Deferred like-kind exchanges: an analysis of the proposed regulations under section 1031(a)(3).

Deferred Like-Kind Exchanges: An Analysis of the Proposed Regulations under Section 1031(a)(3)

Introduction

With the addition of section 1031(a)(3) to the Internal Revenue Code by the Tax Reform Act of 1984, Congress substantially altered the requirements affecting deferred like-kind exchanges.(1*) Prior to this legislation, taxpayers faced little or no time constraints on when they could receive property from the transferee in an otherwise qualifying exchange under section 1031(a). Section 1031(a) placed significant restrictions on this deferral ability by requiring the taxpayer to (i) identify replacement property within 45 days of the transfer of the relinquished property and (ii) receive such property no later than the earlier of 180 days after the transfer or the extended due date of the taxpayer's tax return.

Taxpayers and their counsel soon found that they had to give their own interpretations to section 1031(a)(3), as the brevity of the new statute did not provide the answers to all questions. For example, questions arose concerning the proper way replacement property is to be identified by the taxpayer and the proper manner of receipt of the replacement property.(2) Furthermore, there was a question whether the taxpayer violates the doctrine of constructive receipt where a restricted cash account is used as a means of funding the purchase of the replacement property.

In an effort to address some of these issues, on May 15, 1990, the Internal Revenue Service issued proposed regulations under section 1031(a)(3). This article presents the historical background leading to the enactment of section 1031(a)(3) and provides an analysis of the proposed regulations. The proposed regulations fill some of the informational void facing taxpayers and thus provide a greater degree of certainty for tax planning. Some questions remain unanswered, however, so the article concludes with some suggestions for these remaining omissions.

The Underlying Purpose of Section 1031(a)(3)

Section 1031(a)(3) provides that -

no gain or loss shall be recognized on the exchange of

property held for productive use in a trade or business

or for investment if such property is exchanged

solely for property of like kind which is to be held

either for productive use in a trade or business or for

investment.

If cash or property not of like kind is received, gain is recognized equal to the lesser of the realized gain or the value of this other property, i.e., "boot." The nonrecognition rules of section 1031(a) are mandatory, so a desired escape from their provisions requires careful planning by the taxpayer.

Although section 1031(a) provides for an "exchange" of properties, there is no requirement for a direct exchange between two parties. Moreover, the replacement property received by the taxpayer does not have to come from the party to whom the taxpayer transferred its relinquished property. For example, in W.D. Haden Co. v. Commissioner, 165 F.2d 588 (5th Cir. 1948), the court allowed nonrecognition treatment for the following three-party exchange:(3) Taxpayer A, who owned Property X, wanted to acquire Property Y from Taxpayer B. Taxpayer B did not, however, want to engage in an exchange of properties, but rather wanted to sell Y for cash. To complete the transaction, a third party, Taxpayer C, was found who was willing to consummate the three-party exchange. Taxpayer A transferred Property X to C, who then paid cash to Taxpayer B, who in turn transferred Property Y to A. The nonrecognition rules of section 1031 applied to A, but not to B or C.(4)

Similar arrangements were made where the taxpayer exchanged property for like-kind property to be purchased by the transferee from a third party. Traditionally, the replacement property to be purchased by the transferee was identified by the taxpayer before relinquishing his property.(5) In Starker v. United States, 602 F.2d 1341 (9th Cir. 1979), the Ninth Circuit held, however, that the replacement property need not be identified by the time of the original exchange.(6) In that case, the taxpayer transferred property to the transferee under a "land exchange agreement." The agreement required the transferee to establish for the taxpayer an "exchange balance" of approximately $1.5 million with an annual growth rate of six percent. The transferee was to use this fund to acquire suitable replacement property for the taxpayer, which the latter had to identify within five years. If no replacement property were identified within that time, the taxpayer would receive the balance in the fund. The court held that the original exchange qualified under section 1031(a) because the taxpayer displayed an obvious intent to receive like-kind property rather than cash. The intent at the date of the original exchange was manifested ex post facto by the ultimate receipt of qualifying property. The six-percent growth factor, however, was taxed as interest income when deemed received, in an amount equal to the value of the property eventually received over its value at the date of the original transaction.

In direct response to Starker, Congress enacted section 1031(a)(3). The avowed purpose of the new statute was to bring these deferred exchanges more in line with the general legislative intent of section 1031.(7) Nonrecognition under section 1031 has been justified on the premise that a taxpayer making a like-kind exchange has not, in substance, made an economic exchange, but rather has maintained a continual investment in an economic interest.(8) This "continuity of investment" doctrine logically argues that no realizable event has taken place since the taxpayer merely continues to hold the same investment, though in somewhat different form.(9) To the extent that the taxpayer is able to defer completion of the exchange by designating the property to be received in the future, the transaction begins to resemble not a like-kind exchange, but a sale of the original property followed by a purchase of the replacement property.(10) By enacting section 1031(a)(3), Congress sought to put measurable restrictions on how long taxpayers could defer the receipt of the replacement property, thereby limiting their ability to defer income taxes on what may be essentially a sale. In placing these time limits on the acquisition of qualified replacement property, Congress was placing section 1031 on a consistent course with other nonrecognition provisions of the Code, e.g., sections 1033(a) and 1034(a), that generally allow a two-year period in which taxpayers may find suitable replacement property for principal residences or property condemned or destroyed.

The statute and proposed regulations provide that any property received by the taxpayer in a deferred exchange is treated as property which is not like-kind if:

(a) such property is not identified as property to be received

in the exchange on or before the day which is

45 days after the date on which the taxpayer transfers

the relinquished property in the exchange, or

(b) such property is received after the earlier of:

(1) the day which is 180 days after the date on

          which the taxpayer transfers the relinquished
          property in the exchange, or

(2) the due date, including extensions, of the

          taxpayer's tax return for the taxable year in
          which the transfer of the relinquished property
          occurs.

