Tax Tip Podcast or Blog Post and a Deferred Like Kind Exchange with Examples

Tax Tip Podcasts & Blog Posts for Realtors, Brokers, Real Estate Professionals

A deferred like-kind exchange (also known as a Starker exchange or “delayed” exchange) involves a non-simultaneous like-kind exchange. This type of like-kind exchange was approved by the Ninth Circuit in Starker v. United States, 602 Federal 2d 1341 (9th Circuit 1979). A deferred exchange is defined as an exchange in which, under an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (the “relinquished property”) and subsequently receives property to be held either for productive use in a trade or business or for investment (the “replacement property”). If certain requirements are not met, the replacement property received by the taxpayer is treated as property that is not of a like kind to the relinquished property. For exchanges after 2017, the like-kind exchange rules apply only to exchanges of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of a like kind which is to be held either for productive use in a trade or business or for investment (Code Section 1031(a)).

In order to constitute a deferred Like-kind exchange, the transaction must be a transfer of property for property, as distinguished from a transfer of property for money (Regulations Section 1.1031(k)-1(a); Redwing Carriers v. Tomlinson, 399 Federal 2d 652 (5th Circuit 1968)). Thus, if, before receiving the replacement property, the taxpayer actually or constructively receives money or unlike property in full consideration for the property the taxpayer transfers, the transaction will be treated as a sale rather than a deferred exchange. In that case, the taxpayer must recognize gain or loss on the transaction, even if the taxpayer later receives the replacement property. If, before receiving the replacement property, the taxpayer actually or constructively receives money or unlike property in less than full consideration for the property the taxpayer transfers, the transaction will be treated as a partially taxable exchange (Regulations Section 1.1031(k)-1(a)).

For purposes of a deferred like-kind exchange, a taxpayer actually receives money or unlike property when the taxpayer receives the money or unlike property or receives the economic benefit of the money or unlike property. A taxpayer constructively receives money or unlike property when the money or unlike property is credited to the taxpayer’s account, set apart for the taxpayer, or is otherwise made available so that the taxpayer can draw upon it at any time or so that the taxpayer can draw upon it if the taxpayer gives notice of intention to do so. A taxpayer does not constructively receive money or unlike property if the taxpayer’s control of receiving it is subject to substantial limitations or restrictions. However, the taxpayer constructively receives money or unlike property when the limitations or restrictions lapse, expire, or are waived (Regulations Section 1.1031(k)-1(f)(2)).

(1) the replacement property must be identified within 45 days after the closing of the sale of the initial property; and

(2) the replacement property must be received within 180 days of the closing of the sale of the initial property, or by the extended date of the taxpayer’s tax return for the year in which the initial sale occurred, whichever date is earlier (Regulations Section 1.1031(k)-1(b)(1)).

If, as part of the same deferred exchange, the taxpayer transfers more than one relinquished property and the relinquished properties are transferred on different dates, the identification period and the exchange period are determined by reference to the earliest date on which any of the properties are transferred (Regulations Section 1.1031(k)-1(b)(2)).

Practice Tax Tip: Property is transferred when the property is disposed of within the meaning of Code Section 1001(a).

The 45-Day Identification Rule: To qualify for deferral under the like-kind exchange provisions, the replacement property must be identified within 45 days after the closing of the sale of the relinquished property. The 45-day identification period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the 45th day thereafter (Code Section 1031(a)(3)(A); Regulations Section 1.1031(k)-1(b)(2)(i)). For exchanges after 2017, the like-kind exchange rules apply only to exchanges of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of a like kind which is to be held either for productive use in a trade or business or for investment (Code Section 1031(a)).

Generally, replacement property is treated as identified before the end of the identification period only if two requirements are met. Under the first requirement, replacement property is treated as identified only if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to either:

(1) the person obligated to transfer the replacement property to the taxpayer; or

(2) any other person involved in the exchange ((for example, an intermediary, an escrow agent, or a title company) other than the taxpayer or a disqualified person (Regulations Section 1.1031(k)-1(c)(1) and (2)).

