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QUESTIONS THAT THE FINAL
SECTION 1031 REGULATIONS ANSWERED*

* An excerpt from the Sept. 1991 cover story article
of the Practical Accountant entitled "Twenty Questions Answered by the final Section 1031 Regulations" - Peter A. Karl III and Danny Santucci, co-authors.
 

 


 

I. WHAT IS A DEFERRED EXCHANGE?

The regulations define a deferred exchange as an exchange in which a taxpayer (the "exchangor") transfers property held for productive use in a trade or business or for investment and later receives property to be held for either of these qualified purposes. The definition of "like kind" generally allows real property to be exchanged for other realty (assuming qualified use) while the standard for personal property exchanges is more restrictive (discussed in question 15). The transaction must be a transfer of property for property, not for money. Thus, a sale followed by a purchase of like-kind property will not qualify.
 
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II. WHEN IS GAIN OR LOSS RECOGNIZED UNDER A DEFERRED EXCHANGE?

If an exchangor actually or constructively receives money or other property ("non-like kind") for the relinquished property before receiving like-kind replacement property, the transaction represents a sale and not a deferred exchange, even though the exchangor may ultimately receive like-kind replacement property.
 
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III. UNDER A DEFERRED EXCHANGE, WHEN MUST THE REPLACEMENT PROPERTY BE IDENTIFIED (AND SUBSEQUENTLY ACQUIRED BY THE EXCHANGOR)?

Section 1031 treatment will not apply if the replacement property is not "identified" before the end of the "identification period" or the identified replacement property is not received before the end of the "exchange period." The identification period ends 45 days after the date on which the taxpayer transfers the property relinquished (i.e. the closing).
The property identified must then be acquired no later than:
 
A. 180 days after the date of initial transfer of the relinquished property (i.e. also the first closing), or
 
B. The due date, including extensions, for the exchangor's tax return for the year in which the transfer of the relinquished property occurs.
 
 
Unlike the grace period under Section 7503 for the filing of tax returns and Tax Court Petitions (allowing their submission on the next business day when the due date falls on a weekend or holiday date), the 45- and 180-day rules are strictly construed.

 
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IV. HOW IS THE REPLACEMENT PROPERTY TO BE IDENTIFIED?

REPLACEMENT PROPERTY IS "IDENTIFIED" UNDER THE REGULATIONS IF:
 
A. It is identified in a written agreement for the exchange of properties, or
 
B. It is designated as replacement property in a written document signed by the exchangor and hand-delivered, mailed, telecopied, or otherwise sent before the end of the identification period to a person involved in the exchange other than the exchangor or a "disqualified person".
 
 
The replacement property must be unambiguously described in the document or agreement by a legal description, street, or distinguishable name (e.g. "the Yahnundahsis Apartment Building").
 
Alternatively, replacement property received by the exchangor before the end of the identification period is treated as identified before the identification period ends.
 
The property received must be substantially the same as property identified. The regulations imply a 75% rule of thumb in an example where 2 acres of raw land (worth $250,000) is identified but only 1.5 acres (worth $187,500) are actually received. The 1.5 acres is held to comply with the original identification.

 
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V. WHEN DOES THE 45-DAY PERIOD END IF THE TAXPAYER TRANSFERS MORE THAN ONE "RELINQUISHED PROPERTY"?

Forty-five (45) days after the initial property is transferred (with the same rule applicable for the 180 day period).
 
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VI. WHAT ARE THE RULES WHEN A TAXPAYER WANTS TO IDENTIFY MORE THAN ONE REPLACEMENT PROPERTY?

The regulations permit more than one property to be identified as replacement property. Regardless of the number of relinquished properties, the maximum number of replacement properties the exchangor may identify is:
 
 
A. Three properties of any fair market value, or
 
B. Any number of properties as long as the aggregate F.M.V. of all properties identified as of the end of the identification period does not exceed 200% of the aggregate fair market value of all relinquished properties as of the date of transfer by the exchangor. For purposes of the 200-percent rule, the F.M.V. is its estimated value (and not equity) on the date it is expected to be received by the exchangor. In addition, properties received within the identification period are counted for purposes of the 3-property rule and the 200-percent rule.
 
C. Any number of properties of any value provided that 95% of F.M.V. of all properties identified are received by the end of the exchange period.
 
