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Avoiding traps in deferred like-kind exchanges.

Sometimes, a client wants to structure a Sec. 1031 like-kind exchange, but the potential buyer has no suitable property to exchange in return and is unwilling to acquire it. The Sec. 1031 regulations explain how the buyer can transfer the sales proceeds to an escrow that a qualified intermediary can then use to buy property the client desires. This article explains these rules, which must be strictly followed for tax free treatment to ensue.

Sec. 1031 states that no gain or loss is recognized if property held for trade or business or investment use is exchanged solely for property of like kind that will be held for trade or business or investment use. Often, a taxpayer will transfer property; the transferee then purchases the taxpayer's desired replacement property and transfers it to him. Sec. 1031 (a) (3) and the' regulations thereunder explain how to structure as an exchange a sale followed by a purchase of qualified replacement property; however, tax advisers will find that most deferred exchanges do not fit neatly into the existing safe harbors and that efforts to satisfy them can be easily thwarted. This article describes the requirements for a deferred like-kind exchange of real property, the traps typically encountered and the actions the tax adviser should take to strengthen the claim of tax-free treatment.

General Requirements

Sec. 1031(a)(1) requires that the relinquished and replacement properties be (1) held for trade or business or investment use and (2) of like kind. (Sec. 1031 treatment is not available for inventory or other property held for sale, stocks, bonds, notes, other securities or evidences of debt, partnership interests, trust certificates and choses in action.) If nonqualifying property is also received in an exchange, Sec. 1031 (b) provides that gain is recognized to the extent of the fair market value (FMV) of such property. Under Sec. 1031 (d), the basis of the replacement property is that of the relinquished property, plus any is that gain recognized on the exchange, less money received in the exchange and any loss recognized.

Defining "Like Kind"

Regs. Sec. 1. 1031 (a)-1 (b) states that "like-kind" property refers to the nature or character of the property, not to its grade or quality; thus, real property exchanged for real property will qualify as like kind regardless of the state of improvement of the property. Sec. 1031(h) provides that U.S. real property and foreign real property are not like kind. A split interest in real property may be exchanged for a similar split interest in otherwise like-kind property; thus, a future interest in real property may be exchanged under Sec. 1031 for a future interest in real property,(1) but a life estate may not be exchanged for a remainder.(2) The exchange of a remainder interest for a fee simple qualifies under Sec. 1031 because the remainder interest will eventually become a fee simple interested.(3) An exchange of a present undivided interest for a complete interest in like-kind property also qualifies.(4) The exchange of a long-term leasehold (i.e., 30 years or longer) for a fee simple or another long-term leasehold may also qualify.(5) The IRS recently argued in Beeler(6) that land that had been used for sand mining could not be treated entirely as real property because business operating permits, goodwill and property held for sale (i.e., sand) accompanied the transfer of the property. The Tax Court rejected this argument; because the documents conveying the property did not list permits, the taxpayers could not legally convey them, goodwill was not transferred and unnamed sand was not inventory or held primarily for sale.

Meeting the Exchange Requirements

An "exchange" is defined by Regs. Sec. 1. 1002-1(d) as a reciprocal transfer of property, not a transfer of property for money consideration only. Typically, a taxpayer seeks to use Sec. 1031 to avoid gain recognition and so must structure the transaction as an exchange. A gain nonrecognition provision like Sec. 1031 is strictly construed under Regs. Sec. 1. 1002-1(b) and does "not extend either beyond the words or the underlying assumptions and purposes of the exception." The IRS, on rare occasions, may argue substance over form when the taxpayer intentionally seeks to fail the Sec. 1031 requirements. An exchange may, exist when a sale and purchase is made between the taxpayer and one or more parties, and the transactions are mutually dependent.(7) The more common concern is that a taxpayer desiring a tax-free exchange will fail to follow the required formalities.

An exchange may be difficult to arrange when the buyer of the relinquished property does not have suitable replacement property to exchange and is unwilling to acquire it. The buyer's reluctance is generally attributable to the inconvenience of accommodating the seller, but may also be due to other reasons (e.g., concern about potential environmental liability).

A sale of relinquished property and purchase of replacement property does not qualify as an exchange, even if the sales proceeds are held outside of the seller's control in a trust or escrow, unless another person acts as a facilitator and exchanges property with the seller.

