Time Restrictions for Deferred Exchange Transactions -Topic 4

Prior to the Tax Reform Act of 1984, The Ninth Circuit Court ruled in Starker there could be a relatively long delay between the date the exchanger transfers his property and the date he closes the exchange. The Court held an exchange for a promise to deliver like-kind property in the future qualified for §1031 treatment. They permitted the Replacement Property to be located after the other party acquired the exchanger's property. The agreement was tied to a promise to pay cash if suitable Replacement Property was not located within five years.

The IRS announced early on this decision would not be acquiesced with regard to other taxpayers and instructed their auditors not to follow the decision. Despite this announcement, taxpayers saw this decision as an open door to the “time delayed” real estate exchange. And the rush was on. All kinds of exchange transactions sprung up.

In efforts to beat the constructive receipt doctrine, taxpayers entered into a myriad of agreements with third parties using names such as Accommodators and Facilitators. These third parties would hold the taxpayer’s sales proceeds “in trust” until the taxpayer made his deal for the new property to be acquired. Some paid the taxpayer interest on the proceeds during the time they were held. Others did not hoping to avoid the constructive receipt provision. There were thousands of different arrangements with most not meeting the like-kind exchange requirements in effect at that time. However, many successful like-kind exchanges were fashioned. A great example is the Barker Case.

Barker was a multi-party exchange using an Accommodator to arrange mutually interdependent transfers and escrow arrangements qualified for §1031 exchange treatment. The secret of Barker’s success was the requirement that all legs of the exchange had to be completed successfully. If not, all parties to the transactions agreed that no transactions took place. All were mutually dependent on the others. Think if it as a row of dominos, all standing in a row. Push the first one. If all fall you have a successful transaction. But if somewhere along the line, one or more fails to fall, all parties agree that none fell. In other words, it was all or nothing.

Under the escrow agreements, successful closing of each transaction depended on successful closing of all others. This integrated agreement, and the fact that Barker had no option or right to take cash, guaranteed nonrecognition of gain under §1031. Her only end result possible was the receipt of like-kind property or no exchange transaction at all.

In 1984, Congress amended the Code, adding identification and exchange period time limits for like-kind exchanges. This action signaled their approval for delayed multi-party exchanges. Unfortunately, the IRS did not issue Regs dealing with deferred exchanges until spring 1991.

Section 1031 requires a simultaneous exchange but the Regulations provides time period up to 180 days to complete it. In writing the regulations to satisfy this predicament, IRS wrote a set of rules and procedures to accomplish a deferred exchange and still satisfy the code.

The Tax Reform Act of 1984 imposed two time limitations on §1031 exchanges. One limitation requires Replacement Property to be identified within a certain time. The other requires Replacement Property to be received by the exchanger within a certain time period. To successfully qualify for §1031 treatment, your exchange must satisfy both tests.

In a deferred exchange, any Replacement Property you receive will be treated as property which is not like-kind to the Relinquished Property if

the Replacement Property is not “identified” before the end of the “identification period”, or,

the identified Replacement Property is not received before the end of the “exchange period.”

The identification period begins on the date you transfer the Relinquished Property and ends 45 days after.

The exchange period begins on the date you transfer the Relinquished Property and ends on the earlier of 180 days after or the due date (including extensions) for your tax return for the taxable year in which the transfer of the Relinquished Property occurs.

Parallel Point 4-1

You file your federal income tax return on a calendar year basis. You and Cullinan enter into an agreement for an exchange of property requiring you to transfer Whiteoak to Cullinan. Under the agreement, you are required to identify like-kind Replacement Property which Garland is required to purchase and transfer to you. You transfer Whiteoak to Garland on November 17, 2000.

The identification period ends on January 1, 2001, the day that is 45 days after the date you transfer Whiteoak, even though it is New Year's Day. The exchange period ends on April 15, 2001, the due date for your federal income tax return for the taxable year (2000) in which you transferred Whiteoak. However, if you are allowed the automatic four-month extension for filing your tax return, the exchange period ends on May 16, 2001, the day that is 180 days after the date you transferred Whiteoak.

