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A survivor's guide ... to tax-free exchanges of life-kind property.


to Tax-Free Exchanges of Like-Kind Property

As a tax practitioner, you might come across the following fact-pattern. Assume that your client, the owner of a fleet of vehicles used in its operations, is interested in disposing of a significant portion of the fleet and acquiring an equal number of replacement vehicles. In order to facilitate this exchange, your client will retain an independent third party(an intermediary), who will sell the vehicles at an auction and subsequently acquire replacement vehicles from one of the major automobile manufacturers at a significant discount. Your client requests advice as to whether the transaction can be accomplished free of federal income tax. Your answer would be that Section 1031 of the Internal Revenue Code does allow for tax-free exchanges of like-kind property, but the present transaction poses two questions that must be addressed, before a final conclusion can be drawn.

First, the fact that an intermediary will be retained to facilitate the exchange could destroy the tax-free status. A second issue, related to the first, is that the transfer of the old vehicles does not occur simultaneously with the acquisition of the replacement vehicles. Does a deferred exchange qualify under Section 1031 for nonrecognition of gain? You advise your client that the IRS has issued final tax regulations on deferred like-kind exchanges, in which both of these issues are discussed, and your advice hinges on the ramifications of these regulations.

In this article, the authors will examine these new, final tax regulations, as they apply to the exchange of tangible personal property used in a trade or business, i.e., business equipment.

We will begin with a review of the fundamentals of Section 1031, expanding the analysis to include multi-party and deferred exchanges, and conclude with a discussion of the impact of the regulations on the exchange of business equipment such as the client in the foregoing example is undertaking.

An Overview of Section 1031

Taxpayers have long relied upon the tax-free treatment of like-kind exchanges to avoid federal income tax liability when exchanging interests of either personal or real property. As long as the property received is a like-kind to the property transferred, and both the property transferred and the property received have been held for trade or business or for investment purposes, Section 1031 provides that there will be no gain or loss recognized for purposes of the federal income tax.(1)

Example 1: J Corp. owns business equipment with an adjusted tax basis of $60,000 and a fair market value of $100,000. The equipment has been depreciated by $80,000, so the unrealized gain on the asset is all ordinary income recapture under Section 1245.

J Corp. agrees to exchange this equipment for like-kind equipment owned by B Corp. Assuming no cash or other property is received by J Corp., it will have a realized gain of $40,000, but will not have any recognized gain.

It is important to note that J's realized gain of $40,000 is merely deferred and not permanently eliminated. J's gain is eventually recognized, and a tax liability will be incurred when J sells the acquired equipment. This later recognition is accomplished by requiring J to assign the basis of the relinquished equipment to the acquired equipment. Moreover, any depreciation recapture under Sec. 1245 on the old equipment carries over to the acquired. In the above example, the acquired equipment, even if it is brand new, begins with $80,000 in ordinary income recapture potential.

Example 2: Assume the same facts as in Example 1, except that J sells the replacement equipment two years later for $100,000. Assume further that the equipment had been further depreciated by $20,000, to a new tax basis of $40,000. Sec. 1245 recapture potential is now $100,000. J's recognized gain will be $60,000, and all of it will be Sec. 1245 ordinary income.

Section 1031 requires that any cash or the value of any non-like-kind property received, i.e., "boot," be recognized when received, limited of course to the actual realized gain. Thus, in Example 1, if J had received $20,000 cash in addition to B's equipment, J would have to recognize $20,000 of ordinary income. The basis in the replacement property would remain at $60,000 since Sec. 1031 mandates that basis be adjusted upward for recognized gain on the exchange, but decreased for any cash received.

Multi-Party Exchanges and Section 1031

Section 1031 encompasses more than simultaneous two-party exchanges. For example, J wishes to engage in a like-kind exchange with B, but B does not own property suitable to J. In such a situation, B could purchase replacement property from a third party, C, and exchange this latter property for J's property. A transaction consummated in this manner is called a "three-party exchange," or a three-way exchange. In undertaking these type of exchanges, it is important that the transaction be structured as an exchange rather than as a sale and repurchase by J. If the IRS deems that in substance the transaction was a sale-repurchase, then all realized gain is recognized by J. This principle is illustrated in the following example.

