IRS Sec. 1031 Reverse Exchanges - State of Grace in a Sea of Confusion?
Chris Burti, Vice President and Legal Counsel

On September 15, 2000 the Internal Revenue Service released Revenue Procedure 2000-37, providing safe harbor guidelines for treatment of reverse exchanges under Section 1031 of the Internal Revenue Code. Since then, there has been increasing interest on the part of taxpayers and attorneys in exploring the possibilities of this potential benefit. There are, however, serious questions concerning how transactions that do not fall within the safe harbor guidelines will be treated. This is due to the wording of the Revenue Procedure and interpretations by the office of the Chief Counsel of the IRS on reverse exchanges occurring prior to the adoption of the procedure. In order to explore some of these issues, it will likely be beneficial to discuss them in the context of a general discussion of standard and reverse exchanges.

Section 1031 of the Internal Revenue Code provides that no gain or loss is recognized on the exchange of property held for investment, or for productive use in a trade or business, if it is exchanged solely for property of like-kind that is to be held for a productive business use or for investment. We are often asked, "Can the taxpayer purchase the seller's property before the buyer transfers his or her property to the exchanger?" Generally, no, as this results in a purchase with a subsequent taxable sale, and the evidence is the title transfer [Smith v. Comm., 537 F2d 972 (8th Cir. 1976); §1.1031(k)-1(a)]. Before the adoption of the new procedure, like-kind exchange rules generally were deemed not applicable to an exchange in which the taxpayer acquired replacement property before transferring the relinquished property. (See Lincoln v. Commissioner, T.C. Memo. 1998-421) As a result, taxpayers have entered into various "parking" arrangements where title to the replacement property is taken by a qualified intermediary until the sale of the relinquished property. Alternatively, title to the relinquished property is sometimes transferred to the qualified intermediary, to be parked until final sale, and title to the replacement property is then conveyed to the taxpayer directly. Without guidance from regulations, there has been concern as to whether these parking arrangements might be disqualified due to the beneficial ownership of the parked property being imputed to the taxpayer at the time of acquisition. Reverse exchanges have been upheld by the courts. (See Rutherford v. Commissioner, T.C. Memo 1978-505) As a general rule, the party that bears the economic burdens and benefits of ownership will be considered the owner of property for federal income tax purposes. This new revenue procedure addresses this issue and provides guidelines, which if followed, will provide a safe harbor for taxpayers.

The revenue procedure provides new terminology for Section 1031 transactions. An "exchange accommodation titleholder" (EAT), discussed later, is the party holding qualified indicia of ownership (title) to the parked property. The EAT is treated as the beneficial owner of the property for federal income tax purposes. A reverse exchange is now referred to as a "qualified exchange accommodation arrangement" (QEAA), and is defined by compliance with the requirements of Section 4 of the procedure. If the taxpayer uses a qualified exchange accommodation arrangement (QEAA), the transfer may now qualify as a like-kind exchange.

Under a QEAA, either the replacement property or the relinquished property is transferred to the EAT. If the property is held in a QEAA, the IRS will accept the designation of property as either replacement property or relinquished property, and the treatment of an EAT as the beneficial owner of the property for federal income tax purposes. The rules discussed here apply to QEAA’s entered into with an EAT who acquires title to property after September 14, 2000.

Property is held in a QEAA only if all the following requirements are met.

1. There is a written agreement.
2. The time limits for identifying and transferring the property are met.
3. The title to the property is transferred to an EAT.

Under a QEAA, the taxpayer and the EAT must enter into a written agreement no later than five (5) business days after the title is transferred to the EAT. This will normally occur prior to the transfer, but the rule does provide this grace period for last second transactions. The agreement must provide all the following.

1. The EAT holds the property for the taxpayer’s benefit in order to facilitate an exchange under the like-kind exchange rules and Revenue Procedure 2000-37.
2. The taxpayer and the EAT agree to report the acquisition, holding, and disposition of the property on their federal income tax returns in a manner consistent with the agreement.
3. The EAT will be treated as the beneficial owner of the property for all federal income tax purposes.

