SECTION 1031 EXCHANGES

TEXAS LAND TITLE INSTITUTE

December 4-5, 2008

Michael L. Cook Winstead PC

401 Congress Avenue Suite 2100

Austin, Texas 78701-3619 512-370-2899

512-370-3850 FAX mcook@winstead.com

SECTION 1031 EXCHANGES

Table of Contents

Page

I. INTRODUCTION. ..............................................................................................................1

II. STARKER AND FORWARD.............................................................................................2

A. Starker─The First Judicial Approval of Non-Simultaneous Exchanges .................2 B. Multi-Party Exchange ..............................................................................................2 C. Holding Purpose; Conveyance of Exchange Property Before or After the

Exchange..................................................................................................................3 1. IRS Rulings..................................................................................................3 2. Wagenson.....................................................................................................3 3. Magneson.....................................................................................................4 4. Bolker...........................................................................................................4 5. Mason...........................................................................................................4 6. Chase............................................................................................................5 7. Maloney .......................................................................................................5

D. Partnership Exchanges and Exchanges of Undivided Interests. ..............................6 1. Partnership Interests.....................................................................................6 2. Undivided Interests in Real Estate...............................................................6 3. Rev. Proc. 2002–22......................................................................................8

E. Business Swaps......................................................................................................10 F. Related Party Restrictions......................................................................................10

1. Background................................................................................................10 2. True v. United States..................................................................................11 3. TAMs, FSAs and Rev. Rul. 2002-49 I.R.B. 927 .......................................12 4. Teruya Brothers, Ltd. v. Commissioner.....................................................12

G. Deferred Exchanges─The Regulations..................................................................13 H. Deferred Exchanges and Installment Sales............................................................14

III. DEFERRED LIKE KIND EXCHANGE REGULATIONS..............................................14

A. Overview................................................................................................................14 B. The Intermediary....................................................................................................15

1. The Qualified Intermediary........................................................................15 2. Limitation on Right to Receive “Boot” .....................................................16 3. Qualified Intermediary Cannot Be a Disqualified Person .........................16 4. Written Exchange Agreement....................................................................16 5. Disposition Requirement ...........................................................................17

C. Security Arrangements...........................................................................................17 1. Permitted Security Arrangements ..............................................................17 2. Pledges of Property ....................................................................................17 3. Standby Letters of Credit ...........................................................................18

4. Guarantee ...................................................................................................19 5. Right to Receive Money ............................................................................19 6. Qualified Escrow Accounts .......................................................................20 7. Qualified Trusts .........................................................................................22 8. Early Distributions by an Intermediary......................................................23

D. Specification of Replacement Property .................................................................25 1. Property Acquired By 45th Day ................................................................25 2. Identification Notice ..................................................................................25 3. Recipient of Identification Notice..............................................................25 4. Transmission of Identification Notice .......................................................26 5. Mailed Notices ...........................................................................................26 6. Telecopied Notices.....................................................................................26 7. Hand Delivered Notices.............................................................................26 8. Description of Real Property .....................................................................27 9. Identification of Incidental Items of Property............................................27 10. Revocation of Identification ......................................................................27 11. Alternative and Multiple Properties...........................................................28 12. Three-Property Rule...................................................................................29 13. 200 Percent Rule ........................................................................................29 14. 95 Percent Rule ..........................................................................................30

E. Direct Deeding .......................................................................................................30 1. Assignment of Sales Agreement to Qualified Intermediary ......................31 2. Taking Title................................................................................................31

F. Build to Suit ...........................................................................................................32 1. Identification ..............................................................................................32 2. Acquisition of “Substantially the Same” Replacement Property That was

Designated..................................................................................................33 3. Achieving the Burdens and Benefits of Ownership...................................34

G. Deferred Exchanges and Installment Sales............................................................36 1. Prior to the Regulations .............................................................................36 2. Constructive Receipt..................................................................................37 3. Intent to Exchange .....................................................................................38 4. Examples....................................................................................................38 5. Effective Date of Proposed Regulations ....................................................41 6. The Computation of Gain ..........................................................................41 7. When the Relinquished Property is Encumbered ......................................42 8. Conclusion .................................................................................................42

IV. DEALING WITH THE PRACTICAL PROBLEMS OF DEFERRED EXCHANGES. ..43

A. Picking a Qualified Intermediary...........................................................................43 B. Concerns of the Intermediary.................................................................................44

1. Intermediary’s Gain ...................................................................................44 2. Intermediary’s Fee .....................................................................................44 3. FIRPTA Withholding.................................................................................44 4. Closing Agent Reporting ...........................................................................45 5. Interest Reporting.......................................................................................45

6. State Taxation of Intermediary ..................................................................45 7. Sales and Use Tax......................................................................................45 8. Documentary Transfer Tax ........................................................................45 9. Liability Concerns......................................................................................46 10. CERCLA Liability .....................................................................................46 11. Liabilities to Parties to the Exchange.........................................................47 12. Intermediary as Agent................................................................................47 13. Resignation of Intermediary ......................................................................48

C. Payment of “Boot;” Deposits and Earnest Money.................................................48 1. Deposits......................................................................................................49 2. Earnest Money Deposit..............................................................................49

D. Matching Liabilities; New Financing ....................................................................49 E. Transaction Expenses.............................................................................................50 F. The “Reverse Starker” Deferred Exchanges..........................................................51

1. Authority to Undertake Reverse Deferred Exchanges...............................52 2. Parking the Replacement Property.............................................................52 3. Use of Options ...........................................................................................53 4. The Fact Patterns and the Solutions...........................................................53 5. Case Law Dealing with Reverse Deferred Like Kind Exchanges .............55 6. Revenue Procedure 2000-37 ......................................................................56 7. TAM 200039005........................................................................................57 8. Rev. Proc. 2004-51, I.R.B. 2004-33 (Aug. 16, 2004)................................58

G. The Dealer Issue ....................................................................................................58 H. Interest and Growth Factors...................................................................................59 I. Deferred Exchanges Using an Installment Note....................................................60 J. Exchanges of Leasehold Estates with Less than Thirty Years of Duration...........61 K. Real Estate Loan Workout Problems and Deferred Exchanges.............................61

1. Exchange Prior to Foreclosure...................................................................61 2. Standstill Agreement and Related Party Exchange ...................................62

L. Exchanges by Partners and Partnerships................................................................62 1. The Problem...............................................................................................62 2. ABA Tax Section Project...........................................................................64 3. TAM 9645005............................................................................................64 4. TAM 199907029........................................................................................64 5. TAM 9818003............................................................................................65

M. LLCs for Acquisition of Replacement Properties..................................................66

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SECTION 1031 EXCHANGES: UPDATE AND PRACTICAL APPROACH TO DEFERRED EXCHANGE STRUCTURES

by

Michael L. Cook

I. INTRODUCTION.

IRC §1031 is one of those “opportunity” provisions of the Internal Revenue Code that is in a constant state of change resulting from activity in the area at all levels -- judicial, legislative and regulatory. In its most simplistic form the like kind exchange allows a taxpayer who desires to dispose of an investment or an asset used in a trade or business (with certain exceptions) to exchange such property for a property of like kind of equal or greater value without recognizing the gain or loss which would otherwise be reportable on the disposition of the original property. The gain or loss is deferred until another day. This provision has led to a long history of tension between the IRS and taxpayers who constantly challenge the boundaries imposed by the IRS. The most recent expansion of the benefits of the like kind exchange treatment of §1031 has occurred in the deferred exchange area and is the subject of this paper. Section II of this outline describes the evolution of current law which has resulted from the longstanding tug-of-war between the government and the taxpayer, including the now recognized practice of “non-simultaneous” or “deferred” exchanges. Section III sets forth the operating rules for deferred exchanges under the safe harbor regulations and Section IV discusses the practical problems practitioners face when structuring a deferred exchange.

The general rule of §1031(a) provides as follows:

(a) Nonrecognition of Gain or Loss From

Exchanges Solely in Kind.─

(1) In General.─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 or for investment.

(2) Exception.─This subsection shall not apply to any exchange of─

(A) stock in trade or other property held primarily for sale,

(B) stocks, bonds, or notes,

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(C) other securities or evidences of indebtedness or interest,

(D) interests in a partnership,

(E) certificates of trust or beneficial interests, or

(F) chooses in action.

For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.

II. STARKER AND FORWARD

A. Starker─The First Judicial Approval of Non-Simultaneous Exchanges. Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979), is the first circuit court decision which directly considered the question of delayed exchanges in the context of §1031. In that case, Mr. Starker transferred his property to Crown Zellerbach in May, 1967 pursuant to a contract under which the corporation agreed to acquire other real property in the future and convey the property to Mr. Starker. Crown Zellerbach had up to five years to find suitable exchange property, or pay any outstanding credit balance (which included an annual “growth factor” equal to 6% of the outstanding balance) in cash to Mr. Starker. In 1968, in partial satisfaction of its obligation, Crown conveyed to Mr. Starker a contract right to purchase property from a third party. This property was subject to a life estate and legal title could not pass to Mr. Starker until the life estate expired. However, Mr. Starker had immediate possession of the property, subject to certain restrictions. The IRS argued that the transaction did not qualify under §1031, first, because the transfers were not simultaneous and, alternatively, because the taxpayer had received, in 1967, a contract right which was not of a like kind with the real property he had transferred in the exchange.

The Ninth Circuit held that a simultaneous exchange is not required in a §1031 exchange and, in response to the IRS’ “like-kind” argument, stated:

A contractual right to assume the rights of ownership should not, we believe, be treated as any different than the ownership rights themselves. Even if the contract right includes the possibility of the taxpayer receiving something other than ownership of like-kind property, we hold that it is still of a like-kind with ownership for tax purposes when the taxpayer prefers property to cash before and throughout the executory period, and only like-kind property is ultimately received.

602 F.2d 1355.

B. Multi-Party Exchange. As the Starker case was making its way through the judicial process, the IRS was also challenging the ability of the taxpayer to structure multi-party

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exchanges and to actually bypass the transfer of title to certain of the parties (originally called “facilitators,” now referred to as “intermediaries”), sometimes through the use of an escrow. For the most part, the legislative changes allowing deferred exchanges (1984 Tax Reform Act) and the regulations that followed have rendered the multi-party, escrow and deed bypass cases nothing more than interesting history. The principal cases are: Rutland v. Commissioner, 36 T.C.M. (CCH) 40 (1977); Everett v. Commissioner, 37 T.C.M. (CCH) 274 (1978); Biggs v. Commissioner, 632 F.2d 1171 (5th Cir. 1980) aff’d 69 T.C. 905 (1978); Garcia v. Commissioner, 80 T.C. 491 (1982) acq. 1984-1 C.B. 1; Barker v. Commissioner, 74 T.C. 555 (1980); Allen v. Commissioner, 43 T.C.M. (CCH) 1045 (1982).

C. Holding Purpose; Conveyance of Exchange Property Before or After the Exchange. For a period of time the IRS displayed significant tenacity with regard to its narrow interpretation of the §1031 holding purpose requirements. It argued that a property acquired by the exchanging taxpayer immediately preceding the exchange from a related entity could not have been held for investment or trade or business purposes by the taxpayer; similarly, the IRS argued that property transferred to a related entity immediately after the exchange should not be treated as held for investment or trade or business purposes for purposes of §1031. For the most part, the courts have disagreed, and on balance, the IRS has to be considered the loser in this struggle.

1. IRS Rulings. Rev. Rul. 75-292, 1975-2 C.B. 333, considered a situation where the taxpayer exchanged his exchange property for replacement property, and immediately afterwards transferred the replacement property to a controlled corporation. The ruling held that the transaction does not qualify as a nontaxable exchange, since the taxpayer, after the exchange, did not hold the replacement property for a “qualified use.”

Rev. Rul. 77-337, 1977-2 C.B. 305, reversed the sequence of facts of Rev. Rul. 75-292. In Rev. Rul. 77-337, a corporation liquidated pursuant to §333 (IRC §333 was repealed by the 1986 Tax Reform Act) distributed investment property to its shareholder, and the shareholder (who took the property with a low carryover basis) exchanged that property for replacement property. The ruling held that the new property did not qualify as replacement property and that the exchange transaction did not qualify for nonrecognition under §1031, since the taxpayer did not hold the exchange property prior to the exchange for a “qualified use.” The analyses of Revenue Rulings 75-292 and 77-337 were based on a straightforward, literal interpretation of the requirements of §1031. By its terms, §1031 requires the taxpayer to hold both the exchange property and the replacement property for a “qualified use.” In the view of the Service, this “qualified use” requirement was violated by the preceding or succeeding nontaxable transfers.

2. Wagenson. Wagenson v. Commissioner, 74 T.C. 653 (1980), considered an exchange followed by a gift of the replacement property within 9 months after the exchange; the Tax Court held that the subsequent transfer did not violate the “qualified use” requirement. However, in Click v. Commissioner, 78 T.C. 225 (1982), the Tax Court held that an exchange failed to qualify under §1031 where, at the time of the exchange, the taxpayer intended to give away the replacement property. The taxpayer in fact gave away the property within seven months of the exchange and his children lived in the replacement property until the gift.

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3. Magneson. Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985), considered an exchange of real property by the taxpayer (a tenancy-in-common interest), followed by a contribution of the replacement property to a limited partnership for a general partnership interest. The Ninth Circuit determined that the taxpayer satisfied the “qualified use” requirement. According to the court, the underlying property of the general partnership was of like kind to the taxpayer’s pre-exchange tenancy-in-common interest in real property. The court determined that there was merely a change in the taxpayer’s form of ownership of the property which did not significantly affect the taxpayer’s control of or the nature of the property. The court’s analysis seemed to be grounded on an aggregate rather than an entity view of partnerships. The court rejected the Commissioner’s position that a taxpayer must intend to keep the replacement property indefinitely in his own name. Rather, the court ruled that the holding requirement is satisfied when the taxpayer does not intend to liquidate or use the replacement property for personal purposes. The key factual element in the case was that the taxpayer intended to and did continue to hold the replacement property and that the contribution to a partnership was a mere change in his form of ownership. Significantly, this decision predated the enactment of the partnership interest exclusion of §1031(a)(2)(D) (see II.D. below). To the extent Magneson could be read to hold that a partnership interest could be like kind to a tenancy-in-common interest in real property, it is no longer good authority.

4. Bolker. Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985), involved a distribution of exchange property by a corporation liquidating under §333 to its shareholder, followed by an exchange of the property by the shareholder for replacement property. The facts in Bolker were almost identical to the transaction on which the Service had ruled unfavorably in Rev. Rul. 77-337. Nevertheless, the court held that the transaction did not violate the “qualified use” requirement of §1031. The court identified two distinguishing facts. First, the Bolker liquidation was planned before the taxpayer formed his intention to exchange the properties. Second, the taxpayer actually held the exchange property for three months after the liquidation. As in Magneson, the Bolker court did not consider the law subsequent to the adoption of §1031(a)(2)(D). Furthermore, it is significant that Bolker involved a corporation and not a partnership. It is easy to terminate the corporate ownership of property by merely deeding the property to the shareholders, but it may be more difficult to terminate partnership ownership, since the partnership ownership of property characterizes the business relationship of the partners and is not limited to the form of holding title to the property.

5. Mason. Mason v. Commissioner, 55 T.C.M. (CCH) 1134 (1988), involved a distribution of real property by a partnership to its partner, followed by an exchange by the partner. This case is the partnership analog of Bolker. In a memorandum decision with very little analysis, the Tax Court determined that the property was held for a “qualified use” and therefore that the transaction qualified for nonrecognition treatment. The court did not discuss whether the distribution effectively terminated the partnership relationship; the court appeared merely to assume that it did. Although Mason implicitly presented one of the fundamental issues in exchanges involving partnerships, the court did not address the issue at all. It also neglected to explore the significance of the 1984 amendments to §1031. See II.D. below.

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6. Chase. Chase v. Commissioner, 92 T.C. 874 (1989), on its face looks like a reprise of Mason. Nevertheless, the taxpayer in Chase seems to have done just about everything wrong. As a rare taxpayer defeat in the §1031 arena, Chase is worth reviewing in detail if a taxpayer is planning a partnership distribution followed by an exchange of the distributed property. Unfortunately, it is difficult to say whether Chase stands for some broad tax principle or whether it should be limited to its facts. In a word, the taxpayer lost because of careless form and execution; the distribution/exchange would be better described as “wishful thinking” by the taxpayer as opposed to a structure that was fully agreed to by all of the parties and executed pursuant to the agreement.

7. Maloney. Maloney v. Commissioner, 93 T.C. 89 (1989), undoubtedly will be cited as authority by more taxpayers than the Chase case. Maloney also may be read to imply that taxpayers are better advised to undertake exchanges at the partnership level, followed by a distribution to the partners rather than to distribute partnership property to be followed by an exchange. The partnership-level exchange does not generally involve the same question of whether the distribution could terminate the partnership relationship. The Tax Court in Maloney found a corporate exchange followed by a distribution of the replacement property qualified for nonrecognition treatment under §1031. The taxpayer in Maloney was the controlling shareholder of a corporation. On December 28, 1978, the corporation traded its real estate for replacement real estate. On January 2, 1979, the corporation liquidated under §333 and distributed the replacement property to the taxpayer. Afterwards, the taxpayer used the replacement property in the operations of several of his corporations. The question before the court in Maloney was whether the corporation’s subsequent liquidation violated the “qualified use” requirement with respect to the replacement property. The Maloney court, citing Bolker, stressed that §333 recognizes a taxpayer’s continuing investment in property notwithstanding the interposition of a corporate form. Based on Magneson, the court found that the transaction qualified as a nonrecognition exchange. Further, the court found that a trade of like kind property may be preceded by a tax-free acquisition of the property at the front end or succeeded by a tax-free transfer of property at the back end. The court also stressed that, in a §333 liquidation, the shareholder continues to have an economic interest in essentially the same investment, although there has been a change in the form of ownership. Furthermore, the court found that the corporation’s purpose was equivalent to the shareholder’s purpose. Presumably, the proper “taxpayer” was the corporation and not the shareholder. Nevertheless, Maloney should be even stronger as authority when a partnership undertakes an exchange, since the aggregate view of partnerships is considerably stronger than an aggregate view of corporations implied by the Maloney court. Maloney may indicate that it is reasonably safe for the partnership to exchange its property and then to distribute the replacement property to its partners. Nevertheless, there are significant lapses in the analysis of Maloney. Most significantly, Maloney appears to stress the holding purpose of the shareholder rather than the holding purpose of the corporate taxpayer who effected the exchange. Correspondingly, where a partnership undertakes an exchange, it should be the holding purpose of the partnership and not the holding purpose of the partner that is relevant to ACHIEVING A TAX FREE EXCHANGE UNDER §1031. See Section IV.L hereafter.

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8. PLR 200651030. In PLR 200651030, the IRS rule favorably for the taxpayer. Here a testamentary trust which had systematically engaged in like-kind exchanges throughout its existence was scheduled to terminate according to its terms. Prior to termination the trust entered into two contracts to sell some of its real property with the intent to complete a like-kind exchange pursuant to §1031. During the term of the contracts and prior to closing, the trust terminated and distributed all of its property to an LLC of which it was the sole member. The LLC desired to complete the like-kind exchange and therefore sought a ruling from the IRS as to whether it would meet the holding requirements of §1031. The IRS indicated that the LLC would satisfy the holding requirements of §1031 despite having received the relinquished property subject to a contract. The IRS distinguished this case from Rev. Rul. 77-337 by highlighting the fact that the LLC would continue the current business practices of the trust as a functional continuation of the trust and that the exchanges were independent of the impending termination of the trust. These facts were enough for the IRS to bless this transaction as one which satisfies the holding requirements of §1031.

D. Partnership Exchanges and Exchanges of Undivided Interests.

1. Partnership Interests. The exchange of a partnership interest for an interest in another partnership has always been a problem for the IRS and with the emergence of the judicial liberalization of the holding purpose standard in Magneson, Bolker and the other related cases discussed in II.C. above, the IRS could eliminate partnership interest exchanges definitively only by requesting a change to §1031 through legislation. In the 1984 TRA, §1031 was amended to exclude from the like kind exchange rules an exchange of interests in different partnerships, although the legislative history made it clear that “[t]his rule (excluding interests in different partnerships from §1031(a) treatment) is not intended to apply to an exchange of interest in the same partnership” (emphasis added) H.R. Rep. No. 98-432, 98th Cong., 2d Sess., pt. 2 (1984), pp 1231-34.

2. Undivided Interests in Real Estate.

a. The History. Generally, exchanges of undivided interests are exchanges of real property are not exchanges of partnership interests but relationships between tenants in common may constitute the creation of a partnership. In PLR 9609016 six related parties divided co-ownership in 23 separate parcels of farm land and the IRS extended §1031 treatment to the transaction. But, in PLR 9741017 the IRS ruled that two brothers (A and B) who owned 10 rental properties together were actually partners and their division of the 10 rental properties was in effect an exchange of real property for a partnership interest. Management of the properties was performed by a property management corporation of which A and B were equal stockholders. A and B represented that they have never executed any partnership agreement or considered themselves to be anything other than equal owners of the properties but for five consecutive tax years all net income and losses relating to the properties have been reported on Form 1065, a partnership return. The PLR noted that §1.761-1(a) provides that a joint undertaking merely to share expenses is not

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a partnership. For example, if two or more persons jointly construct a ditch to drain surface water from their properties, they are not partners. Mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a partnership. For example, if an individual owner, or tenants in common, of farm property lease it to a farmer for cash rental or a share of the crops, they do not necessarily create a partnership thereby. Tenants in common, however, may be partners if they actively carry on a trade, business, financial operation, or venture and divide the profits thereof. For example, a partnership exists if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent. In Rev. Rul. 75-374, 1975-2 C.B. 261, two parties each own an undivided one-half interest in an apartment project. A management company retained by the co-owners manages the building. Customary tenant services such as heat and water, unattended parking, trash removal, normal repairs, and cleaning of public areas are furnished at no extra charge. Additional services, such as attendant parking, cabanas, and gas and electricity are provided by the management company for a separate charge. The ruling holds that the furnishing of customary services in connection with the maintenance and repair of an apartment project will not render co-ownership a partnership. The furnishing of additional services by the owners or through an agent will render a co-ownership a partnership. The revenue ruling concludes that since the management company is not an agent of the owners and the owners did not share the income earned from the additional services, the owners were not furnishing services. Therefore, the owners are to be treated as co-owners and not partners under section 761. The PLR further noted, citing Estate of Levine, 72 T.C. 780, 785 (1979), that a crucial test under case law of whether the co-owners of property intended to create a partnership, as evidenced by their actions, notwithstanding the lack of characterization of their relationship. The IRS concluded that Taxpayer’s filing of partnership tax returns for several tax years indicates an intention to be taxed as a partnership.

b. Divisions of Property. The issue of tenancy in common versus partnership relationships do not arise in divisions of contiguous or single parcel property. A partition or division of contiguous property is not a sale or exchange. See PLRs 9633020, 9633033, 9633034, 9327069, 9320037 and 9319032.

c. Tenancies in Common. In the 1990s taxpayers, on a widespread basis, began to avail themselves of convenient replacement property availability through managed tenancies in common (TIC). Generally, the TIC agreements had all of the substantive elements of a partnership. In 2000 the IRS announced that it would not rule on the application §1031 where the replacement property is an undivided interest. Rev. Proc. 2000-46.

