Tax-Free Trades: Simple Concept, Sticky Rules
Clevenger, Novella Noland, Wymore, Cynthia, The National Public Accountant
Considerable investor interest has been shown recently in deferred "like-kind" exchanges of real estate in order to minimize tax consequences. Generally, if property currently being used in a trade or business or held for investment is sold at a gain, the gain is realized and recognized at the time of sale. Under Section 1031 of the Internal Revenue Code (IRC), however, gain may be deferred if "like-kind" property is acquired in an exchange as replacement for the property relinquished.
Those planning to take advantage of such a reinvestment strategy should be forewarned that strict adherence to the rules is demanded. The risk versus rewards should be carefully weighed before jumping.
In reviewing the tax requirements for a "deferred like-kind exchange," the reader may note an amazing similarity between the rules established by the tax laws for executing the real estate transactions and those of a good old-fashioned game of Monopoly. Being a shrewd investor places heavy importance on knowing when to buy and sell, make exchanges, mortgage property and, yes, pay income taxes. For those who have not yet had the pleasure of playing the "Deferred Like-Kind Exchange Game," an overview of Section 1031 is now in order.
Overview--IRC Section 1031
Section 1031 provides for the non-recognition of gain realized from an exchange of property held for investment or business use. The original intent of Section 1031 was to defray tax on businesses and investors alike whose main purpose was to continue their investment by acquiring similar replacement property. Thus, common nontaxable exchanges were created.
Although there are exceptions to what property may be considered for like-kind treatment (e.g., stocks, bonds, notes, choses-in-action), an exchange of property may consist of either real or personal property or some combination of both. However, only real property issues and examples will be presented here.
Under existing regulations, a gain or loss may be recognized if the taxpayer actually or constructively receives money or other property not of like kind in a transaction involving like-kind replacement. Therefore, in order to qualify for deferred exchange treatment, a taxpayer must transfer property for property, as distinguished from a transfer of property for money. The statutory requirements create a structured format within which the taxpayer must operate. Failure to comply will result in sale treatment rather than a qualifying exchange of property.
At one time the Internal Revenue Service (IRS) took the position that the transfer of property for property had to be simultaneous in order to meet the code requirements of Section 1031. In the famous case of T.J. Starker, the notion of delayed exchange was presented and affirmed by the Ninth Circuit Court of Appeals. This decision, while broadening the scope of Section 1031, left tremendous uncertainty as well. Attempts were made in the Tax Reform Act of 1984 to provide clearer guidelines with respect to deferred exchanges. Most recently, final regulations have been promulgated in the hopes of achieving a higher degree of certainty in transactions involving delayed exchanges.
Identification and Exchange Periods
A deferred exchange must be completed within two key dates. The first date falls at the end of the identification period. This period begins when the property relinquished in the exchange has been transferred, and ends 45 days later. During this period, property must be identified in writing, with this signed document being delivered to a person involved in the exchange other than the taxpayer or related party.(1)
The second key date falls at the end of the exchange period. Like the identification period, the exchange period begins on the date the property relinquished in the exchange is transferred, but ends at the earlier of either 1) 180 days later, or 2) the due date, including extensions, of the taxpayer's tax return for the tax year in which the transfer occurred.(2) Both dates are critical to successfully completing a deferred exchange. It is important to note that Saturdays, Sundays and legal holidays are included in the calculations. IRC Section 7503 (which governs an extension of performance should a due date fall on a nonbusiness day to the next available business day) does not apply.(3) While this position is supported by the IRS, the issue may certainly be challenged in the courts. (Taxpayers must report these two critical dates on Form 8824).
Alternative Designation Rules
The final regulations contain three rules which specify the maximum number of replacement properties that can be identified. They are: the "3-property rule,"(4) the "200% rule,"(5) and the "95% rule."(6) These rules, added to the time constraints mentioned above, may cause taxpayers to designate contingent property. In so doing, taxpayers increase their chances of satisfying the requirements by designating contingent property prior to the end of the identification period. It is conceivable that if only one piece of property is identified for the exchange and something goes wrong, the taxpayer could fail to qualify for nonrecognition of gain. It is equally true that a taxpayer who overidentifies replacement property is deemed to have identified none. Situations such as these may force taxpayers to make a decision to either breach an existing contract or fail to qualify for nonrecognition of gain. In order to avoid such predicaments, a closer examination of these three alternative designation rules is warranted.