Property can be treated as being held in a QEAA even if the accounting, regulatory, state, local, or foreign tax treatment of the arrangement between the taxpayer and the EAT is different from the treatment required by the procedure. The taxpayer must have a bona fide intent that the property held by the EAT represents either replacement property or relinquished property in an exchange that is intended to qualify for favorable tax treatment under the like-kind exchange rules.

There are two crucial time limits for identifying and transferring the property under a QEAA.

1. No later than 45 days after the transfer of title to the exchange property to the EAT, the taxpayer must identify the reciprocal exchange property in writing.
2. One of the following transfers must take place no later than 180 days after the transfer of qualified indicia of ownership of the property to the EAT.
   1. The replacement property is transferred to the taxpayer (either directly or indirectly through a qualified intermediary).
   2. The relinquished property is transferred to a person other than the taxpayer or a disqualified person. A disqualified person is either of the following:
      1. The taxpayer’s agent at the time of the transaction. (This includes a person who has been the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period before or after the transfer of the relinquished property.)
      2. A person who is related to the taxpayer or the taxpayer’s agent.
3. The combined time period the relinquished property or the replacement property is held in the QEAA cannot be longer than 180 days.

The EAT must meet all the following requirements.

1. Hold title at all times from the date of acquisition of the property until the property is transferred (as described above).
2. Be someone other than the taxpayer or a disqualified person (as defined above).
3. Be subject to federal income tax. If the EAT is treated as a partnership or S corporation, more than 90% of its interests or stock must be owned by partners or shareholders who are subject to federal income tax.

Qualified indicia of ownership are any of the following:

1. Legal title to the property.
2. Any interests that are treated as beneficial ownership of property under principles of law, such as contract for deed.
3. Interests in an entity that is not treated as an entity separate from its owner for federal income tax purposes. (For example, a single member limited liability company that holds either legal title to the property or other qualified indicia of ownership.)

Property will not fail to be treated as being held in a QEAA as a result of certain legal or contractual arrangements. This applies regardless of whether the arrangements contain terms that typically would result from arm's-length bargaining between unrelated parties for those arrangements. Examples of arrangements as set out in the Revenue Procedure are as follows:

(1) 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.
(2) The taxpayer or a disqualified person loans or advances funds to the EAT or guarantees a loan or advance to the EAT.
(3) The property is leased by the EAT to the taxpayer, or to a disqualified person.
(4) The taxpayer or a disqualified person manages the property, supervises improvement of the property, acts as a contractor, or otherwise provides services to the EAT with respect to the property.
(5) Agreements 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 EAT, and
(6) Agreements providing that any variation in the value of a relinquished property from the estimated value on the date the EAT receives the property will be taken into account upon disposition of the relinquished property. This is accomplished through the taxpayer’s advance of funds to, or receipt of funds from, the EAT.
(A "put" is an option that entitles the holder to sell property at a specified price at any time before a specified future date. A short sale involves property the taxpayer generally does not own. The taxpayer borrows the property to deliver to a buyer. At a later date, the taxpayer buys substantially identical property and delivers it to the lender)

This is a significant departure from the apparent position of the Service as reflected in IRS National Office Technical Advice Memorandum TAM-111776-98 dated May 31, 2000 and released September 29, 2000. This determination was issued before the new procedure was published, but released afterward. Transactions begun before the September 15, 2000 effective date do not enjoy automatic protection by the procedure, even if they comply. The procedure specifically states that no "inference is intended with respect to the federal income tax treatment of arrangements similar to those described in this revenue procedure that were entered into prior to the effective date of this revenue procedure." Under Section 3, the IRS also takes the position of recognizing "that ‘parking’ transactions can be accomplished outside of the safe harbor provided in this revenue procedure. Accordingly, no inference is intended with respect to the federal income tax treatment of ‘parking’ transactions that do not satisfy the terms of the safe harbor provided in this revenue procedure, whether entered into prior to or after the effective date of this revenue procedure." Therefore, transactions that do not comply with the requirements of the procedure will not automatically fail to qualify, but must be analyzed on a case by case basis.

