March 01, 2015

Tax-Deferred Exchanges of Property

Max A. Hansen
  • What are the requirements for a tax-deferred exchange of property?
  • What is a "construction to suit" exchange?
  • Is section 1031 on the chopping block?

The use of tax-deferred exchanges of property continues to grow as taxpayers, realtors, attorneys, and accountants have realized the benefits of Internal Revenue Code (I.R.C.) section 1031. This code section has been part of the IRC since 1921 but did not begin to grow in use until the 1980s. The use of this tax deferral mechanism has evolved from what were primarily real property exchanges into exchanges of personal property and real property interests of all kinds.

It would be impossible to address all aspects of 1031 exchanges in this short article, so I will focus on a brief history of section 1031, the tax policies behind exchanges, a summary of proper methodology for structuring exchanges, recent developments in the exchange industry, and recent threats to the existence of section 1031.   

A Brief History

Section 1031 provides no gain or loss shall be taxable in those instances where a taxpayer exchanges property held for productive use in a business or trade, or for investment for a “like kind” property also to be held for productive use in business or trade or for investment purposes. Initially exchanges were structured as simple simultaneous swaps of either real or personal property. As time has passed, the bulk of exchanges completed now are delayed exchanges.

Prior to 1979, if taxpayers could not complete a simultaneous swap with another party, complex multiparty transactions involving “straw men” were the order of the day. The landmark Starker decision in 1979 established the basis for delayed exchanges (T.J. Starker vs. U.S., 432 F. Supp. 864 (D. OR. 1977) aff’d, rev’d & rem’d 602 F. 2d 1341 (9th Cir., 1979).) The taxpayer, Starker, exchanged title to his property for a contractual promise by the buyer, Crown-Zellerbach, to acquire like-kind property to be selected and designated by Starker at a later date. No cash changed hands on Starker’s conveyance to Crown-Zellerbach. Starker’s net sale proceeds were held by the buyer as a “net exchange value” credit on its books. Starker later selected properties using his credit toward the acquisition price. Crown-Zellerbach acquired the properties and immediately transferred the title to Starker. This delayed exchange transaction was disallowed by the IRS, but Starker prevailed on appeal and set the precedent for 1031 delayed exchanges.

In 1991, the IRS promulgated exchange regulations that resolved uncertainties about exchange structures and clarified many issues, including identification and receipt of replacement property. The regulations also established “safe harbors” for avoiding actual and constructive receipt of cash or other nonqualifying property. Of those safe harbors called qualified trusts, qualified escrows, and qualified intermediaries, the qualified intermediary or QI has become the prevailing safe harbor of choice. QI companies provide the exchange agreement and other exchange documentation, oversee the closings for the different legs of the exchange, and generally assist taxpayers and their advisors in the process.

Tax Policy

When Congress enacted the like-kind exchange statute in 1921, the legislative history makes clear that initially there were three main purposes for enactment. One purpose, administrative convenience or the difficulty in valuing the exchange property, ceased to be relevant in any discussion of the policy underlying the statute as early as 1924. The two remaining primary purposes were to avoid unfair taxation of ongoing investments in property, and to encourage active reinvestment.

First, Congress clearly wanted to permit taxpayers to maintain investments in property without being taxed on theoretical (i.e., “paper”) gains and losses during the course of a continuous investment. Section 1031 accomplishes this purpose by exempting from taxation those transactions representing a continuation of the taxpayer’s original investment merely in different, but like-kind, property. This purpose remains valid because the statute avoids the inequity of speculative taxation in the middle of an ongoing investment.

The second stated purpose of section 1031 was to promote transactional activity dictated by prudent business decisions and changing circumstances. Section 1031 has remained true to its purpose by providing a solution to the “lock-in” problem of the taxpayer who is unable or unwilling to sell investment property because of the burden capital gains and recapture taxes would place on the taxpayer’s cash flow and net worth.

Structuring Exchanges

In each transaction there must be an exchange agreement that sets forth the intentions of the parties. The agreement must clearly provide for retention of exchange funds by the qualified intermediary. It should also describe the limited circumstances under which the taxpayer may terminate the exchange and receive the exchange proceeds. A well-crafted exchange agreement will incorporate the requirements contained in the 1031 regulations and reduce potential problems with an exchange.

There are strict requirements in the 1031 regulations for timing the identification of replacement property (45 days from relinquished property closing), the number of identified replacement properties, and the time period in which the replacement property must be acquired to complete the exchange (180 days from relinquished property closing). The exchange structure is built around these requirements. There are no grace periods in meeting those time limitations unless the taxpayer is adversely affected by a presidentially declared disaster.

The QI must sell the relinquished property and acquire the replacement property in an integrated transaction. By acquiring title to the property or accepting an assignment of contractual rights, notifying all of the parties prior to the transfer date, and causing the direct delivery of the property, the QI can satisfy this requirement.

Recurring Issues

In spite of the increasing evolution of the law of exchanges and development of sophisticated transaction structures, many of the same basic issues continue to surface.

Constructive receipt or actual receipt of exchange proceeds can destroy an exchange. The taxpayer is in constructive receipt of the exchange funds if they even indirectly “enjoy the benefit of” the funds during the exchange period. Proper utilization of the QI or other “safe harbor” alternatives in the 1031 regulations assure the taxpayer will not be considered to be in constructive receipt of exchange proceeds.

