One Exchange or Many?
Investors planning on transferring two or more properties as part of a 1031 exchange face an important decision: whether to combine the properties into one exchange, or open a separate exchange transaction for each property being sold. This distinction is discussed below, along with several questions a taxpayer structuring an exchange of multiple properties should ask to achieve their desired end result.
What are my Exchange Deadlines and Potential Timing Issues?
If setting up one exchange with multiple relinquished properties to be sold, a taxpayer should consider whether they can sell all their relinquished properties and acquire all desired replacement property within one exchange timeframe. If a taxpayer sets up one exchange with two relinquished properties, for example, and the properties close on two separate dates, the deadlines for the 45-day identification period and 180-day exchange period are measured from the earliest relinquished property closing date. This can create a problem for taxpayers if, for example, the second relinquished property closing is delayed. By contrast, if a separate exchange is set up for each relinquished property, there will be a separate set of 45-day and 180-day deadlines for each exchange (see more below on important steps to take to establish two separate exchanges).
What Replacement Property(ies) Will I Identify and/or Acquire?
Whether two or more relinquished properties are set up as part of one exchange or separate exchanges will affect how many replacement properties a taxpayer can identify. If the selling properties are part of one exchange and a taxpayer follows the 3-property identification rule, only three properties may be identified to purchase with proceeds from both relinquished properties. If two separate exchanges are set up, the taxpayer can identify three replacement properties for each relinquished property’s exchange. A taxpayer that knows they intend to acquire the same replacement property(ies) with proceeds from all relinquished properties being sold may find the process of setting up only one exchange simpler and easier to manage. However, many investors do not have a clear picture of what property(ies) will be acquired with proceeds from their respective relinquished properties when they commence the exchange process, or what the timing of the closings will be. In the face of any uncertainty, setting up multiple exchange transactions provides more flexibility in these respects.
Something that is important for investors to keep in mind: many tax advisors recommend that if setting up separate exchanges for each relinquished property and using funds from each to acquire the same replacement property, the taxpayer identify the percentage interest of the replacement property to be acquired through each respective exchange. For example, if relinquished property #1 sells for $450,000, relinquished property #2 sells for $300,000, and the replacement property is being acquired for $750,000, the taxpayer would identify a 60% interest in the replacement property ($450,000 is 60% of $750,000) through exchange #1. In exchange #2, the taxpayer would identify a 40% interest. This, along with more factors outlined below, helps to show that the exchangor is treating the exchanges as separate transactions, with precise interests in the replacement property being acquired through each exchange. If multiple relinquished properties are combined into one exchange, there is no need to allocate percentages in such a way in the identification of the replacement property.
How Will Tax Deferral be Calculated?
Yet another consideration when determining whether to set up one exchange or several is the math to calculate tax deferral. If two relinquished properties are combined in one exchange and a taxpayer is unable to purchase enough replacement property(ies) to fully defer the total combined gain on the two relinquished properties, it may be more difficult to determine the allocation between taxable gain that is deferred and taxable gain that is recognized, because of the trade down in value. For example, if relinquished property #1 sells for $450,000 and relinquished property #2 sells for $300,000, and the taxpayer is only able to buy a replacement property worth $300,000, can they treat property #2 as having complete deferral and property #1 as being a failed exchange? Some tax advisors believe a taxpayer may separate the two sale properties and complete their tax return accordingly; however, when the documentation shows both properties under one exchange agreement and the proceeds are combined into one exchange account, this position may be somewhat aggressive, as the relevant rulings and case law provide little guidance. A more conservative approach may be to open separate exchanges for each relinquished property and to hold the exchange proceeds in separate bank accounts.
How do I Establish Separate Exchanges with Multiple Relinquished Properties?
As alluded to above, it is important that an investor take all appropriate steps possible when setting up multiple separate exchanges to make sure those exchanges are seen as separate transactions upon potential audit. Should the IRS review the transactions and determine that together, they in fact constitute one larger exchange, this could create issues if the deadlines or identification limits for the first exchange are not met in the second exchange. When are two separate relinquished properties considered to be part of two separate exchanges?
Having two separate exchange agreements alone will not automatically establish two separate exchanges. It does provide some evidence of a taxpayer’s intent to create two exchanges, and depending on other factors, the taxpayer may be able to show sufficient intent to create two exchanges. The following additional questions should be considered when trying to establish separate exchanges:
- Are the relinquished properties adjacent to each other?
- Are the properties a single economic unit, such as an office building and parking structure?
- Are they being sold to the same buyer?
- Is there one purchase and sale agreement, or two?
- Are they closing on the same date?
- Are there separate closing statements and escrow instructions?
- Are there two separate exchange agreements and separate bank accounts holding the exchange funds?
- Did the taxpayer identify a % interest in each exchange from which funds are used to acquire any shared replacement property?
When an investor has more than one property to dispose of and wishes to engage in a 1031 tax deferred exchange, it’s important to evaluate whether they should establish one or more exchanges and to understand the consequences in each case. When considering an exchange, consult with your tax advisor and contact First American Exchange before the sale of your relinquished property. As the national leader in 1031 exchanges, First American Exchange can assist you through every step of the process.