TYPES OF REAL ESTATE EXCHANGES

1.

Delayed Sub-title


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2.

Reverse Sub-title


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3.

Related Party Sub-title


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Delayed Exchanges

Until the decision of Starker v. Commissioner, most persons involved with exchanges believed that an exchange to be valid had to be simultaneous. Since it was extremely unlikely that a taxpayer could find someone that owned the property that the taxpayer wanted, multiple parties were needed to effectuate an exchange.

HISTORY

In a typical pre-Starker exchange that taxpayer T located the owner of property A that T wanted. The taxpayer located a buyer B for his property. B entered into an agreement with A to purchase A’s property and then entered into an exchange agreement to exchange property B for T’s property. All of this occurred simultaneously. Unless the properties were of the same value, additional cash was paid to make up any difference in value. Additionally, if mortgages were involved, the transaction became more complicated. Starker changed all of this.

In Starker, the taxpayer entered into an exchange agreement with a large corporation wherein the taxpayer transferred $5,000,000 worth of property to the corporation with the corporation agreeing to purchase property that the taxpayer designated over a five year period up to the value of $5,000,000 with an interest factor for the time use of the money. Over the five year period, the taxpayer designated various properties for the corporation to purchase, which it did, and the corporation deeded the purchased property to Starker in satisfaction of its agreement. The taxpayer claimed that this transaction qualified under S1031 and the IRS disputed the conclusion. The court found in favor of the taxpayer and thus the delayed exchange was born. 1

Current Law

Shortly after the Starker decision, Congress amended S1031 to limit the time frame for delayed exchanges.

The amendment brought about two constraints in a delayed exchange. The first is the 45 day rule and the second is the 180 day rule:

  1. Under the 45 day rule, within 45 days from the date that the original property was transferred, the taxpayer must notify, in writing, the party obligated to provide the exchange property with a list of potential purchases.
  2. Under the 180 day rule, one or more of those listed properties must be purchased and conveyed to the taxpayer within 180 days from the date that the original property was transferred. The 180 day rule further provides that the 180 days is shortened to the due date of the return, as extended, for the year of sale of the relinquished property.

Subsequent Regulations

Subsequent regulations further clarified the limitations of the property designations under the 45 day rule.

A taxpayer has three options:

  1. He may designate up to three properties of any value, the “three property rule.”
  2. A taxpayer may designate as many properties as he wants provided that total value of the designated properties does not exceed 200% of the sale price of the relinquished property, “the 200% rule.”
  3. Finally, if neither rule is complied with, the taxpayer may save the transaction if he purchases at least 95% of the value of all properties listed on an erroneous designation, the “95% rule.”

1  The facts of the case have been simplified. Under the actual facts not all of the transaction qualified under S1031 but the major holding was the allowance of a delayed exchange.

Reverse Exchanges

Although many people in the real estate industry have heard of Internal Revenue Code section 1031, all may not be familiar with its practical application. If complied with, a taxpayer can exchange his existing real estate for other real estate and defer the payment of the capital gains tax.

Although many people in the real estate industry have heard of Internal Revenue Code section 1031, all may not be familiar with its practical application. If complied with, a taxpayer can exchange his existing real estate for other real estate and defer the payment of the capital gains tax. In the usual transaction, the taxpayer, through the use of a Qualified Intermediary, first liquidates the existing property, and with the proceeds of that transaction, and within 180 days, has the replacement property purchased. What happens if the replacement property is found and needs to be purchased prior to sale of the existing property? Can a §1031 exchange still be utilized?

The answer is yes and it is known as a reverse exchange.

Prior to the issuance of Revenue Procedure 2000-37, a reverse exchange usually occurred as follows:

The replacement property was located and the taxpayer entered into an agreement for its purchase. The agreement was then assigned to an entity that was owned by a Qualified Intermediary. The taxpayer then “lent” the entity the money to purchase the replacement property. If financing was involved in the purchase, the loan would be guaranteed by the taxpayer and the entity would sign the loan documents on a non-recourse basis. The entity would then enter into a management agreement or ground lease arrangement where the taxpayer would receive all of the rents and would be responsible for all of operating expenses and the loan payments. When a buyer for the existing property was found, an exchange agreement was entered into with the Qualified Intermediary who would sell the old property, convey the “parked property” to the taxpayer in satisfaction of the exchange, and repay the loan with the proceeds of the old property.

