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Review of Revenue Procedure 2000-37
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Rev. Proc. 2000-37