The Deferred Exchange

The regulation governing this structure is the most important single provision in exchange practice. This chapter establishes what a deferred exchange is, what disqualifies one, and how the paperwork accomplishes the result.

24.1 The definition, and the sentence practitioners must know

The regulation defines a deferred exchange as one in which, pursuant to an agreement, the taxpayer transfers relinquished property "and subsequently receives" replacement property.¹ Failure to satisfy the identification and receipt requirements does not merely disqualify the timing; the replacement property "will be treated as property which is not of a like kind to the relinquished property."²

The sentence that matters most, and that is most often missed, concerns what a deferred exchange must be:

In order to constitute a deferred exchange, the transaction must be an exchange (i.e., a transfer of property for property, as distinguished from a transfer of property for money). For example, a sale of property followed by a purchase of property of a like kind does not qualify for nonrecognition of gain or loss under section 1031 regardless of whether the identification and receipt requirements of section 1031(a)(3) and paragraphs (b), (c), and (d) of this section are satisfied.³

Read that closing clause carefully. A taxpayer who sells, receives the proceeds, and buys like-kind property within forty-five and one hundred eighty days has satisfied every deadline and has no exchange. The deadlines are necessary and are not sufficient.

The regulation states the corollary in terms of receipt. If the taxpayer actually or constructively receives money or other property in the full amount of the consideration for the relinquished property, "the transaction will constitute a sale, and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property."⁴

This is why the intermediary exists, and why the constructive receipt analysis of Chapter 29 is not a technicality but the substance of the structure. Everything the safe harbors do is directed at ensuring that the taxpayer transfers property for property rather than for money.

The most common practical failure follows directly. A seller who closes an ordinary sale, takes the proceeds, and consults an advisor afterward cannot be rescued. There is no retroactive election, and an intermediary engaged after closing is engaged too late. The structure must be in place before the relinquished property transfers.

24.2 The canonical structure

The modern forward exchange proceeds in a fixed sequence, and each step exists to satisfy a specific requirement.

Before closing on the relinquished property, the taxpayer engages a qualified intermediary and executes an exchange agreement. The agreement must expressly limit the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the money or other property held by the intermediary.⁵ Without that limitation the safe harbor does not apply at all.

At the relinquished property closing, the taxpayer's rights under the purchase contract are assigned to the intermediary and written notice is given, as 24.3 develops. Title passes to the buyer, and the proceeds go to the intermediary rather than to the taxpayer.

Within forty-five days, the taxpayer identifies replacement property in the manner Chapter 25 requires.

Within the exchange period, the intermediary acquires the identified replacement property and transfers it to the taxpayer. The period ends at midnight on the earlier of the one hundred eightieth day or the due date, including extensions, of the return for the year of the relinquishment.⁶

Two structural points deserve emphasis.

The identification period and the exchange period both begin on the date the relinquished property is transferred, and property is transferred when it is disposed of within the meaning of section 1001.⁷ They run concurrently rather than sequentially; the forty-five days are the first forty-five of the one hundred eighty.

Where more than one relinquished property is transferred on different dates as part of the same exchange, both periods are measured from the earliest transfer date.⁸ A taxpayer disposing of a portfolio does not get a fresh clock with each closing, and this is a frequent and expensive misunderstanding.

24.3 Assignment and written notice

A qualified intermediary must, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer it, acquire the replacement property, and transfer it to the taxpayer.⁹ Taken literally that would require the intermediary to be a party to contracts the taxpayer has usually already signed.

The regulation solves this by treating assignment as sufficient. An intermediary is treated as entering into an agreement if the rights of a party to that agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property.¹⁰

The regulation supplies its own illustration: where a taxpayer contracts to transfer relinquished property, assigns its rights in that agreement to an intermediary, and all parties are notified in writing on or before the transfer date, the intermediary is treated as having entered into the agreement, and if the property is transferred pursuant to it, as having acquired and transferred the relinquished property.

Three operational points follow, and each is a place where exchanges are lost through paperwork rather than substance.

The notice must be written. Oral notice, or an assumption that the buyer's attorney is aware, does not satisfy the provision.

The notice must reach all parties to the agreement, not merely the counterparty of convenience.

The notice must be given on or before the date of the transfer. This is the operative deadline, and unlike the forty-five and one hundred eighty day periods it is measured in a single day. A notice signed the following week does not cure the omission.

The practical discipline is to prepare the assignment and notices with the closing package and to obtain acknowledged receipt at or before closing, rather than treating them as post-closing administration.

24.4 Direct deeding

A question that troubled early practice was whether the intermediary must take title, given that the regulation speaks of the intermediary acquiring and transferring property. Taking title twice would double transfer and recordation taxes, create a chain-of-title record, and expose the intermediary to liability for the property.

The regulation resolves the question in favor of direct deeding, and does so expressly. Regardless of whether an intermediary acquires and transfers property under general tax principles, solely for purposes of the qualified intermediary definition:¹¹

• an intermediary is treated as acquiring and transferring property if it acquires and transfers legal title;
• an intermediary is treated as acquiring and transferring the relinquished property if it enters into an agreement with a person other than the taxpayer for the transfer of that property and, pursuant to that agreement, the property is transferred to that person; and
• an intermediary is treated as acquiring and transferring the replacement property if it enters into an agreement with the owner of that property for its transfer and, pursuant to that agreement, the property is transferred to the taxpayer.

The second and third rules are the authority for direct deeding. The intermediary need not appear in the chain of title at all. The deed runs from the taxpayer directly to the buyer, and from the seller of the replacement property directly to the taxpayer, while the intermediary is treated as having acquired and transferred both.

The condition is that the intermediary must have entered into the agreements, which returns the analysis to 24.3. Direct deeding works because of the assignment, not instead of it. An exchange in which the deeds run directly and the assignment paperwork was never completed has an intermediary that did not acquire or transfer anything, and the safe harbor is unavailable.

Two further provisions round out the structure.

The safe harbor ceases to apply at the moment the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the money held by the intermediary. Rights conferred by State law to terminate or dismiss the intermediary are disregarded for this purpose.¹²

A taxpayer may receive money or other property directly from a party to the transaction other than the intermediary without affecting the safe harbor.¹³ This permits ordinary closing adjustments to flow to the taxpayer without contaminating the exchange, and it should be distinguished from receipt of exchange proceeds.