Back to
Topics |
Unresolved Deferred Exchange Issues
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Since the deferred exchange regulations were issued in 1991, many issues
have been addressed by the regulations and subsequent cases and rulings.
For example, the regulations specify what constitutes a valid “identification” of
replacement property. Questions remain, however, as to what is the same
or a separate exchange when multiple properties are relinquished, what constitutes
a single “property” for purposes of the 3-property identification
rule, how much detail is required to identify an undivided fractional interest
in property, and when property received is “substantially the same” as
identified. The regulations provide for installment sale treatment if a
buyer’s note is received in an exchange and if a deferred exchange
fails in the next year. See Reg. Section 1.1031(k)-1(j)(2). The regulations
also permit the netting of liabilities in a deferred exchange, including
netting of the liabilities in exchanges by partnerships that straddle tax
years. See Reg. Section 1031(k)-1(j)(3), Example 5; Rev. Rul. 2003-56. A
new Revenue Procedure provides a safe harbor for deferred exchanges of personal
property through sophisticated like-kind exchange (LKE) programs. See Rev.
Proc. 2003-39 (discussed in a separate link on the main menu under “Personal
Property Exchanges”). Notwithstanding all of the progress made in
clarifying the deferred exchange rules, some significant and controversial
issues remain unresolved. The open issues include (i) when funds may be
disbursed by a QI to the taxpayer; (ii) management control over a QI; (iii)
property identification issues; (iv) boot issues; (v) property receipt issues;
and (vi) switching intermediaries.
Disbursement of Exchange Funds. The most controversial open issue involves
situations in which the taxpayer considers the transaction to be over and
demands the exchange funds but a (g)(6) event has not occurred. A (g)(6)
event is an event under the deferred exchange regulations that allows the
taxpayer to receive cash. Under Reg. Section 1.1031(k)-1(g)(6), a taxpayer
may have rights to receive cash or other property not of like kind: (i)
after the end of the exchange period (the earlier of 180 days after the
transfer of the relinquished property or the due date of the taxpayer’s
return for the year of such transfer, including extensions); (ii) after
the end of the 45-day identification period; (iii) upon or after the receipt
by the taxpayer of all of the replacement property to which the taxpayer
is entitled under the exchange agreement; or (iv) upon or after the occurrence
after the end of the identification period of a material and substantial
contingency that relates to the deferred exchange, is provided for in writing,
and is beyond the control of the taxpayer or any disqualified person (other
than the person obligated to transfer the replacement property to the taxpayer).
Taxpayers often want to receive exchange funds prior to the occurrence
of one of the above (g)(6) events. The transaction is not in fact over under
the terms of the exchange agreement, but the taxpayer considers it finished
and wants the balance of the exchange funds, including interest or a growth
factor. These cases present difficult issues for intermediaries. The question
of early distributions from an exchange account has been extensively discussed
and debated in light of PLR 200027028 (April 10, 2000) (provision in original
exchange agreement to allow early release of funds violates safe harbor
because contingency was within the control of the taxpayer) and Florida
Industries Investment Corporation and Subsidiaries v. Commissioner, T.C.
Memo 1999-346, aff’d per curium in an unpublished opinion (11th Cir.
2001) (appeal only of the Section 1033 and related penalty issue) (premature
receipt of boot evidenced the constructive receipt of all sales proceeds
and disqualified the entire exchange). See Weller, “Early Distributions
From 1031 Exchange Accounts - Another Look at a Strange New Ruling,” 93
J. Tax’n 73 (August 2000); Levine, “Premature Distributions
From Section 1031 Exchange Accounts - New Ruling Provides Guidance,” 93
J. Tax’n 7 (July 2000).
The three basic scenarios involving premature disbursements are as follows:
(1) the taxpayer wants to cancel the exchange and demands the exchange funds
prior to the end of the identification period (e.g., the day after the relinquished
property closes and the funds are received by the intermediary); (2) the taxpayer
timely identifies replacement property, but the property is sold to another
person or the taxpayer no longer wants the property, and the taxpayer demands
the exchange funds prior to the end of the 180-day exchange period; and (3)
the taxpayer timely identifies multiple properties and receives one of the
properties, but the taxpayer wants any balance of the exchange funds and interest
or a growth factor immediately thereafter (i.e., prior to the end of the 180-day
period) while there remains identified but unacquired property.
The first two scenarios present an issue for the intermediary and other
persons who exchange with the intermediary (not necessarily the taxpayer).
