Asked Questions About 1031 Exchanges
find answers to the most commonly 1031 exchange questions.
Questions are divided into sections. Click on any question
to see its answer.
WHAT IS A 1031 EXCHANGE?
Internal Revenue Code Section 1031 exchanges allow investors
to sell property and reinvest the proceeds in another property
without having to pay taxes that would otherwise be owed on
recognized gain from sale. The payment of such capital gains
tax is deferred, representing only a potential tax which is
not owed unless and until the replacement property is sold
in a subsequent taxable transaction. The taxes may, in some
cases, be avoided all together, for example if the replacement
property passes through an estate and its basis is stepped
up to the market value at the time of death.
1031 of the IRC provides that no gain or loss is recognized
if property "held for productive use in a trade or business
or for investment" is traded solely for other "like-kind"
property which also is to be held for investment or used in
a trade or business. The essence of such a trade is a reciprocal
and interdependent transfer of one property for another, as
opposed to a simple sale and repurchase.
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WHAT ARE THE MECHANICS OF A 1031 EXCHANGE?
transactions may vary, the basic Xchange Solutions exchange
usually proceeds like this:
TRANSACTION HAS BEEN PROTECTED AS FOLLOWS:
seller ("exchanger") of the property to be exchanged,
("relinquished property"), finds a buyer to purchase
his/her property. The Exchanger includes specific "intent
and cooperation" language in the purchase contract:
the exchanger expresses intent to exchange and the buyer
expresses cooperation in signing any necessary and appropriate
documents to accomplish the exchange.
exchanger and Xchange Solutions ("intermediary")
enter into an Exchange Agreement and an Assignment and Substitution
Agreement which provide that:
(a) The intermediary is substituted into the purchase contract
(and escrow instructions, if applicable) as the seller.
(b) The exchanger conveys the relinquished property to the
intermediary, and the intermediary immediately conveys the
relinquished property to the buyer by direct deed from the
(c) The proceeds from the exchange of the relinquished property
are held in a Qualified Escrow Account.
(d) The exchanger identifies in writing the property they
wish to acquire ("replacement property") in exchange
for the relinquished property.
(e) The intermediary is substituted into the purchase contract
(and escrow instructions, if applicable) as the buyer.
(f) The intermediary, using the funds held on account, acquires
the replacement property, and immediately conveys the replacement
property to the exchanger by direct deed from the seller
of the replacement property to the exchanger.
- A guaranty
of escrow funds by a national title company.
of credit are issued by the institution holding exchange
are held in a restricted, protected, joint-signature account
at a bank.
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WHAT IS THE DIFFERENCE BETWEEN A SIMULTANEOUS AND A DELAYED
exchange: you convey the title to the relinquished property
concurrent with and just before receiving the replacement
exchange (also called a "Starker" or "deferred"
exchange), you convey title to the relinquished property up
to 180 days before acquiring title to the replacement
the IRS held that qualifying exchanges must be simultaneous.
Delayed exchanges were sanctioned by court action in the landmark
case Starker v. United States in 1979. In response
to Starker, Congress formally approved delayed exchanges by
way of the Tax Reform Act of 1984, which added the statutory
45 day identification and 180 day closing time-frames. With
the new Final Regulations for Delayed Exchanges issued in
June of 1991, exchanges adhering to the safe harbors defined
therein are perhaps better able to withstand audit than are
WHAT IS A REVERSE EXCHANGE?
Exchanges ("Reverse Starker") the exchanger acquires
the replacement property before conveying the relinquished
property. These are used when individuals wish to exchange
property they own for property which must be purchased prior
to the sale of the relinquished property.
WHAT IS A "BUILD-TO-SUIT" OR "CONSTRUCTION"
or improvement exchanges are for replacement property to be
built. The replacement property is built-to-suit, or is further
improved or altered, etc., to the specifications of the exchanger.
In a construction exchange, Xchange Solutions usually acquires
the replacement property, causes the improvements to be built
during its ownership, and conveys the improved property to
the exchanger. The building is done in accordance with the
building specifications outlined in the purchase contract,
and/or escrow instructions, prior to the substitution of Xchange
Solutions as the buyer. The exchanger approves all work done
before disbursement of funds by Xchange Solutions and exchangers
may use the contractor of their choice as long as they are
not a "disqualified" person under the Regulations.
real property improvements need not be completed within the
Exchange Period, the value of any portion of the improvements
not completed within this time frame will not qualify as replacement
property. The 180-day Exchange Period may effectively be extended
by delaying the transfer of the relinquished property. This
may allow some time for work to begin on construction of improvement
on the replacement property. Property "to be produced"
in a construction exchange, which is not completed within
the 180-day Exchange Period, must be part of the standing
structure to be considered real property under local law.
A load of raw building material delivered to the building
site, will not qualify as improved real property.
