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New rules for deferred like-kind exchanges.

Taxpayers have long had the opportunity under federal tax law to consummate a tax-free exchange of their ownership interests in real estate for similar, like-kind interests from another taxpayer As long as the taxpayer received no cash or property other than the like-kind property, Section 1031 of the Internal Revenue Code (the Code) provided that there would be no recognition of gain or loss for federal income tax purposes.

Example 1: John has a $100,000 cost basis in Property A, which has a fair market value of $300,000. He agrees to exchange Property A for Property B, which is owned by George. Assuming no cash or other property is received by John, there is no recognition of gain by John, and therefore no tax to be paid.

The nonrecognition rules of Section 1031 serve only to defer the tax on the exchange, however The tax would eventually come due when the property received is sold for cash. This deferral mechanism is accomplished by requiring the taxpayer to substitute the basis of the property relinquished onto the property received. Thus, once the property is sold, the deferred gain on the original exchange will be recognized.

Example 2: Assume the same facts as in Example 1 except that John sells Property B three years later for $350,000. John will recognize a $250,000 gain, since his substituted basis for Property B is $100,000.

If the taxpayer receives any cash or other property in the exchange, gain is recognized in an amount equal to these amounts, which are called "boot." Thus, in Example 1, if John had received $50,000 cash in addition to Property B, he would have had to recognize this amount as taxable gain. His cost basis in Property B would remain at $100,000 because Section 1031 requires that the basis of the acquired property be increased by the recognized gain, but decreased by the cash or other boot received. In this case amounts are both $50,000.

In this article, the authors will examine the changing tax rules surrounding the very fundamental types of transactions involving deferred exchanges. Recently, Congress and the IRS have made serious attempts to alter the tax ramifications of deferred exchanges.

Deferred exchanges and the Tax Reform Act of 1984

Prior to the 1984 Act, taxpayers could enter into deferred exchanges of real estate with little worry that the exchange would not be covered by the nonrecognition rules of Section 1031 of the Code. There was usually no time limit as to when the replacement property had to be received, nor did this property have to be identified by the taxpayer at the time of the original exchange.

This deferral ability could be seen in the leading court case on the issue, Starker v US. In this instance, the taxpayer had transferred land to another person under a land-exchange agreement." In return for the relinquished property, the taxpayer acquired an exchange balance" of about $1.5 million from the transferee, with an annual growth rate factor of 6 percent.

The taxpayer was required to identify suitable replacement property within five years, with the transferee using the exchange balance" to acquire this property. If none was identified within the five-year period, the taxpayer would be entitled to the balance in the "exchange fund." The taxpayer eventually received suitable replacement property, so the balance was never refunded to him.

In Starker the court held that the foregoing qualified under Section 1031 as a like-kind exchange, on the premise that the taxpayer manifested an obvious intent to receive like-kind property, as he indeed received such property. The only taxable gain was an interest income factor, equal to the value of the property eventually received over the value of the property at the original date of exchange.

The IRS refused to acquiesce in the Starker conclusion. Its opinion was that the facts in Starker indicated that there was nothing more than a disguised cash sale.

Eventually the IRS reasoning convinced Congress. In the Tax Reform Act of 1984, Section 1031 was amended in an effort to severely curtail Starker transactions.

The anti-Starker statute

The Act provided that deferred like-kind exchanges were acceptable, only if the taxpayer met two strict requirements. First, the taxpayer must identify the replacement property within 45 days from the time the original property was relinquished to the transteree. This 45-day period is called the "identification period."

Second, the taxpayer must also receive the identified property within the earlier of two time periods: 180 days after the original transfer of the relinquished property, or the due date, including extensions, of the taxpayer's tax return for the tax year in which the original transfer of the relinquished property occurs. This second period is called the exchange period."

Example 3: On November 25, 1990, John transfers Property A to George in a deferred exchange. To receive nonrecognition under Section 1031, John must identify like-kind replacement property by January 9, 1991, and receive it by April 15, 1991, the due date of his tax return. If he receives an extension of his due date to August 15, 1991, he can receive the replacement property as late as May 24, 1991, since this is 180 days from the date of the original exchange.

For several years, taxpayers and their counsel have had only the Code provisions to work with in planning deferred exchanges. In the meantime, the IRS has been working on regulations which interpret the anti-Starker statute. These regulations were finally published during 1990 in proposed form.