Two distinct periods exist in which the taxpayer must meet certain requirements. The first, the 45-day period, is termed the "identification period."(11) The second statutory period, the 180-day period, is termed the "exchange period."(12) These two periods are the main obstacles that the taxpayer must clear to qualify under section 1031. The proposed regulations, however, present several smaller hurdles within the penumbra of these two rules; failure to satisfy these other mandates will obviate all but the most careful planning.

The Identification Period

Because the identification and exchange periods are statutorily set, the taxpayer can expect little relief from the courts if an inadvertent error occurs. One trap for the unwary is that both periods are determined without regard to section 7503 (relating to the time for performance of acts where the last day for performance falls on a Saturday, Sunday, or legal holiday).(13) The following example depicts the interaction of the two statutory periods:

Example 1: Corporation A, a calendar-year taxpayer,

enters into an agreement with Corporation B to exchange

property. Corporation A transfers Whiteacre

to Corporation B on November 17, 1990. On or before

January 1, 1991, Corporation A must identify qualifying

replacement property. The fact that January 1

is New Year's Day is irrelevant. Corporation A must

receive the property by March 15, 1991, the due date

of its tax return. If Corporation A is allowed an

automatic six-month extension of time to file its return,

however, the replacement property must be received

by May 16, 1991 (180 days after the transfer of

Whiteacre).

What if, as part of the exchange, the taxpayer transfers more than one property on different dates? What are the relevant time-periods for the two exchange periods in this instance? Prop. Reg. [Section] 1.1031(a)-(3)(b)(2)(iii) provides that the identification and exchange periods are determined by reference to the earliest date on which any of the properties was transferred.

Example 2: Corporation A and Corporation B agree

to a deferred exchange of like-kind property. Corporation

A is to transfer Whiteacre and Greenacre to

Corporation B, which will purchase and transfer

suitable replacement property when it is identified

by Corporation A. Corporation A transfers title to

Whiteacre on November 17, 1990, and transfers title

to Greenacre on December 15, 1990. The expiration

dates of the two statutory periods are the same as

stated in Example One (i.e., March 15, 1991, the due

date of Corporation A's tax return, or if the return is

extended, May 16, 1991), since the date the first

property (Whiteacre) is transferred controls.

Prop. Reg. [Section] 1.1031(a)-(3)(c) lays out the form and manner in which the replacement property must be identified. Prop. Reg. [Section] 1.1031(a)-(3)(c)(2) states that the property must be identified in a written document, signed by the taxpayer, and hand delivered, mailed, telecopied, or otherwise sent to a person involved in the exchange other than the taxpayer or a related party. Related parties are defined as (i) persons bearing a relationship to the taxpayer described in section 267(b) or 707(b) (substituting 10 percent for 50 percent); (ii) persons acting as the taxpayer's agent (including employees of the taxpayer as well as its attorney or broker); or (iii) persons related to the taxpayer's agent under section 267(b) or 707(b) (substituting 10 percent for 50 percent).(14)

A question arises concerning the proper person to receive the written document if the taxpayer engages in a deferred exchange with a related party. Exchanges with related parties are clearly permitted under section 1031(f), albeit under certain restrictions.(15) According to Prop. Reg. [Section] 1.1031(a)-(3)(c)(2), the taxpayer cannot supply the written document to any related party. Presumably, the related party's attorney or broker may qualify as the recipient, so long as the latter is not also the taxpayer's attorney or broker.

The taxpayer may satisfy the notice requirement in respect of a deferred exchange with a related party in two additional ways. One is to receive the property before the end of the identification period. Prop. Reg. [Section] 1.1031(a)-3(c)(4)(ii)(A) provides that property actually received before the end of the 45-day period is deemed to have been identified; a written notice is not necessary. The other option is to specifically identify the replacement property in the written agreement for the exchange of properties, signed by all parties to the agreement and executed before the end of the identification period. Such a document will be treated as fulfilling the identification requirement and does not have to be physically sent to a person involved in the exchange. Since the regulations only prohibit "sending" the written document to a related party, there appears to be no violation of the requirement if the related party and the taxpayer perform a mutual signing of the contract in which the replacement property is identified.

Prop. Reg. [Section] 1.1031(a)-(3)(c)(3) specifies the description of the replacement property. It must be unambiguously described in the written document or agreement. For real property, the term "unambiguous" means a clear representation of its legal description or its street address. Prop. Reg. [Section] 1.1031(a)-(3)(c)(7) provides an example of an unsatisfactory identification where the taxpayer identified the replacement property as "unimproved land located in Hood County with a fair market value not to exceed $100,000." Personal property must be characterized by a particular type of property, to mean not only its brand name, if any, but its specific make and model, and in the instance of vehicles, the year of the model.

Identification of Alternate and Multiple Properties

In some instances, the taxpayer will find it necessary to identify more than one property as potential replacement property. For example, contingencies beyond the taxpayer's control could foster uncertainty whether preferred replacement property will be either available or acceptable in the future. Moreover, the time periods of section 1031(a)(3), by their brevity, impose additional pressure to designate some contingent property. By increasing the choices available for the transferee's acquisition for ultimate exchange, the probability is increased that there will be at least some property to be acquired. With only one property identified, the taxpayer is constrained to buy that property alone. Should another party acquire such property after the expiration of the identification period, nonrecognition under section 1031 will be denied since no other replacement property was identified during the identification period. Example 3 depicts another situation wherein extraneous legal uncertainties mandate the identification of more than one property.

Example 3: Corporation A transfers Whiteacre to Corporation

B on October 1, 1990. On the same date,

Corporation A identifies Blackacre as the replacement

property to be received if zoning changes are approved

and Brownacre if zoning changes are not approved.

