The initial step in most exchanges occurs when the taxpayer and the Qualified Intermediary enter into the Exchange Agreement. Pursuant to the agreement, the taxpayer will deed the relinquished property to the Intermediary, subject to current obligations including debt and an agreement to sell between the taxpayer and the relinquished property buyer. The Intermediary is substituted as the seller in the agreement and subsequently sells the property to the buyer and receives and holds all net sales proceeds in the exchange escrow. The date of such deeding is called the initial transfer date.
Note that the real estate transactions that make up the typical exchange are standard purchase and sale transactions between the Qualified Intermediary and the buyer and seller, respectively. Note also that the Exchange occurs as a simple swap between the taxpayer and the Intermediary. In fact, the taxpayer gave up qualifying property and received qualifying property prior to the receipt of any non-like kind property.
The properties involved in an exchange have special names too:
Relinquished Property: the property originally owned by the taxpayer and which the taxpayer would like to dispose of in the exchange.
Replacement Property: the new property, the property that the taxpayer would like to acquire in the exchange.
In order for an exchange to be completely tax deferred: 1) the replacement property must have a fair market value equal to or greater than the net sales price of the relinquished property; and 2) all of the taxpayer’s equity or more must be used in acquiring replacement property. This is known as trading up or equal in value and up or equal in equity, and it is essential if the taxpayer desires to defer the tax on all of the gain.
On or before the expiration of 45 days after the initial transfer date, the taxpayer must identify replacement property to the Intermediary. The taxpayer enters into an agreement to purchase the replacement property from the seller. In the exchange, the Intermediary is substituted as the buyer in the agreement. Following the Intermediary’s closing on the replacement property, the Intermediary transfers the title to the taxpayer. This final transfer, which concludes the exchange, must occur before the expiration of the exchange period. Following the termination of the exchange, the Intermediary transfers any remaining escrow to the taxpayer who recognizes receipt of boot to the extent of the fair market value of such escrow.
