Robert E. Ciancola, Attorney at Law

Prior to discussing the rules for tax-deferred swaps of like-kind property, it is useful to briefly note other methods by which deferral of tax liability may be achieved. A detailed explanation of any one of these other deferral methods is beyond the scope of this paper and they are mentioned here merely for the sake of completeness. Any practitioner wishing to consider the use any of these alternative methods is advised to thoroughly research their implications and limitations.

Installment sales under section 453 are available as an alternative provided the seller is willing to wait for his cash. Installment sales are limited in several respects, however. Dealers (those who dispose of personal property under the installment plan in the ordinary course of their business or who hold real property for sale in the ordinary course of business) are not permitted to use the installment sale except with respect to farmland, timeshares and residential lots and in the case of the latter two categories, only if interest is paid with respect to the deferred tax liability. Stocks and securities are eligible. Restrictions are placed on sales to related parties. Recapture income from depreciation and dispositions of property subject to certain leases cannot be reported on the installment method. Finally, any obligation with respect to an installment sale where the sales price exceeds $150,000 are subject to interest charges with respect to the deferred tax where the total of such obligations held at the end of and arising in any year exceed $ 5 million.

The open transaction doctrine stems from Burnett v. Logan, 283 U.S. 404 (1931) and generally applies to prevent taxation of transactions which are not yet capable of valuation. However, the contingent sales rules of Reg. § 15a.453-1 have severely limited the application of this doctrine.

A private annuity is a transaction in which the payment of the deferred portion of the purchase price of property is spread over and dependent in whole or in part on the life of the seller. It is most commonly used in the context of buyouts of interests in closely held corporations and partnerships. A private annuity must be arranged with a payer other than a commercial insurance company. Where applicable, the private annuity will be taxed under the rules of section 72. Each payment is divided into a recovery of basis, which is not taxable; a profit on the sale, which may be eligible for capital gain treatment; and an interest or annuity component, which is taxed as ordinary income. It is currently unclear how a private annuity sale may be affected by the contingent sales rules of the installment sale regulations.

Under section 1031 of the Code no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment.

Code section 1031(a)(2) specifically excludes certain property from application of the section. These properties are property held for sale; stocks, bonds, or other indebtedness; certificates of ownership in trusts; interests in partnerships; and choses in action. Beyond that, the rule is fairly liberal. Under Reg, § 1.1031(a)-1, property held for productive use in a trade or business may be exchanged for property to be held for investment, or vice-versa. Obviously, a personal residence would not qualify as it would not have been held for either investment or use in a trade or business. Note that this rule is looked at separately from the point of view of each party to the exchange. Thus, a taxpayer may exchange real property held by him for investment for the personal residence of another party which the taxpayer intends to hold for investment. The taxpayer would have engaged in a like-kind exchange; the other party would not. Note also that the investment/trade or business requirement must be satisfied both with respect to the property transferred and the property received. Thus, if a taxpayer transfers a parcel of real property held for investment to another in exchange for a parcel with respect to which the taxpayer has a predetermined intention to sell, the exchange will not fall within section 1031. The Service takes the view that if the property received is transferred immediately thereafter to a controlled corporation in a section 351 transaction, the business/investment requirement is not met. See Revenue Ruling 75-292, 1975-2 C.B. 333. This position has, however been rejected by the Tax Court and the Ninth Circuit. See Magneson v. Commissioner, 81 T.C. 767 (1983), aff’d 753 F.2d 1490 (9 Cir., 1985) (transfer to a partnership); Bolker v. Commissioner, 81 T.C. 782 (1983), aff’d 760 F.2d 1039 (9 Cir. 1985) (transfer from a controlled corporation).

