Structuring Like-Kind Exchange Transactions Outside of Revenue Procedure’s 2000-37 Safe-Harbor
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On August 10, 2016, in the case of Estate of George H. Bartell Jr. et al. v. Commissioner
, 147 T.C. No. 5, the Tax Court approved a reverse section 1031 exchange where the safe harbor tests under Revenue Procedure 2000-37 (“Rev. Proc. 2000-37”) were not met. The case and the court’s reasoning may support alternatives for structuring reverse exchanges that, for whatever reason, cannot meet the safe harbor.
The exchange of property for other “like-kind” property may be nontaxable under section 1031. In the majority of like-kind exchanges, the relinquishment of property is generally not simultaneous with the acquisition of replacement property. These non-simultaneous exchanges are referred to as “deferred exchanges.” Where replacement property is acquired before relinquished property is transferred, it is referred to as a “reverse exchange.” Rev. Proc. 2000-37 was issued on September 18, 2000, to provide guidance and a safe harbor for reverse exchanges. The applicability of section 1031 to reverse exchanges outside of the safe harbor is often unclear.
In its opinion in Bartell v. Commissioner
, the court stated that “where a section 1031 exchange is contemplated from the outset and a third-party exchange facilitator, rather than the taxpayer, takes title to the replacement property before the exchange, the exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for section 1031 purposes before the exchange.”
Further, the court noted that “caselaw provides no specific limit on the period in which a third-party facilitator may hold title to the replacement property before the titles to the relinquished and replacement properties are transferred in a reverse exchange.”
The Rev. Proc. 2000-37 Safe-Harbor
IRC Section 1031 allows non-recognition of gain only to the extent that replacement property is “like-kind” to relinquished property. If all or part of the replacement property is not of a like-kind, gain will be recognized to the extent of that portion of consideration which is not of like-kind. Therefore, in order to fully defer the gain realized on the disposition of relinquished property, the taxpayer must acquire like-kind replacement property of equal or greater value to complete the exchange.
Improvements constructed on real property already owned by a taxpayer are not like-kind to other property and do not qualify as like-kind to relinquished property transferred by the taxpayer. Therefore, if a taxpayer uses proceeds from the sale of relinquished property for the construction of improvements on land already owned by the taxpayer, the amount used would be considered to be boot creating recognized gain, even if a qualified intermediary is used.
In order to complete these so-called “build-to-suit” exchanges, it is necessary to ensure that the taxpayer isn’t the owner of the replacement property until construction is complete. Rev. Proc. 2000-37 provides a safe harbor that allows a taxpayer to treat an accommodation party as the owner of the property for federal income tax purposes, thereby enabling the taxpayer to accomplish a qualifying like-kind exchange where proceeds from the sale of relinquished property will be used to fund construction of replacement property.
If the requirements of Rev. Proc. 2000-37 are satisfied, a taxpayer may complete a reverse section 1031 exchange regardless of whether the taxpayer has the various benefits and burdens of ownership with respect to the replacement property during construction and would otherwise be treated as the owner for federal tax purposes. Under the Revenue Procedure, a party that holds bare legal title to the property (referred to as an “exchange accommodation titleholder” or “EAT”) will be treated as the owner of the property for federal income tax purposes.1
Given the nature of a build-to-suit exchange transaction, it is often difficult to meet the 180-day time limit established in Rev. Proc. 2000-37. The Revenue Procedure, however, specifically provides that “the Service recognizes that ‘parking’ transactions can be accomplished outside of the safe harbor provided in this revenue procedure.” Unfortunately, the IRS has provided no guidance describing when such a non-safe harbor transaction could still qualify as a section 1031 like-kind exchange. Based on the Tax Court’s opinion in Bartell, taxpayers may be able to successfully complete a built-to-suit like-kind exchange transaction where the EAT holds bare title for a period exceeding 180 days.2
Estate of George H. Bartell Jr. Et Al. V. Commissioner
In this case, Bartell Drug entered into an agreement to purchase property in Lynnwood, WA, in 1999 and made periodic earnest money payments under the agreement. The sale agreement contained a clause stating that both the buyer and seller agreed to reasonably cooperate with each other to accomplish an exchange under section 1031. Bartell Drug ordered a commitment for title insurance, did due diligence on the property, applied for a building permit for the site and ordered a traffic study from a traffic engineering firm.
Bartell Drug engaged a facilitator for section 1031 exchanges, agreeing that EPC Two, a single member LLC formed for the exclusive purpose of providing services to Bartell Drug, would take title to the Lynnwood property in order to effect the section 1031 exchange. EPC Two obtained the title to the land as well as a title insurance policy. A loan was obtained in order to fund the acquisition of the Lynnwood land as well as the construction of a new drug store on the property. The loan was made to EPC Two, but was nonrecourse to the entity and was guaranteed by Bartell Drug. The commitment letter from the bank stated the purpose of the loan as “to finance the acquisition of land and construction of a new store in Lynnwood, WA under the benefits of 1031 tax-free exchange.”
