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Build-to-Suit Reverse Exchanges
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
In PLR 200251008, the IRS addressed the qualification of a build-to-suit
exchange under the administrative safe harbor for reverse exchanges under
Rev. Proc. 2000-37. The replacement property consisted of a new 32-year
sublease from a related party and improvements made by the EAT. The IRS
also addressed the safe harbor for a QI which was applicable to the reverse
exchange using the “exchange last” method. A reverse exchange
where the replacement property is parked with an EAT may actually be a simultaneous
exchange with a QI which closes when the relinquished property is sold by
the QI. The EAT simply sells the improved replacement property to the QI
and the property is transferred to the taxpayer to complete the exchange.
This was the form of the transaction in the ruling. Finally, the IRS examined
the issues presented by construction of the improvements within the 180-day
period of Rev. Proc. 2000-37, including any failure to complete improvements
before the EAT’s transfer of the replacement property and potential
boot to the taxpayer. These holdings, in and of themselves, were straightforward.
What is most interesting about PLR 200251008, however, is the newly-created
32-year sublease from a related party to the EAT. Without that lease, the
taxpayer’s exchange would not have qualified under Section 1031 since
only leases with a term of 30 years or more to run are treated as of like
kind to a fee interest. Further, a taxpayer cannot exchange property for
construction services on land that it already owns but in this case the
land was controlled by a related party, not the taxpayer itself.
Facts of PLR 200251008. An S corporation (“Taxpayer”) operated
a business on the relinquished property (RQ). Taxpayer owned a fee interest
in RQ and all improvements thereon. CorpW was an S corporation that was
related to Taxpayer. CorpW leased land as lessee land under a lease (“Lease”)
with a city as lessor. The Lease’s term was 45 years and had one 15-year
renewal option. LLC-W, a limited liability company, was related to CorpW
and Taxpayer. LLC-W subleased the land from CorpW and all rights, title,
interest and obligations under the Lease for the entire term of the Lease.
LLC-W planned to utilize the land, in part, as the new location for Taxpayer’s
business that was currently operated on RQ. LLC-W was developing and constructing
the infrastructure required so that the business could be moved to the land.
Taxpayer and CorpW were each owned half and half by Husband’s Trust
and Wife’s Trust, respectively. LLC-W was owned 45%, 45% and 10%,
respectively, by Husband’s Trust, Wife’s Trust and a minority
member.
Buyer and Taxpayer entered into an Option Agreement for Sale and Purchase
of RQ (Sale Agreement). Under the Sale Agreement, the Taxpayer agreed to
sell RQ to the Buyer. However, Taxpayer arranged to have the transfer of
RQ to Buyer structured as a like-kind exchange under Section 1031. To facilitate
a future exchange, Taxpayer used the qualified exchange accommodation arrangement
(QEAA) safe harbor provided in Rev. Proc. 2000-37, with an exchange accommodation
titleholder (EAT). The EAT acted through a single-member LLC, Titleholder.
Taxpayer also used the qualified intermediary safe harbor rules by entering
into an exchange agreement with a qualified intermediary (QI). Initially,
the QEAA was between Taxpayer and EAT. Later, Taxpayer’s rights under
the QEAA were assigned to QI to facilitate transfer of the replacement property
(RP) from EAT to Taxpayer. Titleholder was created to enter into the sublease
and take title to RP. Titleholder was a limited liability company, with
EAT as its sole member, and disregarded for federal income tax purposes.
The entire transaction can be summarized in the following steps: (1) Taxpayer
enters into the QEAA with EAT, and enters into an exchange agreement with
QI as described. (2) LLC-W subleases RP at a fair market rental for 32 years,
to Titleholder, a disregarded entity wholly owned by EAT, as part of a QEAA.
(3) Taxpayer lends to Titleholder the funds which Taxpayer borrows from
Husband’s Trust, Wife’s Trust and Bank to construct improvements
on leased property for the relocation of Taxpayer’s business. (4)
Taxpayer assigns its rights under the Sale Agreement to QI and gives required
notices of such assignment to all interested parties. (5) Taxpayer transfers
RQ free and clear through QI to Buyer and QI receives the sales proceeds.
