The Deferred Exchange Problem

This chapter traces how that assumption failed and what replaced it. The Ninth Circuit's 1979 decision in Starker v. United States allowed a taxpayer to deed property away and receive replacement property years later. Congress answered in the Deficit Reduction Act of 1984 with the identification and exchange periods, and in the same section it removed partnership interests from the statute's reach. Treasury's 1991 regulations then turned the arrangements that had grown up around deferred exchanges into safe harbors, one of which gave the qualified intermediary its legal form. The operative rules are examined in Chapters 23 through 29. This chapter is concerned with how they came to exist and what the record shows about their purposes.

5.1 Simultaneity as an assumed premise

The text said nothing about timing. From 1924 until 1984 the operative sentence provided that no gain or loss would be recognized if qualifying property "is exchanged solely for property of a like kind" to be held for productive use or investment (4.2 through 4.4). It fixed no period within which the exchange had to be completed. The regulations describe an exchange by contrast with a sale: "Ordinarily, to constitute an exchange, the transaction must be a reciprocal transfer of property, as distinguished from a transfer of property for a money consideration only."¹ Reciprocity is a requirement about what is given for what. It is not, in terms, a requirement about when.

The problem the courts faced was the counterparty. A person who wants to buy a taxpayer's property rarely owns the property the taxpayer wants in return. Before 1979 the reported litigation was mostly about how a third party could be interposed to supply it, and on that question the courts were permissive from the start. In Mercantile Trust Co. of Baltimore v. Commissioner, trustees holding two parcels on East Baltimore Street in Baltimore contracted in 1929 with the Title Guarantee & Trust Co. to exchange them for a Lexington Street property and $33,000, with the right to demand $300,000 in cash if the title company could not acquire the Lexington Street property. A hotel company wanted the Baltimore Street parcels. The Commissioner argued that the title company was a dummy and that the trustees had in substance sold for cash and bought separately. The Board of Tax Appeals disagreed. The title company's contract was enforceable against it as a principal, the trustees' tax motive did not convert the exchange into a sale, and "[t]he only condition precedent to that nonrecognition is the actual exchange of property held for investment for like property to be held for investment."² The Fifth Circuit applied the same reasoning in 1948, this time against a taxpayer that wanted to deduct a loss. An independent real estate man had contracted on his own account to acquire one waterfront lot and dispose of another, and the deeds then ran directly between the owners. The court held that the taxpayer had made an exchange, not a sale, because the middleman "could bind himself to exchange property he did not own but could acquire."³

Alderson and its successors. In Alderson v. Commissioner, the taxpayers had agreed through an escrow to sell farmland in Buena Park, California, for cash. They then found farmland in Monterey County that they wanted instead, and in August 1957 the escrow was amended so that the buyer would acquire that property and exchange it for theirs, with the cash sale to proceed if the exchange was not completed by September 11. The Tax Court held the transaction a sale. The Ninth Circuit reversed in 1963, relying on findings that the taxpayers had intended from the outset to sell for cash only if they could not find suitable property to take in exchange.⁴ Less than two months later the Fourth Circuit followed Alderson, Haden, and Mercantile Trust in Coastal Terminals, Inc. v. United States.⁵ By 1969 the Tax Court described the rule as "now well settled": a taxpayer who agrees to sell for cash but, "before there is substantial implementation of the transaction, arranges to exchange the property for other property of like kind," receives the benefit of section 1031.⁶ The Service accepted the three-party form in Rev. Rul. 77-297, which, as the Tax Court later described it, approved the Alderson structure and allowed the taxpayer to search for and select the replacement property.⁷

The limit was the receipt of cash. The line the courts held was that the taxpayer could not touch the money. In Carlton v. United States, ranchers had given a buyer an option on their ranch under a contract that let them require the buyer to acquire other land they designated for exchange, and the government conceded that the original plan would have qualified. At the 1959 closing, to avoid duplicate conveyances, the buyer instead assigned its purchase contracts to the taxpayers and paid them the cash, which they used that day and the next to buy the replacement tracts. The Fifth Circuit held that they had sold their ranch: "The very essence of an exchange is the transfer of property between owners, while the mark of a sale is the receipt of cash for the property."⁸ The court acknowledged how close the taxpayers had come, but "there is no equity in tax law."⁹