Section 1031(a)(3) does not address whether the taxpayer should be allowed to identify alternate or multiple properties. The Conference Report on the 1984 Act anticipated that the designation requirement would be satisfied if the taxpayer identified a limited number of properties when the replacement property would be determined by contingencies beyond the control of both parties.(16) Example 3 describes an event of this nature. The Conference Report did not, however, discuss how many alternate choices the taxpayer could identify. The comment was made that the taxpayer would be entitled to designate a maximum of five alternate properties for each property transferred, although circumstances might exist that would allow the taxpayer to designate more than five properties.(17)

Prop. Reg. [Section] 1.1031(a)-3(c)(4) adopts a position of compromise with respect to the suggestions of the Conference Report. Specifically, two separate rules are adopted, viz., the three-property rule and the 200-percent rule, both of which serve to limit the number of replacement properties that the taxpayer can identify. The taxpayer may use either rule in setting the maximum number of properties to designate, as long as the properties selected are identified before the end of the identification period.

The three-property rule is straightforward and simple, providing that the taxpayer may identify three replacement properties, regardless of value.

Example 4: On May 17, 1991, Corporation A transfers

Blackacre to Corporation B in a deferred like-kind

exchange. Blackacre is unencumbered and has

a fair market value of $100,000. On June 28, 1991,

Corporation A properly identifies Whiteacre,

Brownacre, and Greenacre as replacement properties.

By October 1, 1991, Corporation A will inform

Corporation B which identified property is to be

transferred. Because not more than three properties

were identified, Corporation A will be accorded

nonrecognition treatment on the exchange. The fact

that the final identification does not occur until after

the 45-day identification period is irrelevant, as long

as the property ultimately identified is received before

the expiration of the 180-day exchange period.

The 200-percent rule, applicable when the taxpayer has identified more than three properties, allows the identification of an unlimited number of properties so long as their aggregate value at the end of the identification period does not exceed 200 percent of the value of all relinquished properties as of the date transferred by the taxpayer.(18) If more than one relinquished property is transferred on different dates, the value of each property on the separate dates transferred will be controlling.

Example 5: On May 17, 1991, Corporation A transfers

Whiteacre to Corporation B in a deferred like-kind

exchange. Whiteacre is unencumbered with a

value of $100,000 on the date of the exchange. On

the same date, Corporation A properly identifies

Brownacre, Blackacre, Greenacre, and Grayacre as

alternate and multiple replacement properties. On

July 1, 1991, the last day of the identification period,

the fair market value of the replacement properties

is $30,000, $40,000, $50,000, and $60,000, respectively.

Because Corporation A has identified more

than three properties, it must use the 200-percent

test; because the sum of the property values equals

$180,000, Corporation A has met the 200-percent test.

For purposes of both the three-property test and the 200-percent test, any property actually received during the identification period reduces the number or value of the properties available to the taxpayer for further identification.

Example 6: Corporation A transfers Whiteacre to

Corporation B in a deferred like-kind exchange on

May 17, 1991. Whiteacre has a value on this date of

$100,000. On May 19, 1991, Corporation B transfers

Blackacre with a value of $40,000 to Corporation B.

Corporation B may further identify two properties of

any value or any number of other properties as long

so their value does not exceed $160,000 in total.

Prop. Reg. [Section] 1.1031(a)-3(c)(4)(ii) provides a harsh penalty if the taxpayer does not pass either test. In this situation, the taxpayer is treated as having identified no properties.(19) Prop. Reg. [Section] 1.1031-(3)(c)(4)(ii) provides two limited opportunities to avoid this sharp verdict. In one instance, any property received by the taxpayer before the end of the identification period will be considered as property identified.(20)

Example 7: On May 17, 1991, Corporation A transfers

Blackacre to Corporation B in a deferred like-kind

exchange. Blackacre has a value of $100,000.

On the same date, Corporation A identifies four properties,

all with a value of $100,000: Whiteacre,

Brownacre, Greenacre, and Grayacre. Since Corporation

A has failed both the three-property and 200-percent

test, it must receive one of the properties on

or before July 1, 1991, in order to be considered as

properly identifying such property.

A second exception to the identification rules exempts any properly identified replacement property if received before the end of the exchange period, but only if the taxpayer receives property constituting at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period.(21) As a practical matter, this exception will provide little, if any, relief to the taxpayer. Since the exception applies only if the taxpayer has failed both the three-property and 200-percent tests, the taxpayer will be required to actually receive property equal in value to at least 190 percent of the relinquished property. Although the proposed regulation is not specific, this second exception may prove beneficial, to those taxpayers that identify multiple properties and increase their investment by either paying additional cash or incurring additional indebtedness as a result of the exchange.(22) Unless the taxpayer identifying the alternate properties is willing to pay additional cash equal to 90 percent of the value of the property relinquished, however, this exception is unworkable.

Example 8: On May 17, 1990, Corporation A transfers

Whiteacre to Corporation B in a deferred like-kind

exchange. Whiteacre is unencumbered and has

a fair market value of $100,000. On June 28, 1991,

Corporation A properly identifies Blackacre,

Brownacre, Greenacre, and Grayacre as replacement

properties. On July 1, 1991, the last day of the

identification period, each of the properties has a fair

market value of $100,000 and is subject to a liability

of $75,000. On October 1, 1991, Corporation B transfers

the identified properties to Corporation A.

