By Albert Rush
Senior Vice President - National Counsel
First American Title Insurance Company
Santa Ana, California

1. Why Do a 1031 Exchange?
Here are some pros and cons:
Pro: Defer Payment of Taxes-Indefinitely-Without Penalty or Interest.
By doing a 1031 exchange, a taxpayer may dispose of "property held for productive use in a trade or business or for investment" (which we'll call "income or investment property"), and acquire replacement income or investment property, without recognition of capital gain in calculating the taxpayer's income tax. By avoiding recognition of capital gain, the taxpayer defers payment of income taxes, indefinitely at the taxpayer's discretion, without any penalty or interest coming due to the IRS or state tax authorities.

Pro: Leverage.
By deferring payment of taxes, the taxpayer has additional funds currently available for investment. The effect of this on a taxpayer's investment choices should be obvious, and will be discussed later.

Pro: Make Government an Investment Partner.
Really just a restatement of the first two points, but some folks think this says it best. By deferring payment of taxes, the taxpayer has use of "the government's money" to pursue personal income or investment goals.

Pro: Taxes Avoided by Death.
They say you can't take it with you, but here's how taxes deferred now can become taxes avoided forever. Under Internal Revenue Code § 1014, upon death all property in the decedent's estate is entitled to a stepped-up basis for purpose of calculating the heirs' capital gain upon a subsequent sale. Under this rule, property is valued as of the date of the decedent's death for purposes of determining its "basis," without regard to when the property was originally acquired or its original basis. This allows an heir to avoid tax liability for all capital gains during a decedent's lifetime. While in some cases the benefits of this rule may be lessened by federal estate taxes or state inheritance taxes, potential for "stepped-up basis" is an important factor to be considered in anyone's estate planning.

In sum, the 1031 exchange is an attractive vehicle for deferment of taxes, maximization of income, and accumulation of assets and wealth. This vehicle permits deferment of taxes until a later time, such as retirement, when the taxpayer may be subject to lower tax rates, or after death, when taxes may be avoided by the "stepped-up basis" rule.

So, what are the cons?

Con: Need Tax Advisor.
Each taxpayer's decision to do, or not to do, a 1031 exchange must be made in the context of his or her investment goals and overall estate plan. This decision begins with consideration of the taxpayer's current tax liabilities and potential capital gain upon sale of given property. Likewise, the decision must be made in light of the availability of suitable replacement property. Since these decisions may be complicated, and require technical or legal or accounting expertise, taxpayers are cautioned against attempting a 1031 exchange without the guidance of a knowledgeable tax advisor, such as a tax attorney or certified public accountant.

Con: Must Follow Rules and Regulations, and Meet Deadlines.
Current 1031 exchange practices have evolved from federal statutes and court decisions, culminating in Regulations issued by the IRS. These Regulations were written to strike a balance between the competing interests of taxpayer and tax collector, by establishing procedures, deadlines and protocols which, if observed, will cause the taxpayer's transactions to enjoy "nonrecognition" or tax-deferred status with the IRS.

Con: May be Increased Costs of Transaction.
As explained below, the taxpayer's observance of IRS Regulations in connection with the 1031 exchange will involve additional transaction costs. In addition to a tax advisor, the taxpayer will need to retain an intermediary, an exchange escrow holder or trustee and, in many cases, an appraiser. If a reverse exchange is done, the taxpayer will also need to arrange for the services of an exchange accommodation titleholder.

2. Taxes on Capital Gains
Motivation for doing a 1031 exchange is supplied by capital gains tax liability. The following graphs illustrate how a hypothetical taxpayer's capital gains tax might be calculated.

In this first example, our taxpayer acquired property 15 years ago for $800,000, making a down payment of $240,000 ("equity") and giving a purchase money mortgage for $560,000 ("debt"). Today, the property is being sold for $2,000,000. Mortgage payments have reduced the loan balance to $500,000. The taxpayer expects to receive $1,500,000 in cash from the sale. In calculating his (or her) capital gain, we will assume the taxpayer has made no capital improvements during ownership and, therefore, the tax "basis" will be the acquisition price ($800,000). Subtracting $800,000 from the sale price of $2,000,000 yields a capital gain of $1,200,000. This capital gain is multiplied by the maximum federal capital gains tax rate of 15% to arrive at a tax due of $180,000.

Since the taxpayer expects to receive $1,500,000 in cash from the sale, his net sale proceeds (after payment of taxes) total $1,320,000.

Remember, this is a calculation of federal tax only. In many states additional taxes would be due to state authorities.

In our second example, the facts remain the same except the taxpayer has refinanced during his ownership, so that at the time of sale the mortgage loan balance is $1,700,000 (an 85% loan-to-value ratio). Now the taxpayer expects to receive $300,000 in cash from the sale.

The capital gain and tax calculations remain the same, but because the taxpayer has much less equity his net sale proceeds (after payment if the tax due) total $120,000.

In this third example, the facts remain the same except that during his 15 years' ownership the taxpayer has both refinanced and claimed tax deductions totaling $260,000 for depreciation in value of improvements. The capital gain tax calculation remains the same, but now the taxpayer is also assessed for depreciation recapture at the rate of 25%, so the tax due is $245,000. Since the taxpayer expects to receive only $300,000 in cash from the sale, he will receive $55,000 after payment of the federal tax due.

3. Internal Revenue Code Section 1031
Internal Revenue Code § 1031 (26 U.S.C. section 1031) traces its origins to the 1920's. The essential language of § 1031, as amended, is as follows:

§1031. Exchange of property held for productive use or investment

(a) Nonrecognition of gain or loss from exchanges solely in kind -

(1) In general, - No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Now let's examine this language phrase-by-phrase.

The key concept here is "nonrecognition." Let's revisit our hypothetical to see how nonrecognition benefits the taxpayer.

Here, the taxpayer's net sale proceeds (after payment of taxes due) totaled $1,320,000. If these proceeds are reinvested as a 30% down payment on replacement property, the replacement property value will be about $4,400,000. If, on the other hand, the taxpayer defers payment of tax (through nonrecognition) he has an exchange value of $1,500,000 (net sale proceeds of $1,320,000 plus deferred tax of $180,000) to reinvest in replacement property. If $1,500,000 is reinvested as a 30% down payment, the replacement property value will be $5,000,000.

This is called "Leverage." This is good.