(6) Taxpayer assigns its position in the QEAA to QI and gives required notices
of such assignment to all interested parties. (7) QI uses the sales proceeds
from RQ to pay EAT for all of its ownership interest in Titleholder (which
holds all of RP, consisting of the 32-year sublease and newly constructed
improvements to suit Taxpayer’s business requirements). (8) EAT uses
the proceeds received from QI to pay Construction Manager and to pay the
loan from Taxpayer in full (which Taxpayer, in turn, uses to pay the Bank
Construction Loan in full). (9) QI directs EAT to transfer its membership
interest in Titleholder (which holds RP) directly to Taxpayer.
IRS’s Holding. The IRS ruled that (1) Taxpayer’s exchange
will conform with the requirements of the QI and the QEAA safe harbor rules,
so that QI and EAT will not be agents of Taxpayer and Taxpayer will not
be in actual or constructive receipt of money or other property before receiving
RP; and (2) Taxpayer will not recognize any gain upon the transfer of RQ
to Buyer and the receipt of RP, except that if planned improvements are
not completed within the exchange period, gain will be recognized to the
extent of any boot received in the exchange. Implicit in the IRS’s
holding is recognition of and respect for the newly-created 32-year sublease
from the related party. The IRS assumed that this sublease was bona fide
since it provided for market rent. The IRS did not raise any issues other
than the Section 1031(f)(1) issue (and that was a concern for the IRS only
if there was a subsequent disposition by the taxpayer or related parties
of their respective leasehold interests in the two-year period). The IRS
simply concluded that since the sublease had a remaining term of 30 or more
years, the sublease and improvements were of like kind to the fee interest
in the relinquished property. The IRS also did not express any concern that
the transaction was, in essence, a non-like-kind exchange of land for construction
services.
In PLR 200329021, the IRS approved a leasing structure similar to the structure
used in PLR 200251008 to build improvements on land leased to and controlled
by a related party. In PLR 2003290021, a parent corporation (Parent) held
a leasehold interest as lessee in land owned by an unrelated party. Parent
is the sole shareholder of several subsidiaries, including the exchanging
taxpayer (“Taxpayer”). The Taxpayer holds title to fee-owned
properties with certain business facilities. The facilities are operated
by Parent, and Parent provides compensation to the Taxpayer for use of the
facilities. The lease to the Parent was a ground lease which entitled the
Parent as lessee to construct certain types of real property improvements.
The lease was for a period of twenty years with four 5-year renewal options
held by the lessee. Thus, the lease had a potential term of 40 years. The
lease was on arm’s-length commercial terms with the unrelated owner
of the land. The leasehold interest was never the property of the Taxpayer.
Facts of PLR 200329021. The Taxpayer, a wholly-owned subsidiary of Parent,
was disposing of fee interests in its business sites (relinquished property)
and wanted to receive the lease with newly constructed improvements (replacement
property). The Parent assigned its leasehold interest to a single-member
limited liability company (LLC) whose sole member was an exchange accommodation
titleholder (EAT). The EAT was represented not to be a “disqualified
person” and also served as the qualified intermediary (QI) in the
Taxpayer’s deferred exchange. Within five days, the Taxpayer, EAT,
and LLC entered into a qualified exchange accommodation arrangement (QEAA)
under Rev. Proc. 2000-37. Fee interests in relinquished property were sold
in a deferred exchange with the QI, and the QI received the sales proceeds.
The Taxpayer represented that the exchange would be completed within 180
days after the earlier of (i) the Taxpayer’s transfer of the relinquished
property in the deferred exchange or (ii) the LLC’s acquisition of
the leasehold interest. Under Parent’s supervision, the LLC constructed
improvements on the leased property according to plans and designs provided
by Parent. The QI made monthly disbursements to the LLC from the net exchange
proceeds (which the QI received on the sale of the relinquished property).
The monthly disbursements allowed the LLC to make payments to the general
contractor constructing the improvements. The LLC also reimbursed Parent
for the third-party planning costs incurred in planning the construction
of the improvements.
Before the end of the 180-day period, the Taxpayer assigned its rights
under the QEAA to the QI. The QI then transferred the balance of the Taxpayer’s
exchange proceeds to the LLC, and the LLC transferred the leasehold interest
and improvements to the Taxpayer to complete its exchange. The IRS implicitly
held that this structure avoided the problems created by Bloomington Coca-Cola
Bottling Co. v. Commissioner, 189 F2d 14 (7th Cir 1951). Further, the Taxpayer
represented that neither the Taxpayer nor Parent had any current intention
to sell or otherwise dispose of the replacement property after it is acquired.
