IRS Offers Insight on Deferred Like-Kind Exchanges
The like-kind exchange provisions of the Internal Revenue Code (IRC) provide a unique mechanism for taxpayers to defer recognizing gain or loss on disposition of property. A 1994 letter ruling from the Internal Revenue Service (IRS), LTR 9448010, provides some implied guidance on specific aspects of the like-kind exchange regulations. (See also CIREJ, Fall 1994, page 6.) Although the ruling dealt with a lessor of equipment, the guidance presumably would apply to real estate transactions. In light of the letter ruling and the particular application of Section 1031 to real estate, this is a good opportunity to examine the general aspects of the like-kind exchange provisions along with specific areas addressed in the ruling.
Section 1031 in General
IRC §1031 allows that if a taxpayer holds a property for use in a trade, business, or investment and the taxpayer exchanges it solely for property of a like kind (also held for use in a trade, business, or investment), then the IRS will not recognize any gain or loss on the transaction. For example, if a taxpayer paid $50,000 for real property that is now worth $100,000 and exchanges that property for another property also worth $100,000, there would be no income tax consequences. If the taxpayer later sells the replacement property for $120,000, however, there would be tax due on a gain of $70,000 ($120,000 sales price less the $50,000 cost of the original property).
A like-kind exchange is only subject to income taxes if the taxpayer receives cash or other property (referred to as boot) in exchange for the relinquished property. An example of receiving boot is if a taxpayer exchanges real property that cost $50,000 and is now worth $100,000 for real property worth $80,000 and $20,000 in cash. The taxpayer then faces taxation on the $20,000 cash received.
Deferred Exchanges. The Court of Appeals in Starker v. U.S. [602 F.2d 1341 (9th Cir. 1979)] ruled that like-kind exchanges need not be simultaneous to be tax free. Therefore, taxpayers are free to enter into exchange transactions without immediately receiving replacement property. In 1984, the U.S. Congress imposed time limitations on deferred like-kind exchanges (also referred to as non-simultaneous or delayed like-kind exchanges) to protect against potential abuses. This change means that non-recognition treatment will apply only if the taxpayer identifies the exchange property and completes the exchange within specified time limits.
§1031 Regulations for Deferred Like-Kind Exchanges. In 1991, the IRS issued regulations for complying with the deferred like-kind requirements. A taxpayer who is considered to be in actual or constructive receipt of money or other property will lose the benefit of the non-recognition provisions of §1031. For example, a transaction in which transfer of a property to a third party is pursuant to an agreement entitling the transferee to receive either cash or replacement property will not qualify under §1031. Even if the taxpayer opts to take the replacement property, the IRS considers the taxpayer to be in constructive receipt of the cash. Because of these concerns, the deferred exchange rules provide safe harbors for use in structuring these transactions.
Pulling into Safe Harbors
One of the safe harbors involves the use of a qualified intermediary. The qualified intermediary receives the relinquished property from the taxpayer, acquires the like-kind replacement property, and transfers the replacement property to the taxpayer. The qualified intermediary operates under the authority of an agreement with the taxpayer that specifically limits the taxpayer's right to receive, pledge, borrow, or obtain the benefits of money or other property held by the intermediary.
Another safe harbor involves the use of either a qualified escrow account or a qualified trust. In this situation, the transferee of replacement property secures its obligation to make the property transfer with cash or its equivalent; the security is then held in an escrow or trust. To qualify, the escrow agreement or trust instrument must expressly limit the taxpayer's right to receive, pledge, borrow, or otherwise obtain the cash or its equivalent.
In LTR 9448010, the IRS by implication resolves a few issues relating to compliance with safe harbor provisions not directly addressed in §1.1031(k)-1. This implied assistance may afford greater flexibility in qualifying deferred exchanges for non-recognition treatment.
Rights versus Obligations
The exchange contract involved in the letter ruling between the taxpayer and the intermediary provided that the intermediary will have all of the taxpayer's rights-but not its obligations-under the agreement to sell the relinquished property and the agreement to purchase the replacement property. The regulations at §1.1031(k)-1(g)(4) set out the rules governing the responsibilities of the intermediary. A qualified intermediary is under obligation to acquire relinquished property from a taxpayer and exchange it for replacement property.
The IRS treats an intermediary as acquiring and transferring property if the intermediary enters into an agreement with the owner of the replacement property or, in the case of relinquished property, with a person other than the taxpayer. An intermediary has entered into an "agreement" if the rights of a party to the agreement are assigned to the intermediary.
Because the regulations refer merely to rights, a taxpayer's obligations by implication need not be transferred to the intermediary, but no known authority affirmatively states this distinction. By not commenting on the transfer of obligations to the qualified intermediary, the ruling suggests that it may be possible for a person to serve as a qualified intermediary without undertaking obligations not directly related to the transfers of the relinquished or replacement property. In any case, the qualified intermediary must still acquire relinquished property and transfer back replacement property to the taxpayer.
Escrow Account Consideration
An additional portion of the exchange agreement under consideration directed the intermediary to deposit proceeds from the sale of the relinquished property with an escrow holder with whom the taxpayer apparently had an established business relationship. At the taxpayer's discretion, the funds would be placed in interest bearing or non-interest bearing accounts. For non-interest bearing accounts, the escrow holder would provide non-interest consideration (for example, waiver of certain bank fees) approximating the value of foregone interest.
As stated earlier, the agreement between the taxpayer and the intermediary must expressly limit the taxpayer's right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the intermediary in order to avoid the actual or constructive receipt of money or other property.
Furthermore, the taxpayer may not be entitled to these benefits without replacement property having been identified or received by the taxpayer before the end of the exchange period or, if earlier, the end of the identification period.
The IRS ruled that the receipt of interest or other consideration will not result in the taxpayer being in actual or constructive receipt of any consideration held by the intermediary before the time the taxpayer acquires the replacement property and will not adversely affect qualification of the deferred exchange under §1031.
Replacement Property Exceeds Cost of Relinquished Property
In this ruling, if the cost of the replacement property exceeded the value of the relinquished property, the taxpayer could make up the difference either by paying the excess directly to the seller of the replacement property or by depositing the excess with the escrow holder so that payment to the seller will be made from a single source. Because the IRS did not rule or even comment on this issue, the arrangement by implication did not jeopardize non-recognition treatment of the exchange under §1031 in this situation. However, in situations raising the issue of netting boot given and boot received, the difference should be paid to the qualified intermediary rather than directly to the seller of the replacement property.
No Explicit Guidance
As stated earlier, the ruling did not specifically address real estate, and letter rulings cannot be relied upon as official guidance from the IRS.
However, the guidance provided is still helpful because of the frequent application of §1031 to the area of real estate and the lack of additional guidance on the specific application of the deferred exchange rules.