However, in 2002 the IRS published a safe harbor Revenue Procedure (Rev. Proc. 2002–22, 2002–1 CB 733) that outlines the requirements to be met to obtain a favorable advance ruling for a tenancy in common (“TIC”) syndication.

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3. Rev. Proc. 2002–22. Rev. Proc. 2002–22 lists fifteen conditions that must be satisfied for a taxpayer to receive a favorable ruling as to whether a TIC arrangement will not be treated as a partnership. The IRS has published Rev. Rul. 2004-86, 2004-33 I.R.B. 191 allowing a Delaware statutory trust to hold real estate and be disregarded for tax purposes. The conditions specified in Rev. Proc. 2002-22 and Rev. Rul. 2004-86 are as follows:

a. Tenancy-in-common ownership. Each co-owner must hold title to the underlying property directly or indirectly through an entity disregarded for federal income tax purposes and must be a tenant-in-common under local law. For asset protection purposes, some TIC arrangements require that each TIC interest be owned in a single-asset entity.

b. Limited number of co-owners. The number of co-owners per TIC arrangement is limited to no more than 35 persons.

c. Co-ownership not an entity. The co-ownership may not (i) file a partnership or corporate tax return; (ii) conduct business under a common name; (iii) execute an agreement identifying any or all of the co-owners as partners, shareholders, or members of a business entity; or (iv) otherwise hold itself out as a partnership or other form of business entity.

d. Co-ownership agreement. The co-owners may enter into a co-ownership agreement that runs with the land. Under Rev. Proc. 2002-22, a co-ownership agreement may provide that a co-owner must offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair market value before exercising his right to partition or transferring his interest to a third party.

e. Voting. The co-owners must unanimously approve (i) the hiring of any manager, (ii) the sale or other disposition of the property, (iii) leases of any portion or all of the property, or (iv) the creation or modification of a blanket lien. With respect to all actions on behalf of the co-owners, other than those requiring unanimous consent, the co-owners may agree to be bound by the vote of those holding more than 50% (or some higher percentage) of the undivided interests in the property. Co-owners may not, however, provide the manager or another person with a global power of attorney or proxy to make decisions for them.

f. Right to alienate. Each co-owner generally must have the right (which may be subject to a right of first offer granted to another co-owner, the sponsor, or the lessee) to transfer, partition, or encumber the co-owner’s interest in the property without agreement or approval of any other person. Co-owners are also allowed to place certain restrictions on the right to transfer, partition, or encumber an interest in the property, if such restrictions are required by a lender and are consistent with customary commercial lending practices.

g. Split on property sale. If the property is sold, any debts secured by a blanket lien must be satisfied and the remaining sales proceeds must be

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distributed to co-owners. This condition prohibits arrangements between co-owners that are designed to have perpetual existence following the disposition of the property, perpetual existence being an indication of a partnership.

h. Proportionate sharing of profits and losses. Each co-owner must share n all revenues generated by the property and in all costs associated with the property in proportion to the owner’s undivided interest in the property. Any advances to a co-owner by another co-owner, the sponsor (as defined in Rev. Proc. 2002-22, the word “sponsor” includes a “syndicator”), or the manager to meet expenses associated with the co-ownership interest must be recourse to the co-owner receiving such advance and cannot exceed a 31-day period. If the co-owner is a disregarded entity, the advance must be recourse to the owner of the disregarded entity.

i. Proportionate sharing of certain debt. The co-owners must share in any debt secured by a blanket lien in proportion to their undivided interests.

j. Options. As discussed above in connection with voting, a co-owner may issue a call option with respect to a TIC interest. The exercise price for a call option is required to reflect the fair market value of the property determined at the time the option is exercised. For this purpose, the fair market value of an undivided interest is equal to the co-owner’s percentage interest in the property multiplied by the fair market value of the whole property, thereby precluding minority discounts. The Rev. Proc. prohibits an owner from acquiring a put option to sell the property to the sponsor, the lessee, another co-owner, the lender, or any person related to the sponsor, the lessee, another co-owner, or the lender.

k. No business activities. The Rev. Proc. limits the activities that a co-owner may participate in to those customarily performed in connection with the maintenance of rental property. Rev. Rul. 75-374, 1975 CB 261, defines those customary activities, which include heat, air conditioning, hot and cold water, unattended parking, normal repairs, trash removal, and cleaning public areas. Activities will be treated as customary activities for this purpose if the activities would not prevent an amount received by an organization described in §511(a)(2) from qualifying as rent under §512(b)(A) and the regulations thereunder.

l. Management and brokerage agreements. The co-owners may enter into management or brokerage agreements with an agent, but the activities of the agent, sponsor, or co-owner, acting as manager, may not exceed the activities allowed under the above condition. A management or brokerage agreement must be renewable no less frequently than annually, and while the sponsor or a co-owner may fill such capacity, a lessee may not. Co-owners are allowed to agree to authorize the manager to perform nominal accounting and clerical functions such as (i) maintaining a bank account before dispersing each co-owner’s share of net revenues; (ii) preparing profit/loss statements for the co-

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owners; (iii) obtaining or modifying insurance on the property, subject to the approval of the co-owners; and (iv) negotiating modifications of the terms of any lease or any debt encumbering the property, subject to the approval of the co-owners. The manager must disburse to the co-owners their share of net revenues within three months from the date of receipt of those revenues; therefore, the TIC arrangement probably cannot accumulate earnings to maintain a maintenance or other type of reserve.

m. Leasing agreements. All leasing agreements must be bona fide leases for federal tax purposes. Thus, rents paid by a lessee must reflect a fair market value for the use of the property. This means that the determination of the amount of rent must not depend, in whole or in part, on income or profits derived by any person from the leased property (other than an amount based on fixed percentages of receipts or sales).

n. Loan agreements. Any person related to any co-owner, the sponsor, the manager, or any lessee of the property is prohibited from being a lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire an undivided interest in the property.

o. Payments to sponsor. Except as otherwise provided in Rev. Proc. 2002-22, any payment to the sponsor for the acquisition of the co-ownership interest (and the fees paid to the sponsor for services) must reflect the fair market value of the acquired ownership interest (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the property.

E. Business Swaps. In the 1980s, taxpayers again tested the resolve of the IRS in the personal property exchange area. Taxpayers took the position that an exchange of one business for another business of the same type was nontaxable under §1031 notwithstanding that the mix of assets employed in the respective businesses involved in the exchange were not like kind. The taxpayers found significant comfort in Rev. Rul. 85-135, 1985-2 C.B. 181 (assets of one television station for the assets of another) and subsequent private letter rulings such as PLR 8934069 (June 1, 1989); PLR 8934070 (June 1, 1989) and PLR 8946068 (August 14, 1989). In an action in which the timing would strongly imply a communication problem within the IRS, it then reversed field in a published opinion. See Rev. Rul. 89-121, 1989-2 C.B. 203, where the business for business application of §1031 was rejected, and Rev. Proc. 89-63, 1989-2 C.B. 783, wherein the IRS announced it would no longer rule on a transaction involving the exchange of the assets of similar or identical businesses.

F. Related Party Restrictions.

1. Background. Prior to 1989, taxpayers developed a simple procedure that in the right circumstances artificially transferred basis from one asset to another. For example, if Taxpayer owned two tracts, Whiteacre and Blackacre, which had bases of $100 and $1,000, respectively, and received an offer to purchase Whiteacre for $2,000, Taxpayer could move Blackacre’s $1,000 basis to Whiteacre, thereby deferring the tax on

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$900 gain until the time Blackacre is sold. How? Taxpayer would form two S corporations and convey Whiteacre to S Corporation I and Blackacre to S Corporation II. S Corporations I and II would then exchange Whiteacre and Blackacre S Corporation II, the new owner of Whiteacre, which then had Blackacre’s old $1,000 basis, would complete the sale. Blackacre, now owned by S Corporation I, has a $100 basis. This example seems too good to be true, and it is. The Commissioner elected not to win by litigation, but instead, the transaction was defeated by legislation. Section 1031(f), passed by Congress in OBRA 1989, provides that in the event of an exchange between related parties and a subsequent sale of either of the exchanged properties within two years following the exchange (normally there will only be one with a low basis), the original exchanging party that transferred the subsequently disposed property must recognize the otherwise deferred gain. Therefore, in the above example, S Corporation I must recognize the $900 gain and in such event its basis in Blackacre would be stepped back to $1,000. The relationship that triggers the recognition of gain in the event of a subsequent sale of property exchanged between related parties is controlled by the Code’s primary attribution rule provisions, §§267(b) and 707(b)(1).

2. True v. United States. The IRS has applied theories from other areas of the tax law to frustrate purported like kind exchanges between related parties. In True v. United States, 190 F.3d 1165 (10th Cir. 1999), the Tenth Circuit held that the IRS properly recharacterized a family’s transactions in ranchland through passthrough entities, finding that the various steps were the means to reach a particular result and, thus, should be treated as a single transaction. Jean and Henry True and their children operated businesses through partnerships or S corporations, including ventures in ranching and in oil and gas production. The ranching venture is through True Ranches. Smokey Oil Co. is one of the oil and gas companies. During the 1980s the Trues purchased five new ranch properties. Smokey Oil purchased the real property while True Ranches acquired the operating assets. Smokey Oil then transferred the land to True Oil Co. in exchange for certain oil and gas leases. The Trues treated that exchange as a tax-free like-kind exchange. True Oil immediately distributed the ranchlands to family-member partners as tenants in common. The partners then contributed their undivided interests in the land to True Ranches. The Trues treated the distributions as nonrecognition transactions under sections 721 and 731. Under those transactions, Smokey Oil received depletable oil and gas leases with the same cost basis it had in the ranchland, allowing Smokey Oil to claim cost depletion deductions on its 1989-90 tax returns. True Oil received the nondepreciable ranchland with a zero basis because the oil and gas leases it exchanged were fully cost depleted.

The Trues paid the deficiencies under protest and sought refunds. The district court granted the government summary judgment. The Tenth Circuit affirmed only as to the ranchland transactions. The appeals court concluded that those transactions failed to satisfy the “end result” test, because the evidence established that the Trues intended all along to place the ranch properties in the hands of True Ranches. The Trues asserted that the steps had economic substance because they wanted Jean and Henry to bear a greater percentage of the acquisition costs. Collapsing the steps, they insist, will deprive Jean and Henry of any compensation for the additional amount they contributed to the purchase price, and their greater share of profits from Smokey Oil’s ownership of the oil

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and gas leases acquired in the exchange. The court rejected that argument, explaining that those financing considerations to not establish that the Trues intended an alternative end result. The court reached the same conclusion applying the interdependence test, finding that the steps involved lacked any “reasoned economic justification standing alone.” Noting that Smokey Oil is involved only in oil and gas exploration and production, Judge Brorby said unless Smokey Oil acquired the mineral rights underneath the ranchlands, that the company’s purchase of the lands made no objective business sense.

The holding in True is somewhat troubling to practitioners inasmuch as essentially all like-kind exchanges between related parties can be attacked under the step transaction doctrine. There is no prohibition of exchange between related parties. §1031(f) merely taxes both parties to an exchange if one of the related exchange parties sells the exchange property received within 2 years following the exchange. The goal was to step up the basis of depreciable property for the write off benefit. Section 1031(f) does not prevent the benefit of depreciation deductions following exchanges of related property. Does every §1031 exchange structured for tax savings fail? A more simplified example of the above the IRS seeks to eliminate here is where T owns X, a low basis rental property and Y, a high basis tract of unimproved property. T creates an S corporation and contributes X to S. T and S then exchange X and Y whereby T ends up with X with Y’s old high basis. True would rearrange the steps and hold that T merely contributed Y to the S corporation and T got no basis step up.

3. TAMs, FSAs and Rev. Rul. 2002-49 I.R.B. 927. The IRS has administratively attacked related party exchanges using an intermediary. In TAM 9748006 S had a buyer for his property and he wanted to acquire property from his mother M with the proceeds. S sold the property and entered into an exchange agreement with an intermediary which used the sale proceeds to buy M’s property. The IRS simply rearranged the steps of the transaction as the Tenth Circuit did in True. The IRS held that S and M made the exchange then M sold to the buyer, thus the exchange failed because of Section 1031(f). The IRS applied a similar approach in FSA 1999931002 and Rev. Rul. 2002-49.

4. Teruya Brothers, Ltd. v. Commissioner. In Teruya Brothers Ltd., et. al. v. Commissioner, 124 T.C. No. 4 (2005), the Tax Court held a like-kind exchange of property between related parties through a qualified intermediary was not entitled to nonrecognition treatment under §1031 because the transaction was structured to avoid taxes. Teruya Brothers Ltd. transferred two properties to a qualified intermediary (QI) that, in turn, sold the properties to unrelated third parties. The QI used the proceeds plus additional cash from Teruya to buy replacement properties from Times Super Market Ltd., a company in which Teruya was the majority stockholder. The replacement properties were then transferred from the QI to Teruya. The IRS acknowledged that the transactions met the general requirements for like-kind exchanges under §1031(a)(1). It argued, however, that Teruya was required to recognize more than $12 million in gains because it had violated §1031(f)(4), which prohibits nonrecognition treatment for transactions structured to avoid the purposes of §1031(f). The Tax Court determined that the transactions were economically equivalent to direct exchanges of properties between

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Teruya and Times (with boot from Teruya to Times), followed by Times’ sales of the properties to unrelated third parties. He inferred that Teruya’s use of a QI was an attempt to circumvent the §1031(f)(1) limitation that applies to direct exchanges between related persons.

G. Deferred Exchanges─The Regulations. Congress amended §1031(a), effective for transactions occurring after July 18, 1984, by adding the following additional provision.

(3) Requirement That Property Be Identified And That Exchange Be Completed Not More than 180 Days After Transfer of Exchanged Property.─For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like kind property if─

(A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or

(B) such property is received after the earlier of─

(i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or

(ii) the due date (determined with regard to extension) for the transferor’s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.

On April 25, 1991, the Treasury adopted regulations under the 1984 deferred exchange amendment. Although the final regulations address many questions about deferred exchanges, for most taxpayers the heart of the final regulations is the safe harbor provisions describing qualified intermediaries and security arrangements. It may be significant to note that the safe harbors are nothing more than safe harbors. Congress has not delegated to Treasury any authority to establish substantive rules; the final regulations merely interpret §1031 under the general interpretative authority granted by §7805. Where the taxpayer qualifies a transaction under the safe harbors, the taxpayer will not be, either directly or through an intermediary, escrow holder, or trustee that may be his agent, considered in actual or constructive receipt of money or other property for purposes of the final regulations. In theory, the taxpayer should be free to decide whether or not to take advantage of the safe harbors. Some commentators apparently had questioned whether the safe harbors were mutually exclusive. The regulations clarify that the taxpayer may use more than one safe harbor in the same deferred exchange, provided that the terms of each are satisfied. For example, many advisors will wish to combine the intermediary safe harbor with either the safe harbor for qualified escrows or the safe harbors for security.

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The regulations do not contain a negative inference that a transaction should be presumed to be taxable if it does not qualify for the safe harbors. For example, the regulations do not either approve or disapprove of the use of a related party as an intermediary and they do not, as a substantive law matter, address receiving loans from an intermediary or premature disbursements from escrow. They merely set forth safe harbor rules. In appropriate cases (which would be rare), it seems that a taxpayer might later take the position that a transaction, blessed by a safe harbor, is fully taxable on account of constructive receipt. Someone considering this position, however, should first review the mitigation provisions contained in IRC §§1311-1314 and the effect of the various judicial doctrines such as consistency and estoppel. Nevertheless, it is possible that there are situations in which a taxpayer (or his successor) may determine that it is later advantageous to take the position that the safe harbors do not govern the substantive law and that a transaction within the safe harbors still is taxable. Considering the liberality of the safe harbors, it is entirely plausible that, in appropriate circumstances, this position could prevail. Section III describes the specific safe harbor rules.

H. Deferred Exchanges and Installment Sales. The Starker decision raised an interesting question, academic in Starker but very real in those deferred exchanges that were crafted from Starker’s broad principles. The question is: If, at the end of the five-year period, Crown Zellerbach had not replaced the property but paid Mr. Starker the required cash, how should Mr. Starker’s gain on his property conveyed to Crown Zellerbach be reported? Should it have been reported in the year of the disposition as a nonqualifying like kind exchange or five years later as proceeds received pursuant to an installment sale? The 1984 amendment to §1031 did not resolve the question but merely shortened the potential installment period to two taxable years, since a deferred exchange must close, if at all, within 180 days following the date of closing of the conveyance of the relinquished property. IRC §1031(a)(3)(B). On November 2, 1992, the Treasury issued Prop. Reg. §1.1031(k)-1(j)(2) which made clear the effect of a failed deferred exchange entered into with a good intention. Such a failure would cause the otherwise deferred gain to be recognized in the year the consideration received from the disposition of the relinquished property would be treated as a payment on an installment note and taxed when received by the taxpayer from the intermediary, escrow or trust. See III.C.

III. DEFERRED LIKE KIND EXCHANGE REGULATIONS.

A. Overview. The §1031 regulations put flesh on the bare bones of the statute which provided only two basic rules: (i) that replacement properties must be identified within 45 days following the date of conveyance of the relinquished property (IRC §1031(a)(3)(A)), and (ii) that the replacement property must be acquired within 180 days following the date of conveyance of the relinquished property (IRC §1031(a)(3)(B)). The basic structural steps of a typical deferred exchange described in the broadest form are as follows:

• the taxpayer has a property with an inherent gain and the taxpayer receives a contract for purchase of his property;

• the taxpayer enters into an exchange agreement with an intermediary and then assigns the purchase contract to the intermediary;

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• the purchase contract closes, the relinquished property is conveyed to the buyer and the consideration therefrom is paid over to the intermediary;

• the taxpayer identifies certain replacement property;

• the taxpayer selects the replacement property and contracts to buy it;

• the contract to acquire the replacement property is assigned to the intermediary; and

• the contract is closed whereby the intermediary transfers the cash consideration to the seller and the seller conveys the replacement property to the taxpayer, frequently through a direct deed.

(See the diagram on Appendix 1.)

The regulations expand the rules to cover all elements of a normal exchange which are discussed in detail in this Section III.

B. The Intermediary. Almost all deferred exchanges structured under the regulations will utilize an intermediary although a good exchange does not require it. Generally, qualifying trusts and escrows are regarded as alternatives to the intermediary concept, but they are actually security concepts that should be utilized as a compliment to the qualified intermediary structure and not in lieu thereof. The intermediary safe harbor is sufficiently generous and the risks outside the safe harbor are sufficiently great that few will structure a deferred exchange with an intermediary who is not a qualified intermediary. Prior to the publication of the proposed §1031 regulations, taxpayers had no guidance concerning who could be used as an intermediary in completing a deferred exchange transaction. While some taxpayers used controlled or related persons, there was always an underlying concern that the transaction would result in constructive receipt. Other taxpayers used professional intermediaries, which frequently were shell corporations formed to provide intermediary services, usually for a fee. Some taxpayers were able to find friendly parties to act as intermediaries. The proposed regulations introduced a generous safe harbor that generally blessed the use of intermediaries, provided that the intermediary was not a party related to the taxpayer under broad attribution rules. The safe harbor under the final regulations is similar to the safe harbor under the proposed regulations. A qualified intermediary under the final regulations is not considered the agent of the taxpayer for purposes of applying §1031. The taxpayer’s transfer of relinquished property and/or his subsequent receipt of like kind replacement property from a qualified intermediary is treated as an exchange. If the safe harbor requirements are met, the taxpayer will not be treated as being in actual or constructive receipt of money or other property held by the qualified intermediary.

1. The Qualified Intermediary. Reg. §1.1031(k)-1(g)(4) defines a “qualified intermediary” as a person who (i) is not the taxpayer or disqualified person, and (ii) enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the rights to the relinquished

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property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.

2. Limitation on Right to Receive “Boot”. The intermediary safe harbor requires that its terms will be met only if the agreement between the taxpayer and the qualified intermediary expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary until the occurrence of a “cash-out” event specified in Reg. §1.1031(k)-1(g)(6) (also referred to herein as a “(g)(6) event”). The regulations require an affirmative statement in the exchange agreement between the taxpayer and the intermediary that expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary until a (g)(6) event. In order to meet the terms of the safe harbor, it is necessary that the exchange agreement contain this magic language. It is not enough that, as a matter of state law, the taxpayer actually have no right to the funds held by the intermediary. Indeed, under the final regulations, whether the taxpayer has the state law right to get his hands on the money prior to a “cash out” event is completely irrelevant.

3. Qualified Intermediary Cannot Be a Disqualified Person. A qualified intermediary cannot be the taxpayer or a party related to the taxpayer who falls within the definition of “disqualified person.” It is important to observe that it is the safe harbor and not the rules of substantive law that prohibit related party intermediaries. It is possible that a related party intermediary might be permitted under the substantive rules of §1031 as ultimately determined by the courts, but there will be few taxpayers inclined to test that proposition. It is also significant, in using an intermediary, carefully to explore the full definition of “disqualified person.” This concept is much broader than a related party concept under general principles of tax law. A disqualified person not only includes people related to the taxpayer under normal attribution rules (in this case, under modified attribution rules under §267(b) and §707(b)); disqualified persons also includes a person who is the agent of the taxpayer at the time of the transaction. This includes any person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date of the transfer of the first of the relinquished properties. Also, a person can be treated as a disqualified person to the taxpayer if that person is related to one of the taxpayer’s agents. Nevertheless, an exception is made for those who were agents only in connection with §1031 exchanges. IRS officials have informally acknowledged that a lawyer who had never represented the taxpayer prior to the deferred exchange transaction but who was hired for the sole purpose of structuring the exchange can be a qualified intermediary.

