- Tax-Deferred Exchanges: Rules are Basic
Nothing to Fear, But Fear Itself
By: Raymond J. Bowie, Esq.
Most real estate investors and commercial property owners have heard of tax-deferred exchanges. They know that by exchanging one real property for another, it’s possible to avoid paying tax on the gain they would incur if they would have instead sold the property.
Much fewer, unfortunately, actually attempt to do an exchange, held back not so much by ignorance, but rather by fear – fear of the cost, fear of the legalities, fear of the IRS. As to these things, however, in the words of Franklin Delano Roosevelt: “there is nothing to fear, but fear itself.”
This is not to say that a tax-deferred exchange should be attempted without qualified professional assistance. The services of an accountant or tax advisor familiar with exchanges should be utilized initially to determine the potential tax liability if a property were to be sold compared to exchanged, as well as how best to structure any exchange transaction. Likewise, a knowledgeable attorney should be retained to draft the required documents and shepherd the transaction through closing.
One thing potential exchangers need not necessarily fear, however, is the cost or legal complexity of doing a tax-deferred exchange.
Tax-deferred exchanges of “like-kind” property have long been permitted under Section 1031 of the Internal Revenue Code. The basic principle in an exchange is that the seller swap his commercial or investment real estate for another commercial or investment property without ever receiving the cash proceeds from the sale of the first property. If the seller of a property either receives cash or is entitled to receive cash from the sale, the seller must pay tax on any gain from the sale. To avoid being taxed, the property seller must either directly exchange deeds with the seller of the other exchanged property, or use an escrow agent as a middleman to hold the sale proceeds while waiting to acquire another suitable property -- which is called a “delayed exchange.”
The vast majority of exchanges are delayed exchanges, and this simple fact determines the type of legal documentation the typical property exchanger must use. The good news is that the number, complexity and cost of these exchange legal documents need not be overwhelming..
First, however, some definitions of common exchange terms may be helpful:
“Exchanger”: This is the term used for the owner of real property who wishes to exchange it for another property. He is the seller of the first property and the buyer of the property he exchanges it for.
“Like Kind Property”: Exchanges are only allowed for “like kind” property. Fortunately, any type of investment or commercial use real property is considered to be exchangeable for any other type of investment or commercial use real estate.
“Relinquished Property”: This is the property the exchanger owns that he is giving up to exchange for another property. This is the property being “sold” by the Exchanger.
“Replacement Property”: This is the property the exchanger receives for the property he is giving up. This is the property being “bought” by the Exchanger.
“Qualified Intermediary”: This is the tax code term for the escrow or middleman who, in a delayed exchange, receives the proceeds from the sale of the Relinquished Property and then uses it to acquire the Replacement Property. By law, this Intermediary must be totally independent of the Exchanger and cannot be the Exchanger’s agent, employee, attorney, accountant, broker, or relative, or any company or entity of which the Exchanger is part. The Intermediary must operate under a written agreement with the Exchanger that prevents the Exchanger from receiving the proceeds of the sale of the Relinquished Property.
“The 45/180 Day Rule”: The tax code imposes rigid time limits to complete a delayed exchange. The Exchanger has to identify the Replacement Property within 45 days of the closing date on the Relinquished Property. Then, the Exchanger must actually close on the Replacement Property within 180 days of that same closing date on the Relinquished Property.
There are other more technical rules pertaining to these terms, but the above definitions should suffice to illustrate the legal documentation and steps required to do a tax-deferred exchange.
- Step One: Sales Contract Clauses, Selling the Relinquished Property
- A property owner desiring to exchange a property must add certain special provisions to any standard form real estate sales contract. This is because most standard sales contracts are written for the sale rather than exchange of real property.
- For example, most standard real estate sales contract prohibit either buyer or seller from assigning the contract to another party. But in an exchange, it is essential for the buyer or seller as the Exchanger to be able to assign the sales contract to the Intermediary, and to require the other party to the contract otherwise to cooperate in the exchange process.
