On October 2, 2000 IRS published a new safe harbor for reverse like-kind exchanges.i This welcome development is the first major change for like-kind exchange transactions since the 1991 final regulations provided safe harbors for standard deferred exchanges.ii The 1991 issuance of deferred exchange regulations resulted in the common practice of utilizing a Qualified Intermediary (QI) to accomplish non-simultaneous like-kind exchanges. The final regulations did not apply to reverse exchanges, but neither did the tax code or treasury regulations prohibit reverse exchange transactions. Cautious taxpayers have avoided reverse exchanges in the absence of clear guidelines demonstrating how they can be accomplished. During the past few years, however, more aggressive taxpayers have been attempting reverse exchanges with increasing frequency. The new safe harbor finally provides a solution to taxpayers who must acquire replacement property before the transfer of the relinquished property.
The reverse exchange safe harbor validates the "parking" method that has developed in the exchange industry to accommodate reverse exchanges. In a typical parking arrangement, a third-party accommodator holds title to either the relinquished or replacement property in order to arrange the taxpayer's transfers to simulate a typical, straightforward exchange. Concerns that have commonly arisen in attempting to maintain an arm's length transaction have included the following questions:
- Will IRS attack the titleholder as the taxpayer's agent rather than the beneficial owner or the property?
- Do any time restrictions apply?
- May the taxpayer provide funds to the titleholder for its acquisition of the parked property?
- How should the titleholder treat the property for its tax purposes?
In answer to these questions, the reverse exchange safe harbor provides a mechanism to assure the taxpayer his transaction will not be attacked if he complies with its provisions. Significantly, the ruling does not prohibit other techniques of accomplishing a reverse exchange outside of the safe harbor. But, the safe harbor provides one method that will not be challenged.
Safe Harbor Provisions
In order to comply with the safe harbor, the taxpayer must enter into a written Qualified Exchange Accommodation Agreement (QEAA) with an Exchange Accommodation Titleholder (EAT) within five days after the EAT acquires the property to be parked. The EAT must meet the same agency requirements as a QI. For instance, it may not be a "related party" to the taxpayer, or a "disqualified person" such as an attorney, realtor, or CPA who has represented the taxpayer in any capacity during the past 2 years. Using the safe harbor, there are two basic alternatives for structuring the reverse exchange. The EAT will hold either the relinquished property or the replacement property for the taxpayer. In either structure, 180 days is the maximum period that the EAT may park the property. If the EAT holds the replacement property, the taxpayer must identify his relinquished property within 45 days, under the same identification rules that apply in a straightforward exchange. The EAT may hold the property in a special purpose entity (SPE), such as a single-member LLC. The safe harbor allows the taxpayer to advance funds or guarantee a loan to the EAT for the acquisition of the parked property. The EAT must report the acquisition and disposition of the parked property on its tax return as the beneficial owner of the property. Typical steps for the two alternative methods may be outlined as follows:
Parking the Relinquished Property (Exchange First Structure)
- The Taxpayer enters into a QEAA in which the EAT agrees to hold title to the relinquished property for the taxpayer until an ultimate purchaser is found.
- The Taxpayer enters into a Deferred Exchange Agreement with a QI.
- The EAT acquires a loan, guaranteed by the Taxpayer, for the purchase of the relinquished property.
- The Taxpayer, via the QI in a standard exchange, transfers the relinquished property to the EAT, and the sales proceeds are disbursed to the QI.
- The Taxpayer then, via the QI, acquires title to the replacement property from a third-party seller using the funds provided by the QI.
- The EAT must convey the relinquished property to the ultimate purchaser, who is not the taxpayer or a disqualified person, within 180 days after acquiring it from the taxpayer. The sales proceeds are used to pay off the EAT's loan.
Parking the Replacement Property (Exchange Last Structure)
- The Taxpayer enters into a QEAA in which the EAT agrees to hold title to the replacement property for the taxpayer until an ultimate purchaser is found for the relinquished property.
- The Taxpayer enters into a Deferred Exchange Agreement with a QI.
- Within 45-days after the acquisition of the replacement property by the EAT, the Taxpayer must formally identify the relinquished property.
- The Taxpayer, via the QI in a standard exchange, transfers the relinquished property to a third-party buyer, and the sales proceeds are disbursed to the QI.
- The Taxpayer, via the QI, acquires title to the replacement property from the EAT, using the funds provided by the QI. The EAT's loan is paid off at closing.
- The EAT must convey the replacement property to the Taxpayer within 180 days after acquiring it from the third-party seller.
Advantages and Alternatives to a Reverse Exchange
Reverse exchanges give the Taxpayer more flexibility in structuring his exchange. In moving a business, for instance, the Taxpayer may need to have a new facility in place before he can move out of the old facility. Or, he may need to take advantage of an opportunity to acquire ideal property at optimal market prices before he has found a buyer for his old property. If feasible, the Taxpayer should not forget to explore more traditional methods of extending the time frame for purchase of the replacement property to avoid the added complexity of a reverse exchange. Typical strategies include offering additional earnest money to the seller of replacement property as consideration for delaying the closing, or leasing the new property from the seller with an option to buy after the relinquished property sells. A reverse exchange will require substantially more legal advice and documentation than a straightforward exchange, resulting in a more expensive transaction; but, it may provide a viable option for the taxpayer depending on his particular circumstances and exchange goals.
Carol A. Hayden is Vice President of Investors Title Exchange Corporation. She can be reached at email@example.com or 800-326-4842.
i Rev. Proc. 2000-37; I.R.B. 2000-40.
iiTreas. Reg. § 1.1031(k)-1.