DEFERRED EXCHANGES

A deferred exchange is an exchange in which a taxpayer transfers prop-erty held for productive use in a trade or business or for investment and subsequently receives property held for productive use in a trade a business or for investment. Special rules govern the identification and receipt of property for deferred exchange transactions to qualify for nonrecognition treatment.

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The law is not static in this area. Deferred exchanges remain the “hot corner”

in like-kind exchange practice. Taxpayers are regularly pushing the envelope on how transactions can be structured to stay within the rules yet provide maximum flexibility. At times, the IRS and the courts resist. However, on many recent oc-casions, they have been approving new techniques under the original legislative purpose behind Code Sec. 1031: to encourage capital reinvestment.

Gain, Loss, and Basis Rules

The amount of gain or loss recognized in a deferred exchange is determined under the same like-kind exchange rules for exchanges that are not deferred.

Identification Rules

The identification rules (TRC SALES: 30,602; 30,602.5; 30,602.10, 20,6012.15) allow the taxpayer 45 days starting on the date the taxpayer transfers relinquished property to identify replacement property. If multiple properties are relinquished as part of the same exchange, the identification period starts rolling on the earliest date on which a relinquished property is transferred. Other rules related to identification of property also apply:

The identified property must be described unambiguously in a signed document that is delivered to a qualified party to the exchange. Real property is unambiguously described if the document provides a legal description, street address, or distinguishable name;

Incidental property may be included in the identified property but cannot compose more than 15 percent of the aggregate value of the main property. Property is incidental to a larger property if it is typi-cally transferred together in standard commercial transactions and the aggregate fair market value of the property does not exceed 15 percent of the aggregate fair market value of the larger item of property;

Multiple replacement properties can be identified, even as alterna-tive properties, but there may be no more than three properties identified or 200 percent of the fair market value of all relinquished properties; and

The identification of replacement property can be revoked before the end of the replacement period in a properly signed and delivered document.

_EXAMPLE

Multiple Replacement Properties: Monica transfers Yardley House, which has a fair market value of $100,000. She identifies Yardley Green, Yardley Park, Yardley Terrace and Yardley Towers with fair market values of $30,000, $40,000, $50,000 and $60,000, respectively as replacement properties. Because the aggregate fair market values of these properties ($180,000) does not exceed 200 percent of the fair market value of Yardley House ($100,000 × 2 = $200,000), the properties are properly identified.

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_EXAMPLE

Incidental Property: James receives in an exchange a truck with a fair market value of $10,000 and a spare tire and tool kit with a fair market value of $1,400. The three items are treated as one property because the fair market value of the spare tire and tool kit does not exceed 15 percent of the fair market value of the truck ($10,000 × 0.15 = $1,500).

Receipt of Property Rules

The deadline for receipt of qualified property is the earlier of 180 days after the date of transfer of the taxpayer’s relinquished property or the due date of the transferor’s tax return for the year in which the transfer occurred (including extensions).

_EXAMPLE

ABC Corporation files its corporate tax return on a calendar-year basis.

ABC transfers property in a deferred exchange on November 17, Year 1.

The exchange period ends on March 15, Year 2, the due date for ABC’s tax return for the tax year in which ABC transferred the property. If ABC is allowed an automatic six-month extension to file its tax return, the exchange period ends on May 16, Year 2, the date that occurs 180 days after the transfer of the property.

If, as part of the same exchange, the taxpayer transfers more than one relinquished property and the properties are transferred on different dates, the period starts running on the earliest date on which any of the properties is transferred. In addition, for replacement property to be deemed received before the end of the exchange period, the replacement property received must be substantially identical to the replacement property identified.

The Receipt-of-Other-Property-First Trap

Taxpayers in a deferred exchange may fall into a big trap (TRC SALES:

30,608) if certain cash or other “backstop” guarantees are made part of the deal. Gain in an otherwise qualifying deferred exchange will be recognized if the taxpayer actually or constructively receives money or other property before the taxpayer receives the replacement property. These transactions will be treated as sales, even if the taxpayer does later receive the replace-ment property.

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_EXAMPLE

Bob and Lisa enter into an agreement on May 17, for a deferred exchange and Bob immediately transfers real property worth $100,000 to Lisa. By July 1, Bob is to identify replacement property and by November 13, Lisa is to purchase and transfer it to Bob. At any time on or after May 17, and before Lisa has purchased replacement property, Bob has the right to demand that Lisa pay $100,000 in lieu of purchasing the replacement property. As it turned out, however, Bob identified the replacement property and Lisa purchases and transfers it to him.

Because Bob had the unrestricted right to demand payment of $100,000 as of May 17, he was in constructive receipt of that amount on that date.

The exchange of properties will be treated as two cash sales.

If the exchange qualifies under one of three safe harbors, however, a taxpayer will not be deemed to be in actual or constructive receipt of money or property.

In addition, receipt of prorated rents or other items a seller may receive as a result of disposition of a property and transaction items such as commissions and taxes will also not result in gain if they are received by a taxpayer before the taxpayer receives the replacement property.

Security or guarantee arrangements safe harbor. A taxpayer is not in receipt of other property before receiving replacement property just because the obligation of the other party is or may be secured by a mortgage, deed of trust, or other security interest in property, a standby letter of credit that does not allow the taxpayer to draw on the credit except in the case of the transferee’s default, or a guarantee of a third party.

Qualified trusts and escrow accounts safe harbor. The obligation of the other party to the transaction may be secured by cash or a cash equivalent held in an escrow account or in a qualified trust and the taxpayer will not be deemed to be in receipt of other property before he or she receives re-placement property. However, receipt of escrow funds by the seller before transferring to the escrow agent will result in gain recognition when the escrow agreement does not impose restrictions on the seller.

Interest and growth factors safe harbor. A taxpayer is not in receipt of other property before receiving replacement property just because the taxpayer may be entitled to receive interest or another growth factor with regard to the deferred exchange as long as the taxpayer’s rights to receive the interest or other growth factor are limited.

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STUDY QUESTIONS

10. Exceptions to the two-year minimum period for dispositions of like-kind property exchanged by related parties include all of the following except:

a. Exchanges and dispositions in which the parties’ principal pur-pose was not tax avoidance

b. The property is disposed of following the death of the taxpayer or the related person

c. There is a compulsory or involuntary conversion where the ex-change occurred before the imminence of such event

d. All of the above are exceptions

11. In a _____, a taxpayer transfers property held for productive trade or business use or investment and subsequently receives property held for production use in a trade or business use or investment.

a. Eventual exchange b. Deferred exchange c. Cash-out exchange d. Guaranteed exchange

12. Which of the following is not one of the safe harbors for deferred ex-changes?

a. Qualified trusts and escrow accounts b. Interest and growth factors

c. Proof of receipt of the other property first d. All of the above are safe harbors