Note: This article is a reprint from the February, 1988 issue of the Journal of Taxation, a publication of Warren, Gorham and Lamont.


Tax-Free Exchanges Under IRC Sec. 103(a)(3) After Starker

By Robert L. Sommers

The Starker case which gave rise to the so-called "deferred exchange" probably represented the high water mark for taxpayers in the interpretation of Sec. 1031. Starker, 602 F2d 1341 (9th Cir.. 1979). Section 1031 (a), in general, permits property used in a trade or business or held for investment to be exchanged solely for like-kind property which will be used in a trade or business or held for investment, without the imposition of tax. A deferred exchange allows the taxpayer to relinquish property currently and receive like-kind replacement property in the future. But in 1984, Congress decided to limit the scope of the Starker decision by enacting Sec. 1031(a)(3), a provision which permits deferred exchanges to occur within specific time limitation.

With the enactment of the Tax Reform Act of 1986. P.L. 99-514 and its negative effect on the sale of Sec. 1221 and Sec. 1231 assets -- the elimination of the capital gains deduction and an increase in the capital gains tax for corporations, the changes in the installment sales rules and the elimination or curtailment of many tax credits and deductions -- exchanges under Sec. 1031 remain as one of the only tax planning provisions left in the Code. The practical difficulties in completing a simultaneous exchange will cause heavy reliance on the deferred exchange provisions of Sec. 1031(a)(3).


Starker v. United States

Sec. 1031(a)(3) was the legislative response to the perceived excesses permitted by the Starker decision. In Starker , the taxpayer, T.J. Starker entered into a land exchange agreement with the Crown Zellerback Corporation whereby Mr. Starke r would convey Oregon unencumbered timberland to Crown in exchange for an unsecured promise to provide him with suitable real property chosen by him within 5 years, or pay any outstanding balance in cash. Mr. Starker was also credited with a 6% growth factor (for the timber growth located on the relinquished property) on the outstanding balance. Pursuant to the exchange agreement, Crown purchased and then conveyed nine parcels of like-kind property and assigned one contract to purchase like-kind property. Two other parcels were conveyed by Crown to Mr. Starker's daughter and the court found there is no like-kind exchange since Mr. Starker never acquired an interest in those properties.

In holding that simultaneity was not required under Sec. 1031, the court rejected the government's argument that Reg. 1.1002-1(b) requires a narrow construction of Section 1031. Additionally, the possibility that Mr. Starker could ultimately receive cash did not violate Sec. 1031. The court expressly found that the contract right to assume the rights of ownership is no different than the ownership right itself, even though the actual ownership might occur years in the future and even though the taxpayer could ultimately receive cash. The present exchange of property for the promise to receive like-kind property in the future constituted a valid "deferred" exchange under Sec. 1031.

The 6% growth factor was considered disguised interest since it applied without regard to the actual fate of the timber on the property. A growth factor based on the actual value of the timber in which the risk of loss remained with Mr. Starker may have passed muster under the court's analysis since under local law, timber was considered real property. The proper period of inclusion for the nonqualifying property (the property deeded directly to Mr. Starker's daughter) was in the year the contract was made. The disguised interest was taxable -- presumably under Sec. 1031(b) as boot-- when it was actually or constructively received.


Section 1031(a)(3)

In light of the administrative nightmare caused by Starker , and the potential for abuse of the tax system through the use of the deferred exchange, Congress decided to restrict the time limitations in which a deferred exchange could occur and in the process, codified the deferred exchange concept.

Section 1031(a)(3) appears relatively straight forward; there is a two-prong test to determine whether property is not like-kind:

For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if--

(A) such property is not identified as property to be received in the exchange on or before the day which is 45 days (The original version of Sec. 1031(a)(3) contained a technical error which only allowed a 44 day period. The Tax Reform Act of 1986, P.L. 99-514 Sec. 1805(d) amended the section by striking out "before the day" and inserting in lieu thereof "on or before the day") after the date on on which the taxpayer transfers the property relinquished in the exchange, or

(B) such property is received after the earlier of--

(i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or

(ii) the due date (determined with regard to extension) for the transferor's return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.

