The Starker Case   top of page

Professor T. J. Starker owned timber property, which had a very low basis when Crown Zellerbach approached him with an offer to purchase.

The Starkers wanted to exchange but a simultaneous exchange was not possible. In 1967 they entered into an agreement in which they would deed the property to Crown Zellerbach in return for a promise. The promise was to convey "like-kind" property to the Starkers at an unspecified time in the future. Crown Zellerbach had the right to pay the Starkers cash after five years but it was not required to do so. Between July 1967 and May 1969, fifteen properties were identified, acquired, and deeded or assigned to the Starkers as directed by them. The Starkers considered these transfers to be in fulfillment of an exchange. The IRS disagreed. Over twelve years a series of trials and appeals followed. In the appeal by T. J. Starker, it was held that part of the Replacement Property did qualify as an IRC § 1031 exchange even though it was a non-simultaneous exchange.

REGULATION OF NON-SIMULTANEOUS EXCHANGES   top of page

The Starker cases created a crisis for the Internal Revenue Service. Every investor was prepared to use this new form of exchange and to push it as far as it would go.

1984 CHANGES   top of page

In 1984, Congress was persuaded to act. It created the time lines familiar to all who exchange: the 45-day identification period and the 180-day exchange period. It also defined away some forms of "like-kind" property, including partnership interests.

1989 AMENDMENTS (AND PROPOSED CHANGES NOT PASSED)   top of page

In 1989, Congress further restricted 1031 exchanges. At that time it set out the "related party" rules. It also defined foreign real property as not being "like-kind" to United States real property. [Some changes were proposed which did not become law although many think they did after they passed the U.S. House of Representatives. They include: A one-year holding period before property can be exchanged again and a narrowing of the definition of "like-kind" to "similar or related in service or use." These limitations did not become law in 1989 and were reconsidered during the budget process in 1997, but were again not passed.]

PROPOSED AND FINAL REGULATIONS   top of page

In 1990 proposed regulations were published. The IRS let it be known that transactions following the guidelines with those regulations would not be challenged. These included the Three Property and 200% identification rules, the description rules, and the "safe harbors."

In 1991 these regulations were adopted with certain improvements. The regulations are approved for use in simultaneous as well as delayed exchanges. The regulations specifically excluded their application to reverse exchanges.

1997 TAX CODE AMENDMENTS   top of page

The 1997 Tax Code Amendments have resulted in a reduction in the maximum rate to 20% (previously 28%), which with North Carolina's applicable 7% rate results in a total effective marginal rate of 27%.

EXCHANGE VOCABULARY   top of page

The treatment of Like-Kind Exchanges was solidified in 1991 with the IRC Regulations new vocabulary created.

IRC § 1031 Like-Kind Exchanges

3 different basic types of exchanges (simultaneous, reverse and deferred). The April 1991 regulations specifically permitted deferred exchanges and generally, deferred exchanges account for 95% of the like-kind exchange transactions. Basic definition of an exchange: Exchangor replaces one investment property or property held for trade or business with another.

Like-Kind Property

As a general rule with respect to real estate (as opposed to personal property), most real property will qualify for a like-kind exchange - except for personal-use property - as long as it is held for investment or productive use in business or trade. We have defined what "like-kind" is - but there is a difference in "similar kind." Similar kind would be a rental home for a rental home. Under IRC § 1031, with respect to real property, we do not have to be that restrictive.

Delineating between Sec. 1031 and Sec. 1034 (or Sec. 121) Property. Principal Residences do not qualify for IRC § 1031 treatment. A "principal residence" is frequently adjacent to other investment property also owned by the taxpayer. Typical examples include (a) Rural Setting: a "homestead" property where a house sits on one acre of residential property and is surrounded by contiguous acreage (which may have been used as a farm) and (b) Urban setting: a residence sits on a subdivided parcel with adjacent, subdivided parcels (or where further subdivision is possible). These examples need be dealt with on a case-by-case basis.

Relinquished Property

The property "exchanged out of" or sold. It is often called the Exchange Property.

Replacement Property

The property or properties "exchanged into" or purchased.

Simultaneous Exchange

Where the Relinquished Property and Replacement Property closings occur on the same date. (It is important that separate settlement statements be prepared - this assists the taxpayer in focusing on issues such as differences in Exchange Value and differences in amounts of indebtedness encumbering the respective tracts.)

Deferred Exchange

A deferred exchange is one in which the taxpayer transfers the Relinquished Property and subsequently receives the Replacement Property at a later date (sometimes referred to a Starker Exchange or a Delayed Exchange).

Identification Period

The identification period is the amount of time that any and all potential Replacement Property(ies) must be identified, which is forty-five (45) days. The identification period begins on the date the taxpayer transfers title to the Relinquished Property and ends at midnight on the 45^th day thereafter.