Example 3: Beta Corp. is the owner of a fleet of automobiles used by its sales personnel. Beta, which replaces a portion of its fleet every year, is in the market for 200 replacement vehicles. The fair market value of the vehicles to be replaced is $1 million and their collective basis is $400,000. Beta has been approached by Profit Corporation, an independent corporation, with the following offer. Profit will conduct an auction to sell Beta's vehicles. It will remit the entire selling price, less auction commissions, to Beta Corporation. Profit will then acquire 200 replacement vehicles for a discount from one of the major automakers, and sell these vehicles to Beta.

Although Beta Corp. may contend that Section 1031 should apply here, it would not. The "achilles heel" in this transaction is that Beta actually received the cash from the sale of the relinquished vehicles. The courts have unanimously held that it is the taxpayer's actual receipt of cash, or its unfettered right to the cash, which earmarks the transaction as a taxable sale, followed by a repurchase of like-kind equipment.(2) Fortunately for Beta, the final regulations on deferred exchanges offer some planning opportunities to avoid this harsh result.

Legislative Reaction to Multi-Party, Deferred Exchanges

With the emergence of these multi-party, deferred exchanges, the issue arose as to whether Section 1031 required the exchange to be simultaneous. Or, would Section 1031 still apply despite the fact that there was a delay between the date the taxpayer transferred and received like-kind property? After a series of court cases giving conflicting results, Congress responded by enacting Section 1031 (a)(3) as part of the Tax Reform Act of 1984.(3) Section 1031 (a)(3) provides that:

1. The taxpayer must identify the

property to be received within

45 days of the transfer of the

original property; and 2. The taxpayer must receive the

identified property by the

earlier of two dates:

(a) the due date (including

extensions) of the taxpayer's tax

return for the year in which the

original property was transferred,


(b) 180 days after the original


The first period, the 45-day period, is called the "identification period," and the second period is called the "exchange period." Failure to meet either of the two tests in these two periods disqualifies the taxpayer from tax-free treatment under Section 1031.[4] As mentioned earlier, the IRS has now issued final regulations to administer Section 1031 (a)(3). We will now turn our attention to an analysis of these regulations.

Interpreting the Rules

Section 1031 (a)(3) mandates the taxpayer to timely identify and receive replacement property. The final regulations further state that should the last day of either period fall on a Sunday or holiday, the periods are not extended.

Example 4: On November 25, 1991, Beta Corp. transfers a portion of its commercial vehicle fleet to Profit who will acquire like-kind property from another party. To receive nonrecognition treatment, Beta must identify like-kind vehicles by midnight January 9, 1992, and receive them all by midnight, March 15, 1992, the due date of its tax return. If Beta receives an extension to file its return, it can receive the replacement property as late as May 23, 1992 (1992 is a leap year), since this date is 180 days from the date of the original transfer.

Should the taxpayer transfer more than one unit of property as part of the original exchange(which is often the case with business property), the two critical time periods begin running on the date that the first unit of property is transferred.(5)

Example 5: Assume that Beta Corp. transfers a portion of its fleet on November 25, 1991, and the remainder of its fleet on December 15, 1991. The expiration dates for the two periods are the same as stated in Example 4, since the time periods must begin to run on the date of the first transfer.

