Deferring gains under flexible like-kind exchange rules.by Knight, Lee G.
Taxpayers often find themselves wanting to convert assets with built-in gain into other similar property better suited to their needs without generating a taxable sale. Thanks to flexible like-kind exchange rules, many taxpayers can transform a transaction that in substance seems to be a taxable sale of business or investment property into an IRC Sec. 1031 tax-deferred exchange. The exchange will become the transaction of choice if the taxpayer's goal is to reinvest in other business or investment property. Tax-deferred exchanges under IRC Sec.1031 are not a sure thing, despite the somewhat liberal rules.
Even if certain statutory identification and replacement requirements are met, no cash trades hands, and an exchange takes place, realized gain is recognized unless the relinquished property and the property received in the exchange are 1) held for productive use in a trade or business or held for investment, and 2) are of a like kind. IRC Sec. 1031 property consists of both personal and real property held for productive use in a trade or business or for investment. If property held for productive use in a trade or business or for investment is exchanged for like-kind property that will also be held for productive use in a trade or business or for investment, any gain on the transaction will be deferred. The realized gain is recognized at a later date--usually the date of sale.
Like-kind property refers to the nature or character of property and not its grade or quality. Therefore, one kind or class of property may not be exchanged for a different kind or class of property. In the case of real property, the fact that any property involved is improved or unimproved is immaterial as it merely reflects the grade or quality of the property but not its kind or class. Following this line of reasoning, a parcel of unimproved land may be exchanged for a building on another parcel of land. However, if the transfer of property in an exchange is indeed compensation for services provided by the transferee, there is no qualified IRC Sec. 1031 like-kind exchange. In short, there must be a reciprocal transfer where like-kind property is both given up and received in the transaction.
Example. A taxpayer owns two parcels of land and enters into an exchange with a builder. He conveys one parcel to the builder, in exchange for a new building constructed on the other parcel by the builder. At first glance, the exchange appears to qulify as a like-kind exchange. The IRS, however, may use one of two approaches to defeat potential IRC Sec. 1031 treatment. First, the builder who receives the parcel of land is not exchanging property that he owns. The newly constructed building belongs to the taxpayer from the beginning since the builder never possesses the building; the builder just performs construction services on it. Second, in connection with the condemnation rules of IRC Sec. 1033, the IRS has said these properties are not like-kind. It reasons that land alone is not of the same nature as, and is not property of a like-kind to, a building alone. This is true even though the term "real estate" often is used to describe both buildings and land.
A taxpayer's transfer of property in a like-kind exchange can qualify for nonrecognition of gain or loss even if the replacement property does not exist or is being produced when the exchange takes place. However, the following rules must be complied with:
1. The replacement property has to be identified no later than the forty-fifth day after the date on which the taxpayer transfers the property relinquished in the exchange; and
2. The property is received on or before the earlier of a) 180 days after the date on which the taxpayer transfers the property, or b) the due date (including extensions) for the transferor's tax return for the taxable year in which the transfer of the relinquished property occurs.
The IRS has stated, because both of these timing requirements are established by the IRC, it cannot grant any extensions of time for either the identification or exchange period.
For a transaction to be a deferred exchange under the like-kind exchange rules, the taxpayer must transfer property held for productive use in a trade or business or for investment and subsequently receive property to be held for productive use in a trade or business or for investment. The transfer of the property must be under an agreement.
The transaction must be an exchange. This means it must be a transfer of property for property and not a transfer of property for money. A sale of property followed by a purchase of property of a like kind does not qualify for nonrecognition of gain or loss under the like kind rules even though all the other requirements of a deferred exchange have been met.
The receipt of some money in the transaction does not necessarily mean the whole transaction runs afoul of nonrecognition rules. If the exchange qualifies as a like-kind exchange but for the fact property received also includes money or property not of like kind, the gain, if any, to the taxpayer is recognized in an amount not in excess of the sum of the money and the fair market value of the other property. No loss from the exchange is recognized in this situation.
Gain or loss may also be recognized in a deferred like-kind exchange if the taxpayer actually or constructively receives money or other property before the taxpayer actually receives the like-kind replacement property. In addition, if the taxpayer receives money or other property in the full amount of the consideration for the property given up before receiving the like-kind exchange property, the transaction will be treated as a sale and not a deferred exchange. This rule applies even if the taxpayer ultimately receives like-kind replacement property. In applying the rules concerning actual or constructive receipt, specific safe-harbor provisions may help taxpayers concerned about violating these standards.