Now recall the second example. Because of refinancing the taxpayer expects net sale proceeds of $120,000. If these proceeds are reinvested as a 30% down payment the replacement property value will be $400,000.

If the taxpayer defers payment of taxes, he will have an exchange value of $300,000 (net sale proceeds of $120,000 plus deferred tax of $180,000) to reinvest. If the exchange value of $300,000 is reinvested as a 30% down payment, the replacement property value will be $1,000,000.

In this example, nonrecognition allows the taxpayer to acquire an apartment building, instead of a duplex.

Our third example was the taxpayer having both refinanced and taken deductions for depreciation. After payment of taxes, he has $55,000 to reinvest.

If he defers payment of taxes he will have an exchange value of $300,000 (which was the amount of his equity in the property being sold for $2,000,000). If this exchange value is reinvested as a 30% down payment, the replacement property value will be $1,000,000.

For this taxpayer, the benefits of nonrecognition are most dramatic: He is still a player.

This phrase tells us that only property with certain characteristics, which we have called "income or investment property," will qualify for nonrecognition treatment under § 1031.

For example, an exchange of the taxpayer's personal residence doesn't qualify for nonrecognition treatment. (See, however, Internal Revenue Code § 121, "Exclusion of gain from sale of principal residence.")

A taxpayer's "stock in trade or other property held primarily for sale" doesn't qualify for nonrecognition treatment. (See 26 United States Code § 1031(a)(2)(A).)

This exception to nonrecognition treatment may be, at least for some taxpayers, difficult to interpret.

For example, a taxpayer owning ten acres of raw land may assume that his property will qualify for nonrecognition treatment as "held for investment." But if the taxpayer subdivides the land into 20 lots, to increase its value, does the land then become "stock in trade" or "held primarily for sale," so as to bring it within this exception making it unqualified for nonrecognition treatment? The answer may depend on other factors, such as whether the taxpayer has actively marketed or sold any subdivided lots before doing an exchange with unsold lots.

Taxpayers may be comforted to know that the IRS has not been overly aggressive in using this exception to disqualify exchanges involving land which has been subdivided or improved by the taxpayer prior to an exchange. The exception most clearly applies to developers seeking to exchange unsold inventory of homes or condominium units, but in less obvious cases where this exception might conceivably apply the taxpayer should proceed only with the assistance of a qualified tax advisor.

For further discussion of this exception, see Long and Foster, Tax-Free Exchanges Under § 1031, published by Clark-Boardman-Callaghan (Customer Service: 1-800-328-4880), 2001, § 2:05

A taxpayer's interest in stocks, bonds or notes does not qualify for nonrecognition treatment. (See 26 United States Code § 1031(a)(2)(B).)

A taxpayer's interest in a partnership doesn't qualify for nonrecognition treatment, even if the sole asset of the partnership is income or investment real property which itself would qualify for nonrecognition treatment. (See 26 United States Code § 1031(a)(2)(D).)

In addition, the Internal Revenue Code lists other property interests not qualifying for nonrecognition treatment, including a security interest in real property (such as the interest of a mortgagee or beneficiary under a deed of trust); the interest of a beneficiary under a trust having real property as its res (or asset); and mere rights, claims or causes of action involving real property. (See, generally, 26 United States Code § 1031(a)(2).)

Generally, an exchange involving relinquished real property located in the United States and replacement real property located outside the United States will not qualify for nonrecognition treatment. (See 26 United States Code § 1031(h).)

The key words here are "solely for." The property relinquished and property acquired must be of "like kind." In cases where money or other non like-kind property is received as part of a real property exchange, the non like-kind consideration is commonly called "boot." And, the taxpayer's receipt of boot may be recognized as capital gain, subject to tax, to the extent of the value of the boot.

As a rule of thumb, when a taxpayer "trades down" (relinquishes property having greater value than like-kind replacement property) there is likely to be recognition of capital gain.

In the example above, the taxpayer is trading down: exchanging real property valued at $2,000,000 for replacement property valued at $1,500,000 plus $500,000 in cash. The taxpayer must recognize capital gain, and pay tax, to the extent of the $500,000 in cash received.

On the other hand, as a general rule no capital gain is recognized where the taxpayer "trades up."

In this example, the taxpayer is trading real property valued at $1,500,000, and paying cash, for replacement property valued at $2,000,000. There is no capital gain to be recognized since the value of the relinquished property is less than the value of the like-kind replacement property. (But note, if the consideration is paid in some form other than cash--such as stock--then there may be recognition of taxable capital gain for the value of the stock.)

Another rule of thumb is that cash boot received by the taxpayer will not be considered offset by debt incurred by the taxpayer.

In the example above, the taxpayer is exchanging property valued at $100,000 for replacement property also valued at $100,000. However, the relinquished property is subject to mortgage debt of $40,000, whereas the replacement property is to be subject to mortgage debt of $70,000, allowing the taxpayer to receive $30,000 cash out of the exchange. The IRS will treat this cash received as capital gain to be recognized immediately, and will not permit the cash received to be offset by additional mortgage debt being assumed by the taxpayer.

In light of these rules, some taxpayers would attempt to avoid recognition of gain either by refinancing the relinquished property just prior to transferring it as part of an exchange, or by refinancing replacement property shortly after receiving it. This is another area where taxpayers should proceed only with the help of a qualified tax advisor. Many tax advisors will suggest that the taxpayer observe a "holding period" during which there be no refinancing prior to or on the heels of a 1031 exchange. The duration of this period will vary from one tax advisor to another, depending on individual philosophy (aggressive vs. conservative) and how strongly the taxpayer desires to avoid audit by the IRS.

This is not to say that all replacement property must inevitably be "tied-up," and rendered unavailable for sale or refinancing, for months after an exchange. If the taxpayer faces a true emergency, such as a family member's need for costly medical care, a post-exchange refinancing should not be viewed so as to disqualify the exchange for nonrecognition treatment under § 1031.

Again, this is an area where the taxpayer should obtain the advice of a qualified tax advisor.

The key words here are "like kind."

Personal property exchanges are viewed by the IRS differently than real property exchanges. While § 1031 permits exchanges of personal as well as real property, to be considered a "like kind" exchange the type of personal property acquired must be very similar to the type of personal property relinquished. For example, under the Regulations a truck or fleet of trucks may be exchanged only for a replacement truck or trucks. A truck or fleet of trucks exchanged for an aircraft would be considered a non like-kind exchange.