The regulations also describe the form and manner in which the identification must be made. The replacement property must be identified in a written document, signed by the taxpayer, and either hand-delivered, mailed, telecopied or otherwise sent to either:

1. The person obligated to transfer

the replacement property, or 2. Any other party to the exchange,

other than a disqualified


Basically, a disqualified person includes anyone who served as an agent of the taxpayer during the two-year period preceding the transfer of the first property in the exchange, as well as certain parties related to the taxpayer.(7) Generally, these are family members, but the term "disqualified person" also includes entities in which the taxpayer has a 10% or more ownership interest. Fortunately, the term does not extend to the taxpayer's attorney, accountant or broker, whose only services in the critical two-year period were limited to other Section 1031 exchanges.[8] Furthermore, financial institutions and escrow companies are not deemed "disqualified persons" as long as they have done nothing more than perform routine services for the taxpayer during the two-year period.[9]

Example 6: On May 17, 1992, J engages in a like-kind exchange with B. J retains Sam as an intermediary to facilitate the exchange. Sam is J's lawyer and rendered legal services to J within the two-year period ending on May 17, 1992. Sam is a disqualified person since he has acted as J's lawyer within the prohibited two-year period. Sam would not have been a disqualified person if his only services rendered to J during this period had merely been those related to other Section 1031 exchanges.

The regulations also require that the property be unambiguously described.[10] Personal property must be identified by a specific description of the particular type of property.(11) For example, the identification of an automobile would require a description of its make, model and year.

Identification of Multiple Properties

Circumstances may arise where it is necessary to identify more than one replacement property. Factors beyond the taxpayer's control may eliminate the availability of the replacement property. For example, a casualty to identified property, such as fire or theft loss, or obstacles such as a production or shipping strike, zoning, title or environmental problems may stand in the way of obtaining the desired property. In addition, the brief 45-day identification period itself may be sufficient reason for taxpayers to identify alternate replacement property.

The regulations provide two separate rules which limit the number of replacement properties that the taxpayer can designate: the three-property rule and the 200% rule. The three-property rule allows the taxpayer to identify three replacement properties regardless of value.(12) The final identification of the replacement property that is ultimately received need only occur before the end of the "exchange period," as long as all three properties were named in the 45-day "identification period."

Example 7: On May 17, 1992, J transfers Property A to B. Property A has a value of $100,000. Prior to July 1, 1992, J identifies Properties X, Y and Z as suitable replacement properties in a signed, written document delivered to B. As of July 1, 1992, the values of the three properties were $75,000, $100,000, and $125,000 respectively. On October 1, 1992, J identifies Property Y as the one to be received, and receives this property on the same date. The exchange will qualify under Section 1031.

The 200% rule allows the taxpayer to identify any number of properties as long as their aggregate value (not reduced by any encumbering debt) does not exceed 200% of the value of the relinquished property determined at the date of the original transfer of such property.(13)

Example 8: Assume the same facts as in Example 7, except that J identifies A, B, C and D as replacement properties. On July 1, 1992, the values of these properties are $40,000, $45,000, $50,000 and $55,000 respectively. Since the aggregate values of the properties is less than $200,000, the 200% test is satisfied.

Should both of these value-based tests be failed, the regulations provide some relief by stating that any property actually received during the 45-day "identification period" will be deemed properly identified.

Example 9: On May 17, 1992, J transfers Property A to B. On that date Property A had a value of $200,000. On May 19, 1992, J identifies properties W, X, Y and Z, each with a value of $100,000. J receives Property X and Property Z on June 1, 1992.

Since both properties were received before the expiration of the 45-day period, they are deemed properly identified and Section 1031 applies to the transaction.

Rules on the Receipt of the Identified Property

The taxpayer will satisfy the receipt requirement only if the replacement property is received before the end of the exchange period and the property is "substantially the same" as the property identified.(14) The following example shows this rule.

Example 10: On May 17, 1992, Beta Corp. transfers a portion of its fleet of commercial vehicles, with a fair market value of $1 million to Intermediary Corporation. Intermediary has been retained to dispose of the vehicles and acquire replacement vehicles which will be transferred to Beta. On the same date, Beta, anticipating company growth, identifies a replacement fleet of vehicles having a value of $2 million. It is Beta's intent to also transfer $1 million cash to Intermediary to complete the transaction. On November 2, 1992, Beta suffers a significant financial loss which makes it impossible to complete the transaction as planned. Instead, Beta Corp. proposes that Intermediary acquire replacement vehicles worth $1.5 million.

