Rauschenberger

Section 1031 of the Internal Revenue Code provides for the non-recognition of gain (and loss) on the disposition of property if that property is exchanged for property of a like kind. Such a simple concept is, unfortunately, very complex in practice, requiring thousands of words in statutory provisions and regulations and hours of analysis by taxpayers and their advisors. After providing an extremely brief summary of exchanges and key terminology, this article will discuss some of legal considerations that contribute to the complexity and hours required.

Summary of Exchanges and Key Terminology

A like-kind exchange occurs when someone (called the “exchangor”) sells property (called the “relinquished property”) to another and receives like-kind property (called “replacement property”) in return. The exchangor receives a basis in the replacement property equal to the basis of the relinquished property. If property that is not like-kind to the relinquished property is received, gain is recognized to the extent of such property.

As a general rule, the odds of finding someone who has the very property that an exchangor wants in return for the relinquished property at the very time that the exchangor wants to sell the relinquished property are worse than the odds of finding the proverbial needle in a haystack. This reality led to a number of techniques and structures that initially were not “admired” by the IRS and, therefore, caused heartburn for taxpayers and their advisors. Fortunately, many have now been authorized either by statute, regulation or other IRS guidance. One is the use of a qualified intermediary (QI) that contracts with the exchangor to facilitate an exchange. Another is the use of deferred exchanges, whereby the relinquished property is sold first and the replacement property is not acquired until later. The IRS also has blessed reverse exchanges whereby an exchangor can acquire the replacement property before disposing of the relinquished property.

Selected Legal Considerations

The following is a discussion of some of the legal considerations associated with structuring an exchange.

QIs and Contracts for Sale of the Relinquished Property and Purchase of the Replacement Property — Permitting Assignment to the QI

When a QI is used to facilitate an exchange, a “fiction” is created whereby the exchangor is deemed to have sold the relinquished property to the QI and acquired the replacement property from the QI even though the QI doesn’t even hold title to either property. To qualify for that “fictional” treatment, the QI must be assigned the exchangor’s rights under the contract to sell the relinquished property and any contract for the purchase of the replacement property. At the closing of the sale of the relinquished property, title can be transferred directly from the exchangor to the ultimate purchaser. Similarly, title to the replacement property can go directly from the seller to the exchangor.

The exchangor often will enter into the contract to sell the relinquished property and/or acquire property that could be replacement property before a QI has been retained or a decision has even been made about whether to structure the transaction as an exchange. The contract for the sale of any property that might be relinquished property should give the seller the ability to assign its rights under the contract to a QI to permit the seller to structure the sale as an exchange. The seller can remain liable for all representations, warranties and other obligations under the contract without jeopardizing exchange treatment. But the contract should give the seller that assignment right without the need to get approval from the purchaser.

A similar provision-enabling assignment to a QI is perhaps even more important in a contract for the purchase of any property that could be replacement property. The purchaser can remain liable to the seller in making such an assignment without jeopardizing the ability of the property to be replacement property. Without such authority in the contract, however, the seller’s approval may be necessary and such approval may not be obtained, particularly if another prospective buyer is waiting in the wings offering a higher price than set forth in the original contract.

QIs and exchange agreements

The IRS requires that there be a written exchange agreement between the exchangor and QI before the exchangor sells the relinquished property. The terms that are needed to comply with IRS requirements are quite basic. The exchange agreement must:

• specify that the QI will be assigned the rights of the exchangor under the contract for sale of the relinquished property and any contract for the purchase of the replacement property,

• specify the mechanics for the exchangor identifying replacement property and for closing and transferring title to the relinquished property and the replacement property, and

• limit the exchangor’s right to receive cash proceeds from the sale of the relinquished property to situations and times that satisfy IRS requirements.

Every QI has a “form” exchange agreement that it will present to a prospective exchangor to sign. While the provisions of such exchange agreements are designed to comply with IRS requirements, there are many other aspects of the relationship between the exchangor and the QI that are not dictated by compliance with IRS requirements but nonetheless should be carefully reviewed and negotiated. Among the matters that should be considered/addressed are the following:

Fees and Expenses. Every QI has a fee schedule and no two fee schedules are alike. Fee schedules, like purchase prices, are always open to negotiation — if you ask. The exchangor should be certain that the amount and manner for calculating the fees are fixed and certain, not open-ended or subject to adjustment by the QI. Exchange agreements will obligate the exchangor to reimburse the QI for all expenses incurred by the QI. Controls/ restraints should be imposed for such reimbursement of QI expenses (such as prior approval of the exchangor) or the exchangor may find some surprises when its account with the QI is finally settled. The exchange agreement should also specify that the QI is not authorized to expend any amounts for the acquisition of replacement property without prior authorization from the exchangor.