Bartell Drug and EPC Two entered into an agreement where EPC Two was to construct a drug store on the Lynnwood property. Bartell Drug indemnified EPC Two for liabilities with respect to the project. After the bank loan proceeds were exhausted, the Bartell Drug funded the construction of the project. The agreement allowed Bartell Drug to manage the construction of the project and to lease the property once the construction was complete.
In December 2001, Bartell Drug executed an exchange agreement for the exchange of relinquished property for the Lynnwood Drug Store using a qualified intermediary in a transaction intended to qualify for tax deferred treatment under section 1031. Because the length of time the property was held by EPC Two was greater than 180 days, the safe harbor rules under Rev. Proc. 2000-37 would not have applied even if Rev. Proc. 2000-37 had been effective prior to the initiation of the like-kind exchange.
The central issue between the taxpayer and the IRS in this case is whether Bartell Drug or EPC Two should be considered the owner of the Lynnwood property for Federal income tax purposes prior to EPC Two’s exchange of the Lynnwood Drug Store to the taxpayer. If it were to be ruled that Bartell Drug was the owner of the Lynnwood property prior to the exchange, then the taxpayer would have been engaged in a nonreciprocal exchange with himself.3
The IRS stated that under the benefits and burdens test, Bartell Drug already owned the Lynnwood property before December 2001, thereby precluding any exchange as of that date. The petitioners contended that EPC Two must be treated as the owner and that the agency analysis should be employed consistent with previously permitted like-kind exchanges. They point out that both the Tax Court and the Court of Appeals for the Ninth Circuit, to which an appeal in this case would ordinarily lie, have expressly rejected the proposition that a person who takes title to the replacement property for the purpose of effecting a section 1031 exchange must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement. Previous caselaw has permitted taxpayers to exercise any number of indicia of ownership and control over the replacement property before it is transferred to them, without jeopardizing section 1031 exchange treatment.
The Tax Court acknowledged that courts have historically exhibited a lenient attitude toward taxpayers’ attempts to come within the terms of section 1031, citing several relevant cases. The Court went on to state that it would put considerable emphasis on a taxpayer’s use of a third-party exchange facilitator rather than the benefits and burdens test. Citing previous caselaw (Biggs v. Commissioner,
632 F.2d at 1173; Alderson v. Commissioner
, 317 F.2d at 791), the Tax Court stated that it has been established that where a section 1031 exchange is contemplated from the outset and a third-party exchange facilitator, rather than the taxpayer takes title to the replacement property before the exchange, the exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for section 1031 purposes before the exchange. The Tax Court concluded that the transaction qualified for section 1031 treatment under existing case law principles and that Bartell Drug’s disposition of the relinquished property and acquisition of the Lynnwood property in 2001 qualifies for non-recognition treatment pursuant to section 1031.
- Reverse exchange transactions offer taxpayers advantageous tax deferrals when structured correctly, particularly where the taxpayer wants to build or modify the replacement property. The findings in the Bartell case may allow taxpayers to take advantage of these tax deferrals even when they do not fall within the safe harbor limits of Rev. Proc. 2000-37.
- While meeting the requirements of the revenue procedure ensure that the transaction will avoid IRS challenge, the Tax Court’s decision opens up the possibility that if an exchange facilitator who takes bare legal title of the replacement property is properly utilized, the taxpayer can manage the construction of replacement property, guaranty acquisition and construction loans, lend funds to facilitate completion of the project and make other necessary arrangements and still successfully complete a reverse like-kind exchange even without meeting the safe harbor requirements.
- It is worth noting, however, that the Tax Court specifically stated that “we express no opinion with respect to the applicability of section 1031 to a reverse exchange transaction that extends beyond the period at issue in these cases. In view of the finite periods in which the exchange facilitator in these case could have held, and in fact did hold, title to the replacement property, we are satisfied that the transaction qualifies for section 1031 treatment under existing caselaw principles.” In light of this commentary, caution is warranted in structuring non-safe harbor exchange transactions that go beyond the facts of Bartell and the authorities described therein.
- An attorney from the IRS Office of Associate Chief Counsel (Income Tax and Accounting) recently stated that the IRS considering appealing the Bartell decision to the Ninth Circuit. The IRS is considering the best strategy for supporting its legal analysis, which may or may not ultimately include an appeal. Regardless of its decision regarding an appeal, it appears the IRS is unlikely to give up on its position.
