1031 Exchanges for Tennessee Real Estate Investors: Deadlines, Intermediaries, and Contract Language

A 1031 exchange lets an investor sell real estate held for business or investment and buy other real estate without recognizing the gain now. The gain is deferred, not forgiven: it carries into the replacement property through its basis (26 U.S.C. § 1031(d)). The tax side belongs to your CPA or tax advisor. My focus here is the legal and transaction side: what has to be true about the property, the deadlines, the intermediary, and the contracts for the exchange to work.

What qualifies after 2017

No gain or loss is recognized when real property held for productive use in a trade or business or for investment is exchanged solely for like-kind real property that will also be held for business or investment (26 U.S.C. § 1031(a)(1)). The Tax Cuts and Jobs Act limited Section 1031 to real property, generally for exchanges completed after December 31, 2017, subject to a transition rule (Pub. L. 115-97, § 13303(c)). Machinery, equipment, vehicles, and other personal property generally no longer qualify, although an item that is an inherently permanent structure, a structural component of a building, or real property under state law can still count as real property (Instructions for Form 8824).

• Real property means land and improvements to land, unsevered natural products of land, and water and air space above land (Treas. Reg. § 1.1031(a)-3(a)(1)). Improvements include buildings and other inherently permanent structures and their structural components, such as walls, wiring, plumbing, and central heating and air (§ 1.1031(a)-3(a)(2)).
• Certain interests in real property also count, including co-ownership, a leasehold, an option to acquire real property, and an easement (§ 1.1031(a)-3(a)(5)). The regulations give, as an example of a like-kind exchange, a leasehold with 30 years or more to run exchanged for real estate (§ 1.1031(a)-1(c)).
• Stock (other than certain listed stock, such as stock in a cooperative housing corporation), bonds, notes, and interests in a partnership are not real property for this purpose (Treas. Reg. § 1.1031(a)-3(a)(5); Instructions for Form 8824).
• Real property held primarily for sale is excluded (§ 1031(a)(2)), and so is a property used solely as a personal residence (Instructions for Form 8824).
• Like-kind refers to the nature or character of the property, not its grade or quality. Whether real estate is improved or unimproved does not matter (Treas. Reg. § 1.1031(a)-1(b)). Real property in the United States and real property outside the United States are not like-kind (§ 1031(h)).

The 45-day and 180-day deadlines

Most exchanges are deferred exchanges: the investor sells first and buys later. In a deferred exchange, the replacement property is treated as not like-kind unless two deadlines are met (§ 1031(a)(3); Treas. Reg. § 1.1031(k)-1(b)).

• The identification period begins on the date the relinquished property is transferred and ends at midnight on the 45th day after that.
• The exchange period begins on the same date and ends at midnight on the earlier of the 180th day or the due date, including extensions, of the tax return for the year of the transfer.
• If more than one relinquished property is transferred on different dates in the same exchange, both periods run from the earliest transfer (§ 1.1031(k)-1(b)(2)(iii)).

For a transfer late in the tax year, the return due date can come before day 180, which is why the regulations' own example shows the exchange period cut short unless an extension is in place (§ 1.1031(k)-1(b)(3)). Your CPA should confirm whether an extension is needed.

How to identify replacement property

Replacement property is identified only if it is designated in a written document signed by the taxpayer and hand delivered, mailed, faxed, or otherwise sent before the end of the identification period to the person obligated to transfer the replacement property or to another person involved in the exchange who is not the taxpayer or a disqualified person, such as the intermediary, an escrow agent, or a title company (§ 1.1031(k)-1(c)(2)). The description must be unambiguous. For real property, that generally means a legal description, street address, or distinguishable name (§ 1.1031(k)-1(c)(3)). Property actually received within the 45 days is treated as identified.

The investor may identify more than one property, but only within these limits (§ 1.1031(k)-1(c)(4)):

1. Three-property rule: up to three properties of any value.
2. 200-percent rule: any number of properties, if their total fair market value at the end of the identification period does not exceed 200 percent of the total fair market value of the relinquished properties on the date they were transferred.
3. 95-percent exception: if too many properties were identified, the identification still works for properties received before the exchange period ends, but only if the investor receives identified property worth at least 95 percent of the total value of everything identified.

An identification can be revoked before the 45 days end, but only by a signed written document delivered the same way (§ 1.1031(k)-1(c)(6)). The property received must be substantially the same property that was identified (§ 1.1031(k)-1(d)).

The qualified intermediary and constructive receipt

A deferred exchange must be an exchange of property for property. A sale followed by a purchase does not qualify, even if both happen within the deadlines (§ 1.1031(k)-1(a)). If the investor actually or constructively receives the sale proceeds before receiving the replacement property, the transaction can be taxed as a sale. Money is constructively received when it is credited to the investor's account, set apart for the investor, or otherwise made available to draw on, and receipt by the investor's agent counts as receipt by the investor (§ 1.1031(k)-1(f)).

