New Safe Harbor for Reverse Like-Kind Exchanges
By Linda Garrett Levy, Richard L. Levy, and J. David Mason
Increased Confidence in Qualified Transactions
Like-kind exchanges are powerful tools that can defer gain recognition for taxpayers. The IRS has made like-kind exchanges of qualified property an even more attractive and flexible tax-planning tool with a safe harbor for reverse like-kind exchanges. Although reverse like-kind exchanges are not a new technique, in the past the tax implications were sometimes uncertain. For reverse exchanges that qualify, the safe harbor takes much of the risk out of the transaction. Even for those transactions that don’t qualify for the safe harbor, the IRS no-inference rule leaves the door open for other arrangements.
The like-kind exchange rules under IRC section 1031 allow property owners to change their qualified property holdings while avoiding gain recognition for tax purposes. This tax-planning technique has become extremely popular. As originally enacted, only simultaneous exchanges were contemplated. As more taxpayers have taken advantage of the like-kind exchange provisions, however, new rules have been added and existing rules have been interpreted to fit a variety of exchange scenarios. The 9th Circuit Court of Appeals allowed like-kind exchange treatment to the taxpayers in Starker [Starker v. United States, 602 F.2d 1343 (9th Cir., 1979)], for example, for a transaction that took years to find the replacement property. The Starker decision ultimately led in 1984 to the statutory recognition of deferred exchanges in IRC section 1031(a)(3) and in 1991 to regulations providing safe harbors for deferred exchanges. The preamble to the IRC section 1031 regulations, however, explicitly stated that the safe harbors did not apply to reverse exchanges.
IRC section 1031(a) provides that no gain or loss is recognized if business or investment property is exchanged solely for property of a like kind to be held for either business use or investment. Business property can be exchanged for investment or business property, and vice versa [Treasury Regulations section 1.1031(a)-1(a)(1)]. “Like-kind” refers to the character or nature of the property. Real estate may be exchanged for other real property, whether it is improved or unimproved [Treasury Regulations section 1.1031(a)-1(b)]. To the extent boot is received, realized gain must be recognized [IRC section 1031(b)]. Boot includes cash, any property that is not like-kind, and relief from debt [Treasury Regulations section 1.1031(b)-1].
The most common like-kind ex-changes are “deferred exchanges,” where the taxpayer relinquishes property at one point in time and receives replacement property at a later point in time. To qualify for like-kind exchange treatment under IRC section 1031, the replacement property must be identified before the end of the identification period (45 days from the date the relinquished property is transferred) and the identified replacement property must be received before the end of the exchange period (the earlier of 180 days after the relinquished property is transferred or the due date of the return, including extensions, for the year in which the transfer occurs).
In addition, to qualify for like-kind treatment, it is necessary that the transaction be treated as an exchange rather than a sale. If the transaction fails the exchange test, it will treated as a sale of property followed by a purchase of property and will not qualify for nonrecognition [Treasury Regulations section 1.1031(k)-1(a)]. To meet the exchange test, the taxpayer must not be in actual or constructive receipt of funds. To avoid actual or constructive receipt and accomplish an exchange, a third party is used to facilitate the exchange. To qualify for the safe harbor provisions of Treasury Regulations section 1.1031(k)-1(g)(4), most deferred exchanges use a qualified intermediary (QI) as the third party to accomplish a deferred exchange. The taxpayer’s agent or a related party of the taxpayer cannot act as the QI.
In such a deferred exchange, the QI receives funds from the relinquished property under a written exchange agreement and facilitates the sale of the relinquished property and the acquisition of the replacement property. The exchange agreement must expressly limit the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain benefits of the money or property held by the QI before the end of the exchange period [Treasury Regulations section 1.1031(k)-1(g)(4)].
In a typical or forward exchange, the taxpayer transfers the relinquished property before obtaining the replacement property. In a reverse exchange, the taxpayer acquires the replacement property before transferring the relinquished property. This could happen for a number of reasons: The taxpayer might intend to transfer the relinquished property before buying the new property but run into problems with the planned transfer, or the taxpayer might identify the replacement property before being able to locate a buyer for the relinquished property.
Although many taxpayers have engaged in reverse exchanges, there has been little guidance on how to structure the transaction in order to ensure exchange treatment. Reverse exchanges are not addressed by the tax law and are specifically not covered as deferred exchanges by Treasury Regulations section 1.1031(k) 1. No cases or rulings have explicitly approved reverse exchanges. Where there has been a lack of contractual interdependence between property purchases and sales, IRC section 1031 has been found not applicable to reverse exchanges [e.g., Bezdjian v. Comm’r, 845 F.2d 217 (9th Cir., 1988)]. In addition, where there has been a lack of mutual intent to enter into a like-kind exchange, IRC section 1031 has been found not applicable (TAM 200039005, May 31, 2000).
Generally, two different approaches have been followed in an attempt to avoid the taxpayer being treated as the owner of both properties during the gap period (before the relinquished property is transferred). In either approach, one of the properties is “parked” or “warehoused” with a third party. In the first, preferred, approach, the exchange happens at the end. An accommodation party (AP) acquires and holds the replacement property until the relinquished property can be sold. At this point, the replacement property is transferred from the AP to the taxpayer to complete the exchange. In the second approach, the exchange happens up front and the delay is in selling the relinquished property.