The issue arises as to whether receipt of less than the fleet of vehicles identified satisfies the "substantially the same" test. In a similar example involving real property, the regulations suggest the test is satisfied if the value of the replacement property received is 75% of the entire value of the property identified.(15) In Example 10, the 75% test has been met, and Section 1031 should apply. Unfortunately, the regulations do not address the question of whether the taxpayer's receipt of less than 75% of the identified property would qualify. For instance, if Beta ultimately received only $1 million in replacement property, would nonrecognition result? Until the issue is further addressed by the IRS or the courts, taxpayers and their counsel should be wary about receiving anything less than 75% of the identified property.

Constructive Receipt and Deferred Exchanges

A deferred exchange poses the practical risk of whether the taxpayer will actually receive the replacement property. Contractual promises of performance by either the transferee or intermediary do not guarantee the taxpayer's receipt of replacement property. For example, the transferee or intermediary may suffer insolvency or simply abscond with the exchange proceeds. Consequently, the transferring taxpayer may require a "good faith" deposit in escrow or trust account. Prior to the final regulations, concern existed as to whether such "good faith" deposits would constitute constructive receipt of the deposited cash. For federal income tax purposes, the constructive receipt of cash would be considered as a receipt of the proceeds from a sale, and would constitute taxable gain. The doctrine of constructive receipt is a tax principle which states that a taxpayer will be considered to have actually received cash if there exists an unrestricted right to draw upon the cash or otherwise have use of its benefits.

Example 11: K transfers business property worth $100,000 to B in a deferred exchange on May 17, 1992. By July 1, 1992, J is required to identify suitable replacement property, and must receive it on or before November 13, 1992. As part of the agreement, J has the right, any time after May 17, 1992, and before B purchases replacement property, to demand that B pay him $100,000 in lieu of acquiring replacement property. J subsequently identifies replacement property which B purchases and transfers to J.

In this example, the fact that J never received any cash is irrelevant. Merely the right to receive the cash in lieu of the property triggers the doctrine of constructive receipt. The transaction would be deemed a taxable sale followed by a purchase of the replacement property.

An important feature of the final regulations are some "safe harbor" rules which balance the taxpayer's need to secure performance with the opportunity to keep nonrecognition on the exchange. Tax advisors will find these rules helpful in keeping their clients outside the parameters of constructive receipt.

Security and Guarantee Arrangements

The first safe harbor rule allows the taxpayer to guarantee the transferee's performance by the issue of the three separate categories of security arrangements. These would include a security interest in some property of the transferee, a standby letter of credit or the obtaining of a third-party guarantee.(16)

It is useful to note that any security interest in the transferee's property does not have to be property of a like-kind to the property transferred. Thus, if the transferor is exchanging tangible personal property for like-kind personal property, the performance of the transferee may be secured with a mortgage on real property owned by the transferee.

Qualified Escrow Accounts and Trusts

The most popular vehicle to secure the performance of contracts is to have one of the parties deposit funds in an escrow or trust account. Prior to the issuance of the final regulations, tax advisors were concerned that the taxpayer would be in constructive receipt of the escrowed or trust deposits. The final regulations eliminated this concern by providing a safe harbor for such deposits.(17) The taxpayer will avoid the constructive receipt of the escrowed or trust deposits if certain rules are followed. The regulations restrict the escrow holder or trustee to someone other than the taxpayer or a "disqualified person." Remember that the term "disqualified person" is basically an agent of the taxpayer or a person or company related to the taxpayer.

Furthermore, the safe harbor escrow rule mandates that the transferor must not have the right to receive the escrowed funds before the end of the exchange period except under the following circumstances:(18)

1. After the identification period,

if the taxpayer has not identified

replacement property by then,

or 2. If the taxpayer has identified

replacement property, the escrowed

funds may be received after the

taxpayer has received all of the

identified properties, or 3. If the taxpayer has identified

replacement property, after the

later of the end of the

identification period or the occurrence of a

material contingency that: (a)

relates to the exchange, (b) is

provided for in writing, and (c) is

beyond the control of the


The next two examples illustrate qualifying escrow arrangement which meet the requirements outlined above.