A taxpayer can identify more than one replacement property. However, regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of replacement properties a taxpayer may identify is limited to either:

(1) three replacement properties without regard to the fair market value of the properties; or

(2) any number of replacement properties as long as the aggregate fair market value of those replacement properties (as of the end of the identification period) is not greater than 200 percent of the aggregate fair market value of all the relinquished properties (as of the date the relinquished properties were transferred by the taxpayer) (Regulations Section 1.1031(k)-1(c)(4)(i)).

If, as of the end of the identification period, the taxpayer has identified more properties as replacement properties than permitted, the taxpayer is treated as if no replacement property has been identified. However, there are two exceptions under which a taxpayer will be treated as satisfying the identification requirement even when he identifies more replacement properties than permitted:

(1) Any replacement properties actually received by the taxpayer before the end of the identification period are treated as satisfying the identification requirement.

(2) Any replacement properties identified before the end of the identification period and actually received before the end of the exchange period are treated as satisfying the identification requirement if, before the end of the exchange period, the taxpayer receives identified replacement properties with a fair market value of at least 95 percent of the total fair market value of all identified replacement properties (Regulations Section 1.1031(k)-1(c)(4)(ii); Private Letter Ruling 9826033).

Tax Tips Example 1:

Bob and Carl, both calendar year taxpayers, agree to enter into a deferred exchange. Under their agreement, Bob transfers investment real property to Carl on May 17, 2018. The investment real property is unencumbered and has a fair market value on May 17, 2018, of $100,000. On or before July 1, 2018 (the end of the identification period), Bob is to identify replacement property that is of a like kind to Bob’s investment real property. On or before November 13, 2018 (the end of the exchange period), Carl is required to purchase property identified by Bob and to transfer that property to Bob. To the extent the fair market value of the replacement property transferred to Bob is greater or less than the fair market value of Bob’s investment real property, either Bob or Carl, as applicable, will make up the difference by paying cash to the other party after the date the replacement property is received by Bob. No replacement property is identified in the agreement. On June 28, 2018, Bob identifies real properties A, B, and C as replacement properties by designating these properties as replacement properties in a written document signed by Bob and personally delivered to Carl. The replacement property is described by legal description and is of a like kind to Bob’s investment real property and Bob intends to hold the replacement property received for investment. The written document provides that by July 1, 2018, Bob will orally inform Carl which of the identified properties Carl is to transfer to Bob. As of July 1, 2018, the fair market values of real properties A, B, and C are $75,000, $100,000, and $125,000, respectively. Because Bob did not identify more than three properties as replacement properties, the requirements of the three-property rule are satisfied, and real properties A, B, and C are all identified before the end of the identification period.

Tax Tip Example 2:

Assume the same facts as Example 1 except that, on June 28, 2018, Bob identifies real properties A, B, C, and D as replacement properties by designating these properties as replacement properties in a written document signed by Bob and personally delivered to Carl. The written document provides that by July 1, 2018, Bob will orally inform Carl which of the identified properties Carl is to transfer to Bob. As of July 1, 2018, the fair market values of real properties A, B, C, and D are $30,000, $40,000, $50,000, and $60,000, respectively. Although Bob identified more than three properties as replacement properties, the aggregate fair market value of the identified properties as of the end of the identification period ($180,000) did not exceed 200 percent of the aggregate fair market value of Bob’s investment real property (200% x $100,000 = $200,000). Therefore, the requirements of the 200-percent rule are satisfied, and real properties A, B, C, and D are all identified before the end of the identification period.

Tax Tip Example 3:

Assume the same facts as Example 1, except that on July 2, 2018, Bob identifies real property X as replacement property by designating that real property as replacement property in a written document signed by Bob and personally delivered to Carl. Because the identification was made after the end of the identification period, real property X is treated as property which is not of a like kind to Bob’s investment real property.

Compliance Tax Tip: The identification of replacement properties can be revoked as long as it is done within the 45-day identification period. This revocation must be done in writing and should include a rescission of a purchase and sale agreement, if one was written (Regulations Section 1.1031(k)-1(c)(6)).

For purposes of the identification rules, property that is incidental to a larger item of property is not treated as separate from the larger item of property. Property is incidental to a larger item of property if:

(1) in standard commercial transactions, the property is typically transferred together with the larger item of property; and

(2) the total fair market value of all of the incidental property does not exceed 15 percent of the total fair market value of the larger item of property (Regulations Section 1.1031(k)-1(c)(5)).