The taxpayer will be taxed on the transaction in any event. The taxpayer
just wants the exchange funds and wants them yesterday. If the intermediary
simply complies with the taxpayer’s demand and disburses the funds
without more, are the restrictions contained in that intermediary’s
agreement empty and meaningless words? If an intermediary engages in a course
of conduct whereby it regularly disregards the terms of its agreements,
do all persons who exchange with the intermediary effectively have the immediate
ability or unrestricted right to receive the exchange funds at any time?
See Reg. Section 1.1031(k)-1(g)(4)(vi). This is a serious risk that intermediaries
must avoid. Florida Industries shows that conduct inconsistent with the
terms of an exchange agreement may be fatal. While the court analyzed only
the conduct involved in that particular case, there is no reason why conduct
in other cases would be irrelevant. Conduct in other cases may evidence
the true intentions of the parties or of the intermediary in particular.
The principles set forth in Florida Industries could easily be extended
to reach such a result.
In the first scenario, the intermediary should point out the terms of
the exchange agreement to the taxpayer, explain the legal and practical
problems to the taxpayer and hopefully persuade the taxpayer to wait peacefully
until the end of the 45-day period. If the taxpayer is unconvinced, continues
to demand the funds and threatens to sue the intermediary or otherwise disrupt
its business, the intermediary has a tough decision to make. To avoid and
settle an actual or potential dispute, the intermediary could pursue an
alternative course of action. The intermediary could agree to rescind the
agreement in exchange for a complete release of all claims under these circumstances.
If this course of action is undertaken, the rescission, settlement and release
should be fully documented in writing. It is uncertain whether the IRS or
the courts would find the intermediary’s conduct to be inappropriate
in such a case.
In the second scenario, the taxpayer has identified replacement property
but no longer desires to receive any of those properties. The intermediary
should undertake the same course of action as in the first scenario and
hopefully convince the taxpayer to wait until the end of the 180-day period.
If the taxpayer threatens to sue the intermediary or otherwise disrupt its
business, the parties could enter into a written amendment to the agreement
to avoid a dispute and settle all claims. The amendment could provide that
the taxpayer revokes all identified replacement properties, agrees that
the transaction is completed and that the requirements of Section 1031(a)(3)
can no longer be met, acknowledges that the taxpayer will be fully taxable
on the transaction, and agrees to indemnify, defend and completely release
the intermediary from any and all claims arising out of the transaction.
The amendment could set forth its business purpose, the facts relating to
the failure to acquire the replacement properties, the frustration of the
purpose of the original agreement and similar recitals. In addition to any
additional fees to be paid to the intermediary, the amendment would be supported
by consideration in the form of the release of the intermediary, including
(without limitation) complete release of its obligation to acquire any of
the identified replacement properties.
In the third scenario, the taxpayer has acquired one or more replacement
properties but there remains identified, but unacquired property. The taxpayer
demands any remaining exchange balance and interest or a growth factor before
the end of the exchange period. Some intermediaries simply pay out the remaining
funds and interest thereon without further action. That conduct may not
be prudent since a (g)(6) event may not have occurred. The answer to this
scenario depends on whether the taxpayer has received all of the replacement
property to which the taxpayer is entitled under the exchange agreement.
See Reg. Section 1.1031(k)-1(g)(6)(iii)(A). If so, a (g)(6) event has occurred
and there is no problem disbursing the remaining funds and interest to the
taxpayer. But it is unclear what this means: “the receipt by the taxpayer
of all of the replacement property to which the taxpayer is entitled under
the exchange agreement.” By simply identifying a replacement property
does the taxpayer become entitled to receive it under the terms of the exchange
agreement? Intermediaries might easily be in breach of their obligations
if taxpayers actually became entitled to receive replacement property merely
by identifying it. Moreover, the regulation expressly refers to property
which the taxpayer is entitled to receive under the exchange agreement,
not all of the replacement property that the taxpayer has identified. The
regulation could have said identified rather than entitled but did not do
so.
If the taxpayer or other parties must do more before the taxpayer becomes
entitled to receive an identified property (e.g., enter into a purchase
contract, remove contingencies and close escrow), are these conditions and
further acts within the control of the taxpayer? If so, is there a conflict
between provisions (A) and (B) of Reg. Section 1.1031(k)-1(g)(6)(iii)? Provision
(A) would be within the control of the taxpayer while provision (B) expressly
states that the contingency must be beyond the control of the taxpayer.
We simply do not know what Reg. Section 1.1031(k)-1(g)(6)(iii)(A) means.
