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Tax-Deferred Exchanges Under 1031 Internal
Revenue Code
Derrick M. Tharpe
NET
LEASED PROPERTIES HELP DRIVE THE POPULAR 1031 EXCHANGE
MARKET
Jonathan W. Hipp
Single tenant investments (and NNN or triple net leased,
investments) are gaining widespread appeal among 1031 investors
because of the fact that these investments are not management intensive.
Investors are discovering that single tenant net leases deliver
a predictable income stream over the term of the lease. These investments
can be purchased from $500,000 to $100 million depending on whether
you are looking for a single asset or a portfolio.
Single tenant properties are suitable for ownership
by pension funds, REITs and individual investors. The characteristics
to consider when purchasing these properties are the following:
Convertibility: Investment risk can be minimized if the space
can be used by another company in its current use or retrofited
at a reasonable cost. This issue is generally more of a concern
for the investors purchasing highly specialized properties.
Location: The property should be located in and among other
similar properties in that market. The market should also provide
a strong assurance that other identifiable users would have an interest
in the property. The most important factor is that the property
be positioned in the path of growth for the local market.
Lease Terms: The property's lease should allow the investor
to pass through to the tenant all expenses for the property's operation
and maintenance. This would include the tenant paying the following:
taxes, insurance, utilities, common area maintenance and repairs.
This provides the investor/owner a predictable income stream free
from uncertainties.
Credit Worthiness: The investor price should reflect the
tenant's ability to meet the terms of the lease. It is important
that the cap rate be reflective of the risk that the buyer is willing
to assume because of the direct relationship between net income
and purchase price.
The higher the risk of the tenant not being able to
meet the lease terms, the higher the acquisition cap rate must be.
Although tenant credit risk is always an issue when investing in
commercial real estate, an investor's active underwriting can help
to minimize the credit risk.
What's in store for 2001?
2000 was a strong year for the entire real estate industry,
including the net lease market. It is my opinion that 2001 will
be another exciting year provided that we don't have a spike in
interest rates.
The biggest problem we could experience is lack of
product, not lack of demand for it. Retail has been one of the biggest
players in the net lease market and investors like the comfort of
driving up and down Main Street to view their investments.
The net lease market has expanded dramatically in
the last five years. This is primarily due to the explosive growth
of the economy. However, corporations have also realized that a
7 to 9 percent return in real estate can be greatly increased by
using that money to expand their business.
As the economy goes through its ups and downs, the
net lease business will continue to thrive. Cap rates will simply
fluctuate to compensate the investor for the perceived risk of the
economy, tenant or real estate, but deals will happen.
Jonathan W. Hipp is senior vice president of Grubb
& Ellis of Metropolitan Washington, D.C.
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The concept of the tax-deferred exchange is quite simple: If a taxpayer
exchanges current property for like-kind replacement property there is
no immediate tax consequence resulting from the transaction. Any realized
gain is deferred until the eventual sale of the replacement property.
However, the Internal Revenue Service has imposed mechanical requirements
on the execution of a 1031 Exchange, which must be strictly adhered to
if the taxpayer is to achieve a successful tax-deferred exchange.
Exchange Basics
Under 1031 of the Internal Revenue Code a taxpayer may exchange property
currently held for investment or productive use in a trade or business,
for similar or like kind property. If the exchange of property is carried
out consistent with the provisions of 1031 then the taxpayer will receive
a deferral of the capital gains tax associated with the transfer. The
legislative rationale that forms the basis for tax-deferred exchanges
is that the exchange of an asset for a similar asset of equal or greater
value represents a continuity of investment which should not be taxed
at the time of the exchange.
The 1031 tax-deferred exchange is not a new concept. In fact, the earliest
guidance was set forth in 1921, and, although establishing the initial
framework for the conduct of an exchange, these regulations left many
issues central to a tax-deferred exchange unresolved. As a result, taxpayers
exercised, and the Courts accommodated, wide latitude in structuring various
exchange transactions. However, as a result of the landmark legal decision
in Starker v. Commissioner, basic guidelines were established which made
exchange opportunities much more practical for the taxpayer. Thereafter,
through the Tax Reform Act of 1984 and subsequent 1991 Treasury Department
Regulations, rules were adopted which imposed the mechanical requirements
that define the current structure of 1031 exchanges, including the "Safe
Harbor" rules as well as the 45 day identification period and 180 day
replacement period.