Because years usually elapse before regulations are finalized, the proposed regulations offer taxpayers some insight into IRS thinking on this matter, thereby providing some planning guidelines. The remainder of this article will examine these new rules, which have important implications for those who are contemplating deferred exchanges of realty.

Identifying the replacement property

One question that the regulations address is the time period for identifying the replacement property if two or more properties are relinquished by the taxpayer in the original exchange. Does this period extend to 45 days from the transfer of the second property or the first.? The regulations state that the 45-day period will be determined by reference to the date on which the first property was transferred.

Example 4: John enters into a deferred exchange agreement with George. John transfers Property A to George on November 21, 1990, and Property B on December 15, 1990. The replacement property must be identified by John on or before January 5, 1990, which is 45 days after the transfer of Property A.

The regulations also describe the form and manner in which the identification must be made. The property must be identified in a written document, signed by the taxpayer, and either hand delivered, mailed, telecopied, or otherwise sent to a person involved in the exchange. This written document must also specifically describe the replacement property. This means a clear representation of its legal description or its street address. As an example, an insufficient description would be one that simply described replacement property as "unimproved land located in Cook County, Illinois with a fair market value not to exceed "100,000."

Two or more replacement properties

It may also be necessary to identify more than one replacement property, as a contingency. There may be some factors beyond the taxpayer's control which would eliminate the preferred replacement property from being received. In addition, the brief 45-day identification period itself may induce taxpayers to identify some contingent property.

The regulations propose two separate rules which limit the ability of taxpayers to select alternate properties. Either of the two rules may be used, as long as the properties are all identified within the 45-day period.

The first rule is the "three-property rule." It simply requires the taxpayer to identify three properties, without any limits on their value, within the 45-day period. The final identification of the actual property to be received can be made after the 45-day period, as long-as it is received within the exchange period. The reader should note that the controlling value is the value of the asset itself, not reduced by any debt encumbered on the property.

Example 5: John transfers Property A to George in a deferred like-kind exchange on May 17, 1991. Assume that the value of Property A at the time of the original transfer is $100,000. On June 28, 1991, John properly identifies Properties X, Y, and Z as suitable alternate replacement properties. On October 1, 1991, John identifies Property X as the one to be received and ultimately receives this property on November 1, 1991. John will be accorded nonrecognition treatment on the deferred exchange because he identifies no more than three properties within the 45-day period and eventually received the replacement property within 180 days of the original exchange.

The second rule governing alternate properties is the 200-percent rule," which can be used if the taxpayer wants to identify more than three properties. Under this rule, an unlimited number of properties can be identified as long as their total value at the end of the 45-day identification period does not exceed 200 percent of the value of the relinquished property as of the date of the original exchange of this latter property.

Example 6: On May 17, 1991, John transfers Property A to George in a deferred like-kind exchange. Property A has a value of $200,000 and a cost basis to John of $150,000 on this date. On May 25, 1991, John identifies Properties W, X, Y and Z as potential replacement properties. On July 1, 1991, the last day of the 45-day identification period, the fair market values of these properties are $60,000, $80,000, $100,000, and $120,000 respectively. Since the sum of the values of the alternated properties is $360,000, it has met the 200 percent test, as $360,000 is only 180 percent of $200,000.

Obviously taxpayers would use either the three-property test or the 200-percent test, depending on the circumstances of each case. The three-property rule would be used when the taxpayer can identify three similar properties with values roughly equal to the relinquished properties.

In situations where the taxpayers could not find similar units of equal value, it may become necessary to identify sufficient properties so that enough replacements could be received to provide the taxpayers with sufficient value.

For instance, in Example 6 above, none of the properties individually are equal to the value of Property A, but the receipt of two, plus some additional cash received, would give John the $200,000 value he was seeking. Suppose John received Properties W and Z, with a total value of $180,000. With an additional $20,000 in cash from George, John would receive a total package of $200,000. Of course, there would be recognition of gain of $20,000 on the cash received.

Taxpayers must be careful not to fail either of these tests should multiple properties be identified. Should failure occur, the regulations state that in this instance none of the properties identified will be considered to have been properly identified. This will result in gain being recognized on the original transfer of the relinquished property.

Example 7: John transfers Property A to George on May 17, 1991, On that date property A has a value of $200,000 and a cost basis to John of $150,000. On May 25, 1991, he identifies four properties (W, X, Y, and Z) with an aggregate value of 450,000. Since he has identified more than three properties with an aggregate value in excess of $400,000, John has failed both tests. Therefore, he must recognize a $50,000 gain on the transfer of Property A even though he might receive the replacement properties within the 180-day exchange period.

