by James Robert Deal
When a seller (also referred to as "exchangor") is selling real property held for investment purposes, and when the seller is facing a large capital gain, that gain can be deferred by exchanging that "relinquished property" for "replacement property."
Many sellers who would refuse to sell if they had to pay tax on the gain will sell if they can do an exchange and defer the gain. The tax on the gain will be due when the seller later sells the replacement property. However, if the exchangor holds onto the replacement property or keeps exchanging it for other replacement property, no tax on capital gain will ever be due.
The tax basis of the property will be stepped up to then-current market value when the exchangor dies or, if the exchangor is married, when either spouse dies. So for the person who does tax-deferred exchanges, the odds of ever paying tax on capital gain is low, both for the seller/exchangor and for his/her heirs.
They say death and taxes are inevitable. Obviously, you can't beat death, but you can beat the tax on capital gain. Are these tax policies too generous or not generous enough? I will let you decide that.
Replacement property must be of "like kind" to the relinquished property, however, virtually any kind of investment real estate is considered like kind to any other. One can exchange apartment for farm, warehouse for vacant lot, or strip mall for rental house. Exchanges of personal property are more difficult because a bulldozer must be exchanged for a bulldozer, not for a tractor.
A seller's personal residence is not eligible for §1031 treatment, but it may be exempt from capital gain entirely. Likewise, a vacation cabin cannot be exchanged, however, it can be converted into rental property over a period of years and then exchanged under §1031. Also ineligible under §1031 is dealer property, which brokers or builders buy, hold in inventory, and sell routinely.
To get full benefit of an exchange and defer all tax, the exchangor should trade for replacement property that is greater or at least equal in value to that of the relinquished property, and the exchangor should spend all the sale proceeds on the replacement property.
If the exchangor exchanges for property of a lesser value, or if the exchangor takes part of the cash out of the exchange, the exchange will still be valid. However, gain will be recognized 1) to the extent that the replacement property is of lesser value than the relinquished property and 2) to the extent the exchangor takes cash out of the exchange. The exchange is still effective to defer the balance of the gain.
With a §1031 exchange of investment property, there must be an exchange agreement tying together the two legs of the exchange, and the exchange agreement must be signed before the closing of the sale of the relinquished property. In most §1031 exchanges an exchange intermediary must be involved.
No later than midnight of the 45th day after the closing of the sale of the relinquished property (Leg 1 of the exchange), the exchangor must identify replacement property. The exchangor sends written notice of identification to the exchange intermediary or some other person involved in the exchange, such as the escrow agent or title company.
The identification can be in the form of a purchase and sale agreement, or it can be a simple letter. It must clearly identify the replacement property. A legal description or street address is sufficient. Identification may be communicated by mail or by fax. No price need be stated.
The exchangor may add, delete, and substitute identified properties until the end of the 45-day period. Thereafter, no additional properties may be identified, and no substitutions may be made.
No later than midnight of the 180th day after the closing of the sale of the relinquished property, the exchangor must close on the acquisition of replacement property (Leg 2 of the exchange).
Important note: If the 45th or the 180th day falls on a weekend or holiday, there is no extension to the following workday.
An exchangor may actually have less than 180 days to close Leg 2 of the exchange: If the exchangor’s tax return due date intervenes, Leg 2 will have to be closed by that date, which for most taxpayers is April 15, because both the relinquished and replacement transactions must be reported in the year of the relinquished property sale. For example, if Leg 1 is closed between October 16, 2005, and December 31, 2005, the exchangor will have to complete Leg 2 by April 15, 2006. However, the exchangor can obtain the full 180-day period for completing Leg 2 by obtaining an extension for filing 1998 taxes.
The exchangor must follow one of the following three rules:
The exchangor can identify up to three replacement properties regardless of their value. For the first 45 days, the exchangor can substitute or eliminate identified properties. Although up to three properties are identified, the exchangor need only close on one of them to complete the exchange. On the other hand, in order to obtain full benefit of the exchange, the exchangor should close on enough of the replacement properties to meet or exceed the sale price of the relinquished property.
