1031 Exchange: Structure
STRUCTURING THE DEFERRED REAL PROPERTY EXCHANGE
Terence Floyd Cuff Loeb and Loeb
Los Angeles, California
© Copyright, Terence Floyd Cuff. All rights reserved.
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Deferring or postponing taxes is an important aspect of investing.
The trouble is that deferral normally ends when you sell your real property. Exchanges offer an inviting alternative that permits you to defer taxes even after you sell. Exchanges permit you to reinvest the money that you otherwise would pay in taxes.
You must exchange real property that you hold for investment or for business use for other real property that you will hold for investment or for business use. Property that you hold principally for resale will not qualify for a nontaxable exchange. (Another set of rules apply to selling your principal residence and reinvesting in a new residence. Those rules are not covered by this article.)
For many years, exchanges were limited to true exchanges. You had to transfer your investment property and receive new investment property in exchange on the same day. This resulted in three corner transactions in which the buyer would acquire your replacement property and exchange it to you for your relinquished property.
The trouble with these "simultaneous exchanges" is that closing both ends of the exchange on the same day is difficult. If they failed to close on the same day, you would have to pay tax on your exchange.
This was the state of the law prior to the Starker case in 1979. This case permitted Mr. Starker to transfer his property at one time to an intermediary and for the intermediary later to acquire and to transfer replacement property to Mr. Starker.
It is now possible for you to transfer your relinquished property to a qualified intermediary (a party who participates in the transaction to facilitate the exchange) who will sell your relinquished property to your buyer for you to identify replacement property within 45 days after you transferred your relinquished property, for your qualified intermediary to acquire the replacement property that you identified, and for your qualified intermediary to transfer the replacement property to you within 180 days after you transferred your relinquished property.
Tax regulations add a number of additional requirements. The tax regulations tell you:
- How to identify replacement property,
- How many replacement properties you can identify,
- How you can structure an exchange with a qualified intermediary,
- How you can "direct deed" your relinquished property to your buyer or have your replacement property "direct deeded" to you,
- How you can secure your qualified intermediary's exchange promise,
- how you can structure a qualified escrow or a qualified trust,
- When you can receive any remaining cash that you do not invest in replacement property,
- How can you receive interest on your exchange balance, and
- How to handle closing and other transaction costs.
Use a tax advisor
The tax rules concerning exchanges must be complied with exactly. If you do things wrong, you may have to pay tax on your entire exchange. You also may be liable for interest and tax penalties.
Consult with a qualified tax advisor before signing any agreements pertaining to an exchange.
Basic exchange terminology
A number of basic terms are important when you try to discuss deferred exchanges:
- "Deferred Exchange" means an exchange qualifying for non-recognition under Section 1031 of the Internal Revenue Code where there is a gap in time between your transfer of relinquished property and your receipt of replacement property.
- "Taxpayer" means the person who is trying to accomplish the deferred exchange.
- "Relinquished Property" means your property that you give up in the exchange that qualifies for like-kind exchange treatment.
- "Replacement Property" means the like-kind property that you receive in the exchange.
- "Intermediary" or "Qualified Intermediary" means a person or entity that in theory acquires your relinquished property, resells it to your ultimate buyer, acquires the replacement property from its owner, and retransfers the replacement property to you in exchange for your relinquished property.
- "Identification Period" means the period during which you must identify replacement property, beginning on the day on which you transfer your relinquished property and ending on midnight of the 45th day after that.
- "Exchange Period" means the period during which you must actually acquire the replacement property, beginning on the day on which you transfer your relinquished property and ending at midnight on the 45th day after that.
- "Exchange Balance" means net value of your replacement property, increased by cash that you deposit with your qualified intermediary; it is the net value of replacement property that your qualified intermediary will acquire and transfer to you.
- "Boot" means cash or other property that does not qualify for non-recognition under Section 1031 of the Internal Revenue Code.
- "Disqualified Person" means one of your relatives (determined under income tax regulations) or your agents (including your attorney and your accountant).
- "Direct Deeding" means a transaction where you deed your relinquished property directly to your buyer (and not to your qualified intermediary) or where your seller of replacement property deeds that property directly to you.
- "Tax Basis" or "Basis" means your tax investment in your property. It usually is equal to your cost minus accumulated depreciation. If you get replacement property in an exchange, your beginning basis is usually equal to your tax basis in your relinquished property increased by any new cash (including increase in debt) that you pay to acquire the Replacement Property. Tax basis often is recovered through annual depreciation; any remaining tax basis will reduce the amount of gain that you pay tax on when you sell the property.
