7843 / What is a deferred exchange of real estate? When will this type of exchange qualify as a like-kind exchange?

Where B wants title to A’s property before suitable replacement property has been located, the IRC specifies a limited period of time that may elapse after property is relinquished in a transfer and before the replacement property to be received is identified and transferred. For purposes of IRC Section 1031, the regulations, and this discussion, a deferred exchange is any exchange in which, pursuant to an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (i.e., the “relinquished property”) and subsequently receives property to be held for productive use in a trade or business or for investment (i.e., the “replacement property”).¹

Transfers in which property is conveyed in return for a promise to acquire and convey acceptable replacement property by a certain future date were permitted under case law predating the 1984 revision of IRC Section 1031.²

The IRC states that to be treated as of like kind to relinquished property, the replacement property must be (1) identified as the property to be received in the exchange on or before the 45th day after the property relinquished in the exchange is transferred (i.e., the “identification period”), and (2) received within 180 days after the transfer of the property relinquished or, if earlier, the due date (including extensions) of the transferor’s income tax return for the tax year in which the transfer of the relinquished property occurred (i.e., the “exchange period”).³ “Identified” and “received,” for this purpose, are defined in the regulations as explained below.

Regulations provide that replacement property is “identified” only if it is unambiguously described and designated as such in a written document, signed by the taxpayer and delivered (faxed, mailed, etc.), before the end of the identification period, to the person obligated to transfer the replacement property, or to any other person involved in the exchange (e.g., an escrow agent or a title company), other than the taxpayer or a “disqualified person” (defined below).⁴ However, replacement property actually received before the end of the identification period will be treated as identified.⁵

Because it is not always possible for a taxpayer to identify with precision the replacement property that will ultimately be received, the regulations permit identification of alternative properties. The maximum number of properties that may be identified as replacement property in a single deferred exchange is: (1) three properties, without regard to their fair market values; or (2) any number of properties, as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the fair market value of the relinquished property as of the date of transfer.⁶

If, as of the end of the identification period, the taxpayer has identified more replacement properties than permitted under the above rules, he or she will generally be treated as if no replacement had been identified. There are two exceptions to this general rule: First, any replacement property actually received before the end of the identification period will be treated as satisfying the requirements of the preceding paragraph. Second, a special “95 percent rule” may apply as follows: Any replacement property identified before the end of the identification period and received before the end of the exchange period will be treated as satisfying the requirements of the preceding paragraph if the taxpayer receives, before the end of the exchange period, identified replacement property having a fair market value that is at least 95 percent of the aggregate fair market value of all identified replacement properties.⁷

In order to meet the receipt requirement, the replacement property must be received before the end of the (180-day) exchange period, and the replacement property received must be substantially the same property as identified. If more than one replacement property was identified, these requirements apply separately to each replacement property.⁸ Special rules apply for identification and receipt of replacement property that does not yet exist or is being produced at the time relinquished property is transferred.⁹

For taxpayers implementing a deferred exchange, the necessity of protecting the owner of the relinquished property until the transaction is completed often results in the use of an intermediary and some form of guarantee to secure the obligations of the transferee. Two issues that have tended to result in frequent challenges by the IRS to complex deferred like-kind exchanges are: (a) whether an intermediary is an agent of the taxpayer (see discussion in Q 7842 on simultaneous exchanges) and (b) whether the taxpayer who receives cash or other security guaranteeing the transaction has constructively received payment for the transfer, thus having made a sale rather than an exchange.¹⁰ Regulations address these problems by providing four safe harbors designed to help taxpayers engaging in deferred exchanges avoid such challenges. (Of these four, only one, the qualified intermediary safe harbor, is also applicable to simultaneous exchanges; see Q 7842.)