It may or may not apply to the third scenario depending on the facts, the
terms of the exchange agreement and a court’s interpretation of the
term “entitled.” Unlike the first two scenarios, the taxpayer
has tax risk since the replacement property that has already been acquired
may not qualify for exchange treatment if the entire transaction is poisoned.
Accordingly, the safe course of action for all concerned is to wait until
the expiration of the 180-day exchange period.
If that is not feasible, the parties could enter into a written amendment
containing terms similar to the amendment used in the second scenario. The
taxpayer could revoke the identification of the unacquired replacement property,
acknowledge and agree that he has received all of the replacement property
which the taxpayer is entitled to receive under the exchange agreement,
and release the intermediary from any further obligations under the exchange
agreement. The regulations do not address the issue of post-transfer amendments
and only discuss revocation of a property identification for purposes of
Reg. Section 1.1031(k)-1(c)(6). An identification of property may only be
revoked for identification purposes if the revocation is made within the
45-day period. But there are good reasons to believe that such amendments
should be acceptable to the IRS or the courts. Reg. Section 1.1031(k)-1(g)(4)(vi)
may even contemplate the possibility of such amendments in providing that
the safe harbor “ceases to apply” when the taxpayer has an immediate
ability or unrestricted right to receive money or other property (rather
than providing that the safe harbor never applies at all).
There seems to be no good policy reason for the exchange funds to be continued
to be held by the intermediary in any of these scenarios. But contracts
are contracts and rules are rules. If the parties depart from the terms
of the agreement or the (g)(6) limitations, they should do so only for solid
business reasons, with full disclosure and understanding of the risks, and
through a written amendment that documents the transaction. The court in
Florida Industries mentioned the possibility of a written amendment to the
agreement and noted that the parties never entered into one. In the absence
of such precautions, an intermediary who makes premature disbursements to
taxpayers upon demand may run the risk of disqualifying exchanges. Florida
Industries confirms the worries of many Section 1031 practitioners. Departures
from the terms of an escrow or exchange agreement may be fatal. In the most
egregious cases, the entire transaction may be taxable ab initio. Intermediaries
should make sure that their agreements comply with the safe harbors in general
and the (g)(6) limitations in particular and that they then faithfully observe
the terms of their agreements. Florida Industries shows that conduct counts
more than words. Any departures from the terms of the agreement should be
strongly discouraged. If subsequent events give rise to a potential departure,
the parties should carefully resolve the issue in writing. If necessary,
the parties could enter into a written amendment to the agreement. That
is the proper way to modify a contract, not through a course of dealing
totally at odds with its terms.
PLR 200027028 (April 10, 2000) involves a pre-transfer amendment to a
standard exchange agreement to allow the QI to distribute funds if the exchanger,
after identifying one or more replacement properties and negotiating in
good faith, is unable to conclude a binding agreement to purchase the property.
The IRS held that such an exchange agreement would not meet the requirements
of Reg. Section 1.1031(k)-1(g)(6)(iii). The ruling generated controversy.
It was perceived by some as a ruling request designed to fail and one that,
ordinarily, would and should not have been sought. The QI involved in the
ruling may have had a conflict of interest if it earned more income, directly
or indirectly, by having the ruling fail and retaining the exchange funds.
Perhaps the QI simply wanted clarification of the rule for the benefit of
a client. But in that case, why not simply withdraw the ruling request when
it appeared that it would fail?
Most commentators believe that PLR 200027028 has a very limited scope.
First, it addresses a pre-transfer amendment to a standard exchange agreement
(i.e., a provision in the original exchange agreement) intended to comply
with Reg. Section 1.1031(k)-1(g)(6). It does not analyze a subsequent “post-transfer” or “midstream” amendment.
Second, the ruling addresses only two narrow situations where a taxpayer
identifies (1) multiple replacement properties intending to acquire all
of them, and (2) only one replacement property but fails to negotiate a
satisfactory acquisition agreement with the seller. Finally, the Service
was not asked to interpret the scope of Reg. Section 1.1031(k)-1(g)(6)(iii)(A)
(which allows the disbursement of funds on or after the receipt of all replacement
property that the taxpayer is “entitled” to receive under the
exchange agreement).
