REVERSE EXCHANGES

In September of 2000, the Internal Revenue Service promulgated Revenue Procedure 2000-37 and created a safe harbor structure for transactions known as reverse exchanges.  These transactions were commonly known as parking arrangements because a third party “parks” either the taxpayer’s relinquished property or her replacement property to facilitate the exchange.  Prior to the issuance of the Revenue Procedure, taxpayers were required to try and structure a reverse exchange in which the facts and circumstances indicated that there was an arms length relationship between the taxpayer and the parking agent. The Revenue Procedure provides relief from that uncertainty.  Reverse Exchanges conducted in compliance with Rev. Proc. 2000-37 are referred to as “compliant” or “safe harbor” reverse exchanges.  Although most reverse exchanges are compliant, the Revenue Procedure states very clearly that it is a safe harbor only and that no negative presumption is to be drawn from a transaction being conducted outside that safe harbor.  Those transactions falling outside the safe harbor are referred to as “non-compliant” or “non-safe harbor” reverse exchanges.

Revenue Procedure 2000-37

Made effective September 15, 2000, Revenue Procedure 2000-37 acknowledges the fact that taxpayers have been entering into so-call parking arrangements in order to create a structure which fits into the requirements of the Regulations for deferred exchanges.  In general, a taxpayer who has located suitable replacement property, but has a delay in closing on relinquished property will hire a third party to hold either the relinquished or the replacement property until such time as they can be exchanged in the proper order.  This third party is referred to in the Revenue Procedure and in common practice as an “Exchange Accommodation Titleholder” or “EAT”.

The reason for the creation of a safe harbor was to regulate the use of EATs and to provide the taxpayer a mechanism whereby they could maintain sufficient control over both pieces of property in the transaction.  Without the safe harbor provisions, the EAT must maintain the benefits and burdens of ownership, and its relationship to the taxpayer must be “arms length.”  Alternatively, in a compliant exchange, no such arms length relationship must exist.

In order to have a compliant exchange, the taxpayer must meet certain requirements.  First, the taxpayer must hold the property in a Qualified Exchange Accommodation Arrangement (“QEAA”). The requirements of the QEAA are as follows:

1. Qualified indicia of ownership must be held by a person who is not the taxpayer or a disqualified person (this is the EAT);
2. Taxpayer must have a bona fida intent to complete an exchange with the property;
3. Within five (5) days of the EAT taking title, the EAT and the taxpayer must enter a written agreement providing for the following:
1. the agreement is entered into pursuant to Section 1031 and the Revenue Procedure and that all parties will report pursuant to the Revenue Procedure; and
2. that the EAT will be treated as the beneficial owner for tax purposes;
4. No later than 45 days after the acquisition of replacement property by the EAT, the relinquished property must be identified in a manner consistent with Section 1.1031(k)-1(c) of the Regulations;
5. No later than 180 days after the acquisition of property by EAT: (a) replacement property must be transferred to the taxpayer and (b) relinquished property must be transferred to a person who is not the taxpayer or a disqualified party; and
6. The combined time period that relinquished and replacement property is held by EAT does not exceed 180 days.

The key benefit to entering into a compliant exchange is that the Revenue Procedure allows for a relaxed relationship between the EAT and the taxpayer. The EAT may not be a disqualified person, but may be the QI in the transaction.  The taxpayer may enter into one or more of the following agreements with the EAT without IRS scrutiny of the treatment of the EAT as beneficial owner:

1. The taxpayer or a disqualified person may guarantee the acquisition indebtedness;
2. The taxpayer or a disqualified person may loan the acquisition funds to the EAT;
3. The EAT may lease the property on less than fair market value terms to the taxpayer;
4. The taxpayer may manage the property, supervise construction of improvements or otherwise provide service to the EAT;
5. The taxpayer may indemnify the EAT from any loss on the property and the EAT may allow the taxpayer to benefit from any gain on the property during the time the EAT holds title; and
6. The taxpayer and EAT may enter into puts and calls on the property for a period not in excess of 185 days from the date of acquisition by the EAT.

If a taxpayer complies with the provisions of Revenue Procedure 2000-37, then the Service will not investigate where the true benefits and burdens on ownership of the property lies, and thus will not question the qualification of the relinquished or replacement property as qualified on those grounds.  However, it is important to remember that the remaining rules surrounding Section 1031 still must be met for the exchange to qualify. 

Improvements may be constructed on parked property during a reverse exchange.  In safe harbor reverse exchanges, the EAT obtains construction funding from either the taxpayer or a third-party lender, and constructs improvements during the 180 day period.  For a more complete description of how an improvement exchange is completed see the construction exchange section below.

