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Tax-Deferred Exchanges

Section 1031 of the Internal Revenue Code (“IRC”) allows investors to defer (postpone) paying income taxes on the gains from the sale of business or investment property if the proceeds are reinvested into “like-kind” property (see Question 4, below). Clients who own and plan to dispose of rental property, business or other income-producing property may benefit by using a tax-deferred exchange as part of their estate plan, and doing so may potentially avoid all the income taxes from tax-deferred exchanges (see Question 1, below).

How to Structure a Tax-Deferred Exchange

First Step: Purchase/Sale Agreement for Relinquished Property

When a Qualified Intermediary (“Intermediary” or “QI”) is to be used to facilitate the §1031 Exchange, there is no difference between this contract and a typical sales contract. However, it is important that the contract not have any prohibitions against its assignment to an Intermediary, because it must be assigned tothe Intermediary prior to the closing. If the contract is assignable it is not necessary to mention the prospective 1031 exchange. This allows the exchanger/taxpayer to keep confidential his intent to use §1031 until the closing. **

[This advisory outline does not deal with exchanges in which an intermediary is not used, in which case special rules apply, e.g., if an Intermediary is not being used, confidentiality is lost; and it is vital that the contract include certain exchange language, such as: “Seller is selling the property to Purchaser as part of a like-kind exchange pursuant to IRC §1031. Purchaser agrees to cooperate with the Seller to accomplish the

exchange at no cost or liability to Purchaser. Specifically, Purchaser agrees to the assignment of this contract to a third party simultaneous to closing for the purpose of accomplishing the exchange.”]

Second Step: Contacting a Qualified Intermediary

The exchanger/taxpayer needs to hire a Qualified Intermediary to prepare for the exchange. The QI’s role is to dispose of the exchanger/taxpayer’s relinquished property and acquire replacement property. With the proper documentation, this can be done with direct deeds between the exchanger/taxpayer and the seller or the purchaser of those properties without the Intermediary appearing in the chain of title. The QI’s duty is to provide all exchange documentation (the IRS paperwork with the mandated technical language to turn an ordinary sale into a tax-deferred exchange). The QI will also coordinate the execution of the exchange in compliance with the Internal Revenue Code and Regulations.

Third Step: Disposition of Relinquished Property

Because the exchanger/taxpayer is not allowed to hold or have access to the proceeds of sale of the relinquished property while the exchange is in process, the QI must hold the proceeds in escrow under the IRC “Safe-Harbor” rules until exchanger/taxpayer’s acquisition of the replacement property. Under the Regulations, however, the exchanger/taxpayer can receive the benefit of any interest from investment of those proceeds while in the QI’s hands.

Fourth Step: Identification of Replacement Property

The exchanger/taxpayer must identify potential replacement properties to the QI in writing within 45 days from the transfer of the relinquished property (see Question 3, below). Properties identified do not need to be actually under contract at the time they are identified, and all the properties identified do not have to be purchased, as long as the three rules pertaining to recognition of gain are followed (see Question 10, below). The 45-day period begins on the date of closing and transfer of title to the relinquished property and it ends on the 45^th day after that. You do not count the day of closing when counting the 45 days, but holidays and weekends are counted even if the 45^th day falls on a holiday or weekend. The QI will provide the necessary form for making this identification (see Question 3, below).

Fifth Step: Purchase Agreement for Replacement Property

Again, when a Qualified Intermediary is used to facilitate the §1031 Exchange, there is no difference between this contract and a typical purchase contract as long as the contract has no prohibitions against its assignment to an Intermediary. This contract must be assigned to the QI prior to the closing of the purchase. This allows the exchanger/taxpayer to keep his intent for use of §1031 confidential until the closing. Confidentiality can be important in the negotiation of the purchase contract.