The Regulations even tell us that an exchange of livestock of different sexes is non like-kind. But where real property is concerned the Regulations are quite liberal. Almost any type of income or investment real property may be traded for another type of income or investment real property.

A restaurant can be exchanged for a motel. An office building can be exchanged for a lease of real property having a term of 30 years or more. Improved real property can be exchanged for vacant land. A single real property can be exchanged for multiple replacement properties, and vice versa.

One situation requiring extra care occurs when exchange property, either relinquished or replacement, has mixed characteristics, being partly like-kind and partly non like-kind.

The above depicts farm property valued at $2,000,000. Suppose the property is 200 acres including a personal residence occupying less than one acre. If this property is to be exchanged solely for income or investment real property, then the personal residence and farm equipment (such as the tractor pictured and other non-fixture equipment) are non like-kind property. The like-kind property consists of the farmland, improvements on the farmland (such as the barn pictured), and unharvested crops.

In this case the taxpayer must obtain a qualified appraiser to establish the value of like-kind property, as a portion of the total sale price, for 1031 exchange purposes. Without an appraisal the taxpayer runs considerable risk of his valuations being questioned or disregarded in the event of an audit by the IRS.

4. Three Ways To Exchange:
Historically, exchanging has been done several ways. Here's a brief review.

The simplest form has been the simultaneous exchange, illustrated above. Trading partners meet one day and exchange deeds. This form has always been recognized as qualifying for nonrecognition treatment under § 1031, hence the green light depicted.

Another form has been the delayed exchange. Here the taxpayer relinquishes property on January 14, and later acquires replacement property on April 12. Taxpayers historically preferred the delayed exchange because it allowed their trading partner to acquire relinquished property without having to wait for the taxpayer to locate replacement property.

But as originally enacted § 1031 did not expressly approve the delayed exchange form, and without guidance from Congress the IRS actively opposed and discouraged delayed exchanges. As will be seen, this opposition has now changed to acceptance, subject to the Regulations.

A third form has been the reverse exchange, above. Here the taxpayer acquires replacement property on January 17, and later transfers relinquished property on April 12. This form has also been discouraged by the IRS in the past but, as will be seen, is now accepted, subject to the Regulations and Revenue Procedures published by the IRS.

Remember , it isn't necessary for a taxpayer to find a trading partner who also expects nonrecognition treatment under § 1031. Instead, as shown above, the trading partner may turn around and sell property acquired from the taxpayer, and pay tax on the sale.

Or, the taxpayer may transfer relinquished property to a trading partner who has cash but no property for trade. Here, the taxpayer locates and identifies replacement property, which the trading partner will purchase and cause to be deeded to the taxpayer.

Exchanges can also involve additional parties exchanging properties and/or cash in connected transactions, but having no direct contact with the taxpayer.

5. The Starker Case
As mentioned above, for many years taxpayers and their advisors had no comfort doing anything other than a simultaneous exchange. In fact, the IRS narrowly interpreted § 1031 and threatened to audit and penalize taxpayers whose dealings didn't fit its narrow interpretation.

What changed all of this, forever, was the Starker case, a landmark court decision.

In April 1967, T.J. Starker entered into a "Land Exchange Agreement" with Crown Zellerbach Corporation. Under this Agreement, Starker (and certain of his relatives) agreed to transfer to Crown Zellerbach 1,843 acres of timberland located in Columbia County, Oregon.

In consideration for this transfer, Crown Zellerbach agreed to credit Starker, on its books, for the amount of $1,502,500. Starker would then have five years to identify replacement properties in Washington and Oregon, to be acquired by Crown Zellerbach using Starker's credits, and then the properties would be transferred to Starker. Crown Zellerbach also agreed to add to Starker's credit account each year a "growth factor," equal to 6% of the unused balance. This growth factor compensated Starker for use of his money (akin to interest), as well as for increased value of the relinquished timberland as a growing crop.

The deal was sealed in May 1967, when Starker deeded the timberland to Crown Zellerbach and Crown Zellerbach booked "exchange value credits" of $1,502,500 in favor of Starker.

Between September 1967 and May 1969, Starker selected and Crown Zellerbach acquired and transferred to Starker twelve properties valued at a total of $1,577,387. This total included the growth factor. No cash was paid to Starker under the Land Exchange Agreement.

In April 1968, Starker filed his tax return treating the Crown Zellerbach transaction as an exchange qualifying for nonrecognition treatment under IRS § 1031. The IRS responded by ruling that the transaction did not qualify, and Starker was assessed a deficiency of $300,930, plus interest.

Following required procedures, Starker paid the assessment and filed a claim for refund. After this claim was denied, Starker sued the IRS to recover the refund.

In May 1977, a federal trial court ruled against Starker, and Starker appealed.

In August 1979, the federal court of appeals ruled in favor of Starker, handing down a decision which was the first decisive victory for the delayed exchange concept.

By the time the court ruled in his favor, Starker was 89 years old. He had spent twelve of his "golden years" in litigation with the IRS. He died four years later.

The Court's Reasoning:
"In this case, the taxpayer claims he intended from the very outset of the transaction to get nothing but like-kind property, and no evidence to the contrary appears on the record. Moreover, the taxpayer never handled any cash in the course of the transactions. "

It's important to remember this reasoning; the court ruled as it did because (1) Starker intended throughout the transaction to acquire like-kind property only in exchange for his timberland, and (2) Starker never handled cash during Crown Zellerbach's performance of its obligations under the Land Exchange Agreement.

If one remembers this reasoning, and keeps it clearly in mind, then the Regulations discussed below are best understood.

After the Starker decision, taxpayers and their advisors rejoiced while the IRS stewed. But even though the Starker court had opened the door, encouraging delayed exchanges, it did not address many issues present in the Starker case but not necessary to the court's decision.

