Defer gains with reverse exchanges

A recent Internal Revenue Code provision provides smooth sailing in a safe harbor.

by Michael T. Blacker   Every REALTOR® should consider taking advantage of the opportunities afforded by real estate exchanging. Having a working knowledge of Internal Revenue Code (IRC) Section 1031 and the rules thereunder will help you serve clients more successfully, generate commissions that might otherwise be overlooked, and increase your personal net worth.

Taxpayers avoid "unfair burden"

Tax on income was first imposed in 1918. All gains were required to be recognized at the time of disposition of real and personal property, and the taxes due had to be paid at that time. In 1921, Congress enacted the provisions of IRC Section 1031.

It was felt that if one entered into an exchange for another property without receiving any cash from the transaction, there was actually a continuation of the original investment. To assess a tax on the gain and require the taxpayer at that time to pay taxes would be an unfair burden. Accordingly, although a gain would be realized, it would not be recognized until a subsequent sale of the property occurred.

Section 1031 (1) provides that:

"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business for investment."

In a recent report to the Internal Revenue Service by the American Bar Association Section on Taxation concerning various issues, the committee said:

"We believe that like-kind exchanges under Section 1031 are undertaken regularly by taxpayers of relatively modest means. Our experience indicates that the most common use of Section 1031 is the exchange of a small rental property. As a result, there is a need for practical guidance. The recent regulations published by the service under Section 1031 have shown that the service understands this need and we hope that future guidance continues in the same vein …"

REALTORS® play important role

Real estate agents often participate in planning and structuring exchange transactions. An agent’s role should be limited to finding a buyer for the property of the client, finding a replacement property acceptable to the client, and negotiating the terms of the purchase and sale agreement for each property.

The agent must be careful not to render tax or legal advice; those things are best provided for by accountants and competent counsel. The real estate agent acts as a catalyst and performs the functions of sales and marketing.

Capital gains can add up

For Paula and Joe Cobb, owners of Realty Executives in San Diego, their attention to Section 1031 exchanges has proven successful. During the last 12 years, they have been instrumental in negotiating and closing a number of tax-free exchanges for their clients and themselves. On their own exchanges, they have deferred paying approximately $210,000 in tax on over $750,000 of gain.

If they had sold each investment property they owned and paid the tax, they would neither possess their current wealth nor control investment property that annually nets approximately $110,000.

IRS clarifies stance on exchanges

Before the recent provision regarding reverse exchanges, each time an investor accepted a contract and transferred title for the sale of a property, he had only 45 days to find and identify the property he wanted to own. Then he had to complete an exchange not later than 180 days from the date he transferred his property (called the relinquished property) and to close the transfer on his new property (called the replacement property). Now, thanks to the IRS, exchanges have been made a little easier.

Revenue Procedure 2000-37, reverse exchanges, was made effective on Sept. 15, 2000. With it, investors can seek out, purchase, and transfer a replacement property that they want and then find a buyer for their relinquished property, which is the property they no longer wish to own.

Actually, reverse exchanges are not new. The difference now is that the IRS has provided what is known in the tax world as a "safe harbor." The IRC is filled with safe harbors. And although safe harbors are not in the tax code, they are issued by the IRS so that taxpayers can operate with some assurance in areas that are not clear to them and cause concern.

Reverse exchanges were not provided for in 1921 when Section 1031 was passed, nor prior to the provision of Rev. Proc. 2000-37. However, many reverse exchanges were performed prior to the issuing of Revenue Procedure 2000-37. By issuing the safe harbor, the service has made the following provision: It will not challenge a reverse exchange if the replacement property is held by what is now known as an exchange accommodation titleholder (AT) in a "qualified exchange accommodation agreement" (QEAA) for not more than 180 days. Nor will it challenge the qualification of property as either replacement property or relinquished property.

The intent is to give the taxpayer time to dispose of his relinquished property. There is, however, no intent on behalf of the IRS to create a long-term "bank" for the holding of property. It is absolutely crucial that the transaction be completed in not more than 180 days from the time of transfer of the replacement property to the accommodation titleholder. To go beyond the allotted time causes the entire transaction to be outside the safe harbor and creates the risk of having the exchange denied by the IRS.

Court case highlights time limits

For many years after Section 1031 was passed, taxpayers felt that all exchanges had to be done simultaneously. Of course, that made exchanges very difficult to do, and, in fact, most exchanges involved only two properties. Now multiple-property exchanges occur, but two-party exchanges still predominate.