- For an exchange, provisions similar to the following need to be added to any sales contract in which the Exchanger is the seller: “Seller identifies this transaction as the transfer of Relinquished Property to the Buyer as an interdependent part of an overall plan to effect a tax-deferred exchange for Replacement Property to be identified by Seller, in accord with Section 1031 of the Internal Revenue Code. Seller may assign this contract to a Qualified Intermediary. Buyer agrees to cooperate with Seller in accomplishing this tax-deferred exchange, provided there is no delay in the closing and no increased expense to Buyer.”
- A similar clause would need to be added to any sales contract in which the Exchanger is “buying” Replacement Property, switching the terms “Buyer” and “Seller”.
- The Exchanger must enter into a written agreement with an escrow agent, title company, or other middleman to serve as the Qualified Intermediary for the exchange, prior to the closing on the Relinquished Property. This agreement will spell out the duties and compensation of the Intermediary. It must explicitly restrict the Exchanger’s ability to receive proceeds from the sale of the Relinquished Property. Intermediary fees vary widely ranging from a few hundred dollars to several thousand dollars, and the Exchanger should allow time to shop around for a suitable Intermediary.
- Prior to closing on the Relinquished Property, the Seller, the Buyer and the Intermediary should enter into a Sales Contract Amendment in which the Seller assigns all his right, title, interest and obligations under the sales contract to the Intermediary. The Intermediary accepts the assignment and agrees to transfer the Relinquished Property to the Buyer.
- But in the same document, the Intermediary also should instruct the Seller to transfer the property by deed directly to the Buyer, and likewise to execute the settlement statement, bill of sale, and other closing papers. This latter provision takes advantage of IRS regulations that allow for “direct deeding” from the seller to the buyer in tax-deferred exchanges. It avoids the hassle and expense of the Seller giving a deed to the Intermediary, and then the Intermediary giving a second deed to the Buyer, which used to be the prevalent practice in exchanges.
- At the closing, the settlement statement should state that the transaction is “the transfer by Seller of Relinquished Property incident to a Section 1031 tax-deferred exchange.” The closing statement should also list as the property’s seller the name of the Intermediary acting for the benefit of the Seller.
- The deed given by the Seller to the Buyer should also recite that “this deed is incident to the Section 1031 tax-deferred exchange by Grantor of the subject property as Relinquished Property.”
- This essential step can occur at any previous time in the transaction. It must occur no later than 45 days after the closing on the Relinquished Property. This is where the Seller/Exchanger now identifies, in writing, the Replacement Property (or properties) to take the place of the Relinquished Property. The writing can be in a letter or any other format. The best practice is to send the written identification of the Replacement Property to the Intermediary and to document its receipt. IRS regulations allow for the identification of multiple possible replacement properties under limited circumstances, but this is best done only with professional counsel.
- The Exchanger now becomes the Buyer of the Replacement Property from its seller. In essence, the Exchanger will now repeat the previous steps one, three and four, substituting himself as the Buyer rather than the Seller. The same contract provisions, assignments, and closing procedures will be used, only this time for the Exchanger acting in the role of the Buyer.
The Intermediary now acts for the Exchanger in acquiring the Replacement Property. Closing upon the Replacement Property must occur within 180 days of the closing date on the Relinquished Property. At this closing, the Intermediary releases to the closing agent the funds from the sale of the Relinquished Property, to be applied to the purchase of the Replacement Property on behalf of the Exchanger.
In this manner, the two exchange transactions have come full circle, utilizing fairly standard, fairly simple legal documentation.
Unless an investor or commercial property owner has a masochistic desire to pay taxes that are otherwise avoidable, there is no reason to dread doing an exchange because of fears as to the cost or legal complexity of the procedure. Indeed, when it comes to exchanges, FDR perhaps said it best. There is indeed nothing to fear but fear itself.