A more common fact pattern than the two situations addressed in the ruling
is the identification of multiple properties with the taxpayer intending
to acquire only one of the alternative properties. This situation has been
described as “bought one money left over” (BOMLO). The BOMLO
problem can be solved in the original exchange agreement or in the exchanger’s
identification notice by providing that the QI is obligated to acquire only
one of the identified properties. Following the acquisition of the first
property, the QI will have no further obligations to acquire and transfer
any additional properties. The taxpayer will then have clearly received
all of the replacement property that the taxpayer is entitled to receive
under the exchange agreement. Reg. Section 1.1031(k)-1(g)(6)(iii)(A) should
permit release of the funds after the first and only replacement property
is acquired and transferred to the taxpayer. In other scenarios, it remains
unclear whether a midstream amendment to an exchange agreement will be respected,
assuming it is supported by bone fide business considerations. There is
no tax abuse or evasion involved. The taxpayer is obligated to report the
failed exchange as a taxable sale, just as much as if the taxpayer waited
the full 180 days to receive the exchange funds. There is simply no good
legal, policy or other reason to prohibit such amendments, provided that
they are not a fait accompli at the inception of the transaction. Only in
that case would such amendments render the identification and safe harbor
requirements meaningless.
In Florida Industries the accommodator was a disqualified person (the
taxpayer’s attorney). The case holds that violating the terms of an
exchange agreement and allowing the premature release of exchange funds
may evidence constructive receipt of the entire exchange balance ab initio
and cause the entire transaction to be taxed. The court in Florida Industries
specifically noted that the parties to the escrow agreement never modified,
amended or supplemented the agreement. Moreover, the court stated that “it
is significant that the escrow agreement did not identify what portion of
the escrowed sales proceeds was to be used to purchase replacement property
and what portion was to remain as boot under Section 1031.” Thus,
the question remains open as to whether an agreement can be modified to
provide for the release of funds without prejudicing Section 1031 treatment
for replacement properties previously received.
A Field Service Advice also emphasizes that the terms of an original exchange
agreement and the course of dealing of the parties must comply with the
(g)(6) limitations. FSA 200048021 (August 29, 2000) involved an escrow agent
who did not satisfy the definition of a QI. Among other things, the escrow
agent did not acquire or transfer the properties involved in the exchange.
The FSA concerns a father who transferred the relinquished property to his
children and attempted an exchange. While an exchange agreement was drawn
up with a party acting as “escrow agent,” it appears that the
agreement was never followed. The children paid the purchase price to the
taxpayer’s law firm, not the escrow agent. The taxpayer was then in
constructive receipt of the sales proceeds since the law firm, as the taxpayer’s
agent, received the funds prior to the taxpayer’s receipt of the replacement
property. The terms of the exchange agreement were also deemed to violate
the (g)(6) limitations. The agreement may have been interpreted to allow
for the taxpayer to obtain funds prior to the receipt of replacement property
if a sales contract was presented to the taxpayer but the taxpayer rejected
it after the 45-day identification period. See also PLR 200027028 (taxpayer’s
inability to enter into a binding agreement to acquire replacement property
after negotiating in good faith is not a contingency “beyond the control
of the taxpayer” or otherwise a (g)(6) event).
Management Control of QI. How far may taxpayers or other “disqualified
persons” go in having management control over a QI? In PLR 200338001,
the IRS ruled that an intermediary limited liability company (“Intermediary
LLC”) is not a “disqualified person” and may serve as a QI
or exchange accommodation titleholder (EAT) in the taxpayers’ exchanges.
Intermediary LLC was managed (but not owned) by another LLC (“Manager
LLC”) that had the taxpayers’ son as one of its individual managers
as well as other attorneys who performed legal services for the taxpayers within
two year before the exchange. The key to the ruling is that the sole owner
of Intermediary LLC (the person holding the sole economic and membership interest
in that LLC) was not a “disqualified person.” The sole member of
the Intermediary LLC is referred to in the ruling as “Intermediary Shareholder.”
PLR 200338001 indicates that the IRS will apply the mechanical ownership test
of Reg. Section 1.1031(k)-1(k) in determining whether an intermediary is a “disqualified
person.” See also Example 3 of Reg. Section 1.1031(k)-1(k)(5) discussed
below. This test focuses solely on ownership of the intermediary, not management
powers. The identity of managers, officers and directors under this test is
irrelevant. These persons may be “disqualified persons” with respect
to the taxpayer provided that no “disqualified persons” actually
or constructively own more than 10% of the intermediary. Thus, a client’s
professional advisors, including lawyers, accountants and real estate agents,
may manage and receive compensation from a Section 1031 exchange intermediary
for their clients and others as long as the intermediary is at least 90% owned
by persons who are not “disqualified persons.” PLR 200338001 blesses
one of many possible structures that could be used by professional advisors.