How can you structure an exchange with a qualified intermediary?
A qualified intermediary is someone who facilitates your exchange. Most intermediaries are corporations affiliated with title companies or escrow companies that are in the full-time business of offering qualified intermediary services. As such, the role of a qualified intermediary is a little like (but certainly not identical to) the role of an escrow company or settlement attorney. For a deferred exchange, you must enter a written agreement with a qualified intermediary that provides that:
- you will transfer your relinquished property to your qualified intermediary,
- your qualified intermediary will sell your relinquished property to your buyer,
- your qualified intermediary will acquire the replacement property that you identify,
- the replacement property that you identify must be real property that you will hold for investment or for use in your trade or business and that will qualify for a like-kind exchange under Section 103 1 of the Internal Revenue Code,
- your qualified intermediary will retransfer your replacement property to you as the consideration for your relinquished property, and
- your qualified intermediary cannot transfer any cash or other "boot" to you from the sale of your relinquished property, and you may not receive, pledge, borrow, or otherwise obtain the benefits of cash or other property held by your qualified intermediary (other than your replacement property) until the end of the exchange.
The exchange agreement will credit you with an exchange balance equal to the net sales price of your relinquished property. It will permit you to identify replacement property with a net value equal to your exchange balance. Finally, if you do not acquire enough replacement property to use up your exchange balance, the exchange agreement will require your qualified intermediary to pay you the remaining exchange balance in cash at the end of the exchange.
How can you "direct deed" your relinquished property to your buyer or have your seller "direct deed" your replacement property to you?
An exchange can be accomplished by sequential deeding: first a deed from you to your qualified intermediary and then a deed from your qualified intermediary to your buyer. On the other end of the exchange for acquiring replacement property, your seller of replacement property can deed replacement property to your qualified intermediary, who then will deed the replacement property to you.
Sequential deeding exposes your qualified intermediary to the risks of being in the chain of title to your property. The risks include liability for asbestos and other environmental hazards on your property. Qualified intermediaries are reluctant to accept these risks. Also, sequential deeding results in multiple transfer taxes (imposed on each deed) in many jurisdictions.
Most transfers of property in an exchange involve "direct deeding." This involves you deeding your relinquished property to your buyer rather than to your qualified intermediary; you just skip the deed to the qualified intermediary. In the other direction, it involves the seller of your replacement property deeding your replacement property directly to you rather than to your qualified intermediary; again, you skip the deed to the qualified intermediary. Where you use "direct deeding,"
- for disposing of your relinquished property, your qualified intermediary will enter into an agreement with your buyer for the transfer of the relinquished property to the buyer, or
- for acquiring your replacement property, your qualified intermediary will enter into an agreement with the seller of replacement property for the transfer of that replacement property to you.
Typically, all this requires is for you to assign your rights to sell your relinquished property or to acquire your replacement property to the qualified intermediary. All parties to the agreement must be told in writing of the assignment. Your intermediary never needs to receive title to either the relinquished property or the replacement property.
How do you identify replacement property?
- You must identifyreplacement property during the identification period beginning on the day on which you transfer your relinquished property and ending on midnight of the 45th day after that and must acquire replacement property during the exchange period beginning on the day on which you transfer your relinquished property and ending at midnight on the 180th day after that.
- You cannot get these deadlines extended, even if the 45th day or the 180th day falls on a Saturday, Sunday, or legal holiday; the 45-day identification period and the 180-day exchange period are not extended to the next business day. There is no provision for waiving the 45th day or the 180th day deadline.
- You must identify your replacement property in a signed identification notice that you send by the 45th day. It can be sent by mail, fax, or personal delivery. You may not merely telephone someone and deliver your identification orally.
- You must send your written identification notice to your qualified intermediary or any other person involved in the exchange other than a "disqualified person" (a person related to you or working for you). You should send the identification notice to your qualified intermediary.
- You must sign the identification notice personally. The identification notice is not effective if you do not sign it.
- Your identification notice must describe your replacement property by street address or legal description. If you are buying a condominium, you also must give the unit number.
How many replacement properties can you identify
You may want to identify alternative properties in case your chief target falls through. There are three rules that permit you to identify alternative replacement properties. You need to meet the requirements of any one of these three rules. The best rule lets you identify up to three replacement properties and then to acquire any one or more of the three properties that you identified. The three rules are:
- You may identify any one, two or three replacement properties. Then, you can acquire any of these properties. This is the best identification rule.
