Note: This article is a reprint from the July, 1990 issue of Taxation for Accountants, a publication of Warren, Gorham and Lamont. This article explained the proposed regulations to Section 1031 (a)(3).
By Robert L. Sommers
Eleven years after the Starker decision permitted deferred like-kind exchanges under Section 1031 and six years after Congress added Section 1031(a)(3) in response to the Starker decision, the Internal Revenue Service has finally published proposed regulations intended to answer myriad unresolved issues stemming from the Starker decision and Section 1031(a)(3).
For the most part, the proposed regulations are clear, well-written, brief and, with one major exception, consistent with the body of case law interpreting Section 1031. There are some surprising pro-taxpayer interpretations and, of course, several illogical and unnecessary landmines lurking along the path to a successful deferred exchange. While most examples merely reiterate the text, some draw unnecessary distinctions of form rather than substance. Some glaring problems with the regulations should be eliminated upon finalization. But, overall, if taxpayers (and their advisors) comply with the examples, they should now be able to engage in deferred exchanges -- including the use of intermediaries, direct deeding and the receipt of interest or a growth factor during the exchange period -- without peril.
The regulations also affirm that Section 1031(a) no longer applies to exchanges of partnership interests. To what extent Section 1031(a) applies to beneficial interests in a grantor trust or interests in a cooperative, however, has not been addressed by these regulations.
The concept of a nonsimultaneous exchange (commonly called a "deferred exchange") arose from Starker. The taxpayer, T. J. Starker transferred unencumbered timber property to Crown Zellerbach Corporation ("Crown") in exchange for an unsecured promise by Crown to transfer like-kind property chosen by Mr. Starker to him during a 5-year period. At the end of this 5-year period, Mr. Starker would receive the outstanding balance in cash. There was a 6% growth factor on the outstanding balance. The Ninth Circuit found that Section 1031 did not contain the requirement of simultaneity and that an exchange presently for like-kind property 5 years in the future was permissible. The court found the 6% growth factor as disguised interest which was taxable when received. In addition, the court expressly held that Mr. Starker's mere possibility of receiving cash in the future did not cause the transaction to fail under Section 1031.
In response to the IRS outcry over Starker, Congress in 1984 passed Section 1031(a)(3) to limit deferred exchanges to transactions in which the taxpayer transferring like-kind property first identifies the replacement property within 45 days after the transfer and then receives the replacement property no later than 180 days from the date of transfer, or the due date of the federal income tax return (determined with regard to extensions). Therefore, Congress not only limited the time table for completion of a deferred exchange, but also mandated that the transaction must be completed by the end of the taxable year. Congress did not overturn or modify any other portion of Starker.
Congress did not address the issue of the taxpayer's receipt of interest or a growth factor during the exchange period, nor did it discuss third-party intermediaries as part of deferred exchanges. The proposed regulations address these issues and also provide mechanical rules for implementing Section 1031(a)(3). The regulations dodge the issue of a "reverse Starker" since it falls outside the statutory language of Section 1031(a)(3)1. The regulations will apply to transfers made after July 2, 1990, except for transfers made pursuant to a binding contract in effect on May 16, 1990 and at all times thereafter before the transfer.
Three critical time periods are involved in a deferred exchange: The date when the taxpayer transfers property; the date the taxpayer identifies replacement property; and the date the taxpayer receives the replacement property. Since Section 1031 involves exchanges of like-kind property, and not sales or purchases of like-kind property, these regulations distinguish between an exchange, and a sale or purchase by determining whether the taxpayer -- at any time during the deferred exchange period -- actually or constructively receives cash. If at any point the taxpayer receives cash, or has the right to receive cash, the regulations state that the taxpayer will be taxed as though he sold property.
The regulations label any property that is transferred by the taxpayer as "relinquished" property. They affirm that all critical time frames commence on the very date the relinquished property is transferred. From a practical standpoint this date is the most important: The longer the taxpayer can delay transfer of relinquished property, the more time he has to receive and identify replacement property. Most taxpayers familiar with deferred exchange transactions will want to delay transfer of relinquished property until they have located suitable replacement property because the 45-day identification deadline under Section 1031(a)(3)(A) is unrealistically short and may present the greatest barrier to a successful deferred exchange.
The simplest way to delay transfer of relinquished property is to postpone the closing date of the transaction. This may be done with cooperation of the transferee through a mutual time extension for closing, or through provisions inserted in the sales contract, thereby allowing the taxpayer to unilaterally delay the closing or transfer of property.
Although the concept of transferring relinquished property is important, there is no stipulation under the statute and regulations as to when the transfer actually occurs. Generally, a transfer occurs when the burdens and benefits of ownership pass, rather than when legal title passes, however, consider the following example: On January 10th the taxpayer signs a deed to his property and deposits it with an escrow company. On January 20th the escrow company closes the transaction and transfers the deed to the purchasing party, and on January 30th the purchasing party records the deed. For purposes of Section 1031(a)(3), has the taxpayer relinquished the property on January 10th, 20th or 30th? The statute and regulations are silent as to when the transfer actually occurred. The correct result should be January 20th, the date the benefits and burdens of ownership passed, unless, under local law, the property transfer did not occur until the deed was recorded, or January 30th. Although the taxpayer signed the deed on January 10th, the delivery to escrow was conditional until the escrow closed and the taxpayer received his consideration for the transfer -- the right to receive like-kind property under Section 1031. On audit, however, the examining agent might use the date on which the deed was signed, absent other proof of when the property was actually transferred, such as the closing statement. If a taxpayer is under audit, the closing statement date should be used as evidence of when the property was transferred, not the date the deed was signed.
