Rev. Proc. 2000-37 offers long-awaited reverse-exchange safe harbor.
* In the past, some reverse exchanges failed because they were not structured as exchanges.
* Rev. Proc. 2000-37 allows some flexibility in dealings between the taxpayer and the accommodator.
* By issuing a procedure, the IRS is not necessarily saying that the safe-harbor transactions qualify as Sec. 1031 exchanges as a substantive matter, only that it will not challenge them.
Taxpayers have long used intermediaries to hold property while searching for a like-kind property to exchange and avoid gain recognition. These so-called "parking arrangements" had to be structured correctly to work as intended. In Rev. Proc. 2000-37, the IRS has now offered a safe-harbor structure that it will not challenge. This article examines the history of such arrangements, how they fared and the new provision.
Sec. 1031(a)(1) provides for nonrecognition of gain or loss when property held for investment or trade or business use is exchanged for like-kind property held for investment or trade or business use. Sec. 1031(a)(3) limits the application of Sec. 1031 to deferred exchanges; it provides that any property not both (1) identified within 45 days of transfer of the relinquished property and (2) received within the earlier of (i) 180 days of the transfer of such property or (ii) the due date of the taxpayer's return for the year of the transfer, will not qualify as like-kind property. The deferred exchange rules are a statutory codification of the rule established in Starker,(1) and apply to exchanges in which the taxpayer sells relinquished property and thereafter (or simultaneously therewith) acquires like-kind replacement property. Treasury issued final regulations that, while not complete in the eyes of many tax advisers, provide guidelines for the structure of a deferred exchange.(2)
Less clear is whether a taxpayer may first acquire replacement property, later sell relinquished property, and meet the two-step Sec. 1031 gain nonrecognition requirement. The "reverse exchange" or "reverse Starker" is not addressed in either the Code or regulations,(3) and raises a variety of troubling questions. Because tax advisers with real estate investor clients frequently encounter the reverse-exchange issue, Treasury's lack of interpretive guidance has long been a concern. Several years after the issuance of the final deferred-exchange regulations, the American Bar Association (ABA) Section of Taxation drafted suggested reverse-exchange regulations,(4) which failed to lead to Treasury initiatives. Early in 1999, Treasury officials indicated that reverse-exchange guidance was likely to be issued in some form; on Jan. 17, 2000, an informal ABA task force submitted a proposed revenue procedure to the IRS. On July 13, 2000, a similarly worded proposal followed from a small group of ABA Tax Section members.(5)
The ABA proposals have been adopted in large part in Rev. Proc. 2000-37,(6) which creates a safe harbor for certain post-Sept. 14, 2000 reverse-exchange structures. The most significant difference between the ABA proposals and the procedure is the time period in which the reverse exchange must be completed. Many taxpayers may be unable to complete all the steps within the prescribed deadline. To better understand the safe harbor (and because it does not apply to either pre-Sept. 15, 2000 arrangements or to post-Sept. 14, 2000 structures not within the safe harbor), this article begins with a review of judicial and IRS interpretations of the application of Sec. 1031 to reverse exchanges. After describing the typical pre-safe-harbor reverse-exchange arrangements and the problems encountered, the procedure's safe-harbor provisions are discussed and the merits analyzed.
Judicial and IRS Guidance
In Rutherford,(7) taxpayers entered into an agreement to receive 12 half-blood heifers. They agreed to artificially inseminate them and deliver 12 three-quarter blood heifers to the other party. The three-quarter blood heifers were delivered over three years. The Tax Court concluded that the transaction qualified as a Sec. 1031 exchange, even though the replacement property was received before the relinquished property existed. The agreement between the parties established an intent to exchange; the taxpayer could neither receive cash for the property to be transferred nor be required to pay cash if the three-quarter blood heifers could not be delivered. Instead, the other party could take back the half-blood heifers if the taxpayer failed to satisfy his obligations. Rutherford was marked by a clear intent among the parties to effectuate an exchange.
In Biggs,(8) a taxpayer listed property for sale and found a suitable buyer. Seeking to make an exchange, the taxpayer also located replacement property. Because the buyer did not want to acquire and transfer title to the replacement property, the taxpayer's attorney agreed to serve as an accommodator through a newly formed corporation. The accommodator corporation took title to the replacement property, then contracted to sell it to the buyer of the taxpayer's property; the buyer assigned the contract rights to the taxpayer. Title to the replacement property was then direct deeded to the taxpayer; two days after receipt of the replacement property, he transferred the relinquished property to the buyer. The delay between the receipt of the replacement property and the transfer of the relinquished property was only two days.