Sometimes in a deferred exchange transaction, you transfer more than one Relinquished Property and they are transferred on different dates. If this happens, the identification period and the exchange period are measured from the earliest date on which any of the properties are transferred.

One of the most frequently asked questions we get relates to backdating documents to satisfy the identification and exchange time periods. Here is an example:

I recently sold my condo that was used as a rental property for many years with the intention of a 1031 exchange.  The 45-day identification period is running out fast, and I have not yet found any properties to identify.

 I was told by several people that this 45-day period can be "back dated" and what is really important is the 180-day close of escrow.  Is this correct?  Can I find a property after the 45 day period (but before the end of the 180-day period) and write a letter to my real estate agent dated within the 45 day period identifying the  property and the exchange still qualify as 1031 legal?

 

For the record, this is the answer we sent:

Backdating tax documents is fraud and the IRS does not look kindly on this. The penalties are severe and if you or any of the other parties are audited, this backdating is sure to be discovered. This is a matter to discuss with your attorney right now.

â Tax Case: Here is a case right on point where the taxpayers got slammed with a fraud penalty. David Dobrich, et ux. v. Commissioner, 84 AFTR2d

The Ninth Circuit has affirmed a Tax Court decision holding a couple did not timely identify replacement property under Section 1031 and they fraudulently backdated documents alleging timely compliance with the identification requirement.

In 1988, real estate investors David and Naomi Dobrich executed an option to sell a portion of their real property for $4 million, which was exercised in August 1989. Clack Brothers Inc., hired by the Dobriches to act as intermediary on the sale, transferred $3.9 million of the proceeds to a trust account to be used to purchase replacement property to qualify under Section 1031. The 45-day identification period for replacement property was to expire in October 1989.

Although the Dobriches had begun looking for replacement property in 1988, they did not make offers to purchase such property until January 1990. The couple did not discuss purchasing this property with Clack, any of their real estate agents, or the properties' prior owners during the 45-day identification period. In January 1990 David asked two real estate agents to prepare false letters indicating that he and his wife had identified the purchased property in September 1989.

The Dobriches transmitted the false documents to their accountant, who prepared their 1990 return indicating that the sale of their property qualified as a section 1031 exchange. The IRS determined that the sale did not qualify because the couple did not timely identify the replacement property. The IRS also determined fraud penalties under Section 6663. The Tax Court held the Dobriches did not timely identify replacement property for Section 1031 purposes.

The Dobriches appealed.

Affirming, the Ninth Circuit concluded that the Dobriches' sale did not qualify for nonrecognition treatment under Section 1031 because they did not express intent to acquire the replacement property within the identification period. The appeals court rejected the Dobriches' argument that they were not familiar with the 45-day identification requirement, noting that the couple repeatedly discussed the requirement with their advisors.

The appeals court also upheld the fraud penalties, concluding the Dobriches fraudulently attempted to circumvent section 1031(a)'s identification requirement by backdating documents.

The Replacement Property is considered identified before the end of the identification period only if the following requirements are satisfied. However, any Replacement Property you receive before the end of the identification period will in all events be treated as identified before the end of the identification period.

Replacement Property is identified only if it is designated as Replacement Property in a written document signed by you. This document must be hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to a person (other than yourself or a related party) involved in the exchange.

An identification of Replacement Property made in a written agreement for the exchange of properties signed by all parties thereto before the end of the identification period will be treated as satisfying the requirements. It's not necessary for the agreement to be “sent” to a person involved in the exchange.

Replacement Property is identified only if it is unambiguously described in the written document or agreement. Real estate is unambiguously described if it is described by its legal description or street address.

There are limitations on how many replacement properties you may identify in the same deferred exchange, no matter how many relinquished properties you transfer.

You may identify more than one property as Replacement Property subject to two rules: the 3-property rule and the 200% rule. You only have to satisfy one of these rules—not both.