Exchange Period

The exchange period is the maximum time period allowed to effectuate an IRC § 1031 exchange. The time period begins on the date the taxpayer transfers title to the Relinquished Property (the same day as the identification period) and ends 180 days thereafter or on the date the exchangor files taxes (including extensions), whichever occurs first. There are other situations in which an exchange period can end prior to the 180th day, but they are dependent upon the circumstances within the exchanges themselves (see Safe Harbors).

No grace period is allowed for Saturdays, Sundays, or holidays at the end of either period of time. IRC § 7803 does not apply to IRC § 1031, and this is specifically stated in the regulations.

If more than one Relinquished Property is exchanged and the properties close on different dates, the identification and exchange periods begin on the closing date of the first property.

The result of these time limitations is to require that the transaction be completed in time to document the exchange along with the tax return for the year in which the property is sold. If this cannot be done after all allowable extensions have been filed, the transfer must be reported as a sale, not an exchange.

Boot

There are two types of "boot" to be considered in an exchange, according to offset rules.

Mortgage Boot consists of liabilities assumed in an exchange. If a taxpayer's liabilities are assumed or paid off at the Relinquished Property closing, the taxpayer is considered to have received mortgage boot. These liabilities must be replaced in full on the Replacement Property(ies) by either a new mortgage, or "new money" - cash from a source outside the exchange not related to the properties within the transaction. If they are not replaced, they will be considered "boot" and will be taxable.

Cash Boot consists of cash and non-qualifying property, such as a promissory note. The taxpayer must use all the proceeds received from the sale of the Relinquished Property in order not to incur "boot." If all the proceeds are not used on Replacement Property(ies) by the end of the exchange period, any leftover proceeds will considered "boot" and will be taxable.

Form of Identification

To whom the Exchangor must identify: The identification must be made to the intermediary or some other party who is not a disqualified person and is a party to the transaction.

How described: Properties must be unambiguously identified by street address usually including city, state and ZIP code, legal description such as tax parcel number, or distinguishable name.

Revocation of Identification

The identification can be revoked on the properties identified if the 45-day time frame has not run out. The taxpayer may reissue the identification, or "re-ID" as many times as they wish within the 45-day time frame.

Identifying Multiple Properties

How many properties may be identified: These rules apply to the identification process:

Three Property Rule: Up to three properties of any value may be identified. Until the forty-fifth day, there may be withdrawals and substitutions on the list; or

200% Rule: Any number of properties may be identified if the aggregate total fair market values of all identified properties does not exceed 200% of the value of the Relinquished Property; or

95% Rule: Even if other the rules for identification are not followed, the acquisition of 95% of the aggregate of the fair market value of all properties identified will preserve the exchange. This would apply to a situation in which four or more properties totaling more than 200% of the Relinquished Property were identified.

Property acquired during the identification period will be considered to have been identified, but should still be listed on the identification document for precautionary reasons.

How notice is given: By a written document signed by the exchangor which is then transmitted to the intermediary by hand delivery, mail, telecopy, or "otherwise sent." Many intermediaries now require certified mail with a return receipt or another method, which proves the identification was within the identification period.

EXCHANGE DOCUMENTATION  top of page

Following is a list of the documents that are necessary to accomplish an exchange. Some of these documents are required by the regulations and some are not.

Exchange Agreement. This is the necessary agreement between the exchangor and the intermediary. It will set out the desire to exchange, the form of the real estate transactions, the financial arrangements (including the lack of control over the funds while being held by the intermediary) and the other aspects of the agreement.

Assignment and Notification to Seller. This document assigns to the intermediary the Buyer's position under the agreement between the exchangor and the seller of the Replacement Property. It is often signed by the seller and will contain assignment, warranty, environmental, and release language.

Assignment and Notification to Buyer. This document assigns the intermediary into the agreement between the exchangor and the buyer of the Relinquished Property. It is often signed by the buyer and will contain assignment, warranty, and release language.

Identification Document. Allows the taxpayer to identify potential replacement properties.

First Amendment. This is an illustration of the reference to the Property description and date of execution of purchase contract. The exchangor may enter into the purchase contracts on both sides of the transaction in their name. The Qualified Intermediary should make the appropriate assignments of these contracts and amend the exchange agreement to accept such property into the exchange.

Termination Agreement. As required by the regulations, there are restrictions on a taxpayer's "early termination" ability in an exchange.

Interim and Final Exchange Statements. These documents track the cash flow included in the exchange. These statements are in addition to the closing statements furnished by the respective closing attorneys, and are not a requirement for the exchange.

Form 8824. The qualified intermediary will sometimes provide a draft copy of this tax form as a courtesy to the client's CPA. The CPA finds this very helpful in identifying the properties involved and their identification dates and the exchange date(s).

