Swapping for Tax Breaks : Delayed Exchange Designed to Obtain Deferral

It’s as American as Southern fried chicken, and most of us learned the basics of it at the marble ring on our school playground:

“I’ll give you six peewees and my two red aggies for your yellow shooter.” Agreed and done.

The swap was executed, and not a thought was given to the tax consequences. And then both parties grew up and went into the real estate business.

While a similar swap of commercial and industrial real estate as a means of deferring the tax normally triggered by a conventional sale and repurchase has been technically possible since the 1930s, it took a brave entrepreneur to try it.

But since the landmark Starker vs. United States court decision in 1979, further changes in the tax code in 1984 and, especially, since long-term capital gains will no longer be given special tax treatment in the current tax bill, there is a new spotlight on the tax-deferred exchange, along with predictions of a boom in its usage.

Essentially, any tax liability is deferred if, under still-stiff guidelines, the owner swaps his commercial or industrial real estate for like property of equal or greater value.

And the stimulus for doing so is the elimination of the capital gains tax which, under present law, limits the taxpayer’s liability to a maximum of 20% of his gain.

Under the new law, any such gain becomes taxable at the taxpayer’s regular rate--at least 28%, but in all likelihood as much as 33%. Thus, a developer who has seen his $1-million office building treble in value to $3 million, would have faced a flat 20% tax on his gain ($2 million) under the present law--a maximum of $400,000. However, under the new tax bill, effective next January, his liability will range from $560,000 (28%) to $660,000 (33%). Thus, the incentive to defer tax is almost overwhelming.

“But until the Starker case came along,” Richard L. Sevin, president of American Deferred Exchange Corp., at 6300 Wilshire Blvd., said in an interview, “it had to be so intricate to satisfy the Internal Revenue Service that it was almost impossible.

“The exchange--the conveyance of two pieces of property--had to be simultaneous. Quite literally, the same day, even if they were located in different states. One bad notary stamp bounced by a county recorder, and the whole thing fell apart. But, for a long time, nobody wanted to challenge the IRS on this simultaneity.”

Until Starker, the owner of valuable timberland, “challenged the IRS,” Sevin said, “by telling his buyer, Crown Zellerbach, not to give him any money--because he meant to use the proceeds to buy similar land, but didn’t have any available at the time. But he would trust them and, under his contract, he would find such land within five years. When he did, then he would notify Crown Zellerbach, they would buy the land designated and turn it over to him.”

IRS Not Pleased

The arrangement went over with the IRS like a hiccup in church, and the agency wasn’t mollified, to put it charitably, when the U. S. Court of Appeals found in Starker’s favor.

“But the Starker case still left a lot of questions unanswered,” Sevin added, “particularly as far as the timing was concerned. Starker’s was a five-year contract, although they actually completed it in about 2 1/2 years. The IRS was trying to get away from those three-to-five-year deals because people were escaping from taxes for years while they were looking for properties to buy.”

Because of the IRS’s continued testiness, deferred exchanges still remained little used--and almost exclusively in the West, in the 9th Circuit, where the U. S. Court of Appeal’s position was a matter of record.

What “legitimatized” the deferred exchange was the 1984 tax overhaul where--even though it did away with the casual, “take your sweet time” approach in the Starker case--the validity of the non-simultaneous, or “delayed,” exchange was put securely into place.

Formed Own Firm

“What it did,” Sevin added, “was to give the exchanger 180 days to put his deal together and close it, but he had to identify the property for which he was making the exchange within the first 44 days--the law reads 45 days but, because of the peculiar wording, ‘the day before the day which is the 45th,’ it works out to 44.”

This was when Ticor, parent company of, among others, Ticor Title Insurance Co., became active in putting together delayed exchange transactions as an intermediary, a responsibility that fell to Sevin who had joined the firm in 1983 and who, as vice president and associate general counsel, coordinated the effort.

By the time Ticor, in late 1985, decided to get out of delayed exchanges because of the press of other business, Sevin had handled more than 100 such exchanges, involving properties valued in excess of $100 million.

“That’s when I decided to spin off from Ticor and organized American Deferred Exchange Corp. earlier this summer,” Sevin said. A Phi Beta Kappa graduate of the University of California at Berkeley, Sevin holds a doctor of jurisprudence degree from Yale Law School.

Holds Proceeds of Sale

How does the typical delayed exchange work?

Before Sevin’s ADEC ever enters the picture, he explained, the exchanger has found a buyer for his property and has the deal well lined up. Then, after consulting with his own real estate attorney, the exchanger contacts ADEC and an agreement is signed under which ADEC is substituted for the exchanger (the seller) and the sale is consummated.

Sevin’s ADEC receives and holds the proceeds of the sale. The exchanger then has 44 days to find an appropriate substitute piece of real estate, identify it and begin the purchase transaction.

After Sevin has had an opportunity to study the deal and make sure it conforms to IRS regulations, his ADEC is again substituted--this time as the buyer of the replacement. Sevin completes the transaction and then conveys the replacement real estate to the exchanger--all of this within 180 days.

Unlike the casual approach typified when a principal residence is sold, and the tax is deferred as long as the seller finds a replacement of equal or greater value within two years, not only is the timing far more precise in a delayed exchange of commercial real estate, but any money that the seller might inadvertently pocket in the transaction is taxable as ordinary income for that year.

Ballet-Like Precision

Thus, the ballet-like precision in making sure that no one but Sevin’s ADEC handles the funds. “And the key question here, of course,” Sevin added, “is in the exchanger’s mind about me . I’m holding the proceeds of the sale. How does he know his money is going to be there? How does he know I’m going to perform? How does he know I’m not going to leave town?

“This, I think is where ADEC is different from some of the others that have come into the delayed exchange business--some escrow companies and some law firms that have set up separate companies for this.

“It took months of negotiations, but I have an arrangement with First Interstate Bank where, with each deal, they issue a standby letter of credit to protect that obligation to the exchanger. What if I should get hit by a truck? What if I can’t handle my personal affairs and go into bankruptcy?

From a practical standpoint, he added, the complexity and cost of a delayed exchange “isn’t normally worthwhile unless there is about $300,000 to $500,000 involved.”

Although still complex by layman standards, the long sluggish delayed exchange market has been stirred up as never before by the upcoming death of the capital gains tax--a means of deferring Uncle Sam’s bite “to fight another day.”