The exchangor can identify any number of replacement properties, provided that their combined value is not more than twice the value of the relinquished property. Again, the exchangor can substitute properties for the first 45 days and thereafter eliminate unwanted properties.
The 200-percent rule is generally used in exchanges where the exchangor is acquiring a number of replacement properties.
The exchangor can identify any number of replacement properties of any value, provided that the exchangor must close on 95 percent of these properties. This is risky.
In the typical exchange there are four parties involved. The exchangor/seller exchanges the relinquished property to the intermediary. Then the intermediary sells the relinquished property to the relinquished property buyer and holds the sale proceeds in trust. The exchangor identifies replacement property within 45 days. The exchangor signs a purchase agreement to buy replacement property from the replacement property seller and assigns that agreement to the intermediary. The intermediary buys the replacement property within 180 days and then transfers it to the exchangor in completion of the exchange.
Thus, the exchangor does his/her exchange with the intermediary. Two-way swaps are rare: The buyer of the relinquished property is almost never the seller of the replacement property.
The intermediary is usually a corporation owned by a lawyer. The legal issues involved are complex, and non-lawyers are hesitant to get involved. It is permissible for the lawyer to represent the exchangor as the exchangor’s lawyer and act as intermediary, provided the lawyer has not represented the exchangor on other legal matters (except for previous exchanges and routine escrows) within the past two years.
The Cooperation Clause
It has been traditional to add a simple cooperation clause to the purchase agreement:
"The seller (or buyer in Leg 2) intends to exchange this property for other like-kind property pursuant to §1031 of the IRC. The other party agrees to cooperate with this exchange, provided however, that in doing so the other party will incur no greater liability or cost than he/she would have incurred had this been a regular purchase and sale, and the seller (or buyer in Leg 2) agrees to hold the other party harmless against any such greater liability or cost."
However, the law does not require the use of such a clause, and it may be omitted. The escrow agent need only give notice at closing to the other party that the exchangor is doing an exchange, and the other party need not even sign a receipt of this notice. In some cases it is best not to disclose the intent to exchange to the other party, because the other party may take advantage of the fact that the exchangor is boxed in by inflexible time constraints.
The Replacement Property Feasibility Clause
Assume that something goes wrong with the planned acquisition of the replacement property, e.g., structural or title defects are uncovered. If the exchangor is locked into selling the relinquished property on a fixed date, the exchangor will have only 45 days to locate another replacement property and do a feasibility study. This can be difficult.
The safest strategy is for the exchangor to close the sale of the relinquished property only when it is absolutely clear that the exchangor will be able to acquire the replacement property. Therefore, the exchangor often should have a replacement property feasibility clause in the contract to sell the relinquished property:
"The seller is exchanging this property for other property being identified and researched. The seller's commitment to sell this property is subject to the seller locating satisfactory replacement property and conducting and approving a feasibility study within _____ days after mutual agreement to this contract. Closing will occur _____ days after this contingency is satisfied."
The Accordion Clause
As an alternative, the exchangor should at least obtain the right to stretch out the closing date for the relinquished property. Consider this clause for use in the Leg 1 offer, one which does not inform the buyer that the exchangor is doing an exchange. A similar clause can be used for Leg 2:
"The closing will occur between _____ and _____. The seller shall set the closing date within this range, provided the seller shall give the buyer ____ days notice before the closing date selected."
Attorney and CPA Review Clause
There are always novel issues to consider in setting up a tax-deferred exchange. For the protection of the exchangor, real estate agent, and broker, the exchangor should consult with experienced legal and accounting counsel before the purchase and sale agreement becomes binding. If it is not practical for the exchangor to meet with advisors before signing, the following clause should be placed in the purchase and sale agreement:
"The seller's commitment to sell (or the buyer's commitment to buy in leg 2) is subject to review of this purchase and sale agreement by his or her attorney and accountant within three days after mutual agreement to it."
Copyright © 2008. James Robert Deal.