United States: Qualifying Reverse Exchanges Under Revenue Procedure 2000-37

Originally published in Los Angeles Lawyer, June 2001

The New IRS Procedure Offers Tax Certainty but Also Carries With it Heavy Burdens

On October 2, 2000, a full 10 years after announcing its 0 intent to study the applicability of internal Revenue Code Section 1031 (a)¹ to so called parking transactions.² The IRS, in Revenue Procedure 2000-37,³ gave its blessing to a limited category of these transactions. While many greeted the action as good - even fantastic - news, the limited nature of the blessing and the potential risks associated with undertaking a parking transaction in the manner prescribed by the IRS suggest that the IRS's blessing might more properly be characterized as a burden. In any event the IRS guidance will prove important for many taxpayers wishing to undertake exchanges under Section 1031.

The IRS's guidance in this area must be understood in the context of the tax treatment of like-kind exchanges and an understanding of what reverse exchanges are.⁴ Generally, taxpayers must recognize the gains and losses resulting from an exchange of property However, IRS Section 1031(a)(1) permits taxpayers to defer gains or losses resulting from the simultaneous exchange of property (including real property) that is held either for productive use in a trade or business or investment purposes so long as the property received in the exchange is of like kind to the property conveyed. Courts liberally interpret Section 1031 when it can be shown that the taxpayer has not materially altered his or her economic position by the exchange and that the exchange results in nothing more than a continuation of the tax payer's original investment in the old property.⁵

Congress enacted Section 1031 (a) (3) in 1984 to permit nonsimultaneous like-kind exchange under Section 1031 (a) (1). A nonsimultaneous exchange will generally qualify for like-kind exchange treatment so long as the taxpayer 1) identifies replacement property within 45 days of the transfer of the relinquished property and 2) receives the identified property within 180 days of the original transfer date or by the day (including extensions) upon which his or her tax return is due, whichever is the earlier date.

Unlike more traditional forms of like-kind exchange, a reverse exchange (also referred to as a 'parking transaction" or a "reverse Starker exehange"⁶) involves a taxpayer who acquires replacement property before having conveyed the relinquished property,⁷ thus reversing the order of conveyance in traditional like-kind exchanges. For a reverse exchange to quality as nontaxable, a taxpayer must obtain control of the replacement property before transferring the relinquished property and later exchange the replacement property for the relinquished property. But if the taxpayer owns both the replacement property and the relinquished property, how can the two be exchanged? To the rescue comes the accommodation titleholder (AT).

An AT is a person (individual or otherwise) who agrees to acquire the replacement property and hold it until the taxpayer is ready to complete the like-kindexchange.9 To entice the AT to act, the taxpayer will typically compensate the AT. guarantee acquisition financing, and indemnify the AT against losses incurred in the transaction. When the taxpayer is ready to complete the like-kind exchange, he or she will join the AT, the buyer of the relinquished property and, perhaps, a qualified intermediary⁸ to consummate what appears to be a traditional like-kind exchange.⁹ In support of that treatment, each party to the final exchange will report the transaction as a like-kind exchange.¹⁰

Prior to the issuance of Revenue procedure 200-37, the only authority for reverse exchanges was nonstatutory.¹¹ Section 1031 makes no mention of reverse exchanges, and final regulations that the IRS issued under section 1031 (a) (1) - the deferred exchange provisions-specifically excluded them from the deferred exchange rules.¹²

For several decades, the only judicial decision that directly addressed the tax treatment of reverse exchanges was Rutherford v. Commissioner,¹³ a case involving the reverse exchange at cattle. Other cases, such as Biggs v. Commissioner¹⁴ and J. H. Baird Publishing Co. v. Commissioner¹⁵ while not directly addressing reverse exchanges per included facts that provided support for the argument that gains on reverse exchanges should be accorded the same nonrecognition treatment.