[If an Intermediary is not being used, confidentiality is lost, and the only difference between this contract and a typical purchase agreement is the need to include certain exchange language, such as: “Purchaser is purchasing the property from Seller as part of a like-kind exchange pursuant to IRC §1031. Seller agrees to cooperate with Purchaser to accomplish the exchange at no cost or liability to Seller. Specifically, Seller agrees to the assignment of this contract to a third party simultaneous to closing for the purpose of accomplishing the exchange.”]

Sixth Step: Closing on Replacement Property

The exchanger/taxpayer must take title to the replacement property by the earlier of (i) the 180^th day after transferring title (the “closing”) to the relinquished property, or (ii) the date on which the exchanger/taxpayer’s income tax return is filed for the year in which the exchange commences. The 180-day period begins with the date of closing and transfer of title to the relinquished property and ends on the 180^th day after that. You do not count the day of closing when counting the 180 days, but holidays and weekends are counted even if the 180^th day falls on a holiday or weekend. If the tax return filing date for the exchanger is within the 180-day period, the exchanger must file extensions for the tax return with the IRS. Otherwise, the 180 day period is shortened and the exchange period will end on the date the tax return is filed. The funds held in escrow by OTEC will be used to acquire the replacement property at the closing of the purchase of the replacement property.

Frequently Asked Questions

Question 1: Is an exchange really tax-free?

A properly executed like-kind exchange results in tax deferral which only delays, but does not eliminate, the recognition of capital gains. However, if replacement property is ultimately inherited by the exchanger/taxpayer’s heirs, the heirs receive a “stepped-up basis” to the fair market value of the property at the time of the exchanger/taxpayer’s death, which means that previously deferred gain is eliminated upon resale. (Proper estate planning can ultimately avoid the income taxes deferred in the exchange.)

Question 2: Who cannot serve as a Qualified Intermediary?

Because the purpose of the Intermediary is to keep the exchanger/taxpayer from having actual or constructive receipt of the sale proceeds, the following persons are specifically restricted from acting as a Qualified Intermediary: an agent or employee of the exchanger/taxpayer (attorney, accountant, investment banker or broker) or any person related to the exchanger/taxpayer or related to any agent of the exchanger/taxpayer. The Treasury Regulations specifically state that a title company will qualify as long as its ownership fits certain qualifications.

Question 3: How many replacement properties may be identified or acquired?

The exchanger/taxpayer may identify more than one potential replacement property and may acquire more than one replacement property, subject to the following Treasury Regulations:

Three-Property-Rule: Exchanger/taxpayer may identify up to three properties without regard to the value of the properties; or

200%-Rule: Exchanger/taxpayer may identify as many properties as s/ he desires, as long as the total fair market value of all identified properties does not exceed 200% of the fair market value of the relinquished property; or

95%-Rule: Exchanger/taxpayer may identify as many properties as s/he desires, as long as the fair market value of properties ultimately acquired is at least 95% of the aggregate fair market value of all those properties identified.

Question 4: What is “like-kind” property?

The phrase “like-kind” property for the purpose of §1031 refers to the nature or character of the property, not the grade or quality of the property. In the real estate context, all that is required is that the real property be used either for investment purpose, or be used in a trade or business. A primary residence is not §1031 property. For personal property to be considered like-kind, it must be depreciable tangible personal property either in the same General Asset Class or same Product Class as defined in the Treasury Regulations. Certain interests in Oil and Gas properties will qualify as real estate under §1031. Stocks and partnership interests do not qualify as §1031 property.

Question 5: Can a seller decide to do a tax-deferred exchange after transferring title to a property?

No. A seller can decide to exchange property at any time prior to the actual transfer or “closing” of the relinquished property. All of the QI documentation and the assignment of the sale contract must occur before the closing and the actual transfer of title. Once the transfer has occurred, and the seller is in receipt of the sale proceeds and/or proper exchange documentation has not been executed, the transfer will be treated as a taxable sale and it is too late to do an exchange.

Question 6: How much must be spent on replacement property to avoid paying income tax?

