Martin & Raynor, P.C. Publications

Like-Kind Exchange Handbook-
What Real Estate Owners and Their Advisors Need to Know
September 11, 2007

Gregory M. Johnson, CPA, Attorney-at-Law
Martin and Raynor, P.C.
1228 Cedars Court, Suite A
Charlottesville, VA 22903-4801
Telephone (434) 817-3100
Facsimile (434) 817-3110
E-mail gjohnson@mrlaw.com
Website www.mrlaw.com

Chapter I - Background

Chapter II - Six+++ Things Real Estate Owners and Their Advisors Should Know About Like-Kind Exchanges

1. What is a like-kind exchange and what are the consequences of doing a like-kind exchange.?

2. When do I do an exchange?

3. What to look for in those to be involved in the exchange?

4. Different Types of Exchanges.

5. Steps to take to document and otherwise carry out the average like-kind exchange!!!

6. Other Special Issues in an Exchange.

Appendix A-Section 1031-The Law According to Congress

Appendix B-Definitions.

Appendix C

Appendix D

Chapter I
Background

The federal government has afforded like-kind exchanges preferential treatment as far back as the Revenue Act of 1921. The reasons for requiring non-recognition of either the gain or loss from an exchange which qualifies as a like-kind exchange under the federal tax laws were and, and to some extent still are, as follows:

Congressional desire not to impose a tax on theoretical or paper gains where a taxpayer has (a) not cashed in on the taxpayer’s investment and (b) continued the taxpayer’s investment in “like-kind property“; and
Recognition of the administrative burden required to detect and evaluate thousands of barters and swaps consummated each year.

The types of exchanges envisioned in 1921, which are extremely rare today, were the simple and straightforward two-party simultaneous exchanges in which the two parties simply swap property without the interposition of money. Today, the typical exchange involves at least four parties, namely (a) the Exchangor, (b) the Intermediary, (c) the buyer of the Relinquished Property the Exchangor is relinquishing in the exchange and (d) the seller of the Replacement Property the Exchangor is acquiring in the exchange.

The current version of Section 1031 of the Internal Revenue Code of 1986 provides for the deferral, but not the exclusion, of the recognition of any gain or loss on qualifying exchanges of the following types:

Two-party or multiple-party simultaneous exchanges;
Deferred or Starker exchanges; and
Reverse-Starker exchanges.

This handbook will primarily address real estate exchanges, but will also discuss personal property exchanges to the extent that they may be a part of a real estate exchange. Unless otherwise defined in this handbook, the initially capitalized terms contained herein are defined in Appendix B to this handbook.

Chapter II
Six+++ Things Real Estate Owners and
Their Advisors Should Know
About Like-Kind Exchanges

1. What is a like-kind exchange and what are the consequences of doing a like-kind exchange.? Simply put (or not so simply put), a like-kind exchange is the disposition of qualifying property, (“Relinquished Property“), and the acquisition of qualifying property, (“Replacement Property“), in (a) contractually interdependent transactions; or (b) as part of an integrated plan.

