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. 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. Because of the difficulty of finding and closing a direct exchange of property, most exchanges involve a deferred, three party, transaction. The typical transaction involves a sale of "relinquished property", escrow of proceeds with a "qualified intermediary" and a later purchase of "replacement property". This is referred to as a deferred exchange. The non-recognition of gain or loss in these transactions was affirmed in Starker v. United States, 602 F.2d 1341 (9th Cir. 1979). In certain circumstances, taxpayers need to close on the purchase of the replacement property before they are able to close the sale of the relinquished property. This type of transaction is referred to as a reverse exchange.
Starker did not provide taxpayers with clear guidelines with respect to these exchange transactions. As a result, regulations were mandated by Congress. The IRS issued regulations providing safe harbor rules for deferred like-kind exchanges under Section 1031 on April 25, 1991. The preamble to these regulations states that the deferred exchange rules do not apply to reverse exchanges. Consequently, the final regulations do not provide safe harbor rules for such exchanges. Property purchased directly by the taxpayer prior to the closing of the relinquished property does not qualify as like kind replacement property. 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.
Without guidance from regulations or case law, 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. 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.
This revenue procedure provides new terminology for Section 1031 transactions. An "exchange accommodation titleholder" is the party holding title to the parked property. For the purpose of this article, we will refer to the exchange accommodation titleholder as the AT (for obvious reasons). 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.
Section 1 contains a statement of purpose. The IRS will not challenge the qualification of property as either replacement property or relinquished property or the AT as the beneficial owner of such property if the transaction is structured in compliance with the requirements of the procedure. Section 2 provides the historical context of the need for the procedure. It contains the following statement, "Treasury and the Service have determined that it is in the best interest of sound tax administration to provide taxpayers with a workable means of qualifying their transactions under Section 1031 in situations where the taxpayer has a genuine intent to accomplish a like-kind exchange at the time that it arranges for the acquisition of the replacement property and actually accomplishes the exchange within a short time thereafter. Accordingly, this revenue procedure provides a safe harbor that allows a taxpayer to treat the accommodation party as the owner of the property for federal income tax purposes, thereby enabling the taxpayer to accomplish a qualifying like-kind exchange."
The revenue procedure provides for the treatment of the AT as the beneficial owner of the property for federal income tax purposes. These provisions will only provide a safe harbor in the limited circumstances set out in the procedure. Section 3 limits the applicability of the revenue procedure. 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. This is at variance with the Services position on regular exchanges that fail to meet the requirements of the regulations. Obviously, reverse exchanges that run afoul of the regulations will suffer disqualification and recognition of gain or loss also. Section 3.04 provides that if "the requirements of this revenue procedure are not satisfied (for example, the property subject to a QEAA is not transferred within the time period provided), then this revenue procedure does not apply. Accordingly, the determination of whether the taxpayer or the exchange accommodation titleholder is the owner of the property for federal income tax purposes, and the proper treatment of any transactions entered into by or between the parties, will be made without regard to the provisions of this revenue procedure." While these statements indicate that noncompliance with the procedure may not be fatal to the qualification of the transaction, we are not encouraged by the Services history of analyzing Section 1031 transactions.
Section 3.03 addresses the tax treatment of compensation for services for the taxpayer in connection with the exchange accommodation titleholders role in a QEAA and the related party rules with respect to those services. The services "shall not be taken into account in determining whether that person or a related person is a disqualified person (as defined in Section 1.1031(k)-1(k)). Even though property will not fail to be treated as being held in a QEAA as a result of one or more arrangements described in Section 4.03 of this revenue procedure, the Service still may recast an amount paid pursuant to such an arrangement as a fee paid to the exchange accommodation titleholder for acting as an exchange accommodation titleholder to the extent necessary to reflect the true economic substance of the arrangement. Other federal income tax issues implicated, but not addressed, in this revenue procedure include the treatment, for federal income tax purposes, of payments described in Section 4.03(7) and whether an exchange accommodation titleholder may be precluded from claiming depreciation deductions (e.g., as a dealer) with respect to the relinquished property or the replacement property."