The section applies to transfers after the date of enactment, July 18, 1984. Property received after December 31, 1986 would not be like-kind unless the property was designated in a binding contract before June 14, 1984 as is received on or before December 31, 1988. If property was transferred and treated as a like-kind exchange prior to the date of enactment, and if the taxpayer would be liable for tax under Section 1031(a)(3), then the period for assessing a deficiency would expire on (1) January 1, 1988 for property received after December 31, 1986 or (2) January 1, 1990 for property designated in a binding contract before June 14, 1984.

Sec. 1031(a)(3) is phrased in the negative: if either the 45 day identification period under Sec. 1031(a)(3)(A) ("identification period") or the replacement period under Sec. 1031(a)(3)(B) ("replacement period") are not met, then the replacement property will not be considered like-kind. Both time limits run concurrently, commencing with the time the taxpayer relinquishes his property.

This negative phrasing suggests that even if the taxpayer meets both prongs, the exchange will not automatically qualify under subsection (a)(1) for nonrecognition of gain. Although this section is not, technically speaking, a safe harbor-- it describes what exchanges will not qualify under Sec. 1031(a) -- the purpose of the section was to place time limits on deferred exchanges in response to Starker rather than to question the validity of deferred exchanges as a Sec. 1031(a) transaction. Congress did not challenge the Starker court's decision that deferred exchanges qualify under Sec. 1031(a)(1): "Present law does not require specifically that a like-kind exchange be completed with a specified period in order to qualify for tax-free treatment," citing Starker. S. Rep. No. 169 (Vol. 1), 98th Cong., 2nd Sess. 243 (1984). The focus was on the time limitations for completion of the exchange. Also, Sec. 453(f)(6)(C) enacted in 1982 considers receipt of like-kind property as payment under the installment sales rules which is evidence of legislative consent to deferred exchanges.

The section also looks forward in time: it only applies when the property is relinquished before the replacement property is received. Therefore, the section would not apply to a determination whether replacement property received prior to the time the taxpayer relinquishes his or her own property could qualify as a like-kind exchange. A transaction where the replacement property is received prior to the relinquishment of the taxpayer's property has been referred to as a "reverse Starker" and is discussed, infra.

The replacement period requirement contains two potential traps: It uses 180 days rather than 6 months which will require careful counting by the taxpayer to determine the actual date for completion. Also, the limitation of the due date of the return will mean that calendar year taxpayers relinquishing property after October 17 (October 18 if the ensuing year is a leap year) must complete the transaction prior to April 15 of the ensuing year or must file for an extension.

The time limits imposed by the section are absolutes, there is no provision for extensions of time. Given the litany of difficulties that could confront the taxpayer in any given exchange transaction: loan approvals, inspections, licenses, permits, off-set statements, pay-off figures from lien holders and the diligence and competence of the purchaser and other parties involved, the time limits place the taxpayer at the mercy of factors he cannot control. The time limitations may provide the opposing party leverage to renegotiate a better deal and could cause the taxpayer to accept a transaction on less than favorable terms, in order to comply with the stringent time restrictions.

By placing the deferred exchange requirements under Sec. 1031 subsection (a), if a transaction qualifies as a deferred exchange, the rules and case law regarding like-kind exchanges will apply, including the expansive determination of what is like-kind property under the regulations. Reg. 1.1031(a)-1(b) and (c) permit exchanges of any real property for any other real property, a new truck for a used truck, a fee simple interest in property for a 30 lease in property, a life interest in property for a remainder interest in property and vice-versa.

The line of pro taxpayer court decisions involving three and four party simultaneous exchanges, and the use of escrows and intermediaries to accomplish an exchange. Also, if the deferred exchange fails, the taxpayer should still be entitled to installment sales treatment when the proceeds or nonlike-kind property are received. Practitioners should not overlook the potential for planning under Sec. 453 if the exchange fails.


The Legislative History

The Starker decision posed tremendous problems for the Treasury. Mr. Starker could have received either cash or property for a five year period after he relinquished his property. A proper time limit in which to complete the deferred exchange was both reasonable and fiscally prudent. The purpose of the Tax Reform Act of 1984 was to try and squeeze additional revenue out of the system to counter the massive federal deficit. In light of the budgetary problems, Congress determined the Starker "loophole" was an appropriate target. Although 180 days is much shorter than the 5 years available to Mr. Starker . By placing the date on which the taxpayer receives the replacement property at no later than the due date of the return, the Treasury would not have an open transaction accounting problem.