The facts in the inquiry seem to follow the standard cookbook reverse exchange. The taxpayer began working through a deferred like- kind exchange of its relinquished property for an accommodator’s replacement property. The intent was for the taxpayer to assign the contract of sale of relinquished property to the accommodator who would use the proceeds to acquire replacement property from a third part seller. The taxpayer would then have the accommodator transfer the replacement property to the taxpayer to complete the exchange. However, at the closing of the attempted sale the transaction fell through. Nevertheless, the replacement property seller demanded that closing on the acquisition of the replacement property be completed immediately. Therefore, prior to contracting a new sale of the relinquished property, the taxpayer closed on the purchase of the replacement property. The taxpayer had the property titled to the accommodator. The taxpayer negotiated the purchase, provided the funds, and was personally liable on the purchase money mortgage. The taxpayer ordered that replacement property be titled to the accommodator. There is no evidence that the accommodator would have been involved in the transaction but for the taxpayer.

This determination has been interpreted to require significant risk and opportunity levels for a qualified intermediary/accommodator in cases not falling within the safe harbor of the procedure, in order to avoid beneficial interest problems. The determinative issue stated in the opinion was one of intention and interdependency of the transactions. The Service determined that these crucial elements did not exist, and therefore the transaction was a purchase and sale. Reading between the lines, it can be inferred that the transaction failed because it was structured as a result of circumstances occurring after the original exchange plan was formulated. It should be noted, however, that the Service pointed out that "Taxpayer was personally liable on the purchase money mortgage while (A)ccommodator was not." A private letter ruling released by the IRS on March 16, 2001 contains a much more thorough analysis of the case law supporting reverse exchanges, and ultimately permits one to pass muster.

PLR-120486-00, dated December 8, 2000, involves a complex transaction and permits the taxpayer to structure a reverse exchange outside of the safe harbor of Rev. Proc. 2000-37. This exchange was structured prior to the effective date of the procedure. It is clearly not the result of a failed forward exchange. In most significant respects, it structured in conformity to the rules contained in Rev. Proc. 2000-37 other than preceding the effective date. It is significant that the Service here points out that "Accommodation Party acquired the Replacement Property (the Property) pursuant to a Property Acquisition Agreement … by and between Accommodation Party and Seller …. Accommodation Party funded its purchase of the Property and the related transaction costs by borrowing … from Bank and additional monies from Taxpayer pursuant to a full recourse line of credit, which provides for a loan to Accommodation Party … under certain terms and conditions. The bank loan (Bank Loan)… with Accommodation Party, as borrower, is secured by the Property and is also guaranteed by Taxpayer. Taxpayer’s guaranty of the Bank Loan is evidenced by a payment guaranty and Taxpayer’s environmental indemnification of Bank is evidenced by an indemnity agreement, … made by Taxpayer in favor of Bank. Accommodation Party has agreed to pay Taxpayer … a loan guaranty fee for Taxpayer’s agreement to execute and deliver the Bank Loan payment guaranty." The determination sets out a thoughtful and thorough analysis of agency doctrine under the case law. It ultimately finds all the factors needed to avoid constructive ownership, which the Service found lacking in TAM-111776-98. It is important to note that the accommodator had liability on the loan and risk in this transaction. It is, however permissible for the taxpayer to make or guarantee the loan. See Biggs v Comm., (69 TC 905 (1978), aff'd, 632 F2d 1171 (5th Cir. 1981).

