What is it and why is it the preferred approach?
A delayed exchange refers to a situation where a property is relinquished and sold and after a period of time, a replacement property is acquired. This has become a popular investment model because it is a much easier process than the simultaneous exchanges required of early exchangers. The delayed exchange offers them more freedom to complete the sale and acquisition transactions with different parties.
Before delayed exchanges, simultaneous exchange transactions often required the actual swapping of deeds to ensure the relinquished and replacement property closed simultaneously. When dealing with separate buyers and sellers, the exchanger had to be extremely diligent to keep both parties and their representatives cooperating within the same timeline. The more parties involved, the greater the risk of an incomplete exchange and a receipt of a capital gains tax bill. Furthermore, a delayed exchange offers exchangers a more extensive inventory of investment options. In contrast, simultaneous exchanges that require the swapping of deeds limit the exchanger’s options to properties owned by other investors who were interested in purchasing property owned by the exchanger.
The 1031 tax-deferred exchange has been around since the passing of The Revenue Act of 1921, however these early exchanges proved to be difficult due to the pressure of having to complete all transfers on the same day. In the late 1970s, Starker v. United States was ruled in favor of the Starker family and established a precedent for delayed or deferred exchanges. The Starker family sold some timberland to the Crown Zellerbach Company. Instead of receiving cash on the sale, they took a credit on the books of the Crown Zellerbach. Over the course of a few years, the Starker family found properties they wished to own, and Crown Zellerbach bought the properties and applied the value of the property to the Starker’s credit. Then Crown Zellerbach transferred the property deeds to the Starkers. Because the Starkers did not account for any capital gains on the timberland that was sold and the exchange of property did not coincide with the sale of the timberland, the IRS questioned the transactions, and the case went to court. It was from this tax court conflict that came to the code change in 1984 that formally recognized the delayed exchange for the very first time. Today, this is the most common form of exchange we see.
While the Starker’s delayed exchange spanned several years, today’s delayed exchange is limited to specific timeframes. The exchange period refers to the time between the closing of the relinquished property and the closing of the replacement property. Today’s regulations limit the exchange period to 180 days. However, the exchange period might be shortened if the exchanger’s tax return filing deadline falls before the completion of the 180 days. Regardless of when the relinquished property was sold, the replacement property must be acquired before the exchanger’s tax return filing deadline.
Here is a timeline for a typical delayed exchange:
Day 1: Closing of relinquished property.
Qualified properties include properties that are either held for investment purposes or productive use in a trade or business.
Day 2-44: Identification Period: Exchanger researches properties to acquire as replacement properties.
Exchanger researches like-kind properties to acquire as replacement properties. Like-kind properties do not have to be the same type of property as the relinquished property; instead, they must be used for the same purpose, either for investment or productive use in a trade or business. Another requirement for a full 1031 tax-deferred exchange is the purchase price of the replacement property must be equal to or greater than the net sales price of the relinquished property. All equity received from the sale of the relinquished property must also be used to acquire the replacement property.
Day 45: Deadline to identify replacement properties.
Exchangers have 45 days after the selling their relinquished property to identify the property that will serve as the replacement in their exchange. Multiple properties can be identified as long as the exchanger adheres to the 3 Property Rule, The 200% Rule, or the 95% Exception. See Replacement Property Identification, Choosing an Identification Strategy.
Day 46-179: Exchanger pursues the acquisition of candidate replacement property or properties.
Day 180: Deadline to close on the acquisition of one of the identified candidate properties.
Exchangers have 180 days from the time they sell the relinquished property to the time they acquire their replacement property except for exchangers whose deadlines for filing the tax returns for the year in which the relinquished property was sold arrives before the 180-day deadline. The exchange must be completed prior to the tax return filing deadline. Most exchangers will be able to extend this period to the full 180 days by filing for an extension on their tax returns. See Will the Year-End Cut Your 180 Days Short?
We hope this helps you understand delayed exchanges better. For more information, we invite you to also read The 1031 Exchange Quick Guide.
While the information provided above has been researched and is thought to be reasonable and accurate, 1031 Crowdfunding are not lawyers or tax professionals. It’s important to consult with a licensed tax professional regarding your personal tax situation.