Both the Senate amendment and House bill provided a 180 day period (or the time in which the tax return was due), but the Senate added an additional requirement: The replacement property had to be identified at the time the taxpayer's property was relinquished. Sec. 77; H.R.2163, Sec 61. See generally H.R. Rep No. 98-432, Pt.2 at 1231-1234 and S. Rep. No 98-169 at 241-244 . In order to resolve the difference between the House bill and Senate Amendment, the Conference agreement stated that the replacement property must be "identified" no later than 45 days after the taxpayer relinquished his or her property. Act Sec 77 amending Sec. 1031; H.R. Rep. No. 98-861 at 865-867-- the conference agreement.

The addition of the identification requirement in order to forge a compromise in the legislation has caused an unnecessary and dangerous pitfall for unwary taxpayers. There is no discussion on how to "identify" the property and whether such designation must be in writing. The Conference agreement, which says that the requirement "may be met by designating the property to be received in the contract between the parties," merely states the obvious. Many exchanges do not involve a contract between the parties but arise from additions or amendments to escrow instructions which supersede the original contract. By stating that the designation may be met in such a fashion, other designation methods are not precluded.

The Conference committee then says it anticipates that the identification requirement will be met by designating a limited number of properties that may be transferred provided the particular property selected is determined by contingencies beyond the taxpayer's control. While this statement adds flexibility to the identification requirement -- taxpayers may devise all types of contingencies beyond their control and thus have a series of properties designated by the 45 day deadline -- the example used by the Conference agreement is troubling.

The Conference agreement states that if Property 1 will be transferred if zoning changes are approved and Property 2 if they are not, the exchange would qualify for like-kind treatment. Generally, the approval process for zoning changes is anything but swift and predictable. Given the tight deadlines under Sec. 1031(a)(3), a property undergoing a change of zone application should be an extremely poor candidate for a deferred exchange. Moreover, zoning approval might be within the taxpayers control except the cost of meeting the conditions for approval could be economically prohibitive.

The example does not state when the approval is to be given or what happens if the zoning approval has not been received by the time necessary to purchase and close on Property 2? Assuming a replacement period of 180 days, if the zoning approval is given on the 179th day, must the taxpayer close on the next day? What if on the 60th day the taxpayer determines that zoning will not be approved and switches to Property 2, and thereafter zoning is approved within the 180 day limit?

There is no requirement that the identification must be made in writing, but cautious taxpayers should make a written designation to document their compliance. The party to whom the identification should be made is by no means obvious. While it might be the transferee of the relinquished property, in many complicated exchanges involving several parties, properties and alternative designations, the determination of the proper party to inform could be difficult.

The Conference report sidestepped the difficult issues involving deferred exchanges and the use of escrows, trusts and intermediaries to facilitate the exchange. But it stated that the taxpayer could not receive cash then later purchase the designated property: "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 treatment." This statement can be read to endorse the use of an intermediary in order to prevent the taxpayer from receiving the cash, but it is also clear that the taxpayer is prohibited from actually or constructively receiving the cash.

Has the deferred exchange transaction been relegated to fixing busted simultaneous exchanges?

The identification requirement combined with the legislative example of designating the replacement property in a contract between the parties could suggest that the deferred exchange has been relegated to merely providing a safety net to a multi-party simultaneous transactions under Sec. 1031(a)(1). Usually the replacement property is known either at the outset or is designated during the escrow period and is part of the overall transaction, so the identification requirement is easily met. While Sec. 1031(a)(3) could facilitate the multiple party transaction which is unable to close simultaneously, provided the taxpayer whose exchange is delayed is willing to risk the possibility that the exchange may not be completed by the replacement period, the statute has a broader reach and allows for a true Starker exchange, albeit in shorter time periods.

Extending the time limits under Sec. 1031(a)(3)

Since the clock does not begin to run until the property is relinquished, taxpayers could delay the transfer of the property until a replacement property can be designated and acquired. Such a delay would require the cooperation of the transferee, absent a contractual clause allowing the taxpayer to delay closing for a period. The focus is when the taxpayer relinquishes the property, not when the transaction is closed, although these usually occur simultaneously.

Shortening the time for receiving the replacement property.

