The basic concept of tax-deferred exchanging was introduced into the Internal Revenue Code in 1921in an attempt to eliminate a problem the Treasury Department was having with taxpayers reporting tax losses on barter-type two-party exchanges. This is the reason that taxpayers no longer have the option of reporting a qualifying exchange as either taxable or non-taxable. However, the barter-type exchange which caused so much administrative concern is significantly different from the kind of multi-party transactions that characterizes the present world of tax-deferred exchanging.

The first major change, which was a departure from the barter-type exchange, occurred in 1935 when the board of tax appeals rendered a decision in the case of Mercantile Trust Company of Baltimore vs. Commissioner. The exchange involved a property owner, the taxpayer, a buyer of the taxpayer's property, and a seller of like-kind replacement property. It is interesting to note the transaction also involved a title company that acted as a fourth party facilitator in the transaction. The taxpayer did not want to sell its property because of the tax consequences. Instead, they transferred their property to the title company, which in turn transferred it to the buyer. The title company took the buyer's money and purchased the replacement property, and then transferred it to Mercantile. This was all carried out on a simultaneous basis. The key to the transaction was that all the legs of the transaction were carried out pursuant to appropriate contracts entered into between the respective parties.

The Board of Tax Appeals rejected the Internal Revenue Service's argument that the transaction did not give rise to an exchange because the title company acted as the agent of the buyer. The Tax Board held that the exchange did in fact meet the requirements of Section 112 of the Internal Revenue Code (Section 112 was the forerunner of Section 1031). The courts reasoned that even if the title company was the agent of the buyer, it would not have mattered, because it still would have resulted in an integrated transaction in which the taxpayer received, and was entitled only to receive, like-kind replacement property, and not the buyer's purchase price of the relinquished property.

The rule made in this case has not changed over the years and is still the rule today: ALL OF THE LEGS OR SEGMENTS OF AN EXCHANGE MUST CONSTITUTE AN INTEGRATED, MUTUALLY INTERDEPENDENT TRANSACTION. There has not been any significant change in the test enunciated in Mercantile in the entire 60 years since that decision!

Types of Exchanges

There are Five (5) major types of tax-deferred exchanges: Simultaneous, Delayed, Reverse "Build-to-suit", and Personal Property 1031 Tax Deferred Exchanges.

A Simultaneous Exchange occurs when the relinquished (sale) property and the replacement (acquired) property are transferred concurrently. Taxpayers doing such an exchange often think it is acceptable if the two transactions close on the same day, and that this alone will satisfy the requirements of an exchange. Taxpayers who do not employ a Qualified Intermediary may be surprised to discover their transaction does not qualify for tax deferral, as without the Intermediary, the seller may be deemed to have "constructive receipt" of the sale money. The Qualified Intermediary creates the reciprocal trade by receiving the relinquished property and acquiring the replacement property. The Intermediary also provides the paper trail validating the flow and structure of the transaction and ensures the compliance with Treasury Regulations.

A Delayed Exchange is much like the Simultaneous, but allows the taxpayer to close escrow on the replacement property at a later date than the relinquished property sale. There are some important rules which must be followed to effectuate a valid Delayed Exchange:

• The exchange must be set up before the close of escrow on the relinquished (sale) property.
   
• The taxpayer must identify the replacement (acquired) property within 45 days after the close of the relinquished (sale) property.
   
• The taxpayer must acquire the replacement property within 180 days from the close of the relinquished property, or by the tax return filing of the relinquished property, whichever comes first.
   
• The taxpayer must reinvest all net proceeds into the replacement property.
   
• The taxpayer must obtain a debt of equal or greater amount on the replacement property.

A Reverse Exchange is one in which the replacement property is acquired before the relinquished property is sold. The taxpayer cannot receive title to the replacement property and hold it until the relinquished property is sold and then declare the two transactions to be an exchange. In most reverse exchanges, a facilitator will take title to either the replacement property or the relinquished property. This is known as "parking" the property. In a traditional exchange, there are "safe harbor" regulations to guide and protect the taxpayer, but there are no such regulations for a reverse exchange--or much in the way of favorable court guidance. Thus there is a much higher risk in embarking on a reverse exchange. Reverse exchanges can be complicated, and it is highly recommended that the taxpayer seek professional tax and legal advice.