For example, taxpayers and their advisors wondered:

• How much time should the taxpayer have to identify replacement property? Under the Land Exchange Agreement, Starker had five years, but ended up taking 20 months. The IRS considered both periods too long.
• How much time should the taxpayer have to complete an exchange? Again, Starker had five years but completed his exchange in 20 months. The IRS considered both periods too long.
• Can a third-party intermediary be used to hold funds or other property during the exchange? Remember, Starker had the luxury of dealing with Crown Zellerbach, a major corporation with a strong financial statement. Other taxpayers imagined themselves dealing with trading partners whose solvency and/or integrity might be unknown, or questionable. They saw a need for a third-party intermediary to hold funds and other consideration, and to facilitate orderly acquisition of replacement property. Further, they wondered what guarantees they might get from an intermediary to secure faithful performance of the intermediary's functions.
• Can the taxpayer earn interest without jeopardizing non-recognition status under § 1031? Even though it was a factor present in the case, the Starker court did not indicate approval or disapproval of the growth factor arrangement. Taxpayers wondered whether the IRS might challenge such arrangements.
• Would there continue to be IRS opposition to the "reverse" exchange?

6. The 1984 Amendment of §1031
It took five years for Congress to first address these post-Starker questions, and when it did the guidance provided was somewhat less than taxpayers had hoped for.

In 1984, Congress amended § 1031 to provide that the taxpayer's time within which to identify replacement property would expire 45 days after transfer of relinquished property; and that the taxpayer's time within which to complete an exchange would expire 180 days after transfer of the relinquished property, or upon the due date of the taxpayer's tax return for the tax year in which the transfer of relinquished property occurred, whichever date is earlier.

With § 1031 thus amended, taxpayers and their advisors continued to cautiously structure delayed exchanges so as to avoid practices which might be targeted for enforcement action by the IRS.

7. The Regulations of April 1991 - Rules for the Delayed Exchange
In April 1991, the IRS finally issued Regulations covering the most common type of delayed exchange (i.e., where the taxpayer first relinquishes property, and later acquires replacement property). Unfortunately, the 1991 Regulations did not address reverse exchanges. In fact, approved procedures for reverse exchanges were not published until September 2000 - - and they are discussed under "Revenue Procedure 2000 - 37, below.

In any case, the 1991 Regulations provided taxpayers and their advisors with considerable guidance and assurance in doing a delayed exchange. If the Regulations are observed, that is if the taxpayer follows the steps and meets the deadlines set forth in the Regulations, the IRS will deem an exchange to have been done within the spirit of § 1031, and it will qualify for nonrecognition treatment. If, on the other hand, a taxpayer fails to perform a required step or meet a deadline, the exchange may be deemed disqualified. It is a "see no evil, hear no evil, speak no evil" assurance.

In sum and substance, the Regulations provide as follows:

Identification Period - The 45 Day Rule

• Midnight - 45th day
   
• Identify replacement property(ies)
   
• Written document
   
• Signed by taxpayer
   
• Delivered or sent
   
• To any person involved other than taxpayer or "disqualified person"

The taxpayer must identify replacement property or properties on or before midnight of the 45th day after transfer of relinquished property. Unlike other legal deadlines with which we may be familiar, this one is absolutely firm. In the event that the 45th day falls on a Sunday or legal holiday, there is no allowance for extension of the deadline to the next business day. In fact, there is no allowance for extension of the deadline, at all.

The taxpayer's identification of replacement property must be evidenced by a written document, signed by the taxpayer, to be hand delivered, mailed, telecopied, or otherwise sent to any person involved in the exchange other than the taxpayer or a "disqualified person."

The term "disqualified person" is defined in the Regulations four different ways, becoming very convoluted and far-reaching. The definitions of "disqualified person" are as follows:

1. Any "agent of the taxpayer," meaning any employee, attorney, accountant, investment banker or broker, real estate agent or broker, who within 2 years of transfer of relinquished property has had such a relationship with the taxpayer. This effectively rules out almost anyone from whom the taxpayer regularly obtains legal, financial or business advice. Under this definition, there are two narrow exceptions (those who may meet the criteria but nevertheless will not be considered "disqualified"):
   
    
   1. those performing exchange related services, and
       
   2. companies performing routine financial, title insurance, escrow, or trust services.
      
       
2. Any person or business entity which is a "related taxpayer," as defined by Internal Revenue Code § 267(b). This definition includes a family member or blood relation of the taxpayer, a corporation having the taxpayer as a 10% or greater minority shareholder, a sister corporation of the taxpayer, a fiduciary of a trust having the taxpayer as its grantor, or a grantor or beneficiary of a trust having the taxpayer as its fiduciary, among others.
   
    
3. Any person or business entity having a partner relationship with the taxpayer as described by Internal Revenue Code §707(b). This includes a partnership having the taxpayer as a 10% or greater interest-owning partner, any partner having a 10% or greater interest in the taxpayer partnership, or a partnership having a common 10% or greater ownership with the taxpayer partnership, among others.
   
    
4. Any person or business entity having a disqualifying "related taxpayer" (#2 above) or partner (#3 above) relationship with a person who in turn has a disqualifying "agent of the taxpayer" (#1 above) relationship. This definition is hard to decipher. Our interpretation can be explained with the following example: Suppose the taxpayer proposes to send his identification notice to his family attorney. The attorney is familiar with the Regulations and tells the taxpayer that he, the attorney, is a disqualified person. Suppose further that the attorney hasn't read the definition of "disqualified person" fully, or perhaps misunderstood it, and he (the attorney) suggests that the taxpayer send his identification notice to Melvin, the attorney's adult son, who will also act as an escrow holder in connection with the exchange. Melvin, of course, has a disqualifying blood relationship with the attorney, who in turn has a disqualifying agency relationship with the taxpayer. It is this sort of "second-tier" disqualifying relationship we believe the last definition of "disqualified person" intends to address and prohibit.

Why is this so complicated? The IRS's purpose is to encourage involvement of intermediary, financial, title insurance, escrow and trust service companies in delayed exchange transactions. This is with the expectation that such companies are less likely to have close relationships with taxpayers, and would therefore be less likely to cooperate with those taxpayers who might seek to falsify documentation in their files, such as by changing contents or falsely dating an identification notice.

By making special exception for these companies in the definitions of "disqualified person," the IRS gives the taxpayer a clear and simple choice in line with its preferences.

The Regulations make clear that the identification notice must be unambiguous in describing replacement property, and the taxpayer must acquire "substantially the same property" as identified. Although the Regulations indicate that a street address or name of building may be sufficient, taxpayers are cautioned that street addresses are assigned mainly to facilitate delivery of mail, and they may be misunderstood to include more (or less) property than the taxpayer intends to acquire. For example, a street address may, or may not, include adjacent structures, parking areas or driveways.