In order to beat the deadline of Sec. 1031(a)(3)(B,) the taxpayer might arrange to receive the replacement property prior to the close of the transaction. Merely depositing a deed (or the appropriate title document for personal property) for the replacement property in escrow upon signing of the purchase agreement is not enough since taxpayer's actual receipt is still subject to all the contingencies of the transaction and under common law, the delivery of the deed to the taxpayer is necessary. The delivery of a deed presently transferring the replacement property, subject to a defeasance clause, should be considered as a present transfer, subject to a condition subsequent. Herbert J. Investment Corp. 500 F2d 44 (CA 7, 1974) A sale is completed for tax purposes, despite a future contingency, if the parties intend a sale to occur. Note: Use of a defeasance mechanism causes the exchange to be completed, but could also trigger a taxable sale shortly thereafter if the event causing defeasance occurs. The taxpayer could be adversely affected if the sale occurs in a year the taxpayer is in a higher tax bracket.

This arrangement would protect the owner of the replacement property if the transaction did not close. Also, since receipt of title is not necessary in order to have a valid Sec. 1031(a) exchange. Reg. 1.1031(a)-1(c)(2) allows the exchange of a leasehold with 30 years remaining or more for a fee interest; Starkerpermitted the exchange of a fee interest for an equitable interest in a land contract. The use of long-term leases and installment sales contracts might be used to transfer the replacement property and complete the exchange prior to the replacement period deadline.

Use of alternative designated properties.

When possible, the taxpayer should designate a back-up property in case the transfer of the first replacement property cannot be accomplished. While this technique will not lengthen the 45 day identification period for the primary or alternative properties or cause the completion of the transaction within the replacement period deadline, it will permit the taxpayer to complete the exchange with one of several properties, provided completion can occur within the replacement period deadline.

The Mortgage Boot Issue

Prior to Sec. 1031(a)(3), there was an argument that in a deferred exchange, if the Seller transferred property subject to liabilities, the relief of those liabilities caused the immediate recognition of boot under Sec. 1031(b). With the enactment of Section 1031(a)(3), the mortgage boot issue has been resolved since the replacement property must be received no later than the due date of the tax return for the year the property was transferred. Therefore, the transaction will be closed within one taxable year and the boot netting rules under Section 1031(b) can be applied without any detriment to the taxpayer or the Treasury.

Section 483 and Section 1272 and 1273

Under prior law, a deferred exchange where the promise to transfer property or the receipt of money in lieu of property could occur over 1 year in the future may have triggered the unstated interest rules of Section 483 on the deferred payments. Depending on how the exchange was structured and whether the exchange taxpayer received a debt instrument, the original discount rules of Sec. 1272 and Sec. 1273, or the Sec. 1274 rules for certain debt instruments issued for property may have applied as well. Sec. 1031(a)(3) will prevent the operation of this provision since the replacement property must be received not later than 180 days after the taxpayer's property was relinquished.


The Unresolved Issues

Use of Security Arrangements to Insure the receipt of replacement property.

From the taxpayer's perspective, the main difficulty with applying the Starker case was its unusual set of facts. Mr. Starker exchanged unencumbered property with a solvent, publicly traded corporation which made an unsecured promise to purchase and transfer property at Mr. Starker's direction over a five year period. This situation is so unique that it is almost impossible to structure a transaction to fit within it; a prudent taxpayer would not transfer property to an unknown person or entity in return for an unsecured promise to receive property in the future.

The Installment Sales Provisions Regarding Security.

The transferor will invariably want security for the transferee's promise to cooperate with the exchange. Under the installment sales provisions of Sec. 453, a third party guarantee or a bank's standby letter of credit is permitted to secure an installment obligation. Reg. 15a.453-1(b)(3) The pledge of a certificate of deposit as security might also work. Although Reg. 15a.453-1(b)(3) of the installment sales regulations holds to the contrary, there is nothing in the legislative history to support the regulation and the Tax Court in Porterfield 73 TC 91 (1979)held that a pledge of certificates of deposit placed in an escrow account was proper security for a purchaser's installment note.