4. Written Exchange Agreement. The regulations specifically require that the taxpayer enter into a written exchange agreement with his intermediary. Reg. §1.1031(k)-1(g)(4)(iii)(B). This exchange agreement must require the intermediary to acquire relinquished property for the taxpayer, to transfer the relinquished property from the taxpayer, to acquire replacement property, and to transfer the replacement property to the taxpayer. This means that neither the buyer of the taxpayer’s relinquished property nor the seller of the taxpayer’s replacement property (unless perhaps there are multiple replacement properties) can qualify as a qualified intermediary.

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5. Disposition Requirement. Apparently the exchange agreement must not only require the intermediary to acquire property but also to dispose of it. Failure of the exchange agreement to require the intermediary to dispose of the taxpayer’s relinquished property could cause the transaction to be taxable, and many advisors will be reluctant to take their transactions outside the specific terms of the safe harbor. Those who do may be able to argue persuasively that the case for the seller of replacement property or the buyer of relinquished property should be stronger than the case of the professional intermediary.

C. Security Arrangements. Many intermediaries are completely uninsured and unregulated. In the case of larger transactions, it may be necessary or at least advisable to secure the intermediary’s obligations. Fortunately, the final regulations are generous in permitting a variety of security arrangements. From a tax perspective, these security arrangements are fairly easy to construct. The final regulations permit three types of formal security or security-type arrangements. Unfortunately, these security arrangements are not easily incorporated in a deferred exchange.

1. Permitted Security Arrangements. The determination of whether the taxpayer is in actual or constructive receipt of money or other property before his receipt of the replacement property is made without regard to the fact that the obligation of the taxpayer’s transferee (usually the intermediary) to transfer replacement property to the taxpayer is or may be secured or guaranteed by one or more of a mortgage, deed of trust, or other security interest in property (other than cash or cash equivalent); a standby letter of credit which satisfies all of the requirements of Temp. Reg. §15A.453-1(b)(3)(iii) and which may not be drawn upon in the absence of a default of the transferee’s obligation to transfer like kind replacement property to the taxpayer; or a guarantee of a third party.

For the cautious advisor, these guarantee arrangements will become an important factor in undertaking exchanges with qualified intermediaries.

2. Pledges of Property. The regulations, (Reg. §1.1031(k)-1(g)(2)(i)(A)), permit a mortgage, deed of trust, or other security interest in property other than cash or a cash equivalent to secure the intermediary’s obligations. The exclusion of cash and cash equivalents seems to be a reference to the longstanding controversy over the use of such security in the installment sale area. It is fairly clear that land will qualify as collateral. Therefore, in theory, the relinquished property could serve as security, although this possibility is usually impractical. If the transaction uses an intermediary, the ultimate buyer is unlikely to accept the relinquished property subject to a deed of trust securing the intermediary’s continuing exchange obligation to the taxpayer. If the buyer were acting as the intermediary, the relinquished property may prove to be workable security. Beyond this, a wide range of other properties are permitted to serve as security, however, cash or cash equivalents will not qualify under the security safe harbor. The real question is one which cuts across a number of tax provisions: What is “cash or a cash equivalent?” The term “cash” certainly includes currency. Does it include demand accounts, savings accounts, certificates of deposit, foreign currencies, secured evidences of indebtedness, letters of credit, acceptances, commercial paper, Treasury instruments, corporate debt instruments, installment obligations, registered bonds, registered stock,

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precious metals, diamonds and other stones, etc.? The law so far is not very well developed. In the context of installment sales (IRC §453), bank certificates of deposit and Treasury notes are treated as cash equivalents. This same regulation, however, treats foreign currency, marketable securities, and evidences of indebtedness which are payable on demand or readily tradable as other property. The term “cash equivalent” is used more expansively in Rev. Rul. 66-290, 1966-2 C.B. 112. That ruling uses the term “cash and its equivalent” to include “cash, currency, bank deposits (including time deposits) whether or not interest bearing, share accounts in savings and loan associations, checks (whether or not certified), drafts, money orders, and any other item of a similar nature.” It does not include accounts receivable (as the term is commonly used), inventories, marketable securities, and other similar assets. As important as it is to avoid “cash and cash equivalents” as security, tax advisors must be careful to select a security that will not decline in value and that is easily liquidated in order to complete the exchange transaction. They also must be careful to remember that good security is not entirely a substitute for reliable intermediaries. If the intermediary defaults, the taxpayer will suffer a substantial tax liability, which usually will not be compensated by a foreclosure on the security.

3. Standby Letters of Credit. The regulations also approve a standby letter of credit. Reg. §1.1031(k)-1(g)(2)(i)(B). Unfortunately, the safe harbor is impractical to satisfy in a commercially reasonable transaction. A standby letter of credit must satisfy all of the requirements of Reg. §15A.453-1(b)(3)(iii) and may not be drawn upon in the absence of a default of the transferee’s obligation to transfer like kind replacement property to the taxpayer. The installment sale regulations require that the letter of credit be nonnegotiable and nontransferable (except with the underlying obligation that is secured) and it is important to incorporate these terms in the letter of credit. Normally the letter of credit will be drawable upon the presentation of a draft accompanied by the statement that the intermediary has defaulted. Whether the normal practice is what the Treasury intended needs to be clarified. A serious difficulty derives from the requirement under the final regulations that the letter of credit “may not be drawn upon in the absence of a default of the transferee’s obligation to transfer like kind replacement property to the taxpayer.”

What happens if the intermediary becomes bankrupt? Can the letter of credit be drawn? The bankruptcy of the intermediary certainly is not a default on an obligation to transfer replacement property, although it may constitute a default under the exchange agreement. It appears that the letter of credit cannot be drawn (or drawable) on the bankruptcy of the intermediary. What happens if the taxpayer designates replacement property but is not able to negotiate an agreement to acquire the replacement property? The exchange agreement presumably will provide for the intermediary to pay cash to the taxpayer only upon the occurrence of a (g)(6) event. If the intermediary fails to pay over the cash at the right time, a default will occur under the exchange agreement. The trouble is that it may not be considered a default on an obligation to transfer like kind replacement property and thus that the letter of credit cannot be drawn (or drawable). Another possibility is that the acquisition of replacement property closes, but there is some exchange balance left over and the intermediary fails to pay over that cash as required by the agreement. Again, that failure of action by the intermediary is not a

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default on an obligation to transfer replacement property, and therefore the letter of credit cannot be drawn (or drawable). Accordingly, it is impractical to use a letter of credit that satisfies the literal terms of the safe harbor; that would require accepting a letter of credit that permits draws only on a limited subset of the events for which security is appropriate. As to other events, the taxpayer would be unsecured. Of course, under certain circumstances, advisors may be willing to recommend letters of credit that do not qualify under the safe harbor for letters of credit although it is unlikely that they will often do so. Standby letters of credit are expensive. They require complex mechanics in order to provide the intermediary with funds for deposits and funds to acquire replacement property. It is also important to ensure that the letter of credit is not held in an escrow, since that would make it much more difficult to draw on the letter of credit if the intermediary defaults on his exchange obligation. There is too much risk that the escrow holder would receive conflicting instructions and would merely interplead the letter of credit without drawing on it with the result that the letter of credit held in escrow may just expire undrawn. Usually the intermediary will need to liquidate the underlying collateral security in order to acquire replacement property, but this is difficult to arrange where there may be several draws against the underlying collateral security such as would occur when the intermediary must make option payments or deposits into escrow. Furthermore, it will be necessary to address what happens in an attempted acquisition of replacement property that is unsuccessful. The issuer will want to reduce the letter of credit wherever there is a draw on the underlying collateral.

4. Guarantee. Guarantees are permitted under the regulations (Reg. §1.1031(k)-1(g)(2)(i)(C)) and may become important as affiliates of title insurance companies and other institutions enter the qualified intermediary business. Guarantees are approved for installment sales (i.e., an independent guarantee of an installment note does not constitute constructive receipt of payment of the note), and the final §1031 regulations similarly approve them for deferred exchanges. The guarantee should be structured so that it not only guarantees performance, on an after tax basis, but also any obligations under a liquidated damages clause (including damages for tax consequences). The guarantee should be drafted so that the taxpayer may proceed directly against the guarantor in the event of a default and so that the guarantor cannot raise defenses that could not be raised by the party whose obligation is guaranteed. An interesting issue concerning guarantees is not answered by the proposed regulations: Can the guarantee be secured by cash or cash equivalents or will this cause the taxpayer to be in constructive receipt?

5. Right to Receive Money. Each of the safe harbors for security will cease to apply at the time the taxpayer has an immediate ability or unrestricted right to receive money or other property pursuant to the security or guarantee arrangement. Reg. §1.1031(k)-(g)(2)(ii). The meaning of this provision is not entirely clear, but the general concept is that so long as the taxpayer’s rights to receive the cash are subject to a substantial restriction, constructive receipt should not result. There still is an implication that where the taxpayer had only a deferred ability or restricted right to receive money or other property pursuant to the security arrangement, the safe harbors could continue to apply.

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6. Qualified Escrow Accounts. Prior to the promulgation of the proposed regulations in 1990, some advisors structured exchanges between the taxpayer and the buyer of the relinquished property by having the buyer deposit his cash consideration into an escrow held for both the taxpayer and his buyer. These cash escrows were troubling because of the concern that a cash escrow collateralizing an intermediary’s exchange promise would result in constructive receipt. The regulations, however, following the lead of the proposed regulations, approve the use of qualified escrow account as a means to secure the intermediary’s exchange promise. See Reg. §1.1031(k)-1(g)(3). Advisors should understand that the qualified escrow account does not substitute for the intermediary under the intermediary safe harbor. The intermediary or buyer’s obligation to transfer the replacement property to the taxpayer may be secured by cash or equivalents if the cash or cash equivalent is held in a qualified escrow account. This makes the qualified escrow account especially advantageous as a security device, since many advisors have found it desirable to use cash and cash equivalents as security to deferred exchanges to allay concerns of liquidity and volatility. Cash equivalents usually can be liquidated quickly, and they typically are relatively stable in value, so that funds necessary to complete the exchange should be readily available for the closing of replacement property. The final regulations impose several requirements for the qualified escrow safe harbor. If the requirements of the safe harbor are met, the determination of whether the taxpayer is in actual or constructive receipt of the corpus of the escrow account “will be made without regard to the fact that the obligation of the taxpayer’s transferee to transfer the replacement property to the taxpayer is or may be secured by cash or a cash equivalent.” Reg. §1.1031(k)-1(g)(3)(ii)(B).

a. Safe Harbor Requirements. The safe harbor provision for qualified escrow accounts requires that the escrow holder is not the taxpayer or a disqualified person, and the escrow agreement expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account as provided in Reg. §1.1031(k)-1(g)(6).

A taxpayer may receive money or other property directly from a party to the exchange, but not from a qualified escrow account without affecting the application of the safe harbor provision.

b. Disqualified Person. The definition of disqualified persons already has been addressed in III.B.3. This limitation ensures that the escrow account is not held by the taxpayer’s relative, controlled corporation, or other related party.

c. Limitation on Right to Receive Cash. The second requirement makes it essential that the escrow agreement contain specific language, such as

“The Exchangor shall have no right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the Escrow Holder prior to the first to occur of the events provided in paragraph (g)(6) of Section 1.1031(k)-1 of the Treasury

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Regulations (a ‘(g)(6) event’). Upon the occurrence of such a (g)(6) event and written demand by the Exchangor, the Escrow Holder shall pay over to the Exchangor in current funds within three business days any remaining Exchange Balance.”

The regulations clarify that the possible invalidity of such a restriction under state law should have no effect on the exchange transaction; what is critical is that the escrow agreement contain the language, not that it be enforceable.

d. Payment of “Boot”. If the taxpayer is to receive cash or other “boot” in the transaction, it is critical that either:

(1) the “boot” be paid outside of the qualified escrow, or

(2) the “boot” be paid after the occurrence of a (g)(6) event.

Advisors are cautioned that “boot” is not limited to cash or cash equivalents. “Boot” includes any recognition property. If the qualified escrow is used to close the acquisition of replacement property and the transfer of the replacement property includes any transfer of “boot” at all, it is critical that the transfer of that “boot” not occur prior to a (g)(6) event. This is particularly a concern where there are multiple replacement properties closing on different dates. The payment of the cash not reinvested in replacement properties should not be distributed until the end of the replacement period.

e. Lack of Effectiveness as Security Device. The qualified escrow conveniently segregates the taxpayer’s money from the other funds of the intermediary and, if properly structured, substantially reduces the risk of embezzlement or mismanagement of those funds. The taxpayer can be secure in the sense that he should know where the money is and can visit it daily; however, he cannot get his hands on the money without killing the like kind exchange treatment sought.

Escrow accounts are not considered a form of perfected security under the Uniform Commercial Code. Further acts are needed to perfect a security interest. Also, it seems unlikely that the taxpayer would be considered a secured party if the intermediary should become bankrupt. A bankruptcy trustee should be able to set aside the escrow account and to reclaim its assets as part of the intermediary’s bankruptcy estate. Also, if the intermediary actually has transferred replacement property to the taxpayer within the appropriate preference period, the bankruptcy trustee may also be able to set aside the transfer as a preference.

f. Perfected Pledge of Escrowed Funds. The terms of the qualified escrow account safe harbor invite the creation of another security device. Provided that cash and cash equivalents are held in the qualified escrow account, the taxpayer should be able to take a security interest in that cash and the cash equivalents. There is no rule that the taxpayer’s depth of security should be limited to taking the security interest represented by just having the funds held in

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the qualified escrow account. The taxpayer additionally should be able to perfect his interest in the corpus of the escrow or in the intermediary’s interest in the escrow account under the Uniform Commercial Code. The qualified escrow account coupled with a perfected pledge in the corpus may emerge as one of the leading techniques to secure the intermediary’s exchange obligation.

g. Limitations on Draw. There is an interesting contrast between the draw limitations imposed by the qualified intermediary safe harbor and those required in the qualified escrow safe harbor. The qualified intermediary safe harbor requires that the exchange agreement “limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary as provided in paragraph (g)(6) of this section.” The qualified escrow safe harbor, however, requires that “the escrow agreement expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account as provided in paragraph (g)(6).”

See Reg. §1.1031(k)-1(g)(3)(iii)(B). Query whether there is significance in the use of the terms “money or other property” in the intermediary safe harbor while the terms “cash or cash equivalent” are used in the qualified escrow safe harbor?

7. Qualified Trusts. The final regulations do not permit a trust to act as intermediary under the intermediary safe harbor; trusts, however, are approved as security devices. The safe harbor rules for qualified trusts are parallel to the safe harbor rules for qualified escrows. The final regulations provide that the issue of constructive receipt is determined without considering that “the obligation of the taxpayer’s transferee to transfer the replacement property to the taxpayer is or may be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow account or in a qualified trust.” Reg. §1.1031(k)-1(g)(3).

a. Requirements of Safe Harbor. A qualified trust requires that the trustee is not the taxpayer or a disqualified person, except that for this purpose the relationship between the taxpayer and the trustee created by the qualified trust will not be considered a relationship under §267(b), and the trust agreement must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held by the trustee until the occurrence of a (g)(6) event. Reg. §1.1031(k)-1(g)(3)(iii)(B).

b. Ability to Receive Cash. The qualified trust safe harbor ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the qualified escrow account or qualified trust as provided by paragraph (g)(6) (describing cash out events). For this purpose, rights conferred upon the taxpayer under state law to terminate or dismiss the trustee are disregarded. It is significant to observe that a trust is not a means of creating a perfected security interest under the Uniform Commercial Code. Consequently, the qualified trust should be evaluated carefully in the light of state law and

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bankruptcy law in order to determine whether the qualified trust creates an arrangement that justifiably should make the taxpayer feel secure. Some advisors believe that the qualified trust is the ideal way to secure a deferred exchange promise.

c. “Boot” Paid Outside Escrow; Early Cash Outs . The qualified trust safe harbor permits the taxpayer to receive money or other property directly from a party to the exchange, but not from a qualified trust, prior to the occurrence of a (g)(6) event. If the taxpayer does receive cash or other property from the qualified trust prior to the occurrence of a (g)(6) event, then the transaction will be considered outside of the qualified trust safe harbor, with the concomitant risk that the transaction will be fully taxable.

8. Early Distributions by an Intermediary. In PLR 200027028, the IRS focused on one aspect of the deferred exchange regulations that has troubled the qualified intermediary industry and advisors who work with Section 1031. The ruling addresses the question of what circumstances will allow an intermediary to release funds to an exchanger prior to the end of the 180-day exchange period without disqualifying the exchange from inception. The ruling asked the IRS to rule on the technical limitations of Reg. §1.1031(k)-1(g)(6) to the effect that it would not be violated by including in the exchange agreement a clause allowing a release of exchange funds to an exchange prior to the end of the 180-day exchange period applicable to a transaction if the client proved unable to negotiate a satisfactory purchase agreement with a seller of potential replacement property.

Reg. §1.1031(k)-1(g)(6) (“(g)(6)”) conditions allow the exchange agreement to provide for payment of money by the intermediary to an exchanger on the earliest to occur of three events: (1) the end of the 180-day exchange period; (2) the end of the 45-day identification period if the exchanger has no remaining unacquired identified replacement properties; or (3) where there are remaining unacquired identified properties at the end of the identification period, then on (a) receipt of all properties that an exchanger is entitled to receive under the exchange agreement or (b) the occurrence of a “material and substantial contingency that relates to the deferred exchange,” that is provided for in writing and that is beyond the control of the exchanger or any disqualified person.

The ruling request asked the following questions:

● May an exchange agreement provide that where a taxpayer identifies multiple replacement properties intending to acquire all of them, acquires one or more but then fails to negotiate satisfactory acquisition agreements with the sellers of the others, this failure can serve as basis under the (g)(6) rules for release of cash in the amount of unexpended exchange credits by a qualified intermediary to an exchanger?

● May an exchange agreement provide that where a taxpayer identifies only one replacement property but fails to negotiate a satisfactory acquisition agreement

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with the seller of that property, this failure can serve as the basis under the (g)(6) rules for release of cash in the amount of unexpended exchange credits by a qualified intermediary to an exchanger?

More specifically, the issue is whether an exchanger’s inability to negotiate a satisfactory purchase agreement for replacement property was a condition “beyond the control of the taxpayer and of any disqualified person” as required by Reg. §1.1031(k)-1(g)(6)(iii)(B), where the taxpayer intended from inception to acquire all identified property.

The IRS ruled adversely, noting that language permitting early release on failure to negotiate satisfactory purchase arrangements falls outside all the (g)(6) conditions. The proposed language does not qualify under paragraph (g)(6)(iii)(A) because, as the questions are posed, the owner has not received all replacement property to which it is entitled under the exchange agreement as of the date a failure to negotiate a contract occurs. Furthermore, failure to negotiate such a contract does not involve actions by an independent third party (such as a government agency) denying a request for rezoning or an act beyond anyone’s control (such as destruction) that makes a potential replacement property unsuitable for an exchanger. The questions posed in this ruling request do not incorporate the circumstances that are most prevalent among exchangers seeking early release of funds: (1) the decision not to complete any exchange and (2) the situation where multiple alternative replacement properties are identified, the taxpayer expects to acquire only one (or less than all), and following acquisition of one of the identified properties there is an exchange credit balance due from the intermediary to the exchanger. The IRS concluded that failing to reach a satisfactory purchase contract for replacement property despite good faith negotiation is not a contingency beyond the exchanger’s control. It relied on the language of Reg. §1.1031(k)-1(g)(8), Example 2.

Example 2 involves an escrow agreement between an exchanger and a buyer of relinquished property that provides the exchanger may demand funds from the escrow agent prior to the end of the applicable exchange period. The exchanger identifies a single replacement property (J) during the identification period. The conditions under which a demand may be made after the end of the identification period include (1) destruction, seizure, requisition, or condemnation of property J, (2) a determination that regulatory approval necessary for the transfer of property J to the exchanger cannot be obtained in time to allow the transfer before the end of the exchange period, or (3) if rezoning of property J from residential to commercial use has not been achieved by a date three months following the transfer of the relinquished property. The example provides that the rezoning does not occur within the three-month window provided by the escrow agreement. The Regulations conclude that all these contingencies satisfy the “beyond the taxpayer’s control” requirement of Reg. 1.1031(k)-1(g)(6)(iii)(B) but that since the third condition allows for receipt of funds after 90 days if rezoning is not obtained, the taxpayer is deemed to be in constructive receipt of funds held in the escrow at that point because the third condition failed and the taxpayer would be entitled to withdraw funds from the escrow, whether it did or not.

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The conclusion drawn by the IRS in PLR 200027028 from Example 2 is that a contingency beyond the control of the taxpayer (or of a disqualified person other than the transferor of replacement property) should relate to “actions of a party not involved in the exchange” or “an act beyond anyone’s control.”

Issues relating to external factors affecting the replacement property, other than its complete destruction or loss to a condemning or requisitioning authority remain. Can circumstances such as the existence of hazardous materials, specific physical limitations to development, prevailing interest rates above a specific prestated range, or a host of other criteria applicable to the due diligence process for real estate acquisitions (or comparable criteria for any asset class) be considered contingencies beyond the control of the taxpayer? If so, will they pass the “material and substantial” test? The ruling does not address these points. There is no indication whether a seller’s absolute refusal to make a property available for sale, by withdrawing it from the marketplace, would be a condition beyond the control of an exchanger or, similarly, when the seller actually sells the property to another buyer. Thus, the ruling does not preclude taxpayers from defining conditions relating to the property acquisition that are beyond their control and thus could serve as the basis for early release of funds in a fully or partially cancelled exchange.