The Service argued that the transaction could not be an exchange, because the buyer never held title to the replacement property.(9) However, the transaction was an exchange, because it was clearly part of an integrated plan in which certain formalities were followed. The taxpayer could not receive cash in the exchange; the distinction between an assignment of contract rights and acquisition of legal title was not viewed as a substantive one. Because the buyer of the relinquished property was deemed (through the accommodator's assignment of contract rights) to be the transferor of the replacement property, the Biggs transaction was found to be a valid exchange.
In Letter Ruling 9814019,(10) a regulated public utility held an easement allowing it to build overhead transmission lines over another corporation's property. That corporation, which had granted the taxpayer the easement, intended to develop its property; the taxpayer's easement interfered with approval for that development. Thus, the taxpayer and the other corporation agreed to an exchange of easements; the taxpayer would receive a new easement and transfer the old easement after being satisfied that transmission lines constructed on the former were performing properly.
The Service stated that the "facts of this case present a reverse exchange transaction between two parties" that qualified under Sec. 1031. There was no discussion as to the application of Sec. 1031 to reverse exchanges, although the ruling granted implicit approval to the reverse nature of the transaction. The facts did not indicate the time lapse between the receipt of the new easement and the transfer of the old, although it may have occurred within the same tax year.(11) As with Rutherford and Biggs, there was a clear intent to effectuate an exchange between the parties.
The cases in which a taxpayer failed to qualify a purported reverse exchange under Sec. 1031 suffered from a lack of an exchange. In Lee,(12) a taxpayer purchased farm property in Washington from one party; seven months later, he sold property in Hawaii to others. He contended that he had exchanged the Hawaii property for the Washington property, because the proceeds of the Hawaii sale went directly to the seller of the Washington property to reduce the taxpayer's deferred payment obligation thereon. However, neither the substance nor the form of the purchase and sale transactions resembled an exchange. The documents for the two transactions did not mention each other; further, there was no evidence that the Hawaii sale was even contemplated when the Washington property was purchased.
In Bezdjian,(13) a taxpayer contracted to purchase property, then attempted to sell other property he owned. He sought to structure a two-party exchange with the seller of the new property; after being turned down, he sought a multiparty simultaneous exchange. Because the old property could not be sold before the closing date for the new property, the taxpayer borrowed funds to complete the acquisition of the latter. Within three months of purchasing the new property, the taxpayer sold the old property; the cash proceeds were transferred directly to the bank that financed the acquisition of the new property. Unlike Lee, it was clear that the taxpayer in Bezdjian had always intended to structure an exchange and that the sale of the old property was contemplated when the new property was acquired. However, the form and substance of the transaction was a purchase of one property and sale of another. There was no interdependence of the two transactions, because there was no party (e.g., an intermediary) with which the taxpayer exchanged the two properties. As was the result in Lee, the mere fact that cash proceeds from sale of the old property were used to retire debt on the new property did not evidence an exchange.
Dibsy(14) involved a fact pattern similar to Bezdjian, but arose after 1984 statutory amendments to Sec. 1031 that permitted deferred exchanges. A taxpayer contracted to sell a liquor store and purchase a larger one. When the sale of the old store fell through, he tried unsuccessfully to cancel the purchase of the new store. Instead, the seller agreed to a short-term financing of a portion of the purchase price; after the old store was sold (which occurred less than six months after the purchase of the new store), the sale proceeds were used to retire the debt.
The Tax Court noted that a sale and purchase may often be economically indistinguishable from an exchange, but that the need for boundaries in recognizing an exchange required some formal distinctions. The intent to effectuate an exchange is irrelevant when the substance and form fail to evidence that an exchange has occurred. The Tax Court cited its earlier decision in Barker,(15) noting "whether the cause be economic and business reality or poor tax planning ... taxpayers who stray too far run the risk of having their transactions characterized as a sale and reinvestment."
In Letter Ruling (TAM) 200039005,(16) a taxpayer structured a deferred exchange using an accommodation party. When the planned sale of the relinquished property fell through, but the seller of the replacement property insisted on closing that leg of the exchange, the taxpayer closed on the replacement property and titled it in the accommodator's name. When the sale of the relinquished property was later consummated, the taxpayer closed (what appeared to be) a simultaneous exchange with the accommodator. The IRS held that the transaction was not an exchange, because the accommodator was merely the taxpayer's agent. The taxpayer was treated as if he first acquired replacement property and later sold relinquished property, which was not an exchange. The TAM noted that:
* The taxpayer closed on the purchase of replacement property, then ordered it to be rifled to the accommodator.
* The taxpayer negotiated the purchase of the replacement property.
* The taxpayer provided all funds to purchase the replacement property and was personally liable for purchase-money debt.