The property exchanged must be exchanged for property of a "like-kind", either tangible or intangible, real or personal. Like-kind for this purpose refers to the type of property not its grade or quality. In the case of real estate, Reg. § 1.1031(a)-1(b) specifically provides that whether real property is improved or unimproved is irrelevant, as that goes to grade or quality and not to kind or class. Similarly, an apartment building is considered like-kind to a farm; or a leasehold of 30 years or more is considered like-kind to a fee interest. Real property located in the United States is not, however, considered like-kind to real property located in a foreign jurisdiction. The Administration’s budget proposals contained a provision to change the like-kind rules with respect to real property to require like use as well as like character. This rule would have effectively removed improved-for-unimproved swaps and apartment building-for-farm type swaps from section 1031. The proposal was not included in the tax bill which emerged from Congress.

Personal property has particular rules explained in Reg. § 1.1031(a)-2. These rules basically provide a safe harbor by considering all property in the same "class" to be of the same "kind". What is of the same class is based on the four-digit SIC codes. In addition, depreciable personal property is considered of like kind if it is described in the same asset guideline classification used for depreciation and cost recovery purposes.

Section 1031 is not elective; if a transaction is described within its terms, it applies to the transaction. This is important to recognize because section 1031(c) disallows losses from recognition even when other property not described in section 1031 is involved in the exchange.

If property is exchanged for property of a like-kind and in addition other property not of a like-kind or cash, then under section 1031(b) gain is recognized limited to the value of the other property or cash (boot), Thus, if a party receives boot, he is taxable on the realized gain to the extent of the boot, but cannot recognize a loss. If a party gives, but does not receive, boot no part of the gain or loss is recognized but the boot given is added to the basis of the property received in the exchange. Liabilities, including indebtedness encumbering the property and assumed by the transferee, are considered boot for this purpose. Reg. § 1.1031(d)-2 sets forth an example in which an apartment house owned by D has an adjusted basis of $100,000 and is subject to a mortgage of $80,000. D exchanges this property to E for another an apartment house having a fair market value of $250,000 and subject to a mortgage of $150,000 plus $40,000 in cash. D is considered to receive boot in this transaction of $40,000 - the amount of cash received. The debt of which he is relieved ($80,000) is offset by the debt assumed ($150,000) and therefore does not result in receipt of boot. E is considered to have received boot of $30,000 consisting of the liability of which he was relieved ($150,000) less the liability assumed ($80,000) and the cash transferred ($40,000). Note that the cash can reduce the amount of boot recognized on the assumption of debt when it is paid, but not when it is received.

The basis of the property received is equal to the basis of the property transferred which was of like-kind; increased by the amount of boot transferred and by the amount of any gain recognized; and reduced by the amount of any boot received.

It often happens that one party wishes to do a tax-deferred exchange and finds another willing to acquire the property; however, that party does not have property which the first party wishes to acquire. It is also common that only one of the parties insists on a 1031 transaction. Assume for example that A wishes to exchange property he owns for like-kind property. He locates B, who is willing to acquire A’s property. B, however, does not own any property which A is willing to accept. If one of the parties can locate a third party (C) who owns property which A is willing to accept and is willing to sell his property for cash, the transaction can be structured so that A obtains his tax deferral and C’s property and B obtains A’s property. Here are three formulations which might be used:

In each of the above cases, assuming the other requirements of section 1031 are satisfied, A will get his tax deferral and the property he desires. Note that in none of the above cases does B fall within section 1031.

Code section 1031(f) provides that, following a section 1031 exchange between related parties, gain will be recognized for one party if the related party disposes of the property received within two years of the exchange. There are three exceptions to this rule: (a) death of either party; (b) transfer of property due to involuntary conversion; and (c) the parties are able to demonstrate to the satisfaction of the Commissioner that tax avoidance was not a principal consideration involved in either the exchange or the subsequent transfer. For purposes of this provision, a party is related if the party is described in section 267(b) or 707(b)(1). These sections generally describe family members, 50% controlled corporations and partnerships and fiduciaries and trusts.

