This is the final part of a three-part series explaining the basics of the tax-deferred 1031 exchange, the different types available, the mechanics of how they work, and the benefits to be reaped by a client who decides to partake in such an exchange. To view Part 1, please click here. To view Part 2, please click here.

Foreign Exchanging Parties

Code Sec. 1445. This section is the Foreign Investment m Real Property Tax Act (FIRPTA); it requires withholding of 15% of the gross proceeds at the time of sale of U.S. real property by a nonresident alien. Code Sec. 1445 does not apply to nonrecognition transfers such as a 1031 exchange; however, the exchanging party must comply with special rules under Code Sec. 1445 in order to avoid the FIRPTA withholding in an exchange.

A seller of real property who is a "foreign person" is subject to FIRPTA withholding under Code Sec.1445 which requires that a transferee withhold 15% of the gross purchase price of the property, and pay it to the IRS within 20 days of the date of the closing. A transferee who fails to withhold is subject to liability for the seller's tax on the gain from the sale of the real property if not paid by the seller. A "foreign person" is a nonresident alien individual, foreign corporation that has not made an election under Code Sec. 897(i) to be treated as a domestic corporation, foreign partnership, foreign trust, or foreign estate. A domestic single-member limited liability company that is disregarded for tax purposes whose member is a foreign person is subject to FIRPTA.

Code Sec. 1445 provides that a buyer who received a certification from a seller providing that he or she is not a foreign person is exempt from the withholding requirement, but a foreign person cannot provide such a certification. Reg §1.1445-2(d)(2) exempts nonrecognition transfers such as a 1031 exchange from the withholding requirement however, so long as the foreign seller who exchanges provides a “notice of nonrecognition transfer” to the transferee explaining that the transaction is an exchange, describing the properties sold and purchased, and stating that there will be no boot in the transaction. The notice of nonrecognition transfer satisfies the certification requirement so long as there is no boot in the exchange; if any gain is recognized, the full 15% withholding must be paid. A foreign exchanging party must obtain a U.S. taxpayer identification number that must be included on the notice of nonrecognition transfer.

The notice of nonrecognition transfer is given before closing, but if the foreign seller has not identified replacement property or does not close on the purchase of replacement property simultaneously with sale of the relinquished property, he cannot describe the purchase of replacement property to demonstrate that there will be no boot. At one time it was the custom of foreign sellers who had not identified replacement property to give a notice of nonrecognition transfer that warranted that no gain would be recognized; however, the Code Sec. 1445 regulations have been amended to provide that such a notice cannot be accepted by the transferee in the case of a simultaneous exchange which does not qualify in its entirety for nonrecognition treatment, or in a non-simultaneous exchange in which the transferee cannot determine that the replacement property has been identified. Only if the replacement property has been identified so its purchase price is known can the foreign seller satisfy all the conditions for nonrecognition at the time the transferee is required to pay withholding, within 20 days following closing of the sale of the relinquished property.

These requirements would preclude a foreign seller who exchanges from being exempt from FIRPTA unless the replacement property was identified at the time of closing of the relinquished property, but the regulations permit application for a withholding certificate that tolls the withholding requirement until 20 days following receipt or denial of the withholding certificate. The regulation provides that the application for a withholding certificate must “include information substantiating the requirements of Code Sec. 1031,” which requires identifying the replacement property and its purchase price. The obligation to pay the withholding will be tolled at closing only if the application for the withholding certificate has been submitted, but an exchanging party that has not identified and closed on the replacement property will not be able to substantiate compliance. The regulation appears to permit a taxpayer to identify replacement property after submission of the application for withholding certificate because the regulation provides that the IRS “may require additional information during the course of the application process.” When the replacement property is identified, and the purchase price known, the taxpayer can submit the information to the IRS in order to obtain the withholding certificate; the IRS must act on the application within 90 days. In order to submit an application for a withholding certificate, the foreign seller must obtain a U.S. taxpayer identification number, and the transferee or agent handling the exchange must escrow the 15% withholding.

Determination of Exchange and Identification Periods

The 45-day period in which to identify replacement property is defined in the regulations as the “identification period,” begins on the date the taxpayer transfers the relinquished property and ends on the 45th day thereafter; thus, the date of closing is not counted. Likewise, the 180-day period in which to acquire replacement property, defined in the regulations as the “exchange period” begins on the date the relinquished property is transferred and ends on the 180th day thereafter, or the due date—including extensions—when the taxpayer's next tax return is due, whichever first occurs. A taxpayer who has closed on a date that is fewer than 180 days prior to the date when the taxpayer's next return is due, and the taxpayer requires the full 180-day exchange period he or she should extend the date for filing of his or her return.