It is not clear how the TAM will affect the IRS's approach to pre-safe harbor exchanges with different facts. The TAM concluded that the accommodator was merely the taxpayer's agent. Generally, the parking arrangements described below "paper" the transaction better than appears to have been done in TAM 200039005. For example, in most parking arrangements, the accommodator would be the party to close the purchase; there would be no "order" by the taxpayer that title be transferred to the accommodator. Although the facts of the accommodation arrangement are not entirely clear from reading the TAM, a well-documented parking arrangement entered into prior to the safe harbor may result in a more favorable set of facts (and, thus, a more favorable outcome).(17) IRS officials have been quoted as saying that Rev. Proc. 2000-37 is intended to free Treasury resources from analyzing facts and circumstances of reverse exchanges and to assist taxpayers disadvantaged by TAM 200039005.(18)
In DeCleene,(19) the first case decided after the issuance of Rev. Proc. 2000-37, a taxpayer who owned land and a building (McDonald property) purchased unimproved land (Lawrence property). About a year after the Lawrence property purchase, the taxpayer had the opportunity to sell the McDonald property. Because the basis of the McDonald property was low in relation to value, and the basis of the Lawrence property was relatively high, the taxpayer's CPA suggested a like-kind exchange.
The exchange involved a purported sale of the unimproved Lawrence property to the prospective buyer of the McDonald property for a non-interest-bearing nonrecourse note. The buyer would improve the Lawrence property and convey it to the taxpayer in exchange for the McDonald property. The taxpayer reported the transaction as an exchange; the IRS contended the McDonald property had been sold for the consideration allegedly received for the Lawrence property.
The Tax Court noted that Rev. Proc. 2000-37 applies prospectively only, then held for the IRS, because the nominal buyer of the Lawrence property never acquired any benefits or burdens of ownership. The buyer had no economic outlay, paid no interest, incurred no risk of loss of ownership or on the construction contract and had no exposure to real estate tax liability. The exchange values failed to take into consideration any increase in value of the Lawrence property from the improvements, although the real estate transfer taxes reflected a considerable difference in the values of the two properties. The transaction was viewed as a reverse exchange, because the Lawrence property was purchased more than a year before the McDonald property was sold. The Tax Court was unimpressed with the taxpayer's exchange documentation, because no third-party intermediary was used, creating an "inherently ambiguous situation" that led to the taxpayer's defeat.
The cases cited above demonstrate the need to structure a reverse exchange to resemble an exchange. In none of the taxpayer defeats discussed above was there a finding that a reverse exchange could not fit within Sec. 1031; the taxpayer lost because the basic structure of the transaction was not an exchange, thereby removing the transaction from Sec. 1031. In the cases in which the taxpayer succeeded in qualifying the transaction under Sec. 1031, as well as in Letter Ruling 9814019, the structure supported the conclusion that an exchange had occurred. Under those decisions, as long as an exchange is considered to occur, the fact that it occurs in reverse order (with the taxpayer first receiving the replacement property, then surrendering the relinquished property) does not remove it from Sec. 1031.
Pre-Safe-Harbor Reverse-Exchange Structures
To create a reverse exchange in a multi-party context when the owner of the replacement property will not acquire the relinquished property, tax advisers have constructed "parking arrangements." Such arrangements use intermediaries, giving the appearance of a simultaneous exchange between the taxpayer and the intermediary. These arrangements have created financing complications and raised questions as to whether their form would be respected. Because parking arrangements are the focus of the Rev. Proc. 2000-37 safe harbor, it is useful to review the transactional and tax issues they raise, then analyze the safe-harbor treatment. Two main types of parking arrangements have been used by taxpayers.
Park Replacement Property, then Exchange
Under one form of parking arrangement (see Exhibit 1), the intermediary acquires title to the replacement property (perhaps financed by a nonrecourse loan from the taxpayer) and parks it until the taxpayer can arrange a sale of the relinquished property. At that time, the taxpayer exchanges the relinquished property for the replacement property held by the intermediary and fries Form 8824, Like-Kind Exchanges, reporting a simultaneous exchange with the intermediary. If the sale proceeds from the relinquished property exceed the purchase cost of the replacement property, the excess funds may be used in a deferred exchange in which the parked replacement property is but one of the replacement properties; others may be identified and received within the Sec. 1031(a)(3) replacement periods. Alternatively, the taxpayer may simply choose to report excess proceeds as boot. In either case, parking the replacement property allows the taxpayer to wait until the relinquished property is sold to determine the amount to be reinvested to avoid gain.
[Exhibit 1 ILLUSTRATION OMITTED]
Example 1: T, a calendar-year taxpayer, owned land valued at $2 million with a $300,000 basis. T could have purchased a building for $2 million, but the seller insisted on closing by June 12, 2000. T attempted to sell his land so as to engage in a tax-free exchange through an intermediary, but could not by the required closing date. T engaged A to accommodate the exchange, by purchasing the building using the proceeds of a $2 million nonrecourse loan from T. A purchased the building on June 12, 2000; two months later, T entered into a contract for sale of his land for $2 million, with an Oct. 8, 2000 closing date. On that clay, T exchanged his land for A's building; A then sold the land, by assignment of contract rights, to the purchaser located by T. The Oct. 8, 2000 transaction paperwork documented the separate steps of an exchange between T and A, followed by a sale by A. The proceeds of the land sale were used to retire A's debt to T. T reports the transaction as a simultaneous exchange with A on Oct. 8, 2000.