The "3-Property Rule"
The "3-property rule" is often viewed as the best alternative. This rule allows taxpayers to designate three replacement properties regardless of their fair market value. Then, one of the three properties identified during the identification period will be available as the replacement if received prior to the end of the exchange period.(7) The following example illustrates the 3-property rule.
On May 17, 1992, Mary transfers Blackhawk to Sue in a deferred exchange. Blackhawk is unencumbered and has a fair market value of $100,000 on that date. Mary then identifies in writing Brownpidgeon, Bluebird and Pinkswallow as replacement properties prior to July 1, 1992. This written document also informs Sue that by August 1, 1992, Mary will notify Sue (orally or in writing) which of the identified properties Sue is to transfer to Mary. As of July 1, 1992, the fair market values of these properties are $75,000, $100,000 and $125,000 respectively.
Because Mary has not identified more than three properties, the requirements of the 3-property rule are satisfied. Mary will be allowed nonrecognition on the exchange of Blackhawk for one of the properties. Additionally, the fact that the final identification does not occur until after the 45-day identification period is irrelevant, as long as the property ultimately identified is received before the expiration of the 180-day exchange period.
The "200% Rule"
The "200% rule" comes into play when a taxpayer finds it necessary to identify more than three replacement properties. An unlimited number of properties can be identified as long as their aggregate fair market value is no greater than 200% of the fair market value of the relinquished property.(8) The following illustrates this alternative designation rule.
On May 17, 1992, Mary transfers Blackhawk to Sue in a deferred exchange. Blackhawk is unencumbered and has a fair market value of $100,000 on that date. Mary then identifies Brownpidgeon, Bluebird, Yellowcrow and Pinkswallow as replacement properties prior to July 1, 1992. This written document also informs Sue that by August 1, 1992, Mary will notify Sue (orally or in writing) which of the identified properties Sue is to transfer to Mary. As of July 1, 1992, the fair market values of these properties are $30,000, $40,000, $60,000 and $50,000 respectively.
Because Mary identified more than three properties, their aggregate fair market value must not exceed $200,000 (200% or $100,000). Since their aggregate fair market value totals $180,000, Mary will be allowed non-recognition on the exchange having satisfied the 200% rule.
The "95% Rule"
The "95% rule" is really an exception to the above two rules. Treas. Reg. Sec. 1031 (k)-(1) (c) (4) (ii) states:
"If, as of the end of the identification period, the taxpayer has identified more properties as replacement properties than permitted by paragraph (c)(4)(i) of this section, the taxpayer is treated as if no replacement property had been identified. The preceding sentence will not apply, however, and an identification satisfying the requirements of paragraph (c)(4)(i) of this section will be considered made, with respect to:
* Any replacement property received by the taxpayer before the identification period, and
* Any replacement property identified before the end of the exchange period, but only if the taxpayer receives before the end of the exchange period identified replacement property the fair market value of which is at least 95% of the aggregate fair market value of all identified replacement properties (the 95% rule)."
This exception may be useful to a taxpayer wanting to exchange net equity. The following illustrates the 95% rule.
On May 17, 1992, Mary transfers Blackhawk to Sue in a deferred exchange. Blackhawk is unencumbered and has a fair market value of $100,000 on that date. On June 28, 1992, Mary then identifies Brownpidgeon, Bluebird, Yellowcrow and Pinkswallow as replacement properties. On July 1, 1992, the last day of the identification period, each of the identified properties has a fair market value of $100,000 and is subject to a liability of $75,000. On October 1, 1992, Mary receives all four of the identified properties from Sue.(9)
It is important to note that even though replacement properties are identified, this identification may be revoked at any time before the end of the identification period. Again, the revocation must be in writing and delivered to the person to whom the identification was originally sent. Also, the final regulations further illustrate that the "nature and character" of the property identified must be substantially the same as that which is received.(10)
There are additional items (i.e., constructed property, incidental property, improvements to the land, etc.) that must also meet statutory requirements. These items are addressed in Section 1031.