WHAT IS A PARTIALLY TAX-DEFERRED EXCHANGE?
tax-deferred exchanges are transactions in which some portion
of the realized gain is recognized and some is not (i.e.,
you will pay some of the taxes due upon sale, but not all).
Examples include: 1. Exchanges which are a combination of
a 1031 exchange and an installment sale, with the loan documents
payable to the exchanger; 2. Exchanges involving replacement
property which is comprised of business or investment property
and personal property. You can be fully tax-deferred on these
exchanges if you do a multi-asset exchange, covering both
the real and personal property; 3. Exchanges where a portion
of the gain is taken in cash or other "boot" property,
and the balance of the gain is invested in qualifying replacement
WHY ARE MOST 1031 EXCHANGES STRUCTURED AS DELAYED EXCHANGES?
are several important benefits of delayed exchanges:
- Delayed exchanges allow the exchanger additional time
to find and close the purchase of replacement property.
The replacement need not be identified or acquired when
the relinquished property is sold. The exchanger can consider
market opportunities rather than feel pressured to immediately
identify and purchase all replacement property. A word of
caution: the 45-day Identification period is probably the
most difficult rule to come out the Final Regulations. We
strongly suggest that exchange clients have several properties
ready to identify as potential replacement properties before
they close on their relinquished property. Otherwise, the
exchangers may learn to their dismay, just how rapidly forty-five
days can disappear.
- As a practical matter, it is often extremely difficult
to coordinate concurrent closing, especially if the relinquished
and replacement property transactions are effected in different
counties and states. For example, funds from the sale of
the relinquished property are almost always used to pay
for the replacement property. Funds should flow through
the Intermediary, and even if the closings are in the same
state or at the same escrow company, it's almost impossible
to effectively make the proceeds of the relinquished property
payable to the Intermediary, and then have them instantly
available for funding the closing of the replacement property
on the same day.
- In simultaneous transactions, recording at different locations,
it is extremely difficult to insure that the exchangers'
transfer of the relinquished property occurs before, or
simultaneous with, the exchangers' receipt of the replacement
property, as current law appears to require.
- In almost every simultaneous exchange, only one potential
taxpayer is able to take advantage of trading "even
or up" in equity and debt. The other party to the exchange
is usually, by necessity, exchanging down in both equity
and debt, leaving "boot" to be taxed at the current
capital gains rate. If each party completed a delayed exchange,
both could exchange "even or up" in equity and
debt and effect a completely tax-deferred scenario for both
EXCHANGES SEEM SO COMPLICATED - CAN YOU SIMPLIFY THE RULES
Fully tax-deferred exchanges are effected when you properly
identify and receive like-kind qualifying property of equal
or greater value, subject to equal or greater debt, without
any actual or constructive receipt of cash or other non like-kind
WHAT ARE THE ADVANTAGES OF A 1031 EXCHANGE?
primary advantage of a 1031 exchange is the preservation of
investment capital by deferring payment of capital gains taxes.
If you sell property (rather than exchanging it) you must
pay taxes on any recognized gain. Capital gains tax is usually
20% to 25% of your gain, plus any state taxes. In a tax-deferred
exchange, all your profit (both cash and carry-backs) may
be used to acquire replacement property. Astute investors
understand that 1031 exchanges allow greater net profits,
the purchase of larger or additional investment property and
a faster pyramiding of wealth.
Exchanges are a great tax planning mechanism allowing the
deferment of taxes until the taxpayer is in a lower tax bracket
or until a more beneficial tax rate exists.
for exchanging include: consolidation of several smaller properties
into one larger investment to facilitate easier management
or better cash flow, shifting investment from one area or
locale to another to take advantage of local market opportunities,
avoiding "deferred maintenance" by trading out the
older properties into newer ones and diversification of investment
portfolios by trading out of a single property, or type of
property, into various investments or multiple properties.
WHEN DO I HAVE TO PAY THE DEFERRED CAPITAL GAINS TAX?
if and when you elect to sell, as opposed to exchange, your
WHY NOT LEAVE THE MONEY IN AN ESCROW ACCOUNT?
Closing Agent acts upon instructions from all parties to the
transaction. To leave the funds in the escrow or trust account
requires the Exchanger to give such instructions to the Closing
Agent. This control is called "constructive receipt"
and invalidates the exchange.
HOW ARE MY EXCHANGE FUNDS SECURED?
It is important that you know exactly where your exchange funds are deposited and how they are kept secure. We use the following measures to ensure the security of every exchange client’s funds:
(a) Your exchange funds are deposited in a segregated deposit account with an independent bank. One client’s exchange funds are never commingled or pooled with another client's funds.
(b) Your exchange funds are FDIC insured up to $250,000.