Suppose taxpayers exchange properties which consist of more than one type of like-kind group. How is section 1031 to be applied? For example, assume taxpayer A exchanges a factory building worth $1,200,000 and the manufacturing equipment it contains, worth $1,000,000, with taxpayer B who transfers a factory building worth $1,500,000, and manufacturing equipment of like-kind to A’s worth $700,000. Since the total in both cases is $2.2 million, and the property is like-kind, one might expect that the total exchange would be tax-free under section 1031. After all, if the buildings and equipment were exchanged separately in separate transactions without boot, each would qualify under section 1031. So it may be somewhat surprising to learn that when exchanged as part of the same transaction, the above example is not totally tax free. The reason is that the properties should not, logically, be exchanged separately without boot because their values are different. Therefore, in truly separate transactions, either A or B would have to transfer cash or other property to make up the difference. Reg. § 1.1031(j)-1, promulgated in 1991, seeks to obtain this result with rules which apply when more than one "kind" of property is exchanged in the same transaction. The rules are complex and attempt to take into account the gain or loss realized and recognized, and the basis of property received, by dividing the transaction into one or more "exchange groups" and, if the value of the properties received and exchanged (net of any liabilities) are not equal, to a "residual group." The regulation assumes in all cases that the total value flowing in each direction - including the fair market value of the assets, amount of liabilities assumed, and the amount of cash paid or received - is equal. This presumption is based on the not unreasonable premise that in an arm’s length exchange, the parties will exchange a package of assets and liabilities of equal value. The regulation contains five examples which illustrate its application and the reader encountering such an exchange is urged to study them. Provided below is a brief description of the mechanics of the computation called for by the regulation illustrated by an original example.

The initial step is to separate the properties into groups of like-kind property. Only property of a like-kind with other property in the group and of a like-kind with property to be received, may be placed in an Exchange Group (hereafter EG). Ineligible property - cash and property listed in section 1031(a)(2) - cannot be placed in an exchange group. In the above example, there would be two EGs for A and B - one consisting of the factory buildings and one consisting of the machinery.

If liabilities are to be transferred between the parties, the liabilities assumed and transferred must first be netted for each taxpayer. This is true for all liabilities, recourse and non-recourse, secured and unsecured. If, with respect to a taxpayer, there is a net amount of liabilities assumed, they must be allocated to the EGs in proportion to the fair market value of the properties received in each exchange group. The effect of this allocation is to reduce the fair market value of the property received for purposes of determining the EG deficiency or surplus, explained below. If there is a net amount of liabilities transferred with respect to a taxpayer, that amount is treated as a Class I asset in the Residual Group, explained below.

If the fair market value of the property received in all EGs, net of any liabilities allocated to the EG, differs from the fair market value of the property transferred in all EGs, the net difference is set up as a Residual Group (hereinafter, RG). The RG can consist of property transferred or property received, but not both. The property which will be assigned to the RG can be cash, non-qualifying property, or property not of a like kind with any property being received. Property involved in the exchange is allocated to the residual group until the proper fair market value is achieved and the RG is then full. Assets are placed in the RG in the order of their class number under the regulations under section 1060. Thus, Class I assets, cash, is allocated to the RG first, and if insufficient to equal the aggregate difference in value of the EGs, then Class II assets (marketable securities, etc.) are allocated until the RG is full. If, with respect to a taxpayer, the value of all the property in all the EGs being received, net of liabilities assigned, is less than the value of all the property being transferred in the EGs, the RG will consist only of property being transferred to the taxpayer. If the value of all the property being received in all EGs (net of liabilities) is greater than the value of all the property in the EGs being transferred, the RG will consist only of property being transferred by the taxpayer to the other party. In the factory building/equipment example above, the aggregate value of EG property being received by each taxpayer is the same. Therefore, there is no RG in that example.

If the value of property being received with respect to a particular EG, net of any liabilities allocated, is greater than the value of the property being transferred, the EG has a surplus. If the opposite is true, the EG has a deficiency. In the above example, A exchanged a factory building worth $1,200,000 and manufacturing equipment worth $1,000,000, for a factory building worth $1,500,000, and factory equipment worth $700,000. The factory building EG would have a $300,000 surplus for A, while the manufacturing equipment would have a $300,000 deficiency. The opposite would be true for taxpayer B.