Multi-party exchanges may involve two or more parties. While the two-party exchange is the simplest, it is also the most difficult. For example, Walter wishes to exchange his property for property owned by Jake. Walter must hope that Jake wishes to own Walter's property. While this reciprocal arrangement qualifies under Section 1031, it is limiting in scope. Equally limiting was the IRS' former position (prior to the Tax Reform Act of 1984) that a taxpayer must execute a "simultaneous" exchange. With the heralding of the Starker and the Biggs decisions, three- and four-party exchanges were advanced. An illustration of a three-party exchange is shown below.(11)
Walter would like to acquire property owned by Jake. However, Jake is not interested in acquiring Walter's property but rather property owned by Jewell. Jake instructs Walter to purchase Jewell's property to exchange for his (Jake's) property.
Anytime more than one person is involved in an activity, complications may arise. This is certainly true of four-party exchanges which, by their very nature, involve complex arrangements. An illustration of a four-party exchange is shown below.
Alvin wishes to acquire the property of Carrie through an exchange. Alvin retains the help of an "intermediary," Donald, whose function is to facilitate the exchange. Alvin transfers his property to Donald, who then sells it to Taxpayer Babette for cash. Donald, the intermediary, then transfers the cash to Carrie for her property which had originally been identified by Alvin as suitable replacement property.
The Garcia case(12) did much in the way of expanding the scope of multi-party exchanges. It is interesting to note that Garcia used escrows to "simultaneously" close all the transactions, including encumbrances.
With all these activities, people and transactions abounding, safe harbors were created to provide some calm among the stormy deferred like-kind seas.
Use Of Safe Harbors
Prior to issuance of the final regulations, difficulties arose in two key areas: ensuring proper agency (who may represent the taxpayer) and constructive receipt (when monies are treated as if actually received). Lack of clear guidance in these areas caused disqualification of many attempted nontaxable transactions.
Since a taxpayer's "intent" under Section 1031 is overshadowed by form, the Treasury created four safe harbors as guidelines. Now the taxpayer can be reasonably assured that following one or more of the guidelines will result in qualification for nonrecognition of gain in a deferred exchange. However, it should be noted that failure to follow these guidelines will not necessarily result in a taxable exchange. The four safe harbors are:
1. a qualified intermediary; 2. a qualified escrow account; 3. a qualified trust; and 4. interest.
Each safe harbor has its own rules and limitations. However, the constructive receipt restriction applies uniformly to all four safe harbors.
Constructive Receipt Restriction
With three exceptions, a taxpayer must not have the rights to receive, pledge, borrow or otherwise obtain the benefits of money or property until after the end of the exchange period. These exceptions are:
(i) if the taxpayer has not identified replacement property before the end of the identification period, the taxpayer may have the rights listed above after the end of the identification period;
(ii) if the taxpayer has identified replacement property, the taxpayer may have the above rights (a) after receipt of all replacement property to which the taxpayer is entitled or (b) if, after the identification period has ended, a material and substantial contingency occurs that:
(a) relates to the deferred exchange,
(b) is provided for in writing, and
(c) is beyond the control of the taxpayer or any disqualified person.(13)
Staying within the safe harbor waters will ensure that agency and constructive receipt requirements are met.
For many taxpayers, this safe harbor may be the most important. The final regulations provided some changes to the qualified intermediary safe harbor. One such outcome was the change in the earlier rule so that an intermediary need no longer be paid a fee. Additionally, an intermediary is no longer required to obtain legal title to either the relinquished or replacement properties.
The qualified intermediary safe harbor is now available to simultaneous transfers of like-kind properties, whereas the other safe harbors are not. A qualified intermediary must enter into a written agreement with the taxpayer and must acquire and transfer both the relinquished and replacement properties.
Under agency limitations, a qualified intermediary may not be the taxpayer or a related party who falls within the definition of a "disqualified person." A "disqualified person" is one who is either the taxpayer's agent at the time of the transaction or bears a relationship with either the taxpayer or the taxpayer's agent, described in IRC Sections 267(b) or 707(b) (substituting 10% for 50% in each Section).(14) A person who acted as the taxpayer's attorney, accountant, employee, investment banker or broker, or real estate agent or broker during the two years preceding the transfer of the first relinquished property is said to be the agent of the taxpayer.(15)
Qualified Escrow Accounts
The final regulations approve the use of a qualified escrow account as a means of securing the intermediary's exchange promise.(16) This second safe harbor provides that the obligation of the taxpayer's transferee (intermediary) to transfer the replacement property to the taxpayer may be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow or trust account.(17) It should be noted that the qualified escrow account does not substitute for the intermediary. In fact, the escrow account does not qualify to act as the intermediary under the intermediary safe harbor.