Settlement Statements. The Qualified Intermediary should sign the Settlement Statements, as applicable, on behalf of the Seller/Buyer as their Qualified Intermediary.

REASONS TO EXCHANGE  top of page

1. Better Service to Prospective Purchasers.

Many property owners would sell if it were not for the tax liabilities. They look at the potential benefit if they sell, and then see the taxes they will pay if they sell, and thus decide not to. With IRC § 1031 it is possible to sell, roll the investment into a Replacement Property and defer the capital gains.

Many commercial and residential developments are based on the acquisition of a number of parcels of land. The Wal-Marts in Oregon and Washington were often built on land which was acquired because the sellers were compensated through IRC § 1031 exchanges. It is quite common for a prospective purchaser to need land for smaller projects.

The realtor benefits in two ways: (1) using IRC § 1031, a salesperson can obtain listings on property which might not otherwise be for sale and (2) using IRC § 1031, the salesperson gains an opportunity to make an extra commission on the Replacement Property side.

2. Ease in Closing Transactions.

The ease with which a transaction closes actually depends upon the form of exchange. A simultaneous three party exchange may be more difficult to close than a routine sale transaction. This can be dealt with when the real estate salesperson has experience in this area. Other advisors, such as the attorney and CPA, are also able to guide the transaction to a quick closing. Nonetheless, it is impossible to deny that simultaneous exchanges are sometimes a problem.

On the other hand, an exchange in which there is an intermediary will close as quickly as a routine sale transaction. It may close faster in some cases, as intermediaries are more familiar with escrow procedures and real estate transactions so that there will be no lengthy delays while the escrow paperwork is analyzed, considered, and finally signed.

It is easier to close an exchange transaction using an intermediary for other reasons as well. For instance, if the intermediary is experienced, there will be clear instructions to the closing agent; the intermediary may even have worked with the closing agent before. In addition, the closing agent will be familiar with exchange practices in many cases but if they are not, the experienced intermediary company will be able to guide them through the processes much more quickly than they can be educated on three party simultaneous exchanges.

In any case, once the transaction is ready to go, the exchangor is much less likely to change his mind because of last minute tax issues. This reason will be taken care of by the exchange.

3. Flexibility in Structuring Transactions.

Any real estate transaction can be complex. As the real estate professional approaches a transaction, it is worthwhile to have all options available. The knowledgeable professional works with the traditional sale and purchase tactics and ought to have other opportunities for the seller of Relinquished Properties.

By using an exchange when necessary, the real estate salesperson can improve the odds of getting an offer accepted. The seller who is afraid of taxes can move to Replacement Properties and avoid the taxes. The seller who wants to leverage can acquire a more significant Replacement Property with untaxed proceeds, which ought to assist the salesperson in getting a realistic price accepted.

By utilizing an exchange, the seller avoids certain tax liabilities. When the seller already knows what he wants as his replacement, the exchange expert can structure his transaction around a three party simultaneous exchange, a four party non-simultaneous exchange, or a reverse exchange, depending on what makes the most sense.

4. Clients Exchange to Acquire Multiple Replacement Properties.

Utilizing an IRC § 1031 tax-deferred exchange allows the more ambitious purchase of properties than would otherwise be possible, due to tax consequences. Some taxpayers are not interested in becoming involved in complex management projects with their properties, but instead, prefer to invest in what they are familiar with: single family homes, duplexes, beach condominiums, small commercial properties, etc. Using the excess dollars available from the tax deferred exchange, the client can leverage into more properties of like-kind.

5. Clients Exchange to Pool Resources into a Major Investment.

Some investors would prefer to have one major investment property instead of several smaller properties. Of course, it is always possible to sell the Relinquished Properties outright and reinvest the cash less the taxes owed on the proceeds received. On the other hand, by effectuating an IRC § 1031 exchange, your client can acquire a more significant replacement. Such multiple property transactions can be complex, which is why it makes sense to involve a qualified intermediary in the transaction at the earliest stages.

6. Clients Exchange Businesses to Shelter All Proceeds.

A business owner may have a business with numerous assets which have been depreciated to a basis lower than their value. This means that if the business is sold, there will be gain recognized on the sale, even though the assets seem to have little value. If the owner desires to invest in a new business, it may be possible to exchange the proceeds of this sale into another business.

If it is the same form of business, there might be little difference between the cash realized and the amount, which can be sheltered. If the business is of a different kind, it may still be possible to shelter some proceeds through an exchange.

The determination of the tax deferral comes through the definition of like-kind property in the exchange of personal property. While all real property is like-kind to all other real property, there are specific requirements for personal property, according to their "sic" code. For example, any real type of property may be exchanged for any other type of real property (rental home for raw land, mountain home for a beach condominium, etc.), but with personal property, it must be within the same "sic" code and property type, i.e., an airplane for an airplane, a business client mailing list for a business client mailing list - even livestock must be of the same breed and gender. All personal property exchanges must be analyzed on a case by case basis.