Example 1: In January 1998, T sells real property with a $400,000 basis to P for $ 1,000,000. P will not purchase replacement property for T; the sales proceeds are placed in an escrow account that restricts access to the funds to the purchase of replacement property. In February 1998, T finds suitable replacement property valued at $1,000,000 and directs that the escrowed funds be used to purchase the property for him. This transaction is not a Sec. 1031 exchange, because T cannot exchange with an escrow."

The Four-Party Exchange With a Qualified Intermediary

A solution to the problem in Example 1 is to use a qualified intermediary to complete a four-party exchange. The four parties are the seller of the relinquished property (the taxpayer), the buyer of said property, the seller of the replacement property and the qualified intermediary. A qualified intermediary is defined by Regs. Sec. 1.1031(k)-1(g)(4)(ii) as a person who is not the taxpayer or a "disqualified" person (as defined in Regs. Sec. 1.1031(k)-1(k)), and who, pursuant to a written agreement with the taxpayer:

1. Acquires the relinquished property from the taxpayer. 2. Transfers the relinquished property to the buyer. 3. Acquires the replacement property from the seller. 4. Transfers the replacement property to the taxpayer.(9)

The use of a qualified intermediary converts the taxpayer's sale and purchase of property into a Sec. 1031 exchange. An intermediary is needed when the purchaser of the relinquished property is unwilling to acquire and transfer replacement property to the taxpayer. Thus, a qualified intermediary can be used for a forward deferred exchange (in which the relinquished property is transferred before replacement property is received) or a simultaneous exchange (in which the taxpayer has already selected replacement property and receives it on the transfer of the relinquished property). The intermediary may be reluctant to take tide to the relinquished and replacement properties because of concerns about environmental liability. Regs. Sec. 1.1031(k)-1(g)(4)(v) allows an intermediary to be deemed to have completed the steps outlined above by using written assignments of contract rights.

Example 2: In January 1998, T agrees to sell real property with a basis of $400,000 to P for $1,000,000. P will not purchase replacement property for T, the sales proceeds are placed in an escrow account that restricts T's access to the funds. (The account meets Regs. Sec. 1. 1031(k)-1(g)(3)(ii) requirements.) T hires Q as an intermediary; they sign an exchange agreement. Before title to the relinquished Property is transferred to P, T assigns, in writing, his rights in the contract with P to Q and notifies P of the assignment. In February 1998, T finds suitable replacement property valued at $1,000,000. T contracts to purchase the replacement property and assigns, in writing, his rights in the contract to Q; he also notifies the seller of the assignment. The escrow officer releases funds for the property to be purchased for T. Title to the relinquished and replacement properties is "direct deeded" to P and T, respectively. The execution of the exchange agreement and the assignments of contract rights create a deemed exchange in which Q is treated as acquiring and transferring both the relinquished and replacement properties. An exchange will be deemed to have occurred between T and Q. If the assignments had not been executed, the transaction would have been a taxable sale and purchase.(10)

A taxpayer seeking a like-kind exchange may not initially understand why a qualified intermediary is needed, and may think that the use of a deferred sale escrow (as described in Example 1) will suffice. The use of written contract assignments can alleviate any fear that the taxpayer may have with respect to the intermediary having title; it is critical that the taxpayer understand that the assignments are a required formality to ensure a nontaxable exchange.(11)

Even with the use of a qualified intermediary, a Sec. 1031 exchange will not have occurred if the replacement property is built in exchange for cash and like-kind property.(12) However, replacement property may include improvements to be constructed on land before the transfer(13); Regs. Sec. 1. 1031(k)-1(e) explains how the identification and receipt provisions apply to property to be constructed. It is essential that the owner/builder of the replacement property not act as the taxpayer's agent with respect to the construction.

Motives for Holding Property

Sec. 1031 (a) requires that both the relinquished and the replacement properties be held for investment or trade or business use. The tax adviser will most commonly encounter four situations in which the motive for holding property may be questioned: (1) property held for sale; (2) property held for personal use; (3) property held for contribution to an entity; and (4) property held as the result of a distribution from an entity.

