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Study Notes on Exchanges
XII. Section 1031 Exchange (Delayed Exchange)
In multi-party exchanges involving properties located in different states.
Because often time IRS failed to recognize the distinction between a delayed close and a delayed exchange.
The delayed exchange is considered a nonsimultaneous tax-deferred exchange.
These formats are popular, flexible, and have a history of acceptance by the IRS.
“Missouri Waltz” and “Reverse Missouri Waltz.
The two are normally based upon the sophistication of the buyer or the seller to serve in the central position as accommodator.
When the taxpayer is faced with the certainty of an otherwise taxable disposition, a rapidly approaching closing date, and no replacement property to exchange into, a delayed exchange becomes a necessity.
The practitioner should carefully advise its clients of the inherent risk associated with the use of the delayed exchange.
Not only should the client be prepared to expend time and money in the initial structuring of the delayed exchange, but reserve funds and energies should the transaction be audited.
Because the taxpayer (Starker) had no control over the cash used by Crown Zellerbach and that the transaction constituted a §1031 exchange.
Because he exchanged his property for a promise to convey like-kind property in the future.
Note: The District Court openly admitted that it had reconsidered its position in the original Bruce Starker decision and concluded that it was mistaken in its holding based upon its earlier reading of Alderson.Taxpayer was held to have made neither a reciprocal nor simultaneous exchange, but rather an exchange of all his rights in his timberland in return for a mere promise; and, at the time of such exchange, the taxpayer did not know whether such promise would be paid in like-kind property or in cash.
It was held that the position taken by the federal District Court in the original Bruce Starker case was correct.
Identification “before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange.”
The TRA ‘86 struck out “before the day” and inserted “on or before the day” to clarify that a full 45-day identification period is now allowed.
It is the earlier of (1) The day which is 180 days following the transfer of the property to be relinquished in the exchange, or (2) The due date for the exchangor’s tax return for the year of the transfer including extensions.
A Private Letter Ruling 7938087 (issued in July 1979) issued by National Office which a taxpayer’s proposed delayed exchange involving the use of a trust as the accommodating party.
So long as the intermediary was not held to be the taxpayer’s agent.
Strawman, accommodator, or middleman method.
If the buyer of the exchangor’s property uses a note to acquire such property, problems regarding the acceptance of that note by the seller of the replacement property the exchangor desires will probably arise.
The buyer’s note could be sold to a third party at a discount and the cash proceeds added to the impounded account or placed in the hands of the intermediary.
Release the buyer’s note to the exchangor concurrently with the execution and delivery of the exchangor’s note to the seller of the replacement property. Arguably, this results in the receipt and giving of equivalent amounts of cash boot.
The exchangor could execute a note in favor of the seller of the replacement property but the buyer contractually agrees to make all the payments. This obligation could be secured by the exchangor’s property.
Escrow, custodian, or trust account.
The issue of constructive receipt of cash boot by the exchangor arose.
The exchangor took a deed of trust on the property conveyed or on other real or personal properties to secure the buyer’s or intermediary’s performance.
Third-Party Guarantee or Letter of Credit.
Impound.
Interest.
A payment in the year of sale under §453.
Neither of these items would cause the purchaser’s indebtedness to be considered as received in the year of sale.
In one escrow the delayed exchange was accomplished for the buyer promised to provide the exchangor with suitable exchange property within the 45/180 day time period and the exchangor transferred title to his or her property to the buyer.
The second escrow “impounded” the cash or cash and notes.
Note: The two escrows were linked together by a variety of contingencies and it may create constructive receipt issues.
The impounding of the funds themselves, and,
The receipt by the taxpayer of some use, earnings, or other economic benefits on the money during the period of the impound.
Unless the monies are deposited without substantial restriction and made available to the taxpayer’s immediate control.
It will not thwart the intent of Section 1031 exchange.
Deferred exchange and exchange of partnership interests.
Parking transaction.
The IRS holds that §7503 is limited to procedural acts required to be performed in connection with the determination, collection, or refund of taxes and does not apply to §1031.
The periods are statutory, and no requests for extension will be granted.
(1) Received by the exchangor before the end of the identification period, or
(2) Identified in a written agreement for the exchange of properties, or
(3) Designated as replacement property: a. In a written document
b. Signed by the exchangor
c. Hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period
d. To a person involved in the exchange other than the exchangor or a disqualified person (Reg. § 1.1031(a)-3(c)).
Unambiguously described in the document or agreement by a legal description or street address.
It will be unambiguously identified if the underlying land is properly described and as much detail as is practicable at the time the identification is made is provided for construction of the improvements.
It will consider receipt of services and not like-kind property (boots).
The incidental property will be unambiguously described and separately identified to the large property.
(1) Made prior to the end of the identification period,
(2) In a written document,
(3) Signed by exchangor,
(4) “Hand delivered, mailed, telecopied, or otherwise sent” before the end of the identification period,
(5) To the person to whom the identification was originally sent.
The regulations imply a 75% of the property received must be substantially the same as the property identified.