The newly issued Revenue Procedure (REV. Proc.2000-37) provides a safe harbor for reverse exchanges entered into on or after September 15, 2000 provided the taxpayer does the following:

1. The safe harbor allows a taxpayer to treat. the Exchange Accommodation Titleholder (E.A.T.) as the beneficial owner of the property for federal income tax purposes. The parked property must be held under a Qualified Exchange Accommodation Agreement.
2. The E.A.T. must hold legal title or similar ownership to the property being parked.
3. The taxpayer must have the intent to park with E.A.T. either the relinquished or the replacement property as part of a 1031 tax deferred exchange.
4. No later than five (5) business days after the transfer of ownership of the property to the E.A.T., the taxpayer and E.A.T. must enter into a written agreement indicating that this is an exchange and that the accommodating party will be treated as the owner of the property for tax purposes.
5. Within 45 days after the transfer of ownership of the replacement property to the E.A.T., the taxpayer must identify the property to be relinquished.
6. No later than 180 days after the transfer of ownership of the property (replacement or relinquished) to the E.A.T., the replacement property must be transferred to the taxpayer or the relinquished property to the ultimate to buyer.

An E.A.T. that satisfies the requirements of a Qualified Intermediary under the regulations, may also enter into an exchange agreement with the taxpayer to serve as the Qualified Intermediary in a simultaneous or deferred exchange.   The taxpayer can guarantee some or all of the obligations of the E.A.T., including secured or unsecured debt incurred to acquire the replacement property. The taxpayer can also loan or advance funds to the E.A.T. The parked property can be leases by the E.A.T. to the taxpayer or enter into a property management agreement with the taxpayer.

Build-to Suit: The taxpayer can choose to make repairs or build a structure as part of the replacement property. These types of exchanges can be complicated and very time consuming for everyone involved. The taxpayer must first identify the improvements to be made during the identification period, but the Qualified Intermediary must take title to the land in which the improvement will be built, and must contract for the repairs or construction. There are restrictions on how the sale funds can be handled, and the time periods for completion of the work and conveyance of the improved real property must be done prior to the expiration of the 180 day exchange limit.

A Personal Property Exchange allows the taxpayer to exchange planes, business, boats, etc. and other personal property held for investment purposes or the productive use for trade or business, but the definition of "Like Kind" is more specific than that of real property. Please call us for more details regarding the Personal Property Exchange.

IDENTIFICATION OF REPLACEMENT PROPERTY

The taxpayer has 45 days from the close of the relinquished property in which to identify Replacement Property. When identifying replacement property, you have a choice between two rules.

1st Rule: The first rule is known as the three-property rule. 
The taxpayer may identify a maximum of three (3) replacement properties without regard to fair market value.

2nd Rule: This rule is known as the 200% rule. 
When identifying more than three (3) properties, the total aggregate value of all properties identified cannot exceed 200% of the relinquished property value (or twice the amount of sale price).

Example: Relinquished property sold for $200,000.00 2 x $200,000 = $400,000.00

(The Taxpayer can identify a maximum of $400,000 in Replacement Properties)

REPLACEMENT PROPERTY: Once the taxpayer has located a "like-kind" replacement property, ERI will be assigned into the Contract/Escrow Instructions as the Buyer. When this transaction is ready to close, funds held by ERI will be deposited into to escrow to fund the closing. Should escrow require additional funds to close, the taxpayer can deposit funds directly into escrow. The replacement property must be acquired on or before the following dates: 1) 180 days from the date of the transfer of the relinquished property, or 2) the date the tax return is due for the tax year in which the replacement property is transferred (the taxpayer has the right to request an extension).

How Do Most Exchanges Come Into Being?

As a practical matter, many people list their property for sale, and at the time an offer is submitted, they inform the broker that they want to do a tax-deferred exchange. This is usually accomplished by the broker inserting a few words in the Purchase and Sale Agreement to the effect the "Seller" wants to do a tax-deferred exchange. (See cooperation clause below).

(Contract Language)

"Buyer hereby acknowledges it is the intent of the Seller to effect an IRC Section 1031 tax deferred exchange which will not delay the closing or cause additional expense to the Buyer. The Seller's rights under this agreement may be assigned to Exchange Resources, Inc., a Qualified Intermediary for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and Exchange Resources, Inc. in a manner necessary to complete the exchange."

When a tax-deferred exchange is the ultimate aim of the taxpayer, it is necessary that the taxpayer be restricted from any access or use of the proceeds from the disposition of his property. The essence of an exchange is the transfer of property between owners, while that of a sale is the receipt of cash for property - whether that receipt is actual or constructive if the taxpayer has--or could get--control of the cash.