Example 2: The facts are the same as in Example 1, except that T contracted to sell his land for $2.2 million, On Oct. 8, 2000, T exchanged his land for A's building; A then sold the land, by assignment of contract rights, to the purchaser located by T. A repaid the $2 million loan and transferred $200,000 to T to equalize the exchange equities. T reports the transaction as a simultaneous exchange with A occurring on Oct. 8, 2000, and the receipt of the $200,000 cash as taxable boot. Alternatively, assuming A is a qualified intermediary (QI), so that T was not in constructive receipt of the cash, A could have used the $200,000 excess proceeds to acquire additional property in a deferred exchange.(20) Because the transfer of T's relinquished; property occurred on Oct. 8, 2000, T had until Nov. 22, 2000 to identify replacement property and until April 6, 2001 to acquire replacement property. The building acquired on Oct. 8, 2000 was deemed identified under Kegs. Sec. 1.1031(k)-1(c)(1).
Exchange, then Park Relinquished Property
Under a second parking structure, the intermediary acquires the replacement property and simultaneously exchanges it for the taxpayer's relinquished property. (See Exhibit 2.) The intermediary would park title to the relinquished property until it could be sold (by assignment of contract rights, the structure described above). The intermediary may again execute a non-recourse note in the taxpayer's favor for the proceeds paid to the seller of the replacement property. The note would be repaid from the proceeds of the sale of the relinquished property. The taxpayer reports the exchange of the relinquished property for the replacement property as a simultaneous exchange on Form 8824. If the relinquished property sale proceeds exceed the cost of the replacement property, the taxpayer will receive the excess, which may be reported as income or used to fund the acquisition of additional replacement property. However, when the intermediary parks the relinquished property, the 45-day identification and 180-day replacement periods for a deferred exchange begin on the date of the initial exchange. Any moderate delay in selling the parked relinquished property will make it impossible to complete a deferred exchange funded by any excess relinquished property value. If such a timing problem may arise, the other structure (parking the replacement property) may be advisable.
[Exhibit 2 ILLUSTRATION OMITTED]
Example 3: The facts are the same as in Example 1 except that, on June 12, 2000, after A purchased the replacement building using the proceeds of T's $2 million nonrecourse loan, A immediately exchanged the building for T's land. A's purchase of the building was handled by an assignment of contract rights (i.e., the contract between T and the building's seller); tide was direct deeded from the seller to T. A took title to the land as a result of the exchange.
Two months later, A arranged a sale of the land for $2.2 million, with a closing date of Oct. 8, 2000. On that date, A repaid the $2 million loan and remitted the $200,000 excess as boot to T. T reports the transaction as a simultaneous exchange with A occurring on June 12, 2000. As a general rule, A could have used any cash resulting from a sale of the relinquished property in excess of the cost of the replacement property to acquire additional replacement property in a deferred exchange. However, A would have needed to satisfy the definition of a QI, so that T was not in constructive receipt of the excess funds. Moreover, because the transfer of T's relinquished property occurred on June 12, 2000, T only had until July 27, 2000 to identify replacement property. If the relinquished property were not sold, and excess proceeds not made available within 180 days of June 12, 2000, there would be no opportunity to use the cash boot to fund a deferred exchange.
Pre-Safe-Harbor Transactional Issues
The most common problem faced by taxpayers structuring reverse exchanges is how to finance the acquisition of the replacement property. When structuring a forward deferred exchange, many taxpayers rely on the sale proceeds from the relinquished property to fund the purchase of the replacement property. The accommodation party will seldom provide the temporary financing needed to acquire the replacement property and to park it or the relinquished property. As a result, the examples in this article have assumed that the taxpayer has funds temporarily available to loan, on a nonrecourse basis, to an accommodation party who will park title to either the replacement or the relinquished property. However, the more common situation would require a taxpayer to borrow from a third party to finance the purchase of the replacement property. The accommodator would generally be unwilling to incur any risk of loss as to this debt, requiring the taxpayer to guarantee the debt or to indemnify against loss. Tax advisers have been concerned that a loan or an advance from the taxpayer with no potential economic risk of loss could create the appearance that the accommodator is the taxpayer's agent, not an equity owner. Rev. Proc. 2000-37 permits certain financing arrangements between the accommodator and the taxpayer, which should alleviate these concerns for post-Sept. 14, 2000 arrangements. However, pre-Sept. 15, 2000 parking structures may be at risk of an IRS attack, as evidenced by TAM 200039005.