Dealers

A dealer in real property may want to use Sec. 103 1. Secs. 1221(1) and 1231(b) define a "dealer" as an individual who holds property primarily for sale to customers in the ordinary course of a trade or business. Sec. 1031(a)(2)(A) excludes property held primarily for sale from the nonrecognition provisions; thus, dealers should be aware that the IRS may challenge the use of Sec. 1031, even for property that the dealer contends is held for investment or for trade or business use.(14) The tax adviser should also caution that the threshold activity for denial of Sec. 1031 nonrecognition is lower than that required for dealer classification; Sec. 1031 excludes property held primarily for sale from nonrecognition treatment, while the traditional dealer test requires that a sale be in the ordinary course of a trade or business. Thus, a taxpayer not in the trade or business of selling real property may be found to have held it primarily for sale, denying Sec. 1031 relief on the sale of said property.(15)

Reinvestment

A taxpayer may intend to sell investment property, reinvest in personal-use, residential real property and qualify the latter as held for investment by use of a temporary rental arrangement. Although many tax advisers advise a rental of at least one year to establish investment motive, no specific rental period automatically converts personal use to investment use. The question is one of intent; positive action (e.g., a rental) evidencing investment intent may be counterbalanced by negative action (e.g., later occupying the property as a residence). By the time the issue is raised, the IRS will have the benefit of hindsight.

Contribution to an Entity

Taxpayers have many nontax reasons to hold property in an entity; a taxpayer exchanging real property may prefer that the replacement property be held in a corporation, a limited liability company (LLC) or a limited (or family limited) partnership. The transfer of replacement property to an entity may jeopardize Sec. 1031 treatment. In Rev. Rul. 75-292,(16) the replacement property was contributed to a corporation shortly after the exchange. The IRS ruled that the property was not held for investment or trade or business use because the stock received in the subsequent exchange was not a continuation of the real property investment. However, in Magneson,(17) the Tax Court distinguished Rev. Rul. 75-292 from an exchange and the immediate contribution of the replacement property to a partnership. The transfer to the partnership was held not to be a substantive change (presumably, under an aggregate approach), although a transfer to a corporation could be (under an entity approach). Thus, a prearranged plan to transfer replacement property to an entity should be avoided.

If property is held by an entity for investment or trade or business use and that entity distributes the property to an owner, the IRS may challenge the distributee's ability to claim Sec. 1031 treatment if the property is exchanged shortly after the distribution. A distribution from a corporation followed by an exchange was permitted in Bolker(18) and Maloney.(19) In Bolker, the Tax Court (and, ultimately, the Ninth Circuit) concluded that the taxpayer held the property for productive use in a trade or business or for investment because he did not intend to liquidated the property or use it for personal pursuits. The IRS reached a contrary conclusion when the intent to exchange preceded liquidation and the exchange occurred immediately after the distribution.(20) Sec. 336 now treats a distribution as a taxable sale by the corporation and Sec. 331 requires the shareholder to recognize gain; thus, a corporate distribution followed by an exchange should not create a tax issue.

A distribution by a partnership followed by an exchange continues to be viable.(21) If a partnership intends to sell property, and not all the partners want like-kind exchange treatment, the entity could first distribute undivided interests to the partners, who may then make their own arrangements to defer or recognize gain from a subsequent sale. LLCs with at least two members can do the same.

Time Limits

Deferred exchanges are often called "Starker exchanges" in recognition of a Ninth Circuit decision that approved an exchange in which the taxpayer had five years to find replacement property.(22) A deferred exchange must now satisfy two time requirements. First, under Sec. 1031(a)(3)(A), the taxpayer must identify replacement property by midnight of the forty-fifth day after the date of transfer of the relinquished property. The replacement property must be received by the earlier of (1) midnight of the 180th day after the date of transfer of the relinquished property or (2) the extended due date for the transferor's return for the tax year in which the transfer of the relinquished property occurs.

Regs. Sec. 1.1031(k)-1(b)(2)(iii) provides that if multiple properties are relinquished in one exchange, the clock starts running on the day the first relinquished property is transferred. It is unclear, however, when multiple property transfers are part of the same exchange. A sale of two properties to the same buyer may be part of the same exchange, but sales to two different buyers should be two separate exchanges. This distinction is also important in determining the number of properties that may be identified (discussed below). If the taxpayer desires multiple exchanges, separate closings, exchange agreements and buyers should be used. Form 8824, Like-Kind Exchanges (and nonrecognition of gain from conflict-of-interest sales), requires the date(s) of transfer of the relinquished property and the date(s) of identification and receipt of replacement property. Because failure to satisfy the time periods will be fatal to gain nonrecognition, the tax adviser should carefully keep track.

