• Will an Exchange of Two Properties Be Treated as Two Exchanges or One?
• January 20, 2005
• Law Firm: Miller Nash LLP - Portland Office
• It is hardly uncommon for two properties to be sold at the same time. The properties may be located adjacent to each other and used to operate a single business, or a motel may be placed on one lot while the other lot is undeveloped land. For the purposes of this article, let's consider two hypothetical properties: Whiteacre and Blackacre.

Making the Right Choice

If an exchange of two lots is treated as two exchanges, many significant differences result in the tax treatment of the transactions. The differences can range from blowing a tax-free exchange to saving significant amounts of income taxes.

Exchange and sale. Assume that both Whiteacre and Blackacre had a value of \$1 million. Further assume that Whiteacre had a tax basis of \$1 million, while Blackacre had a zero tax basis. Obviously, the taxpayer would like to sell Whiteacre for \$1 million and pay no tax, and exchange Blackacre as part of an exchange. If the two properties were treated as a single property for tax purposes, the transaction would be treated as an exchange with \$1 million in taxable boot.

Exchange-installment sale combinations. Assume that Whiteacre and Blackacre are each worth \$1 million and that each has a basis of \$400,000. Assume that they are sold for a \$1 million note and \$1 million in replacement property. If the transaction is structured as two exchanges, with the \$1 million note allocated to one of the properties, the gain on the note will be \$600,000. If it is treated as a single exchange, the gain on the note will be \$1 million because the note would be treated as boot in an exchange and no basis could be allocated to it. This counterintuitive result would come as a huge surprise to most taxpayers.

Identification requirement. If the transaction is treated as two exchanges, the taxpayer can make his 45-day designation and use the three-property rule, which allows him to identify three possible replacement properties. Thus, the taxpayer can select three properties for Blackacre and three properties for Whiteacre or use the 200 percent test for each property. An additional wrinkle is that if the transaction is treated as two exchanges, and the taxpayer wants to use proceeds from both transactions to purchase the replacement property, the taxpayer would identify an undivided 50 percent interest (or other appropriate percentage) in the potential replacement property with respect to the exchange of Blackacre, and an undivided 50 percent interest in the potential replacement property with respect to the exchange of Whiteacre.

Receipt requirement. If the transaction is treated as two exchanges, and the taxpayer identifies a particular replacement property and eventually acquires it, he may be found to have violated the receipt requirement. The violation may occur if he identifies a particular replacement property and pays for one-half of it with the proceeds from the exchange of Blackacre, and the other half with the proceeds from the exchange of Whiteacre. He thus would not acquire what he identified because he would have identified the entire replacement property while acquiring only half of it.

G6 rules. The G6 rules (from Treas Reg § 1.1031(k)-1(g)(6)) provide that a taxpayer cannot withdraw funds from an accommodator until after the identification period, if no replacement property is identified; after receipt of all identified replacement property; or after the end of the exchange period. These periods will vary if the taxpayer believes he has two exchanges with two relinquished properties and the IRS ultimately determines that the transaction will be treated as a single exchange.

One or Two Transactions? Determining Factors
Several factors help determine whether a transaction is treated as a single exchange or as two exchanges.

Single economic / contiguous properties. If the two properties are adjacent to each other, it is likely that they will be treated as a single exchange. And if the properties are part of a single economic unit and have a separate practical use -- or even if they are not adjacent -- single-exchange treatment becomes even more likely. For example, many farms consist of various properties that are not necessarily contiguous. Are such properties treated as a single economic unit on the taxpayer's tax return? Section 4 of Rev Proc 2002-22, 2002-14 IRB 733 provides some guidance on what is a parcel of real property for exchange purposes. It provides that to be considered a single exchange property, each parcel constituting the property must be viewed with others as a single business unit. It also provides that the IRS will generally consider contiguous parcels as single business units. It goes on to provide that noncontiguous parcels will also qualify as a property "where there is a close connection between the business use of one parcel and the business use of another parcel." The Revenue Procedure section gives an example of a single parcel: an office building and a parking garage that services the office building.

Documentation. It is much more likely that a transaction will be treated as two exchanges if it is documented as such with two separate sales agreements. At least two commentators have suggested that separate like-kind exchanges be documented by and as separate transactions. Robert L. Whitmire, Planning Tax-Deferred Property Transactions § 5.05[5] (1995); Terence Floyd Cuff, Tax-Free Real Estate Transactions, 24 J Real Est Tax'n 216 (1997). It would also be helpful if the two sales agreements are not entered into as of the same date. Further, in each sales transaction, the closing of the sale should not be conditioned upon the sale of the other property. It also matters whether the transactions were negotiated as two separate transactions or as a single transaction.

Two buyers. Selling the two properties to two different buyers is a key factor in the transactions being treated as two exchanges. It is likely that a sale of two properties by a single taxpayer to two unrelated buyers will be treated as two exchanges. If the two buyers are related, the risk that the transaction will be treated as a single exchange is increased.

Closing timing. The timing to close the transactions is important. It is more likely that the transactions will be treated as two separate transactions if they are closed on different dates. This is especially true if there is a single buyer. Obviously, if the two transactions close a day apart, it is more likely that the transactions will be treated as a single transaction than if the two sales were closed four months apart.

Escrow. It probably does not matter if more than one escrow company is used to close the transactions. Clearly, however, the transactions should be closed in separate escrows, with separate escrow instructions and separate closing statements.

Accommodator. Certainly, the transactions should be documented using two exchange agreements. Would it help to use two different accommodators? Perhaps, because it would be additional evidence that the taxpayer was treating the transactions as two separate transactions. Except for the "window dressing" effect, it seems that it should not really matter, any more so than using two brokers or two attorneys to document the transactions.

Listing agreement. A single listing agreement is evidence of a single sale, especially if there is a single buyer or multiple related buyers.

Advertising. If the properties were advertised as a single sale by the broker, it is more likely that the transactions will be treated as a single sale and thus a single exchange. The advertising is evidence as to whether the properties were part of a single economic unit.

If the exchange of Blackacre and Whiteacre are treated as one or two transactions, and a mistake is made, the result can be disastrous. Unfortunately, there are very few legal precedents as to whether treatment as two separate sales will be respected. Consult your tax counsel and proceed with caution.