(c) Xchange Solutions deposits with several independent banks. The deposit bank used for your funds will be named in your exchange documents. We can set up an account with a bank of your choice; an additional fee will apply.
(d) Xchange Solutions deposit practices comply with Washington State's regulation RCW 19.310.040 (below), enacted into law June 7, 2012. All transactions which involve property in Washington state include a Qualified Escrow Agreement (QEA) along with our exchange agreement. This QEA agreement dictates that any disbursement from your deposit account requires your written authorization, authorization by a bank officer, and authorization of an officer of Xchange Solutions, Inc..
WASHINGTON STATE LAW, RCW 19.310.040, REQUIRES AN EXCHANGE FACILITATOR TO EITHER MAINTAIN A FIDELITY BOND IN AN AMOUNT OF NOT LESS THAN ONE MILLION DOLLARS THAT PROTECTS CLIENTS AGAINST LOSSES CAUSED BY CRIMINAL ACTS OF THE EXCHANGE FACILITATOR OR HOLD ALL CLIENT FUNDS IN A QUALIFIED ESCROW ACCOUNT OR QUALIFIED TRUST.
HOW MUCH IS THE FEE PAID TO DO THE EXCHANGE?
fee varies depending on the complexity of the exchange but
usually varies from $750 to $3,000.
DO I NEED AN ATTORNEY OR A TAX ADVISOR?
legal and/or accounting counsel is always recommended and
should always be engaged. Tax laws are continually changing
and I.R.C. Section 1031 exchanges are often extremely complex
or highly technical, requiring guidance and answers to interpretive
questions best left to competent legal or tax advisors. Xchange
Solutions will assist you in procuring such help at your request.
WHAT RESTRICTIONS APPLY TO EXCHANGES INVOLVING RELATED PARTIES?
Revenue Reconciliation Act of the 1989 Legislative session
effected a two year related party restriction wherein property
conveyed to a related party is now subject to a two year holding
period. If either the exchanger or the related party disposes
of the acquired properties within the two year period, the
non-recognition provisions will not apply and the exchanger
must recognize gain as of the date the disqualifying disposition
occurs. A related party is defined by cross reference to I.R.C.
Section 267(b) which covers a wide range of relationships
including family members, corporations, partnerships and trusts.
CAN I EXCHANGE OUT OF MORE THAN ONE RELINQUISHED PROPERTY
OR INTO MORE THAN ONE REPLACEMENT PROPERTY?
You can exchange one relinquished property into one or more
replacement properties, and vice versa.
MUST THE REPLACEMENT PROPERTY I RECEIVE IN THE EXCHANGE HAVE
ANY MINIMUM VALUE?
for a full tax-deferred exchange. To defer all taxes otherwise
due upon sale, the aggregate fair market value of all replacement
property received must be equal to or greater than the aggregate
fair market value of all relinquished property. If you trade
down in either equity or debt, the difference may be taxable
to the extent of your gain.
CAN I FINANCE THE BUYER'S PURCHASE OF MY RELINQUISHED PROPERTY?
and you have several options should you choose to combine
a 1031 exchange and an installment sale, with the loan documents
payable to the Intermediary:
a. Option #1 - Exchanger can try to locate a seller
of a replacement property who is willing to take the Note
as part of the consideration. If the seller is motivated and
the Note is well-secured, this could be a viable approach.
The Intermediary, as the Beneficiary of the Note and Trust
Deed, would give the cash and Note to the seller in return
for the replacement property.
b. Option #2 - The Intermediary could sell the Note to another
party (usually at a discount) and apply the cash proceeds
towards the acquisition of the like-kind replacement property.
The cash proceeds would be added to the funds the Intermediary
was holding from the sale of the relinquished property. Any
discount from the sale of the Note would have to be offset
with additional cash from the Exchanger before the acquisition
property is closed.
c. Option #3 - In a separate transaction, the Exchanger may
purchase the Note from the Intermediary. The Intermediary
would, in turn, apply the combined funds from the Note sale
and the sale of the relinquished property to acquire a replacement
property. Care must be taken so that the Note sale is indeed
a separate transaction. There is a possibility that the IRS
could view the Exchanger's receipt of the Note from the Intermediary
as boot, or even worse, as constructive receipt, thereby endangering
d. Option #4 - If Option #3 cannot be properly documented,
the Exchanger may wish to lend $200,000 to the Buyer of the
relinquished property outside of the closing in return for
a Note and Deed of Trust to be secured by the property. The
Buyer would then purchase the property from the Intermediary
for $200,000 cash. The Intermediary now has $200,000 cash
to use to acquire the replacement property.