The maximum number of replacement properties you may identify is three properties without regard to fair market value of the properties.

You may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties.

You figure fair market value of Replacement Property as of the end of the identification period. You figure fair market value of Relinquished Properties as of the date you transfer them. If, as of the end of the identification period, you have identified more properties as replacement properties than permitted, you are treated as if no Replacement Property has been identified. However, there are two important exceptions to this rule:

It does not apply to any Replacement Property received by you before the end of the identification period, and

it does not apply to any Replacement Property identified before the end of the identification period and received before the end of the exchange period. However, to qualify for this exception you must receive identified Replacement Property constituting at least 95 percentof the aggregate fair market value of all identified Replacement Properties before the end of the exchange period.

Parallel Point 4-2

You are a calendar year taxpayer. You and Garland agree to enter into a deferred exchange. Under the agreement, you transfer Whiteoak to Garland on May 17, 1991. Whiteoak, which has been held by you for investment, is unencumbered and has a fair market value on May 17, 1991, of $100,000.

On or before July 1, 1991 (the end of the identification period), you are required to identify like-kind Replacement Property. On or before November 13, 1991 (the end of the exchange period), Garland is required to purchase the property identified by you and transfer it to you. To the extent the fair market value of the Replacement Property transferred to you is greater or less than the fair market value of Whiteoak, either you or Garland will make up the difference by paying cash to the other party after the date the Replacement Property is received by you.

In the exchange agreement, you identify real properties, J, K, and L as replacement properties. They satisfy the identification of Replacement Property rules, are of like-kind to Whiteoak and you intend to hold them as investment properties. The agreement provides that by July 25, 1991, you will orally inform Garland which of the properties she is to transfer to you.

As of July 1, 1991, the fair market values of real properties J, K, and L are $75,000, $100,000, and $125,000, respectively. On July 26, 1991, you instruct Garland to acquire real property K. On October 31, 1991, Garland purchases it for $100,000 and transfers it to you.

Because real property K was identified before the end of the identification period and was received by you before the end of the exchange period, the identification and receipt requirements are satisfied for real property K.

Continuing the illustration: Instead of identifying real properties J, K, and L as replacement properties, you identify Blackacre as Replacement Property. Blackacre consists of 2 acres of unimproved land and has a fair market value of $250,000. As of October 3, 1991, Blackacre remains unimproved and has a fair market value of $250,000. On that date, at your direction, Garland purchases 1.5 acres of Blackacre for $187,500 and transfers it to you. You pay $87,500 to Garland.

The fair market value of the portion of Blackacre you received ($187,500) is 75 percent of the fair market value of Blackacre as of the date of receipt. You are considered to have received substantially the same property as identified.

For purposes of applying the 3-property rule and the 200-percent rule, all identifications of property as Replacement Property are taken into account. But don't count identifications of property that have been revoked.

Parallel Point 4-3

Property incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if in standard commercial transactions, the property is

typically transferred together with the larger item of property, and

the aggregate fair market value of all “incidental” property is not more than 15% of the aggregate fair market value of the larger item of property.

Parallel Point 4-5

You are exchanging for an apartment house worth $1,000,000. The furniture, laundry machines, and other miscellaneous items of personal property will not be treated as separate property if their total fair market value is not more than $150,000. (15% of $1,000,000.) For purposes of the 3-property rule, the apartment building, furniture, laundry machines, and other personal property are treated as one property.

For description purposes, the apartment building, furniture, laundry machines, and other personal property are all unambiguously described if the legal description or street address of the apartment building is specified, even if no reference is made to the furniture, laundry machines, and other personal property.

An identification of property as Replacement Property may be revoked at any time before the end of the identification period. The identification is treated as revoked only if the revocation is made in a written document signed by you. This document must be hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to the person to whom the identification of the Replacement Property was sent.

If the identification was made in a written agreement for the exchange of properties, it is treated as revoked only if the revocation is made in a written amendment to such agreement or in a written document signed by you. The agreement or document must be hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to all of the parties to the agreement.