But if the transferee gives a mortgage (or a security interest if the property being exchanged is personal property) for the performance of his obligation to cooperate with a deferred exchange, problems could arise. If the mortgage secures a promissory note or an unconditional obligation to pay money and is placed on the relinquished property, it might be construed as seller carryback financing which would constitute boot under Sec. 1031 (b). A mortgage, even if it only secures the performance of the purchaser rather than a dollar amount, could violate restrictions contained in liens or mortgages which are senior in position. Also, the taxpayer, if forced to foreclose, could be in the unenviable position of proceeding against the transferred property in order to recover it without ever receiving payment or exchange property.

Impounding Transferee's Funds.

If the taxpayer impounds the funds used to purchase the replacement property, he should be in a much stronger position to receive either the replacement property, or the cash equivalent if purchaser fails to obtain the replacement property. When the transferee's funds are impounded in an exchange, in recent cases the courts have generally made two, separate inquiries: (1) Whether there is interdependency between the taxpayer's transfer property and the replacement property (which must be like-kind property) such that the entire transaction is part of a Sec. 1031 exchange; and (2) whether the taxpayer actually or constructively received the proceeds from the transferred property and merely purchased the replacement property. In order to qualify for Sec. 1031, the taxpayer must transfer his property and receive like-kind replacement property as one, interdependent transaction rather than as two separate transactions, and must not have actually or constructively received the proceeds used to acquire the replacement property in the process.


Interdependency

Since the intent to have an exchange is a prerequisite to finding that an exchange occurred, the doctrine of contractual interdependence has been developed to analyze whether the requisite intent was present. Barker, 74 TC 555,566 (1980) wherein the court stated:

We emphasize the contractual interdependence of the transfers, not because contractual interdependence is required in a multi-party exchange, but because it highlights the exchange character of this transaction. Contractual interdependence also helps bolster a taxpayer's case when, as here, there is something in one of the agreements inconsistent with exchange treatment.

But contractual interdependence is not an absolute necessity to finding that an exchange has occurred. In cases where contractual interdependence has not been found, the courts have used the "step-transaction", Minnesota Tea Co. v Helvering, 302 U.S. 609 (1938); Redwing Carriers, Inc. v Tomlinson, 399 F.2d 652 (5th Cir, 1968)wherein the court noted: "An integrated transaction may not be separated into its components for the purposes of taxation by either the Internal Revenue Service or the taxpayer." to determine whether an "integrated plan" for an exchange was present by analyzing all the steps in the transaction.

In Anderson, T.C. Memo 1985-205, the taxpayer sold one parcel of property and the proceeds were placed in escrow. The taxpayer then purchased another property which was like-kind and had the escrow proceeds distributed to the second property. The Tax Court held that although the two parcels were like-kind, there was no exchange because of a lack of interdependence even though the taxpayer could have structured a proper Sec. 1031 exchange under the facts.

In Biggs, 632 F.2d 1171 (5th Cir, 1980) the court found for the taxpayer in a multi-party, simultaneous exchange although there was not contractual interdependence in the technical sense. The court utilized the step-transaction doctrine to determine that the many transactions leading to the ultimate transfers of the taxpayer's property and the replacement property to him "were part of a single, integrated plan, the substantive result of which was a like-kind exchange. Biggs at 1178.

The court affirmed the Tax Court's finding that all transactions were interdependent and culminated in a exchange rather than a sale and purchase of a separate property. Contractual interdependence, either in the technical sense or under the step-transaction analysis, is necessary to establish the requisite intent for an exchange in the multi-party situation.


Who Must Transfer the Replacement Property to the Taxpayer?

The government has argued that the transferee of the taxpayer's property must obtain legal title to the replacement property and exchange it with the taxpayer in order to satisfy Sec. 1031. In Biggs the court rejected the service's argument based on Carlton, 385 F.2d 238 (5th Cir, 1980) that the purchaser must have legal title to the replacement property. In Carlton the court found the taxpayer's receipt of cash, along with the additional facts that the purchaser never acquired legal title to the replacement property and was not obligated on the notes or mortgages in the transaction, was enough to deny exchange treatment.

The court found that the most significant factor in Carlton was the taxpayer's receipt of cash, whereas in the Biggs case, the properties were exchanged simultaneously and the cash received by taxpayer at the closing was "boot" under Sec. 1031(b). The court found the transferee incurred contractual liability by covenanting to pay the promissory note secured by the replacement property, even though the liability was for a short period of time. The court noted that in W.D. Hayden Co., 165 F.2d 588 (5th Cir, 1948) the purchaser never held title to the exchange property, but the fact that he contracted for the exchange property was sufficient involvement to find that an exchange had occurred. As further support for its position that the purchaser need not acquire legal title as a prerequisite to finding that an exchange occurred, the court agreed with Starker and stated Starker was consistent with its analysis of the title issue. In Starker, a land contract was considered like-kind replacement property to a fee simple interest in the property relinquished by Mr. Starker.