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1 Under Rev. Proc. 2000-37, the IRS will not challenge the qualification of property as either “replacement property” or “relinquished property” (as defined in section 1.1031(k)-1(a)) for purposes of section 1031 and the regulations thereunder, or the treatment of the exchange accommodation titleholder as the beneficial owner of such property for federal income tax purposes, if the property is held in a qualified exchange accommodation arrangement (“QEAA”). Property is held in a QEAA if all of the following requirements are met:
Further, property will not fail to be treated as being held in a QEAA as a result of any one or more of the following legal or contractual arrangements, regardless of whether such arrangements contain terms that typically would result from arm's length bargaining between unrelated parties with respect to such arrangements:
- Qualified indicia of ownership of the property is held by an exchange accommodation titleholder. Such qualified indicia of ownership must be held by the exchange accommodation titleholder at all times from the date of acquisition by the exchange accommodation titleholder until the property is transferred. Qualified indicia of ownership means legal title to the property, other indicia of ownership of the property that are treated as beneficial ownership of the property under applicable principles of commercial law (e.g., a contract for deed), or interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes (e.g., a single member limited liability company) and that holds either legal title to the property or such other indicia of ownership;
- At the time the qualified indicia of ownership of the property is transferred to the exchange accommodation titleholder, it is the taxpayer's bona fide intent that the property held by the exchange accommodation titleholder represent either replacement property or relinquished property in an exchange that is intended to qualify for non-recognition of gain (in whole or in part) or loss under section 1031;
- No later than five business days after the transfer of qualified indicia of ownership of the property to the exchange accommodation titleholder, the taxpayer and the exchange accommodation titleholder enter into a written agreement (the “qualified exchange accommodation agreement”) that provides that the exchange accommodation titleholder is holding the property for the benefit of the taxpayer in order to facilitate an exchange under section 1031 and this revenue procedure and that the taxpayer and the exchange accommodation titleholder agree to report the acquisition, holding, and disposition of the property as provided in this revenue procedure. The agreement must specify that the exchange accommodation titleholder will be treated as the beneficial owner of the property for all federal income tax purposes. Both parties must report the federal income tax attributes of the property on their federal income tax returns in a manner consistent with this agreement;
- No later than 45 days after the transfer of qualified indicia of ownership of the replacement property to the exchange accommodation titleholder, the relinquished property is properly identified. Identification must be made in a manner consistent with the principles described in section 1.1031(k)-1(c). For purposes of this section, the taxpayer may properly identify alternative and multiple properties, as described in section 1.1031(k)-1(c)(4);
- No later than 180 days after the transfer of qualified indicia of ownership of the property to the exchange accommodation titleholder, (a) the property is transferred (either directly or indirectly through a qualified intermediary (as defined in section 1.1031(k)-1(g)(4))) to the taxpayer as replacement property; or (b) the property is transferred to a person who is not the taxpayer or a disqualified person as relinquished property; and
- The combined time period that the relinquished property and the replacement property are held in a QEAA does not exceed 180 days.
- An exchange accommodation titleholder that satisfies the requirements of the qualified intermediary safe harbor set forth in section 1.1031(k)-1(g)(4) may enter into an exchange agreement with the taxpayer to serve as the qualified intermediary in a simultaneous or deferred exchange of the property under section 1031;
- The taxpayer or a disqualified person guarantees some or all of the obligations of the exchange accommodation titleholder, including secured or unsecured debt incurred to acquire the property, or indemnifies the exchange accommodation titleholder against costs and expenses;
- The taxpayer or a disqualified person loans or advances funds to the exchange accommodation titleholder or guarantees a loan or advance to the exchange accommodation titleholder;
- The property is leased by the exchange accommodation titleholder to the taxpayer or a disqualified person;
- The taxpayer or a disqualified person manages the property, supervises improvement of the property, acts as a contractor, or otherwise provides services to the exchange accommodation titleholder with respect to the property;
- The taxpayer and the exchange accommodation titleholder enter into agreements or arrangements relating to the purchase or sale of the property, including puts and calls at fixed or formula prices, effective for a period not in excess of 185 days from the date the property is acquired by the exchange accommodation titleholder; and
- The taxpayer and the exchange accommodation titleholder enter into agreements or arrangements providing that any variation in the value of a relinquished property from the estimated value on the date of the exchange accommodation titleholder's receipt of the property be taken into account upon the exchange accommodation titleholder's disposition of the relinquished property through the taxpayer's advance of funds to, or receipt of funds from, the exchange accommodation titleholder.
2 Note that Rev. Proc. 2000-37 was inapplicable to the Bartell case since the exchange was initiated prior to the issuance of the revenue procedure. It is unknown as to whether the applicability of the Rev. Proc. 2000-37 would have affected the court’s opinion.
3 “A taxpayer cannot engage in an exchange with himself; an exchange ordinarily requires a ‘reciprocal transfer of property, as distinguished from a transfer of property for money consideration.’” DeCleene v. Commissioner, 115 T.C. 457, 469.