The regulations provide safe harbors, and the qualified intermediary is the one used in most deferred exchanges of real estate (§ 1.1031(k)-1(g)(4)). A qualified intermediary is a person who is not the taxpayer or a disqualified person and who enters into a written exchange agreement with the taxpayer to acquire and transfer the relinquished property and to acquire and transfer the replacement property. For the safe harbor to apply, the exchange agreement must expressly limit the investor's rights to receive, pledge, borrow, or otherwise obtain the benefits of the money held by the intermediary (§ 1.1031(k)-1(g)(4)(ii)). The agreement may allow access to the funds only at stated points, such as after the identification period if nothing was identified, or after the investor receives all the replacement property (§ 1.1031(k)-1(g)(6)).

The regulation defines a qualified intermediary by what it does and who it is not; it does not require a license. Some states license or regulate qualified intermediaries, but I have not found a Tennessee statute that does. The exchange funds are in the intermediary's hands for months, so ask how the funds will be held before signing. The Instructions for Form 8824 note that if the timing requirements are missed because of the intermediary, the transaction won't qualify as a deferred exchange. If the intermediary defaults because of bankruptcy or receivership, Rev. Proc. 2010-14 offers a safe-harbor method that may let the investor report the gain as payments are received; it does not turn the transaction back into an exchange.

Who cannot serve as the intermediary

A disqualified person cannot be the qualified intermediary. That includes the investor's agent, and a person who acted as the investor's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two years ending on the date the first relinquished property is transferred is treated as an agent (§ 1.1031(k)-1(k)(2)). Services related to Section 1031 exchanges, and routine financial, title insurance, escrow, or trust services by a financial institution, title insurance company, or escrow company, are not counted. Persons related to the investor, or to the investor's agent, under the tax code's related-party rules (using a 10 percent ownership test) are also disqualified (§ 1.1031(k)-1(k)(3), (4)). My office does not serve as a qualified intermediary; my role is the contracts and the closing documents.

Boot: cash, debt relief, and personal property

If the investor receives money or other property that is not like-kind in addition to the replacement real property, gain is recognized up to the amount of the money and the fair market value of the other property, and no loss is recognized (§ 1031(b), (c)). This is often called boot.

• Debt relief counts. When another party assumes a liability of the investor as part of the exchange, the assumption is treated as money received (§ 1031(d)). The Instructions for Form 8824 net liabilities the other party assumes against liabilities the investor assumes, cash the investor pays, and other property the investor gives up.
• Personal property that comes with a building, such as furniture or equipment, is not real property, so receiving it is generally boot under § 1031(b). In a qualified intermediary exchange, the regulations disregard incidental personal property in deciding whether the exchange agreement properly limits the investor's access to the funds. Personal property counts as incidental only if it is typically transferred with real property in standard commercial transactions and its total value does not exceed 15 percent of the value of the replacement real property. It is still taxable boot (§ 1.1031(k)-1(g)(7)(iii); Instructions for Form 8824).
• Some closing statement items, such as property taxes, rent prorations, security deposits, and repairs, are not exchange expenses (IRS Publication 544). How they are handled at closing can affect the result.
• Recognized gain may be reported in part as ordinary income from depreciation recapture (IRS Publication 544). If part of the property was depreciated as section 1245 property, for example after a cost segregation study, the section 1245 recapture rules still apply even though that part is real property for Section 1031 purposes (Treas. Reg. § 1.1031(a)-3(a)(7)).

Same taxpayer, and exchanges with related parties

The regulations describe one taxpayer that transfers the relinquished property and later receives the replacement property (§ 1.1031(k)-1(a), (g)(4)(iii)). Changing who holds title between the sale and the purchase, for example selling in your own name and buying in a newly formed LLC or partnership, raises questions your CPA should answer before the contracts are signed.

Exchanges with related persons have their own rule. If the investor exchanges property with a related person and, within two years after the last transfer in the exchange, either party disposes of the property received, the deferral is lost and the gain is recognized as of the date of that later disposition (§ 1031(f)(1)). Dispositions after the death of either party, certain involuntary conversions, and dispositions shown not to have tax avoidance as a principal purpose are excepted (§ 1031(f)(2)). An exchange structured to avoid these rules does not qualify (§ 1031(f)(4)). The two-year period is suspended while the holder's risk of loss on the property is substantially diminished, for example by a put or a short sale (§ 1031(g)). Related persons include family members such as a spouse, child, grandchild, parent, grandparent, brother, or sister, and certain related entities, and the Instructions for Form 8824 say an exchange with a related party through an intermediary is covered. The instructions also address buying replacement property that a related party sold into the exchange for cash through a qualified intermediary; in that situation, the transaction generally is reported as a sale unless an exception applies.

