INTRODUCTION

                        An important exception to the Internal Revenue Code's general rule requiring recognition of gain or loss on disposition of property is Section 1031, which permits the exchange of qualifying like-kind property without total recognition or partial recognition of realized gain or loss. In order to qualify for Section 1031 nonrecognition, both the property transferred and the property acquired must be held for productive use in trade or business, or for investment.

                         Like-kind refers to the "nature or character of the property and not its quality." For example, real property such as a shopping center may not be exchanged for personal property such as stock in a corporation, because the nature and character of the exchange properties are not the same or like-kind. The property or properties being exchanged must be like-kind in nature requiring that property held for productive use in trade or business or for investment be exchanged for other property held for productive use in trade or business or investment.

                        When nonqualifying or nonlike property (boot) is also received, gain must be recognized to the extent of the boot received. Only the amount of realized gain that is not recognized in a Section 1031 exchange is deferred until there is a subsequent taxable disposition of the real estate.

                        The Internal Revenue Service requires mandatory utilization of the nonrecognition provisions of Section 1031 when the following three requirements are met:

                        (1)       both the property given and the property received are qualifying properties;

                        (2)       the transferror gives and receives property; and

                        (3)       the properties exchanged are of like-kind in nature.

Qualifying Property

                        Section 1031 property must be held by a taxpayer for use in a trade or business or for investment before and after the exchange for it to qualify for nonrecognition in a like-kind exchange. Therefore, dealer property (property held primarily for the sale to customers in the ordinary course of business or as inventory) is precluded from Section 1031 treatment. Once the like-kind requirement is met, and so long as the acquired property is held for productive use or for investment, the acquired property need not be put into the same use as the transferred property.

Property Held for Investment

                        The term "investment" is not clearly defined in the Code, although the Regulations state that property held for future use with any eye to appreciation, is property held for investment. The mere holding of property for a number of years, however, is not conclusive of an investment.

Like-Kind Real Property

                        With respect to “like-kind”, the statute requires that both the property transferred and the property received be held either for use in a taxpayer's trade or business or for investment, and that the qualifying property be of "like-kind". The definition of real property includes virtually all types of property, including land. For example, the Regulations state that unimproved real property may be exchanged for improved real property, and unimproved property is like-kind to buildings without land. An undivided interest as a tenant in common may be exchanged for a fee simple absolute. Exchanges of ownership interests in real property are like-kind for purposes of Section 1931(a), as are exchanges of remainderman interests.

                        Mineral rights are considered real property if state law so provides. Leasehold interest of 30 years or more may be exchanged for a fee interest in real property. A purchaser's interest under a purchase contract for real estate may be exchanged for a fee interest in real estate.

Transactions Involving Boot

                        Taxpayers must be aware of two basic concepts concerning "boot" that raise a number of considerations. First, a taxpayer who under a Section 1031 like-kind exchange, receives money or other nonlike-kind property (i.e., boot) must recognize any realized gain to the extent of boot received; boot transferred is not subject to the Section 1031(a) nonrecognition rule nor the Section 1031(b) partial recognition rule. In addition, the receipt of boot does not create gain where none has been realized, but if gain is realized, the receipt of boot causes recognition of gain, which would otherwise be deferred under the general rule of Section 1031(a) to the extent of boot received.

                        The receipt of money, nonqualifying property, or property which is not like-kind to the property exchanged, are all situations which constitute the receipt of boot. Second, when the transferee assumes the liability of the transferor, or acquires the property subject to a liability as part of the consideration for the exchange, such mortgage relief is treated as money received, and therefore, boot.

