Generally, Section 1001 (c) of the Internal Revenue Code of 1986, as amended (the “Code”) provides that a taxpayer must recognize gain or loss on the “sale or exchange” of property. As a result, the taxpayer is subject to capital gains tax on any realized gain arising out of the sale of real estate held by the taxpayer for business or investment purposes.

However, §1031 of the Code represents one of the last legitimate tax shelters available to owners of real estate; §1031 provides a vehicle to allow real estate owners to defer payment of capital gains tax by reinvesting net sales proceeds derived from the sale of property to a third party (the “relinquished property”) in the purchase of similar real estate (the “replacement property”).

In order for a taxpayer to successfully complete a §1031 tax deferred exchange, it is vitally important that the taxpayer does not receive, actually or constructively, any money or other property before the taxpayer receives its like kind Replacement Property. If the taxpayer does actually or constructively receive money from the sale of the Relinquished Property before it receives the like kind Replacement Property, the transaction will constitute a taxable sale, and will not qualify for nonrecognition treatment. For purposes of evaluating whether a taxpayer is in actual or constructive receipt of money prior to its receipt of like kind Replacement Property, one must determine whether the taxpayer has the right to control or take possession of the funds at will, or whether certain limitations on its ability to control or access the funds lapse, expire or are waived.

In order to ensure that the taxpayer does not receive the net proceeds of the sale prior to the receipt of the Replacement Property, §1031 and its regulations provide four safe harbors. The safest and most often used sale harbor provides for the use of a qualified intermediary to hold the net sales proceeds until the replacement property is purchased. As long as the qualified intermediary holds the funds during the pendency of the exchange, and the taxpayer does not have actual or constructive control or possession of such funds, the taxpayer will not be held in constructive receipt of such funds so as to invalidate the exchange.

A person is disqualified from acting as intermediary if that person is the agent of the taxpayer (such as an employee, attorney, accountant, investment banker or broker, real estate agent or broker, within the two year period ending on the date of the transfer of the first relinquished property) or bears a close relationship to the taxpayer prohibited by the regulations.

In order for a property owner to successfully defer payment of capital gains tax on the sale of its relinquished property: (1) there must be an exchange; (2) the properties exchanged must be of “like kind”; and (3) the property transferred and the property received must be held for productive use in a trade or business, or for investment.

Although it is in some sense a legal fiction, §1031 still requires an exchange of business or investment property, as opposed to a sale of relinquished property and reinvestment of the proceeds in the replacement property. The Internal Revenue Services does not recognize that a taxable event has occurred in situations where a taxpayer merely trades one property for another. However, if a taxpayer sells a property and then voluntarily elects to use the proceeds to purchase another property, the taxpayer will be subject to capital gains tax on the sale of relinquished property. As a result, it is important to structure any exchange transaction in strict compliance with the provisions of §1031 and its regulations to ensure that the transaction is viewed as an “exchange” rather than a “sale/investment”.

Typically, a contract of sale is negotiated and executed by a taxpayer and the other party in the usual fashion. A number of advisors and commentators suggest that the contract contain an exchange cooperation clause for the benefit of the taxpayer seeking to implement the exchange, similar to the following:

Because the exchange regulations allow for “direct deeding”, the taxpayer’s name and tax identification number should be used in most closing documents, including the warranty deed, title policies and closing affidavits (except for reverse exchanges and construction exchanges, as outlined below).

Both the relinquished property sold by the taxpayer and the replacement property subsequently purchased by the taxpayer must be of “like kind” nature to each other. Although the regulations dealing with personal property are extremely strict in its analysis of whether one property is like kind to another, the regulations regarding real estate are much more liberal. For purposes of exchanging real estate for real estate, the regulations provide that it is immaterial whether the property is improved or unimproved, urban or rural, farmland or office tower, residential or commercial. For the most part, as long as the taxpayer is exchanging fee title in real estate for fee title in other real estate, the transaction will meet the like kind requirement. Exceptions to this rule come into play when the taxpayer attempts to include a property in which he or she owns, or will own, something less than fee title to the property (for instance, a leasehold interest or certain oil and gas payment rights).

In order to qualify for non-recognition under §1031, both the property transferred and the property received by the taxpayer must be held either for productive use in a trade or business, or for investment. A taxpayer will not obtain tax deferred treatment if the exchange involves the sale or purchase of property used for personal use (such as residences and vacation homes) or property held primarily for sale to a customer in the ordinary course of its trade or business (such as a real estate dealer or developer). The taxpayer’s intent at the time of purchase controls, and the IRS will consider various factors in an attempt to determine intent, such as the duration of ownership, extent of taxpayer’s efforts to sell the property, amount of development and improvement, advertising and frequency of sale of other real estate.