Reverse-exchange structures have also raised issues as to the identity of the accommodation party. In a deferred exchange, the transaction is typically conducted through a QI; to avoid an agency relationship with the taxpayer, the QI cannot be a "disqualified person," according to Regs. Sec. 1.1031(k)-1(g)(4). Moreover, tax advisers have generally agreed that the accommodator should not be a party related to the taxpayer (as defined in Sec. 1031(f)(3)), to avoid the related-party disposition rules of Sec. 1031(f)(1). The taxpayer's CPA or attorney would generally not be a related party for purposes of Sec. 1031(f), although he would be a disqualified person to serve as a QI. Although not directly applicable to reverse exchanges outside of the Rev. Proc. 2000-37 safe harbor, most tax advisers have counseled taxpayers to use an accommodation party who meets the QI definition to avoid unnecessarily exacerbating the agency issue. The Rev. Proc. 2000-37 safe harbor requires that the accommodator not be a disqualified person as defined in the deferred-exchange regulations.(21) Of course, the safe harbor applies prospectively only; even the use of a QI did not save the taxpayer from IRS attack in TAM 200039005.
In a typical exchange, the QI never enters the chain of title for the relinquished or the replacement properties. Instead, the QI acquires and transfers title to both properties by assignments of contract rights, as sanctioned by Regs. Sec. 1.1031(k)-1(g)(4)(v). In a reverse exchange using a parking strategy, the intermediary must take tide to one of the properties; the transfer of the other is handled by an assignment of contract rights. The necessity for the intermediary to actually take title may create risks for both the taxpayer and the intermediary. It is generally believed that an intermediary who is merely deemed, for tax purposes, to have acquired tide because of an assignment of contract rights, has no environmental liability.(22)
However, the intermediary in a reverse exchange actually enters into the chain of tide and risks exposure to environmental liability, even if title is held for a short period.(23) The taxpayer must also be concerned that the intermediary's financial distress may expose parked property to claims of the intermediary's creditors. This concern was brought to the attention of many exchange advisers after In re Exchanged Titles,(24) in which an intermediary's bankruptcy trustee attempted to include parked relinquished property as an asset of the intermediary's bankruptcy estate; a bankruptcy court ultimately held that the taxpayer's equitable claim to the relinquished property could not be defeated by the trustee.
Nonetheless, it may be advisable for title to the parked property to be held in a single-purpose entity, such as a single-member limited liability company (SMLLC) established by the intermediary for the sole purpose of holding such tide. An SMLLC would not create any separate tax filings, because it would be disregarded under the Sec. 7701 regulations, but it could protect the intermediary's assets from environmental claims and shield the parked property from claims of the intermediary's bankruptcy creditors.
A reverse-exchange intermediary typically has no interest in managing the parked property and the taxpayer would generally want to use that property. Thus, it is necessary to provide for the management and use of the parked property to satisfy the needs of both the taxpayer and the intermediary. This may best be done through a lease of the parked property to the taxpayer, with all costs borne by the taxpayer-tenant and rent payments sufficient to cover the intermediary's obligations to pay interest on the acquisition loan and earn a reasonable return. The intermediary must report rent income and expenses, but will probably be denied a depreciation deduction because the' parked property is held for sale, not for investment or trade or business use.(25) The intermediary and the taxpayer may also enter into a management agreement for the parked property. Either a lease or a management agreement raises the issue of the intermediary as the taxpayer's agent.
The party parking title in a reverse exchange must also have an exit strategy for such property in case there is an extended delay in the sale of the relinquished property. Parking the replacement property may create a greater incentive for a taxpayer to sell the relinquished property and close the exchange. The accommodator who has borrowed on a nonrecourse basis to acquire parked replacement property may set a maturity date for the loan that ensures his involvement will end at a fixed date (either through completion of the exchange when the relinquished property is sold or through conveyance of the replacement property in foreclosure of the note). If relinquished property is parked, the accommodator could again close the transaction by foreclosure or could create an economic incentive for the taxpayer to close the transaction; he can demand that the taxpayer lease the property with rent payments escalating after the intermediary's desired closing date for involvement in the exchange.
Pre-Safe-Harbor Tax Issues
The tax risks associated with the parking arrangements described above arise because the relationship between the accommodator and the taxpayer may be that of a principal and agent, or the taxpayer may be deemed to own the property under general tax principles. Under either theory, the accommodator's putative ownership could be disregarded, with the taxpayer viewed as first purchasing the replacement property from the seller and later selling the relinquished property to the buyer. Such a characterization would cast the transaction as similar to the no-exchange cases of Lee, Bezdjian and Dibsy. The IRS's concern (which was the problem in TAM 200039005) is most likely to arise when (1) there is a written agreement setting forth the accommodator s role as the taxpayer s agent and (2) the accommodator functions as an agent as to the parked asset and is held out as the taxpayer's agent :in dealings with third parties.(26) To minimize the risk of IRS attack, the parking arrangements described above were not typically accompanied by a written agreement between the taxpayer and the accommodator referring to the latter as an agent.