Example 3: On May 13, 1998, T transfers investment real property with a large realized gain to P T must identify replacement property no later than June 27, 1998 (the forty-fifth day after May 13) and receive replacement property no later than Nov. 9, 1998 (the 180th day after May 13).

The preamble to the Sec. 1031 proposed regulations stated that the Sec. 7503 extension of time for acts falling on weekends or legal holidays does not apply to the identification and receipt of replacement property, because it applies only to procedural acts. The preamble to the final regulations contained no reference to the application of Sec. 7503 to deferred exchanges. While it is unclear whether the position stated in the proposed regulations is correct, the taxpayer should not risk a challenge to the statutory time period. The tax adviser should periodically remind the taxpayer of the need to conduct a due diligence review of potential replacement properties to ensure timely identification and receipt.

Identification Requirements

Replacement property is identified, according to Regs. Sec. 1. 1031(k)-1(c)(2), if it is designated as such in a written document signed by the taxpayer and hand delivered, mailed, telecopied, faxed or otherwise sent before the end of the identification period to the person obligated to transfer the replacement property or any other person involved in the exchange (other than the taxpayer or a disqualified person). A qualified intermediary is an acceptable recipient. Delivery (not receipt) must occur by midnight of the forty-fifth day after the transfer of the relinquished property.(23) The taxpayer should obtain acknowledgment of receipt (e.g., by using certified mail) to prove that delivery was timely. Regs. Sec. 1.1031(k)-1(c)(6) provides that an identification may be revoked or amended at any time before the end of the identification period; the revocation must also be in writing and sent to the person to whom the identification was sent.

An identification must be specific; there are restrictions on the number of properties that may be identified:

1. Any three properties may be identified, regardless of their FMVs (Regs. Sec. 1.1031(k)-1(c)(4)(i)(A)).

2. Any number of properties may be identified, provided that their aggregate FMV does not exceed 200% of the aggregate FMV of the relinquished property The FMVs of the identified properties are determined as of the forty-fifth day of the identification period; the value of the relinquished property is determined as of the date of transfer (Regs. Sec. 1.1031(k)1(c)(4)(i)(B)).(24)

3. If the taxpayer has identified more than three properties, any property identified within 45 days and received within 180 days will meet the identification requirements, if the tax payer receives (before the end of the exchange period) at least 95% of the FMV of all identified property. The FMV of each identified replacement property is determined as of the earlier of the date the property is received by the taxpayer or the last day of the exchange period (Regs. Sec. 1.1031(k)1(c)(4)(ii)(B)).(25)

In applying the above rules, Regs. Sec. 1.1031(k)1(c)(4)(iii) provides that any property actually received by the end of the identification period is deemed to be identified and applies toward the maximum number and FMVs of properties that may be identified under the safe harbor.

Example 4: T transfers real property to P for $500,000. The sales proceeds are placed in escrow; T assigns the sales contract to qualified intermediary Q. Before the end of the identification period, T may identify either (1) any three replacement properties or (2) any number of replacement properties if their aggregate FMV (determined at the end of the identification period) does not exceed $1,000,000.

Example 5: The facts are the same as in Example 4, except that before the end of the identification period, T acquires property from S, following a proper assignment of rights to Q, for $300,000. The acquired property is deemed to be identified. T may identify (1) up to two other properties or (2) any number of properties with an aggregate FMV not exceeding $700,000.

Example 6: The facts are the same as in Example 4, except that T identifies five properties with an aggregate FMV (determined as of the end of the identification period) of $1,600,000. T fails both the three-property and the 200% safe harbors. T then acquires four of the properties by, the end of the exchange period at an aggregate cost of $1,550,000 The fifth property identified is not received by the end of the exchange period; its FMV is $70,000 at the end of the exchange period. Because T has acquired 95.7% ($1,550,000/$1,620,000) of the aggregate FMV of the identified properties before the end of the exchange period, the identification meets Regs. Sec. 1. 1031(k)-1(c)(4)(ii)(B).