The better practice is to identify replacement property by reference to its complete legal description, which may be obtained from the current owner's (or lessor's) vesting deed.

Recognizing that 45 days may not be sufficient time for the taxpayer to perform due diligence or satisfy contingency items, the Regulations permit the taxpayer to identify multiple properties. In other words, the taxpayer may identify more properties than he will acquire, allowing additional time (180 days or due date of tax return, whichever is earlier) in which to make final decisions. Here are the alternative and multiple property identification rules:

Identification - Alternative/Multiple Properties

• Up to 3 properties no matters what value,
   
• Any number of properties having aggregate value not more than 200% of relinquished property value, or
   
• Any number of properties provided taxpayer acquires replacement properties having value equal to at least 95% of aggregate value of all identified replacement properties.

Because of its relative simplicity, most taxpayers follow the first rule above, which the Regulations call the "3-property rule."

As can be seen, the other two rules (the "200-percent rule" and the "95-percent rule") rely on property values. Following these rules may require the additional expense of obtaining appraisals.

Once an identification notice is sent, what if the taxpayer wants to cancel it and send another?

Revocation of Identification

• Written document
   
• Signed by taxpayer
   
• Delivered or sent
   
• Same recipient(s)
   
• Midnight - 45th day

The Regulations allow revocation of an identification notice by a written document, signed by the taxpayer, delivered or sent to the same recipients as the original identification notice, on or before midnight of the 45th day after transfer of relinquished property.

It's important to remember that a revocation does not extend the 45-day identification period. The taxpayer who revokes must be careful to send another identification notice within the original 45-day identification period.

It's also important to know that, according to the Regulations, no identification is required at all if the exchange is completed, by the taxpayer's acquisition of all replacement property, within the 45-day identification period.

Exchange Period - The 180 Day Rule

Taxpayer must acquire replacement property(ies) on or before midnight of

• 180th day after date of transfer of relinquished property, or
   
• due date (including extension) of taxpayer's tax return, whichever is earlier.

Following the 1984 amendment of § 1031, the Regulations required that the taxpayer complete the exchange, by acquisition of each and every replacement property, on or before midnight of the 180th day after date of transfer of relinquished property or the due date (including any extension) of the taxpayer's tax return (for the tax year in which relinquished property was transferred), whichever is earlier.

Once again, this deadline is firm, drop-dead, and absolute. And one should never make the mistake of thinking 180 days means six months. Exchanges have been blown, disqualified, because the taxpayer thought he had six months, which turned out to be 182 days.

Since these dates are so important, it may be worthwhile to consider the question of when relinquished property has been "transferred." Does the transfer occur when escrow closes (or the settlement date), when the deed is accepted for recording by the local county recorder, or when the deed is properly indexed by the recorder so as to be locatable in the public records?

Since the Regulations provide no clear answer, it seems best to assume that the transfer will be deemed to have taken place upon close of escrow, or the settlement date, for the relinquished property. Typically, a settlement statement (sometimes called the "HUD-1" form) will be issued showing the settlement date. This is the date to keep your eye on; begin counting the next day. The taxpayer who transfers relinquished property late in the year, October through December, needs to be particularly careful about expiration of the exchange period. For example, if the transfer takes place in mid-December, the exchange period may expire in about 4 months, when the taxpayer's tax return is due on April 15. If the taxpayer files for an extension, the tax return will be due in August but the exchange period will then expire in accordance with the 180 day rule, since 180 days will be earlier than the taxpayer's extended filing date.

Again, although there is no regulation on point the IRS seems to accept the view that replacement property is "acquired" by the taxpayer on the settlement date.

Replacement Property to be Constructed

• Identify by legal description of land and detailed description of improvements to be made
   
• Estimated fair market value
   
• Improvements as-built must be "substantially the same" as described
   
• Should be completed before taxpayer acquires replacement property

Sometimes a taxpayer may want to acquire replacement property which is unimproved or needs substantial renovation in order to have value equal to the relinquished property. For example, suppose the taxpayer transfers relinquished property valued at $2,000,000, and proposes to acquire as replacement property vacant land valued at $200,000. This exchange would qualify for nonrecognition treatment only to the extent of $200,000, the value of the replacement property. If, on the other hand, sufficient improvements are made to the replacement property before it is acquired, then the exchange may qualify for nonrecognition treatment to the full extent of the value of relinquished property ($2,000,000).

The Regulations give considerable guidance where replacement property is to be improved, or constructed, before acquisition by the taxpayer. As shown above, the identification notice must include a legal description of the land, a detailed description of improvements to be made, and the estimated fair market value of the replacement property as improved.

When replacement property is acquired the improvements as-built must be "substantially the same" as described in the identification notice. And, all improvements should be completed before the taxpayer acquires replacement property.

But exchanges involving replacement property to be improved present several practical problems:

First, given the uncertainties of weather and other working conditions, can all improvements be completed within the exchange period?

Second, who will hold title to the replacement property during construction? Remember, once the taxpayer acquires title to replacement property the value, for purposes of qualifying the exchange, is fixed. Therefore, someone else must "hold title" while improvements are being made.

Third, how will the improvements be financed? As discussed more fully below, the Regulations make clear that the taxpayer may not receive or have use of the proceeds from sale of relinquished property during the exchange period. Unfortunately, the 1991 Regulations did not address these problems, although answers for some of them were forthcoming in "Revenue Procedure 2000-37," issued by the IRS in September 2000, and discussed in the next section ("8. Revenue Procedure 2000-37").

Control of Money or Other Property Within Exchange Period
Remember that the Starker decision was based largely on the fact that Starker never handled cash. Mindful of this reasoning, the IRS Regulations are very strict and detailed concerning control of money or other property within the exchange period. Any unauthorized receipt of money or other property before acquisition of replacement property will disqualify the exchange.

Actual or Constructive Receipt
The Regulations prohibit actual or constructive receipt of cash or other property. This means the taxpayer may not receive cash in hand, nor may he derive economic benefit from cash or other property in the exchange escrow account. For example, the taxpayer may not pledge cash in the escrow account as security for a loan to the taxpayer during the exchange.

Likewise, the taxpayer may not cause sale proceeds from relinquished property to be credited to any account in the taxpayer's name, nor may he have unrestricted access to any account in which these proceeds are deposited during the exchange period.