EXAMPLE (1)
 
Dan and Ralph enter into a deferred three party exchange with the third party (owner of the replacement property) to be identified. Dan transfers Beach-Lot to Ralph on May 17, 1991. Beach-Lot, which Dan has held for investment, is unencumbered and has a value of $100,000. By July 1, 1991 (end of the 45-day period) Dan must identify the replacement property. By November 13, 1991 (end of the 180-day period) Ralph must buy the replacement property and transfer it to Dan.
 
On June 3, 1991, Dan identifies the replacement property as "a lot located in Albany County with a value not to exceed $100,000." The designation is made in a written document signed by Dan and personally delivered to Ralph. On July 8, 1991, Dan and Ralph agree that Smallacre is the property described in the June 3rd document.
 
The June 3rd designation is not an unambiguous description. The replacement property was not unambiguously described until July 8th. Since this was after the end of the identification period (July 1, 1991), the exchange of Beach Lot for Smallacre does not qualify.
 
 
EXAMPLE (2)
 
Facts are the same as in Example #1, except that instead of the June 3rd document, Dan, on June 28, 1991, identifies by legal description three specific properties in a written document he signs and personally delivers to Ralph. The written document also provides that by August 1, 1991, Dan will orally inform Ralph as to which of the three properties he must buy and transfer.
 
As of July 1, 1991, the respective values of the three properties are $75,000, $100,000 and $125,000. The 3-property rule is satisfied and the properties have thus been properly identified before the end of the 45-day period.
 

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VII. IS THERE A PENALTY IF A TAXPAYER IDENTIFIES MORE PROPERTIES THAN THE RULES ALLOW UNDER QUESTIONS 6 [SUPRA)?

Yes, the exchange will be considered void in total.
 
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VIII. WHAT PROCEDURE IS PROVIDED FOR THE REVOCATION OF PREVIOUSLY IDENTIFIED REPLACEMENT PROPERTY?

Similar to the procedure for identification, the revocation must be made prior to the end of the identification period in a written document signed by exchangor. This revocation must be hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to the person to whom the identification was originally sent.
 
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IX. WHAT SAFE HARBORS EXIST IN THE DEFERRED EXCHANGE AREA?

For many years, the rule of actual and constructive receipt has been unclear as applied to exchanges. To clarify this area, the regulations provide four safe harbors which can be used without the risk of the IRS arguing that there has been the actual or constructive receipt of non like-kind property:
 
A. Safe Harbor #1
 
The obligation of the exchangor's transferee (i.e. the buyer or intermediary) to complete the deferred exchange can be secured or guaranteed by:

  1. A mortgage, deed of trust, or other security interest in property (other than cash or a cash equivalent),
  2. A standby letter of credit which satisfies all of the requirements of Reg Section 15A.453-1(b)(3)(iii) and which does not allow the taxpayer to draw on the letter of credit except on default of the transferee's obligation to transfer like-kind replacement property, or
  3. A guarantee of a third party

B. Safe Harbor #2
 
The obligation of the exchangor's transferee to complete the deferred exchange may be secured by cash or a cash equivalent if held in a qualified escrow account or a qualified trust. In a "qualified" escrow account or trust, the escrow holder or trustee must not be the exchangor or a disqualified person, and the exchangor's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in escrow or trust must be limited. An intermediary is used in a four party deferred exchange to accommodate the exchange for the benefit of the other three parties (exchangor, exchangor's transferee and owner of the replacement property).
 
C. Safe Harbor #3
 

  1. The exchangor's use of a "qualified intermediary" who acts on behalf of the exchangor does not destroy an exchange, provided the exchangor' s rights to receive money or other property are limited. A "qualified intermediary" is a person who is not the exchangor or a disqualified person and who:
    • a. Acts to facilitate a deferred exchange by agreeing in writing with the exchangor to an exchange of properties in which the intermediary acquires the relinquished property from the exchangor (either on his own behalf or as the agent of any party to the transaction),
    • b. Acquires the replacement property (either on his own behalf or as the agent of any party to the transaction), and
    • c. Transfers the replacement property to the exchangor

 

  1. An intermediary is considered to have acquired and transferred the replacement property if:
    • a. The intermediary acquires and transfers legal title to that property; or
    • b. The intermediary (either on his own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person. Subsequently, the intermediary (either on his own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the replacement property for the transfer of that property and, pursuant to that agreement, the replacement property is transferred to the taxpayer.

