DEFERRED, DELAYED or STARKER EXCHANGE
FINAL DEFERRED I.R.C. SEC. 1031 EXCHANGE REGULATIONS
On April 25, 1991 the Internal Revenue Service announced Final regulations under Internal Revenue Code Section 1031 covering Deferred Exchanges. The regulations apply to both real and personal property deferred exchanges. The regulations do not apply to reverse exchanges (where replacement property is acquired prior to the transfer of the relinquished property). The final regulations apply to transfers made after June 10, 1991.
IDENTIFICATION OF REPLACEMENT PROPERTY
The Exchanger must identify the replacement property or properties in writing and give the writing to another party to the exchange within 45 days after transfer of the relinquished property. Delivery may be in person, by mailing, by telecopy, or by other means. There are no additional days added to the 45 days if the 45th day happens to fall on a Saturday, Sunday, or holiday. If more than one property is relinquished as part of the same exchange and they are relinquished on different dates, then the earliest date commences the 45 day identification period and the replacement period. The identification may be contained in the exchange agreement entered into prior to transfer of the relinquished property. Identification will also be deemed to have occurred if the replacement property is received by the exchanger within the 45 day identification period.
An identification may be revoked in writing within the 45 days. The revocation must be delivered to the same party who received the original identification. As many identification statements as desired may be given and revoked as long as at the conclusion of the 45 day period, no more than the maximum number of properties have been identified. The same maximum applies regardless of the number of properties relinquished as part of the exchange. The maximum is three properties of any fair market value or any number of properties whose aggregate fair market value does not exceed 200% of the fair market value (without regard to liabilities) of the relinquished property. Any property received before the end of the identification period is counted as part of the maximum. If the Exchanger has identified more than the maximum number of properties at the end of the identification period, then the Exchanger is treated as if he or she failed to identify any replacement property. There are two exceptions to that rule: (1) any replacement property received before the end of the identification period; and (2) any replacement property identified before the end of the identification period and received before the end of the exchange period if the Exchanger receives identified replacement property constituting at least 95% of the aggregate fair market value of all identified replacement properties before the end of the exchange period.
In identifying the property either the legal description or the street address must be used. Incidental property typically transferred with the identified property is deemed included even if not mentioned, as long as the aggregate fair market value of that incidental property is not greater than 15% of the total fair market value of the property. For example, furniture, laundry machines, and other personal property would be deemed included with the sale of an apartment complex.
If the property is not in existence at the time of identification (e.g. a building is to be built on bare land as part of the exchange), then the identification must contain as much detail as possible about the property to be constructed. If plans are available, then they should be attached to the identification. If substantial changes occur after the identification period, then the property will not qualify.
RECEIPT OF IDENTIFIED PROPERTY
The identified property must be received before the end of the exchange period (earlier of 180 days after transfer of the relinquished property or the due date plus extensions of the Exchanger’s income tax return for the year the relinquished property was transferred). The property received must be substantially the same as the property identified. If it is not substantially the same, it will not qualify as part of the exchange.
Property identified that is to be constructed must be received before the end of the exchange period. Personal property to be received as part of an exchange must be completed by the date of receipt of the replacement property. Real property does not need to be completely constructed when received. However, it must be deemed real property, and had construction been completed by the date of receipt, it would have to qualify as substantially the same property as identified. Additional work performed on the replacement property after it is received does not count towards the amount of like-kind property received.
ACTUAL OR CONSTRUCTIVE RECEIPT OF MONEY OR OTHER PROPERTY
If the Exchanger is deemed to be in actual or constructive receipt of the money or other property received from the transfer of the relinquished property, then the transaction is deemed a sale of the relinquished property. This occurs when he or she has control of the money or other property, receives the money or other property, or receives the economic benefit of the money or other property. If the money or other property is credited to the Exchanger’s account, is set apart for the Exchanger, or is otherwise made available to the Exchanger, then there is constructive receipt. If there is a substantial limitation or restriction on the availability of the money or other property to the Exchanger, then constructive receipt occurs when the limitation or restriction ceases to exist.
FOUR SAFE HARBORS TO AVOID CONSTRUCTIVE RECEIPT
The regulations create four “safe harbors” concerning issues related to constructive receipt. They are as follows:
- SECURITY OR GUARANTY ARRANGEMENTS – This is an arrangement with the transferee of the relinquished property, the escrow holder, the trustee, or the intermediary which secures their performance. This may be in the form of a mortgage, deed of trust, or other security instrument in property other than cash or a cash equivalent. It also includes a standby letter of credit which can be drawn upon only on the default of the party holding the money or other property. It also includes a guaranty by a third party.