Safe Harbors
In drafting its Regulations, the IRS was also mindful of questions left unanswered by the Starker decision. To answer these and other concerns, the Regulations provide for "safe harbors." The safe harbors are essentially protocols, if the taxpayer follows the formalities dictated by the safe harbor provisions the IRS will deem the exchange to have been conducted within the spirit of § 1031.

There are four safe harbors:

• Security or guarantee arrangements
   
• Qualified escrow accounts and qualified trusts
   
• Qualified intermediaries
   
• Interest and growth factors

Security or Guarantee Arrangements The first safe harbor provides for security or guarantee arrangements. Remembering that not all taxpayers will have the comfort of having a Crown Zellerbach as their trading partner, the Regulations contemplate that the taxpayer will use the services of an intermediary, and during the exchange period the Regulations allow the taxpayer to receive certain forms of security or guarantees backing the intermediary's performance.

Specifically, the taxpayer may receive a mortgage, deed of trust, or other security interest in property, other than cash, to secure the intermediary's faithful performance. The Regulations do not permit receipt of cash as security, since that would be akin to receipt of sale proceeds from relinquished property.

Likewise, the Regulations allow the taxpayer to take a standby letter of credit, or a third party guarantee, to back the intermediary's performance.

Qualified Escrow Accounts and Qualified Trusts
The second safe harbor provides for qualified escrow accounts and qualified trusts. Unwilling to let this issue go unregulated, the Regulations require that during the exchange period sale proceeds from relinquished property must be deposited with an escrow holder or trustee who is not the taxpayer or a "disqualified person." The deposit must be pursuant to a written escrow or trust agreement, which must provide for the strict control of money or other property during the exchange period.

Qualified Intermediaries
The third safe harbor provides for qualified intermediaries. The regulations require that the intermediary may not be the taxpayer or a "disqualified person." The contractual relationship between the taxpayer and intermediary must be formalized by a written "exchange agreement," which must provide for the strict control of money or other property during the exchange.

Also, and very importantly, the exchange agreement may be entered into after the taxpayer agrees to transfer relinquished property. Practically, this is accomplished by the taxpayer giving the intermediary an assignment of the taxpayer's rights under the agreement to sell the relinquished property, and by giving the prospective buyer notice of the assignment.

This latter provision is of great benefit to the taxpayer. Frequently a taxpayer will have found a buyer for his property, and will have entered into an agreement for sale, before considering the tax ramifications. Worse yet, the taxpayer or listing broker may be holding earnest money, paid by the prospective buyer.

By allowing the taxpayer to enter into the exchange agreement after the agreement for sale of the relinquished property, the Regulations permit the taxpayer to convert his transaction to an exchange at any time before close of escrow on the relinquished property. And, intermediary service providers are typically able to provide the necessary forms, converting the transaction to an exchange, on very short notice.

Taxpayers should be cautioned, however, to be careful about holding earnest money after entering into an exchange. Once the transaction is converted to an exchange, all earnest money should be paid into the exchange escrow account --else the earnest money may be considered taxable.

Interest and Growth Factors
The fourth safe harbor provides for interest and growth factors.

The Regulations permit the taxpayer to be credited for interest or a growth factor during the exchange period, as provided by a written agreement (typically a part of the escrow, trust or exchange agreement), which also provides for strict control of receipt of money or other property during the exchange period. In other words, any interest or growth factor earned by the taxpayer is subject to the same receipt rules as are sale proceeds from relinquished property. And, alas, any interest or growth factor earned and ultimately paid to the taxpayer will be taxable as ordinary income.

Cash-Out Rules

1. Written agreement
    
2. Strict control of money or property within 180-day exchange period, except
   • If no identification within identification period,
      
   • After acquisition of all replacement property, or
      
   • Occurrence after identification period of contingency that relates to the exchange, is provided for in writing, and is beyond control of the taxpayer and any "disqualified person"

Leaving no stone unturned, the Regulations spell out when and how the taxpayer (and others) may receive cash or other property from the exchange escrow account.

The Regulations require that provisions for cashing out of an exchange be formalized by written agreement (typically the exchange, escrow or trust agreement), which provides for strict control of money or other property within the 180-day exchange period, except

1. If no identification is made within the identification period, then the taxpayer can cash out. This is, of course, logical, because then the exchange is disqualified anyway.
   
    
2. After acquisition of all replacement property, or
   
    
3. Upon the occurrence after the identification period of a contingency that relates to the exchange, is provided for in writing, and is beyond control of the taxpayer and any "disqualified person." Such a contingency might be unforeseen contamination of the property, inability to obtain needed parking, inability to obtain zoning changes, and the like. In such a case, the taxpayer may be legally entitled to cancel his agreement to purchase replacement property, which then spoils the exchange since his time for making another identification has expired.

Permitted "Receipt" Rules

1. Items received incidental to transfer of relinquished property but not considered sale proceeds
   
   In addition to the cash-out rules, above, there are two rules permitting "receipts" during the exchange period for certain limited purposes.
   
   The first of these rules permits receipt of items received incidental to transfer of relinquished property but not considered sale proceeds. For example, where the relinquished property is an apartment building, the taxpayer is entitled to prorated rents. The logic is that rents are taxable as income and not part of the capital gain calculation. Likewise, the taxpayer may be entitled to receive prorated deposits (such as with a local utility) in connection with sale of relinquished property.
   
   The Regulations make clear that this rule does not permit the taxpayer to receive earnest money or option payments paid in connection with sale of the relinquished property. As discussed above, once the transaction is converted to an exchange any earnest money or option payments should be deposited with the exchange escrow holder.
   
    
2. Transactional items paid in connection with transfer of relinquished property or acquisition of replacement property
   
   The second permitted receipt rule allows for payment of transactional items on connection with the transfer of relinquished property or acquisition of replacement property. For example, commissions, prorated taxes and title company fees may be paid.
   
   On the other hand, the Regulations state that debts unrelated to the exchange may not be paid as "transactional items." For example, the taxpayer may not direct that cash in the exchange escrow account be used to pay off personal credit card or charge accounts.
   