While the courts have rejected the Service's argument that legal title by the taxpayer's transferee in the replacement property is a necessary prerequisite for an exchange, the courts have found some legally binding involvement by the transferee in the replacement property. This suggests that a transferee cannot just transfer the proceeds to a third party and have the third party locate and exchange the replacement property with the taxpayer without further involvement. Recent cases, however, have not addressed the issue of the tranferee's participation in the exchange, instead the focus has been on the taxpayer and the issues of contractual interdependency and constructive receipt. Joyce M. Allen, 43 TC Memo 1982-188 (lack of interdependence was deciding factor, seller's lack of participation in exchanged property was not addressed); Garcia, 80 TC 491 (1983) determination that Sec. 1031 applied was based on interdependence and lack of constructive receipt, rather than transferee's participation in, or liability for, the replacement property).

Courts have sanctioned the use of intermediaries and accommodating parties in Sec. 1031 exchanges. In Alderson v. Commissioner, 317 F.2d 790 (9th Cir, 1963) the court stated that using a third party who acquired title to property solely for the purpose of accommodating taxpayers in an exchange was permissible:

One need not assume the benefits and burdens of ownership in property before exchanging it but may properly acquire title solely for the purpose of exchange and accept title and transfer it in exchange for other like property....[317 F.2d at 795]; (Emphasis in original).


Constructive Receipt

The doctrine of constructive receipt involves funds which are credited to the taxpayer's account or set apart for the taxpayer so that the funds could be drawn by the taxpayer if notice of intention had been given, provided the receipt of funds is not subject to substantial limitations or restrictions, Regulation 1.451-2; United States v Hancock Bank, 400 F. 2d. 975,979 (5th Cir, 1968) where the court said:

It is now well settled that income which is subject to a taxpayer's unfettered command and which he is free to enjoy at his own option is taxed to him as his income whether he sees fit to enjoy it or not."

When funds are impounded there is usually an agency relationship between the party holding the funds and the taxpayer, so the crucial factor is whether the withdrawal of funds by the taxpayer is subject to a substantial limitation or restriction. Obviously, funds left in an escrow account without reference to an exchange and which are without any restriction as to the taxpayer's receipt would constitute constructive receipt.

The Service in Revenue Ruling 79-91 took the position that a restriction which could be met by the mere passage of time did not amount to a substantial restriction. But the court in Reed, 723 F2d 138 (1st Cir, 1983) implicitly rejected Revenue Ruling 79-91 when it held that a deferred escrow agreement in which the only restriction was passage of time, and where the seller could not assign the right to receive the proceeds and did not earn any interest on the proceeds in escrow, successfully shifted receipt of payment to the ensuing year. In a sales transaction where an escrow is used to defer payment and where the seller is also entitled to the interest or earnings generated during the period of the escrow, courts have found there was no substantial restriction involved to prevent constructive receipt under an economic benefit theory, Pozzi, 49 TC 119 (1967); Oden, 56 TC 569 (1971).

Unlike the deferred escrow arrangement for sales discussed above, under the statutory scheme of Sec. 1031, receipt of interest by the taxpayer on impounded funds should be considered the receipt of boot under Sec. 1031(b). The doctrine of constructive receipt should not be applied to treat the taxpayer as the owner of the impounded proceeds since Sec. 1031 provides expressly for the receipt and taxation of property which is not like-kind. Therefore, Sec. 1031 is distinguishable from the deferred sales cases which have applied the economic benefit theory to find constructive receipt. Also, the court in Starker found the "disguised" interest was taxable when received, presumably as boot. But cautious taxpayers will avoid the issue by allowing the purchaser or the intermediary to earn the interest during the time the funds are impounded.

In a Sec 1031 case involving the issue of substantial restrictions in the context of constructive receipt, the Garcia court rejected the Service's contention that funds deposited into an escrow and then transferred to taxpayer's account in another escrow for purposes of completing an exchange were constructively received by the taxpayers. The court noted there were substantial limitations (other than the mere passage of time) which prevented the taxpayers from controlling the deposited funds.