The IRS currently holds that the deferred-exchange rules do not apply to transactions where the taxpayer receives replacement property prior to the date the taxpayer transfers property. However, the IRS states it will continue to study whether the general like-kind exchange rules apply to these reverse exchanges.
Identification Requirements. Compliance with the identification requirements is not satisfied by a mere meeting of the minds of the parties. As a general rule, replacement property is treated as identified if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to either:
1. the person obligated to transfer the replacement property to the taxpayer; or
2. any other person involved in the exchange (e.g., an escrow agent) except the taxpayer or certain disqualified persons (e.g., the taxpayer's agent).
Replacement property may also be unambiguously described in a written agreement signed by all the parties before the end of the identification period. Real property meets this requirement if it is described by a legal description, street address or distinguishable name.
In identifying replacement property that is being constructed, the taxpayer has to observe all the formalities required to properly identify the replacement property. For example, it is acceptable to identify the replacement real property by providing a legal description of the underlying land and as much detail about the construction of the improvements as is practicable at the time identification is made.
The identification requirements for personal property generally are met if there is a specific description of the particular type of property. For example, a replacement truck would be identified if it is described by specific make, model, and year. As a practical matter, to forestall any possible attack from the IRS, a taxpayer should be as specific as possible when identifying both real and personal property.
The regulations also provide that any replacement property received before the end of the identification period is treated as identified before the end of the identification period. The most prudent course would be to fully document the receipt of the replacement property.
A taxpayer is permitted to identify more than one property as replacement property. This relief provision is intended to cover those situations where a taxpayer is encountering difficulties in identifying the replacement property to be ultimately received. Under this relief provision, the maximum number of replacement properties the taxpayer can identify is--
1. three properties of any fair market value, or
2. any number of properties as long as their aggregate fair market value does not exceed 200% of the aggregate fair market value of all the properties given up.
Safe Harbors. In a deferred exchange, gain or loss may be recognized if the taxpayer actually or constructively receives money or other property before actually receiving like-kind replacement property. The IRS provides four safe harbors that will prevent the application of this rule.
Under the first safe harbor, the obligation of the taxpayer's transferee to transfer the replacement property to the taxpayer is permitted to be secured by--
1. a mortgage, deed of trust, or other security interest in property (other than cash or its equivalent);
2. a standby letter of credit that does not allow the taxpayer to draw upon such letter except upon a default of the transferee's obligation to transfer like-kind property; or
3. a guarantee of a third party.
Under the second safe harbor, the obligation of the taxpayer's transferee to transfer the replacement property is permitted to be secured by cash or a cash equivalent if such cash or equivalent is held in a qualified trust and if the taxpayer's rights to obtain the benefits of money or other property are limited to certain specified circumstances.
The third safe-harbor provision permits deferred exchanges to be facilitated by a qualified intermediary if the taxpayer's rights to obtain money or other property are limited to certain specified circumstances.
The fourth safe-harbor provision permits the taxpayer to receive interest or a growth factor with respect to the deferred exchange. The taxpayer's right to receive such an amount must be limited to specified circumstances.
Caution in Structuring. The regulations governing deferred like-kind exchanges were issued in April 1991 and made generally effective for transfers of property after June 8, 1991. There is scant guidance in the form of IRS announcements, rulings, or court decisions on these transactions, except for proposed regulations concerning the use of escrows to secure a taxpayer's right to receive replacement property. Caution should be exercised when attempting to structure a transaction and its related documents and agreements with the deferred exchange requirements, otherwise a substantial amount of tax may be due if the requirements are not met.
Example in Structuring
An example will illustrate the concerns in structuring a valid tax- deferred exchange. Moore, a calendar-year taxpayer, owns Tennessee property free and clear, a $1 million piece of investment real estate with a $500,000 basis. He wants to sell the property and reinvest in comparable Arizona property. Moore is investigating several pieces of property in Arizona. Since the property adjoins its plant facilities, Nashua Corporation is ready, willing, and able to buy the Tennessee property for $1 million. But, Nashua Corporation and its advisers will not agree to acquire replacement property directly, so a straight three- way exchange will not be possible. Moore retains Jones--a middleman or intermediary--to facilitate an exchange.
