Overview: An IRC 1031 Exchange is the structure of a transaction to defer the recognition of capital gains, which realized gains would otherwise be subject to taxation if the transaction was settled as a sale. In a sale (generally, IRC 1001) gain has to be realized and recognized, whereas in an exchange it does not. While IRC 1031 might be used for both the sales of personal property and real property, it is most often found with a real estate transaction. The particular language of IRC 1031(a)(1), around which all successful exchanges are structured, states: “no 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”. The development of this key sentence within the Statute, Regulations, Revenue Rulings and Revenue procedures, if carefully followed, allows the owner of property (the taxpayer/exchanger) to receive a very valuable benefit associated with the “sale” and “purchase” of this property. Read further if interested in the related subjects of “Benefits of Exchanging”, “The Concept of a Delayed Exchange”, and “The Concept of a Qualified Intermediary”.
1. Benefits of Exchanging: There are several which should become principle reasons for exchanging:
a. The time value of money: The capital gain which would otherwise be realized and recognized in a taxable transaction is deferred until a later date. Because this potential gain is deferred until later, any tax which may have otherwise been paid is also deferred; and this tax deferred results in “the time value of money.” Example: If the transaction is a sale in 2009 and gain is recognized and reported, with the tax resulting payable when the individual’s Federal and State income tax returns are filed in 2010, then upon payment of that tax, the tax money is gone. However, if the transaction is completed as a qualified exchange and if later on – let us say in 2014-the replacement property is then sold, and then the tax is paid in 2015; the tax payer has kept this money in hand for five years – the time value of money. For complete understanding of this example, the simple question asked of the taxpayer is “if you have the choice of paying in 2010, let us say, $10,000.00 of tax which results from a recognition of gain on a sale in 2009, or waiting to pay the exact same amount of tax in 2015, which of the two scenarios would you chose?” The answer to this question should be obvious.
b. Control of the transaction: Control refers to the timing of the recognition of gain that results from the sale of property which likely will result in the payment of taxes. A transaction which is structured and reported as a sale, with the resulting tax paid, is a matter of choice. However, by structuring an exchange the taxpayer has the opportunity to report a sale at a later point in the tax life of the taxpayer which may be of an advantage because of numerous outside influences occurring in a particular tax year. Example: By commencing an exchange in 2009 and then later selling in 2014, the taxpayer has the advantage of constructing a later sale to take advantage of characteristics which might affect that taxpayer in 2014 – perhaps a year in which there is less taxable income from other sources, or a loss that might be recognized.
c. Stepped up basis: This involves the application of IRC 1014. This Code Section provides that the basis of property acquired from a decedent is its fair market value on the date of the decedent’s death. Typically, if the property has depreciated in value during the time that the decedent owned it, then upon death the market value of the property could be considerably more than its original value. However, this law allows the basis of the property to be stepped up to the date of death value. The result is that the gain which actually did occur is not recognized for the purpose of paying taxation upon this gain. Thus, the decedent’s heirs, or devisees, have the advantage of acquiring title to the property with a current valuation. Then if, example, shortly after the decedent’s death these heirs/devisees sell the property for what is likely the then current fair market value, the decedent’s gain is not taxed. Furthermore, if this decedent had during his/her lifetime engaged in various exchanges – a succession of them, for example – the decedent would have been passing onto each successive sale a substituted basis without recognizing gain or paying tax. The effective use of stepped up basis, in this context, allows a beneficial joinder of exchanging on the one hand with the passing of title to property at death, with the ultimate result being that capital gains taxation is eliminated. There are several qualifications which relate to this favorable result – which are beyond the scope of this explanation; for example, carefully tracking the title to the property as it was held in the hands of the decedent.
d. Tax law and tax rate changes: The tax laws, both Federal and State, which relate to the recognition of capital gains, may, and probably will, change from time to time – either by the Congress for Federal taxation or by the Nebraska Legislature for Nebraska taxation. So, in the previous example, if the applicable rates turn out to be less in 2014 than they were in 2009, successfully entering into an exchange in 2009 will find less tax payable when later arranged in 2014. Of course, tax rates might increase. However, recent congressional history shows us that tax rates have been decreasing rather than increasing. Example: The basic top federal long – term capital gains rate was 28% before 1997, when in that year the rate was reduced to 20%. This applicable rate was again lowered in 2003 to 15%. As we know, tax rates are subject to political maneuvering, however, presently dominant tax policy seems to recognize that lower rates for capital gains taxation promotes a healthy business environment – in which more revenue is generated because of the lower rates. The Nebraska applicable rate has remained stable for a number of years at just under 7%.