DO I NEED ANY SPECIAL DOCUMENTS TO EFFECT AN I.R.C. SECTION
An exchange is not a sale. A special exchange agreement is
needed. The buyer of the relinquished property must agree
to cooperate in completing the I.R.C. Section 1031 exchange,
as that buyer will actually be purchasing the relinquished
property from the Intermediary. Conversely, the seller of
the replacement property will be asked to cooperate as the
Intermediary is substituted in as the buyer of the replacement
property. Such cooperation is usually secured through "intent
and cooperation" language placed in the real estate contract
for both the relinquished property and the replacement property.
In addition, a comprehensive exchange agreement, assignment
and substitution forms and a qualified escrow agreement should
be prepared in accordance with the provisions of I.R.C. Section
1031. Each exchange is unique, and other documents specific
to each individual exchange may need to be prepared and executed.
WHAT ARE THE GENERAL STATUTORY REQUIREMENTS FOR AN I.R.C.
SECTION 1031 TAX-DEFERRED EXCHANGE SINCE THE FINAL REGULATIONS
PUBLISHED IN JUNE OF 1991?
- Both the property surrendered and the property received
must be held for productive use in a trade or business,
or for investment;
- The property surrendered and the property received must
be of "like-kind";
- The exchange must be a reciprocal transfer of properties
as distinguished from a sale and repurchase; There were
other "rules" to come from the Final Regulations,
such as Identification Period (45 days), Exchange Period
(180 Days), form of Identification, Identification Rules,
and the rule regarding the fact that you must acquire substantially
what you have identified. There are other rules regarding
restrictions on the funds on deposit from the exchange of
the relinquished property. We will address these other rules
as we proceed.
WHAT IS BOOT?
all property transferred in an exchange must be of like-kind.
Other property or money can be transferred in addition, without
invalidating the exchange. Such non like-kind property is
called "boot". In general, boot is only taxable
to the extent of the realized gain. Transactions involving
boot must be very carefully structured so as not to invalidate
the qualifying portion of the trade. The receipt of money
or non like-kind property will cause the realized gain, if
any, to be recognized to the extent of the sum of money and
the fair market value of the property received. In other words,
you have to pay taxes on any money or other non like-kind
property you receive in an exchange. Properly configured exchanges
are structured so as to eliminate or minimize boot.
WHAT IS "CONSTRUCTIVE RECEIPT?"
Receipt occurs in an exchange when a taxpayer has the unrestricted
right to access cash or boot, whether or not such right is
exercised, and regardless of whether there is actual or physical
receipt of the cash or boot. Any cash or boot received by
the exchanger will cause recognition of gain (i.e., taxable
WHAT IS "DEBT RELIEF?"
Relief" or "Mortgage Relief" is any net reduction
in the amount of liability on the replacement property after
the exchange, as compared to the amount of liability on the
relinquished property just prior to the exchange. It will
be considered boot and will result in the recognition of gain
unless offset by the payment of additional cash by the exchanger.
WHAT IS "DIRECT DEEDING?"
streamlines transactions allowing for easier and quicker closing.
More importantly, direct-deeding typically saves considerable
additional expense, such as escrow fees, document preparation
charges and transfer taxes otherwise incurred in "sequentially-deeded"
transactions. Direct-deeding eliminates, to a great degree,
the problems currently associated with environmental clean-up,
as it eliminates the need for anyone other than the proper
purchaser to appear in the chain of title. It also eliminates
the chance that liens, clouds or judgments will attach to
the relinquished or acquisition properties to the extent that
they are attached to any individual chosen to facilitate the
exchange. As the final regulations fully sanction direct-deeding,
it should be employed at every opportunity.
WHAT IS "LIKE-KIND?"
words "like-kind" refer to the nature or character
of the property, not its grade or quality. For example, real
property is not of like-kind to personal property because
they are of a different nature and character. Conversely,
vacant land, for example, is of like-kind to improved property
as the two differ only in their grade/quality. Raw land, condominiums,
single family residences, shopping centers, apartment buildings,
farm and ranch land, commercial real estate, industrial property,
second homes converted to investment property, and almost
all other realty are of like-kind with respect to their intrinsic
nature and character and may, therefore, be interchangeably
exchange. With limited exceptions, any real estate meeting
the above tests can be exchanged for any other real estate.
In addition, the rules excepting incidental property from
the identification requirements should not be construed as
meaning such property will be considered like-kind realty.
Remember, the final regulations for "Multi-Asset/Personal
Property" exchanges provide for very narrow like-kind
qualification of any non-realty business or investment property,
which may be transferred together with real estate in your
transactions. For example, any furniture, manufacturing or
other equipment, autos, or art work, etc. transferred in addition
to real estate is not like-kind to realty received as replacement
property. The definition of realty is determined by each state
in the United States, and any person wishing to exchange should
determine the definition of realty according to the state
or states where the relinquished and replacement properties
WHAT EXACTLY IS A SAFE HARBOR?