Example 12: On May 17, 1992, J transfers business equipment worth $100,000 to B in a deferred exchange. J is required to identify the replacement property and B is required to purchase the property and transfer it to J before the end of the exchange period. B deposits $100,000 in an escrow account as security for its obligation to perform on the contract. The funds in escrow are to be used for the purchase of the replacement property and J has no rights to these funds before the end of the exchange period except in the following circumstances. If J fails to identify replacement property on or before July 1, 1992, it may demand the funds any time after that date. Secondly, if J identifies and receives replacement property, then it may demand the balance of the remaining funds in escrow at any time after the receipt of the property (taxable as boot, however). Lastly, should the replacement property not be received before the end of the exchange period, J is entitled to all funds in escrow (resulting in a complete taxable sale).

Example 13: Assume the same facts as in Example 12 except that on May 17, 1992, J identifies replacement property. The escrow agreement provides as follows. The funds in escrow are to be used to purchase the replacement property. J may demand the funds in escrow at any time after the later of July 1, 1992, or the date on which the replacement property is either destroyed or stolen. Otherwise, J is entitled to the escrowed funds only after the replacement property is received or the end of the exchange period, if earlier.

Qualified Intermediaries

A third safe harbor rule allows the taxpayer to use a qualified intermediary to facilitate the exchange. While intermediaries have long been considered a useful tool to facilitate a like-kind exchange, taxpayers have exercised extreme caution to ensure that the intermediary is not deemed the taxpayer's agent. If agency status exists, any cash received by the intermediary would be considered received by the taxpayer, thus causing the transaction to be considered a taxable sale followed by a purchase of the replacement property. The final regulations dispense with the requirement that the intermediary acquire formal title. The direct titling of the properties exchanged is allowed if the rights of each party to the agreement are assigned to the intermediary and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant property transfers.(20) The following example describes the proper assignments.

Example 15: On May 15, 1992, Beta Corp. enters into an agreement to transfer 200 of its vehicles to Alpha Corp. However, Alpha is unwilling to engage in a like-kind exchange, wishing simply to purchase the vehicles for cash. Beta thus contracts with Profit to act as an intermediary. Beta assigns to Profit all of Beta's rights in the agreement with Alpha. On May 17, 1992, Beta notifies Alpha of the assignment, and on the same date, Beta executes and delivers to Alpha title to 200 of its vehicles. Alpha pays $200,000 to Profit, which places the funds in a qualified escrow account. On June 1, 1992, Beta identifies the 200 replacement vehicles in the inventory of one of the major automobile manufacturers. On July 5, 1992, Beta enters into an agreement to purchase the replacement vehicles from the manufacturer, and assigns its rights in that agreement to Profit, notifying the manufacturer in writing of this assignment. On August 9, 1992, Profit transfers the escrowed funds to the manufacturer which delivers title to the vehicles to Beta.

While the qualified intermediary provisions may be viewed as flexible, they also pose a trap for the unwary. A failure to satisfy any of the requirements, for whatever reason, will preclude qualified intermediary status and result in a taxable transaction. This potential trap is shown in the following example, which repeats the facts of Example 15 with the exception that the vehicles will be sold at auction rather than to Alpha.

Example 16: On May 1, 1992, Beta enters into an agreement with Profit, a qualified intermediary, to replace 200 of Beta's commercial fleet of automobiles. On May 17, 1992, Beta transfers the 200 vehicles to Profit who sells them at auction on the same date. The sales proceeds, less commission, are placed in a qualified escrow account. On June 1, 1992, Beta identifies the 200 replacement vehicles in the inventory of an auto manufacturer. On July 5, 1992, Beta enters into an agreement to purchase the vehicles, assigns its rights to that agreement to Profit and notifies the manufacturer of the assignment. On August 9, 1992, Profit transfers the escrowed funds to the manufacturer who executes and delivers title to the replacement vehicles to Beta. Profit does not take title to either the relinquished nor the replacement vehicles.