Solely for these purposes, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property.
 
 
D. Safe Harbor #4
 
The exchangor can receive interest (or a growth factor) in a deferred exchange provided his rights to receive interest and other economic benefits are limited. The interest (or growth factor) is treated as interest regardless of whether it is paid in cash or in property.
 
There is a time of entitlement test which stipulates that the interest can not be received prior to the termination of the exchange. To the extent the exchangor has the ability or unrestricted right to receive money or other property before the taxpayer receives like-kind replacement property (even if a transaction is within the safe harbors), the transfer of the relinquished property will not qualify for nonrecognition of gain.
 
The proper manner for reporting interest income earned on money held in an escrow account or trust will be subsequently addressed in regulations to be published under Section 468B (g).
 
The determination of whether a transaction qualifies under one of the safe harbors will be based on the terms of the applicable agreement, rather than state law.
 
Of the four safe harbors, applicable to deferred exchanges only the qualified intermediary safe harbor (#3) is also applicable to simultaneous exchanges. This would permit a four party simultaneous exchange (the fourth party being the qualified intermediary) in the situation where the exchangor's transferee and the replacement property owner are unwilling to cooperate in a three party exchange.

 
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X. CAN THE TAXPAYER'S OWN ATTORNEY ACT AS A QUALIFIED ESCROW AGENT OR EXCHANGE TRUSTEE?

No, since he will be deemed to be the agent of the taxpayer if he has acted as counsel for the taxpayer within the two year period ending on the date of the transfer of the first of the relinquished properties. This two year rule is also applicable to accountants, investments bankers and realtors associated with the taxpayer. However, the following are not included:
 
A. Performance of services with respect to Section 1031 exchanges.
 
B. The performance of routine financial, title insurance, escrow, or trust services by a financial institution, title insurance company, or escrow company.

 
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XI. WHO ELSE IS PROHIBITED (AS A "DISQUALIFIED PERSON") FROM ACTING AS A QUALIFIED INTERMEDIARY?

A party is a disqualified person if:
 
A. The person is an agent of the taxpayer at the time of the transaction.
 
B. The person and the taxpayer (or the taxpayer's agent) bear a relationship defined under Section 267(b) or Section 707(b) substituting 10% ownership for 50% ownership [Reg. Section 1. 1031(a)-3(k)].

 
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XII. WHEN IS A TAXPAYER ALLOWED TO RECEIVE MONEY FROM AN EXCHANGE (I.E. FUNDS THAT ARE NOT SUBJECT TO ANY SUBSTANTIAL RESTRICTIONS)?

In safe harbors #2, #3 and #4, the exchangor's right to receive money or other property is limited. These limitations provide that the exchangor has no right to receive money or non like-kind property until:
 
A. The end of the identification period (if the taxpayer does not identify replacement property before the identification period ends), or
 
B. The exchangor receives all the Identified replacement property, or
 
C. If the exchangor identifies replacement property which is subject to a substantial written contingency beyond the exchangor's (or a disqualified person's) control and this contingency fails (e.g. disapproval by a zoning board), or
 
D. The end of the exchange period.
 
 
EXAMPLE (3)
 
Dan and Ralph enter into a deferred three party exchange agreement on May 17, 1991. Dan is to transfer Whiteacre to Ralph. Whiteacre, which Dan has been holding for investment, is encumbered and has a value of $100,000. Dan is to identify replacement property by July 1, 1991. By November 13, 1991, Ralph must purchase the identified replacement property and transfer it to Dan.
 
At any time after May 17, 1991 and before Ralph buys the replacement property, Dan can demand that Ralph pay him $100,000 in lieu of the replacement property. Since Dan has the unrestricted right to demand the $100,000 before he receives the replacement property, he is treated as having sold Whiteacre for $100,000.
 
 
EXAMPLE (4)
 
Same facts as in above Example except that Dan and Ralph use a qualified escrow account and also agree that if the value of the replacement property is more or less than Whiteacre's, the difference will be made up with a cash payment. The escrow agreement provides that the $100,000 deposited by Ralph on his receipt of Whiteacre is to be used to buy the replacement property.
 