Tax Tip Example:

In 2017, Mark makes an agreement to exchange his van for a truck with a fair market value of $5,000. The truck comes with a spare tire and tool kit that have a combined fair market value of $700. In identifying the truck, Mark specifies the make, model, and year of the truck, but does not make any reference to the spare tire and tool kit. Because a spare tire and tool kit would typically be transferred with a truck in standard commercial transactions and because the total fair market value of the spare tire and tool kit ($700) does not exceed 15 percent of the total fair market value of the truck ($5,000), the spare tire and tool kit are not treated as separate property. The truck, spare tire, and tool kit are treated as one property for purposes of the three-property limitation discussed above. In addition, the truck, spare tire, and tool kit are all considered unambiguously described even though no reference was made to the spare tire and tool kit.

The 180-Day Receipt Rule: To qualify for deferral under the like-kind exchange provisions, the replacement property must be received by the taxpayer before the end of the 180-day exchange period. The 180-day exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight of the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s income tax return for the tax year in which the transfer of the relinquished property occurs (Regulations Section 1.1031(k)-1(b)(2)(ii); Christensen v. Commissioner, 149 Federal 3d 442 (9th Circuit 1998)).

In the case of a deferred exchange, the identified replacement property is received before the end of the exchange period only if:

(1) the taxpayer receives the replacement property before the end of the exchange period; and

(2) the replacement property received is substantially the same property as identified.

If the taxpayer has identified more than one replacement property, this rule is applied separately to each replacement property (Regulations Section 1.1031(k)-1(d)(1)).

Tax Tip Example 1:

Bill and Kevin agree to enter into a deferred exchange. Under their agreement, Bill transfers investment real property to Kevin on May 17, 2018. Bill’s property is unencumbered and has a fair market value on May 17, 2018, of $100,000. On or before July 1, 2018 (the end of the identification period), Bill is to identify replacement property that is of a like kind to his investment real property. On or before November 13, 2018 (the end of the exchange period), Kevin is required to purchase the property identified by Bill and to transfer that property to Bill. To the extent the fair market value of the replacement property transferred to Bill is greater or less than the fair market value of Bill’s investment real property, either Bill or Kevin, as applicable, will make up the difference by paying cash to the other party after the date the replacement property is received by Bill. The replacement property satisfies the identification requirements and is of like kind to Bill’s investment real property and Bill intends to hold any replacement property received for investment. Bill identifies real properties A, B, and C as replacement properties. The agreement provides that by July 1, 2018, Bill will orally inform Kevin which of the properties Kevin is to transfer to Bill. As of July 1, 2018, the fair market values of real properties A, B, and C are $75,000, $100,000, and $125,000, respectively. On July 1, 2018, Bill instructs Kevin to acquire real property B. On October 31, 2018, Kevin purchases real property Brett for $100,000 and transfers the property to Bill. Because real property Brett was identified before the end of the identification period and was received before the end of the exchange period, the identification and receipt requirements are met.

Tax Tip Example 2:

Assume the same facts as the above example, except in the agreement, Bill identifies real property X as replacement property. Real property X consists of two acres of unimproved land. On October 15, 2018, the owner of real property X erects a fence on the property. On November 1, 2018, Kevin purchases real property X and transfers it to Bill. The erection of the fence on real property X subsequent to its identification did not alter the basic nature or character of real property X as unimproved land. Bill is considered to have received substantially the same property as identified.

Generally, a transfer of relinquished property in a deferred exchange will qualify for like-kind exchange treatment even if the replacement property is not in existence or is being produced at the time it is identified as replacement property (Regulations Section 1.1031(k)-1(e)(1)).

Practice Tax Tip: The terms “produced” and “production” have the same meanings as provided in the uniform capitalization rules of Code Section 263A(g)(1).

