Reverse Exchanges

The problem is harder than it appears, and the solution is stranger than practitioners generally recognize. This chapter sets out why the statute supplies no answer, what the administrative safe harbor does and does not accomplish, and what happens to taxpayers who operate outside it, where the Service and the Tax Court are in open disagreement.

30.1 The parking problem

Section 1031(a)(3) and the deferred exchange regulations are written in one direction. They address property the taxpayer receives after transferring the relinquished property, and the preamble to the final regulations states that the deferred exchange rules do not apply to exchanges in which the replacement property is acquired before the relinquished property is transferred, and that the regulations consequently do not apply to such exchanges.¹

The obvious workaround is unavailable, and understanding why is the beginning of the analysis. A taxpayer cannot simply buy the replacement property and then exchange the relinquished property for it later, because a taxpayer cannot exchange property for property the taxpayer already owns. An exchange of real estate owned by a taxpayer for improvements on land owned by the same taxpayer does not meet the requirements of section 1031.² The Service reached the parallel conclusion for a building constructed on land the taxpayer already owned.³

What remains is to have someone else own the property in the interval. The Service's own description of the practice is accurate and worth stating in its terms. Parking transactions are designed to park the desired replacement property with an accommodation party until the taxpayer arranges for the transfer of the relinquished property to the ultimate transferee, at which point the taxpayer transfers the relinquished property to the accommodation party in exchange for the replacement property, and the accommodation party transfers the relinquished property onward. In other situations the accommodation party acquires the replacement property and immediately exchanges it with the taxpayer for the relinquished property, thereafter holding the relinquished property until a buyer is found.⁴

That description contains the tension the rest of the chapter is about. Determining the owner of property for federal income tax purposes requires an analysis of all the facts and circumstances, and as a general rule the party that bears the economic burdens and benefits of ownership is treated as the owner.⁵ The accommodation party must therefore be the owner. The taxpayer, meanwhile, wants to select the property, finance it, insure it, improve it, occupy it, and be certain of acquiring it. Those two propositions cannot both be satisfied on ordinary principles, and the safe harbor exists because Treasury decided not to make taxpayers try.

30.2 The qualified exchange accommodation arrangement

Revenue Procedure 2000-37, as modified by Revenue Procedure 2004-51, supplies the safe harbor. Its operative sentence should be read exactly, because what it promises is narrower than its reputation.

The Service will treat an exchange accommodation titleholder as the beneficial owner of property for federal income tax purposes if the property is held in a qualified exchange accommodation arrangement. Property held in a QEAA may therefore qualify as either replacement property or relinquished property in a tax deferred like-kind exchange if the exchange otherwise meets the requirements for deferral of gain or loss under section 1031 and the regulations thereunder.⁶

The safe harbor answers the ownership question and only the ownership question. It does not supply an exchange. The 2004 modification inserted the conditional clause precisely because some taxpayers had read the original language to bless transactions in which the taxpayer transferred property to a titleholder and received the same property back as replacement property.⁷ Everything examined in Parts IV, V, and the rest of this Part continues to apply.

Property is held in a QEAA if all of six requirements are met.⁸

One. The titleholder. Qualified indicia of ownership of the property are held by a person, the exchange accommodation titleholder, who is not the taxpayer or a disqualified person, and who either is subject to federal income tax or, if treated as a partnership or S corporation, has more than ninety percent of its interests or stock owned by partners or shareholders who are subject to federal income tax. Those indicia must be held at all times from the date of acquisition until the property is transferred as described in the fifth requirement.

Two. Bona fide intent. At the time the qualified indicia of ownership are transferred to the titleholder, it is the taxpayer's bona fide intent that the property represent either replacement property or relinquished property in an exchange intended to qualify for nonrecognition, in whole or in part, under section 1031.

Three. The written agreement, within five business days. No later than five business days after the transfer of qualified indicia of ownership, the taxpayer and the titleholder enter into a written qualified exchange accommodation agreement providing that the titleholder is holding the property for the benefit of the taxpayer in order to facilitate an exchange, and that the parties agree to report the acquisition, holding, and disposition as the revenue procedure provides. The agreement must specify that the titleholder will be treated as the beneficial owner of the property for all federal income tax purposes, and both parties must report the federal income tax attributes of the property consistently with it.

Four. Identification within forty-five days. No later than forty-five days after the transfer of qualified indicia of ownership of the replacement property to the titleholder, the relinquished property is properly identified, in a manner consistent with the principles of the identification regulation examined in Chapter 25, and the taxpayer may identify alternative and multiple properties under the same rules.

