Delayed Like-kind Exchanges
| Jurisdiction | United States,Federal |
| Citation | Vol. 20 No. 5 Pg. 929 |
| Pages | 929 |
| Publication year | 1991 |
1991, May, Pg. 929. Delayed Like-Kind Exchanges
Federal income tax law treats tax-free exchanges of like-kind property similar to contributions of property to corporations and partnerships. That is, under the continuity of investment theory, a taxpayer is allowed to defer gain recognition, even though there is a change in the form of investment and a realization of gain.(fn1) Avoiding gain recognition is particularly important at present, given the incremental difference between ordinary income and capital gain rates, as well as the continual attempts by the Bush administration to reinstate a partial inclusion for capital gains.
This article discusses the issues involved in, and the ramifications of, a delayed like-kind exchange.
A qualifying like-kind exchange ("§ 1031 exchange") may be either simultaneous or delayed and may involve two or more properties or parties.(fn2) Because it is unlikely that a party desiring to acquire a taxpayer's property will own property that the taxpayer is willing to accept in trade, the ability to use multiple parties and a delayed exchange greatly enhances the use of this tax deferral technique. Until the Tax Reform Act of 1984,(fn3) there was no statutorily imposed time limit within which a like-kind exchange was required to take place. Further, case law suggested there were no bounds to the period during which an exchange could remain open.(fn4) To alleviate the administrative problems inherent in coordinating the installment sales provisions with like-kind exchanges,(fn5) Congress sought to bring certainty to the tax treatment of exchange transactions by the time the taxpayer filed his or her next income tax return.(fn6)
Internal Revenue Code ("Code") § 1031 (a)(3) sets forth clearly delineated time periods within which a delayed exchange can occur and still qualify for nonrecognition treatment. However, it fails to address three critical elements pertinent to delayed exchanges:
1) the manner in which the replacement property is to be identified;
2) the security arrangements that can be used to hold the exchange proceeds or grant the relinquishing party a lien or other preferred right pending acquisition of the replacement property; and
3) the effect of an interest or growth factor on the exchange proceeds during the time between the transfer of the relinquished property and the acquisition of its replacement.
The Proposed Regulations published by the Internal Revenue Service ("IRS") on May 16, 1990,(fn7) deal with these issues adroitly. As a result, taxpayers now have substantial guidance in structuring delayed like-kind exchanges.(fn8)
Code § 1031(a) provides that no gain or loss is recognized when property held for productive use in a trade or business or for investment is exchanged solely for property which is of a like-kind. This is the case whether the exchange is simultaneous or delayed. Code § 1031(a)(3) limits the time a delayed exchange can be completed by providing that unless the replacement property received by a taxpayer is both timely identified and received, it will not be considered like-kind.
Replacement property is timely identified when the property is identified by the taxpayer who is to receive it within forty-five days of the transfer of the relinquished property ("identification period"). The replacement property is timely received if timely identified property is received by the earlier of (1) 180 days from the date of transfer of the relinquished property or (2) the due date (including extensions) for the taxpayer's income tax return for the taxable year within which the transfer occurred ("exchange period").(fn9)
Property is of a like-kind if it is similar in nature or character, notwith-
standing differences in grade or quality.(fn10) The IRS is liberal in applying the like-kind test to real property. It considers real property, whether improved or unimproved, to be like-kind. Similarly, a real estate leasehold having a term of at least thirty years is like-kind to a fee interest.(fn11)
Code § 1031 also permits like-kind exchanges of personal property. However, both traditionally and in the newly issued Regulations, the IRS takes a much narrower view of the like-kind requirement concerning personal property. It requires personal property, in effect, to be so similar or related that it would satisfy the functional similarity requirements of Code § 1033.(fn12)
In virtually every like-kind exchange, whether simultaneous or delayed, one of the parties will be required to recognize some gain. This is because it is unlikely that the exchanged properties, even if identified or constructed later,(fn13) will be equal in value. Accordingly, some non-qualifying consideration ("boot") generally is included as a part of the transaction. Code § 1031(b) establishes netting provisions for boot. When a taxpayer receives money or property (other than like-kind property), or when the taxpayer is relieved of more debt associated with the property transferred than is taken subject to or assumed on the replacement property, the exchange has involved some boot and likely will require recognition of gain. Losses never are recognized in a § 1031 exchange, regardless of the presence of boot in the transaction.(fn14)
In computing boot, liabilities on the exchanged properties are netted. In netting liabilities in a delayed exchange, the Proposed Regulations provide that the determination of net mortgage boot occurs at the end of the exchange. They also provide that mortgage debt relief on the disposition of relinquished property can be offset by replacement property mortgages assumed or taken subject to.(fn15) No netting of liabilities is permitted if a taxpayer attempts to cash out in anticipation of an exchange or to adjust differing equities between the relinquished and replacement properties by incurring debt on the relinquished property "in anticipation of the exchange."(fn16) This prohibition is similar to the anti-cashout rule of installment sales. However, it represents a substantial departure from prior law.(fn17)
Certain boot (cash and nonqualifying property), received as a part of an exchange, will cause gain to be recognized even if the taxpayer receiving this boot also assumes or takes replacement property subject to a larger debt than on the property relinquished.(fn18) In contrast, when cash is paid or non-like-kind property is given up, boot which would otherwise result from debt relief is reduced. If a taxpayer is required to recognize gain in a like-kind exchange, the recapture rules apply to characterize the first gain recognized.(fn19)
The taxpayer's basis in the property acquired in a § 1031 exchange is determined in part by the relinquished property's basis. That is, the taxpayer's basis in the property relinquished initially is carried over to the replacement property, but is then adjusted for boot. The taxpayer's basis is increased by any gain the taxpayer is required to recognize, including any net mortgages assumed or taken subject to and any cash paid by the taxpayer. The taxpayer's basis is reduced by both the net amount of debt relief the taxpayer enjoys and any cash or other nonqualifying property the taxpayer receives.(fn20)
The manner in which replacement property is to be identified is explained in the Proposed Regulations at § 1.1031 (a)-3(c). Any property that is received before the end of the identification period will, in all events, be treated as having been properly identified. Under the Proposed Regulations, a replacement property is identified by a writing signed by the taxpayer and delivered, mailed, telecopied or otherwise sent before the end of the identification period to a person involved in the exchange. The involved person must be someone other than a related party. An oral identification never will suffice. However, taxpayers may instruct their exchange partners verbally about which of any alternative replacement properties identified they desire.(fn21)
The replacement property also can be identified as a part of the exchange agreement. However, this may not be the best course of action, except in exchanges between related parties.(fn22) Under the Proposed Regulations, the taxpayer is permitted to revoke unilaterally an identification at any time prior to the expiration of the identification period, as...
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