Hot Issues in 1031 Exchanges

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June 06, 2006

Many Section 1031 exchanges involve issues for which the IRS has provided little or no guidance. The planning and execution of exchanges that will withstand IRS scrutiny requires practical solutions. Knowledge of these "cutting-edge" solutions is critical.

Reverse Exchanges

Often, a real estate owner will desire to sell a parcel of real estate he or she currently owns and acquire a new piece. Before the owner is able to sell the existing parcel, a new piece is located which is "perfect." However, the new piece must be acquired immediately, usually because in today's market, the "perfect" piece does not tend to stay on the market very long.

The Internal Revenue Code and the Treasury Regulations generally allow for deferred exchanges only where the relinquished property is sold first, with the sales proceeds being used to acquire the replacement property. Unfortunately, once again, the Regulations do not address a very real problem.

Rather than inform the real estate owner that the desired exchange is not viable, several options exists whereby, with a little ingenuity, the transaction can effectively be consummated and qualify under section 1031. The following is a brief explanation of some planning options.

Change Timing of Closing Dates

The easiest solution is to try to either accelerate the closing date for the sale of the relinquished property or to delay the closing date for the purchase of the replacement property. Most times this solution is not available, since the timing of the closing dates created the problems in the first place.

Lease With Option To Buy

Especially if the real estate owner will use the new real estate in its business, such as a warehouse or factory, the real estate owner may enter into a carefully drafted lease for the replacement property with an option to buy. Then, once the relinquished property has been sold, the exchanger can exercise the option and acquire the replacement property with the proceeds from the sale of the relinquished property, as envisioned by the Regulations. Special care must be given to the option price, the exercise price and terms of payment to avoid having the IRS recharacterize the granting of the option as a taxable sale.

Use of Strawperson

Sellers of real estate tend to want an immediate sale of their real estate and decline to enter into a lease with an option to buy. Therefore, other alternatives must be pursued. In these situations, exchangers request a favor from a trusted, but unrelated, person. This strawperson, or straw, can either purchase the relinquished property from the exchanger, thus beginning the 180 day replacement period, or the straw can acquire the replacement property and hold such property until the relinquished property can be sold. In either scenario, the exchanger, in essence, effectuates a standard deferred exchange since, as to the exchanger, the sale of the relinquished property and the purchase of the replacement property occurs in the proper order.

While the Code and the Regulations provide no affirmative authority for these types of transactions, no prohibitions exist and general tax principles and the principles under section 1031 appear to allow such transactions. Again, careful planning and execution is critical to effectuating a valid exchange.

The choice of the straw is one of the most important considerations. If the wrong straw is chosen, the IRS will claim that the exchanger has constructively received the exchange proceeds because the straw is the exchanger's agent. Generally, the straw cannot be related by blood and cannot be the exchanger's regular accountant or attorney. A qualified intermediary, such as All States 1031, on the other hand, is not considered the exchanger's agent.

Further, most straws lack the financial wherewithal to acquire either the relinquished property or the replacement property without an

outside source of financing. An independent source of financing, apart from the exchanger, is the preferred method. However, even then, the straw will be required to fund the equity portion. Few lenders are willing to lend 100% of the acquisition price, thus, the exchanger will likely have to loan all or a portion of the acquisition price to the straw. Another approach has been to have the exchanger personally guaranty traditional financing. In any event, due care must be given to the form of financing.

In most situations, the Qualified Intermediary can act as the straw. Experienced Intermediaries have the procedures in place to "park" the property until such time as the exchange can be effectuated. Again, your tax advisor should be consulted before embarked down this path.

Planning Points

The bottom-line to reverse exchanges is that some viable solution can generally be devised. Seek competent tax advice from a tax attorney or tax accountant with the experience of multiple exchanges under his or her belt.

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