Qualified Exchange Properties "Held For" Requirement
In determining the viability of a 1031 exchange transaction,
the taxpayer must first determine whether the properties to be exchanged
will meet the qualified purpose requirement of 1031. Pursuant to 1031(a)(2),
property will not be eligible for non-recognition treatment unless it is
held by the taxpayer for use in a trade or business, or for investment.
However, neither 1031 nor the regulations define the terms "held for
productive use in trade or business" or "held for investment." Therefore,
the determination as to whether the property is held for a qualified purpose
is a question of fact, and is to be determined at the time the exchange
takes place. As such, the prior or subsequent use of either the relinquished
or replacement property in the hands of another party is immaterial to
the exchange.
It should also be noted that the taxpayer has the burden of proof in
establishing that the property has been held for a qualified purpose.
Although not determinative, an important consideration in evaluating whether
the exchange property meets the qualified purpose requirement is the amount
of time which the property has been held by the taxpayer. While there
is no specific holding period for either the relinquished or replacement
property, the longer the property has been held the more likely the taxpayer
will be able show the requisite purpose.
The Like-Kind Requirement
Under 1031, the property which the taxpayer intends to exchange must be
"like kind" to the replacement property the taxpayer plans to acquire. In
the context of a tax-deferred exchange, "like kind" refers to the nature
or character of the property, not its grade or quality.
The regulations further provide that both real property and personal
property may be exchanged. However, the distinction as to whether the
property to be exchanged is real or personal property is critical, as
real property is not like-kind to personal property. Additionally, the
definition of like kind is much more restrictive for personal property
transactions. Generally, the determination as to whether the property
to be exchanged is either real or personal property, is based upon the
law of the state in which the property is located.
• Real Property As to the exchange of real
property (or real estate), the regulations are extremely broad, and provide
that, as a general rule, all real property is like kind as to all other
real property. For example, improved real property is like kind with raw
land, and, an apartment complex is like kind with a retail shopping center.
As such, like kind is not defined by the value of the real estate to be
exchanged, but rather it is established by the underlying character of
the property.
• Personal Property Although many tax professionals
are familiar with the use of 1031 exchanges upon the disposition of highly
appreciated real estate, the tax-deferred exchange of personal property
has been relatively underutilized. However, the disposition of personal
property, due to the accelerated depreciation of assets, often presents
a valuable opportunity for 1031 exchanges.
While the definition of like kind for real property is very broad, the
like kind requirement for personal property is much more specific. 1031
contains a "like-class" safe harbor for the exchange of most types of
personal property. Under this "like class" safe harbor, personal property
may qualify as like kind if the properties to be exchanged are within
the same "General Asset Class", or the within the same "Product Class",
as defined by the Standard Industrial Classification Manual. However,
personal property which does not qualify under the like class safe harbor
may still qualify for Internal Revenue Code 1031 treatment if the taxpayer
can demonstrate that the properties to be exchanged are in fact like kind.
Ineligible Properties
Despite the flexibility offered by 1031, certain properties are ineligible
for like kind exchange treatment. These properties include:
• Stock in trade or other property held primarily
for sale (Inventory);
• Stocks, bonds or notes;
• Other securities or evidence of indebtedness;
oPartnership Interests;
• Certificates of trust or beneficial interests,
and
• Choices in action.
Qualified Intermediary
Role of Qualified
Intermediary
A 1031 tax-deferred transaction is defined
by the exchange of property for other like kind property. However, if a
taxpayer receives the proceeds from the sale of the relinquished property
prior to acquiring the replacement property, the transaction will constitute
a sale and not qualify as a tax-deferred exchange. Therefore, the central
element in structuring a deferred exchange is the avoidance of actual or
constructive receipt of the sale proceeds (or "boot") by the taxpayer. According
to the regulations the taxpayer is in receipt of the funds if taxpayer receives
the economic benefit of the money; or when the funds are credited to the
taxpayer's account, set apart for the taxpayer, or otherwise made available
so that the taxpayer may draw upon the proceeds.