Once the transfer of the relinquished property has occurred, the taxpayer must identify replacement property within 45 days thereafter. Consistent with the government's proclivity for double negatives, the regulations define what is not like-kind property:
In the case of a deferred exchange, any replacement property received by the taxpayer will be treated as property which is not of a like-kind to the relinquished property if --
What happens if either the identification period or exchange period ends on a weekend or legal holiday? At this point the regulations set the first of several traps. The identification and exchange periods end on dates that are 45 days and 180 days, respectively, after the taxpayer transfers the relinquished property, even though the dates fall on a weekend or holiday! The regulations state in a parenthetical that Section 7503 -- which states that if the time for performance ends on a weekend or legal holiday then the performance date is extended to the next business day -- does not apply to deferred exchanges. In case the reader misses this parenthetical, Regulation 1.1031(a)-(3)-(b)(3) Example (ii) specifically states that the identification period ending on January 1, 1991, ends on that date even though it is New Year's Day!
There is no justification for interpreting the 45-day and 180-day requirement in such a manner. Section 7503 applies to any act under authority of internal revenue laws and is not conditioned by language stating "except as otherwise provided in the regulations." The IRS may be making a distinction between dates such as April 15th the 15th day of the fourth month and the number of days in which to complete an act, such as 45 or 180 days, but there is no such distinction under Section 7503. Regulation 301.7503-1(a) explicitly provides for filing a Tax Court petition that has a deadline no later than 90 days from the date a notice of deficiency is sent to a taxpayer2. Also, there is nothing in the legislative history to Section 1031(a)(3) or in the statute itself to suggest that Congress intended overriding Section 7503 when it enacted the 45-day and 180-day deadlines. By not applying Section 7503 to the ending dates under the regulations, the IRS set an unnecessary trap for unwary taxpayers who fail to read the Section 1031 regulations and rely instead on express provisions of the Internal Revenue Code.
Identifying replacement property is relatively straightforward. The designation must be made in a written document signed by the taxpayer and delivered or transmitted within the time limits of the identification period to a person involved in the exchange other than the taxpayer or a "related party." Taxpayers are not required to file an identification form with the IRS. Presumably a husband and wife who file a joint return will be considered the "taxpayer" for purposes of this requirement, but what happens if there is more than one "taxpayer" transferring property? Must the written document be signed by all taxpayers to be valid? These regulations do not answer this. Identification of replacement property may also be made in a written exchange agreement signed by all parties thereto prior to the end of the identification period.
In addition to a written and signed document transmitted to a party to the exchange, the replacement property description must be unambiguous. Regulations state that for real property legal descriptions or street numbers will be considered unambiguous. For personal property, such as a truck, the specific make, model and year are sufficient. The regulations should be expanded to permit designation of real property by a tax assessor's parcel number or tax map key. Oftentimes there is no street address for real property and the legal description can be long and cumbersome. If there is neither a street address nor any legal description, the taxpayer could be forced to survey the property to properly identify it under the regulations.
The most difficult problem of the identification period is locating and identifying a replacement property within the 45-day deadline. In the legislative history to Section 1031(a)(3), Congress permitted designation of alternative properties, provided selection of properties was beyond the taxpayer's control. The example given in the Conference Committee's report stated a taxpayer could designate that Property 1 would be transferred if zoning changes were approved and Property 2 would be transferred if zoning changes were not approved on Property 1. This example sheds little light on what other conditions beyond the taxpayer's control are permissible. As a practical matter, naming alternative properties under such limited circumstances would be little use to most taxpayers engaging in deferred exchanges.
In a welcome but unexpected surprise, the IRS ignored the Conference Committee's recommendation and wrote regulations so favorable to the taxpayer, that the identification requirement -- if not rendered toothless by the regulations -- received major oral surgery. The regulations permit identification of three properties, regardless of contingencies or fair market value, within the identification period (called the "3-property rule"). In addition, the taxpayer may choose more than three properties as long as the aggregate value of the identified properties measured at the end of the identification period do not exceed 200% of the fair market value of the relinquished property as of the date the relinquished properties were transferred (called the "200-percent rule"). The 200-percent rule requires two independent measurements of fair market value: the first is the fair market value determination of relinquished property on the date it was transferred, the second is the calculation of the aggregate fair market value of the identified replacement properties on the date the identification period ends. Thus, taxpayers who identify properties early in the identification period run the risk that those properties may appreciate, causing a violation of the 200-percent rule when the identification period ends. Therefore, careful planning and accurate valuations are critical when using the 200-percent rule.
The combination of these rules remove the pressure to identify the exact replacement property within the 45-day period. Often, the taxpayer will be able to identify three properties within the identification period and will then be able to choose which one to acquire during the remaining 135 days after the identification period expires. Under the 200-percent rule, an investor may exchange a parcel worth $1,000,000 and identify as many as 20 properties worth as mush as $100,000 each (or any combination of properties worth $2,000,000 or less) as of the date the identification period ends. He can then limit his choice to the actual parcels he will ultimately receive by the end of the exchange period.