Simultaneity as a premise. The approved structures shared a feature that none of the cases announced as a rule. The taxpayer's conveyance and the receipt of replacement property were generally closed together, at one closing or through escrows that closed at the same time. The Tax Court's description of the four-party exchange built that feature in: the exchange takes place "[i]n a simultaneously executed transaction (usually done through escrow)."¹⁰ In Barker, decided in 1980, the court treated the fact that the escrows were interdependent and "were to be completed simultaneously" as support for finding an exchange, while conceding that "the conceptual distinction between an exchange qualifying for section 1031 on the one hand and a sale and reinvestment on the other is largely one of form."¹¹ In Starker, the government's argument that an exchange must be simultaneous began with the regulation on strict construction of nonrecognition provisions, and the Ninth Circuit observed that there had been "little or no litigation" on whether simultaneity of title transfer was required.¹² The premise went unexamined because the transactions before the courts had not tested it.

5.2 Starker v. United States and the collapse of that premise

The agreement. On April 1, 1967, T. J. Starker, his son Bruce, and his daughter-in-law Elizabeth signed a "land exchange agreement" with Crown Zellerbach Corporation. They agreed to convey their interests in 1,843 acres of timberland in Columbia County, Oregon, and Crown agreed to acquire and deed to them other real property in Washington and Oregon. Crown would provide suitable property within five years or pay any outstanding balance in cash, and each year it would add to the Starkers' credit a "growth factor" equal to 6 percent of the outstanding balance. The Starkers deeded the timberland to Crown on May 31, 1967, and Crown recorded an exchange credit of $1,502,500 for T. J. Starker's interest.¹³

The performance. Bruce and Elizabeth Starker found three parcels within four months, and Crown bought and conveyed them. T. J. Starker's larger credit took longer to use. Between September 1967 and May 1969, Crown delivered twelve parcels he selected: nine deeded to him, two (a residence and a commercial building) deeded at his direction to his daughter, and one conveyed by assigning him a third party's contract right to purchase. By then the growth factor had raised his credit to $1,577,387.91, which equaled the agreed value of the parcels, so no cash changed hands.¹⁴

The district court changes its mind. The Service assessed deficiencies against all three Starkers. Bruce and Elizabeth sued for a refund first, and in 1975 the district court held for them on the authority of Alderson. The government appealed and then voluntarily dismissed the appeal.¹⁵ Its argument in that case had been that no exchange occurred because the transfers were not simultaneous.¹⁶ When T. J. Starker brought his own suit, the same judge ruled for the government: "I now conclude that I was mistaken in my holding as well as in my earlier reading of Alderson. . . . It would merely sanction a tax avoidance scheme and not carry out the purposes of § 1031."¹⁷ Alderson, as he now read it, had involved "a reciprocal, simultaneous exchange," while Starker had given up his land for a promise at a time when Crown owned none of the parcels it would later convey. He contrasted the involuntary conversion and residence replacement provisions, which expressly grant nonrecognition when property is sold and the proceeds are reinvested. Had Congress intended that result under section 1031, "[i]t would have used 'sale or exchange' rather than 'exchange' alone."¹⁸ He found Crown's obligation to be "a bankable asset" worth the full $1,502,500 credit, held it realized in 1967, and treated the growth factor as interest. In a footnote he disclaimed deciding "that there must always be a simultaneous exchange."¹⁹

The Ninth Circuit. Judge Goodwin's opinion for the Ninth Circuit first held that the judgment in Bruce and Elizabeth Starker's case, which the government had abandoned on appeal, collaterally estopped the government as to the nine parcels deeded directly to T. J. Starker.²⁰ The other three parcels required a decision on the merits. The two deeded to his daughter failed: the residence was not held for investment, and in any event he "never received any property ownership himself" in either parcel.²¹ The third, the Booth parcel, which he received as a contract right, squarely presented the timing question. The court treated the contract right as the equivalent of a fee interest and then took up the government's arguments one at a time.²²