7. Some Clients Want to Diversify Their Investments.

Real estate must always be exchanged for other real estate, but it can come in different forms. For instance, the investor may desire to have investment properties in several different parts of the country. The use of an exchange also allows diversification of location. Perhaps the investor wants to focus on a different form of property, such as changing his business from rental management to commercial property management, and needs to change his portfolio. Perhaps he desires to move from the farm and to exchange the farmland for other productive real estate, such as a mobile home park.

A real estate professional can spot trends and work with clients to benefit from the liquidity which IRC § 1031 provides. Of course, these transactions will lead to increased commissions for the salesperson.

8. Some Clients Move Investments as the Market Changes.

Although real estate cannot be moved, the dollars the real estate represents can be. Perhaps your client is one of those who spots trends, or thinks he can, and wants to take advantage of a growth market. Or, perhaps your client wants to get himself out of a particular market because it is depressed.

Your client can sell and pay taxes anytime he wants. However, he would rather preserve as many dollars as possible. Through an IRC § 1031 exchange he can move his investments around the country to take advantage of investment opportunities.

9. Some Clients Retire and Move.

Real estate is not "portable" but the investments can be moved. If your client has retired and wants his investments to be in his retirement haven, it is possible to preserve as many dollars as possible through a tax-deferred exchange. The sale of rentals or commercial property in one part of the country can be exchanged into other rentals or commercial property elsewhere.

10. Some Clients Exchange Passive Investments to Active.

Through inheritance, or through an earlier investment program, the investor may acquire substantial property which is not income-generating. This property has the advantage of not requiring much supervision. It has the disadvantage of taking dollars with little in the way of deduction, and of not being depreciable.

After a talk with the tax advisor, many investors would like to change their investments to more active investments which yield deductions for depreciation, while providing income to pay some of the costs. Any time that they have the inclination, an investor can sell their land and acquire a replacement rental with the proceeds. All they need to do is pay taxes. On the other hand, if they exchange the property pursuant to an IRC § 1031 exchange, all dollars except the costs of closing and other expenses can be available for reinvestment without the previously anticipated tax hit.

11. Some Clients Exchange Active Investments to Passive.

Not every client enjoys being a landlord. The properties which regularly generate income also generate work, stress, and continuing obligations, which are not attractive to every investor. Your client may have begun investing with rentals, possible a first house, which was retained when a bigger one was purchased. Over a period of time, your client may have acquired investments, which they no longer feel capable, or desirous of managing.

The client who wants to get out of an active investment can do so anytime by selling. However, this may result in a substantial tax bill. In many cases, your client wants to continue investing in real property but prefers to retain his dollars rather than sending them to Uncle Sam. This is the time for your client to exchange a property which is a burden for a property which requires little effort. Whether it is farmland with a long-term lease, timberland with growing trees, or raw land in an area where property is appreciating, an exchange may be the answer.

There might be tax problems for some clients who attempt this. For instance: if the improved property has been depreciated on an accelerated basis, there could be a recapture of the excess depreciation. Or, if there have been tax credits under government housing programs, there could be a requirement that the government be compensated for unmet program expectations. These matters would need to be discussed with the client's tax advisor.

Still, this is a way for an investor to relieve some responsibility without leaving the real estate market.

ACCOUNTING ISSUES  top of page

Form Over Substance

Traps Created by Inexperienced Closers

One reason to review the transaction with an exchange accommodator at an early stage of the exchange is to avoid the unintentional disqualification of the exchange.

Example Trap: The exchangor is listed as the principal on the closing statement when selling or purchasing exchange property.

Solution: amend the documentation so that the intermediary is shown as the principal on the closing statement and provide an assignment of rights and notification. If the exchangor is shown as a buyer or seller on a closing statement, amend the statement to show the accommodator relationship. This does not apply to purchase and sale contracts, loan application documents, etc.

Other Traps/Audit Targets in A Deferred Exchange

Items to Clarify When Contemplating an Exchange:

• How long did the taxpayer hold the Relinquished Property prior to the exchange?
• How did the taxpayer use the Relinquished Property? i.e., has the taxpayer or his family used the Relinquished Property or the Replacement Property as a principal residence or vacation (second) home?
• To whom is the taxpayer selling the Relinquished Property?
• How will the taxpayer use the Replacement Property?
• From whom is the taxpayer purchasing the Replacement Property?
• How long will the taxpayer hold the Replacement Property?
• Is the taxpayer planning on making any improvements to the Replacement Property? When?

EXCHANGE ISSUES  top of page

"Qualified Intermediary." Most deferred exchanges are effectuated through an intermediary. Only an exchange effectuated through a qualified intermediary will meet the requirements of the regulations' safe harbors.