Five. Transfer within one hundred eighty days. No later than one hundred eighty days after the transfer of qualified indicia of ownership to the titleholder, either the property is transferred, directly or indirectly through a qualified intermediary, to the taxpayer as replacement property, or the property is transferred to a person who is not the taxpayer or a disqualified person as relinquished property.

Six. The combined ceiling. The combined time period that the relinquished property and the replacement property are held in a QEAA does not exceed one hundred eighty days.

Two structural observations follow.

The deadlines are the mirror image of a forward exchange. The same forty-five and one hundred eighty day periods apply, they run from the titleholder's acquisition rather than from a sale, and it is the relinquished property that must be identified. A practitioner who imports the forward-exchange habit of identifying replacement property has identified the wrong side of the transaction.

A separate limitation, added in 2004, forecloses the most tempting abuse. The revenue procedure does not apply to replacement property held in a QEAA if the property is owned by the taxpayer within the one hundred eighty day period ending on the date of transfer of qualified indicia of ownership to the titleholder.⁹ A taxpayer cannot park property the taxpayer recently owned and exchange back into it.

Noncompliance is not a lesser form of compliance. If the requirements are not satisfied, and the revenue procedure gives failure to transfer within the time period as its own example, the revenue procedure does not apply, and the determination of whether the taxpayer or the titleholder owns the property, together with the proper treatment of the transactions between them, is made without regard to its provisions.¹⁰

30.3 Exchange accommodation titleholders

The revenue procedure does not require the titleholder to take a deed, and the definition of what it must hold is deliberately broad. Qualified indicia of ownership means legal title to the property, other indicia of ownership that are treated as beneficial ownership under applicable principles of commercial law, and the revenue procedure gives a contract for deed as its example, or interests in an entity that is disregarded as separate from its owner for federal income tax purposes and that holds either legal title or such other indicia, and the revenue procedure gives a single member limited liability company.¹¹

The last of the three is the standard structure and is worth describing because it is what a practitioner will actually see. The titleholder forms a single member limited liability company, the company takes title to the property, and the titleholder holds the membership interests. At the end of the arrangement the membership interests are transferred rather than a second deed being recorded. Whether that reduces transfer and recordation charges is a question of State law that must be answered jurisdiction by jurisdiction, and it should not be assumed.

Because the company is disregarded, holding its interests is holding the property, which is the same principle developed at 19.2.

Two eligibility conditions govern who may serve.

The titleholder must not be the taxpayer or a disqualified person as Chapter 28 defines that term. The revenue procedure then supplies the accommodation that makes a professional industry possible: services for the taxpayer in connection with a person's role as exchange accommodation titleholder in a QEAA are not taken into account in determining whether that person or a related person is a disqualified person.¹² This parallels the exchange services exclusion examined at 28.1, and it permits the same firm to serve a client repeatedly.

The titleholder must be subject to federal income tax, or, if it is treated as a partnership or an S corporation, more than ninety percent of its interests or stock must be owned by persons who are subject to federal income tax.¹³ The purpose is evident. A titleholder outside the federal tax system could absorb income and deductions that would never be reported, and the ninety percent test permits ordinary ownership structures while excluding the tax indifferent.

One requirement is procedural and is the one most often violated by inattention. The qualified indicia of ownership must be held at all times from the date of acquisition until the transfer that ends the arrangement.¹⁴ An interruption in title, however brief and however well intentioned, is a failure of the first requirement rather than a technicality.

30.4 Exchange-last and exchange-first variants

The fifth requirement contemplates two structures, and the choice between them is usually made by a lender rather than by tax counsel.¹⁵

Exchange last, in which the replacement property is parked. The titleholder acquires the replacement property and holds it. When a buyer for the relinquished property appears, the taxpayer transfers the relinquished property in an exchange, and the titleholder transfers the parked replacement property to the taxpayer, directly or through a qualified intermediary. This is the more common variant and the one the forty-five day identification requirement is written for, since it is the relinquished property that remains to be identified.

Its advantage is that the taxpayer never appears in the chain of title to the replacement property before the exchange, which keeps the transaction clean on the side where the deferral is claimed. Its cost is that the titleholder must find the purchase price, which is the subject of 30.7.