If the taxpayer identifies more than the permitted number or value of properties under either rule, then none of the properties will be considered replacement properties. There are two exceptions:
This last exception has little practical significance since the only way it could apply is if the taxpayer identified four or more properties worth more than 200% of the replacement property and then acquired at a minimum properties valued 195% higher than the relinquished property. For example, if the taxpayer relinquished property worth $100,000 and identified three properties worth $65,000 each and one property worth $10,000 (total $205,000), the taxpayer could comply with the exception if he closed on the first three properties. If property four were valued at $11,000, the exception would fail since the first three properties are less than 95% of the value of all the identified properties ($206,000).
In summary, four alternatives comply with the identification requirement:
Property that is incidental to a larger item of property is treated as a single property for purposes of the 3-property and 200-percent rules, if the items are usually transferred together in a standard commercial transaction and if the aggregate fair market value of these incidental items does not exceed 15% of the aggregate fair market value of the larger item. For example, a truck worth $10,000 is transferred along with a set of tools and a spare tire. If the aggregate fair market value of the tools and spare tire is $1,500 or less, the items are considered part of the truck and one property. If the truck is unambiguously described by make, model and year, the spare tire and tools are considered part of that description even if there is no separate reference made to the spare tire and tool kit5. A second example, an apartment building worth $1,000,000, is transferred along with laundry machines, furniture and personal property worth no more than $150,000 in the aggregate. All items are considered one item of property and part of the apartment building's description (without the necessity of a separate description) if the apartment building is unambiguously described6. It should be noted that, although incidental properties are aggregated for purposes of the 3-property and the 200-percent rules, there is nothing in the regulations exempting the incidental items from being considered boot for purposes of gain or loss recognition under Section 1031(b).
An identification of property may be revoked at any time prior to the end of the identification period by a written document (or by amending a contract if the identification of property occurred in a contract) signed by the taxpayer and delivered in any manner permitted by the identification procedure.
The regulations give five examples for identifying properties. All examples are forthright applications of the identification rules. For instance, identification of property after the 45-day period is considered not like-kind property7; identification of property as "unimproved land located in Hood County with a fair market value not to exceed $100,000" was too ambiguous to constitute a valid identification8;identification of three properties worth $300,000 in the aggregate (the relinquished property was worth $100,000) was proper identification under the 3-property rule9; identification of four properties with an aggregate fair market value of $180,000 meets the 200-percent rule10; and an identification of four properties with an aggregate fair market value of $310,000 (the relinquished property was worth $300,000) coupled with oral revocation of two of the properties (worth $120,000) violates the 200-percent rule since the oral revocation was invalid11. Once replacement property has been properly identified, regulations state the taxpayer may, through oral notification, choose actual replacement properties to be acquired and transferred to him. Therefore, while written revocation of identified property is required, oral notification of which property will be transferred is permitted. Since the taxpayer generally communicates with the same person for both the identification and transfer of the replacement property, this distinction between the permitted oral and written notification could cause compliance problems.
The taxpayer must receive the replacement property before the end of the replacement period, and the property received must be substantially the same property identified. When more than one property is identified, these requirements are applied to each. The regulations contain an interesting example of how the "substantially the same" property requirement works: The taxpayer relinquishes an unencumbered property worth $100,000 and identifies a two-acre parcel of unimproved land worth $250,000. The taxpayer then directs the transfer of 1.5 acres and pays the difference ($87,500) in cash. The regulations state that acquisition of 75% of the property worth $187,500 on the date of transfer amounts to receipt of substantially similar property as identified12.
Replacement property that is not in existence at the time of identification still may qualify as replacement property under the regulations. Property that is produced has the same meaning as under Section 263A(g)(1) and the regulations thereunder. Where the replacement property is improved real property with additional improvements which are to be constructed, the replacement property should follow the method of identifying the real property (by legal description or street address) with as detailed a description of the improvements as practicable at the time of identification. For purposes of the 200-percent and incidental property rules, the value of replacement property to be produced is its estimated fair market value as of the date the taxpayer expects to receive it.
Property received should be substantially the same property identified with variations due to usual or typical production changes taken into account. Substantial changes made to the property received will not be considered like-kind to the property identified. Replacement personal property must be completed on or before the taxpayer's receipt. If replacement real property is not completed on or before its receipt by the taxpayer, it will be considered replacement property only if the property received constitutes real property, and if it had been completed on time, it would have been substantially the same property as identified.
Personal property must therefore be completed and received by the taxpayer prior to the end of the exchange period. Real property improvements, however, may be completed after the exchange period, provided the taxpayer receives the replacement property on or before the end of the exchange period and the improvements -- when finally constructed -- are substantially similar to the improvements identified. For example, real property with construction of a three-bedroom house cannot be transferred to the taxpayer prior to completion and later converted to a duplex after the exchange period expires.
Transfer of relinquished property in exchange for services, including production services, is prohibited. Once the taxpayer receives the replacement property, additional production services rendered with respect to that property are not treated as like-kind property.
