Talking in Code

Internal Revenue Code Section 1031 contains a mere 1,421 words, yet its significance cant be overemphasized. Investors have enjoyed the advantages since 1921. The overriding principlecontinuity of investmentis pretty simple. Boiled down, it means you should be able to avoid gain recognition by exchanging one relatively illiquid asset for another.

Section 1031 lays out three requirements for investors seeking tax-deferral. First, properties sold and purchased in the exchange must be held for investment or for use in a trade or business. They cant be personal-use properties or primary residences.

If necessary, you must demonstrate intent to hold the property for investment. In instances where youve clearly acquired property strictly for resale, personal use or to hold as dealer property, check with your CPA or tax advisor before attempting to assert tax-deferral.

Second, the properties must be like kind to each other. With real estate as a backdrop, the definition is extremely generous: Vacant land is like kind to industrial, which is like kind to office, which is like kind to retail, which is like kind to multifamily. Provided the properties are real property for local law purposes, they should be like kind to each other.

If youre exchanging other properties, they must be of a like class to one another. This category includes depreciable, tangible, personal property held for investmentclassic cars and artwork, for exampleor property used in trade or business, such as farm equipment. Like class properties fall within the same category in the North American Industry Classification System or General Business Asset Class.

Third, the transaction must be structured as an exchange of properties. When dealing with this requirement, its best to review the safe harbors defined at Treasury Regulation 1.1031(k)-1.

Safe Harbors

Many investors are familiar with the qualified intermediary (QI) safe harbor wherein a third party facilitates the exchange by acquiring and transferring the investors old and new properties. The QI needs to be an unrelated party and cant have acted as the investors attorney, accountant, investment banker or real estate agent within two years of his transfer of relinquished property.

Until the replacement property is acquired, the QI also will hold the proceeds of sale through a trust or escrow account or other exchange fund. The investors rights to receive the proceeds must be limited to specific instancesotherwise hell be deemed to have sold the property rather than exchanged it. Most QIs will guide clients through the transaction, which can be overwhelming.

Timing Is Everything

Strict time limits govern replacement property. Investors have 45 days to identify potential new properties from the time the old property is transferred. They must then acquire the properties within 180 days of the transfer or their tax-return due date, whichever is earlier.

In 1991, the U.S. Treasury Department limited the manner in which property can be identified. An investor has two choices: 1) Identify three potential replacement properties of fair market value. 2) Select any number of properties, as long as their combined value doesnt exceed that of the one exchanged by more than 200 percent.

There are a few exceptions to these rules. Any property received by an investor within the first 45 days will be treated as properly identified. Additionally, if an investor fails to come within either the three-property rule or the 200 percent rule, identification is assumed valid if the properties are acquired within the exchange period.

The time restraints may be the greatest challenge of Section 1031 exchanges. Its been a sellers market for several years and many investors have found it difficult to find high-quality property at reasonable prices. Self-storage isnt immune. Investors looking to build and operate investment-grade facilities are facing longer construction cycles and rising land costs. More are structuring their tax-deferred exchanges as reverse exchange parking arrangements, with the help of formal guidance from the IRS.

The IRS recently created a safe harbor parking arrangement. It allows a third-party titleholder to acquire the old or new property for up to 180 days. The EAT, or exchange accommodation titleholder, is the owner of the property for federal income tax purposes while the investor is the financial reporter. The procedure offers taxpayer-friendly guidance and powerful planning opportunities for institutional and individual investors.

At the time a property is transferred to the EAT, the investor must intend it to be either replacement or relinquished property to qualify for non-recognition of gain. Within five business days of transfer, the taxpayer and the EAT must enter into a Qualified Exchange Accommodation Agreement. The agreement specifies that the EAT is the beneficial owner of the property for federal income tax purposes, and all parties must report it as such.

Replacement-property parking also contains an identification requirement: Potential relinquished properties must be identified no later than 45 days after the transfer of the replacement property to the EAT.

Permissable Agreements

A number of contractual agreements are permissable between investors and EATs. Tax provisions include the following list, a potent tool for taxpayers.

  1. The taxpayer can guarantee some or all of the obligations undertaken by the EAT to secure financing to acquire the property.
  2. The taxpayer can advance funds directly to the EAT.
  3. The EAT can lease the property to the taxpayer.
  4. The taxpayer can manage the property, oversee construction of improvements, or otherwise provide services to the EAT in connection with the property.
  5. The Accommodation Agreement can contain puts and calls at fixed or formula prices.
  6. The EAT also can act as the qualified intermediary on behalf of the taxpayer.

Parking replacement property has become an important device among institutional investors with the financial wherewithal to purchase property without third-party financing. Many institutional investors park nearly every acquisition, estimating some viable disposition can be matched with it.

The procedure also allows investors to manage and development their property while receiving all the economic benefitsbefore ever taking legal title. 

Mary Cunningham is president of Chicago Deferred Exchange Corp. (CDEC), and group senior vice president of LaSalle Bank. She is a frequent lecturer on tax-deferred exchange strategies and an industry lobbyist. With offices in Illinois, California, New York and Massachusetts, CDEC facilitates more than 5,000 exchanges annually. For more information, visit

Editors note: This article is not intended to provide accounting, legal or tax advice. Readers should consult their legal or tax advisors concerning these subjects. To the extent that the above contains an opinion on any federal tax issue, such opinion cannot be used for the purpose of avoiding tax-related penalties under the Internal Revenue Code or for promoting, marketing or recommending to another party any matter addressed herein.

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