If Dan fails to identify the replacement property by July 1, 1991, he may demand payment of the escrowed funds at any time after that date. If Dan identifies and receives replacement property, he may demand any remaining funds in escrow after he receives the replacement property. Otherwise, Dan is entitled to the escrowed $100,000 after November 13, 1991 (the end of the exchange period).
 
Dan does in fact identify replacement property which Ralph purchases, using the escrowed funds, and transfers it to Dan. There is no constructive receipt of the $100,000 and the transaction qualifies as a like-kind exchange.

 
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XIII. CAN FUNDS HELD BY THE QUALIFIED INTERMEDIARY BE USED TO PAY CLOSING COSTS?

The taxpayer is in receipt of the funds to the extent the funds are used to pay the taxpayer's closing costs. The regulations provide that the use of money or other property in a qualified escrow account or qualified trust, or held by a qualified intermediary, to pay the following specified transactional items will not result in actual or constructive receipt of the remaining funds:
 
A. Costs which relate to the disposition of the relinquished property or to the acquisition of the replacement property, and
 
B. Expenses which are listed as the responsibility of a buyer or seller in the typical closing statement under local standards.
 
Examples of these transactional items include commissions, prorated taxes, recording or transfer taxes, and title company fees. In addition, under the regulations, a taxpayer's rights to receive items [such as prorated rents) that a seller may receive as a consequence of the disposition of property and that are not included in the amount realized from the disposition of property are disregarded.

 
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XIV. WHAT IS A "BUILT-TO-SUIT" EXCHANGE, AND WHAT TAX TRAPS ARE THERE IN THESE TYPE OF EXCHANGES?

A "Built-to-Suit" Exchange is one in which the replacement property to be acquired does not exist and needs to be constructed or built. In this type of exchange, the property to be constructed must be identified in as much detail as possible.
 
After the receipt of the constructed property, a "substantial change" test will be applied to determine whether the description of the property eventually received has been altered from the description of the property identified as a result of substantial changes to the plan/design. In determining whether the property received is substantially the same as that identified, variations due to usual or typical (construction) changes are not taken into account. Only that portion of the property to be constructed which constitutes real property at the time of receipt by the exchanger will be included in the exchange and only if when finished it would have been considered substantially the same as the property identified. The balance of the construction completed after the exchanger receives the target is considered the receipt of services and not like kind constructed (permitting the taxpayer to receive as replacement realty construction not completed, i.e. without the need for the issuance of any certificate of occupancy) are in contrast to the requirement that personal property being produced must be completed on or before the date the property is received by the taxpayer.

 
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XV. WHAT ARE THE APPLICABLE RULES IN DETERMINING WHETHER PERSONAL PROPERTY IS LIKE-KIND?

A. Personal, depreciable property used in a trade or business is considered exchanged with like-kind property if exchanged either for property of like-kind or like-class. Properties are of like-class if they are in the same:
 

  1. "General Asset Class" (i.e., asset classes 00.11 through 002.8 and 00.4 found in Rev Proc 87-56), or
  2. "Product Class" (i.e. a 4-digit coding system within Division D of the Standard Industrial Classification set forth in the Executive Office of the president, Office of Management and Budget, Standard Industrial Classification Manual C 1987). Under the 4-digit SIC Manual, for example, diary equipment and haying machinery are both within the same Product Class (SIC Code 3523), and are of a like class.

Under the final regulations, property that is listed in a 4-digit product class ending in a "9" (i.e., a miscellaneous category) is not considered property within a Product Class. Accordingly, that property, and property that is not listed in a 4-digit product class, cannot be of a like class based on the 4-digit SIC Manual classification. However, taxpayers may be able to demonstrate that these properties are of a like kind.
 
EXAMPLE (5)
 
Dan transfers a personal computer (asset class 00.12) to Ralph in exchange for a printer (asset class 00.12). The properties exchanged are within the same General Asset Class and therefore of a like class.
 
 
EXAMPLE (6)
 
Dan transfers a grader to Ralph in exchange for a scraper. Neither property is within any of the General Assets Classes. However, both properties are within the same Product Class (SIC Code 3533). Thus, the properties exchanged are of a like class.
 
Property that falls within a "General Asset Class" can't be classified under a "Product Class".
 
 
EXAMPLE (7)
 
Dan transfers an airplane (asset class 00.21) to Ralph in exchange for a heavy general purpose truck (asset class 00.242) that Dan will use in his business. The properties exchanged are not of a like class because they are within different General Asset Classes. Since each of the properties is within a General Asset Class, the properties may not be classified within a Product Class, The airplane and heavy general purpose truck are also not of a like kind. Therefore, the exchange does not qualify for nonrecognition.
 