Section 1031 According to Congress. Section 1031(a) of the Code states that “[n]o 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.“
Tax Deferral Under Section 1031 is Mandatory, not Optional. If the requirements of Section 1031 of the Code are met, deferral of the tax on the gain recognized on the sale of the Relinquished Property or the deferral of the recognition of the loss on the sale of the Relinquished Property is mandatory, not optional.
Planning Note. In a down real estate market, the client may not want to qualify a transaction as a like-kind exchange so that the loss would be recognized, especially where the client has sufficient capital gains against which to offset the loss.
Section 1031 Generally Provides for Deferral of Tax not Exclusion of Gain from Income. Any tax on the gain recognized on the sale of the Relinquished Property or any loss recognized on the sale of the Relinquished Property is generally deferred until the Replacement Property is disposed of in a currently taxable transaction at a later date.
Planning Note. As will be discussed below in Sections 6.h. and i., it is possible to permanently avoid some or all of the tax on the sale of a Relinquished Property by either (i) holding the Replacement Property until the death of the Exchangor or (ii) converting the Replacement Property to the principal residence of the Exchangor.
What Property is Considered “Like-Kind“. For real estate exchanges, the definition of “like-kind“ is actually quite broad and qualifying property may include (i) raw land, commercial rental property, residential rental property, farm land and outbuildings and other commercial buildings and land, (ii) long term leases with a remaining life of over 30 years in property described in d.(i) and (iii) tenants in common interests in property described in d.(i). For example, you can exchange raw land for and apartment building or farm land for residential rental property so long as the other requirements of Section 1031 are met. However, as will be discussed below in Section 2.b.ii. in more detail, at the time of the exchange, the Relinquished Property and the Replacement Property must be held by the Exchangor either for (a) investment purposes or (b) productive use in a trade of business. Consequently, the Exchangor’s principal residence will not qualifying property but could be converted to qualifying property as discussed below.
Starker Exchange-Don’t Touch that Money! A sale by the Exchangor of the Relinquished Property and the subsequent reinvestment of the proceeds from the sale in the Replacement Property will not qualify as a like-kind exchange if the Exchangor has actually or constructively received the proceeds from the sale of the Relinquished Property, which means that steps must be taken prior to the closing on the sale of the Relinquished Property so that the sales proceeds are delivered by the buyer of the Relinquished Property directly to the Intermediary in order to accomplish the Starker like-kind exchange.
Reverse Starker Exchange-Don’t Touch that Property! Conversely, if the Exchangor wishes to acquire the Replacement Property before the Exchangor disposes of the Relinquished Property (this is generally referred to as a Reverse-Starker Exchange or Reverse Exchange), the title to the Replacement Property must be held by some unrelated third-party until the Exchangor disposes of the Relinquished Property, which means that steps must be taken prior to the closing on the purchase of the Replacement Property so that title to the Replacement Property is conveyed by the seller directly to the unrelated third party in order to accomplish the reverse like-kind exchange.
Are not Just Exchanging Equity. To defer paying the income taxes on the entire gain, the Exchangor must generally receive Replacement Property, the cost of which equals or exceeds the net sales price (total sales price less customary closing costs, which include attorneys’ fees, realtor’s commissions, grantor’s tax, and termite inspection, to name a few, but do not include the mortgage to be paid off at closing) of the Relinquished Property.
Receipt by Exchangor of Cash or other Non-Qualifying Property May Mean There Are Taxes to Pay. If the Exchangor receives cash or other non-qualifying property in an exchange, (generally referred to as “Boot“), the Exchangor will have to recognize gain on the sale of the Relinquished Property to the extent of the cash or non-qualifying property received in the exchange. Cash received in the exchange from the sale of the Relinquished Property can generally be netted against the cash paid by the Exchangor for the purchase of the Replacement Property from sources other than the exchange funds. Mortgages on the Relinquished Property can generally be netted against mortgages on the Replacement Property. The Exchangor’s tax advisors should carefully consider the Boot netting rules, which are fairly complicated, when Boot is part of an exchange.
Held for Productive Use in a Trade or Business or for Investment. Both the Relinquished Property and the Replacement Property must be “Held for Productive Use in a Trade or Business“ or (B) “Held for Investment“. Any of these properties which would be considered Dealer Property, Property Held Primarily for Sale or property held for personal use in the hands of the Exchangor at the time of the exchange would not qualify for a like-kind exchange. See the definitions of “Dealer Property“, “Held for Productive Use in Trade or Business“, “Held for Investment“ and “Other Property Held Primarily for Sale“ in Appendix B for a discussion of the factors to be considered in making this analysis

2. When do I do an exchange? The Exchangor should take the following steps in order to determine if a given series of transactions should be structured as a like-kind exchange:

Step 1-Calculate the magnitude of the federal and state income taxes to be deferred. The client’s tax advisor should determine (i) the magnitude of any gain to be recognized if the transaction were to be structured as a currently taxable sale and not a like-kind exchange and (b) the federal and state income taxes resulting from the recognition of that gain that could otherwise be deferred as a result of a like-kind exchange. In his analysis, the tax advisor should take into consideration the Exchangor’s marginal federal and state income tax rates as well as any depreciation which may have to be recaptured.
Step 2-Determine whether the transactions can legally be structured as an exchange. The client and his tax advisors should then determine whether the contemplated transactions could qualify as a like-kind exchange.
1. Personal Residence in an Exchange. For example, if the client wishes to sell his rental property and immediately reinvest the proceeds in a new personal residence, then a like-kind exchange would not work. Conversely, if the client wants to sell his principal residence and reinvest the proceeds in rental property, a like-kind exchange would not work. However, other rules contained in Section 121 of the Code may provide for an exclusion of the gain realized on the sale of the principal residence of up to $250,000 ($500,000 if married filing jointly), (“Section 121 Exclusion“).
  Planning Note. If the Exchangor wants to sell his qualifying Relinquished Property and is willing to reinvest the proceeds in qualifying Replacement Property as part of a like-kind exchange, he could later convert the Replacement Property into his principal residence a year or longer after its acquisition. Then, the Exchangor could sell the principal residence and qualify for the Section 121 Exclusion, so long as the Replacement Property is not sold within five years of the date of its purchase and the Exchangor otherwise qualifies for the Section 121 Exclusion.
2. Trade or Business or Investment Property. The client and client’s tax advisors should determine whether the Relinquished Property and the desired Replacement Property at all applicable times would, in the hands of the Exchangor, be considered (A) “Held for Productive Use in a Trade or Business“ or (B) “Held for Investment“.
Step 3-Analyze the costs, including attorneys’ fees, accountant’s fees, intermediary’s fees, etc, which would be incurred in an exchange. Attorneys’ fees alone can be anywhere from $2,000 on up depending on the complexity of the like-kind exchange. For even the simplest of exchanges, intermediary’s fees can be between $400 and $500. Other applicable fees and costs such as accountant’s fees, costs to establish an Exchange Accommodation Titleholder, appraisals, and recordation taxes, should be considered as well in evaluating the feasibility of doing a like-kind exchange.
Step 4-Evaluate whether an exchange is appropriate in light of the Exchangor’s investment objectives. The financial and investment plan of the client may dictate that the proceeds from the sale of the Relinquished Property should be invested in something other than qualifying real estate. For example, the client’s investment portfolio may be over-concentrated in real estate and the proceeds should therefore be invested in the stock or bond market. Also, for non-financial reasons, the client may not want to reinvest in real estate for the very simple reason he is tired of being a landlord.
Planning Note. Quite frankly, most Exchangors want cash out of the deal, regardless of whether they are doing a like-kind exchange of not. While this can generally be accomplished by properly structuring a loan to the Exchangor immediately after the exchange, care should be taken to insure that the client does not run afoul of the constructive receipt rules.
Step 5-Evaluate whether an exchange is appropriate for other reasons, including:
1. The age and health of the Exchangor. While not always the main consideration, the age and health of the Exchangor may dictate the need to do an exchange. A young person may decide to go ahead and pay some taxes now and do a taxable sale if he thinks he can get a higher after-tax return over time from a non-real estate investment. Conversely, an older person who is in poor health may decide he does not want to pay any taxes now and, because now may be a good time to sell the Relinquished Property, a like-kind exchange would enable him to pass real estate on to his children with a stepped-up basis, thereby avoiding the capital gains tax altogether.
2. The availability of sufficient acceptable Replacement Property. One of the major impediments to successfully completing a like-kind exchange is locating suitable replacement property, especially in the Central Virginia area. Investment properties are difficult to find and if the Relinquished Property has significant value, say over $1,000,000, the Exchangor may have to locate several properties (in some cases ten or more) to avoid receiving any Boot in the exchange. This challenge can be dealt with, in part, in the contract for the sale of the Relinquished Property by providing for a delayed closing to give the Exchangor more time to locate the Replacement Property, which can be purchased before or after the sale of the Relinquished Property. As a second alternative, the real estate brokerage market continues to evolve so that more and more high grade net lease commercial properties are available for purchase nationwide, either as a tenants in common interests or otherwise, regardless of where the Exchangor may live.
3. The need to dispose of the Relinquished Property for other tax and non-tax reasons. Due to (i) the age and condition of the property itself; (ii) the Exchangor’s relocation to another part of the country or (iii) other non-tax reasons, the Exchangor may have to sell the Relinquished Property and take advantage of a like-kind exchange.
Step 6-Communicate the desire to do a like-kind exchange to all necessary advisors. The Exchangor should then communicate his desire to do a like-kind exchange to his attorney, accountant, and realtor as soon as possible so that steps can be taken at all stages of the transactions to ensure the successful completion of the exchange.