Corporation A has identified more than three properties and the total value of the properties exceeds $200,000. Since Corporation A received all of the identified properties prior to the end of the exchange period, however, it has satisfied the 95-percent test. The 95-percent test provides some flexibility by allowing the taxpayer that receives multiple properties to acquire slightly less than the total identified. This flexibility is illustrated in the following example:

Example 9: On May 17, 1991, Corporation A transfers

Whiteacre to Corporation B in a deferred like-kind

exchange. Whiteacre is unencumbered and has

a fair market value of $2,000,000. On June 28, 1991,

Corporation A identifies 20 different lots as replacement

properties. On July 1, 1991, each lot has a fair

market value of $250,000 and is subject to a liability

of $150,000. On October 1, 1991, Corporation A receives

19 of the lots and cash in the amount of

$100,000. Since Corporation A has received 95 percent

of the identified properties, it has satisfied the

identification requirement.

Incidental Property

An exchange will often include property incidental to the primary property received by the taxpayer. For example, the taxpayer may identify an apartment building as the replacement property and anticipate that the property transfer will include not only the apartment building but also any furniture, laundry machines, and other properties normally included within the building. Prop. Reg. [Section] 1.1031(a)-(3)(c)(5) provides that, for purposes of the three-property rule and in determining whether the replacement property is properly identified, the main property and the incidental property are to be treated as one property. Property is considered incidental to a larger item of property if:(23)

(a) in standard commercial transactions, the property

is typically transferred together with the larger item

of property; and

(b) the aggregate fair market value of all such properties

does not exceed 15 percent of the aggregate fair

market value of the larger item of property.

Example 10: Corporation A transfers Whiteacre

to Corporation B on May 17, 1991. Whiteacre has

been held for investment, is unencumbered, and

has a fair market value of $1,150,000. Pursuant

to the agreement, Corporation A identifies Blackacre,

Brownacre, and Sunnyacres as the replacement

properties. Blackacre and Brownacre are

unimproved lots, each with a fair market value of

$1,150,000. If Corporation A chooses Sunnyacres

as its replacement property, it will receive an

apartment building with a value of $1,000,000

and the following personal property with an aggregate

value of $150,000: furniture, laundry

machines, and miscellaneous property.

Since the aggregate fair market value of the incidental property does not exceed $150,000 (15 percent of $1,000,000 - the value of the apartment building), the entire bloc constitutes one property. Corporation A has thus satisfied the three-property rule. Furthermore, for purposes of the identification requirement, the entire bloc is treated as properly identified if the legal description or street address of Sunnyacres is given. There is no need to make specific mention of the incidental properties.(24)

Receipt of Identified Replacement Property

As previously explained, the taxpayer has basically 180 days from the date of the exchange to receive the identified replacement property. Such property will be considered received before the end of the exchange period only if:(25)

(a) the taxpayer receives the replacement property before

the end of the exchange period, and

(b) the replacement property received is substantially

the same as the property identified.

Generally, the "substantially the same" test will not create an issue, since the taxpayer must receive the specific parcel(s) identified. In effect, this test simply allows the taxpayer to receive less than a 100-percent interest in the identified property. The following example is paraphrased from the regulations:

Example 11: On May 17, 1991, Corporation A transfers

Whiteacre which is unencumbered with a fair

market value of $100,000 to Corporation B. Pursuant

to their agreement, the parties provide that, to

the extent the fair market value of the replacement

property transferred to Corporation A is greater or

less than the fair market value of Whiteacre, either

party will eake up the difference by paying cash to

the other after the date the replacement property is

received by CorporatioN A. In the exchange agreement,

Corporation A identifies Blackacre as replacement

property. Blackacre consists of two acres of

unimproved land and has a fair market value of

$250,000. On October 3, 1991, at Corporation A's

direction, Corporation B purchases 1.5 acres of

Blackacre for $187,500 and transfers it to Corporation

A which pays $87,500 to Corporation B.

According to Prop. Reg. [Section] 1.1031(a)-(3)(d)(2), Example 2, since the value of the replacement property received by Corporation A is 75 percent of the entire value of the property identified, Corporation A is considered to have received substantially the same property as identified. Although the proposed regulations adopt the 75-percent test, they are silent concerning its intended purpose and meaning. Presumably, the 75-percent test is meant to curb the perceived abuse whereby the taxpayer identifies as replacement property three large acres with a fair market value greater than 200 percent of the property transferred and then selects only one building as the replacement property.

The issue arises whether the 75-percent figure constitutes a minimum threshold that must be satisfied in all cases. Certainly, it is arguable that the receipt of less than 75 percent of the designated property may qualify as "substantially the same" property as identified, especially since the most desirable property may be well in excess of the relinquished property, but can be easily subdivided by the seller.

Example 12: On May 17, 1991, Corporation A transfers

Whiteacre to Corporation B. Whiteacre is unencumbered

with a fair market value of $100,000. Corporation

A identifies Blackacre as replacement property

on June 17, 1991. Blackacre consists of two

acres of unimproved land and has a fair market

value of $250,000. On July 19, 1991, at Corporation

A's direction, Corporation B purchases 0.8 acre of

Blackacre for $100,000 and transfers it to Corporation

A.

In the example, Corporation A has received 40 percent of the value of the identified property. Since it has received less than 75 percent of the property, one must ask whether the "substantially the same" test has been satisfied. The only difference between the two examples is that in Example 11 Corporation A paid $87,500 for additional acreage. This fact alone should not change the result and Corporation A should be considered as having received substantially the same property as identified. The final regulations should clarify this ambiguity. Until then, practitioners have little choice but to consider 75 percent as a minimum figure.

