Like-Kind Exchanges – Traps For The Unwary

	By Yunna Barats Co-Partner In-Charge Real Estate Group barats@rbz.com
Publication Date: Fall 2002
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It is fair to say that at any given moment, some “like-kind” exchange related documents awaiting analysis are sitting on my desk. Some of these exchanges are just being entered into; some are already completed. More often than not, the exchanges are facilitated without prior consultation with a tax accountant or a tax attorney. Unfortunately, roughly one out of five of those exchanges do not qualify for a favorable tax treatment because not every requirement of the exchange rules is met. Needless to say, the tax consequences of a failed exchange can be quite painful. A failed exchange transaction is treated as a taxable sale of one property and an unrelated purchase of another.

In this article, I would like to focus on only two elements of the deferred like-kind exchange; the identification rules and the access to cash held by the qualified intermediary. In my experience, most failed exchanges have problems with at least one of these elements.

A like-kind exchange (also referred to as a “1031 exchange”) is an exchange of property used in trade or business, or held for investment for another like-kind property used in trade or business or investment. Generally, the gain realized in an exchange transaction is not included in the taxpayer’s taxable income in the year of the transaction. The gain is included in income only upon the ultimate disposition of the replacement property in a fully taxable transaction. Thus, the payment of taxes could be deferred for many years and, in some cases, never be paid at all during the taxpayer’s lifetime. Personal property, inventory, stock and securities, as well as partnership interests are, among other things, specifically excluded from the application of the 1031 exchange rules.

It is unusual for the owner of a property who wishes to enter into an exchange transaction to perform the entire transaction instantaneously. In reality, it is almost impossible for a person with a property (P1) to find an exchange property (P2) whose owner happens to be willing to swap his property P2 for P1.

Thus, it is more likely that a taxpayer will enter into a deferred exchange transaction. A deferred exchange is an exchange where a transfer of a relinquished property and a receipt of a replacement property do not happen simultaneously. In addition, the “purchaser” of a relinquished property and the “seller” of a replacement property is not necessarily the same person. Then how does the deferred exchange differ from a sale-and-purchase transaction? Simply put, a deferred exchange is a sale-and-purchase transaction with a “twist.”

The twist contains a few restrictions; most notable are 1. the time requirement and 2. the restricted use of cash requirement. The time requirement places certain restrictions on when the replacement property can be identified and purchased, and the restricted use of cash severely curtails the taxpayer’s use of cash.

As most real estate professionals know, in order for the exchange to be valid, the replacement property must be identified within 45 days and purchased within 180 days from the sale of the relinquished property. The identification is usually done in the form of a letter to a qualified intermediary.

Some significant restrictions are placed on the values and on the number of properties that can be identified. Those restrictions are known as a “three property rule,” a “200% rule” and a “95% rule.” In order for the exchange to be valid, a taxpayer must satisfy any one of these rules.

The three property rule allows a taxpayer to identify three potential replacement properties with an unlimited fair market value. Clearly, at least one of the identified properties must be subsequently acquired in the exchange.

The 200% rule allows a taxpayer to identify any number of potential replacement properties; however, the total fair market value of the identified properties can not exceed 200% of the fair market value of the property relinquished.

The 95% rule allows for the identification of any number of potential replacement properties with unlimited fair market values; however, 95% of the identified properties (by value) must be subsequently acquired as replacements.

Please note, that any deviation from the above rules will render the exchange transaction invalid. As a practical tip, if you are trying to qualify for the exchange under either 200% or 95% rule, it is advisable to keep the documents (such as offer letters or broker’s listings) that could substantiate the fair market values of the properties. Please keep in mind that both the 200% rule and the 95% rule require that the valuation of the properties be made at the time of the identification. In my experience, if an exchange is being examined by any taxing authority, the identification letter and the fair market value substantiation are one of the first few items requested by an auditor.

The other area responsible for most failed exchanges is the restricted use of cash requirement. In almost 100% of the cases, the taxpayer enlists the help of qualified intermediaries to facilitate the exchange. A qualified intermediary holds the sale proceeds of the relinquished property and uses them, at the direction of a taxpayer, to purchase a replacement property. A taxpayer must always have a written contract with a qualified intermediary. Such a contract must expressly provide that the taxpayer has no right to receive, pledge, borrow, or otherwise obtain the benefits of the money held by the

intermediary until the exchange is consummated or abandoned. Any cash distribution from a qualified intermediary to a taxpayer or a taxpayer’s agent will constitute boot. (Boot is a non-like kind property, which is subject to taxation).

Let’s consider the following example: a taxpayer “sells” his property for $1,000,000. The sales proceeds are deposited with a qualified intermediary. The taxpayer desires to use only $600,000 in an exchange transaction and keep the remaining $400,000 (boot), which, of course, will be taxable to him in the year of “sale.” The taxpayer complies with all the requirements of the exchange and directs an intermediary to disburse $600,000 to a seller of the

replacement property. When can the taxpayer direct the intermediary to distribute boot of $400,000 to himself?

The agreement between a taxpayer and a qualified intermediary can provide that if a taxpayer has not identified replacement property by the end of the identification period (45 days), the taxpayer can have the right to receive cash proceeds at any time after the end of the identification period. It can also provide that if the taxpayer has identified the replacement property, he can have these rights on or after the receipt by the taxpayer of all of the replacement property to which he is entitled.

However, any receipt of cash proceeds prior to the expiration of the identification period would make the exchange vulnerable to the IRS claim that the taxpayer did not comply with the “no right to receive cash” requirement, thus invalidating the exchange.

As a side note, I would like to mention that a qualified intermediary can make distributions in order to facilitate a number of services incidental to effecting a deferred like-kind exchange. An example is paying attorney fees for negotiating the acquisition and exchange agreements, for financing and other matters related to the exchange, for preparing the escrow documents and for giving tax advice. However, I would advise against any such disbursements being made prior to the expiration of the 45-day period.

In conclusion, I would like to mention that the like-kind exchange rules contain quite a few other traps for the unwary that we will discuss in our upcoming articles.