There are two principal areas in which creative tax practitioners have sought to expand the provisions of Section 1031: Delayed/multiparty exchanges and reverse exchanges.
Section 1031, as originally enacted, contemplated a direct exchange of qualifying property between taxpayers. Section 1031 and the Treasury Regulations now permit the deferred recognition of gain on the sale of appreciated property through a delayed exchange, but only if certain requirements are met.
Essentially, if a taxpayer (1) sells appreciated property (relinquished property), (2) identifies new property to be purchased (replacement property) within 45 days of the closing of the sale of the relinquished property and (3) closes on the purchase of the identified replacement property by the sooner of 180 days of the closing of the sale of the relinquished property or the due date for the taxpayer’s tax return for the tax year in which the sale of the relinquished property occurs, the taxpayer will have met the requirements for the deferred recognition of gain through a delayed exchange.
There are several aspects of delayed exchanges that should be noted. First, the taxpayer will not be afforded the 180 days to close on the purchase of the replacement property where there is less than 180 days before the due date of the taxpayer’s return, unless the taxpayer files an extension to file the return.
Second, the selling taxpayer may not hold the proceeds from the sale of relinquished property pending the purchase of the replacement property. Instead, a qualified intermediary escrow agent must hold the proceeds. A delayed exchange must be adequately documented, and transfers of title to the property and proceeds must demonstrate that all requirements have been met in order to qualify the exchange for delayed like-kind treatment.
Reverse exchanges were born from situations where the taxpayer wanted to purchase replacement property prior to the sale of the relinquished property. As with delayed exchanges, these types of exchanges took place for many years without any legislation or guidance from the IRS.
In 2000, the IRS published Revenue Procedure 2000-37, which provided a safe harbor under which the taxpayer’s categorization of property as replacement property or relinquished property for reverse exchanges would not be challenged if the property is held in what is known as a qualified exchange accommodation arrangement.
That arrangement requires that the arrangement must be in writing, ownership of the replacement or relinquished property must be transferred to a qualified intermediary called an Exchange Accommodation Titleholder (generally a separate legal entity such as a newly formed limited liability company) and the 45-day and 180-day time limits applicable to typical delayed exchanges must be met.
Delayed and reverse exchanges are generally used with larger transactions involving real estate or other investment property, and have been used more and more frequently with personal business property such as rental car fleets, airplanes, antique automobiles and coin collections. Such exchanges, however, demand advance planning and can involve considerable expense.
Given these safe harbors permitted by the IRS, when anticipating purchasing or selling a business or investment property, purchasers should consider well in advance of closing whether they have any business or investment property of like-kind that they desire to sell or purchase which would permit them to utilize the tax deferral techniques outlined above.
John P. Wilkerson Jr. works in the Commercial Law practice area of Carlile Patchen & Murphy LLP. His practice focuses on banking, tax abatements and real estate law with an emphasis on commercial real estate financing. Reach him at (614) 628-0790 or JPW@cpmlaw.com.