Finally, guidance on like-kind exchanges.
Each of these transactions has its unique problems. In real estate, the seller often has not yet identified or located the exchange property it wants by the time the buyer wants to acquire the property. Thus, deferred like-kind exchange techniques have been developed to meet both the buyer's desire for immediate property ownership and the seller's need for time to locate replacement property. In business swaps, on the other hand, although all property is used in the same business, there may be many different types of property involved--real property, personal property and goodwill. Previously, it was unclear how the Internal Revenue Service would treat these multi-asset exchanges.
The IRS recently issued long-awaited guidance governing like-kind exchanges in both areas. The new rules generally are straightforward and mechanical and--very important--provide several safe harbors that allow for more certainty in tax planning. Also, these regulations exemplify the IRS's well-publicized commitment to "simplified" rules; yet both the IRS and tax practitioners can live with them.
Part one of this two-part article focuses on the deferred exchange rules. Part two will focus on the new rules for exchanges of personal property as well as those for multi-asset exchanges.
DEFERRED LIKE-KIND EXCHANGES
The use of deferred like-kind exchanges--especially those involving real estate--grew dramatically after the Ninth Circuit's decision in Starker v. U.S., 602 F.2d 1341 (9th Cir.) 1979. In Starker, a deferred exchange qualified for nonrecognition treatment even though the property to be received could be designated by the seller for up to five years after the exchange and, if suitable replacement properties were not located, the seller could be paid in cash rather than in like-kind property.
A deferred exchange often raises constructive receipt issues--at least in the IRS's view, although the courts have appeared willing to elevate form-over-substance in many nonrecognition cases. Consequently, the IRS sought legislative relief to clean up this area in the Tax Reform Act of 1984. But, as often happens, Congress left many concerns unanswered. The new regulations fill in many of these gaps as well as provide safe harbors under which tax advisers can plan deferred exchanges with more certainty.
Identification and receipt requirements. Replacement property must be identified by the seller before the end of the 45th day after it transfers property to the buyer or intermediary (the identification period). In addition, the seller must receive the identified property before the earlier of either the end of the 180th day after the property transfer or the due date (including extensions) for its federal income tax return for the year in which the transfer took place (the exchange period). Consequently, for an exchange occurring near the end of the taxable year involving the full 180-day replacement period, the seller should be advised to obtain an extension to file its federal income tax return.
If the seller transfers more than one property as part of the same transaction and the properties are transferred on different dates, the identification and exchange periods begin on the date of the first transfer. As a result, practitioners might consider structuring these multiproperty exchanges as multiple transactions in order to use both the full 45-day identification period and the 189-day exchange period for each property. In addition, this approach may buy time for identifying more replacement properties. It still is unclear if the IRS would attempt to treat such multiple exchanges as one exchange.
METHODS OF IDENTIFYING
There are three ways to meet the identification requirement:
* The seller may complete the exchange by receiving the replacement property before the end of the identification period.
* The replacement property may be so designated in a written document signed by the seller and sent to someone other than himself or a "related party" who is involved in the exchange--defined to include the seller's agent (an attorney, employee or broker)--before the end of the identification period. While the document can be hand delivered, mailed, telecopied or otherwise "sent," it would be prudent to obtain proof of timely mailing or delivery to satisfy the 45-day rule.
* The replacement property may be identified in a written exchange agreement signed by all the parties involved before the end of the identification period, whether or not the agreement is "sent" to a person involved in the exchange.
The regulations clearly state that the replacement property must be unambiguously described in the written document or agreement. For example, real property must be described by its legal description or street address, and personal property must be described by a specific description of the particular type of property (for example, a truck must be described by a specific make, model and year).
ALTERNATIVE AND MULTIPLE PROPERTIES
Regardless of the number of properties transferred by the seller as part of one deferred exchange, the maximum number of replacement properties that may be identified are
* Three properties without regard to their fair-market value (the three-property rule).
* More than three properties if the aggregate fair-market value of these properties at the end of the identification period does not exceed 200% of the aggregate fair-market value of all transferred properties on the transfer date (the 200% rule).
If the taxpayer identifies more properties than allowed, the penalty is severe: The taxpayer is treated as if no property had been timely identified. Any property actually received during the identification period, however, would still qualify. Under a de minimis rule, property that is incidental to a larger property will not be treated as a separate item. Further, regulations do not allow the substitution of a particular identified property, even if the property cannot be obtained because of contingencies beyond the taxpayer's control--a rule suggested by the Committee Reports accompanying the 1984 tax act.
Unfortunately, the regulations do not make clear what constitutes a single item of property for purposes of the three-property rule. For example, assume that adjacent properties A and B have separate legal descriptions. If these are contiguous parcels, are they treated as one or two properties? What if the properties are separated by a public street? Should it matter if the taxpayer plans to develop the properties into an integrated, economic unit?
REVOCATION OF IDENTIFICATION
Identification of property as replacement property may be revoked, but only if the revocation is in writing, signed by the taxpayer and sent, before the end of the identification period, to the same person addressed in the original identification. Of course, it would be particularly important to obtain proof of timely revocation.
PRODUCED REPLACEMENT PROPERTY
Under limited circumstances, property may qualify as replacement property even though it is not yet in existence or is being constructed. A transfer of property in exchange for services (including production services), however, can never qualify. Therefore, any construction with respect to the replacement property after the exchange property is received cannot be treated as like-kind property (see exhibit 1 above).