- You may identify as many replacement properties as you want, provided that they are worth no more than twice the value of your relinquished property (ignoring any mortgages). You may identify up to $1 million in replacement property if your relinquished property is worth $500,000.
- You may identify as many replacement properties as you want provided that you acquire 95% (by value) of what you identify (ignoring any mortgages). You may identify $1,000,000 in replacement property and acquire only $950,000 in replacement property.
You will have to pay tax on your exchange if you do not meet any of the three identification rules.
How can you secure your qualified intermediary's exchange promise?
Some qualified intermediaries have become bankrupt or their employees have absconded with their customers' exchange money. This makes it important to use a financially sound qualified intermediary and to consider securing or guaranteeing the exchange balance. Properly securing your exchange balance is perhaps the most important aspect of a deferred exchange. Your attorney's advice will be important on how to secure the exchange balance.
The tax regulations approve a number of forms of security:
- A mortgage, deed of trust, or other security interest in property (other than cash or cash-like investments),
- A standby letter of credit,
- A guarantee of a third party, or
- Cash or cash-like investments held in a qualified trust or a qualified escrow.
It usually is impractical for your qualified intermediary to give a mortgage or pledge to real property or other property (other than cash or cash-like investments) as security for its exchange obligation.
Standby letters of credit are both complicated and expensive. They are useful only in large exchanges. A standby letter of credit is a commitment by a bank to pay you money if your intermediary fails to live up to its contract to acquire replacement property. You may "draw" on this letter of credit only if your intermediary breaches its agreement to acquire replacement property. It is unclear whether the tax regulations permit the letter of credit to be "drawn" if you never identify replacement property (because you never found replacement property that you want to buy), if there is a cash balance remaining in your exchange account at the end of the 180-day exchange period (because the replacement property was less expensive than the amount remaining in the exchange account), or if your qualified intermediary becomes bankrupt.
Guarantees are an excellent form of security. The guarantor will be responsible for refunding your exchange balance if your qualified intermediary does not. Make sure that you have a reliable guarantor if you are relying on a guarantee.
Tax regulations also permit you to secure your qualified intermediary's promise to acquire replacement property with cash held in a qualified escrow or a qualified trust. These are discussed in the next section.
How can you structure a qualified escrow or a qualified trust?
The tax regulations permit you to use a qualified trust or qualified escrow to secure your qualified intermediary's exchange promise. You can then get the money in the qualified trust or qualified escrow if your qualified intermediary fails to acquire your replacement property. It is important that your attorney participate in structuring the qualified escrow or qualified trust.
To structure the qualified escrow,
- your escrow holder must not be you or a "disqualified person," and
- the escrow agreement must limit your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash-like investments held in the escrow account until the end of the exchange.
Similarly, you can secure your exchange with cash or cash-like investments held in a qualified trust if
- your trustee is not you or a "disqualified person," and
- the trust agreement limits your rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash- like investments held in the trust until the end of the exchange.
When can you receive any remaining cash that you do not invest in replacement property
You may fail to identify any replacement property within the 45-day identification period. You may have cash remaining at the end of the 180-day exchange period. You may identify replacement property but be unable to acquire it. In any of these cases, you will want your cash as soon as possible. The tax regulations tell you when you can "cash out" of the deferred exchange:
- After the end of the 45-day identification period if you have not identified replacement property before the end of the 45- day identification period,
- After you have received all of the replacement property that you have identified, or
- After a "material and substantial contingency" (that you specified in writing to your intermediary in advance) outside your control occurs.
- Otherwise, you may receive cash after the end the 180-day exchange period.
When you receive this cash, you are taxed on it. You will not have to pay tax on the rest of your exchange.
How can you receive interest on your exchange balance?
Some authorities questioned whether it was permissible to pay interest on the exchange balance between the time of the transfer of relinquished property and the acquisition of replacement property. The tax regulations tell you that this is OK. You may receive interest, provided that your interest depends upon the length of time elapsed between transfer of the relinquished property and receipt of the replacement property. You may not actually receive this interest until the end of the exchange, the time at which you can "cash out" the exchange (see previous section).
How do you handle closing and other transaction costs?
You will frequently have transactional expenses that you want to pay out of the exchange balance held by your qualified intermediary. The tax regulations permit a limited set of transactional expenses to be paid out of the exchange balance prior to the end of the exchange. The tax regulations permit the following expenses to be paid out of the exchange balance:
- Items that you may receive as a consequence of the disposition of property and that are not included in the amount realized from the disposition of property (e.g., prorated rents), and
- Transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).