Generally, the success or failure of reverse exchanges has hinged Upon the question of whether the AT is die economic owner of the replacement property during the parking period of time between acquisition of the replacement property and consummation of the later like-kind exchange. When a court considers the AT to be the taxpayer's agent the like-kind exchange cannot occur because the taxpayer will be considered to have owned the replacement property during the parking period. An attempted exchange will thus be ineffective because the taxpayer will be considered to have exchanged property with himself or herself Determining the owner of property for federal income tax purposes requires an analysis of all of the facts and circumstances, ¹⁶ 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.¹⁷ 2001 A fine example of this sort of analysis can be found in the recent decision DeCleame v. Commissioner¹⁸ in which the Tax Court for the first time examined the tax consequences associated with the reverse exchange of real property.

Donald DeCleene was the principal of DeCleene Truck Repair and Refrigeration, Inc. (DTRR), a corporation whose primary business was installing and repairing truck refrigeration equipment DTRR operated its business on real property owned by DeCleene, known as the McDonald property. By 1992 DTRR had begun to outgrow the McDonald property, and in September 1992 DeCleene identified and purchased, at a cost of $137,027, a new building site known as the 14-rence Drive property. DeCleene financed his purchase of the Lawrence Drive property through Bank One in Green Bay, Wisconsin.

Prior to beginning construction on the new site, DeCleene learned that Western Lime and Cement Co. was interested in acquiring his McDonald property. DeCleene's accountant suggested that DeCleene might be able to structure the McDonald property sale as a like-kind transaction by; 1) selling the unimproved Lawrence Drive property to WLC by quitclaim deed, 2) having WLC develop the Lawrence Drive property to DeCleene's specifications, and then 3) exchanging the McDonald property for the Lawrence, Drive property in a transaction Qualifying as a like-kind exchange under Section 1031.

Accordingly, on September 24, 1993, DeCleene sold the Lawrence Drive property to WLC for a $142,000 nonrecourse not due and payable upon the closing of an exchange transaction between DeCleene and WLC or six months from the date of the note, whichever was earlier. At or about the same time the sale of the Lawrence Drive property to WLC closed, DeCleene and WLC agreed to exchange the McDonald and Lawrence Drive property. Pursuant to the exchange agreement, DeCleene agreed to 1) Transfer the McDonald property to WLC in exchange for the Lawrence Drive property and WLC's payment of the note, 2) Pay all costs associated with transferring the properties between DeCleene and WLC. 3) Give comprehensive warranties to WLC concerning the McDonald property. (WIX was not required to give warranties concerning the Lawrence Drive property and, in fact, specifically disavowed making any warranties with respect to it.) 4) Pay all costs incurred by WLC in constructing the building on the Lawrence Drive property, including costs incurred by WLC for insurance, real estate taxes, and interest.

To finance construction WLC obtained a $380,000 nonrecourse loan from DeCleene's lender, Bank One in Green Bay, DeCleene guaranteed the loan, assigned WLC's S142,000 note receivable to Bank One, and gave Bank One a new mortgage on the McDonald property. Bank One gave WLC the construction loan without checking WLC's creditworthiness. On these facts, the Tax Court noted in its opinion,¹⁹ DeCleene alone was liable for the construction loan.

Only DeCleene or his designated representatives could approve designs, inspect the project, approve workmanship and materials, visit the construction site, and determine Contractual compliance. WLC had no authority to do any of these things. Similarly, only DeCleene could authorize progress payments. WLC and DeCleene consummated their exchange transaction on December 29, 1993, prior to completion of construction. At the time of the exchange, DeCleene 1) conveyed the McDonald property to WLC by warranty deed, 2) assumed and became personally liable to Bank One for all obligations of WLC by arising from the construction contract (which, it must be remembered, was a nonrecourse debt), and 3) assumed responsibility for completing construction. WLC quitclaimed the Lawrence Drive property to DeCleene and paid the $142,000 note.