The reasoning. The government relied on the regulation providing that nonrecognition is accorded only to an exchange that satisfies "the underlying purpose for which such exchange is excepted from the general rule." The court answered that the underlying purpose of section 1031 "is not entirely clear." The liquidity rationale cannot explain why a taxpayer who sells and reinvests a few days later gets no relief, and the valuation rationale cannot explain why a single dollar of boot requires both properties to be valued (Chapter 2).²³ On the possibility that Starker might have been paid in cash, the Alderson line controlled: "the mere possibility at the time of agreement that a cash sale might occur does not prevent the application of section 1031."²⁴ The government distinguished those cases because no cash could have been received once the taxpayer conveyed, and it asked the court to treat transfers separated by a "substantial" period of time differently. The court's answer was one sentence: "We decline to draw this line."²⁵ Nor did it matter that a contract right resembles cash or is, technically, a chose in action. Title to real property "is nothing more than a bundle of potential causes of action," and a contract right to acquire property is of like kind with ownership "when the taxpayer prefers property to cash before and throughout the executory period, and only like-kind property is ultimately received."²⁶ The growth factor, however, was "disguised interest," ordinary income to a cash-method taxpayer when received.²⁷ The court closed by acknowledging what it had done: "We realize that this decision leaves the treatment of an alleged exchange open until the eventual receipt of consideration by the taxpayer. . . . If our holding today adds a degree of uncertainty to this area, Congress can clarify its meaning."²⁸

What collapsed. Before Starker, the cases asked what the taxpayer received at the closing. Starker separated the conveyance from the receipt by as much as five years, let the transferee hold the value in the meantime, paid the taxpayer a return for the wait, and allowed any balance still owed at the end to be paid in cash. What made the arrangement workable was the transferee's credit, which the district court had called bankable. In economic terms it resembled a sale with the proceeds held by the buyer for later reinvestment, which is how Congress would describe it five years later (5.3). The Fifth Circuit was careful not to adopt the holding. In Biggs v. Commissioner, decided the next year, it quoted Starker's passage on contract rights as consistent with its own view that the buyer need not hold title to the replacement property, but it wrote that "we need not, and do not, express either acceptance or disapproval of the ultimate holding in Starker." The exchange it approved had closed simultaneously.²⁹ Biggs is also a Maryland case. The relinquished property was land in Worcester County, Baltimore counsel represented the taxpayer on appeal, and a Maryland title company owned and controlled by his attorney and members of the attorney's family held title to the Virginia replacement property until the closing.³⁰

5.3 The Deficit Reduction Act of 1984: the 45-day and 180-day periods

The House bill. The response came in H.R. 4170. The Ways and Means Committee reported it in 1984 as the Tax Reform Act of 1984, and it was enacted as division A of the Deficit Reduction Act of 1984. The committee's report described Starker as allowing like-kind treatment "although the property to be exchanged could be designated by the transferor for up to 5 years after the transaction and although the transferor could have ultimately received cash rather than like-kind property."³¹ Its reasons went beyond administration to the rule's premise. The committee was "concerned that like-kind treatment of non-simultaneous exchanges has given rise to unintended results and administrative problems," concerns that "extend to the underlying policy of the like-kind exchange rule."³² If nonrecognition rests on the idea that a taxpayer who receives similar property has not really realized a profit, that idea weakens as the taxpayer's control over the replacement grows. A transaction held open "begins to resemble less a like-kind exchange and more a sale of one property followed, at some future point, by a purchase of a second property or properties."³³ The valuation rationale weakens too. An exchange left open must fix a dollar value for the relinquished property in order to measure what the taxpayer may later receive, so the gain can be measured in the year of the transfer.³⁴ The committee also saw that the installment method and an open-ended exchange together could defer tax indefinitely: "By exercising the right to designate property shortly before death, a taxpayer may conceivably avoid any taxation on the sale."³⁵ The House bill treated property received more than 180 days after the taxpayer relinquished its property, or after the due date of the taxpayer's return, as not like-kind property. It contained no identification requirement.³⁶