Reverse exchanges

Sometimes the replacement property must be bought before the old property sells. Rev. Proc. 2000-37 provides a safe harbor for a qualified exchange accommodation arrangement, where an exchange accommodation titleholder holds title, or another qualified form of ownership such as the membership interest in a single-member LLC that holds title, to one of the properties. Among its requirements: the titleholder cannot be the taxpayer or a disqualified person; the taxpayer and titleholder must sign a written agreement within five business days after the titleholder takes title; the relinquished property must be identified within 45 days after the titleholder acquires the replacement property; the property must be transferred within 180 days; and the combined time both properties are held in the arrangement cannot exceed 180 days. The Instructions for Form 8824 add that property the taxpayer owned within 180 days before its transfer to the titleholder cannot be treated as received in the exchange (Rev. Proc. 2004-51, § 4.05). Reverse exchanges involve financing, title, and entity documents for the parking arrangement, so they need more lead time.

Vacation homes and second homes

A personal residence does not qualify. Rev. Proc. 2008-16 gives a safe harbor for a dwelling unit that is also used personally. For relinquished property, the investor must have owned the unit for at least 24 months immediately before the exchange, and in each of the two 12-month periods before the exchange, rented it to others at a fair rental for 14 days or more, with personal use not exceeding the greater of 14 days or 10 percent of the days rented at a fair rental. Parallel rules apply to replacement property for the 24 months after the exchange. Outside the safe harbor, the question is whether the property was held for investment under all the facts.

Reporting on Form 8824

Each like-kind exchange is reported on IRS Form 8824, filed with the return for the year the relinquished property was transferred. After an exchange with a related party, Form 8824 is also filed for the two following years (Instructions for Form 8824). The form figures the deferred gain, any gain recognized because of boot, and the basis of the replacement property. Your CPA typically prepares it, but the closing statements, exchange agreement, assignments, and identification notice are the records it relies on, so keep them together.

What Tennessee adds

• Individual income tax: the Tennessee Department of Revenue states that the Hall income tax applied to interest from bonds and notes and dividends from stock, and that it was repealed for tax periods beginning on or after January 1, 2021. For an individual holding property in his or her own name, the main tax question in an exchange is federal. A single-member LLC that is disregarded for federal income tax purposes is generally not disregarded for Tennessee excise tax, unless its single member is a corporation (Tenn. Code Ann. § 67-4-2007(d); Tenn. Comp. R. & Regs. 1320-06-01-.40).
• Entities: the Department of Revenue states that corporations, limited partnerships, limited liability companies, and business trusts chartered, qualified, or registered in Tennessee or doing business in this state must register for and pay franchise and excise taxes. Some entities are exempt under Tenn. Code Ann. § 67-4-2008. The excise tax is 6.5 percent of net earnings (Tenn. Code Ann. § 67-4-2007), and net earnings start from income determined under the Internal Revenue Code, with state adjustments (Tenn. Code Ann. § 67-4-2006). Because net earnings start from federal taxable income, a gain that is deferred for federal purposes is generally not in that starting figure for the year of the exchange. Section 67-4-2006 does not contain an adjustment aimed at like-kind exchanges, but it does adjust for differences between state and federal basis on later sales, so the entity's CPA should confirm the treatment.
• Recordation tax: Tennessee imposes a tax on recording transfers of realty of 37 cents per $100, based on the consideration or the value of the property, whichever is greater, paid by the grantee (Tenn. Code Ann. § 67-4-409(a)). Section 67-4-409 has no exemption for deeds that are part of a like-kind exchange, so plan for it on each purchase as you would in any closing. If the replacement property is financed, the recorded deed of trust is also taxed at 11.5 cents per $100 of indebtedness, with the first $2,000 exempt (Tenn. Code Ann. § 67-4-409(b)).

Contract and closing points

• Assignment and notice: the regulations treat the intermediary as entering into the sale and purchase contracts if the investor's rights are assigned to the intermediary and all parties are notified in writing of the assignment on or before the date of the relevant transfer (§ 1.1031(k)-1(g)(4)(v)). Both contracts should allow that assignment, and the written notice should be signed and delivered on or before the date of each transfer.
• Cooperation clause: the contract should include language in which the other party agrees to cooperate with the exchange and to sign reasonable documents. These clauses commonly have the investor bear any added cost, with no added liability to the other party, and the other side may ask for those limits.
• Deeds: under the regulations, the intermediary is treated as acquiring and transferring the property when it is a party to the assigned contracts and the property is transferred under them, so the deed generally can run directly from the investor to the buyer and from the seller of the replacement property to the investor (§ 1.1031(k)-1(g)(4)(iv)). The closing documents should match the structure in the exchange agreement.
• Closing dates: the closing of the relinquished property starts both clocks. The replacement purchase contract should set a closing date, and any extension rights, inside the 180-day period and the tax return due date. Inspection, financing, and title contingencies should leave time to move to a backup property identified within the 45 days.
• Proceeds: the settlement statement should send the net proceeds to the intermediary, not to the investor, and the investor should not receive a check for any part of the proceeds without first talking to the CPA about boot.

Every exchange depends on the property, the entity that holds title, the contracts, and the dates. If you are planning an exchange involving Middle Tennessee property, my office can review the contracts and the exchange timeline with you and your CPA before the first closing.

Educational disclaimer: This article provides general educational information only and is not legal or tax advice for any specific exchange. Coordinate any exchange with your CPA or tax advisor and a qualified intermediary.