You will need to determine:

• Was the intermediary within the safe harbor with relation to the "disqualified party" rules? The regulations do not quite say that the intermediary must be specifically or exclusively a qualified intermediary, but any deferred exchange using an intermediary that does not qualify or is a disqualified person due to agency is a major audit target, and will nullify the exchange.
• Was the intermediary an accountant, attorney, or otherwise an agent of the taxpayer? If so, did the agency relationship extend beyond IRC § 1031 exchanges? An accountant, attorney, or other agent of the taxpayer normally will not qualify as a "qualified intermediary" unless the agency relationship was limited to IRC § 1031 exchanges, or the party has not done any prior work for the taxpayer within the past two years.

The Deferred Exchange Agreement. Many deferred exchange agreements are defective.

You will need to verify:

1. Is there a written exchange agreement? If not, the exchange violates the intermediary safe harbor.
2. Did the exchange agreement permit the taxpayer to designate foreign real property or "dealer" real property as Replacement Property? The exchange agreement must not permit the taxpayer to designate any Replacement Property other than real property that qualifies as valid Replacement Property under IRC§ 1031. An agreement that simply says that the taxpayer may designate "any real property as replacement property" does not qualify under the regulations. This is one key to auditing many exchanges.
3. Did the exchange agreement prevent the taxpayer from receiving "boot" from the intermediary prior to the occurrence of the end of the defined exchange period described in paragraph (g)(6) of the deferred exchange regulations?
4. Did the exchange agreement prevent the taxpayer from receiving interest prior to the occurrence of the end of the defined exchange period described in paragraph (g)(6) of the deferred exchange regulations?
5. Did the exchange agreement expressly require the intermediary to receive Relinquished Property from the taxpayer, to re-transfer the Relinquished Property to a third party buyer, to acquire the Replacement Property from a third party seller, and to re-transfer the Replacement Property to the taxpayer?

Do not accept the deferred exchange agreement merely because it is a form document provided by a commercial intermediary. Just as with any other legal and binding document, make certain you read through it, asking any questions you may have, and even have someone else look it over for you, if you are not comfortable with it.

Designation of Replacement Property. The 45-day designation rule is frequently violated by taxpayers.

Carefully inspect each property designation. Be vigilant for fraudulent designations. Some taxpayers will mail empty envelopes to their intermediaries to establish the date of a designation by postmark. Some taxpayers will sign a number of designations and put them in a file drawer, later using whichever one corresponds to the Replacement Property that they ultimately buy.

The way to ensure that the identification is made in accordance with the regulations is fairly simple. In an exchange, the "Replacement Property is identified only if it is unambiguously described in the written document or agreement." (IRC Reg. § 1031. (k)-1(c))The designation notice must be signed and dated by the taxpayer. Many taxpayers go wrong when they are entities. A partnership or corporation should sign the designation by using an entity signature block. The trustee of a trust should sign if the taxpayer is a trust. The grantor rather than the trustee should sign the designation if the trust is a grantor trust. This confusion can be avoided by the intermediary providing the blank identification to the taxpayer with the signature block already inserted so there is no question on the signature necessary.

Many designations miss an important point in the description of Replacement Property. It is common for each tenant-in-common to designate the entire property as Replacement Property when he plans to acquire only a percentage interest in the Replacement Property. These transactions may fail to qualify under the regulations, since the tenant will be acquiring only a portion of the property that he designated as Replacement Property. The way to combat this problem is to ensure that the taxpayer inserts the percentage of undivided interest they plan to acquire in front of the property as well as in front of the total purchase price for the property.

    Regulations furnish three examples of "unambiguous descriptions":
         (1) A legal description,
         (2) Street address, or
         (3) Distinguishable name (e.g., the "Mayfair Apartment Building").

A full "metes and bounds" legal description (such as that contained in a deed) is the most comprehensive description. In the event of audit, the taxpayer's identification form will be a critical document. Accordingly, special attention should be given to avoid clerical mistakes in the identification. The simplest error in, say, the address numbering may invalidate the identification.

Avoid so-called "Distinguishable Names" Taxpayers should be discouraged from the use of "distinguishable names." Does the "A-1 Office Building" unambiguously describe Replacement Property (without also a street address)? For example, there are over thirteen "Mayfair Apartments" in Los Angeles alone. If using a name of a property, it is best to provide a street address with the city, state, and zip code.

Vacant Land With No Street Address The identification of "24 acres off Clarkson Rd., Cabarrus County, North Carolina, with a fair market value of $100,000" will fail for lack of specificity. A simple reference to acreage with an imprecise location reference is likely to be deemed inadequate. Again usage of the tax map number and the nearest street, then city, state and zip code if the property is raw land or has not been assigned a postal address at that time is the way to ensure no possibility of ambiguity. taxpayers often prepare their identification forms in a last minute, hurried manner. After the 45th day an identification document cannot be amended; and a careful review of the identification description is highly beneficial.

