Deferred like-kind exchanges: an analysis of the proposed regulations under section 1031(a) (3).

• Author: Fellows, James A.

Deferred Like-Kind Exchanges: An Analysis of the Proposed Regulations under Section 1031(a)(3)

Introduction

With the addition of section 1031(a)(3) to the Internal Revenue Code by the Tax Reform Act of 1984, Congress substantially altered the requirements affecting deferred like-kind exchanges.(1*) Prior to this legislation, taxpayers faced little or no time constraints on when they could receive property from the transferee in an otherwise qualifying exchange under section 1031(a). Section 1031(a) placed significant restrictions on this deferral ability by requiring the taxpayer to (i) identify replacement property within 45 days of the transfer of the relinquished property and (ii) receive such property no later than the earlier of 180 days after the transfer or the extended due date of the taxpayer's tax return.

Taxpayers and their counsel soon found that they had to give their own interpretations to section 1031(a)(3), as the brevity of the new statute did not provide the answers to all questions. For example, questions arose concerning the proper way replacement property is to be identified by the taxpayer and the proper manner of receipt of the replacement property.(2) Furthermore, there was a question whether the taxpayer violates the doctrine of constructive receipt where a restricted cash account is used as a means of funding the purchase of the replacement property.

In an effort to address some of these issues, on May 15, 1990, the Internal Revenue Service issued proposed regulations under section 1031(a)(3). This article presents the historical background leading to the enactment of section 1031(a)(3) and provides an analysis of the proposed regulations. The proposed regulations fill some of the informational void facing taxpayers and thus provide a greater degree of certainty for tax planning. Some questions remain unanswered, however, so the article concludes with some suggestions for these remaining omissions.

The Underlying Purpose of Section 1031(a)(3)

Section 1031(a)(3) provides that -

no gain or loss shall be recognized on the exchange of

property held for productive use in a trade or business

or for investment if such property is exchanged

solely for property of like kind which is to be held

either for productive use in a trade or business or for

investment.

If cash or property not of like kind is received, gain is recognized equal to the lesser of the realized gain or the value of this other property, i.e., "boot." The nonrecognition rules of section 1031(a) are mandatory, so a desired escape from their provisions requires careful planning by the taxpayer.

Although section 1031(a) provides for an "exchange" of properties, there is no requirement for a direct exchange between two parties. Moreover, the replacement property received by the taxpayer does not have to come from the party to whom the taxpayer transferred its relinquished property. For example, in W.D. Haden Co. v. Commissioner, 165 F.2d 588 (5th Cir. 1948), the court allowed nonrecognition treatment for the following three-party exchange:(3) Taxpayer A, who owned Property X, wanted to acquire Property Y from Taxpayer B. Taxpayer B did not, however, want to engage in an exchange of properties, but rather wanted to sell Y for cash. To complete the transaction, a third party, Taxpayer C, was found who was willing to consummate the three-party exchange. Taxpayer A transferred Property X to C, who then paid cash to Taxpayer B, who in turn transferred Property Y to A. The nonrecognition rules of section 1031 applied to A, but not to B or C.(4)

Similar arrangements were made where the taxpayer exchanged property for like-kind property to be purchased by the transferee from a third party. Traditionally, the replacement property to be purchased by the transferee was identified by the taxpayer before relinquishing his property.(5) In Starker v. United States, 602 F.2d 1341 (9th Cir. 1979), the Ninth Circuit held, however, that the replacement property need not be identified by the time of the original exchange.(6) In that case, the taxpayer transferred property to the transferee under a "land exchange agreement." The agreement required the transferee to establish for the taxpayer an "exchange balance" of approximately $1.5 million with an annual growth rate of six percent. The transferee was to use this fund to acquire suitable replacement property for the taxpayer, which the latter had to identify within five years. If no replacement property were identified within that time, the taxpayer would receive the balance in the fund. The court held that the original exchange qualified under section 1031(a) because the taxpayer displayed an obvious intent to receive like-kind property rather than cash. The intent at the date of the original exchange was manifested ex post facto by the ultimate receipt of qualifying property. The six-percent growth factor, however, was taxed as interest income when deemed received, in an amount equal to the value of the property eventually received over its value at the date of the original transaction.