In the ruling, Manager LLC served as Intermediary’s sole manager
and was a “disqualified person.” However, the taxpayers represented
that, at the time of the proposed exchange, Intermediary Shareholder (the
sole owner of the QI) will not be taxpayers’ agent as defined in Reg.
1.1031(k)-1(k)(2), and that Intermediary Shareholder is not an employee
or shareholder of the law firm involved with Manager LLC. In addition, it
was represented that Intermediary Shareholder is not a member of the same “family,” as
defined in Section 267(c)(4) as either taxpayer, and that Intermediary Shareholder
does not bear a relationship with either taxpayer described in Section 267(b)
or 707(b) of the Code (applying a 10% threshold in lieu of the 50% thresholds
used in those Code sections as provided in Reg. Section 1.1031(k)-1(k)(3)
and (4)). Based on these representations, the IRS found that Intermediary
Shareholder was not a “disqualified person.”
The IRS scrutinized the provisions of Intermediary’s operating agreement
to determine whether Intermediary was a “disqualified person.” The
Intermediary’s operating agreement gave Manager LLC the authority
and responsibility to manage Intermediary. Manager LLC’s authority
was limited to engaging in acts necessary or incidental to Intermediary’s
business of acting as a “qualified intermediary,” or as an “exchange
accommodation titleholder,” or otherwise as an intermediary to facilitate
tax-deferred exchanges, under Section 1031. Intermediary Shareholder could
remove Manager LLC as Intermediary’s manager only upon 300 days prior
notice or immediately upon the occurrence of certain enumerated events.
Manager LLC would receive compensation for services rendered to Intermediary
for each exchange. The operating agreement contained many special provisions
designed to avoid any deemed ownership interest of Manager LLC in the Intermediary.
The ruling cites and relies on Example 3 of Reg. 1.1031(k)-1(k)(5). Example
3 provides that on May 1, 1991, B [Taxpayer] enters into an exchange agreement
with C [Intermediary] whereby B retains C to facilitate an exchange. C has
no relationship to B described in Reg. Sections 1.1031(k)-1(k)(2), (k)(3),
or (k)(4). C is a corporation that is only engaged in the trade or business
of acting as an intermediary to facilitate deferred exchanges. Each of 10
law firms owns 10 percent of the outstanding stock of C. M is one of the
10 law firms and owns 10 percent of C. J is the managing partner of M and
is the president of C. J, in his capacity as partner to M, has also rendered
legal advice to B within the 2-year period before the exchange on matters
other than Section 1031 exchanges. Example 3 holds that J and M are disqualified
persons. C, however, is not a disqualified person because neither J nor
M own, directly or indirectly, more than 10 percent of the stock of C. Similarly,
J’s participation in the management of C does not make C a disqualified
person.
The structure approved in PLR 200338001 (an intermediary managed by the
taxpayer’s law firm) presents a variety of practical problems. First,
there is the cost of creating and maintaining the structure. If the taxpayer
and other clients of the law firm engage in a lot of exchange transactions,
the cost could be worth it. But if the volume of exchanges is low, the cost
may not be justified. Everything else being equal, the taxpayer may be better
off using a commercial intermediary that charges relatively low fees based
on a large volume of exchanges. Second, the law firm managing the intermediary
will face thorny conflict of interest questions, including ethical rules
regarding entering into a business transaction with a client, the issue
of divided loyalties and fiduciaries duties owed to both a client and the
intermediary and the intermediary’s owner, and the possible waiver
or other loss of attorney-client privilege. If anything goes wrong with
the exchange, the law firm could have greater risk of liability and malpractice
exposure than if it simply acted as the taxpayer’s attorney in the
transaction. At a minimum, such an arrangement would require full disclosure
of the professional’s financial and other interests in the intermediary,
the written informed consent of the client after full disclosure, and a
reasonable opportunity for the client to look elsewhere for intermediary
services. Notwithstanding PLR 200338001, it remains unclear how far taxpayers
and other “disqualified persons” may go in implementing structures
that give them management control over a QI without invalidating the exchange.
Identification Issues. How does the taxpayer certify that the taxpayer “identified” the
replacement property in 45 days? Prior to 2003, taxpayers simply entered
the date on which the replacement property was “identified” on
IRS Form 8824. In 2003, the IRS modified Form 8824 and the instructions
thereto but not in the more onerous way that some commentators proposed.