Safe Harbor is a "suggestion" from the IRS. They
are not substantive rules, but to the degree that auditing
agents understand them, they will be applied as "Holy
Writ". At this point in our outline, I would like to
quote B. Wyckliffe Pattishall, Jr., President of Chicago Deferred
Exchange Corporation, and one of the experts in America on
the subject of tax-deferred exchanges: "The Deferred
Exchange Regulations provide taxpayers with "safe harbors"
which may be employed in structuring and securing both simultaneous
and delayed tax-deferred exchanges. My purpose in what follows
is to provide assistance in navigating the narrow channels
created by the regulations through hazardous waters. The importance
of staying within the channels is more critical today than
prior to the issuance of regulatory guidance when a smattering
of case law and a limited number of public rulings were the
only channel markers. In the words of the Barker Court, 'At
some point, the confluence of some sufficient number of deviations
will bring about a taxable result.' The very existence of
the safe harbors and bright line tests in the regulations
create a burden on tax practitioners to make ever effort to
structure exchanges within these guidelines, where the tax
risk of the transaction can be minimized. Failure to meet
the technical requirements of the safe harbors is likely to
generate a number of malpractice claims in the future. The
regulations provide practitioners with clear channels to safe
harbors, but the sides of these channels, and you will dispose,
sometimes magically, of the issues of agency, constructive
receipt, the like-kind standard, and the exchange requirement.
Venture outside the channels, and you invite disaster...practically
speaking, auditing agents will probably disallow exchanges
which do not meet the requirement of the safe harbors and
leave the issue for resolution at the appellate conference.
In fact, at the time of this writing (late 1994) auditing
agents are recommending exchange transactions for litigation
by the government where strict observance of the regulations
is not apparent."
THE SAFE HARBORS TO COME OUT OF THE FINAL I.R.C. SECTION 1031
REGULATIONS ARE AS FOLLOWS:
- Non-Cash Security for Buyer's Performance:
Mortgage or Deed of Trust
Standby Letter of Credit
Third Party Guarantee
- Cash Security for Buyer's Performance:
Qualified Escrow Qualified Trust
- Qualified Intermediary
The only Safe Harbor which also applies to a Simultaneous
- Exchangers May Receive Interest After Completing The
WHAT ARE THE REQUIREMENTS RELATING TO THE IDENTIFICATION OF
replacement property to be acquired in the exchange must be
"unambiguously described" by legal description,
assessor's parcel number or tax map key or equivalent number,
or address, distinguishable name, etc., and made in a written
document executed by the exchanger and hand-delivered, mailed,
telecopied or otherwise sent to a person involved in the exchange
who is not a disqualified party - preferably the Intermediary.
A single exception to the identification requirement is provided,
which deems any replacement property actually acquired by
the exchanger within the 45-day Identification Period to be
duly identified property. You should document the sending
and/or delivery of the identification letter and confirm their
receipt. Every attempt should be made and reviewed for conformance
and accuracy in advance of the last day of the Identification
Period. A non-conforming identification sent by fax or mail
and received by the Intermediary on the last day of an Identification
Period which ends over a weekend, may at best be reviewed
on the Monday following the expiration of the Identification
Period. It would then be too late to make any required changes,
resulting in an invalid exchange.
HOW MANY PROPERTIES MAY BE IDENTIFIED AS REPLACEMENT PROPERTY?
the following three rules must be followed when identifying
single, multiple or alternative replacement properties:
- Three properties of any value may be identified. This
rule is known as the "Three Property Rule". You
may acquire either one, two or all three properties identified.
- Any number of properties may be identified, provided that
as of the end of the Identification Period, the aggregate
fair market value of all identified replacement property
does not exceed 200% of the fair market value of all relinquished
property. This rule is known as the "Two Hundred Percent
Rule." You may then acquire any number of those properties
- Any number of properties may be identified, as long as
the exchanger acquires replacement property whose aggregate
fair market value is at least 95% of the aggregate fair
market value of all identified properties. This rule is
known as the "Ninety-Five Percent Rule."
MUST I RECEIVE ALL IDENTIFIED PROPERTIES?
if you have relied on the 95% Rule. In other words, you have
identified more than three properties which aggregate more
than 200% of the fair market value of the relinquished property.
In such circumstances, the technical requirement is satisfied
if you acquire 95% of the identified property. This rule,
however, is very difficult to follow, as just one problem
with one identified property could prevent you from acquiring
95% of all identified property.
HOW DO I IDENTIFY REPLACEMENT PROPERTY TO BE PRODUCED IN A
Code provides that property not yet in existence is properly
identified if the underlying land (together with any existing
improvements) is identified, and the improvements to be constructed
are identified in "as much detail as is practicable at
the time of the identification." Plans and construction
contracts should be referenced in the identification, providing
for such documents to be later attached in the event they
are not available within the Identification Period.
