Tax Law Insights

Individuals and businesses seeking to sell trade or investment property may have taxable capital gains or other income from the sale. Section 1031 of the Internal Revenue Code provides an opportunity to instead exchange this property for other property of a "like kind", and to defer, postpone, or even exclude altogether (at death) this tax.

Like all tax rules, Section 1031 contains important definitions and terms, which must be considered in understanding how this tax mechanism works.

3 Property Rule - An Exchangor may identify as Replacement Property like-kind property of any value, so long as no more than 3 properties are identified.

200% Rule - Alternatively, the Exchangor may identify any number of properties, so long as the fair market value of the identified potential Replacement Property does not exceed 200% of the fair market value of the Relinquished Property.

95% Rule - Or, finally, the Exchangor may identify any number of potential Replacement Properties of any value for so long as the Exchangor actually acquires as Replacement Property 95% of the fair market value of such property.

Adjusted Basis - As to an item of property, including Relinquished Property, the initial purchase price, plus certain capital improvements, less any depreciation. Adjusted Basis is the starting point for determining potential tax deferral in a 1031 Exchange.

Boot - Money or the fair market value of "other property" received by the Exchangor. Money includes cash and cash equivalents, plus liabilities of the taxpayer assumed by the other party, or liabilities to which the Relinquished Property is subject. "Other property" is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or a promissory note received for payment of the purchase price of the Relinquished Property. Where an Exchangor does not direct all of the sales proceeds for the Relinquished Property to the QI but instead retains some, the retained funds constitute boot.

Construction (or Improvement) Exchange - A form of delayed exchange where an EAT takes title to the Replacement Property, expends Exchange Proceeds for improvements to the Replacement Property, and then conveys title to the Exchangor before the expiration of the Exchange Period.

Constructive Receipt -Where money or property is credited to the Exchangor's account, set apart for the Exchangor, or otherwise made available so that the Exchangor may draw upon it at any time or so that the Exchangor can draw upon it if notice of intention to draw is given. Where the Exchangor is deemed to have constructive receipt of exchange proceeds, those proceeds are then taxable. Funds received or constructively received by a Disqualified Person are considered constructively received by the Exchangor.

Delayed (or "Starker") Exchange - The most common form of 1031 Exchange. In a Delayed Exchange, the Exchangor sells the Relinquished Property and the funds are held in a QEA by the QI, who then uses these funds to acquire the Replacement Property during the Exchange Period.

Disqualified Person - Generally, an agent of the Exchangor, including, as identified in Treasury Regulations Section 1.1031(k)-1(k), "a person who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties in a like-kind exchange." A Disqualified Person is prohibited from serving as EAT or QI.

Exchange Accommodation Titleholder (EAT) - The entity that holds title to either the Relinquished Property or the Replacement property in connection with a Reverse Exchange. In most cases, the EAT is affiliated with the Qualified Intermediary handling the reverse exchange.

Exchange Agreement - A written agreement between the Qualified Intermediary and Exchangor setting forth the Exchangor's intent to exchange relinquished property for replacement property, as well as the terms, conditions and responsibilities of each party pursuant to the tax-deferred, like-kind exchange transaction.

Exchange Period - The 180-day period, beginning with the day of the sale of the Relinquished Property, during which a Delayed Exchange must be completed.

Exchangor - The taxpayer exchanging like-kind property in a 1031 Exchange.

Identification - Written notice of potential Replacement Property provided by the Exchangor during the Identification Period, subject to (i) the 3 Property Rule, (ii) the 200% Rule, and (iii) the 95% Rule.

Identification Period - The 45-day period, beginning with the day of the sale of the Relinquished Property, during which the Replacement Property must be identified.

Like-Kind - Property that is eligible to be exchanged. Like-kind property is property of the same nature, character or class, and must be either (i) held for investment, or (ii) used in a trade or business. Most real estate is considered like-kind to other real estate. Certain types of personal property is considered of like-kind with other personal property, but never with real property.

Qualified Escrow Account (QEA) - An escrow account wherein the escrow holder is not the Exchangor or a Disqualified Person, and the escrow agreement expressly limits the Exchangor's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account. Funds held in a QEA are not considered constructively received by the Exchangor.

Qualified Exchange Accommodation Agreement - A written agreement whereby the EAT agrees to purchase and hold title to the replacement property or relinquished property until the Exchangor is able to sell the relinquished property.

Qualified Intermediary (QI) - An unrelated third party that administers the tax-deferred, like-kind exchange transaction in order to facilitate the disposition of the Relinquished Property and the acquisition of the Replacement Property. The QI has no economic interest except for compensation (exchange fee) it may receive and may not be a Disqualified Person. The QI generally holds funds in a Qualified Escrow Account on behalf of the Exchangor.

Relinquished Property - The property sold by the Exchangor in a 1031 exchange.

Replacement Property - The property received by the Exchangor in a 1031 exchange.

Reverse (or "Reverse Starker") Exchange - A type of delayed exchange. In a typical Reverse Exchange, Replacement Property is acquired by the EAT prior to the sale of the Relinquished Property. "Safe harbor" rules for Reverse Exchanges are identified in IRS Revenue Procedure 2000-37.