Assuming the accommodator is not the taxpayer's agent, exchange treatment will depend on his being treated as the tax owner of the parked property. The tax law generally determines ownership based on who enjoys the benefits and bears the burdens, which requires a facts-and-circumstances analysis. The Tax Court, in Grodt and McKay Realty, Inc.,(27) identified eight factors in determining ownership: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity in the property was acquired; (4) whether the seller must execute a deed and the buyer make payments; (5) whether the purchaser has the right to possession; (6) which party pays property taxes; (7) which party bears risk of loss for property damage; and (8) which party receives the profits from operation and sale of the property. The court later included whether, and the extent to which, the purchaser has control over the property(28) and whether the transaction involved arm's-length dealing.(29) Passage of legal title is normally viewed as the most important factor,(30) although the failure to observe simple formalities normally associated with ownership (such as obtaining title and hazard insurance in the accommodator's name) may raise questions as to legal ownership. Because parking arrangements have been structured so that most or all of the benefits and burdens of ownership lie with the taxpayer, the ownership issue has been particularly troublesome for tax advisers.
Rev. Proc. 2000-37 favorably resolves the key issues described above, as well as allowing some flexibility in dealings between the taxpayer and the accommodator. If the procedure's requirements are met, the IRS will not challenge the qualification of parked property as either relinquished property or replacement property for Sec. 1031 purposes, nor will it challenge an "exchange accommodation titleholder" (EAT) (discussed below) as the beneficial owner of parked property for all Federal income tax purposes.(31) The final deferred-exchange regulations, issued on April 25, 1991, created the QI job title and expanded the required paperwork to complete most Sec. 1031 exchanges to include an exchange agreement between the intermediary and the taxpayer, a qualified escrow agreement between the taxpayer and the party holding any exchange balance, and, when direct deeding is used, assignment of contract rights and notification of those assignments.
Rev. Proc. 2000-37 further expands the employment base by creating the EAT designation and adding paperwork for a "qualified exchange accommodation arrangement" (QEAA) between the taxpayer and the EAT. The EAT's role is basically that of the title holder (accommodator) in the pre-safe-harbor arrangements described earlier. To qualify under Rev. Proc. 2000-37, the EAT must have "qualified indicia of ownership" (QIO) in the parked property. Also, the parking arrangement must be documented and completed within specified time periods; the safe harbor clarifies that certain arrangements between: the EAT and the taxpayer will not deny Sec. 1031 treatment to the exchange.
Rev. Proc. 2000-37 applies to QEAAs when an EAT acquires QIO on or after Sept. 15, 2000. It states that taxpayers should draw no inferences about the proper treatment of any pre-Sept. 15, 2000 arrangements, even if. similar to those described in the procedure, or to any post-Sept. 14, 2000 arrangements that do not comply with the safe-harbor requirements. It also makes clear that it is not the sole means of qualifying a reverse exchange for Sec. 1031 benefits.(32) As suggested by the ABA proposals, the IRS likely chose a procedure as the form of guidance, because there was no statutory authority on reverse exchanges that would support regulations. By issuing a procedure, the IRS is not necessarily saying that the safe-harbor transactions qualify as Sec. 1031 exchanges as a substantive matter, only that it will not challenge them. This may suggest that taxpayers should be especially wary of proceeding outside Rev. Proc. 2000-37.
To satisfy the procedure, property must be held in a QEAA, as follows:(33)
1. An EAT acquires QIO in the parked property (i.e., a party other than the taxpayer or a disqualified person under Regs. Sec. 1.1031 (k)-1(k)). The EAT must be either a person subject to Federal income tax or, if a partnership or S corporation, more than 90% of its ownership interests must be held by persons subject to Federal income tax. QIO means legal title to the property, beneficial ownership under applicable commercial law or ownership of an interest in a disregarded entity (such as an SMLLC) that holds QIO.
2. When QIO is transferred to the EAT, the taxpayer has a bona fide intent that the parked property represent either replacement property or relinquished property in a Sec. 1031 exchange.
3. Within five business days of the transfer of QIO in the replacement property, the taxpayer enters into a written agreement (i.e., QEAA) with the EAT providing that the latter holds beneficial ownership for the taxpayer to facilitate a Sec. 1031 exchange under the procedure. Further, the taxpayer and the EAT will agree to report the Federal income tax consequences of acquiring, holding and disposing of the property consistent with the procedure. The QEAA is a new document in the exchange accommodator's arsenal.