- QUALIFIED ESCROW ACCOUNTS AND QUALIFIED TRUSTS – These are types of exchange vehicles. The escrow holder or trustee cannot be the Exchanger or a disqualified person (defined below) to the Exchanger. There must be restrictions on the rights of the Exchanger to receive the money or other property received by the escrow holder or trustee from the transfer of the relinquished property (discussed below).
- QUALIFIED INTERMEDIARIES – This is another form of exchange vehicle. The intermediary cannot be the Exchanger or a disqualified person (defined below) to the Exchanger. The intermediary must receive a fee for acquiring the relinquished property from the Exchanger, acquiring the replacement property, and transferring the replacement property to the Exchanger. There must be restrictions on the rights of the Exchanger to receive the money or other property received by the intermediary from the transfer of the relinquished property (discussed below).
- INTEREST AND GROWTH FACTOR – The Exchanger may receive interest or a growth factor based upon the length of time the funds are held from transfer of the relinquished property to the time of receipt of the replacement property. There must be restrictions on the right of the Exchanger to receive the interest or growth factor (discussed below). The interest or growth factor is treated as interest income to the Exchanger regardless of whether the Exchanger ultimately receives cash or property for the interest.
WHAT ARE THE RESTRICTIONS ON THE EXCHANGER’S RIGHT TO RECEIVE THE MONEY OR OTHER PROPERTY AND TO RECEIVE THE INTEREST OR GROWTH FACTOR?
The Exchanger cannot receive money or other property until:
- The end of the identification period if no replacement property is identified.
- After receipt of all identified replacement property.
- If replacement property is identified, after the end of the identification period and the occurrence of a material and substantial contingency that relates to the exchange, is provided for in writing, and is beyond the Exchanger’s control. An example would be where acceptance of identified property is conditioned upon a zoning change for the property and it is denied after the identification period.
- Otherwise, at the end of the exchange period.
WHO IS A DISQUALIFIED PERSON THAT CANNOT BE THE ESCROW HOLDER, TRUSTEE, OR INTERMEDIARY?
The prohibited relationships are set forth in Internal Revenue Code sections 267(b) and 707(b) and in the two others situations enumerated in the regulations (see * below), all of which are as follows:
- Members of a family – brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants
- An individual and a corporation more than 10% in value of the outstanding stock of which is owned, directly or indirectly by or for such individual
- Two corporations which are members of the same controlled group
- Grantor and fiduciary of a trust
- A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of a trust
- A fiduciary of a trust and a beneficiary of such trust
- A fiduciary of a trust and a beneficiary of another trust, if the same person is grantor of both trusts
- A fiduciary of a trust and a corporation more than 10% in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust
- A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual
- A corporation and a partnership if the same persons own
- More than 10% in value of the outstanding stock of the corporation, and
- More than 10% of the capital interest, or the profits interest, in the partnership
- An S corporation and another S corporation if the same person owns more than 10% in value of the outstanding stock of each corporation
- An S corporation and a C corporation, if the same persons own more than 10% in value of the outstanding stock of each corporation
- 13. A partnership and a person owning, directly or indirectly, more than 10% of the capital interest, or the profits interest, in such partnership
- Two partnerships in which the same persons own, directly or indirectly, more than 10% of the capital interests or profits interests
- In applying numbers 1 through 14, the constructive ownership of stock rules set forth in IRC section 267(c) apply with some exceptions
- *A person who acts as the Exchanger’s agent (including by performing services as the Exchanger’s employee, attorney, accountant, investment banker or broker or real estate agent or broker within the 2 year period ending on the date of transfer of the (first) relinquished property to be transferred.
- *An entity relationship described in numbers 1 through 15 with a person in 16. For example, the Exchanger’s broker cannot own directly or indirectly more than a 10% interest in an intermediary used by the Exchanger.
In determining whether or not a person acts as the Exchanger’s agent, the following actions are not taken into account:
- The performance of services for the Exchanger with respect to exchanges under IRC section 1031, and
- The performance by a financial institution of routine financial services for the Exchanger.
Resolve any issue about a related party being involved in the transaction before you begin the exchange.
Direct deeding of properties is permitted if there is a contractual obligation for the escrow holder, trustee, or intermediary to receive the relinquished property from the Exchanger as part of the initial phase of the transaction. Similarly, direct deeding is permitted if there is a contractual obligation for the escrow holder, trustee, or intermediary to transfer the replacement property to the Exchanger.
The following is a diagram of a typical Deferred Exchange using an Intermediary.Deferred Exchange