On his tax return. DeCleene treated the original sale of the Lawrence Drive property as a taxable sale (reporting approximately $5,000 of short-term taxable gain), DeCleene reported no gain on the exchange of the McDonald and Lawrence Drive properties, treating it as a Section 1031 (a) exchange. The IRS disallowed DeCleene's treatment of die McDonald-Lawrence Drive exchange on the theory that, because DeCleene maintained substantial control over the Lawrence Drive property following its transfer to WLC, he had not actually transferred true ownership of the property to WLC. IRS accordingly, assessed an accuracy-related penalty, ²⁰ and DeCleene appealed to the Tax Court.

The sole substantive issue before the Tax Court was whether the McDonald/Lawrence Drive exchange constituted like-kind exchange under Section 1031 (a). In a case of first impression, the Tax Court determined that a reverse exchange would be accorded like-kind exchange treatment under Section 1031 (a) only if the party conveying the replacement property (the AT) held both legal title to the replacement property and the benefits and burdens of ownership. To determine who holds the economic burdens and benefits of ownership a court must examine all facts and circumstances relative to the question of ownership.²¹

In this case, it was obvious where the benefits and burdens of ownership lay with DeCleene. WLC never held the burdens or risks associated with ownership. WLC made no investment in the Lawrence Drive property, held no voice in its management. was indemnified against any loss resulting from ownership, and bore none of the costs associated with operating the property. WLC had no liability for either the acquisition or construction loans and did not participate in construction of the new building.

Similarly, WLC enjoyed no benefits of ownership. WLC had to reconvey the property to DeCleene at a preestablished price and thus stood no chance to benefit from appreciation in the Lawrence Drive property's value. Upon these facts, the Tax Court concluded that while WLC held legal title to the property, all benefits and burdens of owner. ship remained with DeCleene. Thus for tax purposes, DeCleene owned the Lawrence Drive property, and the Tax Court refused to apply Section 1031 (a) to the exchange of the McDonald and Lawrence Drive properties.

The Tax Court's holding in.DeCleene confirms that, in order for a reverse exchange to withstand judicial scrutiny, the AT must hold the benefits and burdens normally associated with ownership. The Tax Court's opinion seems to suggest that at a minimum, that must have an actual investment in the parked property and stand to gain from appreciation in its value. In addition, DeCleene's retention of the full right to manage the property must have damaged his position, In a successful reverse exchange the AT will hold the right to manage the property (which does not preclude the AT from assigning those rights through a lease or similar device).

To alleviate some of the confusion in this area to promote 'Sound tax administration,29 and to provide taxpayers with a workable means of accomplishing reverse exchanges, the IRS issued Revenue Procedure 2000-37.22²² This directive provides a safe harbor for taxpayers undertaking "qualified exchange accommodation arrangements" (QEAAS) after September 15, 2000.²³ Under Revenue Procedure 2000-37, the IRS will neither challenge the qualification of property as replacement property or relinquished property nor challenge the treatment of the AT as the beneficial owner of the property if the transaction is structured as a QEAA.²⁴ Revenue Procedure 2000-37 thus applies only to reverse exchanges that qualify as QAEEs. To become a QAEE a reverse exchange must satisfy six requirements:

1) Use of an exchange accommodation titleholder (EAT). A person referred to as an exchange accommodation titleholder must acquire qualified indicia of ownership of the parked property.²⁵ Section 4.02(l) of the revenue procedure defines "qualified indicia of ownership" as:

[L]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.

This suggests that the EAT need only acquire legal title to the parked proper@ Once title is obtained, however, it must be retained until the parked property is transferred to the taxpayer. Failure to maintain title will disqualify the exchange from QEAA treatment.

Any person subject to taxation, other than the taxpayer or a "disqualified person"²⁶ may serve as an EAT. The revenue Procedure does not clearly indicate to what extent an EAT must be subject to federal income tax. For example, may a nonresident alien with only minimal U.S.-source investment income be subject to federal income tax when it acquires qualified indicia of ownership or is it sufficient that the EAT becomes subject to income tax as a result if the transaction?

