Tax Deferred Exchanges IRC 1031

The nation's oldest and largest exchange accomodator

Due to the inflationary spiral, along with the deduction of depreciation upon the value of real estate, many investors are faced with enormous capital gains upon the sale of their investment property. Whereupon, the question arises as to the method one can utilize the disposition of investment property without realizing capital gains.

Section 1031 of the Internal Revenue Service is the answer. Section 1031 provides that "no gain or loss shall be recognized if property held for productive use in trade or business, or for investment, is exchanged solely for property of a like-kind to be held either for productive use in trade, business, or for investment."

The wording of Section 1031 tells us that "like-kind" means of a similar nature as long as both the property given up and the property received are used in the Sellers trade or business. It is immaterial what the buyer does with your property he or she acquires.

The biggest problem confronting the taxpayer desiring to exchange property was that the potential buyer of the taxpayer's property owns no property that the taxpayer wishes to receive in exchange.

Therefore, a transaction so-called "three-corner" exchange evolved. The Tax Court has agreed that this is an exchange within the meaning of Section 1031. e.g., Alderson vs. Commissioner, 317 F. 2d 790 (9th Cir 1963) State of California rev. 38 T.C. 215 (1962).

The courts have also agreed, that "It is immaterial that the exchange was motivated by a wish to reduce taxes". Mercantile Trust Company of Baltimore et al. Trustees vs. Commissioner, Supra at 87.

One of the most publicized court cases to support Section 1031 was the "Starker" Case, U.S. T.C. No. 77-2826. This paramount decision allows a contractual purchase of property for a future exchange. In other words, there does not have to be a simultaneous closing of escrow as long as the proceeds do not come under the control of the seller.

To prevent such control by the seller, Pacific Financial Exchange Corporation, A California Corporation, will act as a "substituted seller" so that the IRS cannot argue that the seller had actual control.

Therefore, Pacific Financial Exchange Corporation will hold the proceeds of the sale until a suitable property of "like-kind" can be found.

The legal basis for this transaction can be found in; F.B. Biggs vs. Commissioner 69 T.C. No. 78 (1978), T. J. Starker vs. Commissioner 77-2 U.S. T.C. No. 9512, Leslie Q. Coupe 52 T.C. No. 394 (1960).

These are only a few cases involving application of I.R.C. 1031. We advise you to discuss these and other cases with your Tax Advisor and or your Attorney prior to entering into this or other similar transactions.

Section 1031 (a) (3) (B) OF INTERNAL REVENUE CODE

Seller, "Exchanger", must locate suitable like-kind property within 45 days of the close of transfer of exchange property in order to comply with the like kind exchange rules under 1031 (a) (3) (B). Also, Seller, "Exchanger", must be aware that no more than 180 days from the date of the transfer of the property relinquished in the exchange, will be allowed for acquisition, or after the due date (including extensions) of the transferor's tax return for the year in which the transfer occurred, whichever deadline occurs first. However, no more than 180 days will be allowed for the Seller, "Exchanger", to acquire his or her acquisition property.

If the property you acquire within the 180 day period is not one of the properties that you identified within the first 45 days, your exchange will be in jeopardy of complete disallowance.

Identification for tax purposes must be made in writing which must be submitted to the Accommodator by mail or fax machine, on or before the 45th day.

In order to have a complete tax-deferred exchange, you must comply with the following:

1) Sale price of the acquisition or acquisitions of property or properties must be equal or more of the sale price of the sale property.

2) Mortgage or mortgages on acquisition or acquisitions of property or properties must be equal or more of the mortgage on the property given up.

3) No Notes or Trust Deeds should be carried back. (If a note is carried back, it must go into the name of the Accommodator until the transaction has been completed and then transferred back to taxpayer).

4) No cash should be taken out of the exchange funds.

If any one or all of the four above are not complied with, the difference is taxable.

Reverse 1031-Exchanges
Rev Proc 2000-37, 2000-40

For transactions after September 14, 2000 new safe harbor rules
were created for "Reverse" Like-Kind Exchanges.

IRS will not challenge the qualification of property as either
replacement or relinquished property, or the treatment of the
Exchange Accommodation Title holder as the beneficial owner of
either type of property, if the property is held in a "Qualified
Exchange Accommodation Arrangement" (QEAA).