D. Specification of Replacement Property. The Regulations at Reg. §1.1031(k)-1(b) contain detailed rules concerning the identification of replacement property. These rules, carried over from the proposed regulations without material change are not founded in either the statute or the legislative history. Some taxpayers may seek to challenge aspects of the identification regulations, since the regulations were promulgated as interpretive regulations under §7805 (although, in may respects, written in the form of legislative regulations). If the regulations are valid, an identification failing to meet the identification requirements of the regulations would fail to qualify as a deferred exchange under §1031. The identification rules are not a safe harbor; they are mandatory.

1. Property Acquired By 45th Day. Where a taxpayer actually acquires his replacement property by the 45th day, the identification requirements are deemed to have been met without the requirement for a specific identification notice.

2. Identification Notice. In other cases, the replacement property must be designated as replacement property in a written document that is signed by the taxpayer. This may be transmitted by almost any means; it may be hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period.

3. Recipient of Identification Notice. The recipient of the notice must be either the person obligated to transfer the replacement property to the taxpayer (regardless of whether that person is a disqualified person); or any other person involved in the exchange other than the taxpayer or a disqualified person.

The regulations list as examples of permissible recipients any of the parties to the exchange, an intermediary, an escrow agent, and a title company. The identification also can be made in a written agreement for the exchange of properties signed by all parties before the end of the identification period. (Advisors should note that the taxpayer is

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required to report whether the exchange was “made with a related party” on IRS Form 8824.) Sending an identification notice is clearly required by §1031. It may be a reasonable interpretation of the statute that the notice must be in writing, however, the Service may have difficulty sustaining its position that the identification notice must be sent to a party other than a disqualified party (except for the transferor of the replacement property). This requirement seems to go well beyond the statute and its legislative history; such a requirement would seem to be more appropriate for a legislative regulation than for an interpretive regulation, particularly given the government’s position on the broad definition of “disqualified persons.” The identification notice must be in writing and signed by the taxpayer. The regulations do not clarify whether it may be signed on the taxpayer’s behalf under a power of attorney; pending clarification, the safest approach is for it to be signed personally by the taxpayer.

4. Transmission of Identification Notice. The final regulations permit any means of transmission of physical documents. Examples of acceptable delivery methods include hand delivery, mail, and telecopy. Delivery by private overnight mail service should be acceptable. Oral or telephonic identification (except telecopy) fails. Transmission by telex likely fails, since a telex cannot bear the taxpayer’s signature. The regulations clarify that the critical date, for mailed notices at least, is when the notice is sent, not when it is received. The notice must be “hand delivered, mailed, telecopied, or otherwise sent before the end of the identification.” See Reg. §1.1031(k)-1(c)(2). In Dobrich v. Commissioner, 74 T.C.M. (CCH) 985 (1997), the taxpayer was found to have backdated an identification notice and the Tax Court imposed the civil fraud penalty under §6663(a).

5. Mailed Notices. Mailed notices presumably are sent when deposited in the United States mail. There is no requirement that they be sent by certified or registered mail, but that would seem advisable, with a retained certificate of mailing. The regulations do not clarify what happens if the notice is timely mailed but with insufficient postage or the notice is mailed to an incorrect address and is returned to the taxpayer without being delivered. A taxpayer might argue that the regulations require only that the notice be sent and not necessarily received; one can only speculate on whether a court would be receptive to this argument. An identification notice that is properly addressed and stamped but that is delayed in the mail, however, should qualify as a timely notice, provided that it is timely mailed and otherwise meets the requirements of the regulations.

6. Telecopied Notices. The regulations also permit telecopied notices. These are easy to send, but are subject to some peculiar risks. The receiving unit may be out of paper. The transmission may be received by the incorrect telecopy unit. The transmission may be wholly or partially illegible. All of these are practical problems that are not addressed by the final regulations. A taxpayer should seek to confirm receipt of a telecopied notice. Also, he should be careful to ensure that the telecopied material is signed by the taxpayer.

7. Hand Delivered Notices. The regulations permit hand delivered notices. These notices also should be effective when hand delivered. The regulations do not clarify what that means. If the notice is given to a messenger within the identification

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period, will the notice be treated as timely sent? What rule should apply to notices delivered by overnight messenger service, such as Federal Express? Are these notices effective when given to the messenger company or when received?

8. Description of Real Property. The final regulations require that the “[r]eplacement property is identified only if it is unambiguously described in the written document or agreement.” The regulations (Reg. §1.1031(k)-1(c)(3)) give three examples of unambiguous description; real property generally is unambiguously described if it is described by a legal description, street address, or distinguishable name.

It is hard to quarrel with legal description or street address, provided that they are accurate. One may wonder the effects of a mistake in the legal description or street address, which conceivably could invalidate the identification notice. Taxpayers should not be encouraged to use “distinguishable names.”

9. Identification of Incidental Items of Property. An exception to the specific identification rule is provided for incidental items of property that have a fair market value no greater than 15 percent of the fair market value of the larger item. It is not necessary separately to designate property that is incidental to a larger item of property to be purchased because the larger property and the incidental property are treated as the same item of property. This does not, however, avoid the requirement that both the larger item and the incidental item must meet the other requirements of §1031, particularly the multi-asset exchange rules.

Property is incidental to a larger item of property if, in standard commercial transactions, the property is typically transferred together with the larger item of property, and the aggregate fair market value of all the incidental property does not exceed 15 percent of the aggregate fair market value of the larger item of property.

The regulations give several examples of the application of this rule. See Reg. §1.1031(k)-1(c)(5). Although the rule concerning incidental property is useful for transactions involving a single large item of property, it is not very useful where there is a transfer that does not involve a single predominant asset, such as may occur in the transfer of a going business. In that case, there must be separate identification of each and every item.

10. Revocation of Identification. The ability to revoke the identification of replacement property is important for satisfying the various safe harbors for over-identification. It is also significant with respect to the receipt of money and other property, since several of the (g)(6) events depend on the identification of replacement property or the acquisition of designated replacement property.

The identification of replacement property may be revoked at any time before the end of the 45-day identification period. A revocation must be made in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period. Again, the regulations generally key on the date on which the revocation is sent and not on when it is received. The recipient must be the same person to whom the identification of the replacement property was sent.

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Note that an identification of replacement property that is made in the exchange agreement can be revoked only by a written amendment to the agreement or in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to all of the parties to the agreement. There is no provision for revoking identification after the expiration of the 45-day identification period, therefore, where the taxpayer has identified multiple replacement properties, but plans to acquire only one, he generally cannot cash out of the transaction until the end of the replacement period. He could advance the date on which he could cash out of the transaction by timely revoking the identifications of the properties that he will not acquire prior to the end of the identification period if that period has not expired. There is no requirement that the revocation of the identification of one replacement property be accompanied by the identification of a substitute replacement property, although that typically will be the case. Of course, the exchange will fail if there is no outstanding identification on the final day of the 45-day identification period.

11. Alternative and Multiple Properties. The regulations set forth three rules that deal with alternative identification or “over-identification” of replacement property. Failure to satisfy at least one of these rules generally will make the entire exchange taxable. Reg. §1.1031(k)-1(c)(4). The legislative history of the 1984 Act indicated that a taxpayer could designate an alternative property if the condition for moving from the primary to alternative property was outside the control of the taxpayer and his purchaser. It illustrated this point with a zoning condition. The regulations, following the proposed regulations, rejected this guidance and developed its own tests for alternative identification.

Under the regulations, the taxpayer may designate:

● Three replacement properties without regard to their values (“three-property rule”),

● Any number of replacement properties as long as their aggregate fair market value at the end of the identification period does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties as of the date the relinquished properties are transferred by the taxpayer (“200 percent rule”), or

● As many replacement properties as the taxpayer wants, provided that the taxpayer receives identified replacement property constituting at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period (“95 percent rule”).

The taxpayer may satisfy any of these three rules; it is not necessary or even advisable that he attempt to satisfy all three. If the taxpayer fails to satisfy at least one of the three identification rules, the exchange will be fully taxable, except to the extent that the taxpayer acquires replacement property prior to the end of the identification period. These rules should discourage the taxpayer from designating the State of Texas as

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replacement property, unless the taxpayer plans to acquire at least 95 percent of the State of Texas.

12. Three-Property Rule. The most useful of the three alternative identification rules is the three-property rule. This rule permits the taxpayer to designate up to three properties without reference to the values of the three properties. This permits a taxpayer in effect to designate a primary and two alternative replacement properties. It is generally advisable to keep a draft list of the potential replacement properties during the 45-day period and submit one final listing in the identification notice to the designated person. If a notice has been submitted during the 45-day period and a property becomes unavailable, it is important for the taxpayer to revoke the identification of that replacement property within the identification period.

If the taxpayer transfers 50 properties as part of the same deferred exchange transaction, he is still permitted to designate only three properties under the three-property rule. The three-property rule applies regardless of the number of properties transferred by the taxpayer as part of a single transaction. For taxpayers who wish to use the three-property rule, it is important to keep various transfers of relinquished property from being treated as part of the same deferred exchange transaction in order to maximize the number of properties which may be identified for each relinquished property. Where a taxpayer plans to acquire a number of replacement properties, he may seek to structure the original exchange transaction so that it is treated as multiple transactions rather than a single transaction. Alternatively, he might structure the sale transactions as successive transfers of tenancy-in-common interests in his property for different replacement properties, although this procedure risks the Service integrating the successive transfers of tenancy-in-common interests. On or before the 45th day, the taxpayer can identify three separate replacement properties without the need to specify any conditions for deciding among them for final replacement. Provided that the taxpayer acquires one or more of these replacement properties, the property will qualify as a properly designated replacement property.

13. 200 Percent Rule. The taxpayer may wish to designate more than three replacement properties. The 200 percent rule permits the taxpayer to designate as many replacement properties as he wants, just as long as the aggregate fair market value of the designated replacement properties is no greater than 200 percent of the aggregate fair market value of the relinquished properties transferred pursuant to the deferred exchange transaction. This rule originally drew some criticism as a result of the observation that taxpayers tend to imagine that they are exchanging net equities, not unencumbered “values” of properties.

The 200 percent rule is similar to the three-property rule. At any time during the 45-day identification period, the taxpayer can designate a collection of replacement properties with an aggregate unencumbered fair market value equal to 200 percent of the aggregate unencumbered fair market value of the relinquished properties that the taxpayer gave up in the exchange, and if the taxpayer acquires one or more of these properties, it will qualify as a properly designated replacement property. For example, if the taxpayer transfers relinquished property with a gross fair market value of $1,000,000

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and a value net of liabilities of $200,000, he could designate five or even more replacement properties provided that their aggregate gross fair market values did not exceed $2,000,000. The 200 percent fair market value rule requires a determination of when and how fair market value is measured. The determination of the fair market value of replacement properties is made at the end of the identification period; the determination of the fair market value of relinquished properties is made as of the date the relinquished properties were transferred by the taxpayer. For both the three-property rule and the 200 percent rule, all identification of property as replacement property, other than identification of property as replacement property which has been properly revoked, are taken into account. Properly revoked identifications are not counted.

14. 95 Percent Rule. The taxpayer may designate a large number of properties as replacement properties and acquire all (or almost all) of the designated replacement properties. This is permitted under the 95 percent rule. This rule is significant if the taxpayer fails to qualify under either the three-property rule or the 200 percent rule. The 95 percent rule requires that the taxpayer acquire identified replacement property constituting at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period. This rule will apply principally where the taxpayer designates more than three replacement properties and acquires everything that he designates. For purposes of the 95 percent rule, the fair market value of each identified replacement property is determined as of the earlier of (i) the date the property is received by the taxpayer (if the property actually received by the taxpayer during the exchange period) or (ii) the last day of the exchange period (if the property is not received during the exchange period).

E. Direct Deeding. The regulations substantially liberalize the rules for direct deeding. See Reg. §1.1031(k)-1(g)(4)(iv)(B), (C). There are three conditions under which an intermediary is treated as acquiring and transferring property:

• the intermediary may acquire legal title to the property;

• an intermediary may (either on its own behalf or as an agent of any party to the transaction) enter into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person; and

• an intermediary may (either on its own behalf or as the agent of any party to the transaction) enter into an agreement with the owner of replacement property for the transfer of that replacement property and, pursuant to that agreement, the replacement property is transferred to the taxpayer.

For this purpose, an intermediary is treated as entering into an agreement if all the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of the property. The regulations do not directly address “direct deeding” of property where relinquished property is deeded from the taxpayer to the buyer or where replacement property is deeded from the seller to the taxpayer. The provisions set forth above, however, provide a clear structure to permit

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direct deeding of property. The critical element is that the intermediary may (either on its own behalf or as an agent of any party to the transaction) enter into the acquisition or sale agreement for the relinquished or replacement property and this property may be transferred to the proper person under this agreement. There is no requirement that the intermediary ever acquire either legal or beneficial title to either relinquished or replacement property. See Reg. §1.1031(k)-1(g)(8), Examples.

1. Assignment of Sales Agreement to Qualified Intermediary. The regulations do not clarify what it means for the agreement to be “assigned.” Certainly, this does not require a novation with the intermediary, although a novation certainly is more than enough. An assignment that transfers all of the taxpayer’s rights under the contract, subject to the taxpayer’s obligations under the contract, certainly should meet the regulations’ requirement of an assignment. The question remains whether the agreement can be assigned without recourse to the intermediary, so that the intermediary acquires all of the taxpayer’s rights under the contract, but is not subject to any of the taxpayer’s obligations or liabilities (such as warranties that the taxpayer may make in a purchase and sale agreement). If this becomes an issue, it may be possible for the taxpayer and his purchaser to enter into several contracts, one a bare contract made without warranties or representations to transfer the property, which would be assumed by the intermediary, and a second contract containing warranties and representations that would not be assumed by the intermediary.

There is a potential problem with the regulations permitting the assignment of a contract that the taxpayer has entered. Many advisors will seek to structure arrangements in which the intermediary is explicitly the agent of the taxpayer. If the intermediary is explicitly the taxpayer’s agent and the parties are using direct deeding, does it make sense for “rights of a party to the agreement [to be] assigned to the intermediary?” In what capacity are rights being assigned to the intermediary? It seems doubtful that this ever was intended to create a problem, and it seems that the requirements of the final regulations are met if the rights of the taxpayer under the sales contract are assigned to the intermediary to act in his capacity as agent for the taxpayer.

2. Taking Title. Transfer taxes and concerns about environmental liability will cause many to wish to reduce the role of the intermediary as much as possible. It will be a rare instance when a well informed intermediary takes title. If the intermediary actually acquires title to either relinquished property or replacement property, general liens against the intermediary’s property may become liens against the relinquished property or replacement property. If the intermediary enters contracts on its own behalf, these contracts are subject to the rejection power of a bankruptcy court if the intermediary should become bankrupt before the contracts have closed. The regulations seem to clarify that neither the buyer nor the seller in an exchange transaction will qualify as a qualified intermediary. This interpretation results from the regulations’ requirement that, as part of the exchange transaction, the qualified intermediary both dispose of the relinquished property and acquire the replacement property. The seller cannot acquire the relinquished property from himself.

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F. Build to Suit. The regulations at Reg. §1.1031(k)-1(e) set forth specific rules regarding the construction of replacement property and perhaps have been of more interest to tax advisors than their usefulness justifies. Section 1031 provides only 180 days to acquire replacement property. Considering local governmental permits and approvals and normal delays in construction, one is limited in most jurisdictions in the amount that can be constructed within the exchange period. Unless the improvements are modest or nearly completed when the property is designated, most “to be produced” real property cannot meet the 180 day test. Still, the regulations consider building to suit exchanges at length. Tax advisors will seek to exploit the rules on build to suit deferred exchanges and find ways to mitigate the 180-day exchange period. Replacement property will not fail to qualify for nonrecognition under §1031 merely because it is not in existence or is being produced at the time the property is identified as replacement property. Under the rules, the terms “produced” and “production” have the same meanings as those terms have in §263A(g)(1). See Reg. §1.1031(k)-1(e).

The regulations address two problems of “to be produced” exchanges. The first is how you designate property that has not yet been built. The second is what to do if construction has not yet been completed on the 180th day of the exchange period. There are additional problems that the regulations do not address. These include how the taxpayer should handle financing of the construction, construction contracts, inspections, and interim operations. The typical build to suit exchange will involve an intermediary owning the project during some or all of the construction phase. This may be coupled with a lease of the property to the taxpayer pending the exchange. Alternatively, the property may be acquired by the builder with funds provided by or arranged by the taxpayer. There are many practical tax and nontax difficulties that need to be resolved in this arrangement. Build to suit exchanges normally will not be the tax planner’s first choice.

1. Identification. The nature of the build to suit exchange requires a special rule for the identification of replacement property, since part or all of the property does not yet exist. If the identified replacement property consists of improved real property where the improvements are to be constructed, the description of the replacement property satisfies the identification requirement:

“if a legal description is provided for the underlying land and as much detail is provided regarding construction of the improvements as is practical at the time the identification is made.”

It should be possible to use any permissible method for identifying land, which should include legal description, street address, or identifying name. Identifying the improvements is a bigger problem. What level of detail meets the requirements for “as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made”? Comments received by Treasury suggested descriptions denominating use, number of floors, and perhaps approximate square footage. Treasury declined to provide any practicable details concerning what “as much detail . . . as is practicable at the time the identification is made” really means. Planners may wish to provide as little detail as is possible in order to maintain flexibility and to ensure that there is not a violation of the rule that the taxpayer receive “substantially the same” property that was identified. Still, the taxpayer must identify the replacement

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property with “as much detail . . . as is practicable at the time the identification is made.” If the taxpayer already has prepared detailed plans and specifications, it might be practical to identify the replacement property by detailed plans and specifications. Where plans have progressed substantially, it is difficult to know when to stop giving additional details in order to meet the requirements of the final regulations.

Is it possible to treat the designated land as one property but the improvements as another? They are separate assets for most tax purposes, with separate holding periods and depreciation standards. The regulations are not clear on this point. In appropriate circumstances, it might be advantageous separately to designate the land and the improvements. This would permit the taxpayer to meet the “substantially the same” test with respect to the land, even though the improvements did not ultimately qualify because of major construction changes. Sufficient construction changes otherwise could cause both the land and improvements to fail to qualify under §1031 if the two are joined together in the identification notice.

Where property is to be constructed, for purposes of applying the 200-percent rule and incidental property rule, the fair market value of replacement property that is to be produced is its estimated fair market value as of the date it is expected to be received by the taxpayer. This apparently requires a valuation that considers the effects on marketability of an incomplete structure if the property has not been completed at the time it is expected to be transferred.

2. Acquisition of “Substantially the Same” Replacement Property That was Designated. The regulations provide that,

“in determining whether the replacement property received by the taxpayer is substantially the same property as identified, variations due to usual or typical production changes are not taken into account. However, if substantial changes are made in the property to be produced, the replacement property received will not be considered to be substantially the same property as identified.”

Reg. §1.1031(k)-1(e)(3)(iii). This provision does not address the situation in which the taxpayer anticipated that improvements would be complete at the time they are to be delivered, but it becomes necessary to transfer them in a partially completed state. The regulations state that

“[i]f the identified replacement property is real property to be produced and the production of the property is not completed on or before the date the taxpayer receives the property, the property received will be considered to be substantially the same property as identified only if, had production been completed on or before the date the taxpayer receives the replacement property, the property received would have been considered to be substantially the same property as identified. Even so, the property received is considered to be substantially the same property as identified

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only to the extent the property received constitutes real property under local law.” Reg. §1.1031(k)-1(e)(3)(iii).

This is a taxpayer favorable rule. Applied in other contexts, it is possible that the “substantially the same” test applies a fair market value test to the property that is designated and the portion of the property that is received. For example, the taxpayer may be required to receive a portion of the replacement property equal to 75 percent of the larger replacement property that he designated. Without the rule, incomplete construction might have caused the taxpayer to fail to meet a 75 percent test. In applying the “substantially the same” test to constructed property, the final regulations accept as much construction as has been completed at the instant of transfer to the taxpayer. If the property when completed would meet the “substantially the same” test, then the incomplete property as transferred will satisfy the “substantially the same” test.

If the relinquished property is real property, only real property can be treated as replacement property. Consequently, raw construction materials delivered to the site but not incorporated into the structure will not qualify. The regulations look to local law to determine what is real property and what is personal property.

An even more restrictive rule is applied if the identified replacement property is personal property to be produced. Then, the replacement property received will not be considered to be “substantially the same” as the property that was identified unless production of the replacement property received is completed on or before the date the property is received by the taxpayer. The regulations are not clear as to what “completed” means in this context.

3. Achieving the Burdens and Benefits of Ownership. In DeCleene v. Commissioner, 115 T.C. No. 34 (Nov. 17, 2000) the Tax Court held that an attempted reverse like-kind exchange of property without the use of a third-party exchange facilitator was a sale, because the taxpayer at all times had beneficial ownership of the replacement property. The taxpayer operated a business on the McDonald Street property. In 1992 he purchased an unimproved property on Lawrence Drive, where he intended to relocate his business. Another company, the Western Lime and Cement Co. (“WLC”) wished to acquire the McDonald Street property. In 1993, the taxpayer quitclaimed title to the Lawrence Drive property to WLC for a deferred cash consideration, to be paid at a second closing. WLC agreed to have a building built on the Lawrence Drive property to the taxpayer’s specifications and WLC also agreed that, in December 1993, it would reconvey the Lawrence Drive property to the taxpayer, with a substantially completed building on it, in exchange for the McDonald Street property. The transactions closed as agreed. While WLC held title to the Lawrence Drive property, the taxpayer was responsible for all transaction costs and carrying charges. Construction of the building on the property was financed by a note and mortgage guaranteed by the taxpayer but which were nonrecourse as to WLC. The taxpayer assumed the note at the second closing of the conveyance of the Lawrence Drive Property to the taxpayer. The taxpayer reported a small gain from the sale of the unimproved Lawrence Drive property to WLC. He reported the exchange of the improved Lawrence Drive property for the McDonald Street property as a tax-free reverse like-kind exchange under §1031.

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The Tax Court held that the transactions were a sale of the McDonald Street property to WLC rather than a sale of the unimproved Lawrence Drive property, followed by a reverse like-kind exchange of the McDonald Street property for the improved Lawrence Drive property. The court noted several flaws in the taxpayer’s position, but the primary problem was that the taxpayer had never divested himself of beneficial ownership of the Lawrence Drive property. As a result, he could never have acquired it as replacement property in exchange for his relinquishment of the McDonald Street property to WLC.