The Senate amendment and the conference. The Senate amendment followed the House bill with two changes, one of which was stricter than the rule finally enacted: property not identified as the property to be received on the date the taxpayer relinquished its property would not qualify.³⁷ The conference agreement adopted the Senate approach but gave transferors 45 days after the transfer to designate the property. The conferees said that the requirement could be met by designating the property in the contract between the parties. They anticipated that it would be satisfied "if the contract between the parties specifies a limited number of properties that may be transferred and the particular property to be transferred will be determined by contingencies beyond the control of both parties," and they gave as an example a promise to transfer one property if a zoning change is approved and another if it is not.³⁸ They added that, as under prior law, the new rules "would not permit a taxpayer who receives cash and later purchases the designated property to claim like-kind exchange treatment."³⁹

The enacted text. Section 77(a) of the Act rewrote section 1031(a) as three paragraphs: the general rule, a list of excluded property that now included partnership interests (5.4), and a new paragraph (3). Under paragraph (3), property received is treated as not like-kind property if it is not identified "before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange," or if it is received after the earlier of 180 days after that transfer or the due date, with extensions, of the transferor's return for the year of the transfer.⁴⁰ A 1986 technical amendment changed "before the day" to "on or before the day."⁴¹ The transition rules gave open Starker arrangements time to close. The new periods applied to transfers after July 18, 1984, the date of enactment. For transfers on or before that date, they applied only if the replacement property was not received before January 1, 1987 (January 1, 1989, if the property was identified in a binding contract in effect on June 13, 1984), which in practice gave those arrangements until then to finish. For earlier transfers that taxpayers had treated as exchanges, the period for assessing a deficiency attributable to the amendment was held open until at least January 1, 1988 (January 1, 1990, in the binding contract case).⁴²

What the statute left open. Section 77 did not overrule Starker. It accepted that an exchange may be deferred and disciplined the deferral with two clocks (Chapters 25 and 26). It did not say what counts as identification or receipt, how a taxpayer could secure the transferee's promise, or whether money held by an escrow agent or intermediary would be treated as received by the taxpayer. Treasury said as much when it wrote the regulations: section 1031(a)(3) "leaves unclear the application of the rules of actual and constructive receipt and the implications of the taxpayer's possible agency relationship with an intermediary."⁴³ The same preamble cited the House report and a Senate Finance Committee staff explanation of the Act for the proposition that "the greater the discretion a taxpayer has to vary the replacement property that will ultimately be received in a transaction, the more the transaction appears to be a sale rather than an exchange." The Finance Committee staff explanation was not retrieved for this chapter.⁴⁴

5.4 The 1984 exclusion of partnership interests

The litigation. The parenthetical exclusions, expanded in 1923 and carried into section 1031, covered "stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest" (4.1 and 4.2). Partnership interests were not named. The Service took the position in Rev. Rul. 78-135 that they fell within the exclusions anyway.⁴⁵ The Tax Court disagreed. In Estate of Meyer v. Commissioner, a reviewed opinion, a father and son who were the only partners in a California partnership each exchanged part of their interests for interests in a California limited partnership. Both partnerships owned and operated rental apartments in and around San Francisco. The court declined to treat the interests as choses in action. It read the 1923 expansion of the exclusions as a response to taxpayers trading appreciated investment securities, and it described these transactions as "exchanges of proprietary (partnership) interests in one small business solely for proprietary (partnership) interests in a second small business." The son's exchange of a general interest for a general interest qualified. The father's exchange of a general interest for a limited interest did not, because the differences between the two interests under California law were substantial enough to invoke the rule that exceptions to recognition are strictly construed.⁴⁶ The court confined its decision to partnerships owning the same type of underlying assets.⁴⁷ The Ninth Circuit affirmed as to the father. As a limited partner, it said, he "had ceased to be a participant in the business and had become primarily an investor, dependent upon the efforts of others to make a profit," so the interest he received was property of a different class, not merely of a different grade.⁴⁸

