The famous case of Starker v. U.S., permitting for the first time "deferred," "non-simultaneous" or "delayed" tax-free exchanges of real property, was handed down 11 years ago by the U.S. 9th Circuit Court of Appeals.
Since then, however, little official authority has been provided to guide taxpayers and their advisers on the proper structuring of a delayed exchange.
That changed as of May 15, when the Internal Revenue Service issued its long-awaited proposed amendments that would add new Sections 1.1031(a)-1 and 1.1031(a)-3 to the regulations.
The highlights of these new proposed regulations are as follows:
* Manner of designating target properties. The Tax Reform Act of 1984 imposed a 45-day period in which "target" or "replacement" property must be identified, but the manner of doing so was not specified, and has been the subject of much speculation among tax advisers.
The proposed regulations require that the taxpayer sign a written designation "unambiguously" describing the target property or properties.
The designation must be delivered, mailed, telecopied or otherwise sent before the end of the 45-day period to a person involved in the exchange (such as the intermediary) other than the taxpayer or a "related party" (defined as the taxpayer's attorney, broker, employee, family member, or a corporation owned more than 10% by the taxpayer).
An identification made in an exchange agreement signed before the end of the 45 days will qualify.
* Number of target properties to designate. In practice, this has been the most troublesome area of structuring a proper exchange, given the lack of governmental or court guidance. The proposed regulations now solve that defect.
A maximum of three replacement properties may be designated without regard to value (the "three-property rule"), or an unlimited number of properties may be designated, provided that their aggregate fair market value (excluding liabilities) does not exceed 200% of the aggregate fair market value of all relinquished properties on the date they were transferred (the "200% rule").
The IRS has imposed a fairly stiff penalty for violating these guidelines--disallowing the entire exchange, except for replacement property received within the 45 days, or replacement property received within the allowed 180 days, but only if the taxpayer receives identified replacement properties constituting at least 95% of the aggregate fair market value of all identified replacement properties within the 180-day period.
* Qualified intermediaries. To serve as a "qualified intermediary" in a deferred exchange, the proposed regulations require that the intermediary (a) not be a "related party" (see above definition), and (b) charges a fee to facilitate the exchange.
* Treatment of Interest Income. Under the proposed regulations, the taxpayer should not have the right to have interest income paid by the intermediary until (a) after expiration of the 45-day designation period if no replacement property has been identified, (b) after receipt of all identified replacement property, or (c) if the taxpayer identifies replacement property, after the later of the 45-day identification period, or the failure of a material condition provided in the exchange agreement or the designation notice which is beyond the control of the taxpayer or a "related party" as defined above such that the taxpayer need not acquire the replacement property; for instance, the property being destroyed or not rezoned from residential to commercial use.
* Securing the transferee's obligation to deliver the replacement property or properties. The IRS has liberalized the concepts pertaining to this issue by providing that the taxpayer will not be deemed to be in actual or constructive receipt of the cash if the intermediary or other exchange transferee's obligations are secured with either a deed of trust or mortgage, a standby letter of credit (meeting the installment sale rules) that does not allow the taxpayer to draw except upon the default of the transferee's obligation to transfer like-kind replacement property to the taxpayer, a third-party guarantee, or cash held in a qualified escrow account which cannot be accessed by the taxpayer under the same circumstances as item (c) of the preceding paragraph.
* Direct deeding. The background information furnished by the IRS made reference to Revenue Ruling 90-34, issued April 16, 1990, which authorized, at least on the "up leg" of the exchange where the taxpayer acquires the target property, that the seller of such property could convey it directly to the taxpayer, even in the instance where a qualified intermediary is otherwise utilized in the transaction.
Although these regulations have not yet been formally adopted by the IRS, it is recommended that all exchange transactions nevertheless comply with these guidelines, which are intended to become effective July 2, 1990.