Use of a Trust

The use of a trust in deferred exchanges has been the subject of much debate ever since the Service in PLR 7938087 (June, 1979), issued just prior to the Starker decision permitted the use of a trust. Although Letter Rulings do not have precedential value and although this ruling was later suspended in PLR 8005049 issued (November, 1979) and revoked in PLR 8046122 (August, 1980), the term "Starker trust" has crept into the real estate lexicon. Use of a Starker Trust was discussed in an article entitled "How use of a trust enhances the Section 1031 nonsimultaneous real estate exchange" by Anna C. Fowler and Robert W. Wyndelts, Journal of Taxation, July, 1980 issue, at page 22.

Even though the Service revoked PLR 7938087, recent case law suggests that use of a trust may be permissible. The error in PLR 7938987 was the failure to address the constructive receipt issue, rather than the use of a trust. The Ruling provided that the beneficiary -- who was the taxpayer desiring like-kind replacement property-- could have received the trust res consisting of cash at the beneficiary's unfettered discretion. It has been erroneously assumed that the fiduciary relationship between the trustee and the beneficiary was enough to trigger the constructive receipt doctrine. This, of course, is not true or trusts would not be taxed as a separate entity: it is the terms of the trust which control at what time and under what conditions the beneficiary will receive the funds. Use of grantor trusts or revocable trusts, however, could cause the constructive receipt doctrine to apply.

If, however, the beneficiary's right to withdraw trust funds is subject to substantial restrictions and limitations, then the trust vehicle, if property drafted, should be able to serve the purpose of impounding the seller's funds without the beneficiary constructively receiving them.

Support for this position is found in the Garcia case which involved an escrow. An escrow is an arrangement in which the escrow holder is under a fiduciary duty much like a trustee in a trust. In Garcia, the escrow documents had substantial limitations which prevented the taxpayer from constructively receiving the replacement property proceeds; the same result should occur when the trust document prevents constructive receipt of the proceeds. Where there is a deferred exchange, a trust arrangement could be preferable to use of an escrow since the trustee has substantial obligations: to locate, acquire and transfer like-kind property within the statute's time limitations, or to disburse the proceeds if the exchange cannot be accomplished; in contrast, an escrow holder's obligation is usually limited to paying proceeds to the proper party pursuant to instructions.


Will a Reverse Starker work?

A reverse Starker is a transaction in which the like-kind replacement property is acquired first, then the taxpayer relinquishes his or her property and directs the transferee to pay the purchase proceeds to the seller of the replacement property. The advantage of the reverse Starker is that the stringent time limitations and requirements of Sec. 1031(a)(3) will not apply to this variation of the nonsimultaneous like-kind exchange.

Sec. 1031(a)(3) is phrased in the negative and is forward looking; therefore, its requirements do not apply to the reverse Starker transaction. The legislative history did not address the reverse Starker issue since the purpose of Sec. 1031(a)(3) was to limit the time in which the replacement property was acquired, not the time in which the taxpayer's property was relinquished.

If Congress wanted to establish a time frame in which both the relinquishment of taxpayer's property and the receipt of replacement property must occur, it could have amended Sec. 1031 along the lines of Sec. 1034 (the roll-over of a principal residence) which says that the replacement residence must be acquired within two years of the sale of the principal residence. By phrasing Sec. 1031(a)(3) in the negative, Congress only stated what would not qualify as like-kind property; therefore, the reverse Starker transaction is not prohibited by the statute.

In Lee, T.C. Memo 1985-294 (1986), Mr. and Mrs. Lee, tax protesters appearing pro se, purchased a farm in the State of Washington in November, 1977. In June, 1978, 7 months later, the taxpayers sold property they owned in Hawaii and had the proceeds transferred directly to the owners of the Washington farm. The taxpayers claimed nonrecognition under Sec. 1031. Although the transaction constituted a reverse Starker, neither the Service nor the court addressed the issue. The court denied the taxpayers like-kind treatment because of the lack of interdependence, stating: "...the escrow agreement and sales contract executed upon the purchase of the Washington farm...make no reference to the transfer or transferees of the Hawaii property. The purchase of the Washington farm occurred more than 7 months before the sale of the Hawaii property and petitioners have failed to show that the sale of the Hawaii property was even contemplated at the time of the purchase of the Washington farm.