Exchange first, in which the relinquished property is parked. The taxpayer transfers the relinquished property to the titleholder and receives the replacement property at once. The titleholder then holds the relinquished property until it can be transferred to a person who is not the taxpayer or a disqualified person.

Its advantage is that the taxpayer takes title to the replacement property immediately, which conventional lenders greatly prefer, since they are lending against property the borrower owns rather than against property held by an accommodation entity. Its costs are that the titleholder takes title to the relinquished property, with the attendant transfer tax, insurance, and liability questions, and that the parties must address what happens if the relinquished property ultimately sells for more or less than the value assigned at the outset, which the revenue procedure separately permits and which 30.7 examines.

Both variants are bounded by the combined ceiling. The total time that the relinquished property and the replacement property are held in a QEAA may not exceed one hundred eighty days,¹⁶ so a structure that parks one and then the other does not obtain two periods.

The practical counsel is that the variant should be chosen after the financing is understood rather than before. A structure designed as exchange last and then redesigned in week three because the lender will not close on a limited liability company owned by an accommodator has consumed part of a one hundred eighty day period that does not restart.

30.5 Non-safe-harbor parking and the benefits-and-burdens question

The safe harbor is not exclusive, and the revenue procedure says so in terms. The Service recognizes that parking transactions can be accomplished outside the safe harbor, and states that no inference is intended with respect to the federal income tax treatment of parking transactions that do not satisfy its terms, whether entered into before or after its effective date.¹⁷

That leaves a live question, because the one hundred eighty day ceiling is often too short. A taxpayer building a substantial improvement, or one whose relinquished property will take a year to sell, cannot fit inside the harbor and must either abandon the exchange or park outside it.

Outside the harbor, ownership is determined on ordinary principles, meaning by reference to which party bears the economic benefits and burdens.¹⁸ The Service's position is that this is dispositive. The Tax Court has held otherwise.

The leading case arose on facts that could not have used the safe harbor, because the parking began before the safe harbor existed. A facilitator acquired title to the replacement property on August 1, 2000, after which the taxpayer constructed a drug store on it and, in June of 2001, began leasing the property from the facilitator. In December of 2001 a qualified intermediary acquired the taxpayer's relinquished property, sold it, and used the proceeds to acquire the replacement property from the facilitator and transfer it to the taxpayer. The facilitator held title for seventeen months.¹⁹

The Service argued that the taxpayer, not the facilitator, had acquired the benefits and burdens of ownership in August of 2000, so that there was no exchange in December of 2001 but a taxable sale.²⁰

The Tax Court held for the taxpayer. Reasoning from the facilitator cases examined at 23.2, the court concluded that those authorities establish the principle that a third party exchange facilitator, in the Service's own summary of the holding, "need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for section 1031 purposes before the exchange." The transaction was a like-kind exchange even though the facilitator did not have the benefits and burdens and held title for seventeen months while the taxpayer oversaw construction.²¹

Note what that decision is and is not. It is a holding that the pre-regulation facilitator doctrine survives, applied to a transaction predating the safe harbor. It is not a holding that the safe harbor's limits may be ignored for later transactions, a question the case did not present.

30.6 The Service's stated non-acquiescence and its practical weight

The Service responded with an Action on Decision recommending nonacquiescence.²² Its stated position is worth reproducing closely, because it defines the exposure a client is accepting.

For transactions outside the scope of the deferred exchange regulations, the Service does not follow the court opinions taking the view that an exchange facilitator may be treated as the owner of replacement property regardless of whether it has the benefits and burdens of ownership. In determining whether a reverse exchange outside the scope of the revenue procedure meets the requirements of section 1031, the Service will not follow that principle. Taxpayers using accommodating parties outside the scope of the revenue procedure have not engaged in an exchange if the taxpayer, rather than the accommodating party, acquires the benefits and burdens of ownership of the replacement property before the taxpayer transfers the relinquished property. The Service will not follow the Tax Court's opinion to the extent it provides otherwise.²³

The same document contains a concession that is more revealing than the disagreement, and it should be read alongside 30.7. The Service acknowledges that under the revenue procedure taxpayers are permitted to use an accommodating party and meet the exchange requirement of section 1031 even though, applying ordinary benefits and burdens principles, the taxpayer acquires the benefits and burdens of ownership of the replacement property up to one hundred eighty days before the exchange.²⁴

The architecture is therefore explicit. Inside the safe harbor, benefits and burdens do not matter, by administrative grace. Outside it, the Service treats them as dispositive. There is no middle position in which a structure is close enough.

