1031 Exchange Part 2 – the Delayed Exchange
By BPE Attorney Matthew Kirkpatrick
An exchange is simply the giving of something with value in order to receive something else of value. This is what happens in any purchase and sale. 1031 Exchanges however enable a “sale” to occur in certain types of transactions and avoid having to pay capital gains tax at the time of sale, this having more money available for the purchase. Obviously, this can be very valuable for real estate investors.
Rarely are two property owners actually exchanging their property between themselves. Most commonly, Seller is selling his property to Buyer and then Seller uses the sale proceeds to buyer a different property from a different seller. For the seller to avoid the capital gains on his sale, the proceeds are received and controlled by the Qualified Exchange Intermediary so none of the sale proceeds are actually received by the Seller. The Intermediary then acquires the new property and transfers the legal title to the Seller.
It is possible for both real property transactions – the sale of the downleg property and the purchase of the upleg property – to occur in a single escrow session. This is called a “Simultaneous Exchange”. However, in the case of real property, this rarely occurs nor is it generally desireable. This is because timing issues and unexpected title or loan payoff problems could delay the completion of the upleg purchase. If the downleg closes first, the gains could become taxable income and ruin the value of the Exchange and possibly even preclude the Seller from being able to complete the upleg purchase.
Luckily the Tax Code provides relief through the use of a “Delayed Exchange”. When first written, the IRS interpreted the Code as requiring that all exchanges be simultaneous. But in 1979, the Federal Courts decided in the case of Starker v U.S. (602 F.2d 1341) that under certain circumstances, a delay can occur between the downleg sale and upleg purchase while still qualifying as a 1031 Exchange. As a result of this Court decision, delayed exchanges are often called “Starker Exchanges”. The actual provisions for this are now found in Regs §1.1031(k)-1(a).
To be successful with a delayed exchange, the following must occur:
(1) Exchange Agreement – The Seller (also called the Exchanger) enters into an agreement with a qualified intermediary whereby the funds received from the sale of the downleg property are held by the qualified intermediary until an upleg property can be purchased.
(2) Identification Period – Within 45 days after the downleg property has been sold and title transferred, the Exchanger must identify the upleg property to be purchased. This 45-day window is known as the “identification period.” There are three rules of identification that must be complied with:
First: Three Property Rule: The Exchanger may identify a maximum of three (3) replacement properties, without regard to the fair market value of the properties;
Second: Two-Hundred Percent Rule: The Exchanger may identify any number of properties as long as the aggregate fair market value does not exceed two-hundred percent (200%) of the aggregate fair market value of the relinquished property; and
Third: Ninety-Five Percent Exception: The Exchanger may identify any number of properties without regard to the combined fair market value, as long as the properties acquired amount to at least ninety-five percent (95%) of the fair market value of all identified properties.
(3) Acquisition of Upleg – within 180 days of the transfer of the downleg property the Exchanger must actually acquire the upleg property. This is called the “exchange period.”
Full compliance with each of these requirements is necessary for the Seller/Exchanger to avoid having to pay capital gains tax on the sale of the downleg property. Once the downleg property has been sold, the clock is running. If the upleg purchase fails for any reason regardless of the innocence of the Exchanger.
BPE Law has represented many investors – both buyers and sellers – in working with the parties, their escrow, and their Exchange Intermediary to bring about a successful 1031 Exchange. Needless to say, the dangers of a failing Exchange can lead to very contentious litigation. Fast action and immediate intervention can often rescue and Exchange that is going sidewards. BPE Law has also intervened on behalf of parties to rescue an otherwise failing Exchange. Given the short timelines for property identification and upleg closing, it is critical that action occur quickly as soon as difficulties arise with any Exchange.
If you would like to know more, please feel free to contact Matt by e-mail to firstname.lastname@example.org or call our main office at 916-966-2260 to schedule a low-cost Consultation appointment either in our Fair Oaks or Sun City Lincoln office.
The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are facing a legal issue of any kind, get competent legal advice in your State immediately so that you can determine your best options.