Deferred Exchanges

                        An exchange of one piece of real estate for one or more replacement pieces of real estate need not take place simultaneously under Section 1031. Often, delays may be caused by difficulties in locating or obtaining the replacement property. Since the Tax Reform Act of 1984, delayed or "deferred" exchanges can qualify for like-kind treatment as long as the replacement property is identified by the taxpayer within 45 days of sale of the relinquished property and received by the taxpayer before the earlier of 180 days after the transfer, or the due date of the taxpayer's tax return for the year in which the transfer occurs. After the taxpayer has relinquished the exchange property, he will want to secure in some way the transferee's obligation to complete the exchange. However, in attempting to secure the transferee's obligation, constructive receipt concerns are raised. If the taxpayer actually or constructively receives money or nonqualifying property in the full amount of the consideration for the relinquished property before he receives the like-kind replacement property, the transaction will be characterized as a sale and not a deferred exchange even though the taxpayer may eventually receive replacement property.

"Starker Trusts"

                        The accepted means of avoiding constructive receipt by the seller is to place the funds into a trust, often referred to as a "Starker Trust." The settlor, or person contributing the assets to the trust, is the buyer. The trustee is a third party, which may be an escrow company or trust company, and the beneficiary of the trust is the taxpayer/seller, who seeks to effectuate the Section 1031 exchange.

                        The mainstays of the trust agreement are the 45-day and 180-day time periods provided in Section 1031. In the event the taxpayer fails to designate property within 45 days and/or fails to cause the trustee to purchase the designated property within the 180-day period (or the due date, including extensions, for the taxpayer's return, whichever first occurs), the transferor will receive all of the cash held in the trust. However, the trust agreement specifically states that until the occurrence and/or failure, as the case may be, of the 45-day and 180-day periods, the taxpayer will have no right to withdraw, pledge, assign, or otherwise encumber the trust proceeds or assign his rights under the trust agreement. In addition, the trust agreement is irrevocable, which also protects the taxpayer from any claims of constructive receipt.

                        Procedurally, the trust agreement provides for the trustee to purchase and take title to the designated property, with a subsequent transfer of the property by special warranty deed to the taxpayer. However, it is not uncommon and is acceptable for the taxpayer to instruct the trustee to cause a single deed to be executed from the seller of the designated property directly to the taxpayer.

PLANNING FOR LIKE-KIND EXCHANGES

Requirements of Like-Kind, Holding Intent and Exchange

                        The fundamental requirements:

                        1. You need a written exchange agreement between an intermediary or buyer and taxpayer evidencing the obligation of the intermediary or buyer to undertake an exchange.

                        2. You must have held the property pelinquished for investment or for use in a trade or business at the time of the exchange and you must hold the target property for investment or use in a trade or business.

                        3. Real property must be exchanged for real property.

                        4. You must identify the property within 45 days and acquire the property within 180 days (exchange period).

Identification

                        1. How to identify a property.

                        (a) You must unambiguously describe by street address, legal description, assessor's parcel number or distinguishable name.

                        (b) You may identify real property and exclude other property to be acquired in connection with the real property if the other property does not exceed 15% of the value of the real property and if such other property is transferred with the larger item in standard commercial transactions.

For example, if you are to acquire an apartment building that also contains washing machines, you are not required to identify the apartment building and the washing machines. However, the receipt of the washing machines will not be treated as like-kind with the real property traded so there may be recognition of gain up to the value of the washing machines. You should allocate a purchase price for the personal property so|d in connection with an exchange in order to identify the amount of boot that may arise in the exchange.

                        (c) You must identify with the intermediary, in writing, the properties you wish to acquire within 45 days after the initial transfer of your property. If there is more than one property being transferred as part of the same deferred exchange, the identification period begins to run with the first transfer of property.

                        2. How many properties can I identify?

                        (a) You must meet one of three tests:

                                    (1) Three like-kind property pule.

                                    You may identify three properties regardless of their value. Use a street address, assessor's parcel number and legal description.

                                    (2) The 200% Rule.

                                    If you cannot comfortably restrict the identification to three properties, you may identify any number of properties provided the fair market value of the target properties does not exceed 200% of the fair market value of the property transferred.