Exchange Equity Held by the Qualified Intermediary. In a deferred exchange, the QI will receive the proceeds from the sale of the relinquished property (called the “exchange equity”) and hold the exchange equity pending disbursement to acquire replacement property. Except for being used by the QI to purchase replacement property, the exchange equity generally cannot be made available to the exchangor until (a) 45 days after the sale of the relinquished property, if no replacement property is identified within the 45-day identification period required by the Code; (b) acquisition of all replacement property to which the exchangor is entitled under the exchange agreement; or (c) 180 days after the sale of the relinquished property — the maximum period permitted by the Code for acquiring replacement property in a deferred exchange. The IRS permits the exchangor to receive an interest or growth factor on the exchange equity without jeopardizing exchange treatment. The interest/growth factor is taxable income to the exchangor and the exchangor’s access to the interest/ growth factor must be restricted to the same extent as is its access to the exchange equity. An interest or growth factor exists where the amount to be received depends upon the length of time elapsed. There are questions about what that means, whether yields based on Treasury bills or money market funds or other indices are permitted, or if only a simple, fixed interest rate is permitted.

The exchange agreement should be specific on how the exchange equity will be held and invested by the QI, and provide a mechanism for calculating the interest/ growth factor that the exchangor and its advisors are comfortable will both satisfy IRS requirements and provide an acceptable return. The exchange agreement should restrict the investment of the exchange equity by the QI. If the exchange agreement simply specifies that the exchangor will be credited with interest at the rate of 3 percent, for example, while the QI is not restricted in the manner in which the exchange equity is invested, the QI might attempt to invest the proceeds to provide a yield greater than 3 percent, with the QI pocketing the difference. Consideration should also be given to the creditworthiness of the QI and whether the QI has a fidelity bond with reasonable levels of coverage relative to the amount of exchange equity it will hold.

Liability of the QI. Every exchange agreement provides that the QI has no liability whatsoever to expend any amounts for the acquisition of replacement property other than from the exchange equity and requires an indemnity from the exchangor to that effect. That seems entirely appropriate. Careful review nonetheless should be made of the provisions in an exchange agreement limiting the QI’s liability and requiring indemnification of the QI by the exchangor. In the author’s view, a QI should not be able to avoid liability for any acts it may or may not take that are negligent, in breach of the exchange agreement or otherwise inappropriate. The standard language in most exchange agreements will significantly limit the QI’s liability to the extent that they must do something extremely egregious before they are liable — QIs rarely will agree without being asked to be liable for their negligence. Consider the following example: an exchangor is close to the end of the 180-day period within which it must acquire the replacement property. The exchangor gives notice to the QI that it is ready to close, but the QI does not respond or the key person(s) at the QI cannot be located within the time period required. The exchange does not close by the end of 180th day of the replacement period and the exchangor must recognize all the gain it sought to defer. Unless negotiated and revised to address liability of the QI for its action/inaction, the typical exchange agreement will absolve the QI from any responsibility for such a situation. While, ultimately, the greatest comfort an exchangor will get on these issues is the reputation and past history of a QI, it never hurts to consider these contingencies in reviewing the provisions of an exchange agreement that limit the liability of the QI.

Lender Concerns: Special Purpose Entities to Hold Replacement Property and Single-Member Limited Liability Companies

An exchangor often will need debt to finance a portion of the purchase price for replacement property. Lenders often express concern if the exchangor has had or will have activities other than owning and operating the replacement property. Even if the exchangor will have no other activities, a lender may have concern about undisclosed liabilities of the exchangor associated with its prior activities, including environmental and other potential liabilities associated with the relinquished property. These concerns lead lenders to insist that the replacement property be held by an entity whose sole purpose and activity is owning the replacement property. To qualify for exchange treatment, however, the replacement property must be acquired by the exchangor, not by some other entity.

The income tax treatment of single-member limited liability companies provides a useful vehicle to address both lender concerns and exchange requirements: A limited liability company (LLC) is formed for the sole purpose of owning and operating the replacement property. The exchangor is the sole member of the LLC. A single-member LLC is treated as a “disregarded entity” that does not exist for federal income tax purposes. The result is that for federal income tax purposes the exchangor is treated as owning the replacement property (qualifying for exchange treatment), while for state law purposes the LLC, a single-purpose entity, owns the property (satisfying lender concerns). While most states follow the federal income tax treatment of single-member LLCs, this should be confirmed to be certain that exchange treatment will also be available for state income tax purposes.

James Rauschenberger is a partner with Arnall Golden Gregory LLP in Atlanta. He practices law in the area of income taxation of real estate transactions.


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