Generally, when one discusses exchanges, the type of exchange referred to is the delayed or Starker exchange. This term comes from the name of the Exchanger who was first challenged for a delayed exchange by the IRS. From this tax court conflict came the code change in 1984 that formally recognized the delayed exchange for the first time. As mentioned earlier, this is now the most common type of exchange.
In a delayed exchange, the Relinquished Property is sold at Time 1, and after a delay of up to 180 days, the Replacement Property is acquired at Time 2.
Property that qualifies for exchange under Section 1031 must be "like-kind", which is defined in the Regulations as follows:
1. Property held for productive use in a trade or business, such as income property, or
2. Property held for investment.
Therefore, not only is rental or other income property qualified, so is unimproved property which has been held as an investment. Such unimproved property can be exchanged for improved property of any type, or vice versa. Also, one property may be exchanged for several, or vice versa. This means that almost any property that is not a personal residence or second home is eligible for exchange under Section 1031.
The Exchanger has a maximum of 180 days from the closing of the Relinquished Property or the due date of that year's tax return, whichever occurs first, to acquire the Replacement Property. This is called the Exchange Period. The first 45 days of that period is called the Identification Period. During these 45 days, the Exchanger must identify the candidate or target property which will be used for the Replacement Property. The identification must:
- Be in writing,
- Signed by the Exchanger, and,
- Received by the facilitator or other qualified party (faxed, postmarked or otherwise identifiably transmitted through Federal Express or other dated courier service, or digital signature).
This must all occur within the 45 day period. Failure to accomplish this identification will cause the exchange to fail.
Three rules exist for the correct identification of replacement properties.
1) The Three Property Rule dictates that the Exchanger may identify three properties of any value, one or more of which must be acquired within the 180 Day Exchange Period.
2) The Two Hundred Percent Rule dictates that if four or more properties are identified, the aggregate market value of all properties may not exceed 200% of the value of the Relinquished Property.
3) The Ninety-five Percent Exception dictates that in the event the other rules do not apply, if the replacement properties acquired represent at least 95% of the aggregate value of properties identified, the exchange will still qualify.
As a caveat it should be mentioned that these identification rules are absolutely critical to any exchange. No deviation is possible and the Internal Revenue Service will grant no extensions.
* Ironically, although only approximately 3-5 percent of exchanges are audited, the few exchanges which don't pass upon audit, typically they fail because of discrepancies in identification.
Mechanics of a Deferred or Delayed Exchange
It is important that any exchange be carefully planned with the help of an experienced, competent and creative legal and exchange professional. Preferably one who is completely familiar with the tax code in general, not just Section 1031, and who has extensive experience in doing many different kinds of exchanges. Thorough planning can help avoid many subtle exchanging pitfalls and also ensure that the Exchanger will accomplish the goals which the transaction is intended to facilitate.
Once the planning is complete, the exchange structure and timing are decided, and the Relinquished Property is sold and the transaction is closed, the facilitator becomes the repository for the proceeds of the sale. The money is kept in the Exchanger's Qualified Escrow Account until the Replacement Property is located and instructions are received to fund the Replacement Property purchase. The funds are then wired or sent to the closing entity in the most appropriate and expeditious manner, and the Replacement Property is purchased and deeded directly to the Exchanger. All the necessary documentation to clearly memorialize the transaction as an exchange is provided by the facilitator, such as exchange agreement, assignment agreement and appropriate closing instructions.