By S. Andrew Smith, CPA, Principal, Baker Newman Noyes
This article is the second in a 3-part series on the mechanics and tax benefits of Like Kind Exchanges
In Part I of our series of articles we discussed some of the recent legislative changes to the §1031 rules and explained the simplest form of a like-kind exchange, the simultaneous exchange. In Parts II and III, we will talk about the more common and more complex types of exchanges used in the real estate world.
Delayed exchanges involve at least 3 parties and are undertaken when a simultaneous exchange is not feasible. One of the parties is the qualified intermediary, who is introduced for one reason: To hold the cash on behalf of one or more of the primary parties, and take title to the replacement property before transferring it to that primary party. The QI serves in this role because if the cash instead were received by the primary party, even if held only for an instant, it would constitute taxable boot and defeat the intent (tax deferral) of the §1031 transaction.
The QI must be an arm’s length 3rd party and choosing a reputable one is important because the QI ensures the rules of §1031 are adhered to and it often holds large sums of others’ money.
Many delayed exchanges begin almost by accident. Taxpayer A is approached about selling an asset (Property A) but is uninterested in paying the taxes on the gain. Recall that Taxpayer A cannot receive the proceeds from the sale. Instead, Taxpayer A must arrange for the QI to take possession of the proceeds. That sale of Property A starts the clock ticking towards two crucial deadlines:
- 45 day rule: The first deadline occurs 45 days after the sale. Within this period, Taxpayer A must identify a suitable replacement property for Property A. There are very detailed rules regarding identification procedures and among the alternatives, Taxpayer A may identify at least 3 specific, potential properties, and close on at least 1 of them.
- 180 day rule: The acquisition itself must occur within 180 days from the sale date of the relinquished property. However, that 180 day window may be shortened (but not lengthened): If the taxpayer files its income tax return for the period that includes the sale, the date the return is filed represents the last day to make the acquisition. This is an extremely important point to remember and may require taxpayers to file extensions for their tax returns in order to avail themselves of the full 180 days.
During both the identification period and the closing period, the cash received from the sale of Property A is held by the QI and is inaccessible by Taxpayer A. If Taxpayer A fails to identify any replacement properties within the 45 window, the exchange fails and the money will be transferred from the QI to Taxpayer A, thus triggering the gain. If Taxpayer A makes a valid identification, the cash must then be either spent directly by the QI to acquire the property, or held by the QI until the expiration of the entire 180 day period, even if the taxpayer later realizes the acquisition will not occur. Some would consider the potential “tying up” of the cash for 180 days a serious drawback and therefore should weigh the likelihood of closing on a suitable replacement property before starting the exchange process.
Sometimes failed exchanges can produce tax deferrals unrelated to §1031. If a sale that legitimately starts the 45 and 180 day clock occurs late in one year, and the §1031 exchange fails early in the second year, the gain will be fully taxable. However, because proceeds are received in a year following the sale (the QI held the proceeds until that point), gain may be deferred into the second year because the transaction likely qualifies under §453 as an installment sale.
Taxpayers often engage a QI just prior to a sale and only then begin looking for a replacement property. This can create a great deal of urgency and stress on the seller as they only have 45 days in which to identify a potential replacement property. Once the 45 day window closes, the taxpayer may only complete a valid exchange by acquiring one of the identified properties. There are no substitutions allowed beyond the 45 day time frame. For this reason, many exchanges fail, but the fees to keep the §1031 option open, even if only for 45 days, may be quite modest compared to the potential tax savings.
S. Andrew Smith is a Tax Principal at Baker Newman Noyes specializing in closely held business and real estate transactions. He has advised on numerous Section 1031 transactions. If you think a like-kind exchange is something that could benefit you, please contact Andy at email@example.com.