The court found that WLC did not become the owner of the Lawrence Drive property during the three-month period it held title to the property while the building was being constructed on it to the taxpayer’s specifications. WLC had no benefits or burdens of ownership during that period, acquired no equity interest in it, and made no economic outlay to acquire the property. WLC was not at risk with respect to the Lawrence Drive property because the obligation and security interest it gave back on its purported acquisition of the property were nonrecourse —WLC merely obligated itself to return the property to the taxpayer before the end of the year with a building substantially completed. Furthermore, pursuant to prearrangement, the taxpayer was obligated to take and pay for the building through his guarantee and reacquisition obligation. WLC had no risk or exposure with respect to the additional outlay of funds required to finance the construction of the building on the property.

The court also noted that the parties treated WLC’s holding of title to the Lawrence Drive property as having no legal significance — the transaction was not a financing device because no interest was paid by WLC on the nonrecourse note and mortgage. WLC had no exposure to real estate taxes that accrued while it held title.

The burdens and benefits of ownership issue is much like the so called “dealer” issue (see Section IV.G) — they are both fact based and the decisions are not always reconcilable. In Fredericks v. Commissioner, 67 T.C.M. (CCH) 2005 (1994) agreements between related parties did not necessarily lead to a finding of agency. The court ruled that the taxpayer’s wholly-owned subsidiary was not a “mere conduit or agent” of the taxpayer and approved a four corner exchange. The taxpayer owned a 90.83 percent interest in Wildridge Apartments. The taxpayer exchange the Wildridge Apartments with a company of which the taxpayer was the sole shareholder (“Company”). Company then sold the Wildridge Apartments to a third party (“B”). Company purchased and acquired unimproved real property in Buellton with the Wildridge Apartments’ sale proceeds, constructed certain improvements on the Buellton property, and then conveyed the improved property to the taxpayer. The court held that the taxpayer was entitled to nonrecognition treatment under §1031. The taxpayer, acting as an individual, entered into an option agreement on March 6, 1981, to purchase the unimproved real property in Buellton. The taxpayer paid $50,000 for the option agreement which was set to expire on September 6, 1982. The option was extended to September 6, 1983 for the additional consideration of $50,000, this time paid by Company (as opposed to the taxpayer). Company later credited the taxpayer with $50,000 for the initial option. Around May 20, 1983, the taxpayer and LP, an unrelated limited partnership, entered into a contract for the sale of Wildridge Apartments to LP. The taxpayer signed the agreement as an

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individual and as president of Company. In the agreement, the taxpayer disclosed to LP that prior to the close of escrow, the taxpayer intended to arrange a §1031 like-kind exchange whereby the taxpayer would exchange Wildridge Apartments for other property owned by Company. The taxpayer entered into an “Agreement of Exchange Property” with Company on June 10, 1983, under which the taxpayer was to convey the Wildridge Apartments to Company. The agreement stated that Company, as “owner and developer of certain real property in Buellton,” was to construct certain improvements prior to July 1, 1988, including a restaurant, hotel, and movie theater complex, and transfer the improved property to the taxpayer. Company was to receive a $750,000 contractor’s fee for its services. The taxpayer conveyed the Wildridge Apartments to Company by grant deed, and Company then sold them to B. Company then bought the Buellton property and improved it. The taxpayer leased a parcel of the Buellton property from Company until the improvements were completed. Company conveyed the improvements to the taxpayer upon completion and was credited with its $750,000 contractor’s fee.

The IRS argued that the transaction was not an exchange but rather was a sale of the Wildridge Apartments. The IRS contended that Company acted as the taxpayer’s agent or as a mere conduit in the exchange. The IRS seemed to rely on the fact that the taxpayer had originally purchased the option to buy the property that the taxpayer ultimately received from Company. The IRS contended that this fact indicated that Company acted on the taxpayer’s behalf. In addition, the IRS pointed to the fact that Company accepted title to the property at the taxpayer’s request. The court acknowledged that if Company had acted as the taxpayer’s agent or “mere conduit,” then the exchange would be meaningless. The court did not agree with the IRS. The court held that the taxpayer was entitled to the nonrecognition treatment of §1031. The court found the IRS argument without merit because “Company was an active corporation carrying on business as a licensed building contractor and real estate developer.” Company carried out the construction, albeit at the taxpayer’s request as an independent construction company. From the proceeds of the sale of the Wildridge Apartments, Company purchased the Buellton property, acquired financing for the purpose of constructing improvements thereon, and transferred title to the property and improvements for a fee of $750,000.

G. Deferred Exchanges and Installment Sales. In 1992, Treasury published proposed regulations (Prop. Reg. §1.1031(k)-1(j)(2), IA-107-91, 57 Fed. Reg. 49432 (Nov. 2, 1992)) governing combined installment sales/exchanges and attempted deferred exchanges that ultimately close as cash transactions upon a failure to acquire qualifying replacement property. The regulations were made final on April 19, 1994. The regulations minimize some of the theoretical problems that have plagued these transactions.

1. Prior to the Regulations. Prior to the proposed regulations, a theoretical incompatibility existed between some of the features of deferred exchanges and the rules governing installment sales. The issues involved in combining a deferred exchange and an installment sale included the following conflicts:

● An installment obligation secured by cash or cash equivalents will not qualify for installment reporting.

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● A demand obligation will not qualify for installment reporting.

● A third party obligation will not qualify for installment reporting.

● The Starker decision held that gain from “boot” in a deferred exchange relates back to and is taxable in the year of transfer of the relinquished property.

These issues were generally addressed favorably for the taxpayer in the proposed regulations in two principal provisions:

● An intermediary’s exchange promise secured by cash or cash equivalents held in a qualified escrow or trust is permitted without disqualifying the transaction from installment sales reporting if the exchange fails. This escrow account or trust normally would have violated the rules on qualifying for installment reporting (Reg. §1.1031(k)-1(j)(2)(i)).

● A qualified intermediary may receive an installment obligation from the purchaser of the relinquished property and may retransfer that note to the taxpayer without disqualifying the transaction from later installment sales treatment (Reg. §1.1031(k)-1(j)(2)(ii)).

2. Constructive Receipt. The proposed regulations provide that the determination of whether the taxpayer received a taxable payment for purposes of installment reporting under §453 may be made even though the obligation is or may be secured by cash or a cash equivalent so long as the security is held in a qualified escrow account or a qualified trust (Reg. §1.1031(k)-1(j)(2)(i)). Therefore, securing the deferred exchange obligation with cash or cash equivalents in a qualified escrow or qualified trust does not disqualify the transaction from later installment reporting. This provision ceases to apply at the earlier of (i) the time at which the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the qualified escrow account or qualified trust (Reg. §1.1031(k)-1(j)(2)(i)(A)); or (ii) the end of the 180-day exchange period (Reg. §1.1031(k)-1(j)(2)(i)(B)).

Accordingly, constructive receipt is prevented only during the exchange period. At the end of the exchange period, if not earlier, normal installment sales rules will be applied. The proposed regulations also provide that, in the case of a taxpayer’s transfer of relinquished property involving a qualified intermediary, the determination of whether the taxpayer has received a payment for purposes of §453 is made as if the qualified intermediary is not the agent of the taxpayer (Reg. §1.1031(k)-1(j)(2)(ii)). The receipt by the taxpayer of an evidence of indebtedness of the transferee of the qualified intermediary is treated as the receipt of an evidence of indebtedness of the person acquiring property from the taxpayer for purposes of §453. A person who otherwise satisfies the definition of a qualified intermediary is treated as a qualified intermediary even though that person ultimately fails to acquire identified replacement property and transfer it to the taxpayer. This special rule ceases to apply at the earlier of: (i) the time at which the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the

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benefits of the cash or cash equivalent held in the qualified escrow account or qualified trust (Reg. §1.1031(k)-1(j)(2)(ii)(A)); or (ii) the end of the 180-day exchange period (Reg. §1.1031(k)-1(j)(2)(ii)(B)).

3. Intent to Exchange. The special rules in the proposed regulations shall not apply unless the taxpayer has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period (Reg. §1.1031(k)-1(j)(2)(iii)). Query whether bona fide intent means the principal intent? a principal intent? a significant intent? The taxpayer has the burden of proof of establishing this bona fide intent. This presumably may be shown by the overt acts of the taxpayer, such as engaging a broker to find replacement property, examining and negotiating for the acquisition of potential replacement property, and the like. The proposed regulations are somewhat open for taxpayers to structure short-term installment sales so that they are disguised as exchanges. A taxpayer seeking short-term installment sale treatment for an end-of-the-year transaction could easily structure the transaction as a deferred exchange secured by cash in a qualifying escrow. This would provide for short-term deferral of gain under the installment sale rules, notwithstanding that the transaction may be secured by cash in the qualifying escrow or in a qualifying trust. It should be observed that if the relinquished property is not eligible for long term capital gain treatment, a push from 1993 to 1994 may result in higher taxes because of the proposed rate increase. However, the taxpayer should be able to opt out of installment reporting to cause the failed exchange to be taxable in 1993 if desired.

4. Examples. The proposed regulations contain four examples. In the examples, generally B is a calendar year taxpayer who agrees to enter into a deferred exchange. The relinquished property is real property X, which has been held by B for investment, is unencumbered, and has a fair market value of $100,000 at the time of transfer. B’s adjusted basis in real property X is $60,000. Except where otherwise assumed, B identifies like kind replacement property before the end of the identification period, B receives the replacement property before the end of the exchange period, and the transaction qualifies as a like kind exchange under §1031 (Reg. §1.1031(k)-1(j)(2)(v)).

a. Example One─Straddle Years with Replacement Property received in the First Year and Cash Received in the Second Year. The first illustrates what happens when a deferred exchange crosses taxable years and the taxpayer receives both qualifying replacement property and cash in the second year. The receipt of the cash is taxed under the installment sale rules, notwithstanding that the deferred exchange obligation was secured by cash deposited in a qualified escrow account during the earlier year of sale.

On September 22, 1993, B transfers real property X to C, a qualified intermediary, who agrees to acquire like kind property and to deliver it to B. The exchange obligation is secured by $100,000 in cash, deposited in a qualified escrow account. On March 11, 1994, C acquires replacement property (fair market value of $80,000) and delivers it to B. The $20,000 in cash remaining in the qualified escrow account is distributed to B at that time. B recognizes gain,

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reportable under the installment sale rules of §453(f)(6), on account of the $20,000 in cash. Securing the transaction by cash in the qualified escrow account does not cause acceleration of gain on the installment sale portion of the transaction.

b. Example Two─Intermediary Acts as Taxpayer’s Agent on the Exchange. The second example illustrates the application of the regulations where a qualified intermediary is involved as the taxpayer’s agent in a deferred exchange that crosses taxable years and both cash and qualified property are received in the second taxable year. As in the first example, the receipt of the cash is reportable under the installment sale rules.

Because the prospective purchaser of the property is unwilling to participate in a like kind exchange, C acts as the taxpayer’s agent, but otherwise the transaction proceeds as in Example (1). On September 22, 1993, pursuant to the exchange agreement, B transfers real property X to C, who retransfers it to D for $100,000 in cash. B does not have an immediate ability or an unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the money held by C until the earlier of the date the replacement property is delivered to B or the end of the exchange period, both of which are permitted events under subparagraph (g)(6) of the regulations. On March 11, 1994, C acquires replacement property (fair market value $80,000) and delivers it, along with the remaining $20,000 from the transfer of real property X, to B. B recognizes gain to the extent of the $20,000 cash B receives in the exchange, which B is permitted to report under the installment sale rules of §453(f)(6). Any agency relationship between B and C is disregarded for purposes of determining whether B is in receipt of payment.

c. Example Three─No Replacement. The third example illustrates what happens where a transaction is structured as a deferred exchange using a qualified intermediary but the taxpayer fails to identify or to acquire replacement property and he ultimately receives cash at the first (g)(6) event to occur. In that case, the taxpayer is entitled to report the transaction as a partial exchange/partial installment sale.

B enters into an exchange agreement with C under which B retains C as a qualified intermediary. On December 1, 1993, pursuant to the agreement, B transfers real property X to C who transfers it to D for $100,000 in cash. In 1994, at (not after) the end of the identification period, C delivers the entire $100,000 from the sale of real property X to B. This is a confusing fact in the example; the final regulations require that B not have the right to receive cash until after the end of the identification period. B is described as having a bona fide intent to enter into a deferred exchange at the beginning of the exchange period. B does not identify or acquire any replacement property; the example does not explain why. More importantly, the example does not indicate how B’s bona fide intent is manifested. It appears that B must have this bona fide intent only on the first day of the exchange period, the day on which he transferred his relinquished property.

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The transaction should qualify for installment sale treatment under the proposed regulations even though B immediately abandons this intent. It also appears that B’s intent when he enters the deferred exchange agreement is not directly relevant.

d. Example Four─Combining Installment Sales and Exchanges. The fourth example illustrates a combined exchange and installment sale of the relinquished property to a third party purchaser in exchange for that third party purchaser’s installment note. The transaction uses a qualified intermediary. The transaction qualifies for installment reporting.

B enters into an exchange agreement with C to act as a qualified intermediary. On September 22, 1993, pursuant to the agreement, B transfers real property X to C, who then transfers it to D for $80,000 in cash and D’s 10 year installment obligation with a principal amount of $20,000. On March 11, 1994, C acquires replacement property having a fair market value of $80,000 and delivers it, along with D’s $20,000 installment obligation, to B. B does not receive this installment note until the date on which it becomes permissible to receive cash under the “cash out” rules of subparagraph (g)(6) of the regulations.

The example clarifies that D’s obligation is treated as the obligation of the purchaser from B. B’s receipt of that obligation qualifies for installment reporting even though part of the gain is deferred through the §1031 rules. B reports the $20,000 gain under the installment method on receiving payments from D on the obligation.

Certain issues are not answered by the example:

● In many cases, there will be interim payments on the purchaser’s promissory note while the note is held by the intermediary. The payments may be both principal and interest. Can the transaction be structured so that what economically are interest payments by the purchaser are included in the taxpayer’s exchange balance, so that these payments can be reinvested and thus received free of tax under §1031?

● How are interest payments structured by the intermediary so that the intermediary does not accept the risk of default in interest payments by the purchaser on his installment note during the period prior to the transfer of the installment note to the taxpayer.

● Are interest payments structured by the intermediary so that the intermediary does not accept the risk of default in interest payments by the purchaser on his installment note during the period prior to the transfer of the installment note to the taxpayer?

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● How are the intermediary’s obligation to pay interest structured so that it includes interest payments by the purchaser on his installment obligation?

● If the taxpayer wishes to fully defer his gain, may he contribute additional funds to intermediary and purchase replacement property valued at $100,000? In that event, what tax consequences attach to the receipt of the installment note at the end of the exchange period from the intermediary?

5. Effective Date of Proposed Regulations. The regulations are effective for transfers of property occurring on or after their publication as final regulations in the Federal Register (April 19, 1994). The regulations also may be applied at the taxpayer’s election to transfers of property occurring before that publication date but on or after June 10, 1991, if those transfers otherwise meet the requirements of the final regulations on deferred exchanges. In addition, taxpayers may apply the proposed regulations to transfers of property occurring before June 10, 1991, but on or after May 16, 1990, if those transfers otherwise meet the requirements of either the final regulations on deferred exchanges or the earlier proposed regulations (Reg. §1.1031(k)-1(j)(2)(vi)).

6. The Computation of Gain. Regulations have not yet been published on computing gain on combined like kind exchanges and installment sales (But cf. Reg. §1.453-1(f), revoked by T.D. 8270, 54 Fed. Reg. 46375 (Dec. 3, 1989)).

The Code sets forth three principles:

● The total contract price is reduced to take in account the amount of nonrecognition property received in the exchange (IRC §453(f)(6)(A)).

● The gross profit in making installment sale computations is reduced to take into account any amount not recognized under §1031(b) (IRC §453(f)(6)(B)).

● Payment does not include any property received in the exchange without recognition of gain (IRC §453(f)(6)(C)).

Apparently, the position of the IRS is that all of the taxpayer’s basis in the relinquished property will become associated with the (non-taxable) replacement property, to the extent that the value of the replacement property exceeds the taxpayer’s basis in the relinquished property. Accordingly, if the IRS positions prevails, the taxpayer will not have any tax basis associated with the installment note if his tax basis in the relinquished property is less than the value of the replacement property that he receives in the exchange. Therefore, all of the payments the taxpayer will receive on the note are fully taxable in the typical combined exchange and installment sale. It is when the taxpayer transfers property with a tax basis greater than the fair market value of the nonrecognition property that he receives in the exchange that the installment note will have positive tax basis in the taxpayer’s hands. Excess basis (over the amount allocated

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to nonrecognition property) is allocated proportionately to the installment obligation and to cash or other nonrecognition property.

7. When the Relinquished Property is Encumbered. What are the tax consequences when encumbered property is relinquished in a combination installment sale/§1031 exchange? How will the liabilities be allocated between the installment sale and the exchange transactions? What is the result if the transaction is disproportionately an installment sale? These issues remain unresolved. Installment sale computations will take into account the “net qualifying indebtedness” which is equal to the excess of (i) the taxpayer’s liabilities (or liabilities encumbering his property) that are assumed or taken subject to by his purchaser as part of the consideration that he receives, over (ii) the sum of any net cash that the taxpayer pays (cash paid less any cash received) in the exchange and any liability that the taxpayer assumes or takes subject to in the exchange.

For example, if the taxpayer were to transfer a property subject to $1,000,000 in debt and receive replacement property subject to $800,000 in debt, the “net qualifying indebtedness” will be $200,000. The taxpayer’s selling price will be equal to the sum of the face amount of the installment obligation that he receives in the transaction (reduced by any portion that is recharacterized as interest), plus any net qualifying indebtedness, any cash that he receives (in excess of cash that he pays), and the fair market value of any other “boot.” The taxpayer’s basis for undertaking the installment sale computation is equal to his excess basis (basis in the relinquished property in excess of the value of replacement property). The taxpayer’s contract price is equal to the selling price less any net qualifying indebtedness that does not exceed the taxpayer’s excess basis. The taxpayer will be required to treat as a payment in the year of the exchange any net qualifying indebtedness in excess of his basis allocated to recognition property (Prop. Reg. §1.453-1(f)(iii), revoked by T.D. 8270, 54 Fed. Reg. 46375).

8. Conclusion. While the proposed regulations clarified some issues, combined installment sales/exchanges will continue to be marginal transactions since the taxpayer’s basis is first allocated to the receipt of nonrecognition property, and his gain is first allocated to the receipt of recognition property. In a typical transaction, the taxpayer will transfer his property to an intermediary, and the intermediary will immediately resell that property to a third party purchaser. The taxpayer might wish to hold the third party purchaser’s installment note. This is permitted by the proposed regulations if the note is transferred to the taxpayer only after the occurrence of a “cash out” event.

The taxpayer might receive the intermediary’s note, but he cannot receive that note prior to a “cash out” event either. Also, the receipt of the intermediary’s note is not clearly permitted. Another possibility is that, when the intermediary gives his note at the time of the “cash out” event, the intermediary will secure that note with a pledge of the third party purchaser’s note. This arrangement also runs the risk that the taxpayer will be treated as receiving a third party obligation, and that he therefore would not qualify to use the installment method. This would particularly be the case if the arrangement were nonrecourse to the intermediary.

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Another possibility is for the taxpayer to sell a fractional interest in his property directly to the third party purchaser for an installment note and to sell the remaining fractional interest to the intermediary for a deferred exchange obligation. Although this structure is promising (particularly since it gives the taxpayer the maximum benefit of his basis in the relinquished property), it has not yet been tested. In lieu of that arrangement, the taxpayer could merely take receipt of the third party purchaser’s note at closing, similar to taking case before it goes to the intermediary at closing and start recognizing payments on that note under the installment sale rules. Fractionalized sale of part of the relinquished property to the ultimate purchaser for a note and of part to the intermediary may be the most promising among a world of bad alternatives; it also produces an advantageous result in maximizing use of the taxpayer’s basis in his relinquished property to shelter gain.

IV. DEALING WITH THE PRACTICAL PROBLEMS OF DEFERRED EXCHANGES.

While the deferred exchange regulations and the proposed installment sale/deferred exchange regulations satisfactorily address many of the issues that have plagued practitioners, there are many day to day problems on which taxpayers expect guidance that simply are not addressed in either set of the regulations. Indeed, some of them may not be legal or tax accounting issues at all but merely business judgment calls that taxpayers want their professionals to decide for them. This section addresses a number of the practical problems facing practitioners.

A. Picking a Qualified Intermediary. In most cases the intermediary picked by the taxpayer will be a shell corporation owned by a title company or a lawyer or law firm, however, the “professional” intermediaries are usually not the taxpayer’s first choice. With respect to intermediaries owned by title companies (agencies not underwriters), the taxpayer, being the party disposing of the relinquished property, will usually be the party paying for title insurance, a fairly expensive cost, particularly in Texas which has abnormally high, non-negotiable title insurance premium rates (of which the agency retains approximately 80%-85%). Having paid for the title insurance and being told that the intermediary fee will be an additional cost (however nominal), the exchangor usually has an unfavorable visceral reaction. There are two other negative reactions expressed by certain exchangors. First, there is a lack of confidence regarding confidentiality about the taxpayer’s affairs although the title agency already possesses full information about the first leg of the transaction, the disposition of the relinquished property. The second additional concern is the intermediary’s potential bankruptcy during the exchange period. Most title agencies are not highly capitalized and in periods of down cycles (such as experienced in the late 1980s), they fall like tin soldiers. Again, however, the intermediary subsidiary is a separate corporation that should not be affected by the bankruptcy of the agency.

Most taxpayers want their own attorney to act as the intermediary, not because of an unusual affection for attorneys, but because the attorney already owes to his client the highest duty of good faith, zealous representation and confidentiality. However, because of prior representation of the client, most attorneys will be disqualified. (An attorney hired for the first time to represent the taxpayer in the exchange will not be disqualified. See III.B. above.) What then is left?

