Any property owner or investor who expects to acquire replacement property subsequent to the sale of his existing property should consider an exchange. To do otherwise would necessitate the payment of capital gain taxes in amounts which can exceed 20%-30%, depending on the appropriate combined federal and state tax rates. In other words, when purchasing replacement property without the benefit of an exchange, your buying power is dramatically reduced and represents only 70%-80% of what it did previously.

The below diagram illustrates the benefits of exchanging versus selling

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Misconceptions About Tax Deferred Exchanges
Before we continue by identifying the various types of exchange strategies and their associated rules, let’s identify four common exchange misconceptions.

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All exchanges must involve the swapping or trading with other property owners (NO)
Before delayed exchanges were codified in 1984, all simultaneous exchange transactions required the actual swapping of deeds and simultaneous closing among all parties to an exchange. Often times these exchanges were comprised of dozens of exchanging parties as well as numerous exchange properties. But today, there is no such requirement to swap your property with someone else in order to complete an exchange. The rules have been streamlined to the extent that the current process is reflective more of your qualifying intent rather than the logistics of the property closings.

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All exchanges must close simultaneously (NO)
Although there was a time when all exchanges had to be closed on a simultaneous basis, they are rarely completed in this format any longer. In fact, a significant majority of exchanges are now closed as delayed exchanges.

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Like-kind means purchasing the same type of property which was sold (NO)
Although the definition of like-kind has often been misinterpreted to mean the requirement of the acquisition of property to be utilized in the same form as the exchange property. In other words, apartments for apartments, hotels for hotel, farm for farm, etc. However, the true definition is again reflective more of intent than use. Accordingly, there are currently two types of property, which qualify as like-kind:

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!)Property held for investment, and, or

2) Property held for a productive use in trade or business

Exchanges must be limited to one exchange and one replacement property (NO)
This is another exchanging myth. There are no provisions within either the Internal Revenue Code or the Treasury Regulations which restrict the amount of properties which can be involved in an exchange. Therefore, exchanging out of several properties into one replacement property or vice versa, relinquishing (selling) one property and acquiring several are perfectly acceptable strategies.

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Parties to an Exchange
Assuming a delayed exchange scenario, there are three parties involved in a typical transaction.

Upon Phase One (the sale of your exchange or relinquished property), they are: the Taxpayer (also called the Exchanger), the Buyer, and the Intermediary (also called the facilitator)

Upon Phase Two (the purchase of your replacement property), they are:

the Taxpayer (also called the Exchanger), the Seller, and the Intermediary (also called the facilitator)

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Basic Exchange Rules
Let us look at a basic concept, which applies to all exchanges. Utilize this concept to fully defer the capital gain taxes realized from the sale of a relinquished property:
1. The purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property, and
2. All equity received from the sale of the relinquished property must be used to acquire the replacement property.

To the extent that either of these rules is abridged, a tax liability will accrue to the Exchangor. If the replacement property purchase price is less, there will be tax. To the extent that not all equity is moved from the relinquished to the replacement property, there will be tax. This is not to say that the exchange will not qualify for these reasons; partial exchanges do in fact qualify for partial tax deferral. It simply means that the amount of any discrepancy will be taxed as boot, or non like-kind property.

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Exchange Guidelines

The basic concept of tax-deferred exchanging was introduced into the Internal Revenue Code in 1921in an attempt to eliminate a problem the Treasury Department was having with taxpayers reporting tax losses on barter-type two-party exchanges. This is the reason that taxpayers no longer have the option of reporting a qualifying exchange as either taxable or non-taxable. However, the barter-type exchange which caused so much administrative concern is significantly different from the kind of multi-party transactions that characterizes the present world of tax-deferred exchanging.
The first major change, which was a departure from the barter-type exchange, occurred in 1935 when the board of tax appeals rendered a decision in the case of Mercantile Trust Company of Baltimore vs. Commissioner. The exchange involved a property owner, the taxpayer, a buyer of the taxpayer's property, and a seller of like-kind replacement property. It is interesting to note the transaction also involved a title company that acted as a fourth party facilitator in the transaction. The taxpayer did not want to sell its property because of the tax consequences. Instead, they transferred their property to the title company, which in turn transferred it to the buyer. The title company took the buyer's money and purchased the replacement property, and then transferred it to Mercantile. This was all carried out on a simultaneous basis. The key to the transaction was that all the legs of the transaction were carried out pursuant to appropriate contracts entered into between the respective parties.

The Board of Tax Appeals rejected the Internal Revenue Service's argument that the transaction did not give rise to an exchange because the title company acted as the agent of the buyer. The Tax Board held that the exchange did in fact meet the requirements of Section 112 of the Internal Revenue Code (Section 112 was the forerunner of Section 1031). The courts reasoned that even if the title company was the agent of the buyer, it would not have mattered, because it still would have resulted in an integrated transaction in which the taxpayer received, and was entitled only to receive, like-kind replacement property, and not the buyer's purchase price of the relinquished property.