There are two exceptions available to the harsh treatment described in Example 7. One of these allows any property received before the end of the 45-day identification period to be considered as properly identified.

Example 8: On May 17, 1991, John transfers Property A to George in a deferred like-kind exchange. Property A has a value of $200,000 and a cost basis of 150,000, On May 21, 1991, John identifies four properties (W, X, Y, and Z), all with a value of $200,000. John has failed both the three-property test and the 200 percent test, and to avoid recognition of gain on Property A he must receive one of the four properties before July 1, 1991, the expiration date of the 45-day identification period,

The second exception to recognizing gain on the original transfer allows the taxpayer to receive replacement property before the end of the 180-day exchange period, but only if the property received is at least 95 percent of the total value of all the identified properties.

Thus in Example 8, John could not use this test because the total value of property identified is $800,000, and Property A only has a value of $200,000. However, this second exception can still be used by those taxpayers who identify properties which are encumbered by mortgages, and thus whose "net" values approximate the value of the relinquished property.

Example 9: On May 17, 1991, John transfers Property A to George in a deferred exchange of realty. Property A has a value of $200,000 on this date. On May 21, John identifies Properties W, X, Y, and Z. These four properties all have a value of $200,000, and each is encumbered by a mortgage of $150,000. Although John has failed the three-property test and the 200-percent test, he can still avoid recognition of gain on Property A by receiving all four properties before the end of the 180-day exchange period. Receipt of substantially the same" property The regulations also contain a provision whereby taxpayers may receive property "substantially the same" as that relinquished. This means that one is allowed to receive less than the entire interest in the property specifically identified.

Because equality of values between the relinquished and replacement properties is rarely a fact, this provision gives the taxpayer the opportunity to find the best possible replacement property, with differences in value made up by one of the exchange parties offering cash.

Example 10: John transfers Property A to George on May 17, 1991. Property A has a value of $200,000 on this date, and a cost basis of 100,000, On May 21, 1991, John identifies Property B as suitable replacement property. Property B has a value of $300,000 and consists of six acres of unimproved land. On June 1, 1991, George buys five acres of Property B for $250,000 and transfers it to John, who pays him an additional amount of cash of $50,000. John should not recognize any gain on Property A, since he has received substantially the same" property as that identified. His basis in Property B will increase by the $50,000 cash paid, to $150,000.

Is there any limit to the percentage of the property identified, below which the IRS will assert that the taxpayer has not received "substantially the same" property? The regulations give an example in which the taxpayer receives 75 percent of the identified property and indicates that the "substantially the same" test has been passed.

But what if the taxpayer receives less than this 75 percent? The regulations do not specifically state that the receipt of less than a 75-percent interest will result in a taxable transaction. indeed they are silent on this issue. It would seem only equitable that receipt of less than 75 percent of the property identified would still qualify, as the taxpayer is simply receiving a partial interest in his or her choice of property.

In Example 10, then, it should not matter if George simply transfers four acres of Property B to John. In fact, even though these four acres only have a total value of $200,000 and represent only 67 percent of the total six acres, they are exactly equal in value to Property A. Recognition of gain should not occur

Still, until the regulations are clear on this point, taxpayers should be careful on this issue. It might be wise to identify property so that in all contingencies at least 75 percent of the identified property will eventually be received. Constructive receipt of cash Earlier it was mentioned that the receipt of cash by the taxpayer would generate the recognition of gain equal to the lesser of the cash received or the realized gain. It is not necessary to actually receive the cash. A "constructive" receipt of cash will suffice.

The doctrine of constructive receipt is a tax-accounting doctrine which states, generally, that a taxpayer is in receipt of cash if there exists an unrestricted right to draw upon the cash or otherwise have use of its benefits.

This doctrine can be very important in deferred exchanges of realty because the transferor is usually not willing to simply rely on the other party's unsecured promise to acquire the replacement project. Therefore, some "good faith" deposit in an escrow or trust account may be required of the transferee.

Indeed, the terms of the contract may state that the transferor, after the end of a stipulated period of time in which the transferee has failed to acquire the replacement property (probably the 180-day exchange period), will be paid the balance in the escrow account.

As long as taxpayers do not have any right to receive the cash until the end of the 180-day period, the nonrecognition rules of Section 1031 should prevail on the relinquished property, at least until the expiration of the 180-day period. Should the transferor have the right to receive the cash in lieu of the property by simply notifying the trustee of the cash, the nonrecognition rules would not apply even if the replacement property would eventually be received.

