Avoiding traps in deferred like-kind exchanges.

• Author: Hamill, James R.

Sometimes, a client wants to structure a Sec. 1031 like-kind exchange, but the potential buyer has no suitable property to exchange in return and is unwilling to acquire it. The Sec. 1031 regulations explain how the buyer can transfer the sales proceeds to an escrow that a qualified intermediary can then use to buy property the client desires. This article explains these rules, which must be strictly followed for tax free treatment to ensue.

Sec. 1031 states that no gain or loss is recognized if property held for trade or business or investment use is exchanged solely for property of like kind that will be held for trade or business or investment use. Often, a taxpayer will transfer property; the transferee then purchases the taxpayer's desired replacement property and transfers it to him. Sec. 1031 (a) (3) and the' regulations thereunder explain how to structure as an exchange a sale followed by a purchase of qualified replacement property; however, tax advisers will find that most deferred exchanges do not fit neatly into the existing safe harbors and that efforts to satisfy them can be easily thwarted. This article describes the requirements for a deferred like-kind exchange of real property, the traps typically encountered and the actions the tax adviser should take to strengthen the claim of tax-free treatment.

General Requirements

Sec. 1031(a)(1) requires that the relinquished and replacement properties be (1) held for trade or business or investment use and (2) of like kind. (Sec. 1031 treatment is not available for inventory or other property held for sale, stocks, bonds, notes, other securities or evidences of debt, partnership interests, trust certificates and choses in action.) If nonqualifying property is also received in an exchange, Sec. 1031 (b) provides that gain is recognized to the extent of the fair market value (FMV) of such property. Under Sec. 1031 (d), the basis of the replacement property is that of the relinquished property, plus any is that gain recognized on the exchange, less money received in the exchange and any loss recognized.

Defining "Like Kind"

Regs. Sec. 1. 1031 (a)-1 (b) states that "like-kind" property refers to the nature or character of the property, not to its grade or quality; thus, real property exchanged for real property will qualify as like kind regardless of the state of improvement of the property. Sec. 1031(h) provides that U.S. real property and foreign real property are not like kind. A split interest in real property may be exchanged for a similar split interest in otherwise like-kind property; thus, a future interest in real property may be exchanged under Sec. 1031 for a future interest in real property,(1) but a life estate may not be exchanged for a remainder.(2) The exchange of a remainder interest for a fee simple qualifies under Sec. 1031 because the remainder interest will eventually become a fee simple interested.(3) An exchange of a present undivided interest for a complete interest in like-kind property also qualifies.(4) The exchange of a long-term leasehold (i.e., 30 years or longer) for a fee simple or another long-term leasehold may also qualify.(5) The IRS recently argued in Beeler(6) that land that had been used for sand mining could not be treated entirely as real property because business operating permits, goodwill and property held for sale (i.e., sand) accompanied the transfer of the property. The Tax Court rejected this argument; because the documents conveying the property did not list permits, the taxpayers could not legally convey them, goodwill was not transferred and unnamed sand was not inventory or held primarily for sale.

Meeting the Exchange Requirements

An "exchange" is defined by Regs. Sec. 1. 1002-1(d) as a reciprocal transfer of property, not a transfer of property for money consideration only. Typically, a taxpayer seeks to use Sec. 1031 to avoid gain recognition and so must structure the transaction as an exchange. A gain nonrecognition provision like Sec. 1031 is strictly construed under Regs. Sec. 1. 1002-1(b) and does "not extend either beyond the words or the underlying assumptions and purposes of the exception." The IRS, on rare occasions, may argue substance over form when the taxpayer intentionally seeks to fail the Sec. 1031 requirements. An exchange may, exist when a sale and purchase is made between the taxpayer and one or more parties, and the transactions are mutually dependent.(7) The more common concern is that a taxpayer desiring a tax-free exchange will fail to follow the required formalities.

An exchange may be difficult to arrange when the buyer of the relinquished property does not have suitable replacement property to exchange and is unwilling to acquire it. The buyer's reluctance is generally attributable to the inconvenience of accommodating the seller, but may also be due to other reasons (e.g., concern about potential environmental liability).

A sale of relinquished property and purchase of replacement property does not qualify as an exchange, even if the sales proceeds are held outside of the seller's control in a trust or escrow, unless another person acts as a facilitator and exchanges property with the seller.

Example 1: In January 1998, T sells real property with a $400,000 basis to P for $ 1,000,000. P will not purchase replacement property for T; the sales proceeds are placed in an escrow account that restricts access to the funds to the purchase of replacement property. In February 1998, T finds suitable replacement property valued at $1,000,000 and directs that the escrowed funds be used to purchase the property for him. This transaction is not a Sec. 1031 exchange, because T cannot exchange with an escrow."

The Four-Party Exchange With a Qualified Intermediary

A solution to the problem in Example 1 is to use a qualified intermediary to complete a four-party exchange. The four parties are the seller of the relinquished property (the taxpayer), the buyer of said property, the seller of the replacement property and the qualified intermediary. A qualified intermediary is defined by Regs. Sec. 1.1031(k)-1(g)(4)(ii) as a person who is not the taxpayer or a "disqualified" person (as defined in Regs. Sec. 1.1031(k)-1(k)), and who, pursuant to a written agreement with the taxpayer:

1. Acquires the relinquished property from the taxpayer. 2. Transfers the relinquished property to the buyer. 3. Acquires the replacement property from the seller. 4. Transfers the replacement property to the taxpayer.(9)

   The use of a qualified intermediary converts the taxpayer's sale and purchase of property into a Sec. 1031 exchange. An intermediary is needed when the purchaser of the relinquished property is unwilling to acquire and transfer replacement property to the taxpayer. Thus, a qualified intermediary can be used for a forward deferred exchange (in which the relinquished property is transferred before replacement property is received) or a simultaneous exchange (in which the taxpayer has already selected replacement property and receives it on the transfer of the relinquished property). The intermediary may be reluctant to take tide to the relinquished and replacement properties because of concerns about environmental liability. Regs. Sec. 1.1031(k)-1(g)(4)(v) allows an intermediary to be deemed to have completed the steps outlined above by using written assignments of contract rights.

   Example 2: In January 1998, T agrees to sell real property with a basis of $400,000 to P for $1,000,000. P will not purchase replacement property for T, the sales proceeds are placed in an escrow account that restricts T's access to the funds. (The account meets Regs. Sec. 1. 1031(k)-1(g)(3)(ii) requirements.) T hires Q as an intermediary; they sign an exchange agreement. Before title to the relinquished Property is transferred to P, T assigns, in writing, his rights in the contract with P to Q and notifies P of the assignment. In February 1998, T finds suitable replacement property valued at $1,000,000. T contracts to purchase the replacement property and assigns, in writing, his rights in the contract to Q; he also notifies the seller of the assignment. The escrow officer releases funds for the property to be purchased for T. Title to the relinquished and replacement properties is "direct deeded" to P and T, respectively. The execution of the exchange agreement and the assignments of contract rights create a deemed exchange in which Q is treated as acquiring and transferring both the relinquished and replacement properties. An exchange will...