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Exchanging Real Estate: The Qualified Intermediary
By Eric Kea
Since first introduced into the tax code, like-kind exchanges have come to play a major role in the real estate marketplace. The exchange process stimulates transfers of property (and hence contributes to their most beneficial use) by permitting an exchange party to avoid immediate taxation of gain. Instead, the gain is carried forward to the new property. Tax deferral can continue indefinitely over a series of exchanges so long as the tax rules are observed. The most important rule is that the party seeking tax deferral never can be in actual or constructive receipt of money or property other than the exchange property itself.
The Instant Exchange
In its initial form, the like-kind exchange involved two parties, each of whom wished to own the property of the other. In consummating the exchange, no third party was needed. If the market value of one property exceeded that of the other, the difference was made up by a transfer of cash or other property ("boot"), with the party receiving the boot generally recognizing gain to that extent. However, this type of direct exchange found limited appeal because of the difficulty of making a match between two owners.
Complex Exchanges
Real estate professionals and their attorneys soon created two other forms of exchanges that subsequently were approved by IRS and Congress. The two are: (1) the simultaneous exchange with intermediary and (2) the deferred exchange with intermediary.
Simultaneous Three-Party Exchange
Assume Mr. A wants to exchange his rental apartment house for vacant land in a tax-deferred exchange. Ms. B owns vacant land she is willing to sell, but wishes cash and is not interested in an exchange. Mr. C is willing to buy the apartment for cash. Using a qualified intermediary (QI), Mr. A sells his property to Mr. C for cash that is deposited with the QI. The QI then purchases the vacant land from Ms. B and transfers the land to Mr. A. Mr. A is entitled to defer any realized gain because he never had possession of any cash (except to the extent he may have received boot).
Time-Deferred Exchange
The second type of three-party exchange expands even more the ability of an exchange party to acquire a desired property. Modifying the example given above, assume that Mr. A, seeking to sell his rental apartment building, has found a buyer in Mr. C, who is prepared to pay cash but does not wish to exchange. Further, Mr. C wishes to close the sale at once. Mr. A, utilizing a QI, sells the apartment house to Mr. C and the funds are deposited with the QI.
Under time limits established by the tax code, Mr. A has 45 days, beginning on the date of the transfer of the apartment building to Mr. C, to identify a like-kind property. The purchase of the like-kind replacement property must be completed within 180 days, using the sale proceeds from Mr. Co to pay for the property.
An agent of the exchange person, including anyone who has acted as his employee, attorney, accountant, investment banker, broker or real estate agent or broker within the past two years. However, the performance of certain routine services, such as title insurance or trust services, will not disqualify a person or company.
Related to the taxpayer as a family member (as described in Code Section 267 and 707) or corporations and partnerships in which the exchange party has an interest;
Related to an agent of the taxpayer, i.e., anyone related to an agent as described above.
Reverse Like-Kind Exchanges
A QI also can be utilized to consummate a reverse-deferred exchange. Assume John wishes to sell an office building in a tax-deferred exchange. He would like to acquire Mary's property, but she insists on selling for cash immediately. Under the safe harbor created by the IRS (Revenue Ruling 2000-37), John can park Mary’s property with a QI (called in this context an "exchange accommodation titleholder" or EAT) pursuant to a qualified exchange accommodation agreement (QEAA). John furnishes the funds or guarantees a loan to the EAT to pay Mary.
When John finds a buyer for his office building, he transfers it to the EAT in exchange for Mary's property. The EAT then transfers the office building to the buyer and uses the sale proceeds to pay the loan received by the EAT to pay Mary. As in the case of a regular time-deferred exchange, the 45-day and 180-day limitations apply.
Caution Advised
The IRS has issued detailed regulations that must be carefully observed in order for a tax deferral to be obtained in a deferred exchange, whether a forward or reverse exchange. Before entering into a like-kind exchange transaction, the parties should consult with a tax advisor who has significant experience in this area.
Eric Kea is Director of Real Estate Taxation in BDO Seidman’s New York office. He can be reached at (212) 885-8101.
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