The regulations provide four "safe harbor" rules, which provide some guidance to the taxpayer who wishes to avoid this doctrine of constructive receipt.

The first rule allows the taxpayer to guarantee the transferee's performance by use of three separate categories of security arrangements. One of these security arrangements allows the transferor to secure performance through the use of a mortgage, deed of trust, or other security interest in the transferee's property. Meeting one of these four tests will keep the transaction within the purview of Section 1031 and avoid constructive receipt.

Example 11: John transfers Property A to George on May 17, 1991. John identifies Property B as the property to be acquired by George and delivered within the 180-day period. To secure George's performance, John executes a security interest in Property A, retaining the right to take back title to the property should George fail to secure Property B and deliver title to him within 180 days.

If George is not willing to have Property B used as collateral, any property other than cash or cash-equivalents would suffice. Therefore, even tangible personal property, such as equipment, could serve as collateral.

The second type of guarantee is a standby letter of credit. This instrument will allow the taxpayer to draw upon it should the transferee fail to provide the replacement property within the stipulated time period. To avoid the imposition of the constructive-receipt doctrine, however, the provisions of the letter of credit should state that the taxpayer-transferor is prohibited from drawing upon the instrument except in the case of the transferee's failure to perform under the terms of the contract.

The third allowable guarantee under the safe harbor rules permits a guarantee of performance to be made by a third party. The taxpayer-transferor should be careful, however, to avoid a guarantee being made by a party related to the transferor Tax law has always looked with an unfavorable, or at least questioning, eye on arrangements between related parties. However, a guarantee made by a party related to the transferee should pass the safe harbor test. Qualified escrow and trust accounts A popular vehicle for securing performance of contracts is to have one of the parties deposit funds in an escrow or trust account. With deferred exchanges it is, of course, important that the transferor not be deemed in constructive receipt of the escrowed funds.

The regulations require that any escrow or trust account set up to insure performance by the transferee not have as its trustee or escrow holder, the taxpayer-transferor or a party related to this person. For example, the trustee could not be the taxpayer's spouse or a company controlled by the taxpayer. However, a party related to the transferee should qualify.

In addition, the regulations provide that the transferor must not have the right to receive money or other property from the trust or escrow account until:

* after the identification period, if the taxpayer has not identified replacement property by that time; or

* after the taxpayer has received all of the identified replacement property to which the taxpayer is entitled; or

* 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 relates to the deferred exchange, is provided in writing, and is beyond the control of the taxpayer or a related party, or

* otherwise, after the end of the exchange period.

The following examples describe escrow or trust arrangements in which the foregoing requirements are used to insure that constructive receipt of the funds does not occur It is assumed that the trustee or escrow holder is not the transferor or a party related to this individual.

Example 12: On May 17, 1991, John transfers Property A to George in a deferred like-kind exchange. On that date Property A has a value of $100,000. By terms of the contract, John is to identify suitable replacement property which George must purchase and transfer to John before the end of the 180-day exchange period. George deposits $100,000 in an escrow agreement as security for his performance. These funds are to be used to purchase the replacement property.

The escrow agreement further provides for the following contingencies. If John fails to identify replacement property on or before July 1, 1991, the end of the identification period, he may demand the funds in escrow any time after that date. If John identifies and receives replacement property, then, he may demand the balance of the remaining funds in escrow at any time after receipt of the property. Should the replacement property not be received by the end of the exchange period, John is entitled to all funds in escrow after the end of that period.

If John properly identifies the replacement property and George acquires it and transfers it before the end of the 180-day exchange period, the transaction should qualify for nonrecognition under Section 1031 as the escrow agreement has the necessary qualifications. Of course, if John receives the cash, this would constitute a sale of Property A at that point.

The next example shows that a transferor's receipt of the replacement property may be subject to contingencies beyond his or her control. In this instance, the escrow or trust agreement should provide that the transferor is allowed to withdraw the funds only upon occurrence of that stipulated contingency.

Example 13: Assume the same facts as Example 12 except that on May 17, 1991, John identifies Property B as the replacement property. The escrow agreement further provides that John may demand the funds after the later of July 1 (the end of the identification period), or if Property B is destroyed, stolen, seized, or condemned. Otherwise, John may receive the funds after the earlier of November 13, 1991 (the end of the exchange period) if he does not receive Property A by that time. The use of qualified intermediaries The third safe-harbor rule allows the taxpayer to use a qualified intermediary to facilitate a deferred exchange of realty. The use of an intermediary has always been a popular vehicle for consummating deferred like-kind exchanges.