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Relatives that fall outside the attribution rules (See III.B. above) will be considered by the taxpayer but are not good choices. They usually do not want to serve; there is nothing more unpleasant than being an unpaid fiduciary. The best alternative among the above choices is for the taxpayer to allow the attorney to pick another attorney who is close to the taxpayer’s attorney, particularly a tax attorney or real estate specialist. Even though the intermediary will be a shell corporation owned by the selected attorney, there seems to exist a higher degree of faith in the attention a professional intermediary will give to the transaction. Indeed, in some parts of the country the taxpayer’s attorney may not be a real estate tax specialist while the intermediary will be owned by such a lawyer, and the structure of the deal will be taken over by the intermediary, usually for a higher fee.

In Dobrich v. Commissioner, 118 F.3rd 512 (9th Cir. 1999) the taxpayers attempted to pass off their accountant as a qualified intermediary. The Tax Court and the Ninth Circuit Court of Appeals determined that the taxpayers’ professional could not qualify as an intermediary.

B. Concerns of the Intermediary.

1. Intermediary’s Gain. Regulations under §1031 strongly suggest that the qualified intermediary should be respected as the purchaser and reseller of both the relinquished property and the replacement property. This has both tax and reporting implications to the intermediary. The intermediary should compute its tax basis in both the relinquished property and the replacement property by using its cost of that property. That cost should equal the sum of secured liabilities either assumed or taken subject to by the intermediary, plus the net amount of the exchange balance owed the taxpayer, plus any of the intermediary’s capitalized costs of acquisition. On retransferring the relinquished property or replacement property, the intermediary should recognize income or loss computed by reference to that tax basis. This gain, if any, should be reported on the qualified intermediary’s tax return. In most cases the property transactions should result in a wash to the intermediary.

2. Intermediary’s Fee. Qualified intermediaries frequently charge a fixed fee for their services. It is not clear whether this fee should be treated as income for services or whether it should enter the computation of the intermediary’s gain on disposition of the relinquished property or the replacement property. As a practical matter, this normally should not make any difference, since the intermediary’s income from the dispositions of the relinquished property and the replacement property should be ordinary income.

3. FIRPTA Withholding. The intermediary can have several different types of withholding obligations. The intermediary is required to withhold FIRPTA tax on payments to the taxpayer and on payments to the seller of replacement property in the absence of a FIRPTA withholding certificate. Some states (e.g. California) may have similar withholding obligations which could extend to the case where the seller of the property is merely a nonresident of the state, as opposed to a foreigner. It is important for the intermediary to investigate the effects of state law in the jurisdictions of both the relinquished property and the replacement property. The intermediary also may be

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required to withhold tax from interest payments where there is a backup withholding obligation.

4. Closing Agent Reporting. Closing agents should report the acquisitions of both replacement property and relinquished property by the intermediary in addition to the acquisition of replacement property by the taxpayer and the acquisition of relinquished property by the buyer. This is reported on Form 1099-S.

5. Interest Reporting. Although the taxation of interest earnings on the exchange balance may be a little in doubt, it seems likely that interest earnings on the investment of the exchange balance should be taxable to the intermediary. The intermediary then should be entitled to deduct interest paid to the taxpayer. Following the model where the exchange balance is deposited with a bank, the intermediary should give the intermediary’s taxpayer identification number rather than the taxpayer’s identification number for the account. Additionally, the account should appear in the name of the intermediary if the money is not held by a separate escrow agent. The bank should send a Form 1099-INT to the intermediary reporting interest earnings. The intermediary similarly should report interest it pays to the taxpayer using a Form 1099-INT. In those exchanges which have been structured by advisors with the intermediary explicitly acting as the agent of the taxpayer, it is unclear whether the purported agency status will be respected for the purpose of determining to whom interest income should be taxable.

6. State Taxation of Intermediary. States other than the jurisdiction in which the intermediary has its head office may require state reporting and may impose state income tax or franchise tax on the earnings accrued in the name of the intermediary. This will become a particular concern if the intermediary establishes a presence in those states by opening an office, by visiting the state to solicit business, or otherwise. States may become increasingly aggressive in seeking to tax intermediaries. Nevertheless, intermediaries typically will seek to structure their activities so that they are not taxable in foreign jurisdictions.

7. Sales and Use Tax. Intermediaries should consider sales and use taxes where tangible personal property is included in an exchange. The tangible personal property component of the transaction will be subject to sales tax in many states; the intermediary may have primary or secondary liability for the collection of this tax. Usually, the transaction should be able to escape double sales tax where the intermediary gives a resale certificate for the intermediary’s retransfer to the buyer of the taxpayer’s relinquished property or the intermediary’s retransfer of replacement property to the taxpayer. Also, direct deeding may eliminate double sales tax.

8. Documentary Transfer Tax. One of the goals of direct deeding is to seek to minimize documentary transfer taxes in jurisdictions where they are imposed. The theory is that if there is a direct deed that skips the intermediary in lieu of two sequential deeds (first to the intermediary and then from the intermediary), only one documentary transfer tax must be paid on the transaction. Most jurisdictions characterize the documentary transfer tax as a conveyancing tax rather than a recording tax. It is

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possible that direct deeding transactions may be analyzed first as a conveyance to the intermediary and then as a conveyance by the intermediary. This may expose the transaction to double documentary transfer taxes even where direct deeding is involved. However, in most jurisdictions, as a practical matter at least, direct deeding seems to avoid the imposition of double documentary taxes.

9. Liability Concerns. The qualified intermediary is at the center of a structure that attracts potential liability from all directions. The intermediary, however, typically receives relatively modest compensation for its services, does not intend to serve as a guarantor of the tax consequences of the transaction, and certainly does not intend to underwrite environmental or other liabilities. This makes it important for the intermediary to seek to document the arrangement in a manner that minimizes the intermediary’s liability. In this regard, it is important to note that being indemnified against liability is very different from not having any liability at all. Having an indemnity often is nothing more than an invitation to a lawsuit to enforce the indemnity, nevertheless, from the intermediary’s point of view an indemnity is advisable, and most taxpayers should be willing to give it. The following are the primary nontax liability concerns of the intermediary that should be addressed in the documents:

● Liability to the taxpayer on account of a failed nontaxable exchange.

● Liability to the taxpayer on account of failure of the buyer to purchase the relinquished property.

● Liability to the buyer of relinquished property on account of defects in the relinquished property or failure of the sale of relinquished property to close.

● Liability to the taxpayer on account of failure of the acquisition of replacement property to close or on account of defects in the replacement property.

● Liability to the seller of replacement property on account of failure of the acquisition of replacement property to close.

● Liability to the government or other parties on account of environmental problems with either the relinquished property or replacement property.

● Liabilities to third parties on account of defects in either the replacement property or the relinquished property.

● Expenses incurred in connection with the audit of the deferred exchange.

10. CERCLA Liability. Under the Comprehensive Environmental Response and Liability Act of 1980 (“CERCLA”), as amended, present and past owners or operators of a contaminated facility, including real property are liable for the cost of clean up. The courts have not yet clarified the extent of the application of CERCLA to deferred exchange intermediaries, although at least one federal district court in Graybill

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Terminal co. v. Union Oil Co. of California (S.D. Cal. No. 92-0238-K(LSP) Jan. 4, 1993) [7 Toxic Law Reporter 1182 (Mar. 10, 1993)], has found a deferred exchange intermediary has liability under CERCLA on a sequential deeding transaction. Most deferred exchange intermediaries now insist on direct deeding of both relinquished property and replacement property in order to minimize the potential liability under CERCLA, but even so, the effectiveness of direct deeding to eliminate CERCLA liability has not been fully tested in the courts.

11. Liabilities to Parties to the Exchange. Knowledgeable intermediaries fear that they will be sued by the buyer of relinquished property or the seller of replacement property when one of these transactions fails to close or when one of the properties involved in the exchange has defects or otherwise produces subsequent liability claims. The intermediary should be careful not only to receive full indemnifications from the taxpayer but also to be held harmless by both sides to each exchange transaction. Too often, intermediaries merely seek to have the taxpayer agree to indemnify them against transactional problems and property defects; it is important that the intermediary should seek appropriate indemnifications and to be held harmless by both the buyer of relinquished property and the seller of replacement property. The various agreements should be drafted so that the intermediary can extricate itself if the sale of either relinquished property or replacement property fails to close. The intermediary should seek agreements exonerating the intermediary from liability if the transactions fail to close and should seek indemnification from the taxpayer. Additionally, the intermediary should seek to be held harmless by the buyer of relinquished property and the seller of replacement property. Furthermore, the intermediary should receive full indemnifications from the taxpayer with respect to defects on the relinquished property and from the seller of replacement property with respect to defects on the replacement property. The intermediary should consider techniques to minimize its liability. It should wait as long as feasible before having itself substituted into the disposition of relinquished property or the acquisition of replacement property. Such a wait reduces the likelihood that obstacles will develop between the substitution date and the closing date. The intermediary’s contractual agreements should make it clear that the intermediary does not have liability to either the purchaser of relinquished property or to the seller of replacement property. Similarly, the taxpayer should be able to enforce its rights directly against these parties without the need to join the intermediary.

12. Intermediary as Agent. How far can an intermediary go as an agent for the taxpayer? The regulations’ intermediary safe harbor provides that, if its requirements are met, the exchange will not be disqualified because of constructive receipt, and the intermediary will not be treated as the agent of the taxpayer for tax purposes. Reg. §1.1031(k)-1(f)(2). This seems to be an absolute safe harbor and suggests the possibility that the intermediary and the taxpayer might agree explicitly that the qualified intermediary is acting as a taxpayer’s agent. An intermediary acting as a true agent would hold the taxpayer’s funds in a fiduciary capacity. The taxpayer should be able to recover these funds in the event of the intermediary’s bankruptcy, without worrying about preferences. Assuming the intermediary would not be entering agreements as a principal, the liability exposure of the intermediary should be minimized. It is also

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possible that, where the intermediary acts as true agent, the intermediary’s role in the transaction is ignored for tax purposes outside of §1031. Also, it is possible that the intermediary can decrease its exposure to third party liabilities by merely acting as the taxpayer’s agent in the exchange transaction.

Is it a sound approach to make the intermediary a taxpayer’s explicit agent? The regulations suggest that this is a viable possibility, however, most advisors will be hesitant to take this step. Some believe that this approach is simply too aggressive to be sustained by a court, whatever the regulations seem to say. Also, making the intermediary the taxpayer’s agent puts intense pressure on qualification under the intermediary safe harbor. Failure of the intermediary to qualify under the safe harbor would likely be fatal to the exchange. Also, what does it mean to make the intermediary an agent? Merely calling the intermediary the taxpayer’s agent in the exchange documents does not necessarily make the intermediary the taxpayer’s agent. Advisors should consider what they can do to give agency status substance if that is the route desired.

13. Resignation of Intermediary. A “qualified intermediary” is defined as someone who, pursuant to the exchange agreement, acquires the relinquished property from the taxpayer, re-transfers the relinquished property to a third party, acquires replacement property, and then re-transfers the replacement property to the taxpayer. Many exchange agreements with intermediaries permit the intermediary to resign upon certain events. This resignation typically will occur between the date of disposition of relinquished property and the date of acquisition of replacement property. An intermediary may well have legitimate reasons for wanting the ability to resign, however, the resignation of the intermediary may cause the disqualification of the exchange. Circumstances occur that may expose the intermediary to unwanted liability, expense, inconvenience, or irritation. Where the intermediary resigns midway through the transaction, the definition of “qualified intermediary” cannot be satisfied by a new intermediary. Query whether an assignment of the intermediary’s role in the exchange agreement would be treated as a resignation?

C. Payment of “Boot;” Deposits and Earnest Money. Exchange transactions frequently involve the payment of “boot” to the taxpayer. The intermediary safe harbor

“ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. Rights conferred upon the taxpayer under state law to terminate or dismiss the qualified intermediary are disregarded for this purpose.”

However, final regulations also clarify that “[a] taxpayer may receive money or other property directly from a party to the transaction other than the qualified intermediary without affecting the application of” the intermediary safe harbor. See Reg. §1.1031(k)-1(g)(4)(vii).

There is no requirement that the language in the exchange agreement that limits the taxpayer’s right to receive, etc., nonqualifying property from the intermediary be enforceable under state law. This will be important when the intermediary is acting explicitly in an agency

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capacity for the taxpayer. Receiving “boot” directly from a qualifying intermediary prior to a terminating event (the expiration of 45 days without a full identification or the expiration of 180 days without a complete acquisition of the replacement properties, also referred to herein and in the regulations as a “(g)(6)” event, referring to Reg. §1.1031(k)-1(g)(6)) will taint the transaction and disqualify the transaction from the use of the intermediary safe harbor.

Advisors should give special attention to transactions where the purchaser of replacement property makes escrow extension payments. These payments should not be made to the intermediary and passed immediately to the taxpayer. Either they should be paid directly to the taxpayer as boot at the closing of the sale of the relinquished property, or they should be held by the intermediary until the occurrence of a (g)(6) event and then paid to the taxpayer.

1. Deposits. One of the questions that the final regulations do not address is the effect of deposits on the intermediary safe harbor (and the other safe harbors) prior to the exchange. For example, what is the effect of the taxpayer receiving a $100,000 deposit from the purchaser of the relinquished property? Certainly, the taxpayer will be fully taxable if he just keeps the deposit. Will the taxpayer be able to avoid taxation if he returns the deposit to escrow prior to transferring his relinquished property? Can the taxpayer avoid taxation if he returns the deposit prior to receiving replacement property? What are the effects of the taxpayer receiving tenant deposits? None of these issues are addressed by the regulations.

2. Earnest Money Deposit. There is an additional problem created by agreements for replacement property that the taxpayer enters and then assigns to his intermediary. These agreements typically will require an earnest money deposit. Can the intermediary advance the money for that deposit (as a charge against the exchange balance) at a time when the intermediary is not a party to the contract? Will such an advance result in constructive receipt to the taxpayer under the theory that the taxpayer will then “otherwise obtain the benefits of money or other property held by the qualified intermediary” prior to a (g)(6) event? Fortunately, this characterization of the transaction does not seem likely. Deposits should be included in the amounts for transactional expenses that the regulations permit the intermediary to pay. But what is the result if the taxpayer advances the deposit and the intermediary later reimburses him? The regulations are silent, and therefore it is not advisable to reimburse the taxpayer for such deposits prior to the occurrence of a (g)(6) event.

D. Matching Liabilities; New Financing. One of the more time consuming functions for a practitioner planning a deferred exchange for a client who is a novice to the concept is making sure that the client has a thorough understanding of the amount of value required to be replaced and the interactions of liabilities associated with both the relinquished and replacement properties. The general rule is that taxable boot includes the excess of liabilities from which the taxpayer was relieved at the closing of the relinquished property over the liabilities assumed in the acquisition of the replacement property (or which were secured by the replacement property, i.e., taken “subject to.”) See Reg. §1.1031(d)-2. The first mistake most clients make is to assume that the amount that needs to be “replaced” (or stated another way, spent in the purchase of the replacement property) is the net dollar amount received in the closing of the relinquished property. For example, if the relinquished property had a value of

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$1.0 million and was subject to a debt of $500,000 which was paid (or assumed by the buyer) at the closing of the relinquished property, the taxpayer, through the intermediary, must locate and buy a $1.0 million property to completely defer the gain inherent in the relinquished property. The taxpayer usually assumes that if he finds a property that costs $1.0 million but which already has a $700,000 assumable note on it, he can use only the necessary $300,000 from the intermediary’s escrowed funds to make the purchase and pocket the remaining $200,000 distributed from the intermediary as tax free money. On the contrary, this distribution will be treated as boot and reportable under the installment sale provisions. See Reg. §1.1031(d)-1 and Prop. Reg. §1.1031(k)-1(j)(2).

Another classic issue that creative clients lay at the feet of practitioners results from the creation of debt that did not exist until the time of the acquisition of the replacement property or immediately thereafter. In trying to match the liabilities used in the above example, assume the taxpayer identifies a property worth $1.0 million on which there is no debt. There is no prohibition against the taxpayer offering the seller $500,000 in cash and a $500,000 purchase money note for the balance. In that event the taxpayer has replaced in a manner that defers all of his gain. For that matter, the seller could go to a third party lender and borrow $500,000 against the property then sell the property to the taxpayer through the intermediary subject to the liens securing the note or with the assumption by the taxpayer. The key factor in this transaction is that the taxpayer did not pocket any cash.

The client will also ask the advisor if (and when) the taxpayer can refinance the equity that is in the replacement property. For example, assume that the taxpayer in the above facts bought the replacement property for $500,000 down and a $500,000 purchase money note to the seller that carried a high interest rate. The taxpayer knows that he can refinance the property for $700,000 at a lower rate. Is it safe to do so immediately after the purchase is completed? The answer is not clear but it is clear that if the refinancing were prearranged prior to the closing and the taxpayer, as an integral part of the purchase of the replacement property, had arranged to pocket the excess $200,000, the Service would take the position that the $200,000 received at the closing constituted taxable boot.

E. Transaction Expenses. An important exception to each of the safe harbors permits the payment of certain transactional expenses from the exchange balance by the intermediary or from funds held by a qualified trust or in a qualified escrow. The taxpayer’s receipt of or right to receive any of the following items will be disregarded in determining whether the intermediary safe harbor, the qualified escrow safe harbor, or the trust safe harbor are satisfied: (i) items that a seller may receive as a consequence of the disposition of property and that are not included in the amount realized from the disposition of property (e.g., prorated rents and taxes), and (ii) transactional items that relate to disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).

This is not a broad form dispensation for all prorations or transactional items. With respect to prorations, an item-by-item analysis must be made of whether the proration results in an amount realized with respect to the disposition of the property; this may require a considerably more technical analysis that the draftsmen of the final regulations ever

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contemplated. For example, what are the effects of a selected “as of” proration date that differs from the actual date of closing? Rents may be prorated as of the end of the month, even though the closing may occur on a different date. Also, prorations sometimes are made as of a contemplated closing date, even though the transaction does not actually close on that date. The expense of the legal work or accounting work properly to analyze the effects of prorations may exceed the amount being prorated. The effects of even a $1 mistake could be a fully taxable exchange.

Not all transactional items qualify for the exception, but only those that both relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees). See Reg. §1.1031(k)-1(k)(2).

Can transactional items be paid by an intermediary if they relate to an attempted but failed acquisition of replacement property? These transaction items would have seemed to be a sensible charge to the exchange balance, but it is not clearly permitted by the final regulations. One might imagine that a technical correction is appropriate.

The second requirement is that the expenses appear in the typical closing statement, under local standards. This requires an examination of standards in the area in which the transaction is undertaken. Presumably, this normally refers to the standards for the area in which the disposition of the relinquished property occurs for expenses that relate to the disposition of the relinquished property, and the standards for the area in which the acquisition of the replacement property occurs with respect to acquisition expenses for the replacement property. There is some question as to which standards should be applied where the disposition or acquisition closes in an office in one area, but the property is located in another; this often can be the case where a number of properties are involved and there is a single seller.

The regulations give as examples of transaction costs that typically appear in closing statements: commissions, prorated taxes, recording or transfer taxes, and title company fees. Do the taxpayer’s attorneys fees qualify? Apparently, this will depend on the jurisdiction. In some jurisdictions, attorneys fees are reported on closing statements under local custom; in others, they are not. Attorneys should not automatically assume that their fees can be paid from the exchange balance held by the qualified intermediary or in qualified escrow; this potentially could result in losing the benefits of the safe harbors. Another item that may not qualify under the safe harbor for transaction costs in some jurisdictions is the intermediary’s fee. In some geographical areas, there are not enough intermediaries to establish a pattern, so that one can say that an intermediary’s fee typically appears in closing statements. In these jurisdictions, the safe harbor may not be satisfied. In others in which it reasonably can be said that the intermediary’s fee typically appears in closing statements, there should be no trouble. It would seem that a technical correction to the final regulations would be in order.

F. The “Reverse Starker” Deferred Exchanges. What is a reverse deferred exchange? Instead of disposing of the relinquished property first, a taxpayer may have the opportunity to acquire the replacement property first and later dispose of the relinquished property. Until the Treasury publishes interpretive regulations or courts resolve the issues,

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“reverse Starker” exchanges are tax-risky transactions and while tax practitioners discuss them frequently and openly they are difficult to structure.

How does a taxpayer structure a “reverse Starker” exchange? One possibility is simply to acquire a replacement property through an intermediary and later to dispose of relinquished property through the same intermediary. This could be considered a “pure ‘reverse Starker’ exchange,” since it essentially reverses the order of events in the Starker case.

A “reverse Starker” exchange is not directly approved by either the Starker case or the 1984 amendments to §1031 although Rev. Proc. 2000-37 (Sec. IV.F.6 hereafter) is effectively a safe harbor approach to revere like-kind exchanges. The 180-day and 45-day requirements do not, by their terms, apply to the pure ‘reverse Starker’ exchange. Whether the “pure ‘reverse Starker’ exchange” really is an exchange is the key issue. The taxpayer usually must finance the acquisition of the replacement property pending the disposition of his relinquished property. Would this interim financing vitiate the exchange?

1. Authority to Undertake Reverse Deferred Exchanges. The argument supporting “reverse Starker” exchanges is not so strong as the argument supporting direct Starker exchanges. Authorities frequently cite the analog between deferred exchanges and replacements of involuntarily converted property under §1033. This provision requires that the involuntary conversion precede the acquisition of replacement property. Similarly, contingent payouts of stock are permitted in reorganizations. A reorganization, however, requires that the reorganization transaction precede the receipt of the contingent shares. These lines of authority must be balanced against the analog in §1034. This provision permits a person rolling over an investment in a principal personal residence to acquire replacement property at any time during a window period beginning two years prior to disposition of that property and ending two years after the disposition. Reasoning by analogy, however, does not provide an unambiguous answer to whether “reverse Starker” exchanges should be permitted. Furthermore, the Starker itself opinion does not provide clear insight on this question.

2. Parking the Replacement Property. A broad class of reverse Starker transactions is the “parking” transaction. In form, “parking” transactions are direct deferred exchanges, with the disposition of relinquished property occurring immediately preceding the acquisition of replacement property or in a simultaneous exchange. Prior to the disposition of the relinquished property, the taxpayer will arrange for the replacement property to be acquired by his intermediary, by a friendly party or by a party related to the taxpayer. The taxpayer almost invariably provides or arranges all of the financing. The Service might seek to attack these “parking” transactions if the “parking” party could be treated as the agent of the taxpayer. In such situations the taxpayer could be treated as being in constructive receipt of the replacement property. These “parking” transactions could also run afoul of §1031(f) if the “parking” entity is related to the taxpayer.