The foregoing example will fail to qualify for nonrecognition under Section 1031 since appropriate notice of Beta's assignments in the transferred vehicles to Profit was not given. These vehicles were sold at an auction, and therefore it is impossible to know who the purchasers would be beforehand.

A possible solution would be for Beta and Profit to forward to the auction house a general "boiler-plate" notice who describes Beta's requisite assignment to Profit with the instructions that the notice of the assignment be posted for all potential purchasers to read. This should satisfy the notice of assignment requirement contained in the regulations. Unfortunately, the final regulations are silent on this point.


What advice would you now give the anonymous client mentioned at the beginning of the article. You should tell him to act cautiously in consummating the deferred exchange with an intermediary, making sure that any intermediary is not a "disqualified person" and that any funds retained by such intermediary be placed in a qualified escrow or trust account which places the restrictions on client use, as discussed in this article. The final regulations have provided some clear safe harbor rules to allow taxpayer's to complete deferred exchanges, but any deviation from these rules would probably result in a taxable transaction.

In general, these foregoing rules are complex, and tax advisors need to consult them in detail when counseling taxpayers in a step-by-step deferred exchange of like-kind property.


(1)James A. Fellows and Michael A. Yuhas, "Like-Kind Exchanges: An Analysis of the New Judicial Doctrines of the Economic Unit," Texas, September, 1989, Vol. 67, No. 9, pp. 596-607. (2)See for example, L. W. Ross, 48-2 USTC 9341, 169 F, 2nd 483, and Reg. Sec. L451-2. (3)Public Law 98-369, The Tax Reform Act of 1984, Act Sec. 77 (a). (4)Reg. Sec. 1.1031(k)-1(b)(1). (5)Reg. Sec. 1.1031(k)-1(b)(2). (6)Reg. Sec. 1.1031(k)-1(c)(2). (7)Reg. Sec. 1.1031(k)-1(k)(2). (8)Reg. Sec. 1.1031(k)-1(k)(3). (9)Reg. Sec. 1.1031(k)-1(k)(2). (10)Reg. Sec. 1.1031(k)-1(c)(3). (11)Reg. Sec. 1.1031(k)-1(c)(3). (12)Reg. Sec. 1.1031(k)-1(c)(4). (13)Reg. Sec. 1.1031(k)-1(c)(4)(A). (14)Reg. Sec. 1.1031(k)-1(c)(4)(B). (15)Reg. Sec. 1.1031(k)-1(d)(2), Example 4. (16)Reg. Sec. 1.1031(k)-1(g). (17)Reg. Sec. 1.1031(k)-1(g)(2) (18)Reg. Sec. 1.1031(k)-1(g)(6). (19)Reg. Sec. 1.1031(k)-1(g)(4). (20)Reg. Sec. 1.1031(k)-1(g)(4).

James A. Fellows, PhD, CPA, is currently professor of accounting and taxation at the University of South Florida in Fort Myers, Florida. He has written numerous articles on tax topics including several for the National Public Accountant. His other works have appeared in such journals as Taxes-The Tax Magazine, The Journal of Taxation, The Review of Taxation of Individuals, The International Journal of Management, The Practical Accountant and The CPA Journal. Michael A. Yuhas, JD, LLM, is currently associate professor of taxation at Grand Valley State University in Grand Rapids, Michigan. A graduate of the Georgetown University Law School LLM program in taxation, Professor Yubas has written for such journals as The Review of Taxation of Individuals, Taxes-The Tax Magazine, The Journal of Taxation and The Tax Executive.
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Author:Fellows, James A.; Yuhas, Michael A.
Publication:The National Public Accountant
Date:Dec 1, 1991
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