MUST MISCELLANEOUS PROPERTY TO BE RECEIVED IN THE EXCHANGE
Regulations provide that property which
"is incidental to a larger item" and
(ii) "is typically transferred in standard commercial
transactions" (appliances, etc.) and
(iii) "does not exceed 15% of the value of the larger
item, need not be specifically and separately identified.
MAY I REVOKE IDENTIFICATIONS?
may be revoked, if such revocations are made in a written
document, signed by the exchanger, and sent to the Intermediary
before the end of the Identification Period. If the original
identification was made in an exchange agreement, it may be
revoked by an amendment to the exchange agreement, signed
by and sent to all parties to the exchange agreement.
CAN THE IDENTIFIED REPLACEMENT PROPERTY BE MODIFIED OR ALTERED
AFTER THE IDENTIFICATION PERIOD BUT BEFORE MY RECEIPT?
replacement property received must be "substantially
the same property" as that which was identified. While
the rules for deferred exchanges appear to sanction exchanges
in which 75% or more of any vacant land parcel identified
is acquired, some confusion exists as to the application of
this "rule". In a construction exchange, only "variations
due to usual or typical production changes" are allowed.
As a consequence, significant changes should not be made to
property under construction, except within the Identification
Period, during which time such identification can be revoked,
amended and re-submitted.
WHY DO I NEED AN INTERMEDIARY?
is required in all transactions other than those outlined
(a) A two party simultaneous exchange. (*Please
see note below.) Benefit: Simple and Cost-Effective NOTE:
The only safe harbor recommended by the Treasury Department
for simultaneous exchanges is the use of a Qualified Intermediary.
(b) The ABC Exchange, also called the Alderson or Reverse
Missouri Waltz Exchange. (Buyer buys replacement property
from the seller, and then exchanges it with the exchanger
for the relinquished property. These steps all occur simultaneously.)
(i) potential for hazardous waste liability to attach to buyer
of replacement property, as buyer passes through the chain
of title and deeds to the exchanger, and
(ii) the potential for liens, clouds and judgments which might
be filed against the buyer of the relinquished property to
attach to the replacement property, as the buyer enters the
chain of title.
(c) The ABC Exchange, also called the Baird or Missouri Waltz
Exchange. (The exchanger and the seller of the replacement
property exchange properties, and the seller, who now owns
the relinquished property, sells it to the buyer. These steps
all occur simultaneously.) Benefit: Minimizes transfer tax
consequences by having the double title transfer on the relinquished
property, which has a lower value.
(i) potential for hazardous waste liability to attach to seller
of the replacement property, as seller passes through the
chain of title on the relinquished property and deeds to the
ultimate buyer, and
(ii) the potential for liens, clouds and judgments which might
be filed against the seller of the relinquished property,
as the seller enters the chain of title.
(d) The Pot Exchange, (any number of people put their "haves"
and "wants" into one pot, and a single escrow officer
or closing agent sorts everything out and delivers the appropriate
"goods" to each party, whether that be property,
cash or paper, etc. This is accomplished by a direct deed
system, and must occur simultaneously.) Benefit: Avoids or
minimizes transfer taxes or potential hazardous waste liability.
Problem: Requires one very accurate and dedicated closing
agent or escrow officer. A Qualified Intermediary is always
required for the two remaining types of exchanges:
(e) The Simultaneous Exchange With an Intermediary, and
(f) The Delayed Exchange With an Intermediary.
WHAT IS A "QUALIFIED INTERMEDIARY?"
Intermediary is that entity or person who:
(a) acts as the middle-man or "straw-man"
in exchange transactions;
(b) holds the proceeds of the sale of the relinquished property;
(c) does any buying of replacement property or selling of
the relinquished property necessary on behalf of the exchanger.
The Intermediary typically acquires the relinquished property
from the exchanger and sells it to its ultimate buyer, using
the proceeds of the sales to acquire and convey to the exchanger
the replacement property. Your Intermediary should be a corporation
rather than an individual in order to protect against your
Intermediary's death, disability, incapacity, judgment liens,
etc. Furthermore, intermediaries should offer mechanisms and
procedures designed to protect your transactions, together
with any funds held, through the use of letters of credit,
third party guarantees, bonding and Errors and Omissions insurance.
It is also extremely important for an Intermediary to employ
proper custodial procedures for sale proceeds and other funds
held in segregated, restricted accounts, through the use of
a "Qualified Escrow" or a "Qualified Trust".
The final rules for tax-deferred exchanges created a new category
of accommodator or facilitator called a "Qualified Intermediary,"
and provided for certain tests which must be met in order
to "qualify." In addition, these rules prescribe
certain procedural requirements which all Qualified Intermediaries
must meet, together with prerequisite use of an exchange agreement
containing express and specific language. As the Internal
Revenue Service has vowed to pursue any taxpayers who use
accommodators in deferred exchanges other than Qualified Intermediaries,
exchangers should be extremely careful not to breach this
WHAT DOES A QUALIFIED INTERMEDIARY DO DURING AN EXCHANGE?