In the case of replacement property that is to be produced, the replacement property generally must be identified under the rules discussed above. For example, if the identified replacement property consists of improved real property where the improvements are to be constructed, the description of the replacement property satisfies the identification requirements relating to the description of the property if a legal description is provided for the underlying land and as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made. The fair market value of replacement property that is to be produced is its estimated fair market value as of the date it is expected to be received by the taxpayer (Regulations Section 1.1031(k)-1(e)(2)).

In addition, when the identified replacement property is property to be produced, variations due to usual or typical production changes are not taken into account in determining whether the replacement property received by the taxpayer is substantially the same property as identified. However, if substantial changes are made in the property to be produced, the replacement property received will not be considered to be substantially the same property as identified (Regulations Section 1.1031(k)-1(e)(3)(i)).

If the identified replacement property is personal property to be produced, the replacement property received will not be considered to be substantially the same property as identified unless production of the replacement property received is completed on or before the date the property is received by the taxpayer (Regulations Section 1.1031(k)-1(e)(3)(ii)).

If the identified replacement property is real property to be produced and the production of the property is not completed on or before the date the taxpayer receives the property, the property received will be considered to be substantially the same property as identified only if, had production been completed on or before the date the taxpayer receives the replacement property, the property received would have been considered to be substantially the same property as identified. Even so, the property received is considered to be substantially the same property as identified only to the extent the property received constitutes real property under local law (Regulations Section 1.1031(k)-1(e)(3)(iii)).

Caution: The transfer of relinquished property will not qualify as a like-kind exchange if the relinquished property is transferred in exchange for services (including production services). Thus, any additional production occurring with respect to the replacement property after the property is received by the taxpayer will not be treated as the receipt of property of a like kind.

Tax Tip Example:

Brett, a calendar year taxpayer, and Caitlin enter into a deferred exchange. Under the agreement, Brett transfers improved real property X and personal property Y to Caitlin on May 17, 2017. On or before November 13, 2017 (the end of the exchange period), Caitlin is required to transfer to Brett real property B, on which Caitlin is constructing improvements, and personal property C, which Caitlin is producing. Caitlin is obligated to complete the improvements and production regardless of when properties B and C are transferred to Brett. Properties B and C are identified in a manner that satisfies the identification requirements. In addition, properties B and C are of a like kind, respectively, to real property X and personal property Y. On November 13, 2017, when construction of the improvements to property B is 20 percent completed and the production of property C is 90 percent completed, Caitlin transfers to Brett property B and property C. If construction of the improvements had been completed, property B would have been considered to be substantially the same property as identified. Under local law, property B constitutes real property to the extent of the underlying land and the 20 percent of the construction that is completed. Because property C is personal property to be produced and production of property C is not completed before the date the property is received by Brett, property C is not considered to be substantially the same property as identified and is treated as property which is not of a like kind to property Y. Property B is considered to be substantially the same property as identified to the extent of the underlying land and the 20 percent of the construction that is completed when property B is received by Brett. However, any additional construction performed by Caitlin with respect to property B after November 13, 2017, is not treated as the receipt of property of a like kind.

While the exchange period generally cannot be extended, Code Section 7508A and Revenue Procedure 2018-58 provide exceptions for federally declared disasters and terror and military actions. As Revenue Procedure 2018-58 points out, the revenue procedure itself does not provide any postponements under Code Section 7508A. The IRS generally will publish a notice or issue other guidance providing relief with respect to a federally declared disaster, or a terroristic or military action (Revenue Procedure 2018-58).

Practice Tax Tip: With the exception of disasters, wars, and terrorist actions, there are no provisions for extending the 45-day identification period or the 180-day exchange period. If an exchange does not meet those requirements, it is treated as a normal taxable sale.

Brenda Fitch Real Estate Professional
Brenda Fitch Real Estate Professional

In the event of the bankruptcy of a qualified intermediary, there is no provision for extending the 180-day exchange period. However, in Revenue Procedure 2010-14, the IRS announced that when a qualified intermediary’s bankruptcy caused the taxpayer to miss the re-investment deadline in a like-kind exchange, the taxpayer could postpone recognizing the gain on the sale of the original property until the year in which the taxpayer receives a payment attributable to the relinquished property. If payments cover multiple years, the taxpayer will recognize income using a special method established in the revenue procedure (Revenue Procedure 2010-14).

Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.

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