Gulfstream, Long, and Pappas. The Service lost the same argument in other forms. In Gulfstream Land & Development Corp. v. Commissioner, it contended that joint venture interests were "evidences of . . . interest." The Tax Court rejected the contention but added that it would look through to the partnerships' assets to keep the partnership form from turning an exchange of stock in trade into a qualifying exchange, and it denied summary judgment because that question was unresolved.⁴⁹ In Long v. Commissioner the court declined the Service's invitation to overrule Meyer and Gulfstream, while warning that borrowing close in time to an exchange of partnership interests would be carefully scrutinized.⁵⁰ In Pappas v. Commissioner it held that section 741, which provides that gain or loss is recognized on the sale or exchange of a partnership interest, does not override section 1031, and it described the rule as well established: an exchange of general partnership interests is generally an exchange of property of like kind, and an exchange of a general interest for a limited interest is not.⁵¹

Congress's reasons. The House report doubted "whether the like-kind exchange provisions were originally intended to apply to exchanges of partnership interests." The exclusions for stock and securities "prevent taxpayers from trading investment interests," and in the committee's view "partnership interests typically represent investment interest similar to those items already excluded from like-kind treatment."⁵² Its particular concern was tax shelters. The gain inherent in an interest in a "burned out" shelter, one that had taken substantial deductions attributable to nonrecourse liabilities without paying them off, could be avoided if the interest was exchanged for an interest in another partnership. The courts' similar-assets test "may be inadequate to reflect the actual situation of the two partnerships," and the committee concluded that such abuses "are best prevented by specifically excluding partnership interests from the like-kind exchange rule."⁵³ The report stated that the rule "is not intended to apply to an exchange of interests in the same partnership" and that no inference should be drawn about prior law.⁵⁴ The committee estimated that section 77 would raise $226 million in fiscal 1985, rising to $842 million in 1989, and its revenue table assigns those amounts to the partnership interest rule.⁵⁵

The enacted rule and its later history. The Act added "interests in a partnership" to the exclusions in section 1031(a)(2). As enacted, the exclusion applied to transfers after July 18, 1984, rather than after March 31, 1984, as the House bill had provided. It did not apply to exchanges under binding contracts in effect on March 1, 1984, or to general partner interests exchanged under a reorganization plan pursuant to a contract that took effect on March 29, 1984.⁵⁶ In 1990 Congress provided that an interest in a partnership that has elected under section 761(a) to be excluded from all of subchapter K is treated as an interest in each of the partnership's assets, retroactive to transfers after July 18, 1984.⁵⁷ Treasury's 1991 regulations then read the exclusion more broadly than the House report had: it applies "regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same partnership or in different partnerships." The preamble added that the regulations were not intended to affect nonrecognition available under other provisions, such as the conversions of partnership interests addressed in Rev. Rul. 84-52.⁵⁸ The Tax Cuts and Jobs Act of 2017 rewrote section 1031(a)(2) to exclude only real property held primarily for sale, which removed the list. Partnership interests remain outside the statute because they are not real property, and the section 761(a) rule survives as section 1031(e) (Chapters 7, 14, and 20).⁵⁹

5.5 The 1991 regulations and the birth of the qualified intermediary

The rulemaking. Treasury proposed regulations on deferred exchanges and exchanges of partnership interests on May 16, 1990, held a public hearing that September, and published final regulations as T.D. 8346 on May 1, 1991.⁶⁰ The deferred exchange rules apply to transfers on or after June 10, 1991, and taxpayers could apply either the final rules or the proposed rules to transfers made on or after May 16, 1990.⁶¹ The final rules supplied the detail the statute lacked on identification and receipt, including the three-property and 200-percent limits on what may be identified and a 95-percent exception (Chapters 25 and 26). Commentators asked for more room to identify alternatives. Treasury declined, reasoning that more discretion "would give these transactions more of the character of sales rather than exchanges and therefore would be less consistent with congressional intent."⁶² It also deleted a proposed statement that section 7503, which moves deadlines falling on weekends and holidays, does not apply. A 1983 revenue ruling already limited section 7503 to procedural acts, so a special rule was unnecessary. Treasury added that administrative extensions of the two periods would not be granted because the periods are statutory.⁶³

