The Starker case, which gave rise to the so–called "deferred exchange", probably represented the high water mark for taxpayers in the interpretation of Sec. 1031. Starker, 602 F2d 1341 (9th Cir.. 1979). Section 1031 (a), in general, permits property used in a trade or business or held for investment to be exchanged solely for like-kind property which will be used in a trade or business or held for investment, without the imposition of tax. A deferred exchange allows the taxpayer to relinquish property currently and receive like-kind replacement property in the future. But in 1984, Congress decided to limit the scope of the Starker decision by enacting Sec. 1031(a)(3), a provision which permits deferred exchanges to occur within specific time limitations. With the enactment of the Tax Reform Act of 1986. P.L. 99-514 and its negative effect on the sale of Sec. 1221 and Sec. 1231 assets -- the elimination of the capital gains deduction and an increase in the capital gains tax for corporations, the changes in the installment sales rules and the elimination or curtailment of many tax credits and deductions -- exchanges under Sec. 1031 remain as one of the only tax planning provisions left in the Code. The practical difficulties in completing a simultaneous exchange will cause heavy reliance on the deferred exchange provisions of Sec. 1031(a)(3).

Sec. 1031(a)(3) was the legislative response to the perceived excesses permitted by the Starker decision. In Starker , the taxpayer, T.J. Starker entered into a land exchange agreement with the Crown Zellerback Corporation whereby Mr. Starker would convey Oregon unencumbered timberland to Crown in exchange for an unsecured promise to provide him with suitable real property chosen by him within 5 years, or pay any outstanding balance in cash. Mr. Starker was also credited with a 6% growth factor (for the timber growth located on the relinquished property) on the outstanding balance. Pursuant to the exchange agreement, Crown purchased and then conveyed nine parcels of like-kind property and assigned one contract to purchase like-kind property. Two other parcels were conveyed by Crown to Mr. Starker's daughter and the court found there is no like-kind exchange since Mr. Starker never acquired an interest in those properties.

In holding that simultaneity was not required under Sec. 1031, the court rejected the government's argument that Reg. 1.1002-1(b) requires a narrow construction of Section 1031. Additionally, the possibility that Mr. Starker could ultimately receive cash did not violate Sec. 1031. The court expressly found that the contract right to assume the rights of ownership is no different than the ownership right itself, even though the actual ownership might occur years in the future and even though the taxpayer could ultimately receive cash. The present exchange of property for the promise to receive like-kind property in the future constituted a valid "deferred" exchange under Sec. 1031. The 6% growth factor was considered disguised interest since it applied without regard to the actual fate of the timber on the property. A growth factor based on the actual value of the timber in which the risk of loss remained with Mr. Starker may have passed muster under the court's analysis since under local law, timber was considered real property. The proper period of inclusion for the nonqualifying property (the property deeded directly to Mr. Starker's daughter) was in the year the contract was made. The disguised interest was taxable -- presumably under Sec. 1031(b) as boot-- when it was actually or constructively received.

In light of the administrative nightmare caused by Starker , and the potential for abuse of the tax system through the use of the deferred exchange, Congress decided to restrict the time limitations in which a deferred exchange could occur and in the process, codified the deferred exchange concept. Section 1031(a)(3) appears relatively straight forward; there is a two-prong test to determine whether property is not like-kind: For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if-- (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days (The original version of Sec. 1031(a)(3) contained a technical error which only allowed a 44 day period. The Tax Reform Act of 1986, P.L. 99-514 Sec. 1805(d) amended the section by striking out "before the day" and inserting in lieu thereof "on or before the day") after the date on on which the taxpayer transfers the property relinquished in the exchange, or (B) such property is received after the earlier of-- (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferor's return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.

The section applies to transfers after the date of enactment, July 18, 1984. Property received after December 31, 1986 would not be like-kind unless the property was designated in a binding contract before June 14, 1984 as is received on or before December 31, 1988. If property was transferred and treated as a like-kind exchange prior to the date of enactment, and if the taxpayer would be liable for tax under Section 1031(a)(3), then the period for assessing a deficiency would expire on (1) January 1, 1988 for property received after December 31, 1986 or (2) January 1, 1990 for property designated in a binding contract before June 14, 1984. Sec. 1031(a)(3) is phrased in the negative: if either the 45 day identification period under Sec. 1031(a)(3)(A) ("identification period") or the replacement period under Sec. 1031(a)(3)(B) ("replacement period") are not met, then the replacement property will not be considered like-kind. Both time limits run concurrently, commencing with the time the taxpayer relinquishes his property. This negative phrasing suggests that even if the taxpayer meets both prongs, the exchange will not automatically qualify under subsection (a)(1) for nonrecognition of gain. Although this section is not, technically speaking, a safe harbor-- it describes what exchanges will not qualify under Sec. 1031(a) -- the purpose of the section was to place time limits on deferred exchanges in response to Starker rather than to question the validity of deferred exchanges as a Sec. 1031(a) transaction. Congress did not challenge the Starker court's decision that deferred exchanges qualify under Sec. 1031(a)(1): "Present law does not require specifically that a like-kind exchange be completed with a specified period in order to qualify for tax-free treatment," citing Starker. S. Rep. No. 169 (Vol. 1), 98th Cong., 2nd Sess. 243 (1984). The focus was on the time limitations for completion of the exchange. Also, Sec. 453(f)(6)(C) enacted in 1982 considers receipt of like-kind property as payment under the installment sales rules which is evidence of legislative consent to deferred exchanges.