                                    (3) If you identify more than three properties with valued in excess of 200% of the value of the property relinquished, you still properly identified the target properties if you acquire 95% of the aggregate value of the target properties by the end of the exchange period.

                        (b) Fair market value determination is based on gross fair market value without regard to any liabilities at the following times:

                                    (1) For the 200% test, it is made as of the last day of the identification period.

                                    (2) For the 95% test, it is made as of the earlier of the date the property is received by you or the last day of the exchange period.

                                    (3) For constructed improvements, it is made as of the date it is expected to be received by you.

Recommendation: Use the 200% rule only in situations in which you are trading a more valuable parcel for a number of less valuable parcels. In other instances, I recommend that you limit your identification of property to 3 target properties.

                        3. When to identify properties.

                        You must identify property within 45 days after the transfer of the first of the properties transferred in an exchange.

                                    (a) The property transfer occurs when the benefits and burdens of ownership are transferred or received, which usually coincides with deed recordation.

                                    (b) You cannot extend the 45 day identification period to take into account a Saturday, Sunday or federal holiday.

                                    (c) You must identify target properties by written notice, except as noted in paragraph 3(d) below. You can send the notice by fax, mail or hand delivery. (Most exchange intermediaries will send an executed acknowledgment by fax of receipt of your fax on the same day so that you have this document for your records evidencing timely property identification).

                                    (d) If you acquire like-kind property in connection with the exchange before the end of the 45-day identification period, the property is not required to be identified in writing.

                        4. If you are within the 45 days after relinquishing your property and you either incorrectly identified target property or wish to change the selection of target properties, you may amend or revoke the identification in writing at any time before the end of the identification period by sending this revocation to the intermediary before the end of the identification period.

Receipt of Identified Property

                        1. When:

                        You must receive identified property before the earlier of 180 days or the time for filing your return including extensions.

                                    (a) If the exchange occurs after October 17 of any year and you are an individual, you will have to file an extension on your income tax return in order to take advantage of the full 180-day period.

                                    (b) If the exchange occurs after September 16 of any year and you represent a corporation reporting on the calendar year, your corporation will have to file an extension on its income tax return in order to take advantage of the full 180-day period.

                        2. What:

                        You must receive property that is substantially the same as the property identified.

                                    (a) Constructed property. If you wish to construct improvements on property to be acquired, you must exercise great care in the identification of those improvements.

                                                (1) If substantial changes are made in the property to be produced from that identified, the property will not be treated as properly identified.

                                                (2) The determination of whether you properly identified target real property occurs when the construction is completed even though the construction is completed while in your hands.

                                                (3) The determination of whether you properly identified target personal property occurs when the property is received. The construction on personal property, unlike the construction on real property, must be completed before receipt of the improved target property.

                                                (4) Deviations from the description of the improvements in the identification may result in the IRS challenging your identification of the property constructed.

                        3. The 75% Rule.

                        The IRS regulations contain an example which the IRS is presently treating as a rule. If you acquired 75% of the value of the property identified, the target property received will be substantially the same as the target property identified.

Recommendation: The issue of value raises an unnecessary uncertainty, and you should be specific as to the percentage of the target property to be acquired. However, you may rely on this example if you acquire less than all of the target property you identified.

Constructive Receipt

                        There are specific rules to follow in order to avoid being in constructive peceipt of all of the funds held by the intermediary.

                        1. Requirements.

                        The exchange agreement must limit your ability to receive, pledge, borrow or otherwise obtain the benefits of money or other property before the end of the exchange period unless:

                                    (a) You have not identified target property by the end of the identification period.

                                    (b) You have received all of the target properties to which you are entitled under the exchange agreement.

                                    (c) The occurrence of a material and substantial contingency that:

                                                (1) Relates to the deferred exchange;

                                                (2) Is provided for in writing; or

                                                (3) Is beyond your control.