Constructive receipt problems. To the extent a taxpayer is in constructive receipt of cash or other nonlike-kind property, non-recognition treatment will not apply. This can be a particular problem in deferred exchanges since the seller does not want to transfer its property unless and until it has adequate security that the buyer will purchase the exchange property. Much creative tax planning has centered around providing buyers with needed security while, at the same time, not violating the constructive receipt rules.
In order to provide some certainty, the proposed regulations provide four safe harbors under which taxpayers will not be considered in actual or constructive receipt of money or other nonlike-kind property. The IRS expects (and it probably will be the case) that most deferred exchanges will be structured to come within these safe harbors; in fact, failure to do so could be quite costly since the IRS can be expected to closely scrutinize these transactions.
SECURITY OR GUARANTEE
The buyer's obligation to transfer replacement property to the seller may be secured or guaranteed by
* A mortgage, deed or trust, or other security in property (other than cash or a cash equivalent).
* A nonnegotiable, nontransferable standby letter of credit issued by a financial institution that does not allow the seller to draw on this letter except upon default by the buyer.
* A third-party guarantee.
ACCOUNTS AND TRUSTS
The buyer's obligation to transfer replacement property may be secured by cash or cash equivalents if it is held in a qualified escrow account or trust. The escrow or trust is qualified only if the escrow holder or trustee is not the seller or a related party and if the seller cannot receive, pledge, borrow or otherwise obtain the benefits of the cash until
* The identification period expires if no replacement property is timely identified.
* The seller has received the identified property.
* The seller identifies property, then the later of either (1) or (2)
1. The end of the identification period.
2. The occurrence of a material and substantial contingency relating to the deferred exchange that is provided for in writing and is beyond the control of the seller or a related party.
* The exchange period has expired.
As the examples in the regulations make
[TABULAR DATA OMITTED]
clear, the seller cannot have the ability or unrestricted right to receive cash. Extreme caution must be exercised to ensure the seller's right to receive cash is restricted to certain limited circumstances (see exhibit 2 below).
An intermediary can be used in a deferred exchange as long as the intermediary is a person or entity other than the seller or a related party who acts to facilitate the deferred exchange, for a fee, by taking these three steps:
1. Agrees to acquire the seller's property.
2. Acquires the replacement property.
3. Transfers the replacement property to the seller (see exhibit 3 on page 59).
As in cases involving qualified escrow accounts and trusts, the seller's right to receive money from the intermediary must be subjected to the above restrictions.
While the intermediary may not be a party related to the seller, a person qualifying
[TABULAR DATA OMITTED]
as the seller's agent only because he or she performs services involving the exchange is not considered a related party. Therefore, an agent of the seller can be a qualified intermediary if this relationship exists solely as a result of the exchange and does not arise from other relationships. In addition, the use of an intermediary for an exchange will not be disqualified solely because the intermediary acted as the seller's intermediary in previous exchange transactions. This provision has upset certain attorneys who believe it restricts the range of services they can provide to clients.
INTEREST OR GROWTH FACTORS
The IRS surprised many practitioners by allowing sellers to receive an interest or growth factor. The amount of money or property to be received must depend on the length of time elapsed between the property transfer and the receipt of replacement property, and the interest or growth factor must be treated as interest income--whether it is paid in cash or in like-kind property.
The proposed regulations do not address the so-called reversed-Starker situation, where the seller acquires replacement property before locating a buyer for the relinquished property. The IRS has asked for comments on these transactions but has not yet decided what treatment is appropriate. Therefore, caution is advised before engaging in a reverse-Starker. There transactions raise questions of whether an exchange actually has occurred or if it represents two separate transactions (that is, a purchase followed by a sale).
The IRS recently sanctioned the use of direct deeding of property in revenue ruling 90-34, and the regulations confirm this position. As a result, property may be directly deeded from a third party to a seller; there is no need to have separate back-to-back deeds between exchanging properties, thus avoiding duplicate transfer taxes.
The regulations clearly state that liabilities assumed and liabilities relieved are netted in the case of deferred exhanges, even though this relief and assumption may occur several months apart. However, even thrugh relief is granted under the like-kind rules, a partnership involved in a deferred exchange may have deemed distributions under the partnership rules due to the time gap between the liability relief and the subsequent assumption. In short, the partnership tax rules need to be amended to conform with the like-kind rules.
EFFECTIVE DATE AND TRANSITION RULE
The deferred like-kind exchange regulations, as proposed, will be effective for transfers of property made after July 2, 1990. However, the new rules do not apply to an exchange made under a written binding contract that was in effect on May 16, 1990, and which is binding at all times thereafter. A deferred exchange that would not qualify under the regulation's safe harbors may still qualify for nonrecognition treatment, but it is anticipated these will be closely scrutinized by the IRS.
PHILIP P. WIESNER, CPA, JD, is a partner in the national tax practice of KPMG Peat Marwick, Washington, D.C. He is currently chairman of the American Institute of CPAs federal taxation division's partnership subcommittee and a member of the AICPA passive loss task force. DAVID G. MEULMESTER, CPA, is a senior managler in KPMG Peat Marwick's San Diego office. He is currently on a rotational assignment with the firm's national tax practice in Washington, D.C.
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|Title Annotation:||part 1|
|Author:||Meulmester, David G.|
|Publication:||Journal of Accountancy|
|Date:||Oct 1, 1990|
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