4. Within 45 days of the transfer of QIO in the replacement property to the EAT, the relinquished property is identified consistent with Regs. Sec. 1.1031(k)-1(c)(4) (i.e., in a writing signed by the taxpayer); alternative and multiple identifications are permitted. Presumably, this identification should be delivered to the EAT, who functions in a manner similar to a QI in a forward deferred exchange. Because the 45-day period is drawn from the deferred-exchange regulations, it should not be extended by weekends or holidays; the date of transfer of the QIO should be day zero when counting the 45 days. In contrast, the five-day period for the QEAA specifies use of business days (no similar period exists for deferred exchanges).
5. Within 180 days of the transfer of QIO to the EAT, the parked property must either be transferred to the taxpayer as replacement property or to a person other than the taxpayer as relinquished property. The replacement and relinquished properties cannot be held in the QEAA for more than 180 days combined. Because the 180-day period is drawn from the deferred-exchange regulations, it should not be extended by weekends or holidays; the date of transfer of QIO should be day zero when counting the 180 days. In contrast to the deferred-exchange regulations, the 180-day period is not curtailed by the due date (including extensions) of the taxpayer's return for the year of the exchange. Depending on when the QIO are transferred to the EAT, the allowed period may be longer or shorter than that applicable to a forward deferred exchange, which may be shorter than 180 days if the taxpayer's return due date is not extended. This time requirement is likely to be the most troublesome for exchange advisers, because many reverse exchanges do not close within 180 days. The ABA proposals suggested a two-year period, with the ability to request two additional one-year extensions from the IRS.(34)
Example 4: The facts are the same as in Example 1, except that the closing on the replacement property occurred on Wed., Sept. 27, 2000, before T could sell his relinquished property. Because the transaction was to occur after the safe-harbor effective date, T engaged A to serve as an EAT and to purchase the building using the proceeds of a $2 million nonrecourse loan from T. T signed a QEAA with A by Wed., Oct. 4, 2000, five business days after QIO were transferred to A. On or before Sat., Nov. 11, 2000, 45 days after transfer of QIO, T identified the property to be relinquished in the exchange. T must then complete the transaction by Mon., March 26, 2001, 180 days after the transfer of QIO. If T cannot sell his designated relinquished property by that date, the safe harbor no longer applies. However, T may still qualify the transaction under Sec. 1031, using pre-safe-harbor judicial interpretations. T cannot extend the 180-day period by using a direct exchange of the parked replacement property for the relinquished property on March 26, 2001 (with the EAT parking the relinquished property until it can be sold), because the maximum combined time that relinquished and replacement properties may be parked with the EAT is 180 days.
If Rev. Proc. 2000-37's requirements are met, the EAT will be treated as the. beneficial owner of the parked property, removing the pre-safe-harbor risk that the titleholder would be treated as the taxpayer's agent or the tax owner of the replacement property, when no benefits and burdens of ownership had passed. The transactional risks of parking arrangements identified earlier in this article are addressed in Rev. Proc. 2000-37, Section 4.03, which respects the status of a QEAA even if the EAT has entered into certain arrangements with the taxpayer or a disqualified person. Permitted arrangements include:
1. The EAT may serve as a QI in a deferred exchange.
2. The taxpayer or a disqualified person may guarantee any debt used to acquire the parked property or may indemnify the EAT against risk of loss associated with incurring such debt.
3. The taxpayer or a disqualified person may loan or advance funds to the EAT to acquire parked property.
4. The EAT may lease parked property to the taxpayer or a disqualified person.
5. The taxpayer or a disqualified person may manage the parked property, supervise or act as a contractor for improvements to the property or otherwise provide services as to the property.
6. The EAT and the taxpayer may enter into arrangements, not to exceed 185 days from transfer of QIO, for the purchase or sale of parked property, including puts and calls at fixed or formula prices.
7. The EAT and the taxpayer may enter into an agreement for settling up of any difference in value of the relinquished property between the time of transfer of QIO and a sale of the relinquished property.
Tax advisers commonly encounter reverse-exchange fact patterns and, for many years, have been forced to give advice with little or no formal guidance from tax authorities. The lack of guidance has led taxpayers to adopt costly title-parking arrangements that purport to create a multiparty simultaneous exchange governed by Sec. 1031(a)(1) . In response to practitioner concerns about the efficacy of parking arrangements, the IRS created a safe harbor for post-Sept. 14, 2000 transactions. Tax advisers (including those who may not have received what they wished for in Rev. Proc. 2000-37) should find the safe harbor welcome relief from the uncertainty surrounding pre-safe-harbor exchanges. Nonetheless, because the safe harbor may differ from pre-Sept. 15, 2000 arrangements, and because some post-Sept. 14, 2000 arrangements may fail to satisfy it, cases and other authorities dealing with reverse exchanges will continue to be relevant to tax advisers.
