New tool in the real estate biz
A tale of parked properties and reverse exchanges
By Mary B. Foster
A company wants to sell one of its stores and move to a new location. What's the best way to deal with the tax man? Check out this option.
Every business owner should know about tax-deferred exchanges. Tax rates on the gain from the sale of business assets can range from 20 percent to 35 percent. A properly structured exchange can defer these taxes indefinitely.
Exchanges are easy to use. The exchanging party or "exchangor" avoids the taxes by merely reinvesting the proceeds from the sale of the old property in "like kind" or similar new property. While exchanges have traditionally been associated with real estate, they can be used for all types of tangible and intangible business assets. The largest exchanges today are of property such as airplanes, car or truck fleets and plant equipment.
The IRS published taxpayer-friendly regulations in 1991 on deferred or "forward" exchanges in which the old or "relinquished property" is disposed of first and the new or "replacement property" is acquired within 180 days. In September, 2000, the IRS again came through with a taxpayer-friendly procedure for "reverse" exchanges. The procedure allows the exchangor to acquire the replacement property up to 180 days prior to the sale of the relinquished property if the requirements set forth in the revenue procedure are met.
IRS Revenue Procedure 2000-37 creates a "safe harbor" for reverse exchanges. That means the IRS will not challenge the exchange if the requirements are met. A reverse exchange can still be done outside the safe harbor, but at the exchangor's own risk. Therefore, it's wise to comply with the revenue procedure if at all possible.
When is a reverse exchange necessary? A business might need to buy a replacement aircraft before it can find a buyer for its relinquished aircraft. A manufacturing company wishing to relocate might need to start construction of the new facility before it can sell its existing facility. A simultaneous exchange of heavy equipment might have been arranged, but the buyer's financing falls through at the last minute and the exchangor is forced to acquire the replacement property before finding a new buyer.
The revenue procedure provides for two alternative reverse exchange structures. Both are commonly called "parking" arrangements because either the relinquished property or the replacement property is "parked" with a friendly party until the relinquished property is sold to an unrelated buyer. The friendly party is known as an exchange accommodation titleholder (an AT).
In the first and most popular structure, the AT acquires the replacement property and parks it until the relinquished property sells and then the exchange occurs. In the second structure, the exchangor acquires the replacement property up front and simultaneously transfers the relinquished property to the AT. The AT then parks the relinquished property for up to 180 days and then transfers it to the ultimate buyer.
Who is the AT? The AT cannot be a "disqualified person." A disqualified person is generally a related party to the exchangor, or a person who has acted as the exchangor's lawyer, accountant, real estate agent or broker, employee or investment banker on nonexchange matters within the two-year period ending on the date the AT acquires the parked property. ATs are typically affiliates of the "qualified intermediaries" used in forward exchanges. Qualified intermediary companies are usually owned by banks and title companies as well as individual lawyers and CPAs.
The AT must hold "qualified indicia of ownership" at all times from the date of acquisition by the AT of the parked property. This means legal title to the parked property, such as real property, or a bill of sale for personal property. It also includes interests in a single member limited liability company that holds title to the property.
An exchangor should insist that the AT be an entity that holds only the exchangor's property. The most common type of entity is a single purpose limited liability company. The liability risks of combining different exchangors' properties in the same entity are simply too great. If a suit is filed against the AT on one property, it will affect the other properties held by that AT. In addition, a third-party lender may require that the AT be a sole-purpose entity. The exchangor will have to bear the additional cost of setting up a separate entity, including state filing fees and taxes, but it is well worth the extra protection.
There are other requirements to meet the safe harbor. The exchangor and the AT must enter into a written agreement that provides the following specific language:
(1) The AT is holding the property for the benefit of the exchangor in order to facilitate an exchange under Section 1031 and this revenue procedure; and (2) the exchangor and the exchange accommodation titleholder agree to report the acquisition, holding, and disposition of the property as provided in Revenue Procedure 2000-37.
The agreement must also specify that the AT will be treated as the beneficial owner of the property for all federal income tax purposes, and the AT must report this ownership on its federal tax return. The exchangor loses the tax-depreciation deductions on the property during the parking period.
The AT can make improvements to the parked property that add to the value for exchange purposes, and then transfer the improved property to the exchangor. For example, the AT can make repairs or improvements to a parked airplane or can construct a building on parked land.
The revenue procedure allows flexibility for businesses that have several potential relinquished properties at the time the replacement property needs to be purchased. For example, a retail grocery store company buys and sells several store sites each year. It can park a new replacement property with an AT and take up to 45 days to identify in writing which relinquished properties it will sell to exchange for the parked property. The revenue procedure allows the company to identify up to three alternative relinquished properties, or any number so long as the aggregate value of the identified relinquished properties does not exceed 200 percent of the value of the parked replacement property.
The parked property must be transferred no later than 180 days after the transfer of ownership to the AT. This deadline represents the major problem with the safe harbor because it restricts the applicability to short delays. Exchangors desiring to come within the safe harbor may have to reduce the price of the relinquished property to sell it quicker, particularly in a slow market.
Reverse exchanges had been going on for years without any guidance and most lawyers feared these exchanges might be found invalid by the IRS because the AT could be deemed to be the exchangor's agent for federal tax purposes. There were few arms' length provisions between the exchangor and the AT in most reverse exchange structures. Many businesses that would have benefited from a reverse exchange did not feel comfortable with the tax risk involved.