Three points on what the nonacquiescence is worth.

An Action on Decision is not authority and says so on its face, carrying a legend that it is not to be relied upon or cited as precedent by taxpayers.²⁵ It is a statement of litigating position, and it binds examining agents rather than courts.

The Tax Court opinion remains a published decision of that court. A taxpayer in a non-safe-harbor parking arrangement is not without authority; the taxpayer is in a dispute.

The practical consequence is the one to communicate. A non-safe-harbor parking transaction should be undertaken only where the taxpayer understands that the Service has announced in advance that it will challenge the position, that the challenge will turn on a facts and circumstances inquiry into who bore the benefits and burdens, and that the cost of defending it is real and should be estimated before the structure is chosen. Where the transaction can be made to fit within one hundred eighty days, it should be. The advice is not that parking outside the harbor is impermissible. It is that it is litigation, and the client should be told so in writing.

30.7 Financing a parked property

A structural difficulty runs through every reverse exchange. The titleholder must own the property, and the titleholder has no money, no interest in the asset, and no desire to bear risk on it. Somebody must pay, and the only candidate is the taxpayer.

The revenue procedure resolves this by listing arrangements that will not disqualify the structure, and the list is extraordinary. Property will not fail to be treated as held in a QEAA as a result of any one or more of them, and the revenue procedure adds that this is so regardless of whether the arrangements contain terms that typically would result from arm's length bargaining between unrelated parties.²⁶

The permitted arrangements are these.²⁷

A titleholder that satisfies the qualified intermediary safe harbor may also enter into an exchange agreement with the taxpayer and serve as the qualified intermediary in the exchange. One entity may occupy both roles.

The taxpayer, or a disqualified person, may guarantee some or all of the titleholder's obligations, including secured or unsecured debt incurred to acquire the property, or may indemnify the titleholder against costs and expenses.

The taxpayer, or a disqualified person, may loan or advance funds to the titleholder, or guarantee a loan or advance to it. In practice this is the ordinary case: the taxpayer lends the titleholder the purchase price.

The property may be leased by the titleholder to the taxpayer or a disqualified person.

The taxpayer, or a disqualified person, may manage the property, supervise improvement of it, act as contractor, or otherwise provide services to the titleholder with respect to the property.

The taxpayer and the titleholder may enter into agreements 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 one hundred eighty five days from the date the property is acquired by the titleholder.

The taxpayer and the titleholder may agree that variation in the value of a relinquished property from its estimated value on the date the titleholder received it will be taken into account on disposition, through the taxpayer's advance of funds to, or receipt of funds from, the titleholder.

Read as a whole, the list permits the taxpayer to fund the acquisition, guarantee the debt, lease the property back, manage and build on it, hold a fixed price call, and bear the entire economic variation in value. The taxpayer may hold substantially every attribute of ownership except the indicia of title. That is why the concession quoted at 30.6 is candid rather than surprising, and it is the clearest illustration in this Part of what an administrative safe harbor can accomplish that doctrine cannot.

Two limits qualify the list, and both are stated by the revenue procedure itself.

The Service may recast an amount paid pursuant to a permitted arrangement as a fee paid to the titleholder for acting as titleholder, to the extent necessary to reflect the true economic substance of the arrangement.²⁸ Below market rent, an inflated management fee, or an interest rate detached from market on the taxpayer's loan invites recharacterization even though the arrangement itself is permitted.

The revenue procedure expressly leaves open the treatment of the value variation payments and the question whether a titleholder may be precluded from claiming depreciation deductions with respect to the property.²⁹ These are not settled by the harbor, and the parties should address them in the agreement rather than discover them on a return.

One further provision removes an obstacle that would otherwise be constant. Property does not fail to be held in a QEAA merely because the accounting, regulatory, or State, local, or foreign tax treatment of the arrangement differs from the federal treatment the agreement requires.³⁰ A jurisdiction that regards the taxpayer as the owner for property tax or transfer tax purposes does not thereby break the federal structure.

The friction in reverse exchanges is accordingly not where practitioners expect it. The federal tax analysis is largely mechanical once the harbor is satisfied. The difficulties are transfer and recordation charges on two transfers rather than one, title insurance for an entity the parties have never dealt with, due on sale clauses in existing financing, casualty and liability insurance naming an accommodation entity as insured, and lenders unwilling to close on collateral held by that entity. Every one of those is a matter of State law and contract, and every one of them takes time out of a one hundred eighty day period that does not extend.