A change in circumstance may allow a taxpayer to complete an exchange by selling a property which was once used for personal purposes, such as a vacation home. If the home is no longer used for personal purposes, it may qualify for an exchange. However, most commentators agree that such property must not only be vacated by the taxpayer, but also rented out for a period of time as proof that the taxpayer’s intent in holding the property has indeed changed. Any rental of the property must be an arms length transaction, and most commentators suggest a minimum of one year passing before placing the property for sale.

As a general rule, the person or entity selling the Relinquished Property must be the same entity which purchases the Replacement Property.

After the completion of the sale of the Relinquished Property, a taxpayer must identify potential Replacement Property in a written document signed by the taxpayer and delivered to the qualified intermediary before the end of the 45-day identification period. In such written document, the Replacement Property must be identified unambiguously, such as by legal description, street address or distinguishable name (i.e., the Empire State Building). The taxpayer may identify up to three properties as potential Replacement Properties without regard to their fair market value (the “three property rule”). In the event the taxpayer identifies more than three properties, the total aggregate fair market value of all of the properties so identified may not exceed 200% of the aggregate fair market value of the Relinquished Property (the “200% rule”), or the taxpayer must actually acquire 95% of all properties identified (the “95% rule”). An identification of potential Replacement Property may be revoked at any time prior to the expiration of the 45-day identification period, as long as such revocation is made in writing and delivered in the same manner as required for the original identification notice. The 45-Day identification period begins on the date the relinquished property is sold.

The Replacement Property must actually be acquired in the taxpayer’s name on or before the expiration of 180 days after the transfer of the Relinquished Property, or the due date for the Taxpayer’s tax return for the taxable year in which the transfer of the Relinquished Property occurs, whichever is earlier. If the tax return date (usually April 15) occurs prior to the expiration of 180 days, then the taxpayer may file for an automatic extension to obtain the benefit of the full 180 day exchange period.

Exchange deadlines commence upon the day that title to the relinquished property is transferred. The date of transfer is the date the benefits and burdens of ownership are transferred to the new buyer, according to state law. Title companies are encouraged to reflect the actual closing date on the settlement statements to clear up any misunderstandings as to the date ownership actually transfers. Such date is not necessarily the same date documents are filed or proceeds disbursed. Additionally, identification and closing deadlines are not extended due to the fact that the deadline may fall on a Saturday, Sunday or holiday. In counting days, a taxpayer does not count the day the relinquished property transfers; the next day is day 1 for counting purposes.

In order to obtain the benefits of a fully deferred exchange, a taxpayer must not only use all its net proceeds held by the intermediary towards the purchase of replacement property, but it must also purchase property or properties with at least the same value as the relinquished property. As a result, a taxpayer must replace any debt paid off at the closing of the relinquished property sale with new debt or additional equity in purchasing the replacement property. Any debt not so replaced will be considered boot (Boot: Additional Cash or Property for a Like-Kind Exchange), subject to tax liability.

Typical closing costs directly associated with the sale of the relinquished property or purchase of the replacement property may be debited from a taxpayer’s settlement statement without adversely affecting the exchange. Such typical costs include, but are not limited to, the following: title policy premium, title company fees, recording fees, commissions, intermediary fees and legal fees associated with the transaction. It also appears that certain due diligence fees, including surveys, appraisals, inspections and environmental studies may also appear on the taxpayer’s closing statement without harming the exchange, as long as such items appear as contingencies in the contract. There is little authority or guidance in the exchange regulations as to which closing costs may be paid as part of an exchange; however, the rule of thumb seems to be that those closing costs which typically appear on a settlement statement are usually allowed. Those items which do not typically appear on a settlement statement, including property repairs or allowances, accounting fees, and payoff of debts not directly associated with the Property will be considered boot and should not be debited from the taxpayer’s settlement statement. These items should be paid by taxpayer outside of closing. Although there is a difference of opinion, rents and security deposits are typically thought of as operating expenses not directly related to the sale or purchase and should be handled outside of closing.

If a taxpayer agrees to provide seller financing for the sale of the relinquished property, he/she may not be able to complete an exchange. Since the seller must collect and spend the proceeds on replacement property within 180 days, then a long term payout on the note will not work. However, if the seller financing will be paid off in time for the taxpayer to use the proceeds to purchase replacement property within 180 days, then seller financing may be an option. In such cases, it is important for the promissory note to be made payable directly to the intermediary rather than the taxpayer. If the note is made payable to the taxpayer, he/she will be in constructive receipt sales proceeds and the exchange will not qualify as a tax-free exchange.

As stated above, if a taxpayer is in actual or constructive receipt of any part of the proceeds of sale of the relinquished property after closing, the exchange will not qualify as a tax-free exchange. However, many times a taxpayer desires to submit a portion of the proceeds through an exchange, and pocket (and pay taxes on) the remainder. As long as the taxpayer receives a portion of the proceeds directly at closing, and it appears as a distribution to taxpayer on the settlement statement, the taxpayer may successfully complete an exchange on the portion of the proceeds sent directly to an intermediary.