Step 1. On May 1, 1993, Moore enters into an agreement to sell the Tennessee property for $1 million to Nashua Corporation on May 17, 1993.
Step 2. Under a written exchange agreement, Moore assigns all of his rights in the agreement with Nashua Corporation to Jones. On May 17, Moore notifies Nashua Corporation of this assignment.
Step 3. On May 17, 1993, Moore executes and delivers a deed conveying the Tennessee property to Nashua Corporation.
Step 4. As part of the exchange agreement, Nashua Corporation pays $100,000 cash to Moore and $900,000 to Jones. The exchange agreement expressly limits Moore's rights to receive or otherwise obtain the benefits of the cash held by Jones.
Step 5. Moore has until midnight of July 1, 1993 (45 days after he transfers the Tennessee property) to identify like-kind replacement property. Moore locates and designates suitable Arizona property on June 1, well within the deadline.
Step 6. Moore must actually receive the Arizona property by midnight of November 13, 1993, which is the earlier of either 1) 180 days after he transfers the Tennessee property, or 2) the due date for his 1993 return (including extensions).
Step 7. On July 5, Moore enters into an agreement to purchase the Arizona property from its owner for $900,000. He assigns his rights in this agreement to Jones, and notifies the seller of the Arizona property of the assignment.
Step 8. On August 1, 1993, Jones pays $900,000 to the seller of the Arizona property, who executes and delivers a deed conveying the property to Moore.
To the uninitiated, what looks like a complicated sale and purchase is in fact a tax-deferred exchange. Moore's recognized gain is limited to the $100,000 of cash he receives as part of the transaction. A similar transaction using a middleman also works for a simultaneous exchange, where the replacement property has already been located.
The deferred exchange in the example qualifies under IRC Sec. 1031 only if all of the following apply: 1) the transferor's rights to cash deposited with the middleman are properly limited, 2) the middleman is a qualified intermediary, and 3) the middleman is treated as having acquired and transferred both the relinquished property and the replacement property.
Acceptable Limitations on Transferor's Rights. The agreement may provide that Nashua Corporation has no rights to the cash deposited with the middleman until the statutory identification or replacement period expires. It also may provide for release of the funds after the identification period upon the occurrence of a material and substantial contingency that: 1) relates to the exchange transaction; and 2) is beyond the control of Moore or a disqualified person as defined below (other than the person obligated to deliver replacement property). Such a contingency may be the condemnation of the target property or a change in zoning. If and when such a contingency occurs, Moore will be in constructive receipt of the funds held by the middleman.
Qualified Intermediary. The middleman must be a qualified intermediary. This is anyone other than Moore (the transferor) or the following three categories of disqualified persons:
1. An agent of Moore's at the time of the transaction. Agents include those who were Moore's employees, attorneys, accountants, investment bankers or brokers, or real estate agents or brokers within the two-year period ending on the date Moore relinquishes his property. Services performed exclusively in connection with an IRC Sec. 1031 exchange are not counted, nor are routine financial, title insurance, escrow or trust services performed by a financial institution, title insurance, or escrow company.
2. Anyone related to Moore under the attribution rules of IRC Sec. 267(b) or IRC Sec. 707(b), using a 10% test. Related persons include close family members and more than 10% owned corporations and partnerships.
3. Anyone who is related to an agent of Moore's under IRC Sec. 267(b) or IRC Sec. 707(b), using a 10% test, e.g., a real estate broker who is a brother of Moore's personal attorney cannot be a qualified intermediary.
Middleman's Role in Acquiring and Transferring Property. If the middleman actually acquires legal title to the properties, he or she is treated as acquiring and transferring the exchange properties--but that formal step is not necessary. Regardless of whether he or she would qualify under general tax principles, that middleman is treated, under the regulations, as having acquired and transferred the property if he or she properly enters into written agreements to acquire and transfer the relinquished and replacement properties. The middleman is treated as having entered into an agreement if he or she is assigned the rights of any party to the agreement, and all other parties to the agreement are notified of the assignment prior to the date the property is actually transferred.
Avoiding Tax Traps In Tax Deferred Exchanges
Even if all of the IRC Sec. 1031 requirements are met, the transferor may be blind-sided from a completely unexpected direction. The transferor could wind up with fully taxed depreciation recapture income without receiving one cent of cash.