Intermediary typically serves many functions during an exchange:
the exchanger actually or "constructively" receives
any or all of the proceeds of the sale of the relinquished
property, the exchange will not be valid. (This rule would
not apply to a percentage exchange, where the exchanger
may receive the percentage of the sale proceeds which result
from the percentage of the sale not included in the exchange.)
In order to insulate the exchanger from such "constructive
receipt", the Intermediary holds the proceeds of the
sale of the relinquished property in a segregated, restricted
qualify for tax deferment under I.R.C. Section 1031, exchanges
must be pursuant to a written exchange agreement. Some intermediaries
provide this documentation, precluding the exchanger's needs
to engage separate legal counsel to prepare the exchange
agreement. As significant additional costs are incurred
if the exchanger must engage counsel to draft such documentations,
XSI provides the exchange agreement and all other required
exchange documents at no additional cost.
exchanges must, in essence, constitute a reciprocal exchange
of properties between two parties, notwithstanding the fact
that there are almost always three, four or occasionally
more than four parties participating in an exchange. An
important role of the Intermediary is to become the exchanger's
other party to the exchange. Technically, the exchanger
is trading property with the Intermediary. This explains
why the relinquished property is conveyed to the Intermediary
first, and then to the ultimate buyer. Likewise, the replacement
property is transferred first to the Intermediary and then
to the exchanger.
transactions are often extremely complex. A good Intermediary
helps explain, conform and manage all aspects of the transaction,
facilitating document signatures, escrow closing and the
timely cooperation and performance of the parties to the
CAN ANYONE BE A QUALIFIED INTERMEDIARY?
"Disqualified Persons" may not be Qualified Intermediaries.
With limited exceptions, a Disqualified Person is any party
who has acted as your agent, employee, attorney, accountant,
investment banker/broker, or real estate agent or broker within
the two-year period ending on the date of the first transfer
of any relinquished property. Also disqualified are the family
members of the Disqualified Persons, as well as partnerships,
corporations and other entities in which you, or your related
party, own directly or indirectly, more than a 10% interest.
Your attorney owns 11% of the stock in his law firm, and his
wife owns her own Intermediary firm. You wish to use his wife's
Intermediary firm as your Qualified Intermediary. If your
attorney has done any work for you in the last two years,
other than strictly I.R.C. Section 1031 tax-deferred work,
his wife's firm is "disqualified" to act as your
Qualified Intermediary. Conversely, if ten law firms each
own 10% of a corporation organized to act as a Qualified Intermediary,
you could use that Qualified Intermediary even though your
law firm was one of the ten owners.
CAN I EXCHANGE MY PARTNERSHIP INTEREST IN REAL ESTATE?
with extremely limited exception. After much confusion, the
Internal Revenue Code was amended in 1984 to specifically
prohibit the exchange of partnership interests. Similarly,
the exclusion clarified the law that a partnership interest,
whether general or limited, cannot be exchanged for an interest
in real property without recognition of gain. Some highly
technical and relatively complex structures have been employed
in an attempt to legally circumvent the restrictions against
exchanges of partnership interests. Skilled legal and/or accounting
counsel must be engaged for such transactions.
CAN I CONVERT MY PARTNERSHIP INTEREST INTO A TENANT-IN-COMMON
OR SIMILAR INTEREST JUST BEFORE OR JUST AFTER MY EXCHANGE?
is generally accepted that, if a partnership is dissolved
and the partner's partnership interest are converted upon
distribution into divided or undivided real property ownership
interests, the partners may then be able to trade such real
property interests under I.R.C. Section 1031, provided that
the partnership dissolution and distribution occurs long enough
before or after the exchange to satisfy the "held for
investment" requirement. Such liquidation and/or conversion
of partnership interest involves highly technical questions
and favorable treatment of such transactions is by no means
assured. Exchangers must secure qualified legal or accounting
counsel before attempting these transactions.
CAN MY PARTNERSHIP AS A WHOLE TRADE REAL ESTATE OWNED UNDER
I.R.C. SECTION 1031?
Partnerships and corporations are legal entities and, as such,
are not prohibited from exchanging partnership property (as
opposed to a partner's partnership interest) under I.R.C.
Section 1031. Remember, these transactions necessarily involve
the entire partnership trading its real property interest.
WHAT KIND OF REAL ESTATE QUALIFIES FOR A 1031 EXCHANGE?
real property of "like-kind" which is not identified
as condemned property (a 1033 exchange) or your personal residence
(a 1034 exchange), and was not acquired for resale or considered
inventory or dealer property may be traded under the I.R.C.