A case involving T.J. Starker probably brought on the understanding that exchanges need not be done simultaneously. Starker owned a large amount of land in a northwest part of the U.S. A paper company offered to purchase large tracts of his holdings so that it could process the lumber for paper. Instead of selling the tracts and receiving the cash, Starker entered into an agreement with the purchaser whereby the purchaser would, at Starker’s direction, purchase income-producing or investment property that he ultimately would like to own.

Their agreement provided that all of the transaction would be completed not more than five years after the initial transfer of Starker’s relinquished property. Then if he did not choose to exchange for those certain properties, he could receive cash as an alternative. The entire transaction was completed in less than three years.

Upon audit, the IRS denied the exchange, and ultimately the matter wound up in federal court. The court ruled in Starker’s favor and pointed out that tax-free exchanges need not occur simultaneously.

The IRS was concerned because the transaction took so long to complete, and when transactions are extended over a long period of time, opportunity exists that they will be difficult to trace and account for in an orderly manner. Congress also was concerned that the longer a taxpayer had to complete the transaction, and the more latitude given to him to ultimately complete the exchange, the more the exchange appeared to be a sale rather than an exchange.

As a result, Section 1031 (a)(3) was added to the code in 1984. That’s when the aforementioned time limits were defined. So now the 45-day time limit is known as the identification period, and the 180-day period is known as the exchange period.

It is important to note that the time limits are not affected or extended by any holidays. If one of these periods ends on a Sunday or national or state holiday, it has no effect on the statutory tolling of the time period. And, the IRS does not permit requests for extensions.

Exchange basics

When a deferred exchange (a.k.a. tax-free exchange) is entered into, the taxpayer transfers property held for productive use in a trade or business or for investment and, at a later time, receives property to be held either for productive use in a trade or business or for investment. Accordingly, the exchange does not have to be conducted simultaneously.

The taxpayer must be careful not to receive cash during the exchange or receive a benefit that could be termed as "constructive receipt of cash." The taxpayer must also be diligent and not receive any property that is deemed "other property" according to the regulations. If he does receive any of these, the exchange could be determined by the IRS to be a sale and not an exchange, and taxes would have to be paid upon completion.

When the taxpayer (your client) identifies a replacement property that he would like to own, he must transmit the identification of that property in written, telecopied, or other form, before the end of the identification period to a disqualified person, which is defined in the regulations. The identification of the property must be in an unambiguous form, whenever possible including the street address, plot number, legal description, or any other unique description.

The taxpayer may identify more than one property during the identification period with the intent of winding up with not more than three properties being ultimately identified. There are other requirements the REALTOR® should study but that are beyond the scope of this article.

Should the taxpayer identify a property and then change his mind, the revocation must be transmitted to the person who received the notice of the replacement property prior to the termination of the 45-day period. The revocation must be in writing, signed by the taxpayer, and delivered in the same manner as the original identification notice.

The go-between

There is an important safe harbor found in Reg. Sec. 1.1031 (k)1(g)(1). Specifically, safe harbor 3 explains qualified intermediaries (QI). And, in fact, at this time the qualified intermediary safe harbor is the only safe harbor available for simultaneous exchanges.

A qualified intermediary is a person or company, who is not the taxpayer or a disqualified person as explained under the regulations, who performs the necessary acts to facilitate the deferred exchange by entering into a written agreement with the taxpayer for the exchange of the properties in question. The QI acquires the relinquished property, transfers the relinquished property, acquires the replacement property, and transfers the replacement property in order to complete the exchange. The QI generally does not take legal title to either of the properties. The protection of a safe harbor ends when the taxpayer has the unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI.

Where do I begin?

To learn about Section 1031 and the exchange procedure, start collecting free information. One good source I’ve found for answers to common reverse-exchange questions and copies of articles dealing with the process of exchanging is www.rees1031.com. Or, for a free booklet entitled Section 1031 Tax Deferred Exchanges in a Nutshell, e-mail Section 1031 Services Inc. President Jeremiah Long at jlong@1031services.com.

You should also be able to obtain good information from your accountant or an attorney with a tax practice.

Mike Blacker, JD, LLM, CCIM, SRS, has taught more than 5,000 agents in areas of commercial real estate, concentrating in 1031 exchanges and limited-liability partnerships. Currently, he teaches two TREC-approved 15-hour MCE courses: "Real Estate Exchanges Under Section 1031" and "Introduction to Texas Real Estate Securities and Group Investment." Contact him at 972/387-9394 or mtbspeech@aol.com.

Photo © Corbis Images.

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