   The Regulations dictate that cash in the exchange escrow account may not be used (during the exchange period) to reimburse the taxpayer for earnest money paid in connection with purchase of the replacement property. In practice, the same result can be accomplished if the taxpayer directs the exchange escrow holder to pay earnest money directly from the exchange escrow account to the seller of replacement property. In this way, the taxpayer doesn't handle cash and the purity of the exchange is maintained.
   
   Finally, and as discussed above, the Regulations specify that cash in the exchange escrow account may not be used for repairs or improvements to replacement property. Any such work must be paid for from taxpayer resources outside the exchange account.

8. Revenue Procedure 2000-37 - Rules for "Parking" and the Reverse Exchange
As mentioned above, the 1991 Regulations did not address reverse exchanges, nor did they offer answers for some practical problems arising in cases where replacement property would have to be constructed or renovated during the exchange period.

These issues were later addressed, in September 2000, by an IRS policy statement known as "Revenue Procedure 2000-37."

The purpose of the revenue procedure was to acknowledge and announce approved protocols for a practice that had become common among taxpayers (and their advisors) to facilitate reverse exchanges and/or improvements to replacement property during the exchange period - a practice known as "parking."

Under a "parking" arrangement, a taxpayer doing a reverse exchange might cause desired replacement property to be conveyed to a third party under a holding or trust agreement (i.e., "parked") while the taxpayer arranges for transfer of relinquished property to its ultimate transferee, completing the exchange. Or, a taxpayer may cause a third party to acquire desired replacement property and immediately exchange it for relinquished property, thereafter "parking" the relinquished property with the third party until the taxpayer arranges for transfer of the relinquished property to its ultimate transferee. Likewise, a taxpayer wanting improvements to be made to replacement property before completing his exchange, may "park" the replacement property with a third party during the exchange period.

The revenue procedure provides a "safe harbor" for certain "parking" arrangements between a taxpayer and an "exchange accommodation titleholder" (i.e., third party), if the property is held in a "qualified exchange accommodation arrangement" (QEAA). A property will be deemed held in an approved QEAA if all of the following requirements are met:

1. Legal title to the property (or other "qualified indicia of ownership") is held by a person (the "exchange accommodation titleholder") who is not the taxpayer or a "disqualified person," and the "person" is either one subject to federal income tax or, if the "person" is treated as a partnership or S corporation, more than 90 percent of its interests or stock are owned by partners or shareholders who are subject to federal income tax. The term "qualified indicia of ownership" includes indicia "treated as beneficial ownership under applicable principles of commercial law" (such as a contract for deed), or interests in an entity "that is disregarded as an entity separate from its owner for federal income tax purposes (e.g., a single member limited liability company) and that holds either legal title to the property or other indicia of ownership;"
   
    
2. At the time the property is transferred to the exchange accommodation titleholder, it is the taxpayer's "bona fide intent" that it be held for a qualified 1031 tax-deferred exchange;
   
    
3. No later than five business days after the transfer to the exchange accommodation titleholder, the taxpayer and the exchange accommodation titleholder enter into a written "qualified exchange accommodation agreement," providing that the exchange accommodation titleholder is holding the property for the benefit of the taxpayer in accordance with section 1031 and this revenue procedure, that the parties agree to report the holding to the IRS as provided in this revenue procedure, and that the exchange accommodation titleholder will be treated as the beneficial owner of the property for all federal income tax purposes. It's also required that both parties report "the federal income tax attributes of the property on their federal income tax returns" per their written agreement;
   
    
4. No later than 45 days after the transfer of replacement property to the exchange accommodation titleholder, the taxpayer must identify the relinquished property "in a manner consistent" with the rules for identification of replacement property under the 1991 Regulations, described in section 7 above.
   
    
5. No later than 180 days after the transfer of property to the exchange accommodation titleholder, either (a) the property is transferred to the taxpayer as replacement property, or (b) the property is transferred to an ultimate transferee as relinquished property; and
   
    
6. The combined time period that relinquished and/or replacement property(ies) are held in the QEAA does not exceed 180 days.

In addition to the "safe harbor" of the QEAA, the revenue procedure lists "permissible agreements" which, if they become involved in an exchange, will not cause property to fail to be treated as held in an approved QEAA. These are:

1. An exchange accommodation titleholder may also enter into an exchange agreement to serve as the taxpayer's qualified intermediary, subject to the rules contained in the 1991 Regulations;
   
    
2. The taxpayer or a "disqualified person" (as defined in the 1991 Regulations) may guarantee obligations undertaken by the exchange accommodation titleholder in connection with the exchange, or indemnify the titleholder against costs and expenses;
   
    
3. The taxpayer or a disqualified person may loan or advance funds to the exchange accommodation titleholder, or guarantee a loan or advance to the titleholder;
   
    
4. The property may be leased by the exchange accommodation titleholder to the taxpayer or a disqualified person;
   
    
5. The taxpayer or a disqualified person may manage the property, supervise improvements, act as a contractor, or otherwise provide services to the exchange accommodation titleholder with respect to the property;
   
    
6. The taxpayer and the exchange accommodation titleholder may enter into agreements relating to purchase or sale of the property, "including puts and calls at fixed or formula prices," effective for a period not to exceed 185 days from the date the property was transferred to the exchange accommodation titleholder; and
   
    
7. The taxpayer and the exchange accommodation titleholder may enter into agreements providing that any variation in value of relinquished property from the estimated value on the date the property was transferred to the exchange accommodation titleholder may be taken into account upon the titleholder's disposition of the relinquished property.

The revenue procedure states the IRS recognizes that "parking" transactions can be accomplished, without adverse tax consequences, "outside of the safe harbor provided in this revenue procedure." What this probably means is that any agreement or arrangement beyond what is contemplated by the revenue procedure will be considered by the Service in light of its interpretation of section 1031, the 1991 Regulations, and the court's reasoning in the Starker decision. In other words, the fundamental rules that the taxpayer must intend to do a like-kind exchange and may not enjoy use of proceeds from relinquished property during the exchange period should be kept in mind when making "parking" arrangements.

9. Choosing an Intermediary
One of the most important decisions to be made by a taxpayer considering an exchange is selection of the intermediary.

The intermediary should be knowledgeable and experienced, a "qualified" person within the meaning of the Internal Revenue Code and the 1991 Regulations, and able to provide adequate security for faithful performance of intermediary functions.

Frequently we see news reports about escrow and intermediary companies having mishandled and lost client moneys.