With respect to each EG, gain is realized to the extent that the value of the assets being received exceeds the basis of the assets being transferred. Gain recognized under section 1031 for each EG is equal to the lesser of the gain realized or the EG deficiency, if any. Losses are never recognized. With respect to the RG, gain or loss is recognized only if it consists of property being transferred by the taxpayer, in the amount by which its value exceeds its basis. If the RG is composed of property received by the taxpayer, no gain or loss is recognized. If property remains which has been assigned neither to an EG or the RG, gain/loss is recognized on it under normal rules outside of section 1031.

Returning again to our example, let us assume that the taxpayers
have a basis in the assets being transferred as follows:

	Basis	Value
Taxpayer A transfers
Factory building	$650,000	$1,200,000
Manufacturing Equipment	$800,000	$1,000,000
Taxpayer B transfers
Factory building	$1,000,000	$1,500,000
Manufacturing Equipment	$700,000	$700,000

Taxpayer A would recognize no gain on the factory building exchange because that EG has a surplus. Taxpayer A would recognize a gain of $200,000 on the manufacturing equipment exchange (the lesser of the $200,000 gain realized and the $300,000 EG deficiency). Taxpayer B would recognize a $300,000 gain on the factory building exchange and no gain on the manufacturing equipment.

The basis of property received in an EG is equal to the basis of the property transferred in that EG, plus any gain recognized, plus any EG surplus, minus any EG deficiency, and plus any liabilities allocated to the EG. Thus, A would have a basis of $950,000 in the factory building received in the exchange ($650,000 basis in the building transferred plus $300,000 EG surplus) and a basis of $700,000 in the manufacturing equipment ($800,000 basis in the equipment transferred plus $200,000 gain recognized minus $300,000 EG deficiency).

Consider the following situation. Taxpayer B wishes to purchase property owned by taxpayer A. A agrees, but only if A gets section 1031 treatment. Unfortunately, B does not possess any property suitable to A. Therefore, A transfers his property to B, identifies several properties to B, any of which he would be willing to accept in exchange for his property, and allows B some time to negotiate an acquisition of one of them. B would then be obligated to transfer title of that property to A. The IRS initially took the view that this arrangement would not qualify under section 1031. The IRS’s view was that a transfer of property in exchange for a promise to acquire and transfer like-kind property failed both because the exchanges of property had to occur simultaneously

and because in the situation just described A transferred his property in exchange for a contractual right. That, the IRS maintained, is personal property. This position was soundly rejected in Starker v. U.S., 602 F.2d 1341 (9 Cir. 1979). In 1984, section 1031 was amended by adding what is now § 1031(a)(3) to provide rules for deferred exchanges and in 1991 final regulations under § 1.1031(k)-1 were added.

Code section 1031(a)(3) provides that in a deferred exchange the property which is to replace the property which the taxpayer has transferred must be identified within 45 days of the transfer of the relinquished property and received by the taxpayer within 180 days of the transfer (or, if earlier, by the due date of the transferor’s return (including extensions) for the year of the transfer. In the case where multiple properties are exchanged, the periods are measured from the date of the earliest property transferred. In order to meet the 45-day requirement, the transferor must designate the replacement property or properties in a written document sent to the transferee. The regulation allows a certain flexibility on the part of the transferor by allowing the transferor to designate several alternative properties which would be acceptable to the transferor. There are three interrelated rules set forth by the regulation. The designated replacement properties must:

The replacement property must be identified in enough specificity to distinguish it from other properties. For example, a legal description or street address for real property is acceptable. However, a statement specifying "3 acres of unimproved land located in Greenlee County, Arizona" would not meet the identification requirement because it lacks specificity. The transferor may also revoke a selection of replacement property at any time prior to the end of the identification period by providing a written notice to that effect to the transferee. Thus, the transferor may violate the above requirements by naming excessive replacement properties provided the transferor revokes a sufficient number of prior identifications before the expiration of the identification period.

