6.4 Time Limits and Security Arrangements for Deferred Exchanges
Assume you own property that has appreciated in value. You want to sell it and reinvest the proceeds in other property, but you would like to avoid having to pay tax on the appreciation. You can defer the tax on the gain if you are able to arrange an exchange for like-kind (6.1) property.
The problem is that it may be difficult to find a buyer who has property you want in exchange, and the time for closing the exchange is restricted. If IRS tests are met, intermediaries and security arrangements may be used without running afoul of constructive receipt rules that could trigger an immediate tax.
Deferred exchange distinguished from a reverse exchange.
A deferred exchange is one in which you first transfer investment or business property and then later receive like-kind investment or business property (6.1). If before you receive the replacement property you actually or constructively receive money or unlike property as full payment for the property you have transferred, the transaction will be treated as a sale rather than a deferred exchange. In that case, you must recognize gain (or loss) on the transaction even if you later receive like-kind replacement property. In determining whether you have received money or unlike property, you may take advantage of certain safe harbor security arrangements that allow you to ensure that the replacement property will be provided to you without jeopardizing like-kind exchange treatment; see below for the safe harbor security tests.
A reverse exchange is one in which you acquire replacement property before you transfer the relinquished property. The like-kind exchange rules generally do not apply to reverse exchanges. However, the IRS has provided safe harbor rules that allow like-kind exchange treatment to be obtained if either the replacement property or the relinquished property is held in a qualified exchange accommodation arrangement (QEAA) (6.5).
Time limits for completing deferred exchanges.
You generally have up to 180 days to complete an exchange, but the period may be shorter. Specifically, property will not be treated as like-kind property if received (1) more than 180 days after the date you transferred the property you are relinquishing or (2) after the due date of your return (including extensions) for the year in which you made the transfer, whichever is earlier. Furthermore, the property to be received must be identified within 45 days after the date on which you transferred property.
Caution
If the transaction involves more than one property, the 45-day identification period and the 180-day exchange period are determined by the earliest date on which any property is transferred. When the identification or exchange period ends on a Saturday, Sunday, or legal holiday, the deadline is not advanced to the next business day (as it is when the deadline for filing a tax return is on a weekend or holiday).
How to identify replacement property.
You must identify replacement property in a written document signed by you and delivered before the end of the 45-day identification period to the person handling the transfer of the replacement property or to any other person involved in the exchange other than yourself or a related party. The identification may also be made in a written agreement. The property must be unambiguously described by a legal description or street address.
You may identify more than one property as replacement property. However, the maximum number of replacement properties that you may identify without regard to the fair market value is three properties. You may identify any number of properties provided the aggregate fair market value at the end of the 45-day identification period does not exceed 200% of the aggregate fair market value of all the relinquished properties as of the date you transferred them. If, as of the end of the identification period, you have identified more than the allowable number of properties, you are generally treated as if no replacement property has been identified.
If property is valued at no more than 15% of the total value of a larger item of property that it is transferred with, the smaller property is considered “incidental” and does not have to be separately identified.
Avoiding constructive receipt despite security arrangement.
In a deferred exchange, you want financial security for the buyer’s performance and compensation for delay in receiving property. To avoid immediate tax, you must not make a security arrangement that gives you an unrestricted right to funds before the deal is closed. As discussed next, certain safe harbor security arrangements may be used without endangering like-kind exchange treatment.
Safe harbor tests for deferred exchange security arrangements.
If one of the following safe harbors applies to your security arrangement, you are not treated by the IRS as having actually or constructively received cash or unlike property prior to receiving the like-kind replacement, so tax-deferred exchange treatment may be obtained.
The first two “safe harbors” cover escrow accounts, mortgages and other security arrangements with your transferee. The third allows the use of professional intermediaries who, for a fee, arrange the details of the deferred exchange. The fourth allows you to earn interest on an escrow account.
IRS Alert
Escrow account earnings are generally exempt from imputed interest rules.
Under final IRS regulations, it is possible for a taxpayer who has an escrow arrangement with a qualified intermediary to be taxed on imputed interest, but there is a $2 million exemption that is expected to apply to the majority of exchange arrangements with small business exchange facilitators. Under the regulations, when a qualified intermediary holds exchange funds (cash, cash equivalents, or relinquished property) in escrow for a taxpayer under a deferred exchange agreement prior to the acquisition of replacement property, the exchange funds are treated as a loan from the taxpayer to the qualified intermediary unless the agreement provides that all of the earnings (such as bank interest) on the exchange funds will be paid to the taxpayer.
However, even when the intermediary retains the escrow earnings, as is typically the case with small nonbank exchange facilitators, the imputed interest rules do not apply if the deemed loan does not exceed $2 million and the loan does not extend beyond six months. If the loan exceeds $2 million or lasts more than six months, the taxpayer must report imputed interest. For example, a taxpayer transfers property to a qualified intermediary who transfers it to a purchaser in exchange for $2.1 million cash, which the intermediary deposits in a money market account for three months until the intermediary withdraws the funds and purchases replacement property identified by the taxpayer. Assuming that the taxpayer is not entitled to the earnings under the exchange agreement, the taxpayer is treated as having made a $2.1 million loan to the intermediary. The amount of the imputed interest taxable to the taxpayer is based on the lower of (1) the short-term applicable federal rate in effect on the day the deemed loan was made, compounded semiannually, or (2) the rate on a 91-day Treasury bill issued on or before the date of the deemed loan. The IRS could increase the $2 million exempt amount in future guidance.
The final regulations apply to transfers of relinquished property and exchange facilitator loans issued on or after October 8, 2008. For transfers before October 8, 2008, the IRS will accept any reasonable, consistently applied method for taxing the earnings.