The section also looks forward in time: it only applies when the property is relinquished before the replacement property is received. Therefore, the section would not apply to a determination whether replacement property received prior to the time the taxpayer relinquishes his or her own property could qualify as a like-kind exchange. A transaction where the replacement property is received prior to the relinquishment of the taxpayer's property has been referred to as a "reverse Starker" and is discussed, infra. The replacement period requirement contains two potential traps: It uses 180 days rather than 6 months which will require careful counting by the taxpayer to determine the actual date for completion. Also, the limitation of the due date of the return will mean that calendar year taxpayers relinquishing property after October 17 (October 18 if the ensuing year is a leap year) must complete the transaction prior to April 15 of the ensuing year or must file for an extension. The time limits imposed by the section are absolutes, there is no provision for extensions of time.

Given the litany of difficulties that could confront the taxpayer in any given exchange transaction: loan approvals, inspections, licenses, permits, off-set statements, pay-off figures from lien holders and the diligence and competence of the purchaser and other parties involved, the time limits place the taxpayer at the mercy of factors he cannot control. The time limitations may provide the opposing party leverage to renegotiate a better deal and could cause the taxpayer to accept a transaction on less than favorable terms, in order to comply with the stringent time restrictions. By placing the deferred exchange requirements under Sec. 1031 subsection (a), if a transaction qualifies as a deferred exchange, the rules and case law regarding like-kind exchanges will apply, including the expansive determination of what is like-kind property under the regulations. Reg. 1.1031(a)-1(b) and (c) permit exchanges of any real property for any other real property, a new truck for a used truck, a fee simple interest in property for a 30 year lease in property, a life interest in property for a remainder interest in property and vice-versa. The line of pro taxpayer court decisions involving three and four party simultaneous exchanges, and the use of escrows and intermediaries to accomplish an exchange. Also, if the deferred exchange fails, the taxpayer should still be entitled to installment sales treatment when the proceeds or nonlike-kind property are received. Practitioners should not overlook the potential for planning under Sec. 453 if the exchange fails.

The Starker decision posed tremendous problems for the Treasury. Mr. Starker could have received either cash or property for a five year period after he relinquished his property. A proper time limit in which to complete the deferred exchange was both reasonable and fiscally prudent. The purpose of the Tax Reform Act of 1984 was to try and squeeze additional revenue out of the system to counter the massive federal deficit. In light of the budgetary problems, Congress determined the Starker "loophole" was an appropriate target. Although 180 days is much shorter than the 5 years available to Mr. Starker. By placing the date on which the taxpayer receives the replacement property at no later than the due date of the return, the Treasury would not have an open transaction accounting problem. Both the Senate amendment and House bill provided a 180 day period (or the time in which the tax return was due), but the Senate added an additional requirement: The replacement property had to be identified at the time the taxpayer's property was relinquished. Sec. 77; H.R.2163, Sec 61. See generally H.R. Rep No. 98-432, Pt.2 at 1231-1234 and S. Rep. No 98-169 at 241-244 . In order to resolve the difference between the House bill and Senate Amendment, the Conference agreement stated that the replacement property must be "identified" no later than 45 days after the taxpayer relinquished his or her property. Act Sec 77 amending Sec. 1031; H.R. Rep. No. 98-861 at 865-867-- the conference agreement.

The addition of the identification requirement in order to forge a compromise in the legislation has caused an unnecessary and dangerous pitfall for unwary taxpayers. There is no discussion on how to "identify" the property and whether such designation must be in writing. The Conference agreement, which says that the requirement "may be met by designating the property to be received in the contract between the parties," merely states the obvious. Many exchanges do not involve a contract between the parties but arise from additions or amendments to escrow instructions which supersede the original contract. By stating that the designation may be met in such a fashion, other designation methods are not precluded. The Conference committee then says it anticipates that the identification requirement will be met by designating a limited number of properties that may be transferred provided the particular property selected is determined by contingencies beyond the taxpayer's control. While this statement adds flexibility to the identification requirement -- taxpayers may devise all types of contingencies beyond their control and thus have a series of properties designated by the 45 day deadline -- the example used by the Conference agreement is troubling. The Conference agreement states that if Property 1 will be transferred if zoning changes are approved and Property 2 if they are not, the exchange would qualify for like-kind treatment. Generally, the approval process for zoning changes is anything but swift and predictable. Given the tight deadlines under Sec. 1031(a)(3), a property undergoing a change of zone application should be an extremely poor candidate for a deferred exchange.

Moreover, zoning approval might be within the taxpayers control except the cost of meeting the conditions for approval could be economically prohibitive. The example does not state when the approval is to be given or what happens if the zoning approval has not been received by the time necessary to purchase and close on Property 2. Assuming a replacement period of 180 days, if the zoning approval is given on the 179th day, must the taxpayer close on the next day? What if on the 60th day the taxpayer determines that zoning will not be approved and switches to Property 2, and thereafter zoning is approved within the 180 day limit? There is no requirement that the identification must be made in writing, but cautious taxpayers should make a written designation to document their compliance. The party to whom the identification should be made is by no means obvious.

While it might be the transferee of the relinquished property, in many complicated exchanges involving several parties, properties and alternative designations, the determination of the proper party to inform could be difficult. The Conference report sidestepped the difficult issues involving deferred exchanges and the use of escrows, trusts and intermediaries to facilitate the exchange. But it stated that the taxpayer could not receive cash then later purchase the designated property: "As under present law, these new rules would not permit a taxpayer who receives cash and later purchases the designated property to claim like-kind treatment." This statement can be read to endorse the use of an intermediary in order to prevent the taxpayer from receiving the cash, but it is also clear that the taxpayer is prohibited from actually or constructively receiving the cash.

Source: Robert L. Sommers