For purposes of the identification requirements, property of a different type which is normally transferred with the subject property need not be specifically identified if it does not exceed 15% of the fair market value of the designated property. For example, an office building may be transferred with furniture if the furniture does not exceed 15% of the value of the building even if the written designation statement does not mention the furniture. However, this 15% rule applies only for purposes of meeting the identification requirements. Thus, the IRS may take the position that the furniture is not of a like kind to the real property received in the exchange and tax it accordingly.

As stated above, the Code requires that the designated replacement property must actually be received by the transferor by the earlier of 180 days following the transfer of the transferor’s property or the due date including extensions of the transferor’s tax return for the year of the transfer. The property received must be of substantially the same basic nature and character as the property identified. For this purpose, the regulation indicates that a barn and underlying land worth $187,000 is not substantially the same as a barn and two acres of land worth $250,000 identified in the designation statement. However, if 2 acres of unimproved land worth $250,000 had been designated, the receipt of 1½ acres worth 75% of the whole would be considered substantially the same as that described. For purposes of the receipt rule, it is not necessary for the transferee party to actually obtain legal title to the property designated. See Revenue Ruling 90-34, 1990-1 C.B. 154. The time limit will be strictly construed. In Orville Christensen v. Commissioner, T.C. Memo 1996-254, the taxpayer was not allowed to add on an automatic 4-month extension period to the due date of his tax return where he did not actually request the extension.

The regulation permits a taxpayer to designated replacement property which is not yet in existence provided the property is constructed and delivered to the taxpayer within the applicable period. In the case of personal property, the property must be completed by the time the taxpayer takes possession. In the case of real property, it is permissible for the taxpayer to receive the property while it is still under construction provided it is, when finished, substantially the same as the property identified.

i). The problem of constructive receipt. A like-kind exchange will fail if transferor is deemed to be in constructive receipt of non-qualifying property, including money, prior to receiving the like-kind property. In a typical deferred exchange, the transfer will not actually transfer title to the transferee and depend on the transferee’s unsecured promise to obtain and transfer the identified property. If the transferee is required to place funds in an escrow to secure its promise to obtain the property, the transferor could be deemed in constructive receipt of the funds so deposited with the result that the initial transfer will be viewed as a cash sale. The regulation provides that constructive receipt is present where an exchange agreement gives the transferor the right to demand money instead of the identified property. See Reg. § 1.1031(k)-1(f)(3). Prior to the guidance provided in the regulation, taxpayers sometimes were tripped up by the constructive receipt doctrine. In Wakeham v. U.S., 90 TNT 196-15, a per curiam opinion of the 9^th Circuit, A agreed to acquire property owned by C but C did not want to receive A’s property in exchange, preferring to receive cash. They worked out an arrangement whereby another party, B, would be found who was willing to purchase other property owned by A. A would transfer this property to B; C would transfer his property to A; and B would transfer cash to C. Unfortunately, B could not be found in time. Therefore, the parties attempted to reach the same result by having A purchase C’s property for cash. C eventually located a suitable B and use the cash to purchase B’s property and B then purchased other property from A. This was held to constitute separate cash sales as A was in constructive (indeed, actual) receipt of cash from B. Similar in effect was Bezdjian v. U.S., 53 T.C.M. 368 (1987), aff’d 845 F.2d 217 (9 Cir. 1988).

ii). Safe harbors - securing obligation of transferee. The regulation provides three alternatives by which the transferee may obtain more than the mere promise of future performance in exchange for his property. The first of these is to secure the promise of the transferee. This may be done by the transferor retaining a mortgage lien on the property; by the transferee obtaining a letter of credit; or by a guarantee from any other third party. A letter of credit used to secure an obligation of a transferee must be issued by a bank or other financial institution, be non-negotiable and non-transferable, and may not be drawn upon prior to the default of the transferee in transferring the replacement property by the end of the replacement period.

iii). Qualified escrow. The second way the obligation of the transferee can be secured is through use of a qualified escrow. Using a qualified escrow the transferee of the property can secure his performance by depositing cash or other property in the escrow account. If the transferee makes such a deposit, the transferor will not be deemed to be in constructive receipt of the amount so deposited prior to the time the replacement period expires. A qualified escrow must meet all of the following conditions.