The rule made in this case has not changed over the years and is still the rule today: ALL OF THE LEGS OR SEGMENTS OF AN EXCHANGE MUST CONSTITUTE AN INTEGRATED, MUTUALLY INTERDEPENDENT TRANSACTION. There has not been any significant change in the test enunciated in Mercantile in the entire 60 years since that decision!

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Types of Exchanges
There are three major types of tax-deferred exchanges: Simultaneous, Reverse and "Build-to-suit".

A Simultaneous Exchange occurs when the relinquished (sale) property and the replacement (acquired) property are transferred concurrently. Taxpayers doing such an exchange often think it is acceptable if the two transactions close on the the same day, and that this alone will satisfy the requirements of an exchange. Taxpayers who do not employ a Qualified Intermediary may be surprised to discover their transaction does not qualify for tax deferral, as without the Intermediary, the seller may be deemed to have "constructive receipt" of the sale money. The Qualified Intermediary creates the reciprocal trade by receiving the relinquished property and acquiring the replacement property. The Intermediary also provides the paper trail validating the flow and structure of the transaction and ensures the compliance with Treasury Regulations.

A Reverse Exchange is one in which the replacement property is acquired before the relinquished property is sold. The taxpayer cannot receive title to the replacement property and hold it until the relinquished property is sold and then declare the two transactions to be an exchange. In most reverse exchanges, a facilitator will take title to either the replacement property or the relinquished property. This is known as "parking" the property. In a traditional exchange, there are "safe harbor" regulations to guide and protect the taxpayer, but there are no such regulations for a reverse exchange--or much in the way of favorable court guidance. Thus there is a much higher risk in embarking on a reverse exchange. Reverse exchanges can be complicated, and it is highly recommended that the taxpayer seek professional tax and legal advice.

The newly issued Revenue Procedure (REV. Proc.2000-37) provides a safe harbor for reverse exchanges entered into on or after September 15, 2000 provided the taxpayer does the following:

The safe harbor allows a taxpayer to treat. the Exchange Accommodation Titleholder (E.A.T.) as the beneficial owner of the property for federal income tax purposes. The parked property must be held under a Qualified Exchange Accommodation Agreement.
The E.A.T. must hold legal title or similar ownership to the property being parked.
The taxpayer must have the intent to park with E.A.T. either the relinquished or the replacement property as part of a 1031 tax deferred exchange.
No later than five (5) business days after the transfer of ownership of the property to the E.A.T., the taxpayer and E.A.T. must enter into a written agreement indicating that this is an exchange and that the accommodating party will be treated as the owner of the property for tax purposes.
Within 45 days after the transfer of ownership of the replacement property to the E.A.T., the taxpayer must identify the property to be relinquished.
No later than 180 days after the transfer of ownership of the property (replacement or relinquished) to the E.A.T., the replacement property must be transferred to the taxpayer or the relinquished property to the ultimate to buyer.
An E.A.T. that satisfies the requirements of a Qualified Intermediary under the regulations, may also enter into an exchange agreement with the taxpayer to serve as the Qualified Intermediary in a simultaneous or deferred exchange. The taxpayer can guarantee some or all of the obligations of the E.A.T., including secured or unsecured debt incurred to acquire the replacement property. The taxpayer can also loan or advance funds to the E.A.T. The parked property can be leases by the E.A.T. to the taxpayer or enter into a property management agreement with the taxpayer.

Build-to Suit: The taxpayer can choose to make repairs or build a structure as part of the replacement property. These types of exchanges can be complicated and very time consuming for everyone involved. The taxpayer must first identify the improvements to be made during the identification period, but the Qualified Intermediary must take title to the land in which the improvement will be built, and must contract for the repairs or construction. There are restrictions on how the sale funds can be handled, and the time periods for completion of the work and conveyance of the improved real property must be done prior to the expiration of the 180 day exchange limit.

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How Do Most Exchanges Come Into Being?
As a practical matter, many people list their property for sale, and at the time an offer is submitted, they inform the broker that they want to do a tax-deferred exchange. This is usually accomplished by the broker inserting a few words in the Purchase and Sale Agreement to the effect the "Seller" wants to do a tax-deferred exchange. (See cooperation clause below).

(Contract Language)

“Buyer hereby acknowledges it is the intent of the Seller to affect an IRC Section 1031 tax deferred exchange which will not delay the closing or cause additional expense to the Buyer. The Seller's rights under this agreement may be assigned to Exchange Resources, Inc., a Qualified Intermediary for the purpose of completing such an exchange. Buyer agrees to cooperate with the Seller and Exchange Resources, Inc. in a manner necessary to complete the exchange.”

When a tax-deferred exchange is the ultimate aim of the taxpayer, it is necessary that the taxpayer be restricted from any access or use of the proceeds from the disposition of his property. The essence of an exchange is the transfer of property between owners, while that of a sale is the receipt of cash for property - whether that receipt is actual or constructive if the taxpayer has--or could get--control of the cash.

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