3. What to look for in those to be involved in the exchange? Accountants, tax attorneys, real estate attorneys, intermediaries, realtors, and investment advisors may each be involved in an exchange. Care should be taken to choose professionals who have the competency to address the issues which may arise in the course of the like-kind exchange.

Attorneys. In selecting an attorney, the Exchangor should look for someone who is knowledgeable in the area of like-kind exchanges as issues ge In addition, the attorney will generally be asked to shepherd the client through the exchange and work with the client’s accountant, closing attorney, if a separate closing attorney is to be used, and the Intermediary to insure that all of the legal requirements have been met to accomplish an exchange.
Accountants. The client’s accountant should be called upon initially to run the numbers to determine whether a like-kind exchange is appropriate and after the fact to properly report the exchange to the IRS on the Exchangor’s tax return.
Intermediary. Generally, the attorney will assist the client in locating the Intermediary or Exchange Facilitator which could be (i) the attorney, if he has not provided other legal services to the client within the last two years, (ii) a title company, even if the title company has issued a title policy to the Exchangor in the past, (iii) a bank, or (iv) some other company organized to serve as an Exchange Facilitator. In selecting the Exchange Facilitator, the Exchangor should determine whether the Exchange Facilitator (i) will segregate the exchange funds to the extent necessary to protect the funds from creditors; (ii) has an adequate surety bond; (iii) pays interest to the Exchangor on the exchange funds; (iv) can move the exchange funds where needed in a timely fashion; and (v) fully discloses ifs fee schedule. Please see the definition of Exchange Facilitator in Appendix B.
Realtor. The realtor should at least have a basic understanding of the legal requirements for a like-kind exchange to better assist the client from the listing of the Relinquished Property for sale in a forward exchange or contracting for the purchase of the Replacement Property in a reverse-exchange all the way through the exchange process.

4. Different Types of Exchanges. There are many ways to structure a like-kind exchange and they may involve two, three, four or more parties and they range from quite simple to very complex. Following are four of the most common types of exchanges:

The Two-Party Simultaneous Exchange. The two-party exchange, or swap, is the purest and simplest form of exchange. Two-party exchanges are quite rare, since in the typical exchange the buyer of the Relinquished Property is not the seller of the Replacement Property. As the name implies, only two parties are involved and they simply exchange their properties simultaneously. Title to the Relinquished Property is conveyed by the Exchangor to the buyer and title to the Replacement Property is conveyed by the seller to the Exchangor.
The Simultaneous Exchange with Intermediary. Some times the buyer of the Relinquished Property or the seller of the Replacement Property is not willing to act as an accommodation party and risk the possibility of owning unwanted property should the exchange fail. In such a case, the Exchangor will have to employ the services of an Intermediary who will serve as a straw man or facilitator. Quite frankly, it is generally more desirable to limit the involvement of the seller of the Replacement Property and the buyer of the Relinquished Property and use an Intermediary in all exchanges. In a simultaneous exchange with an Intermediary, the Exchangor assigns to the Intermediary his rights in the contract to sell the Relinquished Property as well as his rights in the contract to purchase the Replacement Property. At the direction of the Intermediary, title to the Relinquished Property is transferred by the Exchangor to its buyer at closing and title to the Replacement Property is simultaneously transferred by its seller to the Exchangor. Cash received by the Intermediary from the buyer of the Relinquished Property is transferred to the seller of the Replacement Property. Please note that very rarely will an Intermediary want to take actual title to the property unless an Exchange Accommodation Titleholder is used.