In particular, on line 5 of the 2003 Form 8824, the taxpayer must certify
the date on which the taxpayer sent “written notice” to another
party to identify the replacement property, but the taxpayer need not state
the name and address of the party to whom the written notice was sent. The “written
notice” requirement is now expressly stated on the form itself.
Line 5 of the 2003 Form 8824 now asks “Date like-kind property you
received was identified by written notice to another party (see instructions
for 45-day written notice requirement).” Previously, line 5 of Form
8824 simply asked “Date like-kind property you received was identified” without
specifically referring to the written notice requirement. The instructions
to the 2003 Form 8824 spell out the written notice requirement in detail.
The instructions for line 5 state:
“Enter on line 5 the date of the written notice that identifies the
like-kind property you received in a deferred exchange. To comply with the
45-written notice requirement, the following conditions must be met:
• The like-kind property you receive in a deferred exchange must
be designated in writing as replacement property either in a document you
signed or in a written agreement signed by all parties to the exchange.
• The document or agreement must describe the replacement property in a
clear and recognizable manner. Real property should be described using a legal
description, street address, or distinguishable name (e.g., “Mayfair Apartment
Building”).
• No later than 45 days after the date you transferred the property
you gave up:
1. You must send, fax, or hand deliver the document you signed to the person
required to transfer the replacement property to you (including a disqualified
person) or to another person involved in the exchange (other than a disqualified
person) or
2. All parties to the exchange must sign the written agreement designating
the replacement property.
Generally, a disqualified person is either your agent at the time of the transaction
or a person related to you. For more details, see Regulations section 1.1031(k)-1(k).
Note. If you received the replacement property before the end of the 45-day
period, you automatically are treated as having met the 45-day written notice
requirement. In this case, enter on line 5 the date you received the replacement
property.”
Other identification issues include what constitutes “one property” for
purposes of the 3-property rule. The 3-property rule allows taxpayers to identify
three properties of any fair market value. The three properties may or may
not be “either-or” alternatives. It is believed that an apartment
building (to be acquired as a whole) should be treated as a single property
under the 3-property rule even if it has been converted to many condominium
units. Similarly, separate but contiguous parcels should be treated as a single
property if operated and acquired as a whole. When non-contiguous parcels are
acquired from the same seller as part of a bundle, it remains unclear whether
the parcels are treated as a single property for purposes of the 3-property
rule. Rev. Proc. 2002-22 provides some guidance as to what constitutes a single
property for advance rulings for tenancy-in-common interests but not for Section
1031 identification purposes. Taxpayers should be cautious and avoid identifying
too many properties. Excessive identification of properties may disqualify
the exchange.
It is also unclear when two or more transfers of relinquished properties
are part of the same deferred exchange. Generally, the taxpayer will want
to structure separate exchanges to increase the number of properties that
may be identified under the 3-property rule and to avoid having the 45-day
identification period begin to run for all properties on the transfer of
the first property. The fact that a single replacement property will be
acquired for each relinquished property should not, in and of itself, cause
otherwise separate exchanges to be treated as a single exchange. Some of
the factors that may determine separate exchanges or a single exchange include:
(i) separate exchange agreements (even if there is a single sales contract
for multiple properties); (ii) separate escrows; (iii) contiguous or non-contiguous
parcels; (iv) the same or different buyers; and (v) the timing and interdependence
of the transfers.
The rules for properties transferred in the same exchange especially affect
business exchanges. Reg. Section 1.1031(k)-1(c)(4) provides that the 3-property
and 200-percent rules apply “[r]egardless of the number of properties
transferred by the taxpayer as part of the same deferred exchange.” In
practice, only the 200-percent rule can be used for a true multiple property
exchange or an exchange of a business. Most real estate exchanges are multiple
property exchanges due to the inclusion of small amounts of personal property.
However, most real estate exchangers can use the 3-property rule if the
incidental personal property is less than 15% of the total value as provided
in Reg. Section 1.1031(k)-1(c)(5).
The property received in the exchange must be “substantially the
same property as identified” under Reg. Section 1.1031(k)-1(d). This
requirement presents issues when taxpayers identify undivided fractional
interests in real property. It is unclear exactly how such interests should
be identified (in value or percentage or other terms). We also do not know
how strictly the “substantially the same property” rule will
be applied if the taxpayer receives an undivided interest in the identified
property but the percentage interest is more or less than the interest (if
any) specified in the identification notice. The examples in the regulations
provide some guidance (perhaps implying a 75% value test) but the examples
do not specifically address undivided interests in property.