The most comprehensive method for identification of Replacement Property is for the taxpayer to complete, sign and date the identification form according to whichever identifying rule they are abiding prior to the deadline date, and to then fax the form to the intermediary to be checked over for inconsistencies or recommendations. Once it has been deemed appropriate, the taxpayer should then mail originals of the identification document to the intermediary by the 45th day, and even use certified mail, with a return receipt requested, to prove it was received.

Strict Time Limits In 1984, time period limitations were first codified in the like-kind exchange statutes. IRC §1031 was amended to provide for the 180-day limit on the exchange period and the 45-day limit on the identification period. (Sec. 1.1031(a)(3)).

Initial Uncertainty. Initially, there was uncertainty over the impact of the 45th day falling on a weekend day or a holiday. This was based principally on IRC §7803, which provides that where the performance of an act mandated by the Code occurs on a Saturday, Sunday or holiday; the act may be performed on the immediately following business day. Nevertheless, the regulations under IRC § 1031 (promulgated in 1991) clarified the IRS's position that IRC § 7803 does not apply to exchanges, and that no extension is given to the next business day where the 45th day (or 180th day) occurs on a Saturday, Sunday, or a holiday. This rule is referred to in the preamble to the final regulations (although not restated in the body of the final regulations). It appears that the Internal Revenue Service will continue to apply this rule. (Preamble to T.D. 8346, 26 CFR Part 1).

Earthquakes, Storms. Taxpayers and their professional advisors often wait until the last moment to designate Replacement Property. It was reported that for some taxpayers in San Francisco, the 45th day for identifying their exchange's "Replacement Property" closely followed that city's last major earthquake. The earthquake substantially disrupted all aspects of communication in and around San Francisco. Some taxpayers forgot (or were unable) to identify the replacement properties by the 45th day. The Internal Revenue Service determined that it was outside its power to give any extension of the 45th day even in these cases of hardship.

Acquisition of Replacement Property. The taxpayer must acquire Replacement Property within the 180-day replacement period. No extensions can be granted for either the 45-day identification period or the 180-day replacement period. Taxpayers may make counting errors; these are fatal to the exchange. Start counting with the day immediately following the day on which the Relinquished Property was transferred by the taxpayer. Or, better yet, ask the qualified intermediary to notify the taxpayer in writing of the time limit deadlines for the taxpayer's exchange period. Do not forget to check the time line issues yourself!

A taxpayer may have undertaken several exchanges at approximately the same time. This is termed as a multi-asset exchange, i.e., many Relinquished Properties for, perhaps, one Replacement. The identification period and the replacement period both begin on the transfer of the first Relinquished Property. The regulations provide no guidance concerning when multi-asset transactions should be treated as part of the same transaction.

What has to happen within the 180-day replacement period? Many agents look to the recording date on the deed transferring the Replacement Property. This is a mistake. The critical day is that day on which the burdens and benefits of the Replacement Property move from its prior owner to the taxpayer. This usually is not necessarily the date on which the deed is recorded. Seek an explanation of the inconsistencies where the date of recording and the date of transfer differ materially.

Boot. Funds or proceeds received from the exchange transaction are commonly called "boot." In an exchange of personal property or an exchange of real property, which includes a significant amount of personal property, the description can be more complex because of the necessity to define categories of personal property and to then balance equities. Transferring cash from an exchange to the taxpayer, or not replacing all of the mortgage liability on the replacement side that was paid off on the relinquished sale are examples of boot. Consider other examples:

Basis is essentially the initial sales price of the property, plus improvements, and less depreciation. If the property has been exchanged, the basis will be calculated from the initial basis, plus the additional value above the exchange value of the Relinquished Property, plus improvements, less depreciation. If the property has been refinanced, the proceeds might be very small even though there is a low basis and a large tax liability.

Depreciation is loss of value to property brought about by age, deterioration, or obsolescence. In the case of real property, tax reform has created several systems of depreciation, which have complicated the investor. For those investing between 1981 and 1986, the ACRS system depreciated property rapidly causing substantial tax problems to the seller with a slowly amortizing loan or a refinanced property. In certain cases, the Depreciation Recapture Laws, which were amended in 1997, would cause the taxpayer to be faced with taxes even though an IRC § 1031 Exchange was completed.

Exchange Value is determined by taking the sale price of the Relinquished Property and subtracting from it the allocable costs of the sale. A $100,000 property with $8,000 in allocable closing costs and $2,000 in non-allocable closing costs would have an exchange value of $92,000. Prorates of taxes, rent, utilities, and surveys or pest inspections are not allocable closing costs. If the proceeds of the exchange are used to pay them, those proceeds will be considered to be boot.