The Deferred Exchange with Intermediary (Starker Exchange).
1. The Typical Exchange. The deferred or Starker Exchange is the most common type of exchange as the Exchangor generally does not know what property he wants to acquire by the date on which he is required to close on the sale of the Relinquished Property. The structure of the deferred exchange with intermediary is basically the same as the same as the simultaneous exchange with an intermediary except that the closing on the sale of the Replacement Property from its seller to the Exchangor occurs some time after the closing on the sale of the Relinquished Property to its buyer.
2. Deadlines. From the date of the closing on the sale of the Relinquished Property, the Exchangor has 45 days to identify to the Intermediary the Replacement Property (“Identification Period“). The Exchangor must receive the Replacement Property by the earlier of (A) 180 days to from the date of the sale of the Relinquished Property or (B) the due date, including extensions, for the Exchangor’s federal income tax return (“Exchange Period“).
3. Number of Properties which can be Identified. Generally, the Exchangor can identify (i) up to three Replacement Properties without regard to their value; or (ii) any number of Replacement Properties so long as the combined fair market value of all of the properly identified Replacement Properties does not exceed 200% of the combined fair market value of all of the Relinquished Properties; or (iii) any number of Replacement Properties so long as the Exchangor closes on the identified Replacement Properties whose combined fair market value is at least 95% of the combined fair market value of all of the properly identified Replacement Properties by the end of the Exchange Period. “Fair market value“ does not take into consideration any liabilities secured by the property.
4. No Extensions Allowed. The Identification Period and Exchange Period cannot be extended and the last day for performance may fall on a Saturday, Sunday, or a legal holiday.
5. Multiple Relinquished Properties. When there are multiple Relinquished Properties and they are transferred at different times as part of the same deferred exchange, the Identification Period and Exchange Period begin on the date of the earliest transfer.
6. Revocation of Designation of Replacement Property. The designation of any property as Replacement Property can be revoked at any time during the Identification Period by a written document executed and delivered in the same manner as required for the original notice.
The Reverse-Starker Exchange with Intermediary and EAT. Becoming increasingly popular after the issuance of Rev. Proc. 2000-37 by the IRS, Reverse-Starker exchanges involve the purchase of the Replacement Property before the sale of the Relinquished Property. The Exchangor would still enter into an exchange agreement with the Intermediary with the exception of the fact that title to the Replacement Property would be transferred by the seller to an Exchange Accommodation Titleholder, which would generally be a single-member limited liability company wholly owned by the Intermediary. See Appendix C for Rev. Proc. 2000-37 which provides a safe harbor for completing a reverse-Starker exchange and Appendix D for Rev. Proc. 2004-51 which modified Rev. Proc. 2000-37 to exclude from its safe harbor certain property previously held by the Exchangor.

