Delayed Exchange
The most commonly utilized tax planning strategy available to investors
is the delayed exchange. A delayed exchange results when there is a time
delay between the sale of the relinquished property and the purchase of
the replacement property. Also referred to as a "Starker Exchange"
because of the landmark 1979 federal case entitled, Starker v. U.S.
602 F2d 1341 (9th Cir 1979) wherein the court substantiated the validity
of the delayed exchange process. Prior to the Starker case, 1031 of the
Internal Revenue Code (promulgated in 1924) authorized tax-free exchanges
of real and personal property. Thereafter, Congress, in the 1984
Tax Reform Act, adopted subsection 1031(a)(3)
which created the 45 day identification period and the 180 day exchange
period. Finally, on April 25, 1991, the IRS promulgated the final regulations
under section 1.1031(a)-1, et. seq. which provide specific rules for deferred
like kind exchanges. Personal property is no longer eligible for 1031 exchanges,
effective January 1, 2018.
The delayed exchange provides investors
up to 180 days to purchase replacement property once the relinquished
property is sold. And, the use of a Qualified Intermediary is required
to facilitate a valid delayed exchange. The delayed exchange occurs in
three fundamental steps:
STEP ONE: Sale of the Relinquished
Property: Before closing on the sale of the relinquished property
the Exchanger retains a Qualified Intermediary such as Old Republic Exchange.
Old Republic Exchange prepares an exchange agreement,
assignment of sale contact and closing instructions to the escrow/closing
agent. Old Republic Exchange instructs the escrow/closing
agent to direct deed the relinquished property to the buyer and to deliver
sale proceeds directly to Old Republic Exchange - thereby preventing the Exchanger from
having actual or constructive receipt of the funds. Once the funds are
delivered to Old Republic Exchange, access to the funds is restricted for the remainder
of the exchange period. In short, IRC 1031 provides strict rules pertaining
to the release of funds to the Exchanger even where the Exchanger decides
not to proceed with the exchange.
STEP TWO: Identification of the
Replacement Property: The Exchanger must identify replacement
property within 45 calendar days of the close of the relinquished property.
The identification is proper only if the replacement property is designated
as replacement property in a written document signed by the Exchanger
and hand delivered, mailed, telecopied, or otherwise sent to the person
obligated to transfer the replacement property to the Exchanger (i.e.
the seller of the replacement property) or to any other person involved
in the exchange other than the Exchanger or a disqualified person. Three
identification rules apply:
- 3 PROPERTY RULE: Three properties no
matter what the fair market value; or
- 200 PERCENT RULE: Any number of properties
as long as the aggregate fair market value does not exceed 200% (2x)
of the fair market value of all the relinquished properties; or
- 95 PERCENT RULE: Any number of properties
without regard to value - provided 95% of the value of the identified
properties are acquired.
STEP THREE: Purchase of Replacement
Property: Within 180 calendar days from the sale of the relinquished
property, or the Exchanger's tax filing date (assuming no automatic extension
is applied for), whichever is earlier, the Exchanger must acquire like
kind replacement property and the property acquired must be one or all
of the previously "identified" replacement properties. The Exchanger
again assigns the purchase and sale contract to Old Republic Exchange,
who purchases the replacement property with the exchange proceeds and
causes the transfer of the replacement property to the Exchanger by way
of a direct deed from the seller.