Based on this representation, the IRS specifically held that the structure
avoided the problems created by Section 1031(f) in general and Section 1031(f)(4)
in particular. Under the QEAA Agreement, the purchase price to be paid for
the acquisition of RP will be equal to the costs incurred by LLC in constructing
the Improvements and acquiring the Leasehold Interest, including capitalized
costs such as accrued rent, real estate taxes, and planning costs. The final
purchase price will be determined immediately before the end of the 180-day
period. If the actual purchase price exceeds the qualified funds held by
QI, the excess purchase price will be paid in cash by the Taxpayer or will
be paid by the Taxpayer by assuming the outstanding indebtedness of LLC
for the construction period expenses. If the actual purchase price is less
than the qualified funds held by QI, and if the Taxpayer does not timely
identify and acquire additional like-kind replacement property in the deferred
exchange, the Taxpayer will receive the remaining qualified funds as boot.
Analysis of PLR 200329021. These facts stretch the envelope of “form
over substance” further for build-to-suit exchanges involving land
controlled by a related party. PLR 200329021 had even more “aggressive
facts” than PLR 200251008 in that (1) the related party was the parent
corporation of a consolidated group of corporations and the taxpayer was
a wholly-owned subsidiary; (2) the parent corporation itself operates and
uses the facilities (although it compensates the wholly-owned subsidiary
for such use); (3) the lease was assigned rather than subleased; (4) there
was no ownership by any “minority member” of any interest in
the entity owning the original leasehold (in PLR 200251008 there was a 10%
ownership by a “minority member”); (5) prior to the taxpayer’s
receipt of the replacement property, the QI made monthly disbursements of
deferred exchange funds to the EAT to pay the general contractor and to
reimburse the parent corporation for third-party planning costs; and (6)
these disbursements were held not to have violated the “(g)(6) limitations” (in
PLR 200251008 the exchange appeared to be simultaneous under the “exchange
last” method).
It remains doubtful, however, that the IRS would approve of a similar transaction
if the EAT had acquired a leasehold interest in land owned by the taxpayer
and then constructed improvements. See Rev. Proc. 2004-51 discussed above.
In PLR 200329021, the Taxpayer expressly represented that the leasehold
interest was never the property of the Taxpayer. Rather, the assigned leasehold
interest was previously acquired by Parent under a ground lease with an
unrelated landlord. If the EAT acquires a leasehold in land owned by the
taxpayer itself, the IRS may assert: (1) in substance, the transaction is
a prohibited exchange of property for construction services; (2) in form,
the transaction violates Bloomington Coca-Cola Bottling Co., supra upon
the merger of the acquired leasehold and the previously owned fee; and (3)
the lease should be disregarded under the “step transaction” doctrine.
See DeCleene v. Commissioner, supra.
A key fact in both PLRs was that the leasehold interest had 30 or more
years to run at the time it was acquired by the taxpayer. Thus, the taxpayer
is exchanging a fee interest in improved real estate for a long-term lease
of land for a period of 30 or more years and improvements. Such properties
are of “like kind” under the example in Treas. Reg. Section
1.1031(a)-1(c)(2). The rulings also noted that the courts have permitted
taxpayers “great latitude” in structuring build-to-suit exchanges
and cited many of the key cases. But the IRS did not specifically mention
Boise Cascade Corp. v. Commissioner, 33 T.C.M. 1443 (1974). The facts in
Boise Cascade Corp. are remarkably similar to the facts of PLR 200329021,
except that the parent corporation in the ruling assigned its leasehold
interest rather than sold the land upon which the improvements were made.
The taxpayer in PLR 200329001 could point to Boise Cascade Corp. v. Commissioner,
as comparable authority to support its tax treatment of the transaction.
In that case the court held that land and improvements qualified as like-kind
property under Section 1031, even though the parent corporation sold the
replacement property land to an unrelated buyer, leased back the land for
15 years with an option to repurchase it at the same price, supervised construction
and was responsible for cost overruns, and arranged for the improvements
to the land while title was held by the unrelated buyer. The court found
that title to the land did in fact vest in the unrelated buyer while the
improvements were constructed (similar to the qualified indicia of ownership
in the lease acquired by the EAT through the LLC in PLR 200329001). According
to the court, the fact that the unrelated buyer granted a lease and an option
to repurchase back to the parent corporation affected only the “grade
or quality” of the property and did not make it different in kind
or class. The court also held that the substance of the transaction was
consistent with the form, and that planning and arranging for such an exchange
is permissible under Section 1031 even if it is done for tax purposes.