Identification and Receipt of

Replacement Property to Be Produced

The taxpayer may be in the position where the replacement property has yet to be constructed or produced. Prop. Reg. [Section] 1.1031(a)-(3)(e) provides that a deferred exchange will not fail to qualify for nonrecognition merely because the replacement property is not in existence or is being produced at the time the property is identified as replacement property. Of course, the taxpayer must receive the property, complete or not, by the end of the 180-day exchange period. Moreover, since improvements are being made during this period, its value is necessarily increasing. Therefore, for purposes of the 200-percent test, as well as the exception for receipt of incidental property, the controlling value to be used is the expected value of the property on the date it is received by the taxpayer and not the date it is identified.(26)

Prop. Reg. [Section] 1.1031(a)-(3)(e)(3) requires that the improved property received must be substantially the same property as identified. In the case of personal property, this means that the production must be completed on or before the date the property is received by the taxpayer. The receipt requirement with respect to real property is ambiguous, especially if construction is not completed within the 180-day exchange period. One interpretation is that as much of the property completed and transferred at the expiration of the exchange period will qualify as replacement property while property subsequently constructed and delivered will be regarded as boot. A second interpretation is that the taxpayer may be required to receive property representing 75 percent of the fair market value of the completed structure.(27)

Example 13: On May 17, 1991, Corporation A transfers

Whiteacre (which is unencumbered with a fair

market value of $400,000) to Corporation B in a deferred

like-kind exchange. On June 30, 1991, Corporation

A identifies Blackacre with a fair market value of

$100,000 as replacement property. In addition, Corporation

A has directed Corporation B to construct an

apartment building on Blackacre. On November 12,

1991, Corporation B transfers Blackacre, along with

the unfinished apartment building, to Corporation A

with the intent of completing construction by May 1,

1991. On November 12, 1991, the fair market value of

the unfinished structure is $300,000. Since Corporation

A received 75 percent of the fair market value of

the completed structure, the "substantially the same

property" requirement is apparently satisfied.

Identification of replacement property that has yet to be produced is similar to that of already produced property. If the replacement property is real property, the identification requirement is satisfied if a taxpayer provides a legal description of the underlying land and as much detail as practicable for the construction of the improvements.

Constructive Receipt and Deferred Exchanges

In the past, one onerous trap was the doctrine of constructive receipt of cash. Since the receipt of cash generates recognition (and, if equal to the value of the relinquished property, constitutes a sale), taxpayers had to be careful to avoid the appearance of receiving any cash as part of the exchange. The proposed regulations address this issue and provide taxpayers some "safe-harbor" rules that will enable them to avoid the constructive receipt rules. This avoidance is critical. As Prop. Reg. [Section] 1.1031(a)-(3)(f)(2) points out, the actual or constructive receipt of cash or other property, i.e., boot, before the receipt of the replacement property and in the full amount of the value of the relinquished property, will constitute a sale and not a deferred exchange, even if the property is properly identified and received within the exchange period.

Pursuant to Treas. Reg. [Section] 1.451-2(a), the taxpayer is in constructive receipt of money or other property at the time such money or property is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it if notice of intention to withdraw is given. Moreover, even if the taxpayer is not in constructive receipt due to substantial limitations or restrictions, the taxpayer constructively receives the property at the time such limitations lapse, expire, or are waived.(28) A taxpayer is also in constructive receipt when an agent of the taxpayer is in actual or constructive receipt.

These issues can be of utmost importance in deferred exchanges. A taxpayer is rarely willing to rely on just the transferee's unsecured promise to acquire like-kind property and will generally seek a guarantee of performance. Moreover, an intermediary is often necessary to facilitate the exchange because the transferee is unwilling to acquire the replacement property.

Example 14: Corporation A transfers Whiteacre to

Corporation B in a deferred exchange on May 17,

1991. On that date, Whiteacre is unencumbered and

has a fair market value of $100,000. On or before

July 1, 1991, Corporation A is required to identify

suitable replacement property that it must receive on

or before November 13, 1991. As part of the agreement,

Corporation A has the right any time after May

17, 1991, and before Corporation B has purchased

replacement property, to demand that Corporation B,

after proper notice, pay him $100,000 in lieu of acquiring

the replacement property. Corporation A subsequently

identifies Blackacre as replacement property,

and Corporation B purchases Blackacre, transferring

it within the 180-day exchange period.

Because Corporation A has the unrestricted right to receive cash instead of Blackacre, it is in constructive receipt of the cash. Since it is in constructive receipt of the money before it actually receives Blackacre, the transaction constitutes a sale of Whiteacre followed by a subsequent purchase of Blackacre.

As taxpayers are likely to enter into deferred exchanges in which constructive receipt of cash is problematic, Prop. Reg. [Section] 1.1031(a)-(3)(g) provides four safe harbors to determine that the taxpayer is not in constructive receipt. Even if the taxpayer is within the purview of a safe-harbor test, however, if other circumstances develop that give the taxpayer the ability or right to receive money or other property, constructive receipt will prevail. In other words, meeting one of the four safe-harbor tests does not protect the taxpayer from any other ramifications from other agreements that might constitute constructive receipt. The four tests are discussed seriatim.

Security or Guarantee Arrangements

Pursuant to Prop. Reg. [Section] 1.1031(a)-(3)(g)(2), three categories of security or guarantee arrangements are permitted. The first permits the taxpayer to secure the conveyance of replacement property with a mortgage, deed of trust, or other security interest in the property (other than cash or a cash-equivalent). The taxpayer is thus allowed to secure the transferee's obligation to perform by obtaining a security interest in either the property transferred or any other property owned by the transferee. Since the proposed regulations do not qualify the type of property that may be secured, any property owned by the transferee presumably may be pledged, whether or not it is property of a like-kind to the relinquished property. In other words, it seems permissible to secure a transfer of real property by the transferee's interest in some form of tangible personal property.

Example 15: On May 17, 1991, Corporation A transfers

Whiteacre to Corporation B in a deferred like-kind

exchange. Corporation A secures Corporation

B's obligation to transfer replacement property with

a security interest in five trucks owned by Corporation B.