The regulations provide that the exchange must use only a qualified" intermediary to avoid constructive-receipt rules. This is simply someone other than the transferor-taxpayer or a related party who, for a fee, acts to facilitate the deferred exchange by acquiring the relinquished property from the transferor, then acquiring the replacement property from a third party in exchange for the relinquished property, and transferring this replacement property to the transferor

By using a qualified intermediary there will be the need to have funds escrowed because the intermediary will temporarily have control over funds necessary to acquire replacement property. To avoid the constructive-receipt doctrine, it is imperative that the transferor not have a right to these funds other than under the contingency requirements discussed above in Examples 12 and 13.

Example 14: John enters into a deferred-exchange agreement on May 17, 1991, with George and with Bill, who will act as an intermediary. Pursuant to the agreement John will transfer Property A to Bill, who will then sell Property A to George for its fair market value of $100,000, placing the funds in an escrow account. The terms of the account stipulate that John can only receive the funds under terms similar to Examples 12 and 13, The property is sold to George on May 25, 1991, and the funds are escrowed. On June 1, 1991, John identifies Property B (owned by a fourth party unrelated to John, Bill, or George). Bill then uses the escrowed funds to purchase Property B and transfers it to John on July 1, 1991.

The regulations are quite explicit as to the manner in which the intermediary is supposed to act. To meet the safe-harbor test, the intermediary must do all of the following: acquire the relinquished property directly from the taxpayer, acquire the replacement property directly, and transfer the replacement property directly to the taxpayer Any deviation from this chain of events will cause the transfer of the relinquished property by the taxpayer to be recognized for income-tax purposes.

In Example 14 above, Bill satisfied all of these requirements, but consider the following scenario.

Example 15: Assume the same facts as Example 14 except that John transfers Property A directly to George, directing him to pay $100,000 to Bill. Bill then uses the funds to purchase Property B from an unrelated fourth party, and then transfers Property B to John.

Because John transferred Property A directly to George, the safe-harbor rules are failed, and the transfer of Property A by John is considered a taxable sale. Taxpayers and their advisors should therefore be careful not only to have qualifying language in the escrow or trust document, but also to make sure that any intermediary follows the exact chain of events as outlined in the regulations.

Interest and growth factors

Due to the time lag between the date the relinquished property is transferred and the date the replacement property is received, one may want to be compensated for the time delay by being paid some interest or growth factor

To avoid classification of this interest factor as cash boot," however, the taxpayer must avoid receiving any of the interest element before completion of the deferred exchange. Any amounts received after completion of the deferred exchange will be treated as interest income at the time of receipt.

Example 16: On May 17, 1991, John transfers Property A, with a fair market value of $100,000, to George in a deferred like-kind exchange. The agreement states that John will identify replacement property by July 1, 1991, and George will acquire it and transfer it to John by November 13, 1991. The agreement also provides that John is entitled to an 8 percent interest factor to be paid in either cash or additional property, but only after November 13, 1991.

On June 1, 1991, John identifies Property B as replacement property, and on August 15, 1991, George acquires Property B and transfers it to John. In addition George pays John $2,000 on August 16, 1991, equal to 2 percent of the $100,000 property value. This is a three-month interest factor at 8 percent per annum. John does not recognize any gain on the transfer of Property A, but he does have $2,000 of interest income to recognize in 1991.


The preceding discussion has been an attempt to describe the salient requirements of the new tax rules on deferred like-kind exchanges of realty. Taxpayers who are active in the real estate industry will need to become familiar with these rules if they are to use them to their advantage.

The foregoing has not been a technical and legal analysis of the regulations, but rather was an effort to provide a sound background in the area to those interested in its ramifications. Before any important deferred transaction is consummated, the advice of proper tax counsel is essential.


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

Sec. 77, The Tax Reform Act of 1984. Public Law 98-369 98 Stat. 494, 595-7. Internal Revenue Code, Section 1031 (a)(3). Prop. Reg. Sec. 1.1031 (a)-(3).

James A. Fellows, Ph. D., CPA, is associate professor of accounting and taxation at The University of South Florida in Fort Myers, Florida.

Michael A. Yuhas, LL.M., is associate professor of taxation at Grand Valley State University in Allendale, Michigan.
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Author:Fellows, James A.; Yuhas, Michael A.
Publication:Journal of Property Management
Date:Nov 1, 1990
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