When the 1986 Tax Reform Act abolished rapid depreciation methods for realty, and did away with the capital gains exclusion, many people assumed depreciation recapture provisions would have little practical significance for real estate. While this is true to a certain extent, it pays to maintain a healthy respect for the recapture rules. The recapture rules can still affect taxpayers who placed realty in service before 1987, due to provisions left over from days when there was a substantial differential between capital gains and ordinary income.
Example. Investor bought property in 1984 and depreciated it using the 175% declining balance method under former IRC Sec. 168(b)(2). Total depreciation to date is $700,000, and straight-line depreciation would have produced a total of $600,000 in deductions. In 1993 he exchanges the unencumbered property, consisting of a building and land, for unimproved land of equal value. Assume that he realizes again of $1.5 million.
In the example, investor has a valid tax-deferred exchange under IRC Sec. 1031. However, investor will have recapture income even though he does not receive any cash from the deal. Because investor is replacing his depreciable property with nondepreciable land, any potential depreciation recapture income would disappear forever unless it were currently taxed. The following rules apply in this situation.
Recapture Rule with IRC Sec. 1250 Property. IRC Sec. 1250 recapture applies only if accelerated depreciation was used, and the cumulative mount exceeds the cumulative depreciation that would have been available under straight line. Generally, the amount subject to recapture is the lesser of excess depreciation claimed or the amount of gain realized. IRC Sec. 1250 property is any depreciable real property other than IRC Sec. 1245 property.
IRC Sec. 1250 Recapture in an IRC Sec. 1031 Exchange. If a building is IRC Sec. 1250 property and is exchanged in an IRC Sec. 1031 deal, the amount recaptured as ordinary income is limited to the greater of--
1. the amount of gain otherwise recognized as a result of the transaction (if cash or non-like-kind property is received), or
2. the depreciation that would have been recaptured under IRC Sec. 1250 if the deal were a cash sale, less the fair market value of IRC Sec. 1250 property acquired in the exchange.
In the example, the investor is not replacing his property with IRC Sec. 1250 property, he is receiving nondepreciable land in exchange. If the investor's building is an apartment complex (i.e., IRC Sec, 1250 property), he will have to pay a current tax on $100,000 of recapture income ($700,000 depreciation claimed less the $600,000 in deductions that straight line would have produced). The IRC Sec. 1250 (d) recapture rules specifically override the nonrecognition rules of IRC Sec. 1031.
What's Worse. If the investor's building is commercial property, he will wind up with $700,000 of currently taxed ordinary income. Commercial property placed in service after 1980 and before 1987, and depreciated by an accelerated method, is considered IRC Sec. 1245 property. Under IRC Sec. 1245(a), all depreciation claimed is recaptured as ordinary income on a disposition, up to the gain realized in the transaction.
The IRC Sec. 1031 exchange does not protect the investor. There is IRC Sec. 1245(b)(4) recapture even though the property is disposed of in an IRC Sec. 1031 exchange. The amount recaptured cannot exceed the sum of 1) any gain recognized on the transaction, plus 2) the FMV of property acquired that is not IRC Sec. 1245 property, and that is not taken into account in computing recognized gain. In the example, the investor will have fully taxed ordinary income of $700,000 regardless of whether the transaction is tax-deferred under IRC Sec. 1031.
There may be a more fundamental problem for a taxpayer who wants to exchange nonresidential property that 1) was bought after 1980 and before 1987, and 2) was depreciated using accelerated depreciation. If the property is exchanged today for a commercial or residential building and land, the property received will be part land and part IRC Sec. 1250 properties.
A technical reading of the statute calls for a full recapture when IRC Sec. 1245 property is replaced with non-IRC Sec. 1245 property.
Tax-deferred exchanges under IRC Sec. 1031 are not a sure thing, despite the somewhat liberal rules. The taxpayer must know and understand the rules and hidden complexities before undertaking a tax-deferred exchange. "Dot your i's and cross your t's" is the rule to follow when structuring a deferred like-kind exchange because of the substantial amount of tax that will often be due if the requirements are not met.
Lee G. Knight, PhD, is the E.H. Sherman Professor of Accountancy at Troy State University, Troy, Alabama. Ray A. Knight, JD, CPA, is a consultant in Troy, Alabama. They have published numerous articles in professional publications, including The CPA Journal.
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