There are many practical complexities in arranging “parking” transactions, not the least of which is the timing of financing of the replacement properties. The taxpayer has not yet sold his relinquished property and does not have the proceeds of that sale which is

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normally the consideration paid for the replacement property. The taxpayer’s choices are to either guarantee a loan to the party parking the property or to make a direct loan to that party. In the period during which the replacement property is parked, the intermediary stands effectively in the position of an owner with no equity in the property. It is likely that there will be interim operating activity unless the property is undeveloped land. Who gets the benefits or bears the burdens of this activity? A popular device to handle the interim activity is for the intermediary to triple net lease the replacement property to the taxpayer prior to completion of the exchange. This however raises the question of whether the taxpayer should be considered in constructive receipt of the replacement property prior to his actual receipt of the replacement property. A portion of the financing may be provided by a third party lender. An institutional lender may be reluctant to lend if the taxpayer is not the original owner. The taxpayer may become an interim guarantor if the true economic borrower, the taxpayer, is not on the title. This may alter his economic position with respect to anti-deficiency actions if there is a foreclosure.

The intermediary also has concerns. Interim ownership of the property brings with it environmental risks, tort risks, and all of the other risks of fee ownership. Intermediaries typically seek broad form indemnities or just refuse to serve as parking lots. Parking replacement property with a related party involves an additional set of tax risks. It would be easier for the IRS to convince a court that a related party is a taxpayer’s agent. This would result in constructive receipt of the replacement property by the taxpayer at the time the related party receives the property. Parking the replacement property with a related party also threatens the possible application of §1031(f).

3. Use of Options. The best solution is to seek to avoid a “reverse Starker” exchange. An option with hefty option payments may offer a favorable alternative to a “reverse Starker” exchange. Where appropriate, this option might be coupled with a lease of the replacement property to the taxpayer.

4. The Fact Patterns and the Solutions. The following illustrate typical fact patterns encountered by taxpayer.

a. The Seller is Willing to Defer the Closing. A seller will normally defer the closing of a sale of his property only when the buyer has put significant cash at risk usually by way of an option agreement or a long term contract to purchase with an escrow fund (earnest money). In such an event the taxpayer may hold the option or be the buyer in the contract (whether it is an option or a contract to purchase) but care must be exercised to insure that the burdens and benefits of ownership have not passed to the taxpayer - an event that can happen notwithstanding that the taxpayer does not have legal title. For example, if an option requires significant option consideration to the seller, he may be willing to allow control of the property to pass to the taxpayer prior to the closing. If control is passed to the taxpayer (whether by a net lease, management agreement or other similar arrangement) whereby the taxpayer has possession, pays taxes on the property and enjoys the income from the property, the IRS will

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likely argue that the burdens and benefits of the property passed when the contract was signed, not when title passed. Therefore, there was no exchange, merely a purchase of the property, then a sale of another property (the taxpayer’s relinquished property). See Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981), a case that lays out the question of whether the burdens and benefits of ownership have passed as a question of fact and states as follows:

The issue must be ascertained from the intention of the parties as evidenced by the written agreements read in light of the attending facts and circumstances. Haggard v. Commissioner, 24 T.C. 1124, 1129 (1955) affd. 241 F.2d 288 (9th Cir. 1956).∗ Some of the factors which have been considered by courts in making this determination are: (1) Whether legal title passes (Commissioner v. Segall, 114 F.2d 706, 709 (6th Cir. 1940), cert. denied 313 U.S. 562 (1941); Oesterreich v. Commissioner, 226 F.2d 798, 802 (9th Cir. 1955)); (2) how the parties treat the transaction (Oesterreich v. Commissioner, supra at 803); (3) whether an equity was acquired in the property (Haggard v. Commissioner, 241 F.2d 288, 289 (9th Cir. 1956); Oesterreich v. Commissioner, supra at 803; see Mathews v. Commissioner, 61 T.C. 12, 21-23 (1973), revd. 520 F.2d 323 (5th Cir. 1975), cert. denied 424 U.S. 967 (1976)); (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments (Wiseman v. Scruggs, supra at 902; Commissioner v. Segall, supra at 709); (6) which party pays the property taxes (Harmston v. Commissioner, 61 T.C. 216, 229 (1973), affd. 528 F.2d 55 (9th Cir. 1976)); (7) which party bears the risk of loss or damage to the property (Harmston v. Commissioner, supra at 230); and (8) which party receives the profits from the operation and sale of the property (Harmston v. Commissioner, supra at 230). See generally Estate of Franklin v. Commissioner, 64 T.C. 752 (1975), affd. On other grounds 544 F.2d 1045 (9th Cir. 1976).

b. Seller is unwilling to Defer the Closing. Where the seller is unwilling to wait to close the taxpayer must find a method of “parking” the property until the taxpayer can sell his own property and perfect an exchange. The first (and usually primary) obstacle is the absence of money; the taxpayer does not have the proceeds of the sale of his property to assist in the closing. The second issue in terms of priority is who or what will be the “parking lot.” This person or entity is not a qualified intermediary; it is a person or entity that the taxpayer can contract with and have the comfort that purchase of the property can be enforced without jeopardizing the future exchange by gaining too many of the

∗ See also Midwest Metal Stamping Co. v. Commissioner, T. C. Memo 1965-279.

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burdens and benefits of ownership attributes or be deemed to be the owner of the property because the “parking” lot is deemed the agent of the taxpayer.

With respect to the purchase price, if the “parking” lot can acquire the property with its own case such is obviously the best method. Normally that cannot be done and the parking lot must borrow the funds. If the taxpayer must be the lender or be a guarantor of funds borrowed by the parking lot from a third party, such fact will enhance a potential agency argument by the IRS.

c. The Taxpayer desires to Construct Property to Serve as the Replacement Property. This situation presents issues that are much like the parking arrangement discussed above but the parking lot has to be the contractor or some third party dealing with the contractor. The taxpayer should not own the land on which the improvements are construction, but the taxpayer may have to guarantee the interior construction loan. That fact should not be fatal if none of the other burdens and benefits factors are present. Obviously, control of the construction is an important factor and it works against the taxpayer but certain case law has approved the use of a related entity to construct the property. See Fredericks v. Commissioner 67 T.C.M. (CCH) 2005 (1994). In Fredericks the taxpayer held an option to acquire unimproved land which he conveyed to his wholly owned corporation. He then entered into an exchange agreement with his company whereby the taxpayer transferred real property (apartments) to the company and the company sold the apartments to a third party. Under the exchange agreement the company was to construct improvements on the tract acquired under the option and convey the land and improvements to the taxpayer which it did. The Tax Court approved the transaction as a good exchange. The transaction predated the related party rules under §1031(f) and such a transaction would now trigger gain recognition to the taxpayer and the company. However, the issue of whether a controlled entity could be the “parking lot” was at least tacitly approved.

5. Case Law Dealing with Reverse Deferred Like Kind Exchanges. Except for Fredericks none of the case law is very encouraging. See Rutherford v. Commissioner, T.C. Memo 1978-505 (an agreement requiring the acquirer of heifers to deliver future offspring was an exchange, thereby causing nonrecognition and deferral of the taxpayers loss); Lee v. Commissioner, T.C. Memo 1986-294, (taxpayer acquired a property for debt then sold other property to retire the debt resulting in no exchange); Bezdjion v. Commissioner, 845 F.2d 217 (9th Cir. 1988) (the taxpayer expressed a like kind exchange intention to the seller of replacement property but acquired the replacement property prior to selling the relinquished property resulting in no exchange); In Re: Exchanged Titles, 159 B.R. 303 (Bkrpt C.D. Cal. 1993) (the taxpayer used an intermediary to perfect a reverse exchange whereby the intermediary acquired replacement property with taxpayers money and transferred it to the taxpayers in exchange for legal title only, i.e., the taxpayer retained the economic use of the relinquished property. The intermediary was to return the taxpayers’ advanced funds from sale of the relinquished property but the intermediary declared bankruptcy prior to the sale. The bankruptcy court ruled that the taxpayers had a good exchange and could

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make a direct claim for return of title to the relinquished property; the taxpayers were not merely unsecured creditors.) and Dibsy v. Commissioner, T.C. Memo 1986-294, (taxpayer acquired a property for debt then sold other property to retire the debt resulting in no exchange). See also PLRs 7929091, 9149018 and 9413006 dealing with build to suit replacement property.

6. Revenue Procedure 2000-37. On September 15, 2000, the IRS released Rev. Proc. 2000-37, 2000-40 I.R.B. 308, providing a safe harbor that can be used by taxpayers in connection with like-kind exchanges under Section 1031 to cause the acquisition of replacement property prior to having disposed of the relinquished property.

a. EAT. An “exchange accommodation titleholder” (EAT), who must be an unrelated party, can acquire the replacement property, hold onto it for up to 180 days until a buyer is found for the relinquished property, and then transfer it to the taxpayer in a §1031 exchange. Alternatively, the taxpayer can currently acquire the replacement property in a §1031 exchange and the EAT can hold the relinquished property up to 180 days until a buyer is found.

b. Legal Title. Although it is not necessary for the EAT to hold legal title, the EAT must have “qualified indicia of ownership” of the property that are treated as beneficial ownership under principles of commercial law. Apparently Rev. Proc. 2000-37 does not permit an actual reverse exchange (i.e., the EAT could not enter into a contract to purchase the property and assign the contract to the taxpayer who closes on the property), there is some uncertainty as to whether this could apply to any situation other than perhaps where legal title is held by the lender as security.

c. Intent. Section 4.02 of the revenue procedure states that at the time the EAT obtains legal title, the taxpayer must have a “bona fide” intent that the property held by the EAT represents either replacement property or relinquished property in a Section 1031 exchange. There is no indication of how the bona fide intent is proved but that is probably insignificant since within five days thereafter, the taxpayer and the EAT must enter into a written qualified accommodation agreement (QEAA).

d. 180 Day Rule. The EAT cannot hold the relinquished and or the replacement property, pursuant to a QEAA, for an aggregate period in excess of 180 days.

e. Identification. The relinquished property must be identified within 45 days from the EAT’s obtaining legal title. However, the taxpayer can identify alternative and multiple properties as described in Treas. Reg. 1.1031(k)-1(c)(4). Furthermore, the taxpayer's assignment of a contract to sell the relinquished property to a qualified intermediary within the 45 day period is sufficient to identify the relinquished property. PLR 200718028.

f. Transaction with EAT. Section 4.03 of the revenue procedure permits all kinds of dealings between the taxpayer and the EAT (loans,

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guarantees, leases, management of the property) on non-arm’s length basis. Specifically, one or more of the following can be accomplished, irrespective of the arm’s-length nature of the relationship.

(i) The taxpayer of a “disqualified person” may guarantee some or all of the obligations of the EAT, including secured or unsecured debts, or indemnify the EAT against costs and expenses.

(ii) The taxpayer or a disqualified person can loan or advance funds to the exchange accommodation titleholder or guaranty a loan or advance to the exchange accommodation titleholder.

(iii) The property is leased by the exchange accommodation titleholder to the taxpayer or a disqualified person.

(iv) The taxpayer or a disqualified person manages the property, supervises improvement of the property, acts as a contractor or otherwise provides services to the exchange accommodation titleholder with respect to the property.

(v) The taxpayer and the exchange accommodation titleholder enter into agreements or arrangements relating to the purchase or sale of the property, including puts and calls at fixed or formula prices, effective for a period not in excess of 185 days from the date the property is acquired by the exchange accommodation titleholder.

(vi) The accounting, regulatory or state, local or foreign tax treatment of the relationship between the taxpayer and the exchange accommodation titleholder is different from the treatment required by Rev. Proc. 2000-37. There was some concern previously as to how the accounting firms would treat the parking arrangements. If the EAT had to reflect ownership of the property and the debt as its own, that might preclude EATs who are affiliated with publicly held corporations (or who require certified financial statements) from being in the business. Rev. Proc. 2000-37 would appear to alleviate this concern since it is understood that the EATs might not, from a financial accounting viewpoint, have to reflect the property or the debt.

g. Variation of Values. Section 4.03 also permits the agreement to take variation in the value of the relinquished property from the estimated value into account upon the EAT’s disposition of the relinquished property through the taxpayer’s advance of funds to or receipt of funds from the EAT.

7. TAM 200039005. Prior to the issuance of Rev. Proc. 2000-37, the IRS issued TAM 200039005 which involved a simultaneous exchange that was not respected as a §1031 exchange. At the last minute, the buyer of the relinquished property refused to close and the taxpayer nevertheless demanded that the closing on the replacement

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property proceed. The TAM states that the taxpayer closed on the purchase of the replacement property but directed that title be deeded to an entity that otherwise could have been a QI. The TAM also states that the taxpayer negotiated the price of the replacement property, the taxpayer provided the funds (although it does not state whether this was done by way of a loan), and the taxpayer was personally liable on the third party mortgage. The TAM could be interpreted to state that reverse exchanges are simply not permissible. It is odd that the IRS would announce this conclusion concerning reverse exchanges (which as stated above, was reversed in the regulations) through a TAM. The IRS was obviously working on the Rev. Proc. 2000-37 project at the time the TAM was considered by the National Office and this may have had an impact. The IRS may have felt compelled to take a somewhat harder line in a matter that would not factually have met all the technical requirements under Rev. Proc. 2000-37.

8. Rev. Proc. 2004-51, I.R.B. 2004-33 (Aug. 16, 2004). Rev. Proc. 2000-37, a taxpayer favorable procedure inspired many taxpayers to push a bit more especially with so called “build to suit” transactions. Rev. Proc. 2000-37 took the questionable parking out of exchange deeds by allowing what is in essence qualified parking in the EAT. To take it one step beyond qualified parking, taxpayers tried to obtain deferral by constructing improvements on the taxpayer’s property. It was an interesting intellectual exercise (can there be a separation of land and improvements for tax purposes?) while it lasted but Rev. Proc. 2004-51 chilled it in August 2004. The typical facts were that a taxpayer would structure a leasehold improvements exchange within the Rev. Proc. 2000-37 safe harbor by long-term leasing the replacement land to the EAT, which uses the exchange proceeds to build a building on that land. Within 180 days after entering into the lease, the EAT transfers the leasehold and the newly constructed building to the taxpayer in exchange for the relinquished real estate. The question presented was whether the ground lease would be respected and the EAT would be the owner of the building pursuant to Rev. Proc. 2000-37, notwithstanding that the taxpayer retains ownership of the replacement land and is considered the owner of the building under a benefits and burdens analysis. The IRS said no in Rev. Proc. 2004-51.

If the replacement property is owned by the taxpayer within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to an exchange accommodation titleholder the exchange fails.

G. The Dealer Issue. A constant threat to an otherwise viable like kind exchange is the possibility that either the relinquished property or the replacement property does not qualify as like kind property, i.e., an investment or an asset used in the taxpayer’s trade or business. Specifically, IRC §1031(a)(2)(A) excludes stock in trade and other property held primarily for sale, property commonly referred to as “dealer property.” The danger inherent in this issue is that there are no bright line definitions of dealer property that give solid comfort to the taxpayer. Clearly, there is a judicial history that allows both the taxpayer and the government to take any position they want to take, but certain guidelines can be established. Fortunately for taxpayers in Texas most of the significant law has been developed in the Fifth Circuit Court of Appeals, and while it is impossible to give adequate coverage to the dealer issue in this presentation, taxpayers should be aware of certain problems that tend to appear as consistent fact patterns in the like kind exchange area.

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For example, assume that a taxpayer who owns an asset held for many years, a fact that strongly supports the non-dealer side of the issue, receives an offer for the property, accepts it, and establishes a like kind exchange intent through an intermediary. The taxpayer wants to defer the payment of tax on the disposition of the property as long as possible, but at the same time, the taxpayer would like to be in a position to liquidate the replacement property at the taxpayer’s election; that is, not have to wait on the right market to realize the profit in the investment on the real estate. If the taxpayer identifies a subdivision of lots, the exchange more likely than not fails even though all other elements of the deferred like kind exchange regulations are met because the property received is not like kind property. This example is easy because even if the replacement property clearly is not held primarily for sale, it certainly appears to be stock in trade because it is an inventory of lots. The example raises an interesting contrast in the law. The taxpayer could argue that even though the acquisition was of an inventory of lots, he intended to hold the lots in bulk as an investment for ultimate resale and not to sell them one at a time as one would deal with stock in trade.

The taxpayer would cite in support of his position Buono v. Commissioner, 74 T.C. 187 (1980), wherein the Tax Court held that the taxpayer was entitled to capital gain upon the sale of a large tract of subdivided land as a unit in a single sale, and the taxpayer had not engaged in other similar transactions even though the taxpayer had subdivided the tract of land. It is important to note that in Buono physical improvements to the subdivision had not been made. On the other hand, in S & H, Inc. v. Commissioner, 78 T.C. 234 (1982), the Tax Court held that Buono did not stand for the proposition that a bulk or a single sale would automatically qualify for capital gain treatment (i.e., that it was not dealer property). In S & H, Inc. there was a single sale of a single improved asset, but the critical fact was that the taxpayer had a commitment to sell the property after it had constructed an improvement on the land, therefore establishing the fact that the property was held primarily for sale. A prearranged sale mandated ordinary income treatment according to the Tax Court. The lesson of these cases is that a taxpayer trying to perfect a like kind exchange takes some element of risk no matter what type of property is acquired, but certainly defensive measures can be established to protect the investment intent.

In United States v. Winthrop, 417 F.2d 905 (5th Cir. 1969), the Fifth Circuit Court of Appeals established the now well known seven factors that should be reviewed in determining whether a property is dealer property. While the seven factors have been expanded by some courts and contracted by others, the most meaningful analysis comes from Suburban Realty Co. v. United States, 615 F.2d 171 (5th Cir. 1980), which condensed the more important factors and isolated the “number and frequency of sales made over a period of time” as the most important factor to weigh. The holding period of the property is the second most important factor (i.e., a very long holding period establishes an investment intent and conversely, a short holding period points to a resale intent), and following those factors, the other Winthrop factors, including the activities of the taxpayers and his agents regarding developments and improvements made to property, are to be considered.

H. Interest and Growth Factors. Starker did not disqualify the exchange because of the taxpayer’s right to a “growth factor.” In Starker there was no intermediary, the party (Crown Zellerbach) that received the taxpayer’s property in the first leg of the transaction simply obligated itself to convey to the taxpayer like kind property having a value equal to the agreed value of the taxpayer’s relinquished property plus a growth factor. In a like kind transaction

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structured with an intermediary who will be holding the consideration that otherwise would have been delivered to the taxpayer at the closing of the sale of the relinquished property, the value of that consideration should grow during the intermediary period (usually the 180 day period) either by market appreciation or interest earned. Frequently, a taxpayer will demand that the interest or growth factor be added to the purchase price of the replacement property hoping that the recognition of the interest or growth will be deferred along with the inherent gain in the relinquished property. The taxpayer is permitted to receive interest or a growth factor with respect to the deferred exchange, provided the taxpayer’s rights to receive such interest or growth factor are expressly limited. A taxpayer is treated as being entitled to receive interest or a growth factor if the amount of money or property the taxpayer is entitled to receive depends on the length of time elapsed between the transfer of the relinquished property and receipt of the replacement property. The interest or growth factor is treated as interest regardless of whether it is paid in cash or in property (including property of a like kind). See Regs. 1.1041(k)-1(g)(5) and 1.1041(k)-1(h)(1). Accordingly, the deferral is limited to the period during which the replacement property is acquired.

I. Deferred Exchanges Using an Installment Note. Is it possible to structure a deferred like kind exchange when the consideration received in the disposition of the relinquished property is, in part, an installment note? Most practitioners react negatively to this proposition, first asking the question why a taxpayer would desire such a result, but then acknowledging there is nothing in the regulations that either precludes the possibility or approves it. First, with regard to why the taxpayer would desire such a result, it could likely happen in the situation where the taxpayer receives a desirable offer to purchase his property, but as part of the consideration received, he must accept a deferred payment. The taxpayer’s desire to structure the sale in a deferred like kind exchange would normally arise where the following facts exist:

● the taxpayer had always intended to reinvest in like kind property;

● the deferred portion of the consideration (the installment note) is small in relationship;

● the cash received to the deferred portion of the consideration is a short term note; and

● the taxpayer has a very low basis, and a significant portion of the consideration represents gain.

In III.G.6 and 7 above the rules regarding the allocation of consideration received and basis for a combination of cash and installment note structured deals is discussed, but there are no rules regarding the situation where the taxpayer desires to accomplish a like kind exchange using all of the consideration.

Consider the following example. The taxpayer has a property worth $1,000 which has a $100 basis. The taxpayer receives an offer of $1,000 to be paid $800 in cash and $200 in a two-year note. The taxpayer establishes an intermediary structured like kind exchange, identifies and acquires a $1,000 property by using the $800 in cash the intermediary has in escrow and contributing another $200 toward the purchase. If the taxpayer has successfully deferred all of the gain, he will have a $100 basis in the replacement property and a $200 basis in the note

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receivable. If the only gain deferred is that represented by the $800 cash proceeds received, then the taxpayer will have a $300 basis in the replacement property and a zero basis in the $200 note and will report gain of $200 when the principal is received two years from the date of the sale of the relinquished property.

In lieu of contributing cash toward the purchase of the replacement property, can the taxpayer use the installment note received as a source of the purchase price for the replacement property? If the seller of the replacement property were willing to accept the $200 note, has the taxpayer successfully reinvested in a manner to defer all gain, or has the taxpayer accelerated the deferred gain in the installment note? The same question arises if the intermediary is successful in either selling the note or borrowing against the note to generate the cash necessary to buy the property.

The initial reaction most practitioners have is that the rules of IRC §453 will override and there will be a disposition of a zero basis installment note generating the gain on the note, which has only a timing effect to the taxpayer since the gain in essence is reflected as additional basis in the replacement property. But is this reaction the correct analysis of the situation? What if the facts were changed and in this example, the buyer of the relinquished property offered to taxpayer $1,000 in value in Exxon stock? Is not the intermediary entitled to dispose of the Exxon stock taking the proceeds thereof and acquiring the replacement property? Admittedly, this is an unrealistic example since no one buys property with unliquidated stock, but it illustrates the point.