2. The Concept of the Delayed Exchange: An exchange which is not simultaneously accomplished, is referred to as “delayed” because the second closing occurs sometime later, or it may be referred to as “deferred” because gain recognition is deferred to a later date. The delayed exchange is the process and procedure in which the sale/exchange is arranged so that the “sale” of the taxpayer’s property is finished and closed on a day certain, to be followed at a later time by the “purchase” of other property. The property sold is referred to as “relinquished” and the property purchased is referred to as “replacement.” The time delay between the first sale and the later purchase is the delayed/exchange period, which is 180 days after the commencement of the exchange. The delayed period allows the seller/taxpayer/exchanger the benefit of concentrating on the first transaction, followed by some breathing room before the second transaction is required to be finished. However, to take advantage of a deferred exchange, there are several critical rules to be respected, all of which are time and value sensitive. Briefly: The sale of the taxpayer’s property must, most usually, be done through the use of a qualified intermediary (QI) which QI holds the sale/exchange money during the exchange. After the first closing, and within the rather short timeframe of 45 days, the taxpayer must chose/identify what property the taxpayer wishes to later purchase. This identification is done in writing, and sets up the conclusion of the exchange. Special rules apply to the acquisition of the replacement property. Finally, whatever property was identified must then be, in fact, successfully purchased by the taxpayer to complete both ends of the exchange. If properly structured, a delayed exchange is a very useful tool for the owner of property, because it realistically allows the taxpayer necessary time to find and close upon qualified property. Just described, here, is what is known as the “straightforward exchange”. Additionally, the exchange law allows for a “reverse exchange” which is, just like the name suggests, a transaction completed in reverse order.
3. The Concept of the Qualified Intermediary: The qualified intermediary (QI) occupies a key position in a delayed exchange. It was the 1979 Starker Case which opened the door to the delayed exchange as we now know it. In 1984, the Internal Revenue Code was amended to provide specific rules for the construction of a delayed exchange, and in 1991 the IRS issued regulations which have now settled questions as to how an exchange is to be structured. The important parts of an exchange relative to the function of the QI are:
a. Safe harbors: The concept requiring a QI relates to the principle that in a deferred exchange the landowner/taxpayer may not either actually or constructively receive money or other property before the taxpayer receives like-kind replacement property. The point of this is that the taxpayer chooses to use the net proceeds from the “sale” to reinvest in a “new purchase.” The policy objective here is that if the taxpayer does not personally benefit from the money or property flowing from the “sale” then the law says the taxpayer has effectively exchanged. Thus, enter the function of the QI to provide the conduit of transfer from the “sale” to the “purchase.”
b. Four methods: The conduit which allows for a successful delayed exchange is carried out by the use of one of four methods, the presence of a QI being one of those four. Arrangements might be set up for a security or guarantee arrangement, or a qualified escrow account, or an interest and growth factor combination. However, these three are generally not used but the fourth method of the QI is.
c. Special rules relate to the QI: This QI may be the taxpayer’s agent, but only if this QI is a qualified intermediary. The definition of a qualified intermediary is a person who is not the taxpayer or a disqualified person. A disqualified person/intermediary is specifically defined in the regulations as: a person who is the agent of the taxpayer at the time of the transaction, a relationship otherwise described in the tax code. These regulations go on to recite that examples of a disqualified person would include: An employee of the taxpayer, an attorney of the taxpayer, an accountant of the taxpayer, an investment person or broker of the taxpayer – if these named disqualified individuals occupied that relationship at any time during the two year time period immediately proceeding the taxpayer’s transfer within the “sale.” There are other important exceptions and clarifications of these principles.
d. The choice of the QI: This is a critical decision which the taxpayer must make and careful thought should be given to it. Unfortunately, many taxpayers do not receive valid advice about who this QI should be, and thus the taxpayer makes an uninformed choice which could result in an invalid exchange. The importance of this selection is because the IRS does not consider the taxpayer to be in receipt of the money or property from the “sale.” Rather, the sale proceeds go directly to the QI, who or which then holds them to acquire the replacement property. It is unlikely that any owner of property, upon sale, would intentionally place the sale proceeds in the hands of an unworthy recipient; however, taxpayers who are not properly advised as to the importance of the QI selection might do that.
e. The role of the QI: This role is essentially to successfully guide the taxpayer to the completion of a valid delayed exchange. One specific requirement is that there must be an exchange agreement in writing between the taxpayer and the QI. The essential purpose of the exchange agreement is to limit the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the QI during the exchange period. Within the exchange agreement, the QI steps into the shoes of the taxpayer by assignment, respective provisions which must be carefully laid out.
