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Deferred Like-Kind Exchanges of Real Property

Like-Kind Exchanges of Real Estate

Like-kind exchanges under Internal Revenue Code Section 1031 are a popular method used by real estate investors for disposing of one property and acquiring another without recognition of taxable gain. When taxable gain is not recognized in a transaction, income taxes are not required to be paid as a result of the transaction.

General Rules

There are three basic requirements to be satisfied in order for a transaction to qualify under Section 1031. They are as follows:

  1. Business or Investment Property.   Both the property transferred by the taxpayer and the property received by the taxpayer must be business or investment property. Residential property held for personal use does not qualify.
  2. Exchange.   The transaction must be an “exchange” or “reciprocal transfer of property,” rather than a sale or transfer of property for money, followed by the purchase of a new property.
  3. Like-Kind Property.   The properties exchanged must be of “like-kind,” although they are not required to be of the same grade or quality. In other words, real estate must be exchanged for real estate, but otherwise, city real estate may be exchanged for a farm or ranch, a 30-year leasehold may be exchanged for fee title, and improved property may be exchanged for unimproved property.

With proper planning, virtually any disposition of property can be structured as an exchange. However, the most popular form of exchange is a non-simultaneous or deferred exchange, in which a property owner does not acquire replacement property simultaneously with the transfer or conveyance of the relinquished property.

Since 1984, Section 1031 has contained specific statutory authorization for deferred exchanges. However, the statute itself contains only the applicable general rules. In April, 1991, the IRS adopted final regulations dealing with deferred exchanges under Section 1031. These regulations provide detailed instructions as to how a deferred exchange should be done. In particular, by authorizing completion of deferred exchanges through use of “qualified intermediaries,” the final regulations simplified the manner in which a deferred exchange transaction must be documented, and clarified the manner in which funds generated by disposition of relinquished property must be held pending acquisition of replacement property.

Special Rules Applicable to Deferred Exchanges

There are special rules for deferred exchanges relating to the manner of identification of exchange property, the time period for identification and receipt of exchange property, and the avoidance of actual or constructive receipt of non-like kind property by the taxpayer prior to receipt of exchange property. These may be summarized as follows:

  1. Identification Period.   Exchange property must be identified within 45 days of the date of transfer of the relinquished property. Up to three properties may be identified without limitation as to their value. If the taxpayer wants to identify more than three properties, there are limitations on the total fair market value of property which may be identified as potential exchange property.
  2. Manner of Identification.   Exchange property must be unambiguously identified in a written document, signed by the taxpayer, and hand-delivered, mailed, faxed or otherwise sent, before the end of identification period to another person involved in the exchange.
  3. Exchange Period.   Identified exchange property must be received (i.e. the taxpayer must take title) before the earlier of 180 days of the date the relinquished property is transferred or the due date (including extensions) of the taxpayers return for the tax year in which the relinquished property is transferred.

In addition to compliance with the time periods specified above, the other key to properly completing a deferred exchange is for the taxpayer to avoid actual or constructive receipt of money (which is non-like kind property) prior to receipt of replacement like-kind real property. In the typical situation, the taxpayer has disposed of one property and wants to use the net cash proceeds from that disposition to acquire another property. The taxpayer must be certain that the funds are safe and are readily available to be applied to the acquisition of replacement property, but if the taxpayer has too much control over the money prior to acquisition of replacement property, the entire transaction is too much like a sale. The result will be recognition of gain and a concurrent income tax liability. This is where the “qualified intermediary” comes into play.

Qualified Intermediaries

A qualified intermediary is a person who is neither the taxpayer nor a “disqualified person” (such as a close relative of the taxpayer or his or her real estate broker, accountant, or attorney), who enters into a written exchange agreement with the taxpayer to acquire relinquished property from the taxpayer, transfer the relinquished property to its purchaser, acquire replacement property, and transfer that replacement property to the taxpayer. If the exchange agreement is properly written and the correct procedures are followed, the qualified intermediary may hold the net proceeds from disposition of the relinquished property, and apply them to the acquisition of replacement property on behalf of the taxpayer, without recognition of gain by the taxpayer.

Through the use of a qualified intermediary, an exchange may be completed without the cooperation of either the purchaser of the relinquished property or the seller of the replacement property. The taxpayer is free to enter into a sales contract for the relinquished property, and thereafter to assign that contract to the intermediary. As long as the purchaser of that property is notified in writing of the assignment on or before the closing date, the deed may pass directly from the taxpayer to the purchaser and the transaction will still qualify as the first leg of a like-kind exchange.

The same arrangement works in reverse on the other end of the transaction. The taxpayer enters into a contract for purchase of replacement property. The purchase contract is assigned to the intermediary, and on or before the closing date, the seller of the replacement property is notified in writing of the assignment. The deed to the replacement property may then pass directly from the seller of that property to the taxpayer, and the transaction will still qualify as the second leg of a like-kind exchange.

The agreement between the taxpayer and the qualified intermediary is an important document. It must expressly limit the right of the taxpayer to receive, pledge, borrow, or otherwise obtain the benefits of the money or other property held by the qualified intermediary.


Any time an owner of real property desires to dispose of one property and acquire another property, consideration should be given to structuring the transaction as a like-kind exchange under Section 1031. With proper planning, virtually any transaction may be structured as an exchange, and the tax savings are often substantial. Deferred exchanges can provide substantial flexibility, without substantial risk.

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