The taxpayer will pay tax on the portion of funds received. However, at no time may a taxpayer receive a distribution from the intermediary for a portion of the exchange proceeds, even if he/she elects to pay taxes on the distribution. Such a distribution will cause the entire exchange to fail.

If a taxpayer pays cash for a Replacement Property through the use of exchange funds held by a qualified intermediary, and thereafter desires to place a lien on the property and pocket the loan proceeds, he/she may nullify the exchange. The IRS may claim that the cash purchase and subsequent refinance were “step” transactions, the effect of which allowed the taxpayer to pocket the proceeds of the sale of the Relinquished Property without paying capital gains taxes. Most commentators advise taxpayers to avoid a refinance within a year of the acquisition of the Replacement Property. If a taxpayer cannot wait a year, then there should be evidence of an independent business purpose behind refinancing the property. Certainly, any refinance of the Replacement Property should be handled in a separate transaction from the purchase, and the subsequent use of the loan proceeds should be documented to prove the independent business purpose of the loan.

Generally, a taxpayer can sell its Relinquished Property to a related party as part of an exchange, as long as both the taxpayer and the related party hold on to their respective properties for two years. Any prior disposition of either property will nullify the exchange.

Typically, a taxpayer desires to sell its Relinquished Property and subsequently use proceeds to buy Replacement Property. However, for any number of reasons, many times the taxpayer must complete the purchase of the Replacement Property prior to the sale of Relinquished Property. These situations are called “reverse exchanges”, and may qualify for nonrecognition treatment if the IRS safe harbor for such transactions is strictly followed.

Under the reverse exchange guidelines, a taxpayer seeking to accomplish a reverse exchange must first contract with an Exchange Accommodation Titleholder (the “EAT”), under which the EAT would agree to purchase the Replacement Property utilizing a non-recourse loan from the seller or a friendly lender. The Replacement Property would in effect be “parked” with the EAT until the Relinquished Property is sold.

Unlike regular exchanges in which title to the Replacement Property goes directly from Seller to Purchaser (known as “direct-deeding”) without passing through the qualified intermediary, the reverse exchange regulations require the EAT to purchase and hold the Replacement Property in the EAT’s name pending the taxpayer’s sale of Relinquished Property. This is commonly called a “parking arrangement”, and the EAT must actually hold all the benefits and burdens of ownership, without limitation.

In reverse exchange situations, the Replacement Property will be purchased prior to the sale of the Relinquished Property. As a result, the qualified intermediary will not be in possession of any cash necessary to fund the purchase. Therefore, the purchase price must be financed utilizing a loan from a third party or the Client. In either case, the loan must be in the name of the EAT, on a nonrecourse basis.

After the EAT’s purchase of the Replacement Property, the Client has 45 days to identify potential relinquished property that Client intends to sell to complete the reverse exchange and defer capital gains taxes thereon. After entering into a contract, the Relinquished Property must be sold and title to the Replacement Property must be transferred from the EAT to the taxpayer within 180 days of the purchase of the Replacement Property, or the due date for the taxpayer’s tax return for the taxable year in which the transfer of the Relinquished Property occurs, whichever is earlier. If the tax return date (usually April 15) occurs prior to the expiration of 180 days, then the taxpayer may file for an automatic extension to obtain the benefit of the full 180 day exchange period.

Many times a taxpayer involved in a §1031 Exchange may desire to complete the exchange by applying the proceeds from its sale of Relinquished Property toward the subsequent purchase of a replacement property and certain improvements to be constructed thereon. IRS regulations and tax court cases have imposed strict restrictions on a taxpayer’s ability to use exchange proceeds toward construction costs on replacement property. Basically, the IRS’ position is that a taxpayer cannot use a portion of the exchange funds to purchase replacement property in its own name, and subsequently spend the balance of the funds to construct improvements. Why? Because the IRS views construction costs as payment for labor and materials, rather than payment for fee title to real estate. As such, the payment for labor and materials does not constitute a like-kind exchange in connection with the sale of real estate. However, the release of Rev. Proc. 2000-37 by the IRS finally cleared the way for the legitimate use of exchange proceeds toward the construction of improvements on a desired replacement property, as long as you strictly comply with the IRS regulations. If a taxpayer enters into a Qualified Exchange Accommodation Agreement with an Exchange Accommodation Titleholder (“EAT”), the EAT may purchase the Replacement Property and construct desired improvements utilizing the exchange proceeds.

Only improvements which have been completed and incorporated into the structure as of the date of transfer shall be considered like-kind real property for purposes of §1031. The EAT may not prepay the contractor for work yet to be done, or materials delivered to the site but not incorporated into the structure as of the date of transfer.

Various tax court cases and IRS rulings have made it clear that a taxpayer may not use exchange proceeds to complete improvements on property it already owns, even if the taxpayer temporarily conveys the property to an EAT prior to commencement of construction. If exchange proceeds are to be used for construction, it must be on new property purchased by the EAT from an unrelated third party