5. Steps to take to document and otherwise carry out the average like-kind exchange!!! The client and his advisors need to do the following:

Step 1-Ascertain Status of Title to Relinquished Property and any Related Party Issues. Exchangor should confirm with his attorney that title to the Relinquished Property is held, for tax purposes, in the name of the Exchangor. See the discussion below about what to do if the Relinquished Property is held by an entity and must be deeded in whole or in part out to the Exchangor. Also determine whether there are any related party issues that would jeopardize the exchange under Section 1031(f) of the Code and plan around those issues. For example, the Exchangor may need to (i) wait additional time before selling the Relinquished Property to allow the two-year period set forth in Section 1031(f) to expire where Exchangor acquired the Relinquished Property from a related party in a like-kind exchange or (ii) ascertain that an exception to the related party rules under Section 1031(f)(2) is available, the most common of which is that the prior exchange did not have as one of its principal purposes the avoidance of Federal income tax.
Step 2-Listing Agreement Stage. As early as the listing of the Relinquished Property for sale in a Forward Exchange or the negotiation of a contract for the purchase of the first Replacement Property in a Reverse Exchange, the Exchangor and his realtor must plan for the like-kind exchange to ensure that (i) the Exchangor has sufficient time to complete each stage of the exchange and (ii) all agreements entered into, and documents executed, in connection with the exchange properly document the exchange.
Step 3-Exchange Agreement. The Exchange Agreement between the Exchangor and the Intermediary should be prepared or reviewed by the attorney even though the form may, in many cases, be provided by the Intermediary. The Exchange Agreement must be executed by the Exchangor and the Intermediary prior to closing on the sale of the Relinquished Property in a Forward Exchange or within five business days after qualified indicia of ownership of the first Replacement Property is conveyed to the Exchange Accommodation Titleholder in a Reverse Exchange.
Step 4-Contract for sale of Relinquished Property or purchase of Replacement Property, containing cooperation clause. All contracts for the sale of Relinquished Property or the purchase of Replacement Property, including all addendums and amendments, should be reviewed by the Exchangor’s attorney even though prepared by others. Language should be included in these contracts which (i) references the fact that the Exchangor is intending for the transaction to be part of a like-kind exchange; (ii) requires the other party to cooperate with the Exchangor in accomplishing a like-kind exchange, which generally will not delay closing or result in any additional expense to the other party; (iii) permits the Exchanger to assign the Exchangor’s interest in the contract to either an Intermediary or an Exchange Accommodation Titleholder; and (iv) if tangible personal property or other non-qualifying property is a material part of the transaction, separately allocates a portion of the purchase price to that non-qualifying property and separately accounts for portion of the purchase price allocated to the non-qualifying property.
Step 5-Assignment of contracts and notice thereof to other party. All contracts must be assigned to the Intermediary prior to closing and notice of the assignment must be delivered to the other party to the transaction prior to closing.
Step 6-Deed Language. Language should be included in all deeds referencing the exchange as consideration in addition to the monetary consideration for the real estate only (excluding portion of purchase price allocated to personal property)
Step 7-Closing Statement. The closing statement for all transactions should contain language referring to Exchangor as the seller or buyer, as applicable, and should be reviewed by the attorney to insure that only expenses related to the closing are reflected on the closing statement.
Step 8-Real Estate Taxes and Other Prorated Items and Security Deposits. Payment of Exchangor’s share of pro rated real estate taxes and rents as well as all security deposits should be made outside of closing to the other party to the contract to avoid Boot problems.
Step 9-W-9 Form. The attorney for the Exchangor will generally be required to complete the IRS Form W-9 necessary to provide the Exchangor’s taxpayer identification number to the Intermediary or Exchange Facilitator prior to closing on the first transaction in the exchange.
Step 10-Bill of Sale. For the sale of personal property, a bill of sale should be used to convey any personal property pursuant to the contract. As discussed above, there should be an allocation in the contract or addendum of a portion of the purchase price to any tangible personal property or other non-qualifying property being conveyed pursuant to the contract.
Step 11- Identification of Replacement Property or Relinquished Property, as applicable. The identification of the Replacement Property in a Forward Exchange or the Relinquished Property in a Reverse Exchange must be in writing and signed by the Exchangor and hand delivered, mailed, or faxed to the Intermediary before the end of the Identification Period. The identification must be unambiguous and can identify the property by street address or distinguishable name. See Section 4.c above for more information on the identification of Replacement Property or Relinquished Property, as applicable.
Step 12-Convey property in a timely manner. Convey all Replacement Property to Exchangor in a Forward Exchange or all Relinquished Property to their buyers in a Reverse Exchange within the Exchange Period.
Step 13-Tell the Accountant about the Like-Kind Exchange. Send the Exchangor’s accountant copies of the exchange documents right away so that the accountant can (i) properly report the exchange on the Exchangor’s income tax return for the year of the sale of the Relinquished Property on IRS Form 8824 and (ii) file an extension request for the Exchangor’s tax return to the extent necessary to maximize the length of the Exchange Period.