The concern of the court was the failure of proof showing interdependency, not the fact that the transaction, if properly interdependent, would amount to an unprecedented reverse Starker. Since the court did not address the reverse Starker issue, at most, the decision should be considered an implied endorsement of the concept. But the Lee decision, coupled with the language of Sec. 1031(a)(3), strongly indicate that a reverse Starker may be a permissible transaction under the current, liberal court interpretations of Sec. 1031.

Moreover, the reverse Starker does not present the Service with the accounting problems associated with the Sec. 1031(a)(3) type of deferred exchange since the taxable event both arises, and is completed, when the taxpayer relinquishes the like-kind property. Therefore, from a policy standpoint as well as from the purpose behind Sec. 1031(a)(3), a reverse Starker is distinguishable from the Starker deferred exchange.


Deferred exchanges and the Tax Reform Act of 1986

Although the only change to Sec. 1031(a)(3) under the Tax Reform Act of 1986 was the technical correction to Sec. 1031(a)(3)(A) (extending it from 44 days to 45 days), exchanges, including deferred exchanges, should become more pervasive under the new law. In addition to being one of the only tax planning provisions left in the code, Sec. 1031 has a history of favorable taxpayer decisions. With the change in capital gains rates, the cost of selling verses exchanging property will heavily favor the exchange route. Starting in 1988 the maximum rate on capital gains will be the same as for ordinary income, 33%. The 33% figure will apply through the combination of a 28% federal tax rate plus the elimination of the preferential 15% bracket and the dependency exemptions at the rate of 5% for taxpayers between certain income levels. Also, loss of the capital gains deduction will exacerbate the tax problem for those taxpayers in states which follow the federal tax code for deductions, if those states fail to adjust their rate brackets downward to compensate for the elimination of deductions. Moreover, the advantages of selling property and using the installment sales provisions to defer gain have been greatly curtailed under new Sec. 453C.

Additionally, the extension of depreciation schedules, especially for real estate, has eliminated the lure of the "sale and basis step-up" technique which became popular in 1981 under the Equity and Recovery Act. Since an exchange uses a carry-over basis, taxpayers in need of a passive income generator may exchange low basis, low income property for like-kind property which produces higher income. For example, the exchange of low basis raw land for rental income property could be beneficial to the taxpayer with excess passive losses from tax shelters, in order to offset passive losses under Sec. 469. Finally, postponing the taxation of property through a Sec. 1031 exchange could defer the tax until a more favorable capital gains rate differential is reinstated. The capital gains provisions were left in the code so that they could be reactivated in case Congress raised the top income tax bracket, or until the taxpayer dies. The beneficiaries will receive a stepped-up basis in the property under Sec. 1014 which could eliminate the capital gains tax entirely.


Conclusion

While taxpayers must now identify property and complete the exchange within strict time limitations, the principles embodied in the Starker decision are far from moribund. Once the identification requirement is met, the creative use of purchase contracts, a technique sanctioned by Starker, can permit compliance with the replacement period even though title is transferred at a later date. Since the receipt of interest in Starkerdid not amount to constructive receipt of the exchange proceeds, the Pozzi and Oden line of cases applying the constructive receipt doctrine to situations involving escrows to defer payment in purchase and sale transactions, are distinguishable. And most importantly, Congress has sanctioned the deferred exchange by enacting Sec. 1031(a)(3).

In its effort to reduce the reach of Starker, Congress enacted a statute which limits the time in which a deferred exchange may occur; introduced a needlessly complicated "identification" provision in the law; failed to address the difficult and important issues involving the impounding of funds and constructive receipt and left the door open for the reverse Starker transaction. Sec. 1031(a)(3) could be improved immeasurably if the section was changed to allow the taxpayer to receive cash, provided there was a reinvestment in like-kind property within 6 months (or the due date of the return, including extensions, whichever occurs first). This would change a formalistic requirement into a rational, workable statute similar to Sec. 1034 and would eliminate the horrendous complications of multi-party transactions, double escrows, constructive receipt issues and the endless technical attacks launched by the Service regarding those issues which currently interfere with the operation of Sec. 1031.



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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.