Similar to the escrow account, a qualified trust is not permitted to act as an intermediary under the intermediary safe harbor. It is approved as a security device in which replacement property may be secured by cash or cash equivalent. An area of difficulty in using the trust safe harbor lies with the attribution rules contained in Section 267(b) and 707(b) of the Code. Determining the relationship of persons related to the agent of the taxpayer may prove difficult at best. These relationships are expansive in nature and, therefore, must be identified so as not to taint the exchange.
Previously, there was some concern about the paying of interest to the taxpayer prior to the end of the exchange period. If this was deemed constructive receipt, the deferred exchange would be violated. However, this issue was also brought to light in the Starker case. Since then the interest safe harbor provides for both interest and growth factors.(18) The final regulations provide that any interest or growth factor will be treated as interest, regardless of whether it is paid to the taxpayer in cash or in property (including property of like-kind).(19)
Six requirements must be met successfully to exchange property for like-kind property and create a non-taxable exchange. They are:
1)the property must be business or investment property;
2) the property must not be held for sale to customers;
3) there must be an exchange of like-kind property (i.e., real estate for real estate or personal property for personal property);
4)the property must be tangible property (stocks, bonds, etc. do not qualify);
5) the identification period must be met (45 days); and 6) the exchange period must be completed (180 days).
The details, which are spelled out in IRC Section 1031, are numerous and all-inclusive. Fortunately, deferred exchanges are optional. Those taking advantage of IRC Section 1031, however, must adhere strictly to proper form in order to avoid the chance of disqualification.
Novella Noland Clevenger, CPA, is an attorney and associate professor of taxation at Washburn University in Topeka, Kansas. She worked for nine years with the Internal Revenue Service as a tax auditor and audit group manager.
Cynthia Wymore is a professional tax preparer and has been involved with the IRS VITA Program.
1 Treas. Reg. 1031(a)-3(b)(2)(ii).
2 Treas. Reg. 1031(a)(3)(b).
3 Preamble to the Final Regulations, 1991-21 IRB 5, citing Rev. Rul. 83-116, 1983-2, CB 264.
4 Treas. Reg. 1031(k)-1(c)(4)(i)(A).
5 Treas. Reg. 1031(k)-1(c)(4)(i)(B).
6 Treas. Reg. 1031(k)-1(c)(4)(ii).
7 Treas. Reg. 1031(k)-1(c)(4)(A).
8 Treas. Reg. 1031(k)-1(c)(4)(B)
9 Fellows and Yuhas, "Deferred Like-Kind Exchanges: An Analysis of the Final Regulations," The Review of Taxation of Individuals, Spring, 1992, 132.
10 Treas. Reg. 1031(k)-1(d)(2), Ex. 2.
11 Additional support for this three-party arrangement is found in Rev. Rul. 57-244, 1957-1 CB 247.
12 Garcia v. Comr., 80 T.C. 491 (1983), acq., 1984-1 C.B. 1.
13 Treas. Reg. 1031(k)-1(g)(6).
14 Treas. Reg. 1031(k)-1(k)(3) and (4).
15 Treas. Reg. 1031(k)-1(k)(2).
16 Treas. Reg. 1031(k)-1(g)(1), (3).
17 Treas. Reg. 1031(k)-1(g)(3)(i).
18 Treas. Reg. 1031(k)-1(g)(5).
19 Treas. Reg. 1031(k)-1(h)(2).…
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Publication information: Article title: Tax-Free Trades: Simple Concept, Sticky Rules. Contributors: Clevenger, Novella Noland - Author, Wymore, Cynthia - Author. Magazine title: The National Public Accountant. Volume: 39. Issue: 6 Publication date: June 1994. Page number: 17+. © 1999 National Society of Public Accountants. COPYRIGHT 1994 Gale Group.
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