The 1031 regulations define a disqualified person who cannot act as the QI. A disqualified person is anyone who acted as the taxpayer’s attorney, employee, accountant, investment banker or broker, or real estate agent or broker within two years of the disposition of the relinquished property. Persons with a relationship to the taxpayer within the definitions of I.R.C. section 267(b) and 707(b) are also disqualified. If a disqualified person acts as the QI, the entire exchange may be jeopardized.

Another problem is transactions between related parties as more fully defined in section 1031(f). Related parties are spouses, some immediate family members and those persons or entities listed in sections 267(b) and 707(b). Anytime there is an exchange between related parties resulting in a basis shift and one of the related parties “cashes out” within two years there is high probability that the exchange will be disallowed. There has been a great deal of recent litigation about this issue.

Another important issue covered in the regulations is the taxpayer’s receipt of cash or other nonqualifying property, or “boot.” Boot can be cash received by the taxpayer at some point during the exchange transaction. Boot issues can arise where part of the transaction value is allocated to an asset that is not like-kind. Boot can also arise in a sale of relinquished property that includes debt payoff not replaced with new or assumed debt on the replacement property.

Recent Developments

There have been a number of more recent developments in the exchange industry. One development is the increased use of section 1031 in exchanges of other than just fee interests in real property. Any real property interests are fair game, such as conservation easements, water rights, timber rights, wetland mitigation credits, oil and gas rights, pipeline easements, and other fractionalized interests.

There has also been an increase in personal property exchanges. Personal property exchanges are governed by a narrower standard of what is “like-class” defined by the NAICS depreciation class codes. Despite the more restrictive standard, large numbers of exchanges of aircraft, art and other collectibles, vehicles, equipment, and livestock continue. Certain intangibles such as sport franchises, broadcasting licenses, liquor licenses, and the like are also exchanged.

Reverse exchanges, sometimes referred to as parking arrangements, have increased since the issuance of Revenue Procedure 2000-37 on September 15, 2000 (Rev. Proc.). These transactions involve an exchange accommodation title-holder (EAT) who acquires a replacement property using a qualified exchange accommodation agreement. The EAT parks the property until the taxpayer exchanges out of their relinquished property. Upon closing the relinquished property transaction, the taxpayer completes the exchange transaction by acquiring the replacement property using their QI.

Construction to suit exchanges are a reverse exchange variation, increasingly utilized, where the taxpayer exchanges out of the relinquished property but is unable to find a suitable replacement property without constructing improvements on the replacement property as part of the exchange. In those situations, the taxpayer enters into an agreement with an EAT to acquire the replacement property, construct the improvements and, when the improvements are complete, convey the improved property to the taxpayer to complete the exchange.

In some instances, taxpayers may also elect to utilize parking arrangements, which are structured outside of the safe harbor of the Rev. Proc. A successful “non-safe harbor” parking arrangement requires a parking entity with true benefits and burdens of ownership to park the replacement property for eventual acquisition by the taxpayer. These transactions are typically utilized in situations where the construction to suit timetable is longer than 180 days or the taxpayer needs more time to market a relinquished property. These complicated transactions require the taxpayer to employ qualified attorneys, tax advisors and a knowledgeable QI.

Current Threats to Section 1031

There are three looming threats to the continued vitality of section 1031 emanating from the White House and both houses of Congress. The administration’s 2016 proposed budget would limit the deferral of gain using a section 1031 exchange to $1,000,000 annually on real estate and collectibles transactions.

In the House, Chairman Paul Ryan of the Ways & Means Committee indicates he will release a draft tax reform proposal by August. The proposal he inherited from the former chair included complete repeal of section 1031, but the new draft’s impact on section 1031 is unknown.

In the Senate, Chairman Orrin Hatch of the Senate Finance Committee has stated that June/July is the target for a tax reform bill. The Committee’s Working Groups are to provide their input to Hatch by the end of April. The proposal Hatch inherited from former Chair Baucus provided for repeal of section 1031 or perhaps a limitation to a much narrower “similar use” standard instead of “like kind.”

Although most are in favor of fair and equitable tax reform, there is fear that section 1031 will become a casualty for the sake of lowering corporate tax rates and broadening the tax base. Substantial evidence indicates that section 1031 repeal would reverse the nearly 100-year history of exchanges encouraging economic vitality and growth and would have a negative impact on the nation’s economy. For more information on tax reform and section 1031, consult


Tax-deferred exchanges continue to be a sensible, cost-effective way of deferring capital gains taxes. Section 1031 remains true to the tax policies which were the bases for enactment in 1921. Any attorneys practicing in real estate or business should be aware of the basics of section 1031, and developing uses of exchanges that may benefit their clients. Consulting with a professional QI and CPA is also wise. To find a professional QI, ask other attorneys or real estate professionals for someone they have used and recommend. Another source is the QI Locator on the Federation of Exchange Accommodators website at The hope is that this valuable tool continues to be a vital part of our tax code for many years to come.


Max A. Hansen

Max A. Hansen is president and CEO of American Equity Exchange, Inc., one of the first 1031 qualified intermediary companies in the Rocky Mountain Region formed more than 23 years ago. He is also President of Reverse Exchange Services, Inc. Max is also licensed to practice law in Montana, California, Utah, and Idaho and a Certified Exchange Specialist. He is a former President of the State Bar of Montana, former ABA delegate to the House of Delegates, and is currently a member of the Committee on Sales, Exchanges and Basis of the ABA Section of Taxation. Max is also a member of the Board and a Past President of the Federation of Exchange Accommodators (FEA) and serves as the co-chair of the FEA Government Affairs Committee. He has conducted seminars and appeared on panels of experts around the country on the subject of section 1031 exchanges.