Deferrring Capital Gains taxation through a Like Kind Exchange

Section 1031 of the Internal Revenue Code allows the owner (called the taxpayer here) of appreciated real property used in a trade or business (such as rental) or held for investment to be exchanged for like kind property without payment of capital gains taxes. Like kind property is other real property the taxpayer intends to hold for investment or use in a trade or business. However, in order for the exchange to avoid recognition of all capital gains taxes: a) the taxpayer must not assume a mortgage on the new property unless it is a mortgage smaller than one assumed from him on his former property; b) the taxpayer must not receive any cash or non-like-kind property in the transaction; c) if the transaction is a deferred transaction, then the acquisition cost of the new property must exceed the price paid for the former property.

The taxpayer never will find another person with property the taxpayer wants who wants the taxpayer's property. Instead, the taxpayer must establish an exchange by linking together a Buyer who wants the taxpayer's property to a seller who has property the taxpayer wants. This is referred to as a deferred exchange. IRS regulations allow a taxpayer who has a contract to sell his property to assign the contract and the property to a qualified intermediary for the purpose of completing a Section 1031 deferred exchange. This must be done pursuant to an exchange agreement with the qualified intermediary clearly setting forth the duties of both parties to meet the requirements of the regulations. When the taxpayer finds property that he wishes to acquire to complete the exchange, the intermediary can acquire that property using the proceeds from the intermediary's sale of the taxpayer's former property. The most important rules governing the procedures, stated generally, are: a) the qualifiied intermediary must be unrelated, independent, trustworthy and must be required by the exchange agreement to hold the funds separate from the taxpayer while an exchange is pending; b) the taxpayer must unambiguously designate potential replacement properties (3 or less) within 45 days of the closing of the the sale of his former property; c) the taxpayer must acquire title to the new property within 180 days of the closing of the sale of his former property; and d) the taxpayer must not have ever had the ability receive the proceeds from the sale of his former property.

IRS rulings have allowed the intermediary to "acquire" the taxpayer's former property by simply assigning the contract or property to the intermediary pursuant to the exchange agreement. Then the intermediary instructs the taxpayer to deed directly to the buyer to complete the intermediary's obligation to deliver title to the property in exchange for intermediary receiving the proceeds from the transaction. The purpose is to avoid the expense of additional documentary stamps which would be required to be placed on a deed to the intermediary. Such stamps must still be placed on the deed to the buyer, but duplication of the expense is avoided. In a similar fashion, the intermediary can "acquire" the new property to convey to the taxpayer to complete the exchange. The intermediary delivers the proceeds to close the transaction and simply instructs the Seller to deed the property directly to the taxpayer in order to avoid duplication of the documentary stamps. IRS rules allow the taxpayer to later receive the benefit from earnings on the proceeds held by the intermediary pending completion of the exchange. From the generosity of the IRS in these procedures, one can readily see that the most important rule (but only one of many) for avoiding the capital gain taxation of the series of transactions constituting the exchange is that the taxpayer must never have the ability to obtain the funds.

This explanation has been made simple and general in order to communicate the basic structure of like-kind exchanges. Every exchange must follow more detailed rules and document full compliance. Experience has shown that the variables in facts and unanticipated misunderstandings and failures of non-exchanging parties to folow instructions result in complications in even well-planned exchanges. Every exchange should have a tax attorney preparing the documents and guiding compliance.

This article contributed by Richard W. Winesett - Fort Myers, Florida
Richard W. Winesett may be contacted at:
2248 1st Street
Fort Myers, Florida 33901
239-334-7040