• John V. Maggi, Congress Asset Exchange

The advantages of tax-deferred asset exchanges - Forward and reverse exchange strategies


A tax deferred asset exchange, also referred to as a like-kind exchange or 1031 exchange, can be a valuable part of a company’s or individual’s asset strategy. They allow for the deferral of income tax liabilities associated with the gain on the sale of real property or assets used in a trade or business or held for investment purposes. Exchanges have been used extensively in the real estate industry since the early 1990’s and have been part of the U.S. tax code since the 1920’s. They should be considered anytime a property transaction is planned. We will discuss two types of exchanges - forward and reverse exchanges. Forward Exchanges: The forward exchange is the most common type of exchange and involves first selling the old property and then identifying new property to buy within 45 days of the date of the old property sale. Properties that are exchanged must be of a like kind, which for real estate is broadly defined - and the use and/or quality of the properties being exchanged does not have to be the same. Settlement must be made on the new property within 180 days of selling the old property, or by the taxpayer’s tax return date with extensions, if earlier. In order to defer income taxes on the gains it is extremely important for sellers to not have “constructive receipt” of cash – this includes avoiding directly receiving any cash from a buyer of their old property - a qualified intermediary (QI) should be engaged prior to any sale and any cash transactions to handle the necessary funds transfers. Exchange transactions are often complicated by the timing differentials of the parties involved and by the normal complexities surrounding real estate and asset transactions. Many times a taxpayer must acquire new property before the sale of the old property can be accomplished. Reverse Exchanges: In this case, the reverse exchange is a useful approach that allows greater flexibility in the timing and funding of exchange transactions. These reverse transactions allow the taxpayer to first obtain the use of their new property and then later dispose of their old property. Depending on how the reverse exchange is structured, there may or may not be exchange related limitations on the timing of the purchase and sale transactions. These potential timing constraints may be critical in situations where, for instance, the taxpayer may possibly need more than 180 days to sell their old property or desires to make improvements and/or modifications to their new property prior to completing an exchange. Additionally, for a reverse exchange to effectively defer income taxes on capital gains, the taxpayer must use a properly structured special purpose entity (SPE) that is independent of the taxpayer. From a practical perspective, the exchange process can take several years to accomplish and may also have additional cash flow and financial reporting benefits. Also, to ensure the maximum safety of all exchange related cash, it is advisable that it be held in a dedicated escrow/trust account at a reliable financial institution separate and apart from the financial institution’s own assets. The key to any successful exchange strategy is independence with valid business purpose – That is, the greater the independence between the taxpayer, QI, financial institution, SPE, etc., coupled with transactions that make business sense, the better the exchange. John Maggi is the president of Congress Asset Exchange.

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