For there to be a valid exchange, a taxpayer cannot actually or constructively receive cash and then purchase like-kind investment property. Receipt of cash, either actually or constructively, according to the regulations, will be immediately taxable. A taxpayer actually receives money or property when he physically receives it in his possession or receives the economic benefit of the money or property. A taxpayer constructively receives money or property when it is set aside or credited to the taxpayer's account in such a manner that the taxpayer could draw upon it at any time without restriction if a notice of intent to withdraw is given.
A taxpayer is not in constructive receipt of money or property if there are substantial limitations or restrictions to the receipt, but once those restrictions lapse, expire or are waived, the taxpayer will be found to be in constructive receipt of the money or property. According to regulations, a taxpayer is in actual or constructive receipt of money or property if his agent is in actual or constructive receipt of it.
The regulations illustrate the doctrine of constructive receipt: A taxpayer relinquishes property worth $100,000 on day one to the transferee who is required to purchase and transfer replacement property to the taxpayer. The taxpayer has the right, upon notification to the transferee, to receive $100,000 in cash as of day one. Under the agreement, the taxpayer identifies replacement property and receives it in accordance with Section 1031(a)(3) and the regulations. The regulations state that because the taxpayer had the unrestricted right to receive $100,000 upon notice to the transferee, the taxpayer was in constructive receipt of the cash as of day one, and the transaction is treated as the sale of relinquished property and the purchase of replacement property13. The example also states that if the right to receive the cash was subject to a substantial limitation or restriction (including those in the regulations), then there would be no constructive receipt unless those restrictions or limitations lapsed, expired or were waived.
The problem with the example and the interpretation of the constructive receipt doctrine is that the IRS is trying to win in the regulations what it lost in Starker. The IRS is attempting to make new law by administrative fiat on an issue for which there is no legislative guidance or mandate either in the statute or the legislative history to Section 1031(a)(3). In the process, the IRS is overruling the settled case law in three appellate jurisdictions14. With respect to the same issue raised in the regulations, the court in Starker made it clear that the mere right to receive cash does not invalidate an exchange if the taxpayer intended an exchange:
...the mere possibility at the time of agreement that a cash sale might occur does not prevent the application of section 1031...where the taxpayers had the contract right to opt for cash rather than property, a preference by the taxpayers for like-kind property rather than cash has guaranteed nonrecognition despite the possibility of a cash transaction.15
Under the example, the taxpayer clearly intended an exchange, since he complied with the requirements of Section 1031(a)(3) with respect to the identification. He received the replacement property and he never received any cash. The legislative history to Section 1031(a)(3) stated that Starker was modified only by the time periods for identifying and receiving replacement property16.Therefore the regulations -- to the extent they attempt to overrule existing case law with respect to an unconditional right to receive cash in a Section 1031 transaction -- stand a strong possibility of being declared invalid.
In the example of constructive receipt, the taxpayer retained an affirmative right: "the unrestricted right to demand payment of $100,000." The issue is whether the IRS will apply the doctrine of constructive receipt if the taxpayer does not explicitly retain the right to receive cash during the exchange period. For instance, if the taxpayer retains no affirmative right to receive cash or to sell, assign or pledge his interest in the exchange-- but does not explicitly limit those rights -- will the government argue the doctrine of constructive receipt since those rights have not been affirmatively eliminated? The regulations should clarify that only if the taxpayer affirmatively retains the right to receive cash (or to assign or pledge his rights for cash) in the exchange will the doctrine of constructive receipt apply.
After attempting to overrule Starker with respect to constructive receipt, the regulations set forth four safe harbors for avoiding the constructive receipt doctrine. The regulations caution that even though a transaction may fall within a safe harbor, if the taxpayer has the unrestricted right to obtain cash or other property prior to the actual receipt of replacement property, the replacement property will not be considered like-kind property, and the transaction will fail under Section 1031. The regulations expect most transactions to qualify under one of the four safe harbors. They state that if a transaction falls outside the safe harbors, the transaction will be subject to careful scrutiny.
Exclusive of some unnecessary pitfalls, the safe harbor provisions are generally pro-taxpayer. Deferred exchange transactions can be easily structured to fall within the safe harbors provisions, and they are relevant to how deferred exchanges are actually accomplished. The regulations solve the major concern stemming from Starker -- the use of a third party exchange intermediary in lieu of the transferee's unsecured promise to transfer replacement property. Under the safe harbor provisions, the person who receives the relinquished property is called the "taxpayer's transferee."
The taxpayer is allowed to receive the following security devices or guarantees: (1) a mortgage, deed of trust, or other security interest (other than cash or a cash equivalent); (2) a standby letter of credit that satisfies the requirements of Sec. 15A.453-1(b)(3)(iii) relating to letters of credit securing installment sales obligations, provided the taxpayer draws on the letter of credit only upon default of the transferee's obligation to transfer like-kind property; or (3) a guarantee of a third party.
These security devices are based on a two-party exchange without the use of an intermediary to perform the acquisition of replacement property. This approach is useful when the transferee party has the economic strength to obtain a letter of credit or third-party guarantee. In the typical exchange transaction, however, the taxpayer will want the transferee's payment to be made at the time of the transfer so that the replacement property may be obtained without foreclosing on a security device.