Section 1031 exchange rules. The property relinquished in
the exchange must have been either productively used in your
trade or business, or held for investment, i.e., you must
have effected a "qualified use" of the property.
Likewise, it must be your intention as you acquire your replacement,
to either hold that property for investment or use it for
a business purpose.
IS THERE ANY PROPERTY WHICH MAY NOT BE TRADED UNDER I.R.C.
following property is specifically excluded under I.R.C. Section
1031 and therefore cannot be of "like-kind":
- Stock in trade or other property held primarily for sale;
- Stocks, Bonds, Notes or other Securities or Evidence of
Indebtedness or Interest;
- Interests in a Partnership;
- Certificates of Trust or Beneficial Interest;
- Chooses in Action;
- Real Property located within the United States is no longer
like-kind with Real Property located outside of the United
HOW LONG MUST I HOLD PROPERTY RECEIVED IN AN EXCHANGE?
long one must hold property in order to qualify for tax deferment
under I.R.C. Section 1031 is unclear. While it is generally
accepted that a one-year to two-year period may be sufficient,
there is no statutory holding period. Although the IRS has
taken the position that a transaction will not qualify under
1031 if a property acquired is immediately disposed of (particularly
if such disposition is prearranged), conflicting precedents
exist. Exchangers are well advised to use extreme care in
structuring exchanges of property with short holding periods
and quick resale.
CAN FOREIGN PROPERTY BE EXCHANGED?
a result of the Revenue Reconciliation Act of 1989, real property
located within the United States and real property located
outside of the United States are no longer of like-kind. However,
foreign property may still be exchanged for other foreign
CAN A LEASEHOLD PROPERTY BE EXCHANGED?
provisions apply to leasehold property. While owners of leasehold
property do not possess a fee simple interest, a leasehold
of 30 years or longer (including optional renewal periods)
is deemed to be of like-kind to fee simple property. Leaseholds
of less than 30 years duration may only be traded for other
leasehold property with remaining lease terms of less than
30 years. Again, remember that optional renewal periods are
included in determining whether a lease for a period of years
is of like-kind.
CAN I EXCHANGE MY PRINCIPAL RESIDENCE UNDER I.R.C. SECTION
Personal residences should be exchanged under the relatively
less demanding provisions of I.R.C. Section 1034 and cannot
be exchanged under I.R.C. Section 1031.
WHAT ARE SOME OBVIOUS EXAMPLES OF PROPERTY THAT MAY NOT QUALIFY
addition to the non-qualifying property previously discussed,
examples of property which probably will not meet the qualified
use test are:
(a) Land which was acquired for the express purpose
of subdivision and resale and only held long enough to effect
such subdivision and resale;
(b) Homes held for sale by speculation builders, such as
builder's inventory of unsold homes;
(c) Any transaction which constitutes a sale followed by
a reinvestment in other property, whether or not the replacement
property is considered to be like-kind, wherein the transfers
are no reciprocal and interdependent, and are absent in
an exchange agreement.
is important to Note that this Section ONLY APPLIES
if the Taxpayer had a bona fide intent to enter into
a deferred exchange at the beginning of the exchange
period. Examples of the most important points are as
A. The Taxpayer enters into a deferred exchange and
transfers his relinquished property in 1992. In 1993
he validly acquires replacement property and also receives
some cash (boot). The cash will be taxed in 1993 on
the installment method.
A Taxpayer enters into a deferred exchange and transfers
his relinquished property in 1992. In 1993 the exchange
fails and he receives the cash. The cash will be taxed
as having been received in 1993 and given installment
A Taxpayer enters into a deferred exchange and transfers
his relinquished property to a Qualified Intermediary.
Upon the transfer of the relinquished property the Taxpayer
also receives a Note directly from the Buyer of the
relinquished property. Notwithstanding the fact that
the property was transferred to the Qualified Intermediary,
but the Note received from the Buyer, the Taxpayer will
still receive installment sale treatment on the Notes.
A Taxpayer enters into a deferred exchange and transfers
his relinquished property to a Qualified Intermediary
in 1992. The Qualified Intermediary concurrently sells
the property to the Buyer. In addition to cash, the
Buyer executes a Note to the Qualified Intermediary
which is held in the exchange. In 1993 the Qualified
Intermediary acquires replacement property but the Note
is not used in the acquisition. In addition to delivering
the replacement property to the Taxpayer the Qualified
Intermediary also delivers an Assignment of the Note.
The Taxpayer may report the Note on the installment
method, as payments are received.
For purposes of installment sale treatment, the determination
of whether the Taxpayer has "received payment"
will be made without regard to the fact that an exchange
agreement is secured by cash placed into a Qualified
Escrow or a Qualified Trust and/or without regard to
the fact that a Qualified Intermediary is used to facilitate