Are you interested in obtaining §1031 like-kind exchange treatment upon disposition of a property but have not located suitable replacement property? You may be able to qualify for deferred exchange treatment under Reg. §1.1031(k)-1 but the Regulations will keep you on a very short leash.
Section 1031 provides for nonrecognition of gain or loss on an exchange of property held for use in a trade or business or for investment for like-kind property which will also be held for use in a trade or business or for investment. Cash, net debt relief to the taxpayer and receipt of non-like-kind replacement property (collectively “boot”) is taxable to the extent the net boot received is not in excess of the gain realized on the exchange.
A. Deferred Like-Kind Exchange Requirements.
1. Safe Harbors.
In order to qualify for deferred like-kind exchange treatment the interest in the sale contract must generally be assigned to a qualified intermediary (“Q.I.”), qualified escrow holder or qualified trust. The most common form of deferred exchange is with a Q.I. who will acquire the exchange funds at the closing of the relinquished property and arrange for transfer of that property to the taxpayer within 180 days after the sale of the relinquished property. The taxpayer must enter into a written agreement with the Q.I.
2. Identification and Receipt Requirements.
One of the most limiting aspects of the deferred exchange rules are the identification and receipt requirements.
- The replacement property must be identified within a 45 day period (the “identification period”) that begins on the date of transfer of the relinquished property and ends at midnight on the 45th day thereafter.
- The replacement property must be acquired within a 180 day period (the “exchange period”) that also begins on the date of transfer of the replacement property and ends at midnight on the 180th day thereafter, or, if earlier, the due date of the return for the taxable year of transfer of the relinquished property, including extensions.
The 45 day identification period can make it extremely challenging to find potential replacement property for identification within the identification period. It pays to commence doing your homework as to possible replacement property candidates well in advance of closing the sale transaction of the relinquished property.
3. Identification Documentation.
Replacement property must be identified pursuant to a written document which is signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to:
- The person obligated to transfer the replacement property to the taxpayer (such as the qualified intermediary); or
- Any other person involved in the exchange who is not a “disqualified person.
4. Description of Replacement Property.
The Regulations do not specify any particular form for the identification. However, there are requirements as to the sufficiency of the description, as follows:
- The replacement property is properly identified only if it is unambiguously identified in the written document.
- Real property is generally unambiguously described if it is described by a legal description, street address or distinguishable name (e.g. “the Mayfair Building”).
- Personal property is unambiguously identified by a specific description of the property, such as the make, model and year of a truck.
5. Limits on Number of Properties Identified.
The Regulations impose limits on the number of potential replacement properties that can be identified, as follows:
- Three properties can be identified regardless of the fair market values of the properties (the “3-property rule”); or
- Any number of properties may be identified so long as the aggregate fair market value of such identified properties, at the end of the identification period, does not exceed 200% of the aggregate fair market value of the relinquished property as of the date the relinquished property was transferred by the taxpayer (the “200-percent rule”).
- If at the end of the identification period the taxpayer has identified more replacement properties than is permitted, the taxpayer will be treated as if no replacement property was identified, resulting in a taxable sale (with certain exceptions for: (i) identified property acquired by the taxpayer within the identification period, or (ii) property acquired by the end of the exchange period with an aggregate fair market value of at least 95% of the fair market value of all identified replacement properties).
6. Must Acquire Substantially the Same Property.
The taxpayer will be treated as having acquired like-kind replacement property within the exchange period only if:
- The taxpayer receives the replacement property by the end of the exchange period; and
- The replacement property received is substantially the same property as identified.
The Regulations do not define what is substantially the same property. However, Reg. §1.1031(k)-1(d)(2), Example 4, indicates that receipt of property which is 75% of the fair market value of the identified property, as of the date of receipt, is considered to be receipt of substantially the same property.
7. Revocation of Identification.
A replacement property identification may be revoked only within the identification period and only pursuant to a written document signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to the person to whom the identification was delivered. So why does this rule matter? No portion of the exchange funds held by the Q.I., or other qualified recipient, may be distributed to the taxpayer until the end of the 180 day exchange period unless:
- The taxpayer has acquired within the 45 day identification period all of the property that was identified; or
- To the extent other property was also identified, such identification is revoked within the 45-day identification period; or
- The occurrence of certain material and substantial contingencies. See Reg. §1.1031(k)-1(g)(6)(iii)(B).
Thus, if there remains any identified property after the end of the identification period which has not been acquired or revoked, the taxpayer does not have access to the remaining funds until the end of the 180-day exchange period. It is important to keep in mind that while the exchange funds may generate some investment return in the interim, the rate of return in today’s economic environment is relatively small.
8. Constructive Receipt.
One final significant restriction on a qualified deferred exchange is that any constructive receipt of the exchange funds by the taxpayer will result in taxable boot. The agreement with the Q.I. must provide that the taxpayer has no rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period (with certain exceptions noted above). For instance, arranging refinancing of debt on replacement property prior to acquisition of the property may run afoul of the constructive receipt requirements.
The deferred exchange regulations were promulgated by the IRS in 1991 pursuant to §1031(a)(3), which was added by Congress in an apparent attempt to rein in the so-called Starker Trust transactions which were in vogue in the 1980s. However, the Regulations shackle taxpayers with relatively short identification and exchange periods as well as ample opportunities to blow like-kind exchange treatment through failure to follow the exacting requirements of the Regulations. Obtaining a favorable result under the deferred exchange regulations will often require that the taxpayer commence the search for potential replacement properties well in advance of the closing on the relinquished properties.