Now these businesses can rely on the safe harbor.
The revenue procedure is a gift from the IRS. It completely lets the exchangor off the hook on the agency issue by providing that the parking arrangement may contain several nonarm's length provisions without any risk of agency. The AT will, in most circumstances, simply be performing a service for a flat fee and will have no real risk of ownership of the parked property.
The revenue procedure permits the following nonarms' length provisions:
- the exchangor may loan all the funds to the AT to acquire the parked property, or the exchangor may guarantee a loan to the AT from a third-party lender;
- the exchangor may indemnify the AT against costs and expenses;
- the parked property may be leased by the AT to the exchangor;
- the exchangor may manage the parked property, supervise improvement of the parked property, or act as a contractor; or
- the exchangor and the AT may enter into puts and calls for the parked property at fixed or formula prices during the safe harbor period. Effectively, the exchangor and the AT may put all the management and risk of loss and potential for profit relating to the parked property on the exchangor and not on the AT.
How does a reverse exchange work in a practice? First, the exchangor must decide whether the AT will park the relinquished property or the replacement property. If the replacement property requires improvements, then the AT will park the replacement property and do the improvements. If the lender on the replacement property requires the exchangor to take title, then the AT will park the property.
Then, the following will often occur:
- The exchangor will enter into an agreement with the AT that provides that the AT will purchase the parked property. The agreement must contain the required language stated above.
- The AT will not actually pay any cash for the parked property. The exchangor typically makes a noninterest-bearing loan to the AT, or guarantees a bank loan to the AT for all or a portion of the purchase price.
- The parked property is leased by the AT to the exchangor on a triple net basis, with the exchangor responsible for all taxes, insurance and operating expenses. If debt payments are due on the parked property, then the exchangor can pay these as additional rent to the AT. The AT reports these amounts as rental income on its tax return, with the offsetting deductions. The exchangor deducts these amounts as rent paid to the AT. The exchangor may also manage the parked property. The AT is not required to make a profit on the rent.
- The AT holds parked property until the relinquished property is sold, but not for a period in excess of 180 days. If the parked property is the relinquished property, then the exchangor receives the replacement property at the beginning of the reverse exchange. If the parked property is the replacement property, then the exchangor retains the relinquished property and acquires the replacement property from the AT at the end of the reverse exchange.
- The proceeds from the sale of the relinquished property to the unrelated buyer are used to pay down the exchangor's loan to the AT, or the bank loan on replacement property. If the relinquished property sale does not generate enough funds to pay off the exchangor's loan to the AT, the balance is forgiven. If the relinquished property sale generates proceeds in excess of the AT's debts, this excess is paid to the exchangor. The AT thus bears no benefit of increased value, or burden of decreased value of the relinquished property.
- If the relinquished property does not sell within the 180 day period, the exchangor has the right to call the parked property back from the AT for the amount of the loans owed by the AT. This call is effective for a period not in excess of 185 days after the AT acquired title. Likewise, the AT has the right to put the parked property back to the exchangor for only the amount of the debt owed by the AT. A fixed or formula price put or call longer than 185 days will knock the AT arrangement out of the safe harbor.
What if the exchangor is unable to dispose of the relinquished property within the 180 day period and wants to cancel the exchange? If the replacement property has been parked, then the AT will convey the parked replacement property to the exchangor and the exchangor will be treated as purchasing the parked property on that date. If the relinquished property has been parked with the AT, the AT simply transfers it back to the exchangor and the original transfer is rescinded.
The cost to the exchangor of the failed reverse exchange is the fee paid to the AT and the delay in taking the deduction for the tax depreciation. There can be other costs, such as state filing fees and double transfer taxes. Sales and use tax laws should also be considered in personal property exchanges.
Many reverse exchanges fail to close within the 180 day period and the exchangor must decide whether to cancel the exchange or take the risk of venturing into the gray tax waters outside the safe harbor. Many expect that conservative IRS agents might automatically disallow reverse exchanges that go beyond 180 days and the exchangor will have to fight for the validity of the exchange.
In deciding on whether to go beyond 180 days, the exchangor should analyze whether the AT is the exchangor's agent for federal tax purposes, or is acting independently. In many safe harbor reverse arrangements, the AT could probably be considered the exchangor's agent because of the lack of nonarms' length provisions.
Many exchangors know from the outset that the parking arrangement will extend beyond 180 days because of construction schedules or market conditions. Parking exchanges outside the safe harbor should be structured differently than those within the safe harbor to increase the probability that the AT will not be considered the exchangor's agent. This will be more costly for the exchangor and will entail more tax risk.
The safe harbor created by Revenue Procedure 2000-37 is a wonderful tax tool for many businesses to buy and sell assets without the cost of taxes. It creates welcome certainty for short-term reverse exchanges. It does not work for long term reverse exchanges; other alternatives should be considered when the exchangor knows the parking period will go beyond 180 days.
Foster is general counsel to Section 1031 Services Inc. in Bellevue, Wash. Her e-mail is mfoster@1031services.com.
A brief glossary
- Exchangor: The individual or business owning the assets being exchanged.
- Relinquished property: The property being sold in the exchange.
- Replacement property: The property being purchased in the exchange.
- AT (accommodation titleholder): The accommodating party who holds title to the parked property.
- Parked property: The property held by the AT for up to 180 days.
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