Boot Issues. The taxpayer may receive funds directly from the buyer of
the relinquished property at closing. Those funds will be taxable boot but
will not jeopardize the entire exchange or cause the safe harbors to cease
to apply to the balance of the exchange proceeds going to the QI. A more
difficult issue is whether the taxpayer’s premature receipt of boot
from a QI or an escrow will cause the entire exchange to become taxable.
This may occur inadvertently through escrows or arise out of uncertainty
over what “transactional items” may be paid by a QI. Florida
Industries (discussed above) had very egregious facts indicating that the
taxpayer had constructive receipt over all of the exchange funds from the
outset of the transaction. This case arguably should not be applied to the
inadvertent receipt of small amounts that are technically treated as boot.
The treatment of prorations and other items that may be considered boot
is discussed above.
Most commentators believe that earnest money deposits and option payments
received by the taxpayer from the buyer before the relinquished property
closes should not be taxable until the transaction closes. This treatment
is supported by a line of authority involving deposits and option money.
See Rev. Rul. 69-93, 1969-1 C.B. 139; Ahadpour v. Commissioner, T.C. Memo
1999-9. If the taxpayer deposits the payments into escrow before closing,
the taxpayer may avoid receiving taxable boot, and the payments will be
treated as part of the exchange proceeds. To avoid any issues, however,
the safest approach is to have the payments made by the buyer to the QI
instead of the taxpayer. A taxpayer should also be allowed to receive tax-free
reimbursement of earnest money deposits and similar amounts advanced by
the taxpayer to acquire replacement property. Further, such amounts should
qualify as “transactional items” that may be reimbursed out
of exchange funds under Reg. Section 1.1031(k)-1(g)(7). To avoid any questions
of a premature disbursement from the QI, refunds may be made by the seller
or closing agent, including refunds at the time of closing. Rev. Proc. 2003-39
allows similar repayments of lease security deposits at closing, similar
reimbursements and similar netting of funds in program personal property
exchanges of 100 or more properties.
Property Receipt Issues. Ordinarily, a transfer of property for tax purposes
occurs on the recording of the deed and transfer of legal title. But a tax
transfer may also occur on the transfer of beneficial ownership even if
legal title has not yet been transferred. Tax ownership depends on the benefits
and burdens of ownership, including such factors as possession, the right
to rents and profits, the obligation for taxes and other liabilities, and
the risk of loss or damage. Thus, it is possible that the benefits and burdens
of ownership to property pass before the transfer of record legal title.
The date of transfer for tax purposes is important to determine when the
relinquished property was in fact transferred (including for purposes of
the 45-day and 180-day requirements) and when the replacement property was
in fact received (for purposes of the receipt requirement). Certain “options,” leases
with an option to buy, and land sale contracts may transfer beneficial ownership
of property for tax purposes before the transfer of legal title.
Another issue that arises with respect to replacement property is the identity
of the owner for tax purposes. The same taxpayer that starts the exchange
must generally finish the exchange and receive the replacement property.
It is permissible for the taxpayer to receive ownership through an entity
that is disregarded for tax purposes, such as a single member LLC or revocable
trust owned by the taxpayer, or a true agent or nominee of the taxpayer.
Complications arise, however, in other cases where the ownership of the
properties may not be the same. For example, the relinquished property may
be owned by only one spouse and title to the replacement property will be
vested in the names of both spouses (the spouses are separate “taxpayers” even
if they elect to file joint returns). The lender for the replacement property
may require that both spouses sign the loan for the replacement property.
In such a case, the spouses should have a written agreement that the other
spouse is acting merely as a co-signer on the loan and does not have any
beneficial ownership interest in the replacement property. Similar agency
or co-signer agreements may be needed if other persons, including entities
that are not disregarded for tax purposes, must go on title to the replacement
property. It is unsettled whether and under what circumstances the IRS will
respect such agency agreements.