The general rule is that in order to defer all of the taxable gain of the sale of the relinquished property, the fair market value of the replacement property must equal or exceed the sale price of the relinquished property; all of the cash from the relinquished property must be applied to the replacement property; and the mortgage on the replacement property must be equal to or greater than the mortgage on the relinquished property. There are exceptions to these rules and tax counsel should be consulted in each particular case (see Question 10, below).

Question 7: What happens if I don’t comply with the requirements discussed in Question 6?

Failure to comply completely does not necessarily mean the exchange will be invalidated. However, anything received other than “like-kind” property is considered to be taxable “boot” which will be taxed as capital gains. Therefore, that portion of cash from the relinquished property that is not applied to the replacement property is “boot” and will be subject to capital gains tax. Also, if the exchanger/taxpayer takes back a “seller note and mortgage” from the sale of the relinquished property, the amount of the note will be “boot” and will be subject to capital gains tax as the principal of the note is paid. If the total gain of the transaction is greater than the “boot,” the transaction will still defer capital gains tax on the amount of their difference (see Question 10, below).

Question 8: Can I pay for improvements to the replacement property with proceeds of the relinquished property sale?

Yes, but the improvements must be substantially completed prior to acquisition of the replacement property. Usually, this requires the seller to do the improvements. If this cannot be negotiated in the contract for the replacement property, there are other techniques that may be used, such as a “Reverse Exchange”; but tax counsel should be consulted well in advance for planning such an exchange.

Question 9: Can I arrange to have the replacement property acquired before the closing of the relinquished property?

Yes, under special circumstances this can be done as a “Reverse Exchange.” Reverse Exchanges should never take place without the involvement of experienced tax counsel, and Reverse Exchanges require advanced planning. Tax counsel, such as Riddle & Wimbish, P.C., should be contacted well ahead of any such contemplated transaction so that the Reverse Exchange can be properly structured.

Question 10: How do I determine the amount of “gain” in the exchange and the “tax basis” of the replacement property?

The otherwise complex rules for computing the gain recognized from an exchange and the tax basis of the replacement property can be restated using three simple rules. Note that these rules only apply to an exchange of one kind of property for the same kind of property, and not to exchanges of multiple groups of properties. Also, there are special rules when multiple properties are involved in the exchange, and these general rules are also subject to depreciation recapture.

Rule One: To totally defer taxable gain in an exchange, the exchanger/taxpayer must equal or trade up in both value and equity from the relinquished property to the replacement property.

Failing to do this causes the gain to be partially or wholly taxable in the year of the transaction.

The gain that would be realized if the transaction were taxed in the year of the transaction as an ordinary sale is called “Realized Gain.” However, even though gain is “realized” from the sale, in a properly structured exchange it will not actually be “recognized” (nor will taxes have to be paid) in the year of the transaction because the gain is being deferred by adjusting down the basis of the replacement property. The Realized Gain will thus be deferred until the sale of the replacement property.

Realized Gain usually equals the Fair Market Value minus the Basis and minus the qualifying exchange expenses. What qualifies as an exchange expense is subject to certain rules.

Rule Two: The exchanger/taxpayer is taxed on the greater of the trade down in value or trade down in equity from the relinquished property to the replacement property, but only to the extent of the Realized Gain from the exchange.

The trade down in value and the trade down in equity are both reduced by the qualifying exchange expenses.

First compute the Realized Gain, then compute the trade down in value or equity. If the trade down in value or equity is less than or equal to the Realized Gain, then the amount of the difference will be taxed in the year of the transaction. This taxed amount is also called the “Recognized Gain” because it is recognized and taxable in the year of the transaction.

Rule Three: The exchanger/taxpayer's basis in the replacement property equals the fair market value of the replacement property less the amount of the gain deferred by the exchanger/taxpayer from the sale of the relinquished property.

The amount of gain deferred is the Realized Gain minus the Recognized Gain.