Example 7: T transfers property to P for $500,000. One week later, T transfers another parcel to P for $300,000. If the two transfers are separate, T may identify as many as six replacement properties (three for each exchange); if the transfers are part of a single exchange, T may identify only three properties. Because the transfers are to the same purchaser and occur within one week, the tax adviser should suggest that T treat them as part of the same exchange. If the transfers were to different purchasers and used separate exchange agreements, they would probably qualify as separate exchanges.

Regs. Sec. 1.1031(k)-1(c)(3) requires an identification to be unambiguously described in writing. Real property is unambiguously described by a legal description, street address or distinguishable name (e.g., the Mayfair Apartment Building). Property incidental to a larger piece of identified property (e.g., personal property in an apartment complex) need not be separately identified. "Incidental" property is defined by Regs. Sec. 1. 1031(k)-1(c)(5) as property that normally would be transferred with the identified property, if the aggregate FMV of the incidental property does not exceed 15% of the FMV of the larger identified property. Although incidental property need not be separately identified, its receipt could require the taxpayer to recognize gain.

Property to be constructed presents special problems. According to Regs. Sec. 1. 1031(k)-1(d)(1)(ii), the replacement property received must be "substantially the same" as that identified. Under Regs. Sec. 1. 1031(k)-1(e)(2) (i), an identification of real property to be produced should include a legal description of the underlying land and as much detail regarding construction of the improvements as is practicable at the time the identification is made. Regs. Sec. 1.1031(k)-1(e)(3)(i) provides that whether the property received is substantially the same as that identified is determined without regard to variations due to "usual or typical production changes"; the property will not be substantially the same if "substantial changes" are made.

To minimize the risk that "substantial changes" will be found, the taxpayer should avoid being overly specific as to the construction. For example, identifying "a two-story office building of approximately 20,000 square feet" may suffice; however, a more specific identification may be required to determine whether "usual or typical production changes" or "substantial changes" have been made. More guidance is needed on this issue; until such guidance is issued, the taxpayer should be as specific "as is practicable" at the time the identification is made.

Avoiding the Receipt of Boot

Sec. 1031 (b) provides that gain must be recognized in an otherwise qualifying like-kind exchange to the extent the taxpayer receives boot. In a Sec. 1031(a)(3) deferred exchange, the taxpayer sells the relinquished property and later acquires replacement property. The sales proceeds must be held outside of the taxpayer's control to avoid either actual or constructive receipt of boot. Regs. Sec. 1.1031(k)-1(g)(2) and (3) contain safe harbors for security and guarantee arrangements and qualified escrow accounts and trusts. Generally, the taxpayer (or his agent) must not have a right to receive, pledge, borrow or otherwise obtain any benefit from the sales proceeds. However, proceeds may be used for certain purposes, as set forth in Regs. Sec. 1.1031(k)-1(g)(6) and (7).

Using a Qualified Escrow

Sales proceeds held in a qualified escrow may be used to purchase identified replacement property. Because a qualified intermediary must transfer (or be deemed to transfer) the relinquished and replacement properties, the taxpayer's contract rights to purchase replacement property should be assigned to the intermediary before funds are released to purchase the replacement property. If the taxpayer contracts to have replacement property constructed on land owned by another party, the intermediary should be assigned construction contract rights before construction funds are released from the qualified escrow. Such an assignment is needed to carry out the fiction that the intermediary is acquiring the replacement property or the land and constructed improvements.

Taxpayer's Access to Escrowed Funds

Regs. Sec. 1.1031(k)-1(g)(6) allows funds to be made available to the taxpayer in the following cases:

1. If the taxpayer has not identified replacement property by the end of the identification period, the funds may be made available to him (because he may no longer meet the requirements of Sec. 1031(a)(3)).

2. If the taxpayer has identified replacement property by the end of the identification period, funds may be made available to him only after:

(a) the receipt of all of the replacement property to which he is entitled under the exchange agreement, or

(b) the occurrence after the end of the identification period of a material and substantial contingency that is provided for in writing (e.g., in the escrow agreement), is beyond the taxpayer's or his agent's control, and relates to the exchange (e.g., the destruction or condemnation of identified property or the inability to rezone identified property). (The contingency must occur after the end of the identification period because the taxpayer could make a new identification if property is destroyed before the close of the identification period.)