The agreements used to facilitate a "Reverse" Exchange are
considerably different and more complex than those used for the
standard "Delayed Exchange". The method is described as follows:

PFE II, will establish a Limited Liability Company in the State
the property is located in ("Exchange Accommodation Titleholder"
or "E.A.T"). The taxpayer/exchange ("Exchanger") and the E.A.T.
will enter into a Real Estate acquisition a "Qualified Exchange
Accommodation Agreement" ("QEAA"), the E.A.T will agree on certain
terms, to acquire the property, which the Exchanger wishes to use as
it's "Replacement Property" in the tax deferred 1031 exchange and to
transfer the replacement property to Exchanger at such time as Exchanger has sold the "Relinquished Property" to a third party buyer.

The Exchanger will assign to the E.A.T all of its contractual
rights to purchase the replacement property, and the E.A.T will close escrow and acquire the replacement property. The title to the
replacement property will be vested in the E.A.T. The Exchanger's
relinquished property will be sold pursuant to the first phase of a
"Delayed Exchange" using a qualified intermediary ("QI"). This
property must be identified within 45 days of the E.A.T agreement and closed within 180 days. The "QI" proceeds from the sale of the
relinquished property will be used to purchase the replacement
property from the E.A.T. The E.A.T. will deed the replacement
property directly to the exchanger, which will complete the exchange.

FIVE MISCONCEPTIONS OF 1031 EXCHANGES

1. In order to complete a 1031 Tax-deferred Exchange, a taxpayer has to find someone to “swap” a property with. Originally, prior to 1970, taxpayers would exchange property as “you give me your property, I will give you my property”. After 1970 with the “Starker” Exchange and with the use of a third party called an “Accommodator”, properties are exchanged for other property. Most Exchanges are structured like a sale with the use of an Accommodator allowing for a subsequent purchase.

2. A taxpayer seeking to exchange property has to buy the exact same type of property he is selling in order for it to be considered a “like-kind” exchange. As long as both the property to be sold and the property to be purchased are held for productive use in a trade or business, or for investment purposes, taxpayers are free to purchase whatever type of property they want. For example, a taxpayer can sell an apartment building and exchange it for an industrial warehouse. Income producing property such as rental income can be exchanged for non-income producing property. Zoning is not an issue. California conforms to most IRS rules on Exchanging.

3. Taxpayers must complete the 1031 exchange in one completely simultaneous transaction. Simultaneous or concurrent closings are no longer recommended. Klein vs Comm. 66-TCM, 1115 1993 has allowed IRS to disallow concurrent closings. By virtue of a favorable ruling to the taxpayer in the now famous case of Starker v. United States in 1979, taxpayers have the ability to complete an exchange on a delayed basis so long as they purchase replacement property within 180 days of selling their first relinquished property. Other structures, including reverse exchanges and improvement exchanges, afford taxpayers other types of flexibility during the exchange time frame.

4. Taxpayers must use all the proceeds from the sale of their relinquished property to purchase replacement property. In order to have a completely tax-deferred exchange a taxpayer must follow three essential steps: (1) buy replacement property where the value is equal to or greater than the value of the original relinquished property; (2) use all of the original equity realized from the sale to purchase a replacement property; and (3) obtain equal or greater financing on the replacement property as was paid off on the relinquished property at the time of its sale.

However, while those are the rules for a complete deferral, a taxpayer may violate any one of them and complete a partial deferred exchange. For example, a taxpayer who seeks to buy a replacement property of a lesser value, or with less financing, will recognize a capital gains tax on that amount not reinvested in the new property. Simply put, taxpayers can buy replacement properties for a lesser amount and put cash in their pocket, so long as they don’t mind paying some taxes.

5. I don’t need a qualified intermediary. I can simply have my attorney or accountant hold the sale proceeds until the replacement property is purchased. A qualified intermediary is essential to completing a valid delayed exchange. Basically, the IRS disqualifies any person or entity from acting as an intermediary, if that individual has had an existing business relationship with the taxpayer within the past two years.

Although that statement is somewhat broad, some parties who may be considered disqualified parties are the taxpayer’s relatives, attorney, accountant and real estate broker. The IRS provides that neither the taxpayer, nor any disqualified person, or entity, can come into receipt of the exchange funds nor during the exchange, or the exchange will be void. Using a well-established qualified intermediary enables a taxpayer to avoid situations that might void an otherwise valid exchange. It is also a good practice to research the expertise and security of the qualified intermediary.

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