A trade down in value or equity is caused by either: (1) the exchanger/taxpayer receiving "boot" in the form of cash, a note, or other property in the exchange instead of reinvesting that equity in the like-kind replacement property; or (2) the exchanger/taxpayer obtaining a replacement property of lesser value than the relinquished property by reinvesting all of the equity from the relinquished property but incurring less in liabilities for the replacement property than those liabilities given up on the relinquished property.

Example 1. “A” relinquishes (sells) an apartment house with a fair market value of $220,000, a mortgage of $80,000 (and therefore, equity of $140,000), and an adjusted basis of $100,000 and buys a replacement apartment house with a fair market value of $250,000, a mortgage of $150,000 (and, therefore, equity of $100,000), and cash of $30,000 after paying “A's” exchange expenses of $10,000.

Example 1	Relinquished Property	Replacement Property
Fair Market Value	$220,000	$250,000
Mortgage Debt	$80,000	$150,000
Equity	$140,000	$100,000
Basis	$100,000	$170,000
Exchange Expenses	$10,000	---------

Rule One: “A” has traded up in value ($220,000 to $250,000), but not in equity ($140,000 down to $100,000). Therefore, “A” will recognize gain and owe tax on the exchange.

Rule Two: “A” is taxed on the greater of the trade down in value (value was not traded down) or equity ($140,000 down to $100,000, or $40,000 traded down), but only to the extent of realized gain ($220,000 minus $100,000 basis, and minus $10,000 exchange expenses for Realized Gain of $110,000). “A's” trade down in equity of $40,000 is reduced by exchange expenses of $10,000, so “A” is taxed on $30,000 of the Realized Gain (the “Recognized Gain”). Note that “A” is taxed on all of the $30,000 cash received.

Rule Three: “A's” basis in the replacement property equals the purchase price of the replacement property ($250,000) less the gain deferred on the exchange ($110,000 of Realized Gain less $30,000 of Recognized Gain equals $80,000 of deferred gain), for a new basis of $170,000.

To avoid the taxable receipt of cash caused by a trade down in equity, an exchanger/taxpayer may withdraw the equity out of the property by increasing the debt on the relinquished property before the exchange or on the replacement property after the exchange. However, doing so may cause the transaction to be currently taxed if certain rules are not followed. Seek the advice of qualified tax counsel such as Riddle & Wimbish, P.C. before doing this. An exchanger/taxpayer may want to receive some taxable boot in the form of cash if the exchanger/taxpayer has deferred passive losses from the relinquished property.

A Word of Caution:

“A little knowledge can be a dangerous thing.”

Because §1031 Exchanges are becoming so commonplace, many taxpayers and real estate industry professionals fail to appreciate the pitfalls and intricacies of the law. They may not realize that, like high-voltage electricity, there is great power and safety in proper handling, but that disaster can result from mistakes made by persons without qualified tax counsel and advice. Every day, taxpayers and well-meaning closing agents and real estate brokers transact §1031 Exchanges without ever seeking the oversight of expert tax counsel. If done with precision and proper documentation, non-recognition transactions are safe and appropriate. But, if the intricacies of the law are violated, the transaction will not only be subject to the assessment of the unpaid taxes and penalties, but because the taxes are usually assessed years after the transaction takes place, substantial interest may also be assessed by the IRS.

LEGAL NOTICE

This article is for informational purposes only and is not intended to be tax or legal advice. No warranty is being made as to whether these materials are up to date, and these materials may not reflect the most current tax developments and should not be relied upon. You should not take action based on anything you find here, but you should always obtain the guidance and advice of qualified tax counsel after you fully inform them of the facts and circumstances of your particular situation.

** Riddle & Wimbish, P.C. maintains a relationship with Oklahoma Title & Escrow Corporation www.oklahomatitle.com to serve as aQualified Intermediary for clients involved in §1031 Exchanges.