The 1031 exchange often comes with two big challenges: following the timeframes and finding the “goldilocks property.” An exchange typically refers to a trade between two parties, but this isn’t always feasible.
The replacement property for your 1031 exchange must have a purchase price and a mortgage balance equal to or greater than that of the replacement property being sold. And what if someone desires your property but does not have the property you want to exchange? The likelihood of finding the perfect property with an owner who wants to do an exchange and having the values work out is small. This is where the three-party exchange comes into play.
What is a Three-Party Exchange?
Since the start of the 1031 exchange, the typical two-party exchange expanded over time to give investors greater opportunity to complete an exchange. A three-party exchange, formally recognized by the IRS in Revenue Ruling 77-297, is when an “accommodating party” is used to assist in the transaction between you and the other property owner.
A like-kind exchange can be completed without having to find an owner of property willing to trade with you directly. For this transaction, you need to find:
- A buyer for your property
- A property for sale of equal or greater value that you hope to acquire
There are also different formats of the three-party exchange. In a Baird exchange, the title is passed directly through the seller while in the Alderson format, the title is transferred through the intended buyer.
Let’s say you find a willing buyer for your property, but instead of receiving the property of the buyer, you find a suitable property from a third-party seller. In this situation, the buyer purchases the property from the third-party seller and uses that property to complete the tax-deferred exchange. Alternatively, you could have completed the 1031 exchange with the third-party seller, who could have then sold your relinquished property to the willing buyer.
Pros and Cons of a Three-Party Exchange
The obvious advantage is that by adding a third party, the opportunity to defer taxes through a 1031 like-kind exchange can be more easily achieved. Additionally, there is no need for a Qualified Intermediary.
On the other hand, the third-party exchange may be considered risky because the “accommodating party” takes title to a property that they know little, if anything, about. Because this party is now associated with the title, they could be exposed to issues connected with that property. Another downside is that there is little documentation aside from recording the deeds to confirm that an exchange was properly structured.
While 1031 three-party exchanges are formally allowed by the IRS, taxpayers must be careful when structuring this type of transaction. In the tax court case, Barker v. Comm'r of Internal Revenue, 74 T.C. 555, 563-564, the court found that a “sufficient number” of deviations from the standard multiple-party exchange will bring about a taxable event.