Because it is permissible for the taxpayer to enter into agreements in a QEAA with the EAT regarding loans and guarantees, another potential trap for the unwary may arise from the requirement that all parties report the transaction on their tax returns. If the other party to a nontaxable exchange assumes or pays off any of the taxpayer’s liabilities, the taxpayer will be treated as if the taxpayer received cash in the amount of the liability. (See section 357(d) of the Internal Revenue Code). Example. The property the taxpayer gives up is subject to a $3,000 mortgage for which the taxpayer was personally liable. The other party in the exchange has agreed to pay off the mortgage. The gain realized is calculated as follows:

FMV of relinquished property is $24,000

FMV of replacement property =$20,000

Cash = 1,000

Mortgage treated as assumed by other party (payoff) = 3,000

Total received = $24,000

Minus:

Exchange expenses = (500)

Amount realized =$23,500

Minus: Adjusted basis of property the taxpayer transferred = (8,000)

Realized gain = $15,500

The realized gain is taxed only up to $3,500, the sum of the cash received ($1,000 - $500 exchange expenses) and the mortgage payoff ($3,000).

This recognition of gain can also occur where the loan on the replacement property is greater than the debt on the relinquished property plus the difference in value, even when there is no cash out to the taxpayer.

FMV of relinquished property is $24,000

FMV of replacement property =$40,000

Purchase Money Mortgage = (19,500)

Mortgage payoff treated as assumed by other party = 3,000

Total received =$23,500

Minus:

Exchange expenses = (500)

Amount realized =$23,000

Minus: Adjusted basis of property the taxpayer transferred = (8,000)

Realized gain =$15,000

The realized gain is taxed to $2,500, the sum of the cash constructively received ($3,000 mortgage payoff - $500 exchange expenses).

Under the like-kind exchange rules, the taxpayer must generally make a property-by-property comparison to figure the taxpayer’s recognized gain and the basis of the property the taxpayer received in the exchange. However, for exchanges of multiple properties, the taxpayers do not make a property-by-property comparison if they do either of the following:

1. Transfer and receive properties in two or more exchange groups.
2. Transfer or receive more than one property within a single exchange group.

In these situations, the taxpayer figures the taxpayer’s recognized gain and the basis of the property the taxpayer received by comparing the properties within each exchange group. Each exchange group consists of properties transferred and received in the exchange that are of like- kind or like classes. If property could be included in more than one exchange group, the taxpayer can include it in any one of those groups. However, the following may not be included in an exchange group:

1. Money
2. Stock in trade or other property held primarily for sale
3. Stocks, bonds, notes, or other securities or evidences of debt or interest
4. Interests in a partnership
5. Certificates of trust or beneficial interests
6. Chooses in action.

Special rules apply to like-kind exchanges between related persons. These rules affect both direct and indirect exchanges. Under these rules, if either person disposes of the property within 2 years after the exchange, the exchange is disqualified from nonrecognition treatment in the year of disposition. Under these rules, related persons include:

1. The taxpayer and a member of the taxpayer’s family (spouse, brother, sister, parent, child, etc.), the taxpayer and a corporation in which the taxpayer has more than 50% ownership,
2. The taxpayer and a partnership in which the taxpayer directly or indirectly owns more than a 50% interest of the capital or profits, and
3. Two partnerships in which the taxpayer directly or indirectly owns more than 50% of the capital interests or profits.

The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. If the holder's risk of loss on the property is substantially diminished during any period, that period is not counted as part of the 2-year holding period. The holder's risk of loss on the property is substantially diminished by any of the following events:

1. The holding of a "put" on the property
2. The holding by another person of a right to acquire the property
3. A short sale or other transaction.

The following kinds of property dispositions are excluded from these rules

1. Dispositions due to the death of either related person
2. Involuntary conversions
3. Dispositions, if it is established to the satisfaction of the IRS that neither the exchange nor the disposition had as a main purpose the avoidance of federal income tax

In conclusion, great care should be taken when operating outside of the safe harbor rules. Elements of a transaction that would be permissible under the procedure may cause a complete loss of tax deferral. Conversely, PLR-120486-00 seems to indicate that certain requirements of Rev. Proc. 2000-37 may be avoided. It will be some time before we know the full extent of the Service’s leniency in interpretation. We are readily available to help in addressing issues in reverse exchanges. Be sure to visit our Statewide Title Exchange Corp. Web Site: www.1031stec.com at your first opportunity.