Under the foregoing scenario, Corporation A would not be considered in constructive receipt of the trucks, since they are not cash or a cash equivalent. Query the result if Corporation A had obtained a security interest in U.S. government bonds, even long-term bonds. Would they be a cash equivalent? Certainly, short-term Treasury bills would be considered such equivalent. In any event, taxpayers should avoid the use of any financial instrument as collateral if the first safe-harbor test is to be met.

The second type of guarantee permitted is the standby letter of credit. This device permits the taxpayer to draw upon the instrument if the transferee fails to provide replacement property. The letter of credit will qualify as a safe-harbor instrument if it satisfies the requirements of Treas. Reg. [Section] 15A.453-1(b)(3)(iii) and prohibits the taxpayer from drawing upon the instrument except for the transferee's failure to transfer the like-kind property. Treas. Reg. [Section] 15A.453-(1)(b)(3)(iii) defines a standby letter of credit as a non-negotiable, nontransferable letter of credit issued by a bank or other financial institution that guarantees debt secured by the letter of credit. Local law, and not the instrument's terms, will determine whether the letter of credit is non-negotiable and nontransferable.(29) The letter of credit will not qualify as a standby letter of credit if it may be drawn upon prior to the transferee's failure to acquire and transfer replacement property.(30)

A third allowable security or guarantee arrangement involves a third-party guarantor. Although the guarantor may certainly be related to the transferee, the question arises whether the third-party guarantor may be related to the taxpayer. Despite the silence of the proposed regulations, it is doubtful that an entity related to the taxpayer will pass muster as a qualifying guarantor under these rules. This conclusion is especially convincing in light of the identification rules which do not permit written notification to be sent to a related party of the taxpayer. In addition, as explained below, related parties are not permitted to act as escrow agents or trustees for a qualifying escrow account or trust, nor are they allowed to act as qualifying intermediaries to effect the exchange.

Qualified Escrow Accounts and Trusts

The taxpayer may secure performance by requiring the transferee to deposit cash in an escrow or trust account. The transaction will be treated as a sale and not an exchange if the taxpayer is deemed in constructive receipt of these funds. According to Prop. Reg. [Section] 1.1031(a)-(3)(g)(3), the taxpayer will not be considered in constructive receipt if the transferee's obligation is secured by a "qualified" escrow or trust. To be qualified, the escrow holder or trustee must not be the taxpayer or a related party. Moreover, the agreement must state that the taxpayer must not have the right to receive money or other property from the escrow account or trust until:(31)

(a) after the identification period, if the taxpayer has

not identified replacement property by that time;

(b) after the taxpayer has received all of the identified

replacement property to which the taxpayer is entitled;

(c) if the taxpayer identifies replacement property, after

the later of the end of the identification period

or the occurrence of a material and substantial contingency

that

(1) relates to the deferred exchange,

(2) is provided for in writing, and

(3) is beyond the control of the taxpayer or a related

party, or

(d) otherwise, after the end of the exchange period.

These four limitations are hereinafter referred to as "the (g)(6) limitations" (the subsection of the proposed regulations wherein they are discussed). The following example illustrates the use of a qualified escrow account (assume the holder of the account is not related to the taxpayer):

Example 16: On May 17, 1991, Corporation A

transfers Whiteacre to Corporation B. Whiteacre is

unencumbered and has a fair market value of

$100,000. Corporation A is required to identify the

replacement property and Corporation B is required

to purchase the property and transfer it to Corporation

A before the end of the exchange period. Corporation

B deposits $100,000 in an escrow account

as security for its obligation to perform under the

agreement. The escrowed funds are to be used to

purchase the replacement property. The escrow

agreement further provides for the following contingencies:

If Corporation A fails to identify replacement

property on or before July 1, 1991 (the

end of the identification period), it may demand the

funds in escrow any time after that date. If Corporation

A identifies and receives replacement property,

it may demand the balance of the remaining

funds in escrow at any time after receipt of the

property. If the replacement property is not received

by the end of the exchange period, Corporation A is

entitled to all funds in escrow after the end of that

period.

If Corporation A properly identifies the replacement property and Corporation B acquires and transfers it within the statutory periods, the transaction should qualify as a nonrecognition event, since the escrow agreement meets all of the (g)(6) requirements limiting Corporation A's ability to obtain the economic benefits of the funds.

Since the receipt of the replacement property may be subject to contingencies beyond the taxpayer's control, the escrow agreement may provide that the taxpayer is entitled to withdraw the funds upon the occurrence of the stated contingency. In this circumstance, the contingency language must be consistent with the pertinent (g)(6) limitations stated in the regulations. Consider this example:

Example 17: Assume the same facts as in Example

16, except that on May 17, 1991, Corporation A identifies

Blackacre as the replacement property. the

escrow agreement provides that the funds in escrow

are to be used to purchase the replacement property.

Corporation A may demand the funds in escrow at

any time after the later of July 1, 1991, or the occurrence

of any of the following events: (a) Blackacre is

destroyed, stolen (if personal property), seized, requisitioned,

or condemned; or (b) a determination is

made that the regulatory approval necessary for the

transfer of Blackacre cannot be obtained in time for

Whiteacre to be transferred before the end of the

exchange period. Otherwise, Corporation A is entitled

to the escrowed funds after the earlier of November

13, 1991, or the time at which Corporation A

has received Blackacre.

Under this example, Corporation A is not deemed to be in constructive receipt of the $100,000. The critical question is when can Corporation A draw upon the escrowed funds. Although Corporation A has the right to withdraw the funds after July 1, 1991 (the end of the identification period), its right is only permitted by the (g)(6) regulatory limitations allowing the taxpayer to withdraw funds from escrow if the taxpayer's rights to the replacement property are subject to a material and substantial contingency beyond the taxpayer's control. Only those contingencies actually preventing the taxpayer from taking physical possession of the property are relevant under this analysis.