In direct response to Starker, Congress enacted section 1031(a)(3). The avowed purpose of the new statute was to bring these deferred exchanges more in line with the general legislative intent of section 1031.(7) Nonrecognition under section 1031 has been justified on the premise that a taxpayer making a like-kind exchange has not, in substance, made an economic exchange, but rather has maintained a continual investment in an economic interest.(8) This "continuity of investment" doctrine logically argues that no realizable event has taken place since the taxpayer merely continues to hold the same investment, though in somewhat different form.(9) To the extent that the taxpayer is able to defer completion of the exchange by designating the property to be received in the future, the transaction begins to resemble not a like-kind exchange, but a sale of the original property followed by a purchase of the replacement property.(10) By enacting section 1031(a)(3), Congress sought to put measurable restrictions on how long taxpayers could defer the receipt of the replacement property, thereby limiting their ability to defer income taxes on what may be essentially a sale. In placing these time limits on the acquisition of qualified replacement property, Congress was placing section 1031 on a consistent course with other nonrecognition provisions of the Code, e.g., sections 1033(a) and 1034(a), that generally allow a two-year period in which taxpayers may find suitable replacement property for principal residences or property condemned or destroyed.

The statute and proposed regulations provide that any property received by the taxpayer in a deferred exchange is treated as property which is not like-kind if:

(a) such property is not identified as property to be received

in the exchange on or before the day which is

45 days after the date on which the taxpayer transfers

the relinquished property in the exchange, or

(b) such property is received after the earlier of:

(1) the day which is 180 days after the date on

which the taxpayer transfers the relinquished property in the exchange, or (2) the due date, including extensions, of the

taxpayer's tax return for the taxable year in which the transfer of the relinquished property occurs. Two distinct periods exist in which the taxpayer must meet certain requirements. The first, the 45-day period, is termed the "identification period."(11) The second statutory period, the 180-day period, is termed the "exchange period."(12) These two periods are the main obstacles that the taxpayer must clear to qualify under section 1031. The proposed regulations, however, present several smaller hurdles within the penumbra of these two rules; failure to satisfy these other mandates will obviate all but the most careful planning.

The Identification Period

Because the identification and exchange periods are statutorily set, the taxpayer can expect little relief from the courts if an inadvertent error occurs. One trap for the unwary is that both periods are determined without regard to section 7503 (relating to the time for performance of acts where the last day for performance falls on a Saturday, Sunday, or legal holiday).(13) The following example depicts the interaction of the two statutory periods:

Example 1: Corporation A, a calendar-year taxpayer,

enters into an agreement with Corporation B to exchange

property. Corporation A transfers Whiteacre

to Corporation B on November 17, 1990. On or before

January 1, 1991, Corporation A must identify qualifying

replacement property. The fact that January 1

is New Year's Day is irrelevant. Corporation A must

receive the property by March 15, 1991, the due date

of its tax return. If Corporation A is allowed an

automatic six-month extension of time to file its return,

however, the replacement property must be received

by May 16, 1991 (180 days after the transfer of

Whiteacre).

What if, as part of the exchange, the taxpayer transfers more than one property on different dates? What are the relevant time-periods for the two exchange periods in this instance? Prop. Reg. [Section] 1.1031(a)-(3)(b)(2)(iii) provides that the identification and exchange periods are determined by reference to the earliest date on which any of the properties was transferred.

Example 2: Corporation A and Corporation B agree

to a deferred exchange of like-kind property. Corporation

A is to transfer Whiteacre and Greenacre to

Corporation B, which will purchase and transfer

suitable replacement property when it is identified

by Corporation A. Corporation A transfers title to

Whiteacre on November 17, 1990, and transfers title

to Greenacre on December 15, 1990. The expiration

dates of the two statutory periods are the same as

stated in Example One (i.e., March 15, 1991, the due

date of Corporation A's tax return, or if the return is

extended, May 16, 1991), since the...