Exchanging a Property With Environmental Contamination

Contamination changes the buyer's diligence and the closing date, not your exchange deadlines

A buyer of a commercial site with any history of fuel, solvents or industrial use will usually commission a Phase I environmental site assessment. The reason is federal liability: under 42 U.S.C. 9607(a) the current owner of a facility is liable for cleanup costs, and the defenses for an innocent or bona fide prospective purchaser depend on having made "all appropriate inquiries" before buying.

EPA's rule at 40 CFR 312.20 requires those inquiries to be made within one year before acquisition, with interviews, lien searches, records reviews and site visits updated within 180 days of closing. It names ASTM E1527-21 as a standard that satisfies the rule. If the Phase I flags a recognized environmental condition, a Phase II with sampling follows, and that can add weeks.

For your exchange, the timing is forgiving in one direction. Reg. section 1.1031(k)-1(b)(2) starts the identification period on the date you transfer the relinquished property, so a slow Phase II delays your closing but does not eat into your 45 or 180 days. The exception is a reverse exchange, where you already own the replacement and the sale has its own deadline; see the reverse exchange guide.

Selling does not end your exposure, which is why contracts carry indemnities and holdbacks

Section 9607(a)(2) makes liable "any person who at the time of disposal of any hazardous substance owned or operated any facility" where it was disposed of. If the release happened on your watch, the deed transfer does not remove you from the list of liable parties.

Buyers know this, and they also know they may become liable as the new owner. The contract therefore usually allocates the risk in one of three ways: a lower price, a seller indemnity, or part of the price held in escrow until remediation reaches an agreed point. Each has a different tax result in an exchange.

Keep the Phase I and Phase II reports, the remediation estimate and the signed allocation of risk with your exchange records. If a question about the price or a holdback comes up when your return is examined, those documents show why the amount realized changed and who received each dollar of the escrow.

A price cut costs you equity but no tax, while a holdback released to you is boot

A price reduction or a closing credit lowers your amount realized. You realize less gain, the net sale price you must match drops by the same amount, and nothing is paid to you, so there is no boot.

A holdback is different. The money is part of what the buyer paid you, but it sits in an escrow rather than with your qualified intermediary. The deferred exchange regulation is strict about who controls sale money: an escrow from which you have an unrestricted right to draw is constructive receipt, and Example 2 of Reg. section 1.1031(k)-1(g)(8) treats a transaction as a taxable sale for exactly that reason.

The safer drafting points every release to the intermediary while the exchange period is still open, so released money can still buy replacement property. Anything released to you after the exchange ends is money received and is recognized up to your gain. Money paid out of the escrow to a remediation contractor, or back to the buyer, simply reduces what you received.

Worked example: a $2,000,000 sale and a $150,000 cleanup estimate

These are hypothetical round numbers. An owner sells a former service station for $2,000,000 with $100,000 of selling costs. The buyer's Phase II estimates cleanup at $150,000 and offers two structures.

Under option A, the price drops to $1,850,000. The net sale price becomes $1,750,000, so a replacement at that figure with all exchange cash reinvested and the old debt replaced defers all of the gain. Nothing is taxed now.

Under option B, the price stays at $2,000,000 and $150,000 goes into a holdback escrow. Cleanup comes in at $90,000 and the remaining $60,000 is released to the owner eight months later, after the exchange period has ended. That $60,000 is cash boot, recognized to the extent of the realized gain. The owner also had to match a $1,900,000 net price with only $1,750,000 of cash at the intermediary. Run your own numbers with your CPA.

• Option A, price cut: $150,000 less equity, $0 recognized now.
• Option B, holdback: $90,000 spent on cleanup, $60,000 released after the exchange period and taxed as boot.
• Option B with releases payable to the intermediary before day 180: the same $60,000 can buy replacement property.

Plan the replacement side as the buyer of a clean property, with your own inquiry

When you buy replacement property you are the one who needs the all appropriate inquiries defense. Order your own Phase I early in the 45-day window, because the 180-day update requirement in 40 CFR 312.20 means a report the seller hands you may be too old to rely on.

Lenders on the replacement will ask for the same report, and a finding there can stall a loan you need to replace debt. Identify a backup property, as a DST backup strategy describes, so one bad report does not end the exchange.

If the next property will be a Delaware statutory trust interest, the trust's sponsor commissions the environmental work and buys any insurance; DST environmental and insurance risk covers what to read in the offering documents.