6. Other Special Issues in an Exchange.

Residence or other Non-Qualifying Property Involved in an Exchange. When non-qualifying property is involved in an exchange, such as a principal residence in a farm sale, the tax advisors will have to make a reasonable allocation of a portion of the purchase price to the non-qualifying property and a portion to the qualifying property. This allocation should be reflected in the contract for the sale of the property or an amendment to that contract. While an appraisal would be ideal, an allocation based on tax assessments would generally be considered reasonable if agreed to by both parties. With respect to a farm sale, the tricky part is determining how much land should be allocated to the residence. There is no definitive answer to this question and you will have to examine the facts in each case to determine how much land is actually being used for residential purposes and how much for farming purposes. The IRS and courts have allowed up to twenty acres in certain cases.
Multiple Relinquished Properties. If there are multiple Relinquished Properties involved in the same deferred exchange, keep in mind that the Identification Period and Exchange Period start to run on the date of the first sale. If there will be more than one Relinquished Property, consider separate exchange agreements for each property so that the IRS will treat each disposition as a separate exchange.
Difficulty in Locating Replacement Property. If the Exchangor is having a difficult time locating suitable Replacement Property, he may want to consider a tenants in common interest in large shopping centers, apartment complexes, and office buildings currently being marketed by investment advisors. These types of investments are considered securities and are regulated accordingly. Care should be taken to ensure that such ownership interests will be considered real estate and not partnership interests by the IRS. In addition, the Exchangor would have to be willing to allow someone else to manage the Replacement Property in order to consider this option.
Related Party Exchanges. While related party exchanges are permissible, if the Replacement Property is disposed of within two years of its acquisition, the exchange may be blown where the Exchangor or the related party is attempting to replace the low basis in a property we will call property A with the higher basis in a property we will call property B and then sell property A soon thereafter at a lower gain that the party would otherwise be entitled to. See the detailed rules in Appendix A.
Build-to Suit-Exchanges.
1. Seller or Intermediary to Construct Improvements. If improvements are to be constructed on the Replacement Property, either the seller of the Replacement Property or the Intermediary should construct the improvements prior to the transfer of the Replacement Property to the Exchangor.
2. May Delay Exchange. Be careful, adding the construction aspect to the exchange can in many cases push the envelope with respect to the receipt of the Replacement Property by the Exchangor by the end of the Exchange Period. Remember, there are no extensions available to extend the 180-day deadline for the Exchange Period.
3. Identification of Improvements. Where the Replacement Property will consist of improvements to be constructed by the seller or the Intermediary prior to Exchangor’s receipt, the improvements to be constructed must be identified in as much detail as is practicable. Further, upon receipt, the improvements must be substantially the same as those identified. The improvements will be considered “substantially the same“ only if (A) the improvements constitute real property under local law, and (B) had construction been completed on or before the receipt date, the improvements would have been considered to be substantially the same property as identified. Treas. Regs. Section 1.1031(k)-1(e)(3)(iii).
4. Construction of Improvements-The Wrong Way. Any construction of improvements occurring after the Replacement Property is received by the Exchangor is considered boot. Treas. Regs. Section 1.1031(k)-1(e)(iv).
5. Use a single-member LLC to Hold Title While Constructing Improvements. If improvements are to be constructed as part of either a deferred exchange or reverse exchange, a single-member limited liability company, (“Exchange Accommodation Titleholder“ or “EAT“), owned solely by the Intermediary, may have to be formed to take title to the Replacement Property during construction should the seller or Intermediary not wish to hold or take title thereto. The EAT should then contract for the construction of the improvements, generally with the Exchangor (i) guaranteeing the construction contract and (ii) to the extent necessary, loaning the funds to the EAT necessary to complete the construction. In such a case, the Exchangor will also have to loan the EAT the funds necessary to pay for real estate taxes, insurance, and other costs of maintaining the property while it is being held by the EAT.
6. Property held by Partnership or other Entity. If some, but not all, of the owners of the entity are not interested in doing a like-kind exchange, care should be taken so that the applicable percentage ownership interest in the Relinquished Property is timely conveyed to the owner who is interested in participating in a like-kind exchange. By the word “timely“ I mean both (i) prior to the negotiation and execution of any contract for the sale of the Relinquished Property and (ii) well in advance (months not days, hours or minutes) of the closing on the sale of the Relinquished Property, so that the Exchangor will be deemed to have owned and held the Relinquished Property for a qualifying purpose.
7. Mortgages on Replacement Property-Wait for the Cash. Many people want to get some cash out of a like-kind exchange. The best way to do this is to obtain a loan secured by the Replacement Property, but only fund that loan at the closing on the purchase of the Replacement Property to the extent necessary to close on that purchase after exhausting the exchange funds. Then, after the closing on the purchase of the Replacement Property, have the lender fund all or part of the remaining balance of the loan amount which the Exchangor can use however the Exchangor wants.
8. Avoid Capital Gains Tax by Converting the Replacement Property to Principal Residence. The Exchangor may be able to convert the Replacement Property to his principal residence and take advantage of the $250,000 ($500,000 for married taxpayers filing joint returns) exclusion available upon the ultimate sale of the Replacement Property under Section 121 of the Code so long as the Exchangor has (i) held the Replacement Property at least five years from the date of its acquisition as required under Section 121(d)(10) of the Code and (ii) has met the other requirements of Section 121 of the Code.
9. Avoid Capital Gains Tax by Holding Replacement Property Until Death. The Exchangor may be able to avoid the capital gains tax altogether on the capital gains that have built-up over the life of the Exchangor by holding the Replacement Property until the death of the Exchangor, at which time the Exchangor can devise the Replacement Property to his intended beneficiaries who will then receive a step-up in the basis of the Replacement Property to its fair market value on the date of the death of the Exchangor under Section 1014 of the Code.