What if a loan is required to acquire the Replacement Property?

The exchangor will need to qualify for the loan. If the loan is from a bank, the trust deed will be signed by the exchangor and recorded after the exchange is completed. If the loan is a purchase money loan from the seller of the Replacement Property, it is common to have the intermediary sign, or at least participate in the purchase money note documentation.

CPA ISSUES  top of page

Questions the Certified Public Accountant Will Have

• Did the exchangor receive cash?
• Was there any relief of debt?
• What closing costs were allocable? Non-allocable?
• Was there property received in the exchange which was not "like-kind" to that exchanged?
  

TRANSACTIONAL ISSUES  top of page

"Cashing-Out" of the Exchange. The regulations permit a taxpayer to receive interest, cash, or boot only after the occurrence of a specified "cash-out" event. The four permitted "cash-out" events are:

1. After the acquisition of the only identified Replacement Property;
2. After the end of the identification period, if the taxpayer has not identified Replacement Property before the end of the 45-day identification period;
3. After the taxpayer has received all of the identified Replacement Property to which the taxpayer is entitled; and
4. After the end of the 180-day exchange period.
   

The regulations permit the taxpayer to cash-out of the exchange after the occurrence of a material and substantial contingency that relates to the deferred exchange, as provided for in writing, and is beyond the control of taxpayer and of any disqualified person. A great deal of care must be taken to determine that such a contingency is outside of the taxpayer's control. A contingency that depends on the taste or judgment of the taxpayer (e.g., whether the taxpayer has been able to negotiate a purchase agreement for Replacement Property at an acceptable price) will not qualify under the regulations. However, a contingency where all other Replacement Property identified has since been purchased by other parties and is no longer available for sale whatsoever would most likely be acceptable.

Closing and Transaction Costs. The funds held in a qualified escrow account or qualified trust or otherwise held by a "qualified intermediary" typically are used to pay

• Company fees.
• Earnest money deposits or valuable consideration with regard to purchasing Replacement Property for the taxpayer.
• Funds will usually also earn interest in the escrow account in which they are held.
  

PARTNERSHIP PROBLEMS  top of page

A partnership may exchange real or personal property it owns in an IRC § 1031 exchange, but an interest in the partnership may not be exchanged. One should be VERY careful when "changing up" ownership interests, debt equity ratios and/or making improvements to a property in anticipation of an exchange. It is clear that any one of these situations may result in the IRS's disqualification of such a transaction. The taxpayer should meet a "Qualified use period" (i.e. A period of time one should hold a property to be considered to have held the property for investment for IRC § 1031 purposes) prior to allowing the exchange to take place.

What Entity Holds Title to the Relinquished Property?

If the last deed or contract naming the parties as the owners of the property vests the parties in "Smith, Jones, and Brown Partnership," the answer is obvious. This question is asked to cover the less obvious circumstance. A review of deed records for the county in which the property is located may disclose that two or three individuals own the property with no indication of the relationship or it may even show them to be tenants-in-common. This is a good sign but the final decision is based on two, "off the record" issues: (1) What relationship do the parties think they have to each other? (2) Is there a partnership return filed and a Form K-1 given to each of the parties? If a tax return shows that there is a partnership, there are several strategies to be considered later in this section. If there is no tax return but there is strong evidence that the parties considered themselves to be in a partnership, there should be careful consideration given to adopting some strategies to avoid the possibility of an invalid exchange. Strong evidence includes records, which show the relationship to be that of partners, decision making as partners and not as individuals, an agreement in the form of a partnership, and/or a profile presented to third parties, which expresses, or implies, that the parties are partners. It is possible to be co-tenants without being partners. The regulations honor a decision not to be treated as a partnership but the election must be documented.

What Entity Will Own the Replacement Property?

Careful attention must be paid to the outward appearance. If the exchangor is an individual planning to acquire a co-tenancy with other individuals or entities, some care must be taken not to appear as a partnership.

Buying a fractional interest in a large project is can possibly create future problems. Assuming that the project claims not to be a partnership, there may still be evidence which could be the basis of a future disqualification of the property.

Consider these danger signs:

• Is there an agreement which could be construed to be a partnership agreement even if it says that it is not?
• Is there an individual organizing the venture who looks and acts like the general partner in a limited partnership even though he says he is not?
  

Restructure of the Partnership: After the Exchange The same partnership owns the Relinquished Property. It has been sold and there is not time, or perhaps assets are lacking, for an orderly liquidation of the partners desiring to take their profit from the sale of the asset. The partnership goes through the delayed exchange and owns the Replacement Property. At this time the partners desiring to leave the partnership are paid off.