Switching Intermediaries. It is unclear whether an intermediary can be
fired prior to the expiration of the 180-day exchange period. In certain
cases, the taxpayer may retain full power to discharge the intermediary
under state law. See Reg. Section 1.1031(k)-1(g)(4)(vi). There is no requirement
that the exchange agreement expressly disclaim the taxpayer’s common
law right (or statutory right) to discharge an agent (assuming the intermediary
is the taxpayer’s agent). At the same time, it may not be advisable
to provide specifically in the exchange agreement that the taxpayer retains
the unrestricted right to discharge the intermediary. It is unclear what,
if any, contractual rights to dismiss the intermediary (e.g., for certain
breaches of the exchange agreement) are permitted prior to the occurrence
of a (g)(6) event. The regulations require that “the agreement between
the taxpayer and the qualified intermediary expressly limits the taxpayer’s
rights to receive, pledge, borrow, or otherwise obtain the benefits of money
or other property held by the qualified intermediary as provided in paragraph
(g)(6).” But there is no requirement that this expressed limitation
be enforceable under state law: “Rights conferred upon the taxpayer
under state law to terminate or dismiss the qualified intermediary are disregarded
for this purpose.” See Reg. Section 1.1031(k)-1(g)(4)(vi). The regulations
merely provide that rights to fire the intermediary under state law shall
be ignored in determining whether a party is a qualified intermediary and
do not address contractual rights. The (g)(6) limitations could be undermined
by an unrestricted contractual right to dismiss the intermediary.
Whether a dismissed intermediary may be replaced by a successor intermediary
depends on how far the transaction has progressed. Once the taxpayer has
transferred the relinquished property to the first intermediary, the first
intermediary usually cannot be replaced by a successor intermediary and
still be within the qualified intermediary safe harbor. There are at least
two exceptions: (1) the first intermediary signs the contract to acquire
replacement property; and (2) the second intermediary acts as the agent
of the first intermediary to complete the exchange. Further, the second
intermediary who undertakes to complete the transaction may not be able
to qualify as a qualified intermediary. The second intermediary will not
have acquired the relinquished property from the taxpayer as is required
by the definition for a qualified intermediary. See Reg. Section 1.1031(k)-1(g)(4)(iv)(B).
Neither the first intermediary nor the replacement intermediary would meet
the requirements of the definition of qualified intermediary if the first
intermediary acquires and transfers the relinquished property, but the second
intermediary acquires and transfers the replacement property to the taxpayer.
The regulations define a qualified intermediary as a person who is not the
taxpayer or a disqualified person and who enters into a written agreement
with the taxpayer (the exchange agreement) and, as required by the exchange
agreement, acquires the relinquished property from the taxpayer, transfers
the relinquished property, acquires the replacement property and transfers
the replacement property to the taxpayer. Reg. Section 1.1031(k)-1(g)(4)(iii)(B).
In this case, all the first intermediary must do is enter into a contract
for the acquisition of the replacement property. Reg. Section 1.1031(k)-1(g)(4)(iv)(C)
provides that an intermediary is treated as acquiring and transferring replacement
property if the intermediary (either on its own behalf or as the agent of
any party to the transaction) enters into an agreement with the owner of
the replacement property for the transfer of that property and, pursuant
to that agreement, the replacement property is transferred to the taxpayer.
Further, the intermediary may enter into such an agreement using the assignment
and notice method. Accordingly, the exchange funds could be placed with
another intermediary or in a qualifying trust or escrow account and the
first intermediary could have no further role in the transaction as long
as the first intermediary enters into the acquisition agreement for the
replacement property.
Similarly, if the second intermediary acts as the first intermediary’s
agent to complete the exchange, the safe harbor should also apply since
the acts of the agent should be treated as those of the principal. The
first intermediary may allow the second intermediary to act as its agent
if the
changeover is consensual and if the first intermediary is comfortable
with the second intermediary and receives appropriate releases and indemnifications.
If the first intermediary’s exchange agreement is simply assigned
to the second intermediary (without the second intermediary becoming
the first intermediary’s agent), the safe harbor may not apply for
the reasons discussed above. A court or the IRS could adopt the fiction
that
the two intermediaries together constitute a qualified intermediary,
but that seems unlikely. Ordinarily, an assignee would step into the assignor’s
shoes only as of the date of the assignment and not retroactively. Further,
an assignee would not become the agent of the assignor solely by reason
of the assignment or a novation. To become an agent, an express or implied
agency agreement would be required. In summary, if the taxpayer desires
to switch intermediaries for whatever reason, the exchange may fall outside
of the qualified intermediary safe harbor unless one of the above exceptions
applies. This may be a risk that the taxpayer is willing to take if a
good reason exists for the desired changeover. Significant case law and
other
authority support the position that neither the first intermediary nor
the second intermediary is the taxpayer’s agent (assuming each company
is in fact independent of the taxpayer). However, an IRS agent reviewing
such a transaction may be quite confused, seeing one intermediary close
on the relinquished property and a different intermediary close on the
replacement property. Accordingly, any changeover should be well-documented
and supported
by a legitimate business reason.
|