To assist the taxpayer in avoiding actual or constructive receipt of
the proceeds from the sale of the property, the 1991 regulations provided
newly defined "Safe Harbors" for the conduct of 1031 exchanges. Through
the establishment of these safe harbors, the regulations provided taxpayers
with mechanisms which, if followed, would preclude a determination by
the IRS that the taxpayer is in actual or constructive receipt of money,
boot or the other proceeds from the exchange. The safe harbors provided
by 1031 are:
• security or guarantee arrangements
• qualified escrow
• qualified intermediaries
• growth factors & interest.
The most significant safe harbor created by the 1991 regulations is that
for qualified intermediaries. A qualified intermediary ("QI") is an independent
third party who is designated by the taxpayer to receive the proceeds
from the sale of the taxpayer's relinquished property. Following receipt
of the funds, the QI will continue to hold the proceeds throughout the
entire term of the exchange. As a result of this direct conveyance of
funds to the QI, the taxpayer is able to avoid constructive receipt of
the proceeds from the relinquished property sale. At present, the regulations
regarding the use of a QI are clear and sufficiently generous to allow
a high degree of flexibility in structuring transactions so that most
tax-deferred exchanges are currently conducted using a QI.
In selecting a qualified intermediary, the taxpayer should be aware that
certain persons may be disqualified from acting as the Intermediary. Most
notably, any person who has acted as the taxpayer's employee, attorney,
accountant or real estate broker/agent within the two years preceding
the exchange may not act as the Intermediary.
The Exchange Agreement
To effectuate a 1031 exchange using the qualified
intermediary safe harbor, the taxpayer and the Intermediary must enter
into an exchange agreement prior to the sale of the relinquished property.
The exchange agreement defines the QI/taxpayer relationship and must
set forth the procedures, consistent with the terms of the 1031(k)-1,
for accomplishing a like kind exchange through the use of an intermediary.
Most notably, the exchange agreement must specifically limit the taxpayer's
right to receive, pledge, borrow or otherwise obtain the benefits of the
relinquished property sale proceeds prior to the expiration of the exchange
period.
Upon execution of the exchange agreement the taxpayer must also assign
all rights and duties under the relinquished property sales contract to
the Qualified Intermediary. Thereafter, upon the sale of the relinquished
property, the proceeds from the sale are forwarded to the QI. The QI will
then hold these proceeds until the taxpayer's acquisition of the replacement
property. Prior to the acquisition of the replacement property, the taxpayer
must also assign the replacement property purchase contract to the QI.
The QI will then transfer the proceeds to the seller of the replacement
property to complete the 1031 exchange. Because the proceeds from the
relinquished property sale are held by the Qualified Intermediary throughout
the exchange process, the taxpayer is deemed not to be in constructive
receipt of the proceeds.
Despite the fact that the QI receives an assignment of both the relinquished
property sales contract and the replacement property purchase contract,
the regulations do not require the QI to take legal title to the properties
involved in the exchange. Rather, the regulations provide that the relinquished
property may be directly conveyed to the buyer, and the seller may directly
convey the replacement property to the taxpayer. This mechanism of "direct
deeding" has become the preferred method of undertaking an exchange as
it allows the taxpayer to avoid duplication of costs associated with the
closing and transfer of property.
1031 Time Limits
Pursuant to IRC 1031, there are strict time limits imposed upon all tax-deferred
exchanges. Following the transfer of the relinquished property which the
taxpayer intends to exchange, the taxpayer then has 45 days to identify
the replacement property and 180 days to actually purchase the property.
Both the 45 and 180 day time periods are calculated from the date upon
which the taxpayer transfers the relinquished property. If there are multiple
transfers of relinquished property, the respective time periods begin
to run on the date of the earliest transfer.