(1) T.J. Starker, 602 F2d 1341 (9th Cir. 1979).
(2) Regs. Sec. 1.1031(k)-1, promulgated by TD 8346 (4/25/91).
(3) See the preamble to TD 8346, note 2 supra; see also Regs. Sec. 1.1031(k)-1(a).
(4) See "Report on the Application of Sec. 1031 to Reverse Exchanges," 21 Journal of Real Est. Tax'n 44 (Fall 1993).
(5) See "PricewaterhouseCoopers Forwards Proposed Guidance on Reverse Exchanges," 2000 TNT 16-27 (1/25/00), and "ABA Tax Section Members Push for Guidance on Reverse Like-Kind Exchanges," 2000 TNT 145-22 (7/27/00)(hereinafter, "ABA Proposals").
(6) Rev. Proc. 2000-37, IRB 2000-40, 1.
(7) Bennie D. Rutherford, TC Memo 1978-505.
(8) Franklin B. Biggs, 69 TC 905 (1978), aff'd, 632 F2d 1171 (5th Cir. 1980).
(9) Direct deeding with assignment of contract rights is the typical form of a deferred multiparty exchange involving a qualified intermediary. Biggs, id., pre-dated the current deferred-exchange rules, which recognize assignments and direct deeding as valid steps in an exchange.
(10) IRS Letter Ruling 9814019 (12/23/97); see also IRS Letter Ruling 9823045 (3/10/98).
(11) See comments attributed to Kelly Alton, IRS Special Counsel to the Assistant Chief Counsel (Income Tax and Accounting) in Tax Notes Today (5/19/98).
(12) Edward C. Lee, TC Memo 1986-294.
(13) Garbis S. Bezdjian, TC Memo 1987-140, aff'd, 845 F2d 217 (9th Cir. 1988).
(14) Julius Dibsy, TC Memo 1995-477.
(15) Earlene T. Barker, 74 TC 555, 563-564 (1980).
(16) IRS Letter Ruling (TAM) 200039005 (5/31/00).
(17) See Jesse C. Bollinger, Jr., 485 US 340, 359-360 (1988), for factors that evidence an agency relationship. If the tide holder is held out to third parties as an agent, the risk of an agency relationship increases. The statements in TAM 200039005, note 16 supra, that the taxpayer closed on the purchase and then directed that title be placed in the accommodator's name may have been an important indicator of an agency relationship.
(18) See comments attributed to Kelly Alton, Senior Technical Reviewer, IRS Office of Associate Chief Counsel, and James Sowell, Treasury Associate Tax Legislative Counsel, 2000 TNT 200-5 (10/16/00).
(19) Donald DeCleene, 115 TC No. 34 (2000).
(20) See Regs. Sec. 1.1031(k)-1(g)(4) for the definition of a QI.
(21) See Kev. Proc. 2000-37, note 6 supra, Section 4.02(1).
(22) See Dukes, III, "Direct Deeding May Avoid Intermediary's Environmental Exposure in Like-Kind Exchange," 79 J. Tax'n 210 (October 1993).
(23) See cases and articles cited by Dukes, id., at n. 5.
(24) In re Exchanged Titles, 159 Bankr. 303 (CD CA, 1993).
(25) See Sec. 167(a). If relinquished property is parked, the taxpayer should no longer claim depreciation deductions, to avoid reporting inconsistently with the form of the exchange transaction. Section 3.03 of Rev. Proc. 2000-37, note 6 supra, states that the intermediary may be denied depreciation on parked property, although resolution of that issue is beyond the scope of the procedure.
(26) See Bollinger, note 17 supra.
(27) Grodt and McKay Realty, Inc., 77 TC 1221 (1981).
(28) See Marion O. Houchins, 79 TC 570, 591 (1982).
(29) See Michael S. Falsetti, 85 TC 332, 348 (1985).
(30) See James T. Ryan, TC Memo 1995-579, citing E. F. Baertschi, 412 F2d 494, 498 (6th Cir. 1969).
(31) See Rev. Proc. 2000-37, note 6 supra, at Section 1.
(32) Id. at Sections 3.02 and 3.04.
(33) Id. at Section 4.02.
(34) See ABA Proposals, note 5 supra.
For more information about this article, contact Dr. Hamill at (505) 277-8890 or firstname.lastname@example.org.
James R. Hamill, Ph.D., CPA KPMG Professor of Accounting Anderson Schools of Management University of New Mexico Albuquerque, NM
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|Title Annotation:||IRS procedure|
|Author:||Hamill, James R.|
|Publication:||The Tax Adviser|
|Date:||Mar 1, 2001|
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