Under these two safe harbors, the taxpayer's transferee is still the party who must acquire and transfer the replacement property. The transferee's obligation, however, is secured with cash or a cash equivalent that is placed into a qualified escrow account or qualified trust, usually when the taxpayer transfers the relinquished property. A qualified escrow account and qualified trust is an escrow account or trust where the escrow holder or trustee is not the taxpayer or a "related party" (discussed later in this article), and the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefit of the cash or cash equivalent -- held in the escrow account or by the trustee -- are limited to additional restrictions on safe harbors described later in the article.
Use of a qualified escrow account or qualified trust still relies on the taxpayer's transferee to perform the job of purchasing and transferring the replacement property to the taxpayer. The obligation is secured by the purchase price of the relinquished property. The funds serve not only as security for an obligation but may actually be used by the transferee to purchase the replacement property. Therefore, if funds are merely left in escrow or with a trustee and the taxpayer then directs the escrow officer or trustee to purchase the replacement property, the transaction will fall outside these safe harbors and will probably be considered a sale and purchase and not an exchange. Presumably, the taxpayer is the beneficiary under the qualified trust, but the regulations are silent on this point.
A qualified intermediary is a person who is not the taxpayer or a related party and who, for a fee, acts to facilitate a deferred exchange by acquiring the relinquished property and transferring it to the taxpayer's transferee in return for payment and then acquiring the replacement property and transferring it to the taxpayer. The intermediary may acquire the relinquished property or the replacement property on its own behalf or as an agent of any of the parties to the transaction. The taxpayer will not be treated as actually or constructively receiving money or other property -- whether or not the taxpayer's transferee is or may be the taxpayer's agent -- provided the taxpayer's right to receive money or other property from a qualified intermediary is limited to the additional restrictions on safe harbors discussed below.
Most deferred exchange transactions are structured using an intermediary; indeed, acting as an intermediary for deferred exchanges has become big business within the real estate industry. The definition of an intermediary may be narrower than what is currently permitted under analogous case law. The intermediary must receive both relinquished property and replacement property in the transaction; however, this rule is relaxed to allow "direct deeding" of property under some circumstances. The provisions regarding the qualified intermediary are the most complex under the regulations and are discussed later.
One of hottest topics after Starker was to what extent a taxpayer could receive interest or a growth factor and still qualify for Section 1031 treatment. The issue centered around receiving interest on principal that was held for exchange purposes. On the one hand, Starker explicitly permitted interest as part of the Section 1031 exchange, but under Starker, Crown ( the taxpayer's transferee) had possession of the principal used to effectuate the exchange. In a typical deferred exchange transaction in which an intermediary was used, one argument said that receipt of interest by the taxpayer meant the taxpayer was in constructive receipt of the principal since the right to receive interest flows from ownership of the principal17.
The IRS came down squarely on the side of Starker, stating that a taxpayer may receive interest or a growth factor with respect to a deferred exchange without triggering the doctrine of constructive receipt. The taxpayer is subject to the additional restrictions on safe harbors with respect to receiving the interest or growth factor. This safe harbor could spell the death knell for many professional exchange intermediaries who retained the interest earned as their compensation on the principal deposited with them until the replacement property was purchased.
To comply with the safe harbor provisions discussed above, the taxpayer cannot receive the money or other property until the following events have occurred:
The first restriction is a pro-taxpayer interpretation of constructive receipt. Until the regulations were issued, it appeared that, if the taxpayer had the right to receive money or other property by deliberately failing to identify property within the 45-day period, the taxpayer constructively received the money at that date so the exchange would fail. Cautious tax advisors, therefore, would recommend the taxpayer not have the right to receive money or property until after the exchange period. This regulation now makes it clear that a deferred exchange agreement may permit the taxpayer to receive money or property if the taxpayer deliberately fails to identify property within the identification period once the identification period expires.
The second and fourth restrictions avoid the doctrine of constructive receipt by providing that the receipt of cash is delayed until either the exchange is completed or terminated because it was not completed in time. The third restriction permits the receipt of cash if the exchange is terminated due to an event identified in the contract that is outside the taxpayer's control, such as the denial of rezoning on the replacement property.
The IRS does not want a related party acting as an escrow holder, a trustee or an intermediary in a deferred exchange transaction. The regulations define a related party as someone who bears a relationship with the taxpayer as defined under Section 267(b) and Section 707(b), but for purposes of the related party definition, 10% is substituted for 50% in each place it appears. For example, under Section 267(b)(2) an individual owning (directly or indirectly) more than 50% in value of the outstanding stock of a corporation and the corporation are considered related; under the regulations, an individual owning only 10% of the stock will now be considered related to the corporation.
The regulations go further and state that a party who "acts as an agent" (note the use of the present tense "acts") of the taxpayer will be considered a related party. Parenthetically, the regulations says persons performing services for the taxpayer such as, for example, an employee, broker or attorney are considered agents. Note, the regulation does not specifically mention accountants, financial advisors or other professionals, but the language is broad enough to include them.
The final category of related parties includes agents of the taxpayer who bear a relationship described under Section 267(b) or Section 707(b), again substituting 10% for 50% in each place it appears. This last category will include, for example, an intermediary corporation in which the taxpayer's attorney, employee or broker (or accountant, perhaps) owns more than 10% of the value of the outstanding stock, or a trustee who is an agent's spouse.
A major exception to the related party rules pertains to the taxpayer's agents: if the person or entity performing services does so with respect to exchanges intended to qualify under Section 1031, or if the agent is a financial institution performing routine services, then that person or entity will not be considered an agent for purposes of the safe harbor provisions.