Example 18: Assume the same facts as in Example

17, except that in addition the escrow agreement

provides that Corporation A may demand the funds

at any time after August 14, 1991, if Blackacre has

not been rezoned from residential to commercial use

by that time. Moreover, Corporation A has properly

identified Greenacre as an alternate replacement

property if Blackacre is not rezoned. In essence, if

Blackacre is not rezoned, Corporation A has the option

of receiving cash or Greenacre. On August 14,

1991, Blackacre is not rezoned.

The proper conclusion here is that Corporation A is in constructive receipt of the $100,000 on August 15, 1991. The critical point is that the zoning issue did not prevent Corporation A from actually receiving the property. The result is the same even if Corporation A chooses not to demand the funds and opts for Greenacre instead. The fact that it could have drawn funds is controlling and, indeed, all that is necessary under the doctrine of constructive receipt. If Corporation A chooses to receive Greenacre, the transaction will be characterized as a sale of Whiteacre on August 15, 1991, with a subsequent purchase of Greenacre.

Qualified Intermediaries

The third safe-harbor rule allows for the taxpayer to utilize a qualified intermediary to facilitate the deferred exchange.(32) A qualified intermediary is a party other than the taxpayer or a related party that, for a fee, acts to facilitate the exchange by (i) acquiring the relinquished property from the taxpayer (either on its own behalf or as the agent of any party to the transaction), (ii) acquiring the replacement property (on its own behalf or as an agent), and (iii) transfering the replacement property to the taxpayer.

Example 19: On May 1, 1991, Corporation A enters

into an agreement to sell Whiteacre to Corporation B

for $100,000 on May 17, 1991. On May 16, 1991,

Corporation A retains Intermediary Corporation

(which is unrelated to Corporation A). Pursuant to

the agreement, Corporation A will transfer Whiteacre

to Intermediary Corporation on May 17, 1991, subject

to Corporation B's right to purchase Whiteacre

on that date. Corporation A's right to receive money

or other property is subject to the previously discussed

(g)(6) limitations. Corporation A pays Intermediary

Corporation a fee to facilitate the transaction.

As a part of the agreement, Intermediary Corporation

acquires Whiteacre from Corporation A and

simultaneously transfers that property to Corporation

B in exchange for $100,000. For reasons unrelated

to federal income tax, legal title to Whiteacre is

transferred directly from Corporation A to Corporation

B. On June 1, 1991, Corporation A identifies

Blackacre as replacement property. On August 9,

1991, Intermediary Corporation purchases Blackacre

for $100,000 and transfers it to Corporation A.

Under the proposed regulations, the foregoing factual situation meets the qualified intermediary requirements. It is noteworthy that Intermediary Corporation is considered to acquire Corporation A's property despite the fact that it never received title to Blackacre and acquired the property subject to a binding agreement to retransfer it to Corporation B. This result is consistent with Revenue Ruling 90-34 holding that section 1031 applies despite a "direct deed" of legal title by the current owner of the property to its ultimate owner.(33)

On the one hand, the qualified intermediary provisions are flexible because they permit the qualified intermediary to be the taxpayer's agent. These rules could, however, prove to be a trap. In order to satisfy the definitional requirements, the qualified intermediary must: (i) acquire the relinquished property from the taxpayer; (ii) acquire the replacement property; and (iii) transfer the latter to the taxpayer. Failure to satisfy any of the requirements will preclude qualified intermediary status.

Example 20: On May 1, 1991, Corporation A enters

into an agreement to transfer Whiteacre to Corporation

B in exchange for like-kind property. Whiteacre

is unencumbered and has a fair market value of

$100,000. On May 16, 1991, Corporation A retains

Intermediary Corporation, an unrelated party, to facilitate

the deferred exchange. On May 17, 1991,

Corporation A transfers Whiteacre directly to Corporation

B and directs the corporation to pay $100,000

directly to Intermediary Corporation. On June 28,

1991, Corporation A identifies Blackacre as replacement

property. On November 12, 1991, Intermediary

Corporation purchases Blackacre for $100,000 and

transfers it to Corporation A. At all times, Corporation

A's right to receive money or other property from

Intermediary Corporation is subject to the (g)(6)

limitations. Corporation A pays Intermediary Corporation

a fee to facilitate the transaction.

Under the proposed regulations, Intermediary Corporation is not a qualified intermediary since Corporation A transferred the property directly to Corporation B.(34) Taxpayers and their counsel should be aware that the mere failure to have the intermediary acquire the taxpayer's property will result in subjecting the transaction to careful scrutiny.(35)

Interest and Growth Factors

Because of the time lag between the date the relinquished property is transferred and the date the replacement property is received, the taxpayer may wish compensation for the delay, using an interest or growth factor to be paid either in cash or as an increase in the value of the like-kind property to be received. The taxpayer receiving such payments prior to the completion of the delayed exchange is deemed to receive the economic benefit of the property value to which the interest or growth factor applies. The taxpayer may therefore be in constructive receipt of money or other property. Prop. Reg. [Section] 1.1031(a)-(3)(h)(1) provides that utilization of such interest or growth factors in a deferred contract will not result in constructive receipt. In order to qualify for safe-harbor treatment, the amount the taxpayer is entitled to receive must depend upon the length of time elapsed between the transfer of the relinquished property and receipt of the replacement property.