What should be in your agreement with your buyer of relinquished property and your agreement with your seller of replacement property?
Your buyer of relinquished property and your seller of replacement property do not automatically have to cooperate with you in closing your sale of your relinquished property as an exchange. This makes it important for your agreements with your buyer and your seller to contain an "exchange cooperation clause."
Many contracts say something like this: "At Seller's option and at no loss, cost, liability or expense to Buyer, Buyer agrees to cooperate with Seller in closing this transaction as an like-kind exchange under Section 1031 of the Internal Revenue Code." This language does not tell your buyer what he is supposed to do to cooperate in your exchange. It can lead to confusion and disputes.
Your "exchange cooperation clause" should tell your buyer or seller precisely what he is expected to do. Usually, this involves permitting you to assign your agreement to your qualified intermediary and for your qualified intermediary to become substituted for you as a party to the transaction. The following language is a more thoughtful "exchange cooperation clause" to use with your buyer:
" Buyer and Seller agree that Seller may substitute an intermediary ('Intermediary~) to act in place of Seller as the seller of the property. Intermediary shall be designated in writing by Seller. Upon identification of Intermediary, Intermediary shall be substituted for Seller as the seller of the property. Buyer agrees to accept the property and all other required performance from Intermediary and to render its performance of all of its obligations to Intermediary. Buyer agrees that performance by Intermediary willbe treated as performance by Seller, and Seller agrees that Buyer's performance to Intermediary will be treated as performance to Seller. Seller shall unconditionally guarantee the full and timely performance by Intermediary of each and every one of the representations, warranties, indemnities, obligations and undertakings of Intermediary. As guarantor, Seller shall be treated as a primary obligor with respect to these representations, warranties, indemnities, obligations and undertakings, and, in the event of breach, Buyer may proceed directly against Seller on this guarantee without the need to join Intermediary as a party to any action against Seller. Seller unconditionally waives any defense that it might have as guarantor that it would not have if it had made or undertaken these representations, warranties, indemnities, obligations and undertakings directly. In the event of the breach of any representations, warranties, obligations and undertakings by Seller or Intermediary or in the event of any claim upon any indemnity of Seller or Intermediary (whether the representation, warranty, indemnity, obligation or undertaking is express or implied), Buyer's exclusive recourse shall be against the Seller; Buyer shall have no recourse (any type against the Intermediary arising from this transaction. "
How can you structure a transaction that in part is a sale and in part is an exchange?
Sometimes you want only part of the sale of your relinquished property to be structured as an exchange and the rest as a cash sale, since you want to receive cash immediately. The tax regulations do not tell you how to do this.
One possibility is that you set your sale up as a single transaction, so that all of the cash from the resale of your property goes to your qualified intermediary. Then, it is important that you not receive any of the cash from the resale of your relinquished property until the end of the exchange transaction. All of your gain is allocated to the cash sale portion of the transaction if you use this format. The result is that you usually pay tax on 100% of all of the cash that you receive.
Some taxpayers try to divide their sale into two parts. They set up part of their sale as an exchange with a qualified intermediary. They set up the other part of their sale as a cash sale to their buyer that does not use a qualified intermediary. They will exchange a percentage of their relinquished property in the exchange part and will sell a percentage of their relinquished property in the sale part.
No one is quite sure how the tax laws work where you use this part sale/part exchange approach. It has major tax advantages, however, if it works as intended.
Part of your tax investment in your relinquished property (or tax basis) will be allocated to each part of the deal. Part of your tax basis will be allocated to the exchange part; your remaining tax basis will be allocated to the sale part. The tax basis that is allocated to the exchange part will become tax basis in your replacement property. The tax basis that is allocated to the sale part will reduce your tax on the cash that you get in the sale part.
You should be particularly careful to consult with your tax advisor and make sure that you understand the tax risks if you decide to use a part sale/part exchange approach.
Exchanges are an ideal way to defer taxes on real property dispositions. Deferred exchanges have become the most important type of exchange, since they avoid the inconvenience of closing both legs of the exchange on the same day. The tax law and tax regulations impose a number of requirements for deferred exchanges. Make sure that you have a tax advisor who understands the rules.
You must identify replacement property during the identification period, beginning on the day on which you transfer your relinquished property and ending on midnight of the 45th day after that. You must acquire the replacement property within with exchange period, beginning on the day on which you transfer your relinquished property and ending at midnight on the 180th day after that.
More important than any of the tax rules, make sure that you use a qualified intermediary who will complete his part of the deal and will not lose your money.