Corporate Law: Rules change for 1031 tax-free exchanges

You may be the owner of investment property that you have desired to sell for some time. Because the federal capital gains tax would consume 20 percent of your profit and the state of Missouri would take an additional 6 percent, you consider making a tax-free exchange under Section 1031.

Although you have not yet found a buyer for your property, you have found a property that you would like to trade for, but you must act quickly and cannot wait until your property sells. You prudently decide to consult your tax adviser and learn that a new tax-free exchange revenue procedure may, for the first time, provide you with a safe harbor for buying the replacement property before you sell your current property.

Section 1031 of the federal tax code has long provided for the tax-free exchange of property held for investment if the replacement property is identified with 45 days of the sale of the exchange property and closed within 180 days of the sale.

The type of property that qualifies for a tax-free exchange is property that is held for use in a trade or a business, or held for investment. Thus, a motel or office building may qualify for deferral of the tax liability, while a personal residence or vacation home will not.

For many years it has been standard practice to recommend the sale of the exchange property prior to the purchase of the replacement property because the IRS did not look favorably on purchase of replacement property prior to sale of the exchange property. It was not clear that such a transaction would qualify as a tax-free exchange.

With Revenue Procedure 2000-37, the IRS has created a safe harbor for such reverse exchanges. The Revenue Procedure contemplates the use of a qualified exchange accommodation agreement (QEAA). This arrangement allows an exchanger to have a third party, who may not be a related party or agent of the exchanger, to purchase the replacement property until the exchanger can find a buyer for the property being exchanged.

Upon the sale of the ex-changer's property, the accommodation party transfers the replacement property he has been holding to the exchanger to complete the tax-free exchange.

Several requirements must be met by the terms of the QEAA for the transaction to qualify as a tax-free exchange. First, as stated above, the accommodation party must hold qualified indicia of ownership, and may not be a related party or agent, all as further defined in the Revenue Procedure.

Second, the exchanger must intend that the accommodation party hold the replacement property for the purpose of making a tax-free exchange.

Third, within five days of receiving the property, the accommodation party and the exchanger must enter into a QEAA, and agree to make tax reports consistent with the requirements of the QEAA. Finally, the exchange property must be identified not more than 45 days after receiving the replacement property, and it must actually be transferred within 180 days.

The revenue procedure gives exchangers a safe harbor when they wish to make a tax-free exchange by purchasing the replacement property prior to transferring the exchange property. Under prior law, it was questionable whether such transactions would qualify as tax-free exchanges under Section 1031. Other technical rules apply, so check with your tax advisers before making the exchange.

(Stephen F. Aton is a Springfield attorney practicing in the areas of corporate law and taxation, and estate planning.)