Regs. Sec. 1. 1031(k)-1(g)(7) allows the taxpayer to receive any funds related to the disposition of the relinquished property that are not included in the amount realized on sale (e.g., prorated rents). There is no constructive receipt if the funds are used to pay transactional items related to the sale of the relinquished property or the purchase of replacement property, if payment of such items is, under local standards, typically the responsibility of the buyer or seller (e.g., commissions, prorated taxes, recording fees, tide company fees, etc.).(26) The taxpayer may also receive funds from another party to the exchange (but not from the qualified escrow, trust or intermediary) without being in constructive receipt. For example, a buyer pays the taxpayer $5,000 as earnest money and later deposits all remaining sales proceeds in a qualified escrow; the taxpayer will recognize $5,000 of boot, but will not be in constructive receipt of the escrowed funds. Similarly, receipt of payment to grant an option to purchase the relinquished property should not taint sales consideration attributable to exercise of the option. However, it is not clear whether the taxpayer could, before title to the relinquished property is transferred, fund the qualified escrow with a deposit or option payment to avoid gain recognition for the payment received.

Unanswered Questions

Use of deposits: Because it is common for practitioners to use standard forms available on disk, CD-ROM or other media, the tax adviser may see exchange and escrow agreements containing language patterned on Regs. Sec. 1. 1031(k)1(g)(6) and (7). Unfortunately, this language may not cover common situations that the tax adviser can encounter. For example, can a taxpayer who makes a $3,000 deposit on certain identified replacement property later be reimbursed from a qualified escrow? The answer is unclear, because such a reimbursement is not one of the protected Regs. Sec. 1. 1031(k)-1(g)(6) or (7) conditions. Because the regulations allow funds to be used to acquire replacement property, it seems reasonable to allow the reimbursement when the property is actually purchased; the consideration payable from the escrow at closing would be reduced by the deposit. However, if the property is not acquired and the deposit is forfeited, it may be more prudent to not reimburse the taxpayer.

Closing costs: It is also unclear which expenses may be paid at closing from a qualified escrow. Regs. Sec. 1.1031(k)-1(g)(7) allows payment of transactional items that "appear under local standards in the typical closing statements." This suggests that certain items may be paid in one market but not in another. Professional fees are not mentioned in the regulations, but attorney's fees are typical in closing statements in many markets. However, the application of the safe harbor may arguably depend on the nature of the professional services rendered. For example, a deferred exchange will often involve fees of an attorney or an accountant engaged to help ensure compliance with Sec. 1031. Such fees are not "typical" (because most closings do not require Sec. 1031 advice), but they may be typical in deferred exchange closings. The same can be said of qualified intermediary fees. Nonetheless, intermediary fees should be treated as transactional items typical of deferred exchange closings that may be paid from the escrow. It may be easier to avoid problems by paying fees from the sales proceeds of the relinquished property before the remaining funds are transferred to the qualified escrow; in such case, the funds used to pay the professional fees may be viewed as coming from the buyer, not the escrow. Fees to obtain a loan on the replacement property may not be within the safe harbor because they are financing, not transactional, items. Additional guidance from Treasury would be helpful in defining the scope of the Regs. Sec. 1. 1031(k)-1(g)(7) safe harbor, because the cost of noncompliance can be loss of the tax deferral.

Receipt/nonreceipt of property: Regs. Sec. 1. 1031(k)1(g)(6) relates to the taxpayer's inability to successfully consummate the exchange. Thus, if no property has been identified at the end of the identification period, there is no reason to restrict access to the funds. Similarly, once all property has been received, any remaining funds may be released to the taxpayer and will be treated as boot. However, Regs. Sec. 1. 1031(k)-1(g)(6) provides that funds may be received only when the taxpayer has received all of the replacement property to which he is entitled under the exchange agreement. It is not clear how this safe harbor applies when the taxpayer has received all the property that he intends to receive, but not all property that has been identified.

