Delayed Exchanges – The Exchange Process and Time Clocks

A taxpayer desiring to do a 1031 Exchange lists and/or markets the property for sale in the normal manner without regard to the contemplated 1031 Exchange. A buyer is found and a contract to sell the property is executed. Accommodation language is usually placed in the contract securing the cooperation of the buyer to the seller’s intended 1031 Exchange, but such accommodation language is not mandatory.

When contingencies are satisfied and the contract is scheduled for a closing, services of an Intermediary are arranged. The taxpayer enters into an Exchange Agreement with the Intermediary, which permits the Intermediary to become the “substitute seller” in accordance with the requirements of the Code and Regulations.

The Exchange Agreement usually provides for:

• An assignment, to the Intermediary, of the seller’s Contract to Buy and Sell Real Estate.
• A closing where the Intermediary receives the proceeds due the seller at closing. Direct deeding is used. The Exchange Agreement will comply with the requirements of the Code and Regulations wherein the taxpayer can have no rights to the funds being held by the Intermediary until the exchange is completed or the Exchange Agreement terminates. The taxpayer cannot touch the funds.
• An interval of time where the seller proceeds to locate suitable Replacement Property and enter into a contract to purchase the property. The interval of time is subject to the 45-Day and 180-Day rules.
• An assignment, to the Intermediary, of the contract to purchase Replacement Property.
• A closing where the Intermediary uses the exchange funds in its possession and direct deeding to acquire the Replacement Property for the seller.

The 45-Day Rule for Identification. The first timing restriction for a delayed Section 1031 exchange is for the taxpayer to either close on the purchase of the Replacement Property or to identify the potential Replacement Property within 45 days from the date of transfer of the Relinquished Property. The 45-Day Rule is satisfied if Replacement Property is received before 45 days have expired. Otherwise, the identification must be by written document (the identification notice) signed by the taxpayer and hand delivered, mailed, faxed, or otherwise sent to the Intermediary. The identification notice must contain an unambiguous description of the Replacement Property. This includes, in the case of real property, the legal description, street address or a distinguishable name.

The 45-Day Rule for Identification imposes limitations on the number of potential Replacement Properties, which can be identified and received as Replacement Properties. More than one potential Replacement Property can be identified by one of the following three rules:

• The Three-Property Rule – Any three properties regardless of their market values.
• The 200% Rule – Any number of properties as long as the aggregate fair market value of the replacement properties does not exceed 200% of the aggregate FMV of all of the exchanged properties as of the initial transfer date.
• The 95% Rule – Any number of replacement properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified.

Although the Regulations only require written notification within 45 days, it is recommended practice for a solid contract to be in place by the end of the 45-day period. Otherwise, a taxpayer may find himself unable to close on any of the properties which are identified under the 45-day letter. After 45 days have expired, it is not possible to close on any property which was not identified in the 45-day letter. Failure to submit the 45-Day Letter causes the Exchange Agreement to terminate and the Intermediary will disburse all unused funds in his possession to the taxpayer.

The 180-Day Rule for Receipt of Replacement Property. The Replacement Property must be received and the exchange completed no later than the earlier of

• 180 days after the transfer of the exchanged property or
• The due date of the income tax return, including extensions, for the tax year in which the Relinquished Property was transferred.

The Replacement Property received must be substantially the same as the property that was identified under the 45-day rule described above. There is no provision for extension of the 180 days for any circumstance or hardship. There are provisions for extensions for presidentially declared disaster areas.

As noted above, the 180-Day Rule is shortened to the due date of a tax return if the tax return is not put on extension. For instance, if an Exchange commences late in the tax year, the 180 days can be later than the April 15 filing date of the return. If the Exchange is not completed by the time for filing the return, the return must be put on extension. Failure to put the return on extension can cause the replacement period for the Exchange to end on the due date of the return. This can be a trap for the unwary.