J. Exchanges of Leasehold Estates with Less than Thirty Years of Duration. Reg. §1.1031(a)-1(c)(2) establishes the safe harbor rule that a leasehold estate with thirty years or more remaining on the lease term is real property for purposes of like kind exchanges. An isolated problem can arise when a taxpayer desires to exchange a property with less than thirty years life for a real property that is not a leasehold estate with a similar remaining lease term. This issue is rare but is particularly troublesome when a significant improvement is placed on a leasehold estate such as an office building, and the real value in the property being exchanged is the value of the improvements, not the underlying ground lease. The Service has considered this issue and has not yet made a decision as to how it would rule in this situation, but it would appear that the taxpayer has a solid argument that what is being exchanged is the building itself and not the leasehold estate. A more practical solution is to go to the ground lessor and negotiate an extension on the ground lease beyond thirty remaining years.

K. Real Estate Loan Workout Problems and Deferred Exchanges. Taxpayers owning improved properties that have been significantly depreciated for tax purposes and secure non-recourse loans face a serious tax problem upon the foreclosure of the property; there will be a significant gain to be recognized. Practitioners have developed a number of theories that utilize the deferral methods of §1031 to postpone the agony of recognition of the inherent gain in the foreclosed property.

1. Exchange Prior to Foreclosure. Assume that a taxpayer, immediately before a foreclosure, conveys the subject property to a qualifying intermediary pursuant to an exchange agreement with the intermediary. The transfer is subject to the debt and while the intermediary owns the property the lien is foreclosed by the lender. Within the

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45-day identity period, the taxpayer identifies the maximum possibilities of replacement with a hope to close one with enough debt on it to avoid boot issue (presumably, the taxpayer does not have cash to contribute to the purchase price of the new property, or he would have used it to avoid the foreclosure of the exchanged property). The most significant practical problem would be identifying a property (or properties) which has the right amount of debt on it and which is held by (or controlled by) a lender which will allow this taxpayer to purchase it. The obvious tax question is whether there can be a like kind exchange of a property that has no equity, and presumably, this point goes to the investment intent. A taxpayer should be able to make a convincing argument that he has an investment intent if the exchange results in the acquisition of a property that the taxpayer can factually demonstrate has a potential upside. The point is that perhaps the taxpayer could have allowed the foreclosure and acquired the new property as a new investment, but why should he if he can defer the gain through a reduction of basis in the new property?

2. Standstill Agreement and Related Party Exchange. The facts that set up this possibility are as follows: Taxpayer owns two properties, A and B. A has a low basis and B has a high basis. A is subject to a lien that secures a nonrecourse note with a principal balance significantly in excess of A’s basis. The note is in default, and taxpayer negotiates a standstill agreement with the lender to allow taxpayer two years to bring the property back to economic viability. The note is amended to allow the taxpayer to meet the debt service during the standstill period. Immediately after the standstill agreement is reached, the taxpayer puts B in a new entity (S Corp). It is taxpayer’s intent to salvage A, if possible, but if not, A, subject to the mortgage, will be exchanged for B immediately after the §1031(f)(1) two year period expires but prior to the foreclosure by the lender. A will then have B’s original basis, and B will have A’s original low basis. When the foreclosure of the lien on A occurs, A will be in the hands of the S Corp with a substituted high basis. The following possible results come to mind: (i) all that the taxpayer has accomplished through this series of steps in the exchange is to put himself in a more favorable tax posture on the ultimate foreclosure of A. The Service could use the step transaction doctrine and its sister, substance over form, to ignore the exchange and (ii) as a practical matter, to effect the desired result, B must be subject to the same amount of debt that A secures, otherwise, boot will be recognized at the time of the exchange (with the attendant tax consequences to the taxpayer at that time).

L. Exchanges by Partners and Partnerships.

1. The Problem. When a partnership contracts to sell a property, frequently the partners will have different desires as to whether to reinvest in like kind property or take the proceeds in a taxable transaction. Even if all the partners do agree to defer tax in a like kind exchange but desire to liquidate the partnership by distributing the individually chosen properties to the respective partners, the following described complications will occur if all of the partners do not acquire the property they want for the correct amount of consideration split between cash and assumed debt. Consider the following example:

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Partners A, B and C each own a 1/3 interest in ABC partnership. It owns real property that has a zero basis and is worth $120. A, B and C have zero outside bases in their partnership interests. A contract for sale is entered into by ABC. A and B each desire to acquire replacement property but C wants cash. The partnership enters into a deferred like kind exchange agreement using an intermediary. The intermediary closes the sale and receives $80 in escrow to acquire replacement property for A and B. The partnership agreement is amended to specially allocate the $40 gain (the boot) to C and distributes $40 to C in redemption of his partnership interest.

The foregoing example is easy to deal with but it is unrealistic for two reasons. Very rarely will the basis in the asset be zero and more often than not ABC will have debt secured by the property.

Assume the same facts except that the basis of the property is $90 and A, B and C each have $30 outside basis. Since C will not replace his pro rata amount of the consideration, there is $40 boot which will require full recognition of the $30 gain. C will be hard to convince to accept an allocation of the entire $30 gain since $10 is his pro rata share. But if C will accept the gain then his outside basis goes to $60 and when he receives the distribution of $40 he will recognize a $20 loss, thereby causing a net $10 gain recognition to C, his pro rata share of the gain. The timing and character of the gain and loss could be troublesome to C. If the gain is allocated in one year and the loss on distribution occurring in another the gain and loss may not be matched, but ordinarily timing should not be an issue because the distribution should occur on the same day of the sale causing the gain recognition. Character mismatching may be a bigger issue. If the asset sold produced ordinary income (inventory or Section 1245 or Section 1250 gain) C will be reporting $30 of ordinary income and a $20 capital loss. C will not agree to this result.

Furthermore, practitioners are concerned that the special allocation modification to the partnership agreement inasmuch may not have substantial economic effect required by §704(b). The IRS has not blessed the above described accommodating special allocation.

There and two alternative approaches to the special allocation method discussed above. The first alternative is to distribute to C an undivided interest in the property subject to a pro rata portion of the debt. This method requires the cooperation of the buyer since the buyer will contract with two sellers, C and the ABC partnership with only A and B as its partners. There is some concern as to whether, under these conditions, C and ABC partnership can effectively avoid partnership status.

The second alternative is to negotiate a short term installment note for C’s portion of the sales price and distribute the note to C in redemption of C’s interest. His basis in the note will equal his basis in his partnership interest and upon collection C will report his pro rata share of the gain.

In the April, 1996 issue of the Journal of Taxation (page 254) Messrs. Sheldon I. Banoff and Richard M. Lipton discuss the first example and alternative solutions and

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ultimately agree that they cannot agree on the best approach to the problem. They did agree that the special allocating solution was less desirable than the two distribution alternatives. It is suggested here that the distribution of C’s undivided interest is the best method. As far as the concern that C will still be in a partnership with A and B following the distribution, a contingent special allocation provision is suggested to incorporate the first method discussed as a back up defense.

2. ABA Tax Section Project. On February 21, 2001, the ABA Tax Section, through members of the Committee on Sales, Exchanges and Basis, Partnerships and Real Estate, submitted a report to the Internal Revenue Service urging the IRS to issue interpretive authority to the effect that taxpayers could indeed exchange for property and contribute the replacement property to another entity without violating the holding purpose rule or could distribute the property from another entity (almost always a partnership) and the individual partners could sell their undivided interest as relinquished property and perfect an individual like-kind exchange. The report further urges favorable treatment on special allocations of boot to partners who do not desire to exchange when the exchange is actually consummated by a partnership. The report does not address an approach taken by the IRS in §1033 application with respect to involuntary conversions. The IRS has applied the Court Holding Company v. United States, 324 U.S. 331 (1945) doctrine in numerous §1033 situations and it would seem that given the opportunity the IRS will also apply the same approach in §1031 exchanges where the contract for sale of the relinquished property is handled at the partnership level and at some point prior to the same of the relinquished property, the property is distributed to the various partners. Recently, a number of private letter rulings and technical advice memoranda have demonstrated that, contrary to the prior myth, the IRS will look at both the substance of the transaction and the form of the transaction in §1031 exchanges.

3. TAM 9645005. In TAM 9645005, the IRS applied the Court Holding Company doctrine in a replacement of involuntarily converted partnership property and held that the only taxpayer that could replace the property under the facts set forth there was the partnership itself. The partnership was a venture between a limited partnership and a corporation and a governmental authority instituted condemnation proceedings against a portion of the venture’s property. Eventually, the condemning authority and the venture reached an agreement under the threat of condemnation and a sale agreement was entered into. On the day preceding the closing date the venture distributed 50% tenants in common interests in the property to the limited partnership and the corporation. On the date before the distribution the venture and its two partners entered into an assignment and assumption of the contract with the condemning authority and the partners also assumed all of the venture indebtedness that was secured by the property subject to the contract. The IRS held that under the principles of Court Holding Company, the realities and substance of the events determined that the taxpayer making the sale to the condemning authority was the venture and only it could replace the property. In a similar fact pattern the partners took a different approach.

4. TAM 199907029. In TAM 199907029, title to a tract of property subject to condemnation by a condemning authority was on undivided interests by A, B and C (and eventually a portion to D, wife of A who received her portion of the property

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incident to a divorce). However, A, B and C had entered into a partnership agreement and had filed partnership tax returns for 22 of the 25 years the property had been owned. The IRS concluded that the individual taxpayers were partners of a partnership they intended to form and they could not disregard its existence for federal tax purposes. Therefore, only the partnership could replace the condemned property and be the exchanging property in a subsequent §1031 exchange of property that was not condemned.

5. TAM 9818003. In TAM 9818003, taxpayer (a limited partnership) had held qualifying property for 14 years. It entered into an earnest money contract to sell the property. The partnership agreement provided a mechanism upon liquidation under which, when the property was sold, the individual partners could elect to cause the partnership to designate separate replacement properties, effectively on behalf of each respective partner, utilizing that partner’s pro rata partnership share of the sales proceeds. Each partner was responsible for making up any shortfall in the purchase price of that partner’s designated replacement property. The partnership property was sold pursuant to an exchange agreement with an intermediary, with ultimately several of the partners who did not wish to participate in an exchange receiving cash in redemption of their partnership interests and the remaining partners receiving direct deeds of replacement properties from the respective sellers. IRS ruled against the qualification of the exchange as not being in the form of an exchange, since the exchange party (which was the partnership) did not actually receive title to the replacement properties. The bottom line requirement identified here by the IRS as not having been met was that the owner of the relinquished property did not receive title to any of the replacement properties (i.e., it was not the same exchange party taking title to the replacement property). The IRS also relied on Rev. Rul 75-292, which would support a finding that even if the partnership had received title to the replacement properties and then distributed title to the respective partners, the partnership would have failed to hold the property for a qualified use, i.e., for investment or for use in a trade or business (i.e., taxpayer did not meet the holding purpose test).

Suggested planning alternatives that might have worked:

● dissolving the partnership prior to the sale, distributing the property to the partners and having them engage in separate exchanges;

● having the partnership acquire the replacement properties and subsequently distribute them to the partners in redemption of their partnership interests, and

● use of installment notes from buyer to be distributed to the “cash out” partners in redemption of their partnership interests.

Likely attacks on the first structure are (i) that the partners are nevertheless deemed to be a partnership under Section 761, which would either require the partnership to enter into the exchange agreement or cause the partners to be viewed as selling/exchanging nonqualifying partnership interests, and (ii) the individuals would

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presumably need to establish their own holding periods and purpose so as to qualify their undivided interests as being held for investment or for use in a trade or business. The second structure raises significant issues of (i) the special allocation of the gain attributable to any boot received by the partnership to those partners receiving cash in redemption of their interests and (ii) the establishment of the partnership’s holding period and purpose prior to the distribution of the various replacement properties to the remaining partners. Consider instead the third scenario, the possibility of the partnership receiving short term notes instead of cash on sale of the exchange property and distributing those installment obligations to the “cashed out” partners.

In any event, this TAM underscores that form does matter — the exchange party that sells the exchange property must be the same party that receives the replacement property. In addition, numerous nontax considerations come into play, including (i) individual partners getting into the chain of title with respect to possible environmental liability, and (ii) other liability concerns about being the individual owners of an undivided fee interest owner rather than through a limited partnership as a limited partner.

M. LLCs for Acquisition of Replacement Properties. Because, in theory, single-owner LLCs provide their owners with limited liability for state law purposes but are disregarded as an entity for federal income tax purposes, they provide a preferred means of holding real estate and offer planning opportunities in connection with §1031 exchanges. In most states (but not including Texas because of the Texas Franchise Tax) limited liability companies have become the entity of choice for those engaged in the business of real estate acquisition, ownership, management and sale. The LLC offers the most comprehensive benefits in terms of liability protection, flexibility in management and capital structure, and tax treatment. In PLRs 9751012, 9807013 and 199935065, the IRS ruled that a taxpayer’s transfer of replacement property directly to the taxpayer’s wholly owned, single member LLC in the second leg of a §1031 exchange would not disqualify the taxpayer from receiving nonrecognition treatment. The rulings rely on the check-the-box regulations, which provide that unless a single-owner LLC elects to be taxed as a corporation, it will be disregarded as an entity separate from its owner for federal income tax purposes. Reg. §301.7701-2(a)(1). The IRS concluded that because the single-owner LLC is disregarded as an entity, the transactions in question would be viewed as if the taxpayer itself had directly received the replacement property, and therefore satisfied the holding requirement of §1031.

APPENDIX 1

Diagram of Deferred Exchange Using an Intermediary and Direct Deeding

See Reg. §1.1031(k)-1(g)(8), Example 4 (1) Taxpayer enters into contract with Buyer to sell Taxpayer’s property to Buyer. (2) Taxpayer enters into exchange agreement with Intermediary and assigns rights to contract

with Buyer to Intermediary. (3) Taxpayer given notice of assignment of contract to Buyer. (4) Taxpayer conveys property to Buyer. (5) Buyer pays consideration to Intermediary. (6) Taxpayer identifies replacement property. (7) Taxpayer enters into contract to buy property from Seller. (8) Taxpayer assigns rights to contract with Seller to Intermediary. (9) Taxpayer given notice of assignment of contract to Seller. (10) Seller conveys property to Taxpayer. (11) Intermediary pays consideration to Seller.

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APPENDIX 2

SECTION 1031 EXCHANGES

OVERVIEW

I. Introduction to Section 1031

A. Gain or Loss on the Sale or Disposition of Property

1. GENERAL RULE – the entire amount of the gain or loss on the sale or disposition of property shall be recognized. Section 1001(c).

2. EXCEPTION - the gain or loss from the exchange of property held for productive use in trade or business or for investment may qualify for nonrecognition. Section 1031.

II. Section 1031 Basics

A. The Background

1. Congress considered it inappropriate for the taxpayer to recognize the "theoretical" gain or loss when the taxpayer's investment in property continues in similar or like kind property.

B. The Statute:

1. What Property Qualifies?

a. Property must be "held" for tax purposes

i. There is no holding period requirement, it just must be held by the taxpayer

ii. The determination of intent is determined at the time of exchange

b. Property held for investment

i. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale. Treas. Reg. § 1.1031(a)-1(b)

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ii. Properties held for the production of income also fall into this category. See e.g. Grier v. United States, 218 F.2d 603 (2d Cir. 1955).

c. Property held for productive use in trade or business

i. If a taxpayer can establish that an activity is a trade or business (as opposed to a hobby), any property used productively in that trade or business should be business-use property for Section 1031 purposes.

ii. A taxpayer is engaged in a trade or business if involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity is for income or profit. Comm'r v. Groetzinger, 480 U.S. 23, 35 (1987).

d. Other property in the transaction must be "like kind"

i. Like kind refers to the nature and character of the property and does not refer to its grade or quality. Treas. Reg. § 1.1031(a)-1(b).

ii. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its class or kind. Treas. Reg. § 1.1031(a)-1(b); but cf. Rev. Rul. 76-390, 1976-2 C.B. 243.

iii. This requirement does not mean that property held for investment can only be exchanged for other property to be held for investment. Property held for productive use in a trade or business MAY be exchanged for property held for investment, and vice versa.

e. Treas. Reg. § 1031j-1(a) provides that properties may be grouped together when multiple properties are being exchanged – you do not have to compute gain and basis on a property by property basis

2. What constitutes an exchange?

a. Basic definition is the transfer of property in return for other property

b. The substance (what is actually done) and not the form of the transaction is what is crucial

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i. This issue comes up quite often when a taxpayer is seeking to recognize a loss, but wants to acquire a replacement property

3. Nonelective – The application of Section 1031 is automatic with respect to any transaction which meets the statutory, regulatory and judicial requirements.

4. Exceptions - This subsection shall not apply to any exchange of—

a. stock in trade or other property held primarily for sale;

b. stocks, bonds, or notes;

c. other securities or evidences of indebtedness or interest;

d. interests in a partnership;

e. certificates of trust or beneficial interests; or

f. choses in action.

C. The effect of boot on gain realized

1. If the taxpayer receives not only qualifying property, but also money or "boot", gain will be recognized, but not in excess of the sum of such money and the fair market value of such boot received. Section 1031(b).

2. This flexibility allows a "mixture" of consideration in like kind exchanges without causing the whole transaction to fall outside the purview of Section 1031.

a. No loss will be recognized with respect to qualifying property in these mixed transactions. Section 1031(c).

D. Basis

1. The basis adjustment provisions under Section 1031(d) ensure that the gain or loss realized on the exchange, but which went unrecognized, will at some appropriate point be recognized.

2. In the absence of liabilities, the basis of the property received in each exchange group is:

a. The transferor's adjusted basis in the property transferred in that group (carryover basis);

b. Increased by any gain recognized;

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c. Decreased by any exchange group deficiency; and

d. Increased by any exchange group surplus.

3. With a group of properties, the aggregate adjusted basis for the group, is allocated among the items received in the group in proportion to their fair market values.

E. Timing of the Exchange

1. Identify property within 45 days after the date on which the taxpayer transfers the property relinquished in the exchange.

a. Identifying alternative and multiple properties – taxpayer may designate:

i. Three properties without regard to their values - Three Property Rule

ii. Any number of replacement properties as long as their aggregate fair market value at the end of the identification period does not exceed 200 percent of the aggregate fair market value of all of the relinquished properties as of the date the relinquished properties are transferred by the taxpayer - 200 Percent Rule

iii. As many replacement properties as the taxpayer wants, provided that the taxpayer receives identified replacement property constituting at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period -95 Percent Rule

2. Receive the property after the earlier of (i) 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date for the transferor's tax return for the year in which the transfer of the relinquished property occurs.

F. Typical Structure:

1. the taxpayer has a property with an inherent gain and the taxpayer receives a contract for purchase of his property;

2. the taxpayer enters into an exchange agreement with an intermediary and then assigns the purchase contract to the intermediary;

3. the purchase contract closes, the relinquished property is conveyed to the buyer and the consideration therefrom is paid over to the intermediary;

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4. the taxpayer identifies certain replacement property;

5. the taxpayer selects the replacement property and contracts to buy it;

6. the contract to acquire the replacement property is assigned to the intermediary; and

7. the contract is closed whereby the intermediary transfers the cash consideration to the seller and the seller conveys the replacement property to the taxpayer, frequently through a direct deed.

III. The Reverse Exchange

A. What is a reverse exchange?

1. This is a like kind deferred exchange where the replacement property is acquired (or "parked") before the relinquished property is sold

a. The parking of replacement property really turns this type of exchange into a direct exchange because the relinquished property will still be acquired immediately before the acquisition of the replacement property

b. These transactions and the case law surrounding them are inherently risky and so it is wise to comply with the safe harbor rules

2. Safe Harbor Reverse Exchange

a. An "exchange accommodation titleholder" (EAT), who must be an unrelated party, can acquire the replacement property, hold onto it for up to 180 days until a buyer is found for the relinquished property, and then transfer it to the taxpayer in a §1031 exchange.

i. Although it is not necessary for the EAT to hold legal title, the EAT must have "qualified indicia of ownership" of the property that are treated as beneficial ownership under principles of commercial law.

b. Section 4.02 of the revenue procedure states that at the time the EAT obtains legal title, the taxpayer must have a "bona fide" intent that the property held by the EAT represents either replacement property or relinquished property in a Section 1031 exchange.

c. The relinquished property must be identified within 45 days from the EAT’s obtaining legal title.

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• Transaction with EAT. Section 4.03 of the revenue procedure permits all kinds of dealings between the taxpayer and the EAT (loans, guarantees, leases, management of the property) on non-arm’s length basis.

d. 15 Steps:

i. Taxpayer enters into a Qualified Exchange Accommodation Agreement (QEAA) with an EAT

ii. EAT forms LLC or other SPE

iii. Taxpayer assigns its rights as purchaser under PSA for replacement property to EAT and provides written notification to all parties involved in the transaction

iv. Taxpayer advances money to LLC to fund the purchase of the replacement property. Loan is non-recourse to the LLC, but can be guaranteed by the taxpayer on a recourse basis

v. EAT acquires title to the replacement property and gives taxpayer and/or a 3rd party lender a note secured by a deed of trust on the replacement property

vi. Under the QEAA, taxpayer leases the replacement property from the EAT under a triple-net lease

vii. Taxpayer identifies relinquished property within 45 days after the closing and parking of the replacement property

viii. Taxpayer executes PSA to sell relinquished property

ix. Taxpayer executes 1031 Exchange Agreement with a Qualified Intermediary (QI)

x. Taxpayer assigns its rights as seller under PSA for relinquished property to QI and gives written notice to the buyer

xi. Taxpayer deeds property to the buyer and closer distributes all exchange proceeds from relinquished property to QI

xii. Taxpayer and EAT execute PSA for replacement property

xiii. Taxpayer assigns rights as purchaser under PSA for replacement property to QI

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xiv. At closing, QI pays off taxpayer and/or 3rd party lender in satisfaction of the note given by EAT. Closing must be simultaneous with the relinquished property closing.

xv. QI instructs EAT to either transfer title to replacement property to taxpayer or transfer 100% of the membership interest in EAT to taxpayer

IV . Two Interesting Rules

A. Section 1031(e) Exchanges of livestock of different sexes.--For purposes of this section, livestock of different sexes are not property of a like kind.

B. Section 1031(h) Special rules for foreign real and personal property.--For purposes of this section—(1) Real property.--Real property located in the United States and real property located outside the United States are not property of a like kind.