Example 8: T sells property to P for $600,000 on Jan. 12,1998. The sales proceeds are deposited in a qualified escrow under Regs. Sec. 1. 1031 (k)-1(g)(3)(ii), T uses a qualified intermediary and assignments of contract rights to facilitate the exchange. The identification period ends on Feb. 26, 1998; the exchange period ends on July 11, 1998. Before Feb. 26,1998, T identifies three properties. On June 5, 1998, T purchases two of the three identified properties, using $587,000 of the escrowed funds. The remaining identified property is listed for sale at $120,000, T decides that he will not acquire that property, and wants to receive the $13,000 remaining in escrow. Can the remaining escrowed funds be released to T before July 12, 1998, or must they remain in escrow because the third identified property is property T is entitled to receive under the exchange agreement? The answer is unclear; unless guidance to the contrary is issued,(27) it is best to leave the funds in escrow until July 12,1998.

If the more restrictive interpretation is correct, and the funds cannot be released until the end of the exchange period even when the taxpayer knows that not all identified property will be acquired, what happens if the escrow officer releases unused funds before the close of the exchange period? Based on Regs. Sec. 1. 1031(k)-1(g) (6) (the language of which is found verbatim in many deferred exchange escrow agreements), the early release may violate the escrow instructions. Nonetheless, it is quite common for escrow officers (who, generally, are not versed in the Sec. 1031 regulations) to accommodate the taxpayer's desires. The early release may be treated as boot, but may also cause the entire exchange to fail the Sec. 1031 requirements. It may also be the case that all the sales proceeds of the relinquished property have been expended on replacement property, but that interest earned on funds remains in escrow and may be used to fund the acquisition of additional identified property. A release of the interest may violate the safe harbor, with the possible result that all property received is nonqualified. A burden is thus imposed on either the tax adviser or the qualified intermediary to carefully monitor each step of the exchange process to avoid mistakes. The qualified intermediary role is often assumed by a title company; the tax adviser and the taxpayer should not assume that such company has the requisite knowledge of Sec. 1031 and the regulations to ensure compliance.

Regs. Sec. 1. 1031(k)-1(g)(6) restricts actual or constructive receipt of money or other property. Thus, the transfer of personal property in connection with real property may invalidate the safe harbor if it occurs before the end of the replacement period. The incidental property rule discussed earlier in connection with the identification of property does not extend to the receipt of such incidental property. Violations of the Regs. Sec. 1. 1031(k)-1(g) (6) and (7) safe harbors will be quite common if Treasury takes a hard line as to some of the scenarios discussed in this article.

Conclusion

The majority of real property like-kind exchanges are structured as deferred exchanges. The Sec. 1031 regulations provide needed guidance on many issues that arise in such exchanges, including the use of qualified intermediaries and escrows. The tax adviser must become familiar with the regulations to guide clients through the process of selling relinquished property and identifying and receiving replacement property. Many deferred exchanges will generate issues not directly addressed in the regulations. Without further guidance from Treasury, the tax adviser will need to make reasoned judgments as to how the rules apply.

(1) Rev. Rul. 78-4, 1978-1 CB 256.

(2) Rev. Rul. 72-601, 1972-2 CB 467.

(3) IRS Letter Ruling 9143053 (7/30/91).

(4) IRS Letter Ruling 9522006 (2/15/95).

(5) Regs. Sec. 1.1031(a)-1(c); Rev. Rul. 66-209, 1966-2 CB 299, provides that an exchange of a long-term lease for a fee simple is a like-kind exchange for the lessee, but the receipt of advance rent for the lessor.

(6) Larry L. Beeler, TC Memo 1997-73.

(7) Rev. Rul. 61-119,1961-1 CB 395, and Redwing Carriers, Inc., 399 F2d 652 (5th Cir. 1968) (22 AFTR2d 5448, 68-2 USTC 19540) (like-kind exchange occurred on subsidiary's purchase of new equipment from seller to which parent had sold old equipment for cash).

(8) Regs. Sec. 1.1031(k)-1(g)(3) explains that a qualified escrow is used to avoid the seller's constructive receipt of funds, but the exchange still must involve a third party.

(9) The qualified intermediarys resignation after accomplishing steps 1 and 2 may invalidate use of the safe harbor. Regs. Sec. 1.1031(k)-1(g)(4)(vi) provides that the taxpayer's state law rights to dismiss or terminate a qualified intermediary do not make the intermediary the taxpayer's agent for safe harbor purposes. However, the exercise of such rights may prevent the completion of a nontaxable exchange.

(10) Compare Regs. Sec. 1.1031(k)-1(g)(8), Examples 4 and 5.

