EXPLANATION OF TAX-DEFERRED EXCHANGE

A “tax-deferred exchange” is a transaction involving the sale and purchase of investment property or property held for productive use in trade or business which meets the requirements of Section 1031 of the Code and qualifies for nonrecognition of gain or loss. These transactions come in a variety of formats and fact patterns, but the basic concept of changing ones investment assets without changing the underlying investment methods or goals remains constant.

The language regarding exchanges was drafted into the Code in 1921, just three years after the Code’s implementation in 1918.  For a long period, the idea was long thought to cover only simultaneous trades of property, or “swaps”.  This notion that all exchanges must occur simultaneously was challenged by an individual named T. J. Starker and his family.  In Starker v. United States, 602 F.2d 1341 (9th Cir., 1979), the Court held the Code contained no requirement that an exchange be a simultaneous transfer of property between two owners.  As a result of the outcome of Starker, the essential definition of a deferred exchange as we know it today was added to the Code in 1984.

Significant expansion to this understanding came when the Service promulgated the first set of Regulations that govern IRC §1031 tax-deferred exchanges effective June 10, 1991. These Regulations approved the concept of a deferred exchange within certain limitations, and address the majority of questions which arise in every day deferred transactions.  The final major expansion to governmental guidance came in the form of Revenue Procedure 2000-37, which set forth a safe harbor for taxpayers wishing to purchase replacement property prior to selling Relinquished Property and to complete a Reverse Exchange.

Types of §1031 Exchanges

Simultaneous:   An exchange where the relinquished property and replacement property are transferred concurrently.

Deferred:          An exchange that begins the date relinquished property is transferred if replacement property is identified within 45 days and acquired no later than the end of the 180-day exchange period.  A deferred exchange is the most common type of exchange that occurs.  A qualified intermediary or similar safe harbor as described in Section 1.1031(k)-1(g) of the Regulations must be involved in the transaction for it to be eligible for tax deferral.

Construction:    An exchange in which the replacement property desired by the taxpayer includes improvements to be constructed.  These may entail repairs or remodeling of an existing structure, or construction of a new building on raw land.  These may not include construction of improvements on property already owned by the taxpayer.

Reverse:            An exchange in which a taxpayer wishes to acquire the replacement property prior to the sale of the relinquished property.  There are many reasons why this may happen.  The taxpayer may have lost or not yet located a buyer for the relinquished property, or perhaps she is in a position to lose favorable financing or a substantial earnest money deposit if she fails to close on the replacement property by a specified date.  These transactions require the involvement of an accommodating titleholder who steps in and takes title to either the relinquished or the replacement property on the taxpayer’s behalf, and entails additional requirements to the more common deferred exchange process.