Such was the case with San Diego Realty Exchange, an intermediary company once operating in San Diego, California.

The proprietor misappropriated client trust funds by loaning about $6,000,000 to a startup business he was backing, which was to offer electronic tax return filing services.

The startup business failed, the intermediary went into bankruptcy, and 29 taxpayers saw their exchanges evaporate.

Then things got worse. A trustee in bankruptcy was appointed, who filed adversary proceedings seeking to undo 40 exchange transactions closed by the intermediary within 90 days of the commencement of bankruptcy. Calling the intermediary's operation a "Ponzi scheme," the trustee sought to have all cash or property "passing" through the hands of the intermediary during the 90-day period restored to the bankrupt debtor's estate, for the benefit of unsecured creditors. These proceedings were based on the "voidable preference" provisions of the Bankruptcy Code.

When the judge handling the bankruptcy announced he would rule in favor of the trustee, and against the taxpayer clients, settlements were reached involving payments totaling several million dollars.

Nightmares like this one can only be avoided by careful selection of the intermediary, with particular attention to guarantee or security arrangements the intermediary has to offer.

10. The Delayed Exchange Transaction
Step-by-step as conducted by First American Exchange Corporation Here is a step-by-step description of a typical exchange (without a parking arrangement) as handled by intermediary First American Exchange Corporation.

1. Taxpayer retains services of independent tax advisor
   
    
2. Taxpayer enters into agreement to sell property, including a recital that the taxpayer intends to relinquish property as part of 1031 exchange and provision for the right to substitute an intermediary as seller.
   
    
3. Taxpayer enters into Exchange Agreement with First American Exchange as intermediary, intermediary becoming a principal in each transaction (not an agent).
   
    
4. When all contingencies are satisfied, taxpayer causes intermediary to be substituted in as seller in sale transaction for taxpayer's relinquished property.
   
    
5. Intermediary is instructed by taxpayer to execute escrow/closing instructions and other documents in connection with transfer of relinquished property. Typically, intermediary will cause taxpayer to be shown as grantor/transferor on deed to buyer of relinquished property. This is called "direct deeding," the intermediary does not come into title with respect to the relinquished property.
   
    
6. The first half of the exchange closes with transfer of the relinquished property-time periods begin to run.
   
    
7. Intermediary deposits net proceeds from sale of relinquished property into qualified exchange account to be held solely for the benefit of the intermediary.
   
    
8. All interest earned on funds deposited in the exchange escrow account accrues to the benefit of the intermediary. Per the Exchange Agreement, taxpayer may receive credit for a "growth factor" on funds deposited in exchange account.
   
    
9. Taxpayer identifies replacement property(ies) on or before the 45th day after transfer of relinquished property.
   
    
10. Taxpayer enters into agreement to acquire replacement property, including recital that taxpayer intends to acquire property as part of a 1031 exchange and provision for the right to substitute intermediary as buyer.
    
     
11. When all contingencies are satisfied, taxpayer causes intermediary to be substituted in as buyer of replacement property.
    
     
12. Intermediary is instructed by taxpayer to execute escrow/closing instructions and other documents in connection with acquisition of replacement property. Typically, intermediary will cause taxpayer to be shown as grantee/transferee on deed from seller of replacement property. Again, the intermediary does not come into title with respect to replacement property.
    
     
13. The final portion of the exchange closes concurrently with acquisition of replacement property - or in stages if multiple properties are involved - all on or before 180th day after transfer of relinquished property or due date (including extension) of the taxpayer's tax return, whichever is earlier.
    
     
14. Intermediary provides taxpayer with Settlement Statement showing receipts and disbursements of all money and other property involved in the exchange.
    
     
15. Taxpayer files Form 8824 with the IRS (and, depending on state law, equivalent documentation with state tax authorities).

11. Questions, Answers, and Best Guesses

Q: We want to do an exchange, but we don't want to use all of the sale proceeds from our relinquished property. Can we proceed using only half the proceeds?

A: Yes. As part of the exchange agreement, you will be asked to execute an assignment of your rights as to a 50% interest in the sale proceeds from the relinquished property. The intermediary can take it from there.

Q: I want to do a 1031 exchange including property which has been used as my personal residence as recently as 6 months ago. Is there any problem?

A: Yes, perhaps. Obviously, you know your personal residence does not qualify for nonrecognition treatment under § 1031. There is no written regulation on this, but we know that the IRS is interested whenever a taxpayer changes the use or financing of real property shortly before, or after, a 1031 exchange. You need a tax advisor, and most would probably suggest that the property be used as income or investment property for a significant period before becoming part of a 1031 exchange.

Q: I want to exchange investment property for a personal residence which I would live in. How can I qualify the transaction for nonrecognition treatment under § 1031?

A: This is similar to the problem discussed above. You need a tax advisor, and most would suggest that your replacement property be used as income or investment property for a significant period after completion of your exchange.

Q: I am a limited partner in a limited partnership whose sole asset is an apartment building. I know that my interest in the partnership will not qualify for nonrecognition treatment under § 1031. Is there any way I can structure the transaction to use this asset of mine as part of a 1031 exchange?

A: Your tax advisor will recommend that you seek agreement from the limited partnership for a conversion of your 10% partnership interest into an undivided 10% interest in the fee title to the apartment building. If this can be done and you can meet any holding period issues described above, your 10% undivided interest in the real property may be used as part of a 1031 exchange.

Q: I want to do a 1031 exchange with my daughter as my trading partner. Are there any problems?

A: It's not necessarily a problem, but you should be aware of Internal Revenue Code § 1031(f), which provides special rules for exchanges between related persons. If either of you should dispose of exchange property within two years of the exchange period, the exchange may be disqualified retroactively.

Q: I entered into an agreement for sale of my investment property three weeks ago. Yesterday, it occurred to me that my capital gain on this sale will be substantial. Is it too late to get into a 1031 exchange?

A: No, not until you close escrow on sale of the relinquished property. Remember that under the "safe harbor" rule for qualified intermediaries, there is express provision for entering an exchange agreement after you have agreed to sell relinquished property. You need to choose an intermediary as soon as possible (but don't be hasty - - remember how important selection of the intermediary is), and make sure any earnest money collected in connection with sale of the relinquished property is deposited in the exchange escrow account promptly.

This concludes our "short course," we hope you will find it useful.
 

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