This exception creates a host of issues as to whether a person becomes an agent under the safe harbor provisions. For instance, if a real estate broker routinely places in his contracts a statement that his principal intends to comply with a Section 1031 exchange, will that language insulate him from the related party provision if he or a corporation of which he owns more than 10% of the stock acts as an intermediary?
Suppose a taxpayer engages an attorney to structure a Section 1031 deferred exchange and the attorney acts as the intermediary. Two years later the taxpayer or the taxpayer's spouse asks the attorney to draft a promissory note unrelated to the exchange. Will the rendering of insubstantial services two years later disqualify the deferred exchange? What happens if an accountant's partner prepared a tax return for a taxpayer and two years later that taxpayer engages in an exchange using an intermediary corporation that is more than 10% owned by the accountant? Under the related party rules as drafted, the broker is probably not a related party, but the attorney and accountant might be considered related parties. Note, however, that neither the attorney nor the accountant were agents of the taxpayer at the time of the deferred exchange transaction. Therefore, it could be argued that neither person acted as the taxpayer's agent at the time of the deferred exchange. Although it is unclear, from the literal language of the regulations, one must presently "act as the agent" of the taxpayer in other to be considered a related party.
The regulation falters when it assumes that someone performing services for a taxpayer is an agent of the taxpayer for Section 1031 purposes. Oftentimes, the taxpayer may want to engage a person he trusts to assist him in a deferred exchange rather than risk his investment to a stranger19. If the government is concerned about the taxpayer's ability to manipulate the agent, then the related party definition should apply only to those who have an ongoing relationship with a broker, attorney or accountant, rather than potentially ensnaring someone who performs services for a taxpayer without regard to the frequency, nature or extent of those services. Also, even if the taxpayer does not engage an attorney in a Section 1031 transaction and even if the attorney is unaware of the transaction, the regulations -- as written -- would encompass an intermediary company that is related to the attorney, thereby invalidating the transaction. There is no justifiable tax reason for creating such uncertainty in the regulations. They should be narrowly redrawn to prevent persons who are true agents of the taxpayer from acting as intermediaries.
The first example under the regulations confirms that the sales proceeds may be deposited into an escrow account (provided the escrow holder is not a related party) and then used to purchase the replacement property, rather than serving merely as security. In that example, the taxpayer ("B") transfers the relinquished property to the taxpayer's transferee ("C"). C deposits $100,000 into escrow and the escrow agreement provides that if B fails to identify replacement property within the identification period, the proceeds will be paid to B. B is entitled to demand and receive the remanding escrow proceeds after C acquires replacement property with the funds. The regulations state this transaction is valid20.
In the second example, B has an unrestricted right to demand funds on August 14, 1991 (89 days after he transfers the relinquished property), if a rezoning contingency is not satisfied by August 14, 1991. The example states that if B does not actually receive the replacement property prior to the time the unrestricted right to demand the funds accrues, then B is in constructive receipt of the money on the first day he has the unrestricted right to demand the funds, a later transfer of replacement property will be considered a sale and purchase rather than an exchange 21. The example also states that if a rezoning contingency was met prior to the time the unrestricted right to the funds arose, then B could have received the replacement property since he would never have had an unrestricted right to the funds. This example is consistent with the regulations' attempt to redefine the law of constructive receipt and to overrule the Starker and Alderson line of cases.
Examples 3 and 4 are the most complex, dealing with the typical deferred exchange transaction using an intermediary. Taxpayer B enters into an exchange with D. On the day before the exchange, B enters into a deferred exchange agreement with C, an intermediary and unrelated party, with B paying C a fee. B will transfer his relinquished property -- which is subject to D's right to purchase it -- to C. B will identify like-kind property and notify C who will then purchase the property and transfer it to B within the requirements of Section 1031(a)(3) and the regulations.
At this point, the example states that, for reasons unrelated to federal income tax, B engages in a direct deed transfer with D. The example concludes that, even though there was a direct deed transfer, C is a qualified intermediary and the transaction complies with the regulations.
This position was taken in PLR 8852031 and more recently in Revenue Ruling 90-34, IRB 1990-16 (April 16, 1990), and is aggressively pro-taxpayer. In many jurisdictions, there is a double transfer tax if the property is first deeded from B to C and then from C to D. In addition, an intermediary may not want to have his name on the title because of recent legislation involving toxic and hazardous waste on real property since the potential for anyone who has been a property owner may be named in a later lawsuit. Therefore, the government's sanction of direct deeding will save taxpayers on property tax transfers and may eliminate the need for a professional intermediary company because of toxic and hazardous waste concerns.
After giving the taxpayer a big break by allowing an intermediary and direct deeding, Example 4 sets the most insidious trap in the entire set of regulations. Example 4 is similar to Example 3 but -- instead of providing in the deferred exchange agreement the fictional transfer from B to C -- B engages in a direct deed to D, and D pays the money to the qualified intermediary.
Unbelievably, the regulations hold that because C never acquired the property from B, he is not a qualified intermediary and the transaction fails! The only difference between Examples 3 and 4 is that in the former, B and C engaged in a fictional transfer of property. No actual transfer of property occurred between B and C since B directly deeded the property to D, which was permitted. In both examples, C never acquired any right, title or interest in the relinquished property and never became the owner of it. In Example 3, B transferred the right to sell the relinquished property to C in return for C's obligations under the deferred exchange agreement, but ,if that is the distinguishing feature, it is a classic case of form over substance.
