E-DIRT
Fall 2000
(Volume I, Issue 4)
Newsletter
of the Real Property Probate and Trust Law Section
of the American Bar Association
Back
to Table of Contents
Gerson, Grekin
& Wynhoff
Honolulu, Hawaii
(808)
524-4800 (Voice)
(808) 537-1420 (Fax)
E-mail: ngrekin@ggwlaw.com
The Internal Revenue
Service has recognized that taxpayers were carrying out so-called "reverse"
exchanges since issuance of the deferred exchange Regulations in 1991.
The preamble to the deferred exchange Regulations characterized such
an exchange as one in which the taxpayer acquired the replacement property
before selling the relinquished property, and indicated that the Regulations
did not apply to reverse exchanges, and that the Service would continue
to study the applicability of the Regulations to reverse exchanges.
During the intervening nine years, there were no PLR's, Revenue Rulings,
cases nor TAM's discussing the issue and it appeared that the Service
did not intend to challenge reverse exchanges. Finally on September
15, 2000, the Service issued a Revenue Procedure providing a safe harbor
for reverse exchanges. Ironically, on September 15, 2000 the Service
issued a TAM disallowing a reverse exchange which was not structured
within the safe harbor although the transaction occurred prior to September
15.
Structure of a Reverse
Exchange
Prior to issuance of
the Rev. Proc., exchange attorneys did not structure these types of
exchanges as pure reverse exchanges in which the taxpayer acquired replacement
property in his own name prior to sale of the relinquished property,
but typically used "parking arrangements" in the following manner:
With no guidance or time
limits prescribed for these transactions by the Service, accommodators
could and often did hold replacement property for extended periods of
time if the taxpayer was unable to sell the relinquished property, and
it was possible to structure multi-property reverse exchanges in which
the taxpayer sold several relinquished properties over an extended period
of time while the accommodator held the replacement property.
It is likely that the
Service did not challenge these transactions because they were difficult
to detect. The second leg of a reverse exchange in which the relinquished
property was sold and exchanged for the replacement property was reported
as a forward exchange and there would be nothing about the transaction,
except the identity of the seller (which is not reported on the return)
to indicate that an accommodator had first parked the replacement property
in a reverse exchange.
The Revenue Procedure
If the Service had challenged
the typical reverse exchange parking arrangement, it would likely have
been on the theory that the accommodator held the replacement property
as the taxpayer's agent and that there was no exchange because the taxpayer
constructively owned the replacement property, and could not acquire
it from himself in an exchange. The Rev. Proc. seems to address this
as the issue in reverse exchanges by providing that so long as the safe
harbor is followed, the Service will not challenge the qualification
of property as either replacement property or relinquished property,
nor treat the accommodator as the agent of the taxpayer. The Rev. Proc.
includes the following requirements:
The Safe Harbor is
Not Exclusive
The safe harbor does
not apply to transactions that occurred prior to its issuance, nor is
a transaction necessarily disqualified even after the issuance of the
Rev. Proc. if it outside the safe harbor. Of course taxpayers should
be cautioned that success of a transaction not within the safe harbor
cannot be assured, and unless and until there are rulings affirming
transactions outside the safe harbor, it is not clear how far a taxpayer
can deviate without risk of disallowance.
Qualified Exchange
Accommodation Arrangements
The taxpayer must enter
into a "qualified exchange accommodation arrangement" with a third party
in order to be within the safe harbor. Such an arrangement requires
the following:
Time Limits
Although the Rev. Proc.
validates the typical structure of reverse exchanges, it imposes time
limits for completion of the transactions. Under the Rev. Proc. the
taxpayer must identify the relinquished property to be exchanged for
the replacement property within 45 days of transfer of the replacement
property to the accommodator. The 3 property/200%/95% rules of Reg.
Sec. 1.1031(k)-1(c)(4) apply to designation. Oddly, the Rev. Proc. does
not address identification of replacement property if the relinquished
property is transferred to the accommodator. No later than 180 days
after transfer of either property to the Accommodator, the exchange
must be completed by transfer of the replacement property to the taxpayer
or the relinquished property to an unrelated buyer.
Although the Rev. Proc.
is a non-exclusive safe harbor, this requirement will make it far more
difficult to qualify reverse exchanges or to assure taxpayers that if
they do not meet the time deadlines that they can be assured of a successful
exchange. Under these requirements, if the taxpayer arranges to have
the accommodator acquire replacement property, the relinquished property
must be sold within 180 days. If this is not done, then the relinquished
property cannot be exchanged for the replacement property under the
safe harbor. Of course it could be exchanged for other property, but
this deprives the taxpayer of the ability to use the net funds for this
purpose. If the taxpayer is attempting to sell multiple properties and
identifies more than 3 properties but does not sell 95% in value of
the relinquished properties designated, he may be treated as having
identified no replacement property.
Apparently tax practitioners
have reacted to the time limits imposed by the Rev. Proc. because the
Service has announced that despite pressure from tax practitioners,
the 180-day time limit is unlikely to change. James Sowell, associate
tax legislative counsel told a session of the ABA Section of Taxation
on October 13 that it expected a lot of comments to the 180-day time
limit, but nevertheless issued the Rev. Proc. because officials were
"quite confident" that the 180-day limit was what they preferred. He
indicated that the safe harbor "target audience" was the smaller, less
sophisticated owner, and that the 180-day limit was sufficient for them.