Both the IRS and the court in Boise Cascade Corp. recognized that separate
taxable entities were involved, even though they were a parent and subsidiary
corporation. The court rejected any theory based on “one economic
family” in analyzing the substance of the transaction. Rather, the
court found that the substance of the transaction was an exchange of like-kind
property since the unrelated buyer acquired and held fee title to the replacement
property and thus had like-kind property to exchange with the taxpayer.
This fundamentally distinguished the case from the Seventh Circuit’s
core holding in Bloomington Coca-Cola Bottling Co., v. Commissioner, 189
F.2d 14, 16 (7th Cir. 1951) in which the court stated: “But this is
not a case where the contractor exchanged a completed plant owned by the
contractor for property and money, hence the contractor at no time had like-kind
property . . . . ” [Emphasis added.] In Bloomington Coca-Cola Bottling
Co., the form of the transaction was a construction contract and the contractor
was engaged to construct a new bottling plant on land owned by the taxpayer.
Under the contract, the contractor furnished the necessary material and
labor, completed the new building at a price of $72,500, and was paid $64,500
in cash and received the taxpayer’s old plant valued at $8,000. The
contractor simply performed construction services and never had like-kind
property to exchange with the taxpayer.
PLR 8304022 is the only ruling to address an exchange in which the replacement
property is a newly-created leasehold interest together with leasehold improvements
constructed on land owned in fee by the taxpayer. This is not only an older
private letter ruling but also there is no analysis of the effect, if any,
of the taxpayer’s prior and continuing ownership of the fee interest
in the replacement property and the applicability of the substance-over-form
or step-transaction doctrines to the transaction. For that reason, it is
possible that the IRS might reconsider its holding in PLR 8304022 in analyzing
a similar transaction today. See Rev. Proc. 2004-51. In PLR 200329021, the
IRS specifically noted that the assigned leasehold interest “was never
the property of Taxpayer.” In PLR 9243038, the IRS mentioned but did
not apply the step-transaction doctrine where there was a seven-year period
in between the granting of a 90-year ground lease by the taxpayer and the
subsequent exchange for the leasehold interest and improvements on the land
owned by the taxpayer. The IRS noted that there was no binding obligation
to make the exchange at the time of the lease. But PLRs 200329001 and 200251008
indicate that the IRS may not consider or apply these judicial doctrines
at least where (1) there is a business purpose for the transaction (i.e.,
the taxpayer’s business relocation), (2) the lease is at a market
rental rate and is not transitory, and (3) the land is owned by or leased
to a related party (not the taxpayer itself).
If the taxpayer sells the land to the accommodator, the transaction may
be the most vulnerable to an IRS challenge. See Rev. Proc. 2004-51. An IRS
attack most likely would use the same step-transaction approach with which
the IRS prevailed in DeCleene v. Commissioner, 115 T.C. 457 (2000). See
also Smith v. Commissioner, 537 F.2d 972 (8th Cir. 1976). After their purported
exchanges, the taxpayers in DeCleene and Smith ultimately ended up with
cash and with property that they previously owned. The application of the
step-transaction doctrine to find a taxable sale was not surprising in these
cases. If the taxpayer receives a leasehold interest and leasehold improvements
as replacement property (and no cash), the transaction may seem less abusive
but it is still susceptible to a challenge as an exchange of property for
construction services following Bloomington Coca-Cola Bottling Co., supra.
See also PLR 8921058 (2/27/89), revoking PLR 8847042 in which the IRS originally
approved an exchange of property with a contractor for a townhouse constructed
on land previously owned by the taxpayer. PLR 8921058 revoked PLR 8847042
because the IRS was concerned that the transaction was, in substance, an
exchange of property for construction services.
In summary, if the replacement property land was previously owned by the
taxpayer and improvements are made after either a sale of the property
or the granting of a long-term leasehold interest to the accommodator, there
is great risk that the IRS or a court will disqualify the exchange as
a
transfer of property for construction services. If a related party sells
the replacement property land for cash within two years of an exchange,
Section 1031(f) may disqualify the exchange. See Rev. Rul. 2002-83. However,
if a related party (not the taxpayer itself) owns or leases the land,
the related party may grant, assign or sublease a leasehold interest to
a build-to-suit
accommodator. A leasing structure with a related party is certainly the
least risky of these alternatives in light of the IRS’s holdings in
PLRs 200329021 and 200251008. The IRS has now ruled twice that such a
structure avoids the Scylla of Section 1031(f) and the Charybdis of Bloomington
Coca-Cola
Bottling Co. |