If the taxpayer is transferring multiple replacement properties in a single exchange, the exchange period begins on the date of transfer of the first of the properties to be transferred in the exchange, causing potential problems in timing if the taxpayer is unable to sell all of the relinquished properties prior to expiration of the exchange period as to the first relinquished property.

Planning Note: If a taxpayer wants to sell multiple properties in an exchange and acquire a single replacement property with the aggregate proceeds, he or she might structure each sale as a separate exchange and acquire a pro rata portion of the replacement property in each exchange. If all of the properties can be sold within 180 days of the first sale, the taxpayer can acquire the replacement property in one transaction. If not, and if the seller will agree, he or she can acquire partial interests in the replacement property equal to the exchange value of the relinquished property sold before the exchange period for such property has passed. If the taxpayer is unable to sell all relinquished properties prior to the date for closing of the replacement property, he or she could also structure acquisition of the remaining portion of the replacement property as a partial reverse exchange, acquiring it when the remaining property or properties have been sold.

The identification and exchange periods cannot be extended except under Code Sec. 7508, or if the IRS publishes a notice providing relief under Code Sec. 7508A with respect to a presidentially declared disaster.

In a letter ruling involving similar facts in which taxpayers could not acquire replacement property due to events completely beyond their control: a state agency had taken possession of the taxpayer's qualified intermediary, appointed a receiver, and frozen the assets of the intermediary. Because the intermediary's assets were frozen, the taxpayer's funds were not released in time to close before the end of the exchange period. The taxpayer argued that the exchange period should be suspended under Code Sec. 6065(b), which provides that where the assets of a taxpayer are in the control or custody of a court, the running of the period of limitations for collection of tax is suspended for the period of the custody, plus six months. The IRS ruled that Code Sec. 6065(b) does not apply and that even under these circumstances the exchange period would not be extended.

Code Sec. 7503 provides that “[w]hen the last day prescribed under authority of the Internal Revenue laws for performing any act falls on Saturday, Sunday, or a legal holiday, the performance of such act shall be considered timely if it is performed on the next succeeding day which is not a Saturday, Sunday, or a legal holiday.” The provision would appear on its face to apply to the time limits for identification and receipt of replacement property under Code Sec. 1031; however, Rev. Rul. 83-116, 1983-2 C.B. 264 held that the coverage of Code Sec. 7503 is limited to procedural acts that are required to be performed in connection with the determination, collection, or refund of taxes. Since the exchange period under Code Sec. 1031 is not a procedural act in connection with the determination, collection or refund of taxes, Code Sec. 7503 does not apply to extend the identification and exchange periods.

Alternate and Multiple Replacement Properties

The deferred exchange regulations permit identification of multiple alternate replacement properties, however, failure to follow the rules for identification of multiple properties will cause the taxpayer to be treated as if no replacement properties had been identified, thus causing the entire exchange to fail.

Prior to the 1991 deferred exchange regulations, the regulations were silent as to the number of properties a taxpayer could identify. In Raymond St. Laurent v. Comm 'r, the taxpayer identified 20 replacement properties and the IRS challenged the exchange in part because of the number of properties, and in addition because the actual property to be received was not determined by contingencies beyond the control of the taxpayer. The concept that contingencies outside the control of the taxpayer determined the status of multiple identified properties came from the legislative history of Code Sec. 1031 (a) (3) providing for the 45-day identification period, and the 180-day exchange period. The conference report at the time of adoption of this section stated that:

It is anticipated that the designation requirement in the contract will be satisfied if the contract between the parties specifies a limited number of properties that may be transferred and the particular property to be transferred will be determined by contingencies beyond the control of both parties.

The Tax Court held that both the legislative history and statute were silent regarding the meaning of a “limited number” of properties. Further, it held that the conference report meant that contingencies beyond the control of the parties would satisfy the requirement, but that such a contingency was not in fact required to satisfy it, and it therefore held that the taxpayer had met the requirements of the statute. By the time the case was decided in 1996, the deferred exchange regulations had already been adopted; but because they had not even been proposed at the time of the exchange, the court refused to apply them.

The regulations permit identification of multiple alternate properties, and the identification rules are as follows:

• Three properties of any fair market value may be identified (the “three-property rule”);
• If more than three properties are identified, the aggregate fair market value of the identified properties cannot exceed 200% of the aggregate fair market value of all the relinquished properties as of the date of sale of the relinquished properties (the “200% rule”), unless 95% of the aggregate value of the identified properties is acquired (the “95% rule”);
• If the taxpayer has not complied with the three-property, 200% and 95% rules, he or she is treated as having not identified any replacement property; and
• Any replacement property received by the taxpayer before the end of the identification period is qualified replacement property, regardless of whether it was expressly identified.