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Introduction to Delayed Exchanges
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Non-simultaneous exchanges include (i) deferred exchanges (also known
as delayed exchanges, Starker exchanges and forward exchanges) and (ii)
reverse exchanges. The Treasury Regulations use the term “deferred
exchange” to describe delayed exchanges. In a deferred exchange,
the taxpayer transfers the relinquished property and subsequently receives
the replacement property. See Reg. Section 1.1031(k)-1(a). The use of
the term “deferred” to mean this type of delayed exchange
may be confusing since all exchanges qualifying under Section 1031 involve
the deferral of tax.
In a simultaneous exchange, the transfer of the old property and the
receipt of new property occur at the same time. The owner and intermediary
enter into an exchange agreement. The intermediary acquires the owner’s
property, sells it to the buyer, acquires the new property, and transfers
it to the owner. These transactions are interdependent and close concurrently.
If the owner exchanges with a qualified intermediary, a safe harbor is
provided so that the transfer and receipt of property is treated as an
exchange. See Reg. Section 1.1031(b)-2(a). An owner may also engage in
a three-party simultaneous exchange with the buyer of the old property
or the seller of the new property. There is no safe harbor for such exchanges
under the Section 1031 regulations but case law has allowed three-party
simultaneous exchanges where either the buyer or seller acts as the accommodator
for the taxpayer’s exchange.
In a deferred exchange, the owner’s old property is transferred
before the new property is received. The owner and intermediary enter
into an exchange agreement. The intermediary acquires the old property,
immediately sells it to the buyer, and receives the sales proceeds. The
owner identifies new property in 45 days after closing. The intermediary
uses the sales proceeds to purchase one or more identified properties,
transfers the identified property to the owner, and completes the exchange
in 180 days. The IRS endorses this procedure for effecting a deferred
exchange. See Example 4 of Reg. Section 1.1031(k)-1(g)(8). The advantage
of a deferred exchange over a simultaneous exchange is additional time.
In a deferred exchange, the owner has more time to identify (45 days)
and to receive (180 days) new property after transferring the old property.
The classic deferred exchange is the case of Starker v. United States,
602 F.2d 1341 (9th Cir. 1979), in which the taxpayer transferred the
relinquished property to the buyer and the exchange could have remained
open for up to 5 years. The taxpayer actually received all of the replacement
property approximately two years after the transfer of the relinquished
property. In 1984, Congress responded to the Starker decision with the
enactment of Section 1031(a)(3) which imposed a 45-day property identification
requirement and a 180-day property receipt requirement. The receipt requirement
of Section 1031(a)(3) provides that the replacement property must be
received on or before the earlier of (i) 180 days after the transfer
of the relinquished property or (ii) the due date (including extensions)
of the taxpayer's return for the year of the transfer of the relinquished
property. This receipt requirement assures that it will be known whether
or not the transaction qualifies under Section 1031 before the taxpayer
files his tax return for the year of the transfer. Thus, Section 1031(a)(3)
avoids the statute of limitations and other administrative problems that
would otherwise be presented by a deferred exchange left Aopen@ for many
years.
In a true reverse exchange, the taxpayer receives the replacement property
and subsequently transfers the relinquished property. For example, pursuant
to an exchange agreement and without any cash consideration, A transfers
Blackacre to T on February 1, 2005 and T transfers Whiteacre to A on
March 1, 2005. The transaction is a deferred exchange as to A and a reverse
exchange as to T. See Rutherford v. Commissioner, T.C. Memo 1978-505.
Reverse exchanges are usually accomplished through parking transactions
in which the exchange itself takes the form of a current or future simultaneous
exchange. The replacement property or the relinquished property is parked
with an exchange accommodation titleholder. See Rev. Proc. 2000-37, 2000-40
I.R.B. 308 (effective September 15, 2000); Biggs v. Commissioner, 69
T.C. 905 (1978), aff’d 632 F.2d 1171 (5th Cir. 1980).
Most exchanges today are structured using a fourth-party intermediary.
This is especially true for delayed exchanges where the sales proceeds
must be held by someone other than the taxpayer or the taxpayer’s
agent. The intermediary begins and ends the transactions owning no property,
and its sole purpose in the transaction is to facilitate the taxpayer’s
exchange. The intermediary acquires the relinquished property from the
taxpayer pursuant to an exchange agreement, sells the relinquished property
to the buyer, acquires the replacement property from the seller using
the proceeds of sale, and then completes the exchange by transferring
the replacement property to the taxpayer. These transactions constitute
a two-party exchange by the taxpayer and the intermediary, except that
the intermediary does not own any property at the beginning or end of
the transactions. Direct deeding is used at the direction and on behalf
of the intermediary who would otherwise be entitled to receive and be
obligated to convey title to the properties. Four-party exchanges have
been approved by the courts in numerous cases. The seminal case is Mercantile
Trust Co. v. Commissioner, 32 B.T.A. 92 (1935). In that case, a title
company acted as the fourth-party intermediary, and the court held that
the title company was not the taxpayer’s agent and need not acquire
beneficial ownership of the properties but could simply acquire and transfer
title for purposes of facilitating the exchange. See also Barker v. Commissioner,
74 T.C. 555 (1980); J.H. Baird Publishing Co. v. Commissioner, 39 T.C.
608 (1962), acq. 1963-2 C.B. 4; Fredericks v. Commissioner, T.C. Memo
1994-27; Coupe v. Commissioner, 52 T.C. 394 (1969), acq. in result 1970
C.B. XV; Brauer v. Commissioner, 74 T.C. 1134 (1980).
Most deferred exchanges today are done through a qualified intermediary
(“QI”) for several good reasons: (1) the security of using
a safe harbor provided by the regulations, rather than relying on a patchwork
of case law to support the exchange; (2) the reluctance of buyers to
participate in the exchange beyond the closing of the relinquished property
for legal and other reasons; (3) the risk that an unhappy buyer may use
the subsequent acquisition of the replacement property as leverage to
get repairs or other concessions from the taxpayer after the closing
of the relinquished property; (4) the risk of insolvency or other failure
to perform by the buyer; and (5) the sophistication and exchange expertise
of an intermediary compared to most buyers.
Notwithstanding the above, buyers sometimes act as accommodators in
deferred exchanges. Such transactions are often implemented incorrectly
resulting in a taxable sale. Language in the purchase and sale agreement
that the buyer will accommodate or cooperate in the taxpayer’s
exchange will not suffice. The taxpayer must not constructively receive
the exchange funds and the buyer must participate in the subsequent acquisition
of the replacement property. In one case, the taxpayer and the buyer
directed that the exchange funds be placed in an escrow account following
the closing of the relinquished property. The escrow account did not
expressly limit the taxpayer’s right to receive the funds in accordance
with the limitations of Reg. Section 1.1031(k)-1(g)(6) (known as the “(g)(6)
limitations”). The escrow agreement merely provided that the taxpayer
would designate replacement property within 45 days and that the escrow
holder would not hold the funds beyond 180 days. The buyer was not required
to acquire the replacement property or otherwise participate in the exchange
beyond the closing of the relinquished property. See Hillyer v. Commissioner,
TC Memo 1996-214 (attempted deferred exchange with buyer was held to
be a taxable sale).
To avoid the problems associated with using the buyer to accommodate
a delayed exchange, including incorrect and fatal structuring of the
exchange, nearly all modern delayed exchanges use a QI. The attached
diagram shows the structure of a delayed exchange facilitated by Pacific
Realty Exchange, Inc. (PRE) as the QI.
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