                        2. Closing costs.

                        Using the exchange proceeds for prorated taxes, recording or transfer taxes and title company fees, will not result in constructive receipt of the entire amount held by a qualified intermediary, trust or escrow. However, if the agreement states that you are in receipt of the funds to the extent that the funds are used to pay your closing costs, you may avoid this boot by paying the transaction costs separately.

                        3. Prorated income and expense items.

                        You can disregard items that you may receive as a consequence of the disposition of the property and that are not included in the amount realized from the disposition of the property, such as prorated rents.

                        4. Return of deposits.

                        You should use the escrow through which the property is acquired to return any deposit.

                        5. Receipt of nonlike-kind property.

                        If you are receiving property in the exchange which includes nonlike-kind property, such as personal property, there is a questions whether the intermediary may transfer that property to you before the events described in paragraph

Reporting Requirements

                        1. For the year in which you complete your exchange, you must prepare and file a Form 8824 which identifies the type of property transferred and the dates of disposition, identification and acquisition of properties.

                        2. You must also report whether the exchange was between related persons.

Documenting the Exchange

                        While particular forms or documents for a tax-deferred exchange are not required under IRC section 1031, thorough and accurate documentation of your exchange offers visible proof to the IRS, and if necessary a court, that all requirements have been met. In addition, the exchange must be reported on Form 8824 with the tax return for the year the transfer occurred.

IMPROVEMENT EXCHANGE

                        An improvement exchange allows you to sell your old property and use that money to buy a property with part of your funds, and to use the remainder of your funds to make improvements. There are a few critical things that you need to know.

You Must Equalize Your Exchange

                        The first critical rule is that you only have 180 days from the closing of your old exchange to equalize your exchange. For example, you sell your old property for $2,500,000 and you are thinking of buying unimproved property or property needing repairs. The purchase price of the target property is $1,750,000 and you plan to make repairs or improvements costing $1,500,000. The total project will cost $3,250,000. By the 180th day, you need to have at least $2,500,000 invested in the new project (both land and improvements) to equalize your exchange.

What Happens if You Don’t Meet Your Equalization Target?

                        If you don’t meet your equalization target ($2,500,000 in our example), you pay tax on the amount that you fall short. Using our example, if you are only able to complete $500,000 of the improvements by the end of your 180 days, you would pay tax on the difference of $250,000, since the purchase of the property for $1,750,000 and the $500,000 of improvements only totals $2,250,000.

Once You Take Title to the Target Property,Your Exchange is Over

                        When you take title to the property, your exchange is over, at least on that property. For this reason, you need someone, other than your self (or your entity is the relinquished property is held by an entity), to take title to the land and make the improvements. It may be possible for the qualified exchange intermediary to take title to the property. The title would likely be in the name of a limited liability company (an “LLC”) that is established for just this purpose. The money for the purchase of the property and for payment of the improvement costs would come from your exchange account that the qualified exchange intermediary is holding. Normally, you still would be able to select the contractors. The LLC will continue to hold the property until the improvements are completed, or until the 180 day limit is reached, whichever first occurs.

How Do You Identify the Improvements on Your 45 Day Letter?

                        Since you (or your entity) will be taking title to the improved building to complete your exchange, you need to identify this as such on your 45 Day Identification Form. In most cases your identification will read something like this: “Purchase of the 16 unit apartment building at 123 Main Street, San Francisco, CA, for $1,750,000 with the following improvements: new exterior facade - $250,000; interior renovations to all units $500,000".

The Improvements Must Be Completed to Count

            For the improvement costs to count towards your 1031 exchange, they must be completed. This means that you only want to include improvements that can be completed before the end of the 180 day period. Include only enough improvements to equalize your exchange. In our example, even though you are planning $1,500,000 of improvements, you only want to identify $750,000 of these since that is all that you require to equalize your exchange. In our example we can assume, for example, that the additional improvements after the target property is received by you would be paid from the proceeds of a new loan on or refinance of the target property.