Identification Period
Under IRC 1031, the taxpayer must identify the replacement property within
45 days after the transfer of the relinquished property. The identification
of the replacement property must be in writing and must be delivered to
the appropriate party, usually the qualified intermediary, prior to the
expiration of the 45 day period. If, however, the taxpayer completes the
acquisition of the replacement property prior to the expiration of the
45 day identification period, there is no need to designate the property
in a written document.
Replacement Period
IRC 1031 requires that the taxpayer must complete the
purchase of the replacement property before the earlier of:
• 180 days following the transfer of the
relinquished property: or
• The due date of the taxpayer's tax return
for the year in which the transfer of the relinquished property occurred.
Therefore, if the taxpayer's return is due prior to the expiration of
180 days, the taxpayer will have less than 180 days to close on the replacement
property, unless he or she requests an extension for filing the return.
For example, if the relinquished property closing occurs on December
1, 2001, the Taxpayer will have 45 days within which to identify the replacement
property. However, if the due date for his or her individual tax return
is on April 15, 2001, this is prior to the expiration of the 180 day period.
Therefore, the taxpayer must acquire the replacement property on or before
April 15, 2001 or obtain an extension for filing his or her return.
Strict Compliance
When considering a 1031 exchange, the taxpayer should be
aware that there are no exceptions to these deadlines. The 45 and 180 day
time periods terminate on exactly midnight of the respective dates, and
are calculated without regard to weekends or holidays.
Identification of Replacement Property
As stated previously, following the transfer of the relinquished property,
the taxpayer has 45 days to provide written identification of the replacement
property which he or she intends to purchase to complete the exchange.
As to the nature of the identification required, 1031 requires the written
identification to "unambiguously" describe the replacement property to
be acquired. The regulations provide three examples of unambiguous descriptions
of real property:
• Legal description; or
• Street address; or
• A distinguishable name.
For an exchange of personal property, the regulations require a specific
description of the particular type of property. The example provided by
the regulations indicates that for a truck, the identification should
include the specific make, model and year.
For the taxpayer, careful preparation and review of the written identification
is essential. If an improper identification is submitted, it may be determined
that the taxpayer failed to acquire substantially the same property as
he or she identified, thereby eradicating any taxable benefit of the exchange.
Identifying Multiple or Alternative Properties
For purposes of a 1031 like-kind exchange , a taxpayer may also identify
multiple or alternative replacement properties. However, 1031 imposes
mechanical, and oftentimes confusing, limitations on the number of properties
which may be identified. Pursuant to the regulations, the maximum number
of replacement properties which may be identified are set forth in the
following rules.
• Three Property Rule
The taxpayer may identify three replacement properties without regard
to the fair market value of the properties.; or
• 200 Percent Rule
The taxpayer may identify any number of replacement properties limited
by the total fair market value not to exceed 200 percent of the fair market
value of all relinquished properties valued as of the date they are transferred
by the taxpayer.
However, if the taxpayer violates both the 200 percent rule and the three
property rule, the taxpayer is deemed not to have identified any replacement
property, with two exceptions:
• Any property received
within 45 days following the sale of the relinquished property
will qualify for 1031 treatment; and
• If the fair market value of the replacement
property actually received by the taxpayer is at least 95 percent of the
total fair market value of all identified replacement properties.
Tax-deferred exchanges are intended to allow business owners, individuals,
and corporations to transfer the full value of one asset or group of assets
to another of like-kind without currently paying capital gain taxes on
the transaction. While conceptually the rules for a successful 1031 transaction
appear clear, the taxpayer should seek the advice of his or her tax counsel
to determine whether, given the particular property and the current tax
situation, it would be favorable to consider a tax-deferred exchange transaction.
Tax-deferred exchanges are highly regulated and both taxpayers and tax
advisers should use due care in exchange matters and adhere to the Regulations
to the greatest extent possible.
Derrick M. Tharpe is an Exchange Specialist with Wachovia Exchange
Services, Inc., in Winston-Salem, North Carolina.
©2001 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints of
this article contact Barbara
Sherer at (630) 554-6054.
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