Under the identification rules, all identifications of Replacement Properties are taken into account. But you don't count identifications that have been revoked! And an identification of Replacement Property may be revoked at any time before the end of the identification period.

Let's say you identify three Replacement Properties and two of them fall through in the first week. Following the revocation rules, you revoke both identifications. Now you have only one identification in place and more than four weeks left in the identification time period. Since you are allowed up to three at any given point in time, you have the opportunity to identify two more and still qualify. And so on for the entire identification time period. 

It's sad how many people lose or give up their exchange because they don't understand how all this identification stuff really works.

The identified Replacement Property is treated as received before the end of the exchange period if

you receive the Replacement Property before the end of the exchange period, and

the Replacement Property received is substantially the same property as identified.

One of the greatest stipulations in the final deferred exchange regulation permits you to exchange for real estate that has not been built yet. Exchangers are still smacking their lips over this one.

A transfer of Relinquished Property in a deferred exchange will not fail to qualify for nonrecognition of gain or loss under §1031 merely because the Replacement Property is not in existence or is being produced at the time the property is identified as Replacement Property.

Replacement Property to be produced must be identified. For example, your identified Replacement Property consists of improved real property where the improvements are to be constructed. The description of the Replacement Property will satisfy the requirements if a legal description is provided for the underlying land and as much detail as is practicable at the time the identification is made is provided for construction of the improvements. Two examples of identification of the property to be produced are blueprints and the contract with the builder.

For the 200-percent and incidental property rules, the fair market value of the Replacement Property to be produced is its estimated fair market value as of the date you expect to receive it.

For property to be produced, variations due to usual or typical production changes are not taken into account. However, if substantial changes are made in the property to be produced, the Replacement Property received will not be considered to be substantially the same property as identified.

If identified Replacement Property is real property to be constructed and the construction is not completed on or before the date you receive the property, the property received will be considered to be substantially the same property as identified only if it is real property, and it would have been considered to be substantially the same property as identified had construction been completed on or before the date you received it.

The value of the Replacement Property must be figured on the day of transfer. Construction work completed after the day of transfer will not be treated as part of the exchange.

IRS Letter Ruling 9149018 is an excellent guide for planning and “building” a §1031 exchange involving construction and packaging of Replacement Property by the “buyer” of your client's property. Here's what happened:

Needing additional office space, Taxpayer was looking for new property. To avoid taxable gain, he wanted to exchange his old property instead of selling it. He found land owned by LM that was perfect for his new building. LM leased the land to Buyer. The lease was a 30-year lease and gave Buyer the right to build on the property. In addition, Buyer and successors were given an option to buy the land from LM.

Taxpayer and Buyer agreed that Buyer would build a building on the land. Buyer approved the plans, the costs of construction, and the architect, contractors, and other parties involved in the construction. The taxpayer provided the construction financing in the form of a nonrecourse mortgage.

After completion of the building, Taxpayer would exchange his old property for Buyer's leasehold interest in the land and new building. At the closing, a portion of the mortgage would not be repaid to balance the equities.

The IRS said the exchange of Taxpayer's old property for the long-term lease plus the new buildings were interdependent parts of an overall plan resulting in a like-kind exchange. It qualified for §1031 non-recognition of gain treatment. It was not a transfer of the old property for cash followed by a separate and unrelated purchase of the new property. IRS noted Buyer bore risks of ownership before the exchange and had the obligation to build the building. In addition, Buyer was obligated under the lease with LM.

 Reminder: A lease on real estate with 30 years or more to run qualifies as like-kind when exchanged for qualified like-kind real estate. See Chapter 3.

An interesting aside is the IRS ruling permitted Taxpayer to assist in financing the exchange property with a mortgage loan.

âCaution: Be very careful not to get caught in an exchange for services trap. The transfer of Relinquished Property won't qualify for §1031 treatment if it's transferred in exchange for services. This includes production services.

Any additional production or construction occurring with respect to the Replacement Property after you receive the property will not be treated as the receipt of like-kind property.