2) The taxpayer must establish a bona fide intent to qualify the QEAA for nonrecognition treatment under IRC Section 1031. When acquiring the parked property, the taxpayer must intend to treat the parked property either as replacement property or relinquished property in a later Section 1031 exchange. The procedure does not indicate how the taxpayer establishes intent. Perhaps undertaking the exchange will in and of itself, establish the requisite intent- Assuming it does no@ the taxpayer should coiltei-Aporan2ously document intent by delivering a written statement to the EAT, escrow agent, title company, or some other person involved with the transaction.²⁷

3) The taxpayer and the EKI- must enter a qualified exchange accommodation agreement. No later than five business days after the EAT acquires title to the parked property, the taxpayer must enter into a written agreement (the 'qualified exchange accommodation agreement") with the EAT. The written agreement must provide that the EAT is holding the parked property for the taxpayer's benefit and for, the purpose of facilitating a like-kind exchange. The agreement must also treat the EAT as beneficial owner of the parked property for all federal income tax purposes. Finally, the agreement must require both the taxpayer and the EAT to report the acquisition, holding, and disposition of the parked property, as well as tax attributes resulting from this ownership in a manner consistent with Revenue Procedure 2000-37.

This requirement involves substantial uncertainty and potential risk for the taxpayer. First, by requiring the taxpayer to state affirmatively that the EAT is holding the parked property for the benefit of the taxpayer, the revenue procedure requires the taxpayer to essentially identify the EAT as his or her agent.

Second, the extent to which the parties must treat the EAT as beneficial owner of the parked property is uncertain. For example, must the EAT depreciate the property? Considering the transitory nature of the EATs investment. must the capitalize all costs incurred in operating the parked property? An answer to these questions might materially affect the EATs willingness to participate in the transaction. Finally, by requiring consistent reporting of the exchange, the procedure places the taxpayer at the mercy of an unscrupulous EAT. Should a dispute arise between the EAT and taxpayer, or should EAT simply refuse or fail to report altogether, the taxpayer's desired tax treatment may be lost. To avoid this risk, the taxpayer should ensure that agreement properly addressed such issues as dispute resolution. reporting of applicable tax attributes (including depreciation, interest expenses on acquisition indebtedness etc.), and failure to report.

4) The taxpayer must identify relinquished property within 45 days of the EATs acquisition of title to the replacement property. This 45-day period, known as the "Identification period,' is similar to the requirement found in Section 1031 (a) (3).

To identify relinquished property the taxpayer must prepare a written document (the 'identification statement') that unambiguously describes the relinquished property and designates it as relinquished property for purposes of Revenue Procedure 2C400-37.²⁸ To describe the property unambiguously, the statement must include the Property's legal description, street address, or refer to the property in some other way that uniquely describes the relinquished property.²⁹

The identification statement should be deemed either to the person who will receive the relinquished property or some other person involved in the exchange (other than the taxpayer or a disqualified person).³⁰The identification statement must be delivered prior to the end of the identification period. Revenue Procedure 2000-37 permits the taxpayer to 'identify alternative and multiple properties, as described in [Treasury Regulations Section] 1.1031 (k)-1(c)(4).³¹ Reading those sections in the context of a QEAA, it would appear that a taxpayer may identify more than one relinquished property, but the maximum number of relinquished property ties that a taxpayer may identify is either three properties (determined without regard to the properties' fair market value) or any number of properties so long as the aggregate fair market value of the properties at the end of the identification period does not exceed 200 percent of the aggregate fair market value of the properties as of the date transferred.

5) The replacement property must be conveyed within 180 days of acquiring title. The EAT must convey the parked property within 180 days of acquiring title. If the parked property is replacement property, the EAT may satisfy this requirement by transferring the property to the taxpayer as part of a larger exchange transaction. (In those instances where the parked property is used as relinquished property, the EAT must convey the parked property to a person other than the taxpayer or a disqualified person as relinquished property.)

