished property and actually or constructively receives money or other property before receiving like-kind replacement property, gain may be recognized. Treas. Reg. §1.1031(k)-1(a). Additionally, where the full amount of the consideration for the relinquished property is received, actually or constructively, before the replacement property is received, the transaction will be considered a sale rather than an exchange. Treas. Reg. §1.1031(k)-1(f).

 

A taxpayer is considered to be in actual receipt of money or other property at the time he receives the money or other property, or receives the economic benefit of the money or other property. Treas. Reg. §1.1031(k)-1(f)(2). A taxpayer is considered to be in constructive receipt of money or other property at the time it is credited to his account, set aside for him, or otherwise made available to him. Treas. Reg. §1.1031(k)-1(f)(2). A taxpayer is neither in actual or constructive receipt of money or other property if his control over the money or other property is subject to substantial limitations or restrictions. Treas. Reg. §1.1031(k)-1(f)(2).

 

In an effort to clarify the rules for deferred exchange transactions under §1031, the Regulations provide several safe harbor arrangements which state that certain issues, such as agency and receipt, will be disregarded for purposes of determining whether the taxpayer is in actual or constructive receipt of money or other property.

Under Treas. Reg. §1.1031(k)-1(g) the taxpayer will not be considered to be in actual or constructive receipt of money or other property if the exchange satisfies one of the following safe harbor arrangements:

1. A security or guarantee arrangement;

2. A qualified escrow or qualified trust arrangement; or<

3. A qualified intermediary arrangement.

To satisfy a safe harbor arrangement, a taxpayer must satisfy all of the safe harbor's terms and conditions. See Treas. Reg. §1.1031(k)-1(g)(1). Additionally, the written agreement governing the safe harbor arrangement must specify that the taxpayer has no rights to receive, pledge, borrow, or otherwise obtain the benefits of the money or other property before the conclusion of the exchange. Treas. Reg. §1.1031(k)-1(g)(6). The agreement may allow the taxpayer to take actual or constructive receipt of the money or other property at the end of the identification period if no replacement properties are identified by the taxpayer, upon receipt of all identified replacement properties to which the taxpayer is entitled, or upon the occurrence after the conclusion of the identification period of a material or substantial contingency that relates to the exchange, is provided for in writing, and is beyond the taxpayer's control or of any disqualified person other than the person obligated to transfer the property to the taxpayer. Treas. Reg. §1.1031(k)-1(g)(6).

A taxpayer may receive money or other property from a party to the transaction, other than the safe harbor, without triggering actual or constructive receipt of the money or other property. Treas. Reg. §§1.1031(k)-1(g)(3)(b), 1.1031(k)-1(g)(4)(vii). However, if the taxpayer is allowed to receive money or other property from a party to the exchange other than the safe harbor, such as the buyer of the relinquished property, how can all rights to the relinquished property contract possibly be assigned to a qualified intermediary as required by the qualified intermediary safe harbor arrangement? This is just one of many unanswered questions in the §1031 arena.

Finally, it is important to note that more than one safe harbor arrangement can be used in any given transaction. Treas. Reg. §1.1031(k)-1(g)(1).

1. SECURITY OR GUARANTEE ARRANGEMENT

Regulation §1.1031(k)-1(g) provides for the security or guarantee arrangement safe harbor.

Under Treas. Reg. §1.1031(k)-1(g) a taxpayer will be considered to have actual or constructive receipt of money or other property before receiving replacement property if the obligation of the taxpayer's transferee (i.e., the Purchaser of the relinquished property) is, or may be, secured or guaranteed by one or more of the following:

1. A mortgage, deed of trust or other security interest (other than cash or a cash equivalent);

2. A stand-by letter of credit which satisfies all of the requirements of Treas. Reg. §15(a).453-1(b)(iii) and which does not allow the taxpayer to draw upon the stand-by letter of credit except on a default of the Transferee's obligation to transfer like-kind replacement property to the taxpayer; or

3. A guarantee of a third party.

This safe harbor arrangement is rarely utilized.

2. QUALIFIED ESCROW OR QUALIFIED TRUST

Treas. Reg. §1.1031(k)-1(g)(3) provides for the Qualified Escrow and Qualified Trust safe harbors. A taxpayer will not be considered to have actual or constructive receipt of money or other property simply because the obligation of the taxpayer's transferee to the transaction is or may be secured by cash held in a qualified escrow account or in a qualified trust.

To be qualified, the escrow holder or trustee must not be a disqualified person, and the taxpayer's ability to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent in escrow must be limited as provided in Regulation §1.1031(k)-1(g)(6).

A qualified escrow account is one in which the escrow account holder is not the taxpayer or a disqualified person. Treas. Reg. §1.1031(k)-1(g)(3)(ii)(A). A qualified trust is a trust in which the trustee is not the taxpayer or a disqualified person. Treas. Reg. §1.1031(k)-1(g)(3)(iii)(A). Although the fiduciary relationship created by a trust arrangement would ordinarily result in the trustee being considered a disqualified person, the relationship created by the qualified trust arrangement will be disregarded for this purpose. Treas. Reg. §1.1031(k)-1(g)(3)(iii)(A)

Qualified Escrow and Qualified Trust safe harbor arrangements cease to apply at the time the taxpayer has the immediate ability or an unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in escrow or in trust. Treas. Reg. §1.1031(k)-1(g)(3)(iv).

Like the security or guarantee arrangement discussed above, the qualified escrow or qualified trust is also a very rare §1031 safe harbor.

3. QUALIFIED INTERMEDIARY

The most common §1031 safe harbor is the Qualified Intermediary. The Qualified Intermediary safe harbor is easy to use, so it is usually preferred to the other safe harbor arrangements. Treas. Reg. §1.1031(k)-1(g)(4) provides that the Qualified Intermediary is not the agent of the taxpayer. Furthermore, Treas. Reg. §1.1031(k)-1(g)(4) provides that in exchanges in which a Qualified Intermediary is used as the safe harbor arrangement, the taxpayer's transfer of relinquished property and subsequent receipt of like-kind replacement property will be treated as an exchange, and the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives the like-kind replacement property is made as if the Qualified Intermediary is not the taxpayer's agent. Treas. Reg. §1.1031(k)-1(g)(4).

Like the other safe harbor arrangements discussed above, the Qualified Intermediary safe harbor arrangement is also subject to Treas. Reg. §1.1031(k)-1(g)(6) limitations. Very simply put, the limitations under Regulation §1.1031(k)-1(g)(6) limit, with few exceptions, the taxpayer's right to receive, pledge, borrow, or otherwise obtain the benefits of the money or other property before the end of the exchange period.

Under Treas. Reg. §1.1031(k)-1(g)(4)(iii), a Qualified Intermediary is any person who:

1. Is not the taxpayer or other disqualified person;

2. Enters into a written agreement with the taxpayer under which the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the money or other property held by the Qualified Intermediary are limited; and

3. Acquires the relinquished property from the taxpayer, transfers the relinquished property to the purchaser, acquires the replacement property from the seller and transfers the replacement property to the taxpayer as required by the written agreement.