As originally drafted, the Revenue Procedure did not prohibit an EAT from purchasing property from the taxpayer, constructing improvements on the property, and then transferring the property back to the taxpayer as replacement property.  This omission served to grant the taxpayer a method for constructing improvements on their own property.  In 2004 the IRS promulgated Revenue Procedure 2004-51 which supplemented the original revenue procedure by adding a prohibition on these types of arrangements.  Specifically, the Service will not apply the safe harbor to property owned by the taxpayer within the 180 day period prior to the transfer of the qualified indicia of ownership to the EAT.  This basically prevents the taxpayer, either directly or through a qualified intermediary, from transferring property to the EAT for the construction of improvements on their own land.

Non-Compliant Reverse Exchanges

As stated in Revenue Procedure 2000-37, no negative inference is to be drawn from a taxpayer’s decision to enter into an arrangement for the parking and subsequent exchange of property outside of the safe harbor.  The qualification of property involved in these “non-compliant” arrangements becomes subject to IRS scrutiny and is dependent upon the specific facts and circumstances surrounding each transaction. The basic structure of property being held by a parking agent is the same, but the parking agent must take not only qualified indicia of ownership, but must also bear the benefits and burdens of ownership with all facts taken into account.

The difficulty in creating an arrangement which provides the EAT with all of the benefits and burdens of ownership is twofold.  First is the general apprehension of an accommodating title holder with respect to taking the benefits and burdens of too many properties, and the risk of being left with those properties in the event of a taxpayer collapse.  The second is a taxpayer’s desire to maintain control over the property throughout the transaction, which was the intention of the transaction from the beginning.

The two main attacks on the structure of non-compliant reverse exchanges rest in the areas of failure of the EAT to take true tax ownership of the property and the treatment of the EAT as an agent of the taxpayer.  Only one case has been decided on the agency issue.  In DeCleene, the Court held that the accommodating party was acting as the agent of the taxpayer and that the improvements constructed on the relinquished property were tantamount to improvements constructed on property owned by the taxpayer.  DeCleene did not have many taxpayer friendly facts and is a case which showcases the need for careful planning on the front end of any non-compliant exchange.  The court focused on the prior ownership of the property by the taxpayer, and the inability to show a true divestiture of the property during the parking time period.

Other non-exchange scenarios have addressed the agency issues and been determined in favor of taxpayers.  Additionally, at least one Private Letter Ruling exists which addresses the specifics of a reverse exchange and its qualification under Section 1031 using an agency relationship analysis.  PLR 200111025 provides the clearest “roadmap” to what the IRS may consider to be a true arms length transaction.  However, it is important to note that private letter rulings may not be relied upon for precedence by anyone other than the requesting taxpayer.  Also, several more recent and similarly weighted promulgations from the IRS result in a different outcome based on the tax ownership issue. 

In the PLR the requesting taxpayer arranged his transaction with the following specifics:

1. The EAT took title to the property and borrowed funds from a third party lender with full recourse;
2. EAT paid the taxpayer a fair market value guarantee fee to guarantee the loan;
3. Eat borrowed the down payment from taxpayer in an arms length loan transaction;
4. The property was net leased back to the taxpayer;
5. Taxpayer had an 18 month option to purchase the property;
6. EAT assigned underlying leases to taxpayer; and
7. EAT reported the property as its own for all tax purposes.

The author of the PLR focused on the agency relationship between the parties, and ultimately determined that because no agency relationship existed, the transaction qualified for non-recognition treatment.

In FAA 20050203F, the Service focused on the “benefits and burdens” of the transaction.  The EAT did not invest any initial capital, but rather borrowed all of the purchase and construction funds from a third party lender.  It then net leased the property to the taxpayer.  Because all expenses were paid by the taxpayer under the lease, the EAT had no capital investment, and the taxpayer had a 24 month fixed price option, the Service determined that the taxpayer and not the EAT bore the economic risk in the transaction. It is interesting to note that the Service cites certain cases for the agency argument and other, unrelated cases for support of the benefits and burdens test.

In light of the uncertainty surrounding non-compliant reverse exchanges, significant care should be taken to structure the parking arrangement in a truly arms-length fashion and with the benefits and burdens of the transaction resting with the EAT.  Whenever possible, the taxpayer should not loan purchase or construction funds, and when such a loan is made it should be at prevailing market rates with proper security taken back.  Any lease to the taxpayer should be at fair market value rates and on commercially reasonable terms.  The taxpayer should not guarantee any loans, and if such a guarantee is required it should be in exchange for a commercially reasonable guarantee fee.  Finally, any options or other price fixing mechanisms in favor of the taxpayer should be of a short duration and should be paid for by the taxpayer.