6) The term of the QEAA is limited to 180 days. The relinquished and replacement property cannot remain subject to the QEAA for more than 180 days. Consequently, taxpayers should seek to employ the QEAA procedure only with exchanges of relatively short duration. Taxpayers who are unsure whether their exchanges can be effected in 180 days or less should consider avoiding Revenue Procedure 2000-37 altogether.

Recognizing the taxpayer's interest in the parked property and the EAT's role as transaction facilitator, the M5 permits the parties to structure their accommodation arrangement in a flexible manner.³² Section 4.03 of Revenue Procedure 2000-37 provides that the following arrangements will not cause the parked property to fall outside the QEAA .regardless of whether such arrangements contain terms that typically would result from arm's length bargaining between unrelated parties with respect to such arrangements:

1) The EAT may also serve as the qualified intermediary in a simultaneous or deferred exchange of the property under Section 1031. This should entice companies that presently perform qualified intermediary services to enter the EAT field-assuming this step makes economic sense.

2) Either the taxpayer or a disqualified person may guarantee some or all of the EATs obligations, including Secured or unsecured debt incurred to acquire the property. or indemnify the EAT against costs and expenses incurred by it in connection with the property. Had Revenue Procedure 2DOO-37 existed at the time DeCleene entered into his transaction with WLC, this provision might have allowed him to achieve the tax results lie desired under Section 1031.

3) Either the taxpayer or disqualified person may loan or advance funds to the EAT or guarantee loans or advances to the FAT This may protect the parked property from other creditors of the EAT during the parking period. Notice that the lending arrangement need not be established on arm's-length terms. That might permit the taxpayer to make noninterest bearing loans to the EAT.

4) Either the taxpayer or a disqualified person may lease the parked property from the EAT. Use of a lease between the taxpayer and the EAT may go far in addressing some of the concern for allocation of ownership costs during the parking period. By entering a triple net lease, the taxpayer will become responsible for payment of property taxes, insurance, and property maintenance. And, because the arrangement need not be at arm's length, there is no requirement that rent be paid.

5) Either the taxpayer or a disqualified person may manage the property, supervise its improvement, act as a contractor, or otherwise provide services to the EAT with respect to the property. Here again, DeCleene might have been decided differently had Revenue Procedure 2000-37 existed when DeCleene entered into his arrangement with WLC.

6) The taxpayer and the EAT may 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 EAT.

7) The taxpayer and the EAT may enter into agreements or arrangements providing that any variation in the value of a relinquished property after the exchange accommodation title holder's receipt of the property may be taken into account. This allows the taxpayer to make the EAT whole far any loss that the EAT suffers as a result of acquiring and holding the parked property for the taxpayer.

By permitting the taxpayer and EAT to enter into any one or more of the these arrangements, the IRS has expressed its intent to grant taxpayers a full opportunity to accomplish their reverse exchange goals. The failure of a reverse exchange to qualify as a QEAA does not mean that the taxpayer cannot obtain like-kind treatment for the exchange. On the contrary, Revenue Procedure 2000-37 states unambiguously that reverse exchange transactions can be accomplished in ways that do not qualify for safe harbor treatment under the directive.³³ Moreover, the IRS has stated that no inference should be drawn from the fact that the transaction, whether entered into prior to or after the effective date of the procedure, fails to qualify as a QEAA. For these reasons, taxpayers who find themselves unable to qualify a reverse exchange as a QEAA, or who doubt that their reverse exchange will qualify, may look to case law to obtain like-kind exchange treatment under Section 1031.

When trying to qualify a transaction as a reverse exchange under existing case law, a taxpayer who has never attempted to comply with the provisions of Revenue Procedure 2000-37 may have a better ability to do so than one who has. To qualify a reverse exchange as a QEAA the taxpayer and EAT must enter into a written exchange agreement. As part of that agreement, the parties must provide that the EAT is holding the property for the benefit of the taxpayer. In making this statement, the taxpayer is indicating that the EAT is holding the replacement property as an agent for tile taxpayer. However, courts will generally treat the taxpayer as owner of property held by as agent for him. ³⁴ Consequently, by making tile required statement of agency, the taxpayer may foreclose, the possibility of claiming like-kind exchange treatment under existing case law if the transaction ultimately fails to qualify as a QEAA.