Section 4.01 provides that "the Service 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 QEAA."
Section 4.02 states that property is held in a QEAA if all of the following requirements are met. The requirements are reasonably straightforward and therefore are set out in their entirety. We have set out a brief summary comment in brackets [ ] before each paragraph for easy reference.
[Legal title in exchange accommodation titleholder/qualified intermediary.]
(1) Qualified indicia of ownership of the property is held by a person (the "exchange accommodation titleholder") who is not the taxpayer or a disqualified person and either such person is subject to federal income tax or, if such person is treated as a partnership or S corporation for federal income tax purposes, more than 90 percent of its interests or stock are owned by partners or shareholders who are subject to federal income tax. 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 as described in Section 4.02(5) of this revenue procedure. For this purpose, "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;
[Property held by AT actually intended by taxpayer to be part of exchange.]
(2) 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 nonrecognition of gain (in whole or in part) or loss under Section 1031;
[Written agreement required between taxpayer and AT]
(3) 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;
[Relinquished property must be identified within 45 days after acquisition.]
(4) 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);
[Transaction must be complete within 180 days of first transfer.]
(5) 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
(6) The combined time period that the relinquished property and the replacement property are held in a QEAA does not exceed 180 days.
The time limitations parallel the limitations in the regulations governing deferred exchanges. A typical cause for utilizing reverse exchange arrangements arises when the purchase of the taxpayers desired replacement property must be closed while the relinquished property remains unsold on the market. While identification is not an issue, it is not unusual for a property to remain unsold for more than 180 days. Another frequent situation implementing the reverse exchange process occurs when the replacement property requires the construction of improvements in order to maximize the deferral of gain on the relinquished property. This procedure clearly provides for the use of this type of QEAA. Many of the approved arrangements, set out in the following paragraphs, are the ones commonly used to carry out a construction reverse exchange. Again, in complex projects 180 days is often insufficient time to complete the necessary construction. As noted above, this procedure is a technical safe harbor. If it is meticulously followed, the Service will not challenge the deferral of gain or loss. As also noted, the service is not taking any position on arrangements that do not meet the requirements of the procedure. It is well established that the time limitations contained in the IRS Regulations are absolute. There is no possibility of extension, no grace period and no good faith compliance if these deadlines are not met. Failure to meet a deadline under the regulations will result in recognition of gain, accrual of interest and possible penalties. If the Service adopts the same hard line policy for reverse exchanges on the time limitations set out in the new procedure, it will reduce the usefulness of QEAAs. We believe that the stated purpose of the procedure should lead the Service to adopt a more subjective standard that would qualify a QEAA that clearly demonstrated bona fide intent, observed the due formalities and documented reasonable delay.
Section 4.03 sets out contractual and legal arrangements that will be permitted with respect to the property without disqualifying the transaction. These provisions are set out fully as follows and as noted above, are customary and necessary in completing reverse exchanges. These arrangements provide for management of the property, funding, secured financing, coordinated management of the transaction and related activities. Since they are relatively straight forward, they are set out without further comment.
(1) An exchange accommodation titleholder that satisfies the requirements of the qualified intermediary safe harbor set forth in Section1.1031 (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;
(2) 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;
(3) 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;
(4) The property is leased by the exchange accommodation titleholder to the taxpayer or a disqualified person;
(5) 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;
(6) 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
(7) 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.
In addition, the procedure provides that the fact that 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 this revenue procedure will not prevent treatment of the property as being held in a QEAA as provided in section 4.04.
Section 5 provides that the revenue procedure is effective for QEAAs entered into where the exchange accommodation titleholder acquires qualified ownership of property on or after September 15, 2000.
The primary author of this revenue procedure is J. Peter Baumgarten in the Office of Associate Chief Counsel (Income Tax and Accounting). Further information regarding this revenue procedure may be obtained by contacting Mr. Baumgarten directly at (202) 622-4950. A copy of the procedure may be downloaded at the following URL: http://www.irs.ustreas.gov/plain/bus_info/bullet.html