It should be noted that the last point, concerning the occurrence of a contingency, means that an agreement containing such a provision will not be deemed to trigger constructive receipt on the part of the transferor. It does not mean that the transferor will not be in constructive or actual receipt if the contingency in fact occurs. For example, a common contingency is the securing of a change in zoning restrictions to permit a certain use. The agreement might provide that the transferor has a right to the funds in the escrow if the change in zoning is not secured by a certain date. The existence of this contingency will not disqualify the escrow and the transferor will not be in constructive receipt of the funds unless the zoning change is in fact not obtained. At that point, the transferor will have an unrestricted right to demand the funds in the escrow account and will be in constructive receipt of them even if he decides not to demand the cash and continues to seek the zoning change.

iv). Qualified intermediary. The third way to secure the transferee’s performance is by use of a qualified intermediary to receive and transfer the property. A qualified intermediary will not be considered the agent of the transferor in a deferred exchange. Use of a qualified intermediary can be an extremely useful technique to accomplish a qualified exchange where one party wants an exchange but the other does not. For example, A offers to buy B’s property for cash; B wants a section 1031 exchange but A does not. Rather than attempt a scheme such as that in the Wakeham case (see 6.d.i. above) B can obtain the services of an intermediary, C. B will transfer his property to C and C will sell the property to A for cash. C will use a qualified escrow to hold the cash. B can then identify replacement property which C will purchase using the escrow cash. C then transfers the replacement property to B. The result is B will have achieved a good section 1031 exchange. Under general principles of tax law, C’s momentary holding of B’s property and A’s cash would be disregarded and the transaction restructured as one directly between A and B. The qualified intermediary provision, however, allows the desired result to be achieved as the regulation specifically provides that C will be deemed to have acquired the property and C’s existence will not be ignored. A qualified intermediary is one who is not a disqualified person as described above under qualified escrow. In addition, the restrictions on the transferor’s rights to receive money or other property held by the intermediary as described under the preceding section apply. The use of an intermediary must be handled with care. In the above example, B must notify A that C will act in the intermediary capacity and C must actually receive title to the property being relinquished by B. Alternatively, B can transfer the property directly to A provided he assigns his rights to the sales proceeds to C prior to the actual transfer and notifies A. In addition, B can directly negotiate and enter into an acquisition agreement with the owner of the replacement property provided B assigns his rights under the agreement to C and notifies the owner of the replacement property. However, if C neither acquires title nor is assigned B’s rights, C will not be treated as a qualified intermediary.

Use of a qualified escrow or qualified intermediary as described above will be treated in a manner which preserves the taxpayer’s right to use the installment sale method. Thus, receipt by the qualified intermediary of cash will not be treated as the taxpayer’s receipt of cash until actually distributed to him. In addition, receipt by the intermediary of an installment obligation of the transferee, followed by a distribution of the obligation to the taxpayer will be treated as if the taxpayer had received the installment obligation directly from the buyer. To illustrate how an installment sale may be combined with a 1031 exchange, assume that A transfers real property worth $100,000 to B, a qualified intermediary, in December of Year 1. B immediately transfers the property to C and C transfers $100,000 in cash to B. A identifies replacement property costing $90,000 and B acquires the replacement property in March of Year2. B then immediately transfers the acquired property to A along with the remaining $10,000 of cash. Assuming A’s basis in the transferred property was $60,000 he would realize a gain of $40,000 on the exchange of which $10,000 - the amount of "boot" - would be recognized. Under the regulations, because A utilized a qualified intermediary he will not recognize that gain until Year 2. If instead of all cash, C transferred to B $90,000 in cash and his installment note for $10,000, A would be able to elect installment payment treatment and take into income in Year 2 only the proportionate amount of the $10,000 gain related to the principal payments on the installment note in Year 2.

Tax Deferred Swaps