It was thought that this arrangement avoided the IRC requirements that the exchange occur within 180 days since it was generally believed that the 180 days ran from the date of the sale of the relinquished property. In order for the foregoing arrangement to work, it was necessary that neither the Qualified Intermediary nor the entity holding title to the replacement property be treated as an agent of the taxpayer.

Rev.Proc. 2000-37 set forth a “safe harbor” for reverse exchanges. It provides that if the title-holder and the Qualified Intermediary comply with its provisions, then neither the QI nor the title-holder would be deemed to be the agent of the taxpayer. So far so good. What the Revenue Procedure added is that to qualify under the safe harbor provisions the entire transaction, i.e. the purchase of the replacement property and the disposition of the old property must occur within 180 days from the acquisition of the replacement property.

The conclusion is that reverse exchanges are still viable. While it is always better to be able to utilize the safe harbor provisions of Rev. Proc. 2000-37, if the 180 day provision cannot be complied with, it may still be possible to bring about a reverse exchange but the documentation and the mechanics are more involved in order to bring about the desired result.

SECTION 1031(f) DEALS WITH EXCHANGES BETWEEN RELATED PARTIES. THE DEFINITION OF A RELATED PARTY FOR PURPOSES OF §1031 IS SET OUT IN INTERNAL REVENUE CODE SECTIONS 267(B) AND 707(B) (1) AND INCLUDES BROTHERS, SISTERS, SPOUSE, ANCESTORS, LINEAL DESCENDANTS, CERTAIN PARTNERSHIPS AND CORPORATIONS DEPENDING UPON THE AMOUNT OF OWNERSHIP BY THE TAXPAYER AND RELATED PARTIES, AND CERTAIN FIDUCIARIES. §1031(f) DOES NOT PROHIBIT RELATED PARTY EXCHANGES BUT SETS OUT SPECIAL RULES.

Section 1031(f) deals with exchanges between related parties. The definition of a related party for purposes of §1031 is set out in Internal Revenue code sections 267(b) and 707(b) (1) and includes brothers, sisters, spouse, ancestors, lineal descendants, certain partnerships and corporations depending upon the amount of ownership by the taxpayer and related parties, and certain fiduciaries. §1031(f) does not prohibit related party exchanges but sets out special rules.

Basically, the rules provide that if either party to the exchange disposes of the property involved in the exchange within 2 years after the date of the last transfer that was part of the exchange, the non-recognition provisions of §1031 will not be applicable. Many people felt that this provision only applied to actual exchanges without the use of a Qualified Intermediary (QI). However, Revenue Ruling 2002-83 changed that thinking.

The facts in the Rev.Rul 2002-83 are as follows:

Taxpayer entered into an exchange agreement with a Qualified Intermediary. Pursuant to the exchange agreement the taxpayer transferred his property to the QI who sold it to c, an unrelated party for X$. The QI used the proceeds to purchase property from B, a related party and transferred the acquired property to the taxpayer in satisfaction of its exchange obligation. Note, that at no time did A contract with the related party B.

Part of the reasoning behind section 103l(f) was to eliminate the ability of related parties to transfer high basis property for low basis property and then have the low basis property sold without tax. Assume that the taxpayer has property worth $500,000 with a basis of $100,000 and the related party has property worth $500,000 with a basis of $400,000. Upon a section 1031 exchange between the two parties the taxpayer’s basis in the acquired property would be the same $100,000. The taxpayer intends to keep the property and all is well. However the related parties basis in his acquired property would be the same $400,000. But for §103l(f), the related party would be able to sell the acquired property and pay gain on only $100,000 where a sale by the taxpayer would result in a $400,000 gain. Section 103l(f) (4) provides that §1031 will not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this section. The IRS held that exchange of the taxpayer’s property with the QI was part of a transaction structured to avoid the purpose of 103l(f) and under section 1031(f) (4), since the related party received non like-kind property, i.e. cash, the transaction would not qualify for non-recognition under §1031.

Because of the complexities of exchanges with related parties it is extremely important that any taxpayer contemplating such a transaction obtain competent counsel before venturing into the transaction.