Business Tax

Client Letter

Dear Mr. & Mrs. Johnson

Thank you again for requesting my advice concerning the tax treatment for your deferred exchange with Paul. I do have some bad news for you. You are required to recognize a gain on the exchange of your property.
In reaching this conclusion, I consulted the relevant Internal Revenue Code and related Judicial Rulings. The facts as I understand them are as follows:
You made an agreement between yourselves and Paul to engage in a 1031 Deferred Exchange. On July 1 you transferred title to a parcel of land with an adjusted basis of $20,000 and fair market value of $75,000 to Paul. The agreement required Paul to purchase and transfer title to you of a like-kind property within 180 days of July 1. On August 1, two parcels of land were identified that was acceptable to you, one near Dallas and another near Houston. Negotiations were begun by Paul with the owner of the Dallas property but no deal could be reached so he began negotiations with the Houston property owner. On January 1 Paul purchased the property and immediately transferred title to you.
Even though a good faith attempt was made to meet the required 180 day replacement period the IRS Code only allows 180 days from the original transfer of title for a like-kind exchange to occur. The reasoning behind this is to prevent an open transaction, with long term exchange periods, from occurring. After 180 days the exchange falls under Section 1001 requiring the recognition of a gain or loss on the exchange of property. Therefore you are required to recognize the gain on the exchange. My research did uncover a similar case to yours in that a “good faith attempt” was made to complete the exchange within the required time period but the court ruled that it did not meet the required replacement period (Knight v. Commissioner, 75 TCM 1992).
Please contact me if you have any further questions.

Memo to File

Client: Fran & Bob Johnson
Subject: Research Problem 19
For: Business Taxation
Research by: Paul Fisher
Date: November 10, 2008

Facts

Fran and Bob Johnson engaged in a 1031 deferred exchange with Paul on July 1 by transferring a parcel of land with an adjusted basis of $20,000 and a fair market value of $75,000. On August 1 two like-kind properties were identified, one near Dallas and the other near Houston, both were acceptable to the Johnson’s. Paul began negotiations with the Dallas property owner but was not able to reach a deal so it fell through. Negotiations began with the Houston property owner but it did not close until January 1. Paul immediately transferred title to the Johnson’s.

Issues

1. Did the like-kind exchange take place within the Identification and Replacement Period?
2. What are the tax consequences for the Johnson’s?

Conclusions

1. The identification period of 45 days was met. The replacement period was not met by the Johnson’s. The statutory period for like-kind exchanges are 180 days from the date of the Johnson’s transferred the property relinquished.
2. Because the 180 day replacement period was not met the property is considered unlike-kind and subject to IRC Section 1001 requiring that you recognize the entire amount of your gain on the exchange of your property.

Discussion of Reasoning and Authorities

1. Section 1031 deals with Exchange of Property held for Productive use or Investment. Section 1031 allows the like-kind exchange of property without the recognition of a gain or loss. Section 1031(a)(3) requires the identification period of replacement property be on or before 45 days from date the “taxpayer transfers the property relinquished in the exchange.” The replacement period is 180 days from the time time taxpayer transfers the property relinquished or “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.” Which ever is earlier, thus the 180 days applies.
In David A. and Marilyn P. Knight v. Commissioner (75 TCM 1992) the court ruled that even though a good faith attempt was made to exchange the property within the 180 day replacement period it does not entitle them to avoid the application of the plain language of IRC Sec. 1031.
2. Section 1031 provides for the “non-recognition of such gain or loss on ‘the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.’” Because the replacement period of 180 days has not been met IRC Sec. 1001 requires recognition of the entire amount of gain or loss on the exchange of property.