Prop. Reg. [Section] 1.1031(a)-(3)(h)(2) provides that such amounts received will not be considered "boot", but rather will be treated as interest to be included in taxable income according to the taxpayer's method of accounting. The following example depicts an acceptable agreement on interest and growth factor that does not violate the constructive receipt doctrine:

Example 21: On May 17, 1991, Corporation A tranfers

Whiteacre which is unencumbered with a fair

market value of $100,000 to Corporation B in a deferred

like-kind exchange. Pursuant to the terms of

the agreement, Corporation A will notify Corporation

B of suitable replacement property by July 1, 1991,

and Corporation B will transfer the identified property

to Corporation A on or before November 13,

1991. The contract provides that Corporation A will

be entitled to an annual growth factor of eight percent

to be paid in either cash or an increase in the

value of the property. On June 1, 1991, Corporation

A identifies Blackacre as replacement property, and

on August 15, 1991, Corporation B transfers

Blackacre to Corporation A, as well as $2,000 in cash,

equal to two-percent interest on $100,000 for three

months at eight-percent per annum. Corporation A

recognizes no gain or loss on the receipt of Blackacre,

but does recognize $2,000 in interest income.

Conclusion

This article attempts to analyze the pertinent parts of the new proposed regulations pertaining to deferred like-kind exchanges. A few tangential issues, such as the computation of gain or loss, as well as the basis of the replacement property, were not discussed, as they offered nothing really new to established law.

There is no question that the proposed regulations have succeeded in providing more certainty to taxpayers and their counsel by establishing some benchmark tests and safe harbors. There still remain some clouded issues, however, that may be clarified with the issuance of final regulations.

Notes

(1) Tax Reform Act of 1984, Public Law No. 98-369, [Section] 77, 98 Stat. 494, 595-97.

(2) Lord, Section 1031 Like-Kind Exchanges Under the Tax Reform Act of 1984, 63 Taxes 304-11 (April 1985).

(3) W.D. Haden Co. v. Commissioner, 165 F.2d 588 (5th Cir. 1948); see Rev. Rul. 57-244, 1957-1 C.B. 247.

(4) For a discussion and analysis of the "held" requirement under section 1031, see Fellows & Yuhas, Like-Kind Exchanges: An Analysis of the New Judicial Doctrine of the Economic Unit, 67 Taxes 596-607 (Sept. 1989).

(5) J.H. Baird Co. v. Commissioner, 39 T.C. 608 (1962).

(6) Starker v. United States, 602 F.2d 1341 (9th Cir. 1979).

(7) S. Print No. 98-169, 98th Cong., 2d. Sess. 243 (1984).

(8) Treas. Reg. [Section] 1.1002-1(c) (1960); Fellows & Yuhas, supra note 4, at 597.

(9) Treas. Reg. [Section] 1.1002-1(c) (1960).

(10) S. Print No. 98-169, 98th Cong., 2d. Sess. 242 (1984).

(11) Prop. Reg. [Section] 1.1031(a)-(3)(b)(1)(i).

(12) Prop. Reg. [Section] 1.1031(a)-(3)(b)(1)(ii).

(13) Prop. Reg. [Section] 1.1031(a)-(3)(b)(2)(iii).

(14) Prop. Reg. [Section] 1.1031(a)-(3)(k).

(15) For a discussion of section 1031(f), see Fellows & Yuhas, Like-Kind Exchanges and Related Parties under Section 1031(f), 68 Taxes 352-62 (May 1990).

(16) H.R. Rep. No. 98-861, 98th Cong., 2d Sess. 867 (1984).

(17) ABA Section of Taxation, Proposed Questions and Answers Relating to Exchanges of Partnership Interests and Delayed Exchanges, Question 19, filed with the Internal Revenue Service on June 8, 1987.

(18) Prop. Reg. [Section] 1.1031(a)-(3)(c)(4)(i)(B).

(19) Prop. Reg. [Section] 1.1031(a)-(3)(c)(4)(ii).

(20) Prop. Reg. [Section] 1.1031(a)-(3)(c)(4)(ii)(A).

(21) Prop. Reg. [Section] 1.1031(a)-(3)(c)(4)(ii)(B).

(22) For an excellent discussion of this issue, see Cuff, "1031 Real Estate Exchanges: Understanding the New Regulations on Deferred Exchanges," in Successful Structuring of 1031 Real Estate Exchanges, Third Annual Conference 23 (Nat'l Real Estate Development Center 1990).

(23) Prop. Reg. [Sub-Section] 1.1031(a)-(3)(c)(5)(i)(A) and (B).

(24) Prop. Reg. [Section] 1.1031(a)-(3)(c)(5)(ii), Example 2.

(25) Prop. Reg. [Section] 1.1031(a)-(3)(d).

(26) Prop. Reg. [Section] 1.1031(a)-(3)(e)(2)(ii).

(27) Cuff, supra note 22, at 30.

(28) Prop. Reg. [Section] 1.1031(a)-(3)(f)(2).

(29) Treas. Reg. [Section] 15A.453-1(b)(3)(iii), Example 7.

(30) Id.

(31) Prop. Reg. [Section] 1.1031(a)-(3)(g)(6).

(32) Prop. Reg. [Section] 1.1031(a)-(3)(g)(4).

(33) Rev. Rul. 90-34, 1990-1 C.B. 154.

(34) Prop. Reg. [Section] 1.1031(a)-(3)(g)(7), Example 4(ii).

(35) Notice on Proposed Rulemaking on Limitations on Deferred Exchanges and Inapplicability to Section 1031, Like-Kind Exchanges, To Partnership Interests (Supplementary Information) (May 15, 1990), reprinted in 1990-1 C.B. 674

JAMES A. FELLOWS is an associate professor of accounting and taxation at the University of South Florida. He is a certified public accountant and received his Ph.D. degree from Louisiana State University. He is the author of numerous tax articles and publications, several of which have appeared in The Tax Executive.

MICHAEL A.YUHAS is an associate professor of taxation at Grand Valley State University. He received his LL.M. degree (Taxation) from Georgetown University, his J.D. degree from Indiana University, and his undergraduate degree from University of Notre Dame. Mr. Yuhas is a member of the Sales and Exchange Committee of the ABA Section of Taxation.