In Example 4, B and C did not engage in a fictional transfer. B directly deeded his property to D and the regulations conclude the transfer fails as a deferred exchange. While those taxpayers who have been advised of this trap will comply with it by adding a couple of sentences of boilerplate to their contracts, there will be some taxpayers engaging in essentially the same transaction, but who will fail to have a valid Section 1031 transaction under the regulations. Note that in Example 4, at no time did B ever actually or constructively receive the funds. The transaction under Example 4 is identical to the use of a qualified escrow holder or qualified trustee, except that in those transactions, the taxpayer's transferee (D) is the person purchasing the replacement property. Does it really matter whether it is the taxpayer's transferee or a qualified intermediary, escrow holder or trustee who actually purchases the property and transfers it to the taxpayer? In all safe harbor exceptions, the transferring party is under a contractual obligation to purchase and transfer property identified by the taxpayer, the funds are secured with an intermediary, escrow holder trustee, or security device; and in every transaction, the taxpayer has not actually or constructively receive the funds.
The regulations make changes to the Section 1031 provisions regarding gain or loss recognized and basis of property received with respect to deferred exchanges. The regulations use the following fact pattern: The taxpayer B transfers the relinquished property to his transferee, C. The property has a fair market value of $100,0000 and an adjusted basis of $40,000. C will find replacement property. If the value of the replacement property is greater than $100,000, B will make up the difference; and if the value is less than $100,000, C will transfer the difference in cash to B. All other aspects of the transaction comply with Section 1031 and the regulations.
In the first example, C first transfers $10,000 to B and later transfers the replacement property worth $90,000. Both transfers occur within the time limits of Section 1031(a)(3). B recognizes gain of $10,000 under the normal Section 1031 rules. His basis in the replacement property is $40,000 [the basis in the property transferred ($40,000), decreased by the cash received ($10,000) increased by the gain recognized ($10,000)]22.
In the second example, on the date B transfers the property to C, C transfers $10,000 in cash to B. Within the exchange period, C transfers the replacement property to B worth $100,000, and B transfers back the $10,000 he received from C. The regulations state that B has received money or other property on the day he received the $10,000, notwithstanding that he later transferred the $10,000 back to C as part of the deferred exchange. B's basis in the replacement property is $50,000 [the basis in the property transferred ($40,000), decreased by the cash received ($10,000), increased by the gain recognized ($10,000) and increased by the additional consideration paid by B ($10,000)]23.The lesson of this example is that the taxpayer should not receive money or other property until the end of the exchange. An interim receipt of money or property is taxable, even if it is later returned to the taxpayer's transferee.
This last example draws an inappropriate technical distinction. Under the current regulations to Section 1031, cash received and cash given up should be netted out, except that one cannot offset cash received with an assumption of liabilities.24 By focusing on the time cash is received (rather than waiting until the end of the transaction period) to determine whether money or other property was received, the regulation creates an unnecessary schism between the simultaneous and deferred Section 1031 transactions, with respect to the netting of cash. Since the deferred exchange will be completed within the taxable year, any net cash received will be income in the year the exchange occurred. But, unlike the attempt to override the Starker and Alderson line of cases in the area of constructive receipt, this portion of the regulation is within the IRS's authority, although it makes bad law from a tax policy standpoint.
In the third example, B has the unrestricted right to receive $100,000 in lieu of replacement property any time during the exchange. The regulations treat the taxpayer as constructively receiving $100,000 on the date he transfers the relinquished property, and thus conclude that the transaction is a sale in which the taxpayer realizes $60,000. If C transfers replacement property worth $100,000, B's basis in the replacement property will be $100,000. 25 This example is consistent with the interpretation of constructive receipt under the regulations, but is inconsistent with the Starker and Alderson line of cases.
In Example 4, B has the unrestricted right to receive $30,000 in cash in lieu of replacement property. The transaction qualifies as a deferred exchange, but the taxpayer is treated as constructively receiving $30,000 on the date he transferred the relinquished property. If during the exchange period C transfers replacement property worth $100,000, B's basis in the replacement propertywill be $70,000 [B's basis in the relinquished property ($40,000), decreased by the sum of money received ($30,000), increased by the gain recognized ($30,000), and increased by the amount of additional consideration paid by B ($30,000)]26.The same comments regarding Example 3 apply to this example with respect to the constructive receipt issue.
In the final example, the IRS applies the mortgage boot netting rules in a manner consistent with simultaneous exchanges under Section 1031. The excess of liabilities transferred over the liabilities assumed is considered money or other property under Section 1031(b) and Regulation 1.1031(b)-1(c). B relinquishes property worth $100,000 that is encumbered with a $30,000 mortgage, and C assumes the mortgage. C purchases replacement property for $90,000 by paying $70,000 and assuming a $20,000 mortgage. The replacement property is then transferred to B. B has a gain of $10,000, (the liability transferred to C of $30,000 is netted against the liability assumed of $20,000 by B). B's basis in the replacement property is $40,000 [B's basis in the relinquished property ($40,000), decreased by B's transfer of liabilities to C ($30,000), increased by the amount of liabilities B assumed with respect to the replacement property ($20,000) and increased by the amount of gain recognized in the deferred exchange ($10,000)]27. In this example, the amount of money or other property received is determined once the transaction is completed, rather than when B transfers the relinquished property which is subject to the liabilities.
