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New Safe Harbor for Reverse Like-Kind Exchanges

In response to urging from the real estate industry and the legal community, the Internal Revenue Service just issued guidance with relating to "reverse" tax-free exchanges (i.e., like-kind exchanges where the replacement property is acquired before the relinquished property is transferred). This guidance takes the form of a revenue procedure providing a safe harbor if certain technical requirements are met.

Background

Section 1031(a)(3) of the Code and the regulations thereunder expressly permit like-kind exchanges where the relinquished property is transferred prior to or simultaneously with the acquisition of the replacement property, if the replacement property is identified within 45 days of the transfer of the relinquished property and is acquired within 180 days of such transfer (or prior to the due date of the taxpayer's return, including extensions, if earlier). The Service has reserved judgment as to whether section 1031 applies if the replacement property is acquired before the relinquished property is transferred. In response to this position, taxpayers have engaged in numerous variations of what are commonly called "parking" transactions.

Parking transactions commonly take one of the following two forms:

Format 1 -- A friendly party acquires the replacement property and retains it until the taxpayer is ready to dispose of the relinquished property, at which point the friendly party transfers the replacement property to the taxpayer in exchange for the relinquished property.

Format 2 -- The friendly party acquires the replacement property, immediately exchanges it with the taxpayer for the relinquished property, and then retains the relinquished property until the taxpayer arranges for its sale to a true third party.

In either case, the objective of protecting the friendly party from any economic exposure raises various issues regarding the substance of the parking transaction and whether its form should be respected.

Revenue Procedure 2000-37

Revenue Procedure 2000-37 sets forth a safe harbor under which a taxpayer may engage in either of these parking formats in connection with a like-kind exchange and the Service will not challenge (1) the qualification of property as "replacement property" or "relinquished property" or (2) the treatment of the friendly party as the beneficial owner of such property for federal income tax purposes. (The Revenue Procedure refers to the friendly party as the exchange accommodation titleholder; we will refer hereafter to the accommodation titleholder as the "AT".) The Revenue Procedure applies to an AT which acquires property on or after September 15, 2000.

The Revenue Procedure requires that an AT be a taxable entity or individual (or in the case of an AT which is an S corporation or a partnership, that 90% of its stock or interests must be owned by taxable entities or individuals) or a limited liability company wholly owned by such an entity or individual. The taxpayer and the AT must enter into an agreement incorporating various required provisions within five days of the acquisition of legal title by the AT. The most significant requirements for qualification under the safe harbor are (1) that the property cannot be parked for more than 180 days and (2) in the case of Format 1 above, that the relinquished property must be identified within 45 days of the AT's acquisition of the replacement property.

The AT will typically wish to enter into arrangements with the taxpayer which have the effect of eliminating the AT's economic exposure. The Revenue Procedure states that an AT arrangement will qualify for safe-harbor treatment notwithstanding the presence of one or more specified legal or contractual arrangements, even if those arrangements contain terms that would not typically result from arm's length bargaining. For example:

a. the AT may act as a "qualified intermediary" in connection with the exchange,

b. the taxpayer or certain persons related to the taxpayer (hereafter referred to as "disqualified persons") may guarantee the obligations of the AT or indemnify the AT against costs and expenses,

c. the taxpayer or a disqualified person may lend funds to the AT or guarantee a loan to the AT,

d. the AT may lease the property to the taxpayer or a disqualified person,

e. the taxpayer or a disqualified person may manage the property, supervise the improvement of the property, or otherwise provide services to the AT with respect to the property,

f. the taxpayer and the AT may enter into a contract relating to the purchase or sale of the property, including puts and calls at fixed or formula prices (as long as they are not effective beyond 185 days from the date the property is acquired by the AT), and

g. the taxpayer and the AT may enter into an agreement providing that any variation in the value of the relinquished property from the estimated value on the date of the AT's receipt of the property will be accounted for by a cash payment.

The Revenue Procedure, by providing a safe harbor in an area of the law that was previously unsettled, is likely to open the door for many who would otherwise be precluded from engaging in like-kind exchanges.

If you have any questions on these or related matters, please call Howard Levine (202-293-3400), Lary Wolf (212-903-8719), Joseph Lipari (212-903-8765), or Ezra Dyckman (212-903-8785), all of whom work extensively in this area.