Four safe harbors drawn from existing practice. The preamble described the practical problem plainly. Taxpayers "typically are unwilling to rely on a transferee's unsecured promise to transfer the like-kind replacement property," so security and guarantee arrangements were common, and "because persons who want to purchase the relinquished property may be unwilling or unable to acquire the replacement property, taxpayers often retain an intermediary to facilitate the exchange." Those arrangements raised questions of actual receipt, constructive receipt, and agency that the statute did not answer.⁶⁴ The regulations responded with four safe harbors "based on commonly used security, guarantee, and intermediary arrangements": security and guarantee arrangements, qualified escrow accounts and qualified trusts, qualified intermediaries, and interest or growth factors (Chapter 27).⁶⁵ The fourth is Starker's growth factor brought inside the rules. A taxpayer may be paid for the time between relinquishment and replacement without being treated as in receipt of the underlying funds, and the payment is treated as interest, as the Ninth Circuit had held.⁶⁶

The qualified intermediary. The proposed regulations defined a qualified intermediary as a person, other than the taxpayer or a related party, who facilitates a deferred exchange under an agreement with the taxpayer, and they required it to acquire the relinquished property from the taxpayer, acquire the replacement property, and transfer the replacement property to the taxpayer. The final regulations added a fourth act, transferring the relinquished property.⁶⁷ Commentators asked what an intermediary must do to acquire property. Treasury's answer shaped the modern transaction. An intermediary is treated as acquiring and transferring property if it acquires and transfers legal title, or if it enters into the agreement under which the relinquished property is transferred to the buyer or the replacement property is transferred to the taxpayer. It is treated as entering into an agreement if a party's rights under the agreement are assigned to it and all parties are notified in writing by the date of the transfer.⁶⁸ Those provisions are why a qualified intermediary can take an assignment of the sale and purchase contracts while the deeds run directly between the taxpayer and the other parties (24.3 and 24.4). The regulations also provide that a qualified intermediary "is not considered the agent of the taxpayer for purposes of section 1031(a)," that rights under state law to terminate or dismiss the intermediary are disregarded, and that the exchange agreement must expressly limit the taxpayer's rights to the money the intermediary holds (Chapter 29).⁶⁹ In response to comments, the final regulations also made the qualified intermediary safe harbor, and only that one, available for simultaneous exchanges.⁷⁰

From related party to disqualified person. The proposed regulations barred a "related party" from serving as escrow holder, trustee, or intermediary. Commentators pointed out that the term could be confused with the "related person" rules Congress had added in section 1031(f) in 1989 (Chapter 6). Treasury considered the section 1031(f) definition too narrow for the safe harbors and adopted a new term, "disqualified person." The final definition reaches the taxpayer's agent, including anyone who acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two years ending on the date of the first relinquished property's transfer, and persons related to the taxpayer or to such an agent. Services with respect to exchanges, and routine financial, title insurance, escrow, or trust services, do not count (Chapter 28).⁷¹ The definition was narrowed in 2002 in response to changes in federal banking law.⁷²

What the regulations deferred. Three questions were left for later. The regulations do not apply to "reverse-Starker" transactions, in which the taxpayer receives the replacement property before transferring the relinquished property. Treasury said it would "continue to study" whether the general rule of section 1031(a)(1) could reach them, and no safe harbor came until Rev. Proc. 2000-37 (6.3 and Chapter 30).⁷³ Reporting of interest earned on exchange funds was deferred to comprehensive regulations under section 468B(g), which were not finalized until 2008.⁷⁴ Coordination with the installment method was reserved and later added for transfers on or after April 20, 1994.⁷⁵

What was born in 1991. The intermediary itself was not new. A title company played the part for the Baltimore trustees in 1929, a real estate man did so in Haden, a Maryland title company did so in Biggs, and a real estate company did so in Barker. What the regulations created was a legal status. Before 1991, whether an intermediary was the taxpayer's agent was litigated case by case, and the taxpayer bore the risk that a court would find that it was. After 1991, a person who is not a disqualified person and who signs an agreement containing the required terms is not considered the taxpayer's agent for purposes of section 1031(a), and rights to dismiss it under state law are disregarded. That made the arrangement reproducible, and it made providing it a business. The regulations govern the tax consequence, not the business, and the risks of that choice are the subject of Chapter 55.⁷⁶