The regulations for deferred exchanges under Section 1031 are clear, well-written, relatively brief and generally pro-taxpayer. There are several annoying and unnecessary traps waiting for unsuspecting taxpayers. But overall, transactions can be easily and safely structured to avoid the pitfalls.
On the pro-taxpayer side, the regulations emasculate the identification period requirement, by allowing a taxpayer to identify three properties without regard to contingencies or price. The regulations permit a number of security arrangements, including the use of an intermediary to facilitate an exchange and even permit direct deeding from the taxpayer to the taxpayer's transferee, even when an intermediary is involved. During the exchange period, taxpayers may receive interest or a growth factor is taxable as interest.
On the negative side, the doctrine of constructive receipt -- as applied by the regulations -- contradicts the settled case law under Section 1031 as decided by the courts of appeals in three separate circuits by claiming that the mere right to receive money or other property will violate Section 1031, even where an exchange is intended and where taxpayer never actually receives cash. There is a serious trap involving the use of an intermediary and direct deeding: Unless the contract to sell the property is assigned to the intermediary prior to the transfer, the transaction will fail. Finally, the term "related party" and the exceptions thereto are vague and too broad.
But even with the imperfections, a deferred exchange agreement that complies with the regulations should not be difficult to draft. Taxpayers who understand these regulations will be able to aggressively use this vital code section and defer payment of their tax.
1 See Sommers, Deferred Like-Kind Exchanges under Section 1031(a)(3) after Starker, 68 Journal of Taxation 92 (1988). In a reverse Starker, the taxpayer receives the replacement property prior to transferring the relinquished property, thereby avoiding the statutory time frames of Section 1031(a)(3) which only address the deferred exchange in which the taxpayer first transfers the relinquished property and then receives the replacement property.
2 The IRS might be making a distinction between communicating with a public agency such as the IRS or the courts which are closed on weekends and holidays making communication impossible, and communicating with a private party under Section 1031(a)(3), but Section 7503 is not limited to public agencies, and it is just as probable that the private party would be indisposed on a weekend or holiday.
3Transmitted means sent by mail, telecopier, or otherwise sent -- a facsimile transmission should suffice as being "otherwise sent."
4 At this juncture, the regulations introduce the concept of a related party, which will be discussed later in the article.
5 1.1031(a)-3(c)(5) Example 1.
6 1.1031(a)-3(c)(5) Example 2.
7 1.1031(a)-3(c)(7) Example 1.
8 1.1031(a)-3(c)(7) Example 2.
9 1.1031(a)-3(c)(7) Example 3.
10 1.1031(a)-3(c)(7) Example 4.
11 1.1031(a)-3(c)(7) Example 5.
12 1.1031(a)-3(d)(2) Example 2.
13 1.1031(a)-3(f)(3) Example (i).
14 The Service is well aware that in the Starker (9th Cir.) decision which relied on Alderson v Cm, 317 f2d 790 (9th Cir, 1963), Carlton v U.S. 385 F2d 238 (5th Cir, 1967) and Costal Terminal, Inc. v. United States, 320 F 2d 333 (4th Cir, 1963) the mere possibility that the taxpayer could receive cash did not amount to constructive receipt, and as long as the taxpayer intended to engage in a Section 1031 exchange, he would receive exchange treatment.
15 Starker at page 1354
16 The Conference Committee report, Act Sec. 77 of the Tax Reform Act of 1984, Pub L. No. 98-369, 98 Stat. 494, 595-97, states, "As under present law, these new rules would not permit a taxpayer who receives cash and later purchases the designated property to claim like-kind exchange treatment." The present law referred to in the legislative history includes the Starker decision with respect to the doctrine of constructive receipt. There is clearly no change intended in the present law involving the receipt of cash under a Section 1031(a)(3) transaction and the government has no basis for trying to overrule a long line of established cases on this point. Alderson v Cm, 317 f2d 790 (9th Cir, 1963); Carlton v U.S. 385 F2d 238 (5th Cir, 1967) cited with approved by Starker.
17 This is the fruit of the tree argument. If a taxpayer is entitled to the fruit (interest), he must actually or constructively own the tree (princpal).
19 An article appearing in the May 27, 1990, edition of the San Francisco Examiner discusses the dangers of using a company involved in the deferred exchange buisness. According to the article, San Diego Exchange Services just failed as a professional intermediary, leaving some $10,000,000 in unaccounted funds in addition to whopping tax bills for its clients stemming from the failure to complete the exchanges.
20 1.1031(a)-3(g)(7) Example 1.
21 1.1031(a)-3(g)(7) Example 2.
22 1.1031(a)-3(j)(3) Example 1.
23 1.1031(a)-3(g)(7) Example 2.
24 1.1031(d)-2 Example 2(b) and 2(c) (second sentence of parenthetical explanation)
25 1.1031(a)-3(g)(7) Example 3.
26 1.1031(a)-3(g)(7) Example 4.
27 1.1031(a)-3(g)(7) Example 5.
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