Time Requirements And Mechanics Of A Tax Exchange
The Exchangor has a maximum of 180 days from the closing of the relinquished property or the due date of that year’s tax return, whichever occurs first, to acquire the replacement property. This is called the Acquisition Period. The first 45 days of that period is called the Identification Period. During this 45 days, the Exchangor must identify the candidate or target property which will be used for replacement. The identification must:
– Be in writing,
– Signed by the Exchangor, and,
– Received by the facilitator or other qualified party (faxed, postmarked or otherwise identifiably transmitted through Federal Express or other dated courier service).
This must all occur within the 45-day period. Failure to accomplish this identification will cause the exchange to fail.
Three rules exist for the correct identification of replacement properties.
1) The Three Property Rule dictates that the Exchangor may identify three properties of any value, one or more of which must be acquired within the 180-Day Acquisition Period.
2) The Two Hundred Percent Rule dictates that if four or more properties are identified, the aggregate market value of all properties may not exceed 200% of the value of the relinquished property.
3) The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.
As a caveat it should be mentioned that these identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
* Ironically, although only approximately 3-5% of exchanges are audited, the few exchanges which don’t pass upon audit typically fail because of discrepancies in identification.
Mechanics of a Delayed Exchange
It is important that any exchange be carefully planned with the help of an experienced, competent and creative exchange professional. Preferably one who is completely familiar with the tax code in general, not just Section 1031, and who has extensive experience in doing many different kinds of exchanges. Thorough planning can help avoid many subtle exchanging pitfalls and also ensure that the Exchangor will accomplish the goals which the transaction is intended to facilitate.
Once the planning is complete, the exchange structure and timing are decided, and the relinquished property is sold and the transaction is closed, the facilitator becomes the repository for the proceeds of the sale. The money is kept in the facilitator’s secured account until the replacement property is located and instructions are received to fund the replacement property purchase.
The funds are wired or sent to the closing entity in the most appropriate and expeditious manner, and the replacement property is purchased and deeded directly to the Exchangor. All the necessary documentation to clearly memorialize the transaction as an exchange is provided by the facilitator, such as exchange agreement, assignment agreement and appropriate closing instructions.
Partnership Exchanges and IRC §1.761-2(a) Elections
The Tax Reform Act of 1984 made it very clear that partnership interests cannot be exchanged and qualify for deferred gain treatment under IRC Section1031. The regulations also interpret no difference between general partnership interests or limited partnership interests. Although actual partnerships can exchange with other partnerships under Section1031, the exchange of an individual interest is prohibited.
However, the Omnibus Budget Reconciliation Act of 1990 did amend IRC Section1031 to incorporate the use of IRC Section1.761-2(a), Election of Partnerships to not be treated under Subchapter K of Chapter 1 of the Code, for the purposes of taxation. This means that Section1.761-2(a) can potentially provide an avenue to utilize Section1031 to those investors currently owning partnership interests.
So, how does an election under Section1.761-2(a) provide a benefit to the typical investor? Well, if every individual or entity within a partnership, elects to have his individual interest treated as his own real property interest, similar to a tenant in common interest, then that individual interest can qualify to be exchanged under Section1031. And since that partnership interest can qualify for deferred gain treatment, the amount realized from the sale of that interest can be used to acquire any qualifying replacement property.
Therefore, an interest from a partnership in which all partners have made individual elections under Section1.761-2(a) can be exchanged for any other property. And, there is no requirement that the investor exchange into replacement properties with his or her previous partners, only that the exchange be used for investment purposes only and not for the active conduct of a business.
Also, the converse of the above Section1.761-2(a) situation is possible. It is permissible for a partnership to acquire a property and elect to have the partnership interests treated as individual real property interests for taxation purposes, at the time of purchase. Therefore, as seen in some sophisticated transactions, particular partnerships which have already elected under Section1.761-2(a) may be established for the sole purpose to solicit investments from other partners exchanging out of one partnership (with the benefit of Section1.761-2(a)) into the new entity. This process enables the Exchangor to exchange out of one previously non-qualifying exchange investment into one which provides little or no management and superior cash flow or other benefits.
This strategy can also be used for business assets. In both cases, however, it is important to outline the goals and objectives of all parties involved in the exchange.
It should be noted that in every case involving an election under Section1.761-2(a), it is critical to evaluate the status of your election and exchange with the advice of a qualified tax professional. They will relate your situation to specific Internal Revenue Letter Rulings and other interpretations, which could assist in the strategic structuring of your transaction.
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