The basic issue for taxpayers and their advisors when planning reverse exchanges has been whether the AP or other third party will be respected as the owner of the property during the gap period. For this to occur, the AP must be dealt with at arm’s length and must bear some of the risk and burdens of ownership. This is problematic for a number of reasons. The taxpayer usually receives many of the benefits of ownership by, for example, leasing it under a triple net lease. The parties generally want and expect property value fluctuations to be borne by the taxpayer rather than the AP. As a result, contracts between the parties usually contain price terms protecting the AP. When the AP has bare legal title but few of the risks and benefits of property ownership, the AP may be viewed as merely the agent of the taxpayer, thus defeating like-kind exchange treatment.
Example 1. Taxpayer identifies qualifying realty (replacement property) with a FMV of $235,000 and enters into an agreement with an AP to purchase (park) the property from the seller. Taxpayer loans AP the full purchase price, and AP purchases the replacement property and leases the property to Taxpayer for an amount that covers the loan payment from AP to Taxpayer. Taxpayer subsequently identifies a buyer for the relinquished property at $235,000, and arranges with AP to transfer the relinquished property to AP in exchange for the replacement property. AP then sells the relinquished property to the buyer and pays off the note with funds from the sale of the relinquished property.
Since reverse exchanges were not covered by the safe harbors of the section 1031 Regulations, and since AP has none of the normal risks and burdens of ownership, there is a danger that AP could have been considered merely an agent of Taxpayer. If so, Taxpayer would be treated as owning both properties concurrently, and the gain on the sale of the relinquished property would be recognized.
New Safe Harbor for Reverse Exchanges
The IRS issued long-awaited guidance for reverse exchanges in Revenue Procedure 2000-37 (IRB 2000-40) on September 15, 2000. This revenue procedure provides a safe harbor under which the IRS will not challenge reverse exchanges. The safe harbor is structured so as to reduce transaction costs, and the IRS’s stated intent was to “provide taxpayers with a workable means of qualifying their transactions under IRC section 1031 in situations where the taxpayer has a genuine intent to accomplish a like-kind exchange at the time it arranges for the acquisition of the replacement property (not the mutual intent of all parties as required in the recent TAM) and actually accomplishes the exchange within a short time thereafter.” Revenue Procedure 2000-37 applies only to transactions in which an exchange accommodation titleholder (EAT) acquires qualified indicia of ownership of property on or after September 15, 2000.
Under the safe harbor provisions, the IRS will not challenge 1) the qualification of property as either replacement property or relinquished property or 2) the treatment of the exchange accommodation titleholder as the beneficial owner of the property for federal income tax purposes if the property is held in a “qualified exchange accommodation arrangement” (QEAA).
Example 2. Taxpayer identifies qualifying realty (replacement property) with a FMV of $235,000 and enters into a QEAA with an EAT to purchase (park) the property from the seller. Taxpayer loans EAT the full purchase price at below market rate. EAT purchases the replacement property and leases the property to Taxpayer for an amount that covers the loan payment from EAT to Taxpayer. Taxpayer subsequently identifies the relinquished property (within 45 days), negotiates with the buyer to sell the relinquished property for $235,000, and arranges with EAT to transfer the relinquished property to EAT in exchange for the replacement property (all within 180 days). EAT then sells the relinquished property to the buyer and pays off the note to Taxpayer with funds from the sale of the relinquished property.
Unlike Example 1, the transaction in Example 2 will be protected by the new safe harbor and will qualify for like-kind exchange treatment (i.e., the property will be considered held in a QEAA) if all of the following conditions are met:
Permissible agreements. The safe harbor provisions also permit the taxpayer to enter into a variety of non–arm’s-length transactions with the EAT. Seven arrangements (permissible agreements) are specifically permitted:
Permissible treatment. Finally, Revenue Procedure 2000-37 states that “property will not fail to be treated as being held in a QEAA merely because the accounting, regulatory, or state, local, or foreign tax treatment of the arrangement between the taxpayer and the exchange accommodation titleholder is different from the treatment required by section 4.02(3) of this revenue procedure.” Because the taxpayer, not the EAT, will generally hold the benefits and burdens of the ownership of the property, GAAP may require the taxpayer to treat the property as its asset. The same could be true for state and local tax purposes. Such treatment by other authoritative bodies will not taint the property for purposes of the safe harbor.
Revenue Procedure 2000-37 provides much-needed guidance and a workable procedure for taxpayers wanting to use reverse exchanges. The revenue procedure ensures that parties to the transactions will treat them consistently. The revenue procedure acknowledges that many arrangements currently used by taxpayers are acceptable.
Giving parties five days to enter into the QEAA could be quite helpful. Often, reverse exchanges become a necessity at the last minute when a planned exchange fails. Such rushed arrangements make it difficult to restructure the other parts of the transaction. This five-day delay will allow taxpayers to finish the transactions and then make sure the technical QEAA requirements are met.
Probably the biggest benefit is that the taxpayer can take on many of the risks and benefits of ownership while qualifying for the safe harbor. Allowing taxpayers to lease property and supervise construction will make reverse exchanges feasible for many taxpayers. Similarly, the safe harbor accepts financing arrangements that protect the EAT and put risks on the taxpayer, recognizing the underlying economic realities of the situation and ensuring that the parties to the exchange are treated as they intended. Both of these concessions will make reverse exchanges more attractive and less risky.
Revenue Procedure 2000-37 makes it clear that the total time of the exchange cannot be more than 180 days. Reverse exchanges spanning more than 180 days may still qualify for like-kind exchange treatment, just not under the safe harbor provision. Where a taxpayer wishes to construct improvements on the replacement property as part of the exchange, the 180-day period is frequently inadequate to complete the construction. How these and other exchanges extending beyond 180 days will be treated is still an open question.
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