The tempting approach to the problem of cashing out the partners is to use excess funds from the exchange accounts. This will have to be carefully evaluated. It might be possible to shift the tax liability for the funds retained to the partners leaving. It might defeat the exchange. This is almost certain to be a major problem if done midway through the exchange.

The source of the cash may have to be from borrowing. This might be a taxable event if there is close timing between the acquisition of the Replacement Property and the borrowing of the money, particularly if this was part of the structure of the transaction. If the cash came from parties to the transaction it seems likely it will be challenged.

If there is more than one property in the partnership, there could be a distribution of a property to the partner exiting. It is possible this could even be done if the Relinquished Property is one property and the replacement is two properties. There are still some traps. Could the IRS claim that the Replacement Property distributed shortly after acquisition was held for distribution as part of a dissolution of the partnership rather than for use in the partnership's trade or business or for investment? Holding periods do not give all the answers, but are definitely excellent recommendations to abide by, especially in questionable situations. Frankly, the longer the time a property is held, the better the chance.

Dissolution and Distribution: Long Before the Exchange Time is the solution to most problems caused by a partnership dissolution in which some partners exchange into new property. No matter how long the time has been, it would be wise to review the checklist in the next section with a tax attorney and CPA to be sure that the partnership will definitely appear to be dissolved if there is an audit.

Dissolution and Distribution: Immediately before Exchange This is a higher risk approach to exchanging but it is often the only practical one. If all, or almost all assets must be sold to generate cash to pay the partners wanting out, then it is necessary to structure the form of dissolution and the ownership of the assets after the dissolution to minimize exposure to the claim which might otherwise be made by the Internal Revenue Service that there is not qualification for non-recognition of the gain. If dealing with a number of smaller properties, it should be possible to divide them among partners. Usually there is one major asset and that will be more difficult to structure.

The best way to structure a large asset distribution (assuming the partnership does not have the cash and cannot easily raise it) is to divide the property into undivided interests. There will be logistical difficulties in the operation of the property and accounting for the income but these are preferable to the tax consequences being avoided.

At the time of the dissolution of the partnership, the assets must be distributed to all partners by recorded deed and the distribution documented in the books of the partnership. This includes filing of a final partnership tax return through the date of the partnership dissolution. The former partners must then actively enter into the management of the property. The income and expenses must be reported on their individual income tax returns.

The former partners should keep the management and income separate from each other. Use of powers of attorney, management agreements, common bank accounts, and the like could lead to a "guilty until proven innocent" assumption in a future audit.

The exchange of the asset should proceed with all former partners acting on their own behalf. There should be no negotiations for the sale, much less signing of the agreement, by one of the former partners on behalf of the dissolved partnership. If the property had been listed for sale with a real estate broker in the partnership name, the listing needs to be withdrawn and a new listing on behalf of the individuals signed.

The closing of the property should show the separation of the former partners. At the least, those with dissimilar interests need to separate their interests in escrow. This may mean separate deeds and separate escrow instructions for those selling versus those exchanging.

Costs of sale will need to be divided among the former partners on their closing statements. Liability for the real estate commission needs to be shared among them.

Example:

"ABC LLC", a limited liability company, owns The Elm Apartments, which is a swank apartment building. Peter is a member who acts as managing member and is also a limited partner. Sam and Roger are members. A sale to "The Purchaser Group" is pending. The members have approved the sale.

Peter decides to exchange his interest in The Elm Apartments by taking advantage of the opportunities afforded by IRC § 1031. Acting as the Managing Member, he conveys to himself, as an individual, a 46% interest in the company's property. This is not allowed by the operating agreement. He does not record the deed nor does he advise the other members, Sam and Roger, nor does he advise The Purchaser Group.

The initial sale fails but The Purchaser Group come back to the table. Two months after his initial deed to himself, he negotiates a new sale on behalf of the limited liability company. His interest is not disclosed in the new sale agreement.

During this time, he is not exercising any individual management control even though he has a forty six percent interest in the property. The limited liability company pays all expenses of the property. He receives no income as an individual.

A month before the sale, Peter records his deed. The Purchaser Group is made aware of his interest. His other members are not.

At closing, Peter signs on behalf of the company although his other members are now aware that he has deeded some interest to himself without their consent. The company pays the broker's commission. Peter's share of the proceeds is allocated according to the operating agreement. It is not forty six percent. The distribution is made to XYZ Intermediary pursuant to Peter's instruction in closing.

When audited, the exchange fails.

Dissolution and Distribution: Long After the Exchange If enough time has elapsed, a distribution to partners who desire to be bought out will be no problem. If this is done immediately after the exchange, there can be a question as to whether the Replacement Property was acquired for use in a trade or business or whether it was acquired for other purposes related to the structuring or restructuring of the partnership.

Contributing Property to a Partne