Permissible Agreements
The Rev. Proc deals in
a very taxpayer-friendly way with many of the perplexing problems of
structuring reverse exchange parking arrangements by providing that
the taxpayer and accommodator may structure the exchange as follows:
Remaining Issues
Reverse exchanges can
be difficult to structure because of the difficulty of characterizing
and reporting income and expenses while the property is owned by the
accommodator. The Rev. Proc. makes clear that the accommodator must
be treated as the owner of the property for tax purposes which will
mean that it must recognize income earned from it, and should be entitled
to deduct expenses of ownership incurred while it holds title which
will offset income. The following issues involving ownership for tax
purposes arise in reverse exchanges:
Technical Advice
Memorandum 200039005
On September 29, 2000,
two weeks after issuing the reverse exchange Rev. Proc., the Service
issued a TAM which disallowed a reverse exchange. This taxpayer had
intended to enter into a deferred exchange, but at closing the sale
of the relinquished property fell through. The seller of the replacement
property demanded that the taxpayer complete the closing of that purchase,
so the taxpayer borrowed the funds necessary to purchase the replacement
property, and paid the purchase price directly to the seller, but had
the seller convey the property to the accommodator. The taxpayer apparently
did not enter into an exchange agreement of any kind with the accommodator.
At a later date the taxpayer sold the relinquished property, entered
into an exchange agreement, exchanged the relinquished property for
the replacement property, and reported the transaction as a Section
1031 exchange.
The Service ruled that
this transaction was in fact a reverse exchange and reiterated its comments
in the preamble to the deferred exchange Regulations that the Regulations
and the safe harbors therein do not apply to reverse exchanges. It further
ruled that the qualified intermediary safe harbor of the deferred exchange
Regulations was not available to the taxpayer because he did not enter
into an exchange agreement with the accommodator, a requirement for
the accommodator to be a qualified intermediary. Since the Accommodator
did not qualify as an intermediary under the deferred exchange Regulations,
it was deemed to hold the replacement property as the taxpayer's agent,
and because the taxpayer failed to enter into an exchange agreement
it followed that the disposition of the relinquished property and acquisition
of the replacement property were treated as separate and not an integrated
exchange transaction.
This ruling reinforces
the theory of the reverse exchange Rev. Proc., the deferred exchange
Regulations, and the post-Starker cases with a giant exclamation
point! The taxpayer paid for the replacement property directly but directed
that it be deeded to the accommodator. The accommodator could not be
treated as the owner of the property for tax purposes because it had
not paid for the property. It was apparent that it held as agent or
nominee for the taxpayer. Because the taxpayer failed to enter into
an exchange agreement it could not qualify under the deferred exchange
Regulations, and had it concluded the transaction after the issuance
of the Rev. Proc. he would not have met its requirements for the safe
harbor.
Conclusion
Prior to issuance of
the reverse exchange Rev. Proc. many tax advisers believed it was dangerous
to attempt reverse exchanges, even though it was apparent that the Service
was not challenging them as it had deferred exchanges following Starker
but before issuance of the deferred exchange Regulations. So it is encouraging
to have the Service finally approve these transactions and to do so
in a manner which validates the practices of exchange advisers in structuring
them. Prior to issuance of the Rev. Proc. several prominent members
of the exchange bar submitted a proposed procedure to the Service which
would have given taxpayers two years to complete a reverse exchange
and the ability to request an extension if this could not be done. But
the Service obviously rejected that proposal preferring to require as
it did with forward deferred exchanges that the transaction be completed
within a relatively short period of time.
The time limits imposed
by the Rev. Proc. will make reverse exchanges suitable only for those
taxpayers who have either already agreed to sell the relinquished property
but were unable to close before being required to acquire the replacement
property, or for taxpayers who are willing to take the risk that they
may have to purchase the replacement property with funds other than the
net proceeds of sale of the relinquished property.
NANCY N. GREKIN
was awarded her B.B.A., With High Distinction, from The University of
Michigan in 1969, and her J.D. magna cum laude, from The University
of Michigan Law School in 1976. Mrs. Grekin is admitted in Michigan and
Hawaii, and practices in the areas of transactional real estate, ground
and space leasing, 1031 exchanges, condominiums, commercial and secured
transactions, and general business counseling. She is an active member
of the Board of the Real Estate and Financial Services Section of the
Hawaii State Bar Association, served as editor of its quarterly newsletter
in 1993, was the 1994 Chair of the Section and created and maintains its
Web site at http://www.hsba.org/sections/rpfs. She was the 1998 Treasurer
of the Hawaii State Bar Association and is the current Chair of the Continuing
Legal Education Committee of the Bar. Mrs. Grekin is the Hawaii reporter
for the State Limited Liability Company and Partnership Laws treatise
published by Aspen Law & Business.
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E-DIRT
Fall 2000
(Volume 1, Issue 4)
Newsletter
of the Real Property Probate and Trust Law Section
of the American Bar Association
Back
to Table of Contents
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