The rules described above for determining like-class by reference to General Asset Class or 4-digit SIC Manual apply to depreciable tangible personal property used in a business.
 
 
B. The regulations apply the same like-class standard to depreciable tangible personal property held for investment. Examples of such property include the lamps, carpets, and other furnishings in a building held for investment.
 
C. Intangibles, and nondepreciable personal property (i. e., items considered to be collectibles for example, works of art, antiques, gems, stamps, precious metals, coins, and historical objects) are not assigned classes. They must be of like-kind to qualify for tax-free treatment under Section 1031.
 
D. Intangible rights are like-kind when the types of rights and the underlying properties are similar. The regulations say that the exchange of a copyright on a novel for a copyright on another novel is a like-kind exchange. However, the exchange of a copyright on a novel for a copyright on a song does not qualify.
 
E. The going concern values or goodwill of two businesses are not of like-kind. The Internal Revenue Service has concluded that the nature and character of goodwill and going concern value of a business are so inherently unique and inseparable from the business that goodwill or going concern value of one business can never be of a like kind to goodwill or going concern value of another business.

 
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XVI. WHAT IS AN EXCHANGE OF "MULTIPLE PROPERTIES"?

An exchange is one involving multiple properties if the assets transferred by the exchangor can be separated into more than one "exchange group". For example, an exchange of apartment buildings may be an exchange of multiple assets if, in addition to real property, personal property is transferred and received by the taxpayer in the exchange. Exchanges of entire businesses are also exchanges of multiple properties.
 
Instead of requiring taxpayers to compare each individual asset in the case of an exchange involving personal property, the regulations require taxpayers to group their assets in "exchange groups". An "exchange group" consists of all properties transferred and received in the exchange which are of a like-kind or like-class. Thus, when a taxpayer trades a computer and a car for a printer and a car, he puts the computer and the printer (which are in the same class) in one exchange group and the two cars in another.
 
If the aggregate value of the properties transferred and the properties received in each exchange group are not equal, a portion of the "other property or money" received as part of the exchange is allocated among the exchange groups in order to equalize the aggregate value of the properties transferred and received in each exchange group. For this purpose, "other property or money" includes property received that is not of like-kind and like-class with the property transferred.
 
 
EXAMPLE (8)
 
Dan exchanges a car with a value of $1,100 and a computer with a value of $800 for a car with a value of $800, a computer with a value of $1,000 and $100 in cash. The exchange consists of two exchange groups under the regulations, car (value $1,100) for car (value $800) and computer (value $800) for computer (value $1,000).
 
To equalize the aggregate value of the properties transferred and the aggregate value of the properties received in each exchange group, the $100 cash and one-fifth of the computer received by Dan (i.e., $200 worth of the computer) are allocated to the first exchange group (the autos). These are treated as "other property or money" received in the exchange (i.e. the car worth $1,100 was transferred by Dan for which he only received a car worth $800 within the exchange group of the automobiles).
 
Once exchange groups are created, like-kind exchange rules are applied separately to each exchange group to determine the amount of gain recognized and the basis of the property received in the exchange. For example, if the aggregate adjusted basis of the properties transferred in an exchange group exceeds the aggregate fair market value of the properties received in the exchange group, the realized loss is not recognized.
 
 
EXAMPLE (9)
 
In Dan's case, from the above example, the amount realized on the exchange of the automobile is $1,100. If the adjusted basis of the automobile transferred by Dan was $400, then there is a realized gain in the exchange of $700 and a recognized gain of $300. The latter is computed as the sum of the money received ($100) and the fair market value of the other property received ($200 or the excess of fair market value received from the exchange group of the computers).
 
Property that does not fit an exchange group, any property that does not qualify for tax-free exchange treatment under Section 1031(a)(2), and any money transferred or received in the deal are put in a residual group. Gain or loss on each property transferred within this residual group is separately calculated and recognized.

 
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YOUR 1031 EXCHANGE RESOURCE
 
©All Rights Reserved 2016
 
AUTHOR: PETER A. KARL III

(315) 735-6481

pak@attorney-cpa.com

 

 
WEBMASTER: KELLY KOHL


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