Three properties of any fair market value (Reg. §1.1031(a)-1(c)(4)(i)(A)) or;
Any number of properties as long as the aggregate F.M.V. of all properties identified as of the end of the identification period does not exceed 200% of the aggregate fair market value of all relinquished properties as of the date of transfer by the exchangor (Reg. §1.1031(a)-1(c)(4)(i)(B)), or
Any number of properties of any value provided that 95% of F.M.V. of all properties identified are received by the end of the exchange period (Reg. §1.1031(a)-1(c)(4)(ii)(B)).
Because taxpayers typically are unwilling to rely on a transferee’s unsecured promise to transfer the like-kind replacement property.
The transaction represents a sale and not a deferred exchange, even though the exchangor may ultimately receive like-kind replacement property.
Actual receipt occurs when the taxpayer actually receives money or the economic benefit of it.
Constructive receipt occurs when cash is credited to the taxpayer or otherwise made available so that the taxpayer may draw upon it.
Taxpayer control over cash does not constitute constructive receipt if such control is subject to substantial limitations or restrictions (§83). However, when such limitations or restrictions lapse or expire constructive receipt will occur.
Actual or constructive receipt of cash by an agent of the taxpayer is attributed to the taxpayer.
It will result in a determination that the taxpayer is not, either directly or through an intermediary that may be an agent, in actual or constructive receipt of money or other property.
A mortgage, deed of trust, or other security interest in the property (other than cash or a cash equivalent),
A standby letter of credit that satisfies all of the requirements of Reg. §15A.453- 1(b)(3)(iii) and which doesn’t allow the taxpayer to draw on the letter of credit except on default of the transferee’s obligation to transfer like-kind replacement property, or,
A guarantee of a third party (Reg. §1.1031(a)-3(g)(2)).
If held in a qualified escrow account or a qualified trust.
Note: In a “qualified” escrow account or trust, the escrow holder or trustee must not be the exchangor or a disqualified person, and the exchangor’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in escrow or trust must be limited (Reg. § 1.1031(a)-3(g)(3)).
The person is an agent of the taxpayer at the time of the transaction, or, the person and the taxpayer (or the taxpayer’s agent) bear a relationship defined under §267(b) or§707(b) substituting 10% ownership for 50% ownership (Reg.§1.1031(a)-3(k)).
A person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer at the time of the transaction.
Notes: The mere performance of services with respect to exchanges intended to qualify under §1031 will not make one an agent of the exchangor. Additionally, the performance of routine financial, title insurance, escrow, or trust service by a financial institution, title insurance company, or escrow company is not taken into account.
When it is provided the exchangor’s rights to receive money or other property are limited.
The potential agency attack on the exchange is eliminated.
A “qualified intermediary” is a person who is not the exchangor or a disqualified person (see definition above) and who, for a fee, acts to facilitate a delayed exchange by agreeing with the exchangor to an exchange of properties in which the intermediary:
(i) Acquires the relinquished property from the exchangor (either on its own behalf or as the agent of any party to the transaction),
(ii) Transfers the relinquished property,
(iii) Acquires the replacement property (either on its own behalf or as the agent of any party to the transaction), and
(iv) Transfers the replacement property to the exchangor (Reg. §1.1031(a)-3(g)(4)).
Acquire the relinquished property from the taxpayer, acquire the replacement property, and transfer the replacement property to the taxpayer.
a) Acquires and transfers legal title to that property;
(b) Enters into an agreement (either on its own behalf or as the agent of any party to the transaction) with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person;
(c) Enters into an agreement (either on its own behalf or as the agent of any party to the transaction) with the owner of the replacement property and, pursuant to that agreement, the replacement property is transferred to the taxpayer.
If the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property.
When he or she provided his or her rights to receive interest and other economic benefits are limited.
It is treated as interest regardless of whether it is paid in cash or in property (Reg. §1.1031(a)-3(g)(5)).
Note: The interest or growth factor is interest income for tax purposes, includible in income according to the exchangor’s method of accounting, whether paid in cash or property (like-kind or otherwise.)
That nothing in any provision of law will be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax. It also directs the Secretary to prescribe regulations relating to the taxation of these accounts or funds whether as a grantor trust or otherwise.
(1) The end of the identification period (if the taxpayer does not identify replacement property before the identification period ends), or
(2) The exchangor receives all the identified replacement property to which he or she is entitled, or
(3) If the exchangor identifies replacement property, the later of: a. The end of the identification period, and b. The occurrence of a material and substantial written contingency beyond the exchangor’s (or a related person’s) control, or
(4) The end of the exchange period (Reg. §1.1031(a)-3(g)(6)).
The final regulations clarified that the limitations on a taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the funds apply only to the money or other property in a qualified escrow account or qualified trust, or held by the qualified intermediary.
Under the final regulations, a taxpayer may receive money or other property directly from another party to the transaction, but not from a qualified escrow account, a qualified trust, or a qualified intermediary, without affecting the application of a safe harbor.
It does not result in actual or constructive receipt of the remaining funds, and furthermore, disregarded in determining whether the applicable agreement properly limits the taxpayer’s rights to receive, borrow, pledge, or otherwise obtain the benefits of money or other property.
(a) Relate to the disposition of the relinquished property or to the acquisition of the replacement property, and
(b) Are listed as the responsibility of a buyer or seller in the typical closing statement under local standards.
Note: Examples of these transactional items include commissions, prorated taxes, recording or transfer taxes, and title company fees.
These are not included in the amount realized from the disposition of property are disregarded.