(11) Regs. Sec. 1.1031(k)-I(g)(4)(iv) also allows for other forms of direct deeding.

(12) Bloomington Coca-Cola Co., 189 F2d 14 (7th Cir. 1951) (40 AFTR 648, 51-1 USTC [paragraph] 9320) (no Sec. 1031 exchange on taxpayer's transfer of cash and old plant for construction of a new plant).

(13) Rev. Rul. 75-291, 1975-2 CB 332 (X exchanged land and factory for Y's land and a factory built solely for exchange purposes; the IRS held that X qualified for Sec. 1031, but Y did not); IRS Letter Rulings 9413006 (12/20/93) (partnership's exchange with city that agreed to construct building on property prior to exchange qualified, even though a partner built the building before the exchange, because he was paid under the construction contract and not from receipts from the transfer of the partnership's property) and 9428007 (4/13/94) (Sec. 1031 applied; improvements were made after the qualified intermediary acquired the property).

(14) A dealer may also hold investment property, although it may be difficult to segregate the properties. However, a home builder who also owns a hotel should be entitled to Sec. 1031 relief on the disposition of the hotel.

(15) See Ethel Black, 35 TC 90 (1960) (taxpayer denied Sec. 1031 relief because property was held primarily for sale even though she was not in the trade or business of selling real property).

(16) Rev. Rul. 75-292, 1975-2 CB 333.

(17) Norman J. Magneson, 81 TC 767 (1983), aff'd, 753 F2d 1490 (9th Cir. 1985)(55 AFTR2d 85-911, 85-1 USTC 19205).

(18) Joseph R. Bolker, 81 TC 782 (1983), aff'd, 760 F2d 1039 (9th Cir. 1985)(56 AFTR2d 85-5121, 85-1 USTC [paragraph] 9400).

(19) Bonny B. Maloney, 93 TC 89 (1989).

(20) Rev. Rul. 77-337, 1977-2 CB 305.

(21) Miles H. Mason, TC Memo 1988-273 (however, the taxpayer had to recognize gain to the extent the liabilities he exchanged exceeded those he assumed).

(22) T.J. Starker, 432 F Supp 864 (DC Ore. 1977)(40 AFTR2d 77-5460,77-2 USTC [paragraph] 9512), aff'd in part and rev'd in part, 602 F2d 1341 (9th Cir. 1979)(44 AFTR2d 79-5525, 79-2 USTC [paragraph] 9541).

(23) Regs. Sec. 1.1031(k)-1(b)(2)(i); see Regs. Sec. 1.1031(k)-1(c)(7), Example 2. Delivery by hand or fax should satisfy the identification requirement, even if the intended recipient is not present to receive it.

(24) The FMV of the relinquished property will generally not be difficult to determine, because the property has been sold at the date of transfer. However, the FMVs of the identified properties may be difficult to determine. The seller's asking price should be used, as it serves as an upper limit on the FMV of the replacement property.

(25) Because FMV is generally determined after the end of the identification period, this exception should be used only in the absence of prior planning.

(26) Rev. Rul. 72-456, 1972-2 CB 468, provides that money paid out in an exchange can be offset against money received in the exchange.

(27) Regs. Sec. 1.1031(k)-1(g)(8), Example 2, illustrates that funds may be released before the end of the replacement period when identified property cannot be rezoned; it concludes that the Regs. Sec. 1.1031(k)-1(g)(3) safe harbor is in force until the contingency that permits release of the funds occurs. However, this example involves a contingency beyond the taxpayer's control; if funds are released before the end of the replacement period and there is no contingency, it may be that the safe harbor was never applicable.

RELATED ARTICLE: EXECUTIVE SUMMARY

[] For an escrow to be qualified, the taxpayer must not be able to receive, pledge, borrow or otherwise obtain any benefit from the sales proceeds.

[] The transfer of replacement property to an entity may jeopardize Sec. 1031 treatment.

[] If multiple properties, are in one exchange, the clock starts running on the day the first such property is transferred.

James R. Hamill, CPA, Ph.D. Associate Professor and Rogoff, Erickson, Diamond & Walker LLP Tax Research Fellow Anderson Schools of Management University of New Mexico Albuquerque, N.M.
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Publication:The Tax Adviser
Date:Nov 1, 1997
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