Recognizing this risk, taxpayers considering a reverse exchange objectively determine the likelihood that they can implement the requirements for a QEAA. If, after that analysis, a taxpayer determines that the QEAA requirements will not be met, he or she may be better served by looking to existing case law.

In addition to considering the income tax implications of a reverse exchange, taxpayers should also consider various non-income-tax issues. For example, California has thus far not adopted the procedure described in Revenue Procedure 2000-37 for reverse exchanges. If the California Franchise Tax Board considers this procedure inconsistent with the principles of law set forth in the state's Revenue and Taxation Code, the FTB may refuse to recognize reverse exchanges made under Revenue Procedure 2000-37. In that event, taxpayers might be left to argue for like-kind exchange treatment under existing case law. However, as with a failed QEAA transaction, the provisions of the written exchange agreement could harm the taxpayer's case by providing evidence that EAT is the taxpayer's agent.

The taxpayer- also needs to consider property tax issues. If the EAT owns the parked property for tax purposes, then it might well follow that the EATs transfer of the parked property to the taxpayer will constitute an change in ownership for property tax purposes. If so, the taxpayer may be required to pay twice the amount of transfer taxes that otherwise would have been due had the exchange not 13eeti structured as a reverse exchange.

To avoid paying transfer taxes twice an the same properly, the taxpayer might argue that he or she, and not the EAT, beneficially owns the property. As evidence of this beneficial ownership, the taxpayer might point to the QEAA, which must affirmatively state that the EAT holds the parked property for the benefit of the taxpayer. When making this argument, However, the taxpayers should remember that the QEAA also requires the EAT to be treated as beneficial owner of tile parked property for federal income tax purposes- It is unclear whether this federal income tax treatment will preclude the taxpayer from establishing that he or she is the beneficial owner of the parked property for local tax purposes. Finally, the taxpayer should develop an asset protection strategy. As owner of the parked property under Section 1031 or Revenue Procedure 2000-37, the EAT could transfer the property, refinance the property, or convey the property to creditors as part of a larger assignment for the benefit of creditors. Moreover, the parked property might become subject to creditor claims, including those of lien creditors, if the EAT becomes insolvent.

To guard against these dangers, the taxpayer should conduct the reverse exchange through a single-purpose entity- When possible the taxpayer might provide acquisition financing-but only after recognizing that doing so may create problems if the EAT defaults prior to the identification of the relinquished property- Alternatively, the taxpayer should seek acquisition financing from a friendly lender, one who is knowledgeable about the relationship between the taxpayer and the EAT and who is prepared to implement whatever measures are necessary to see that the underlying exchange transaction is consummated. Because Revenue Procedure 2000-37 offers a relatively short timeframe to consummate a reverse exchange, can result in a potentially adverse tax treatment if the attempt to implement a QEAA is unsuccessful. and leaves state-tax treatment unclear, many taxpayers will probably avoid Revenue Procedure 2000-37 altogether. These taxpayers wilt instead opt for case law treatment.

For those taxpayers able to fit within its narrow requirements, Revenue Procedure 2000-37 creates comfort of federal income tax clarity. No longer will reverse exchanges falling within the safe harbor be subject to IRS challenge. Instead, taxpayers can be assured that, so long as they have complied strictly with the requirements of Revenue Procedure 2000-37, their transactions will be accorded like-kind exchange treatment under Section 1031.

While Revenue Procedure 2000-37 will stand as a beacon of tax clarity for some, that number may he relatively small. The IRS estimates that no more than 1,600 like-kind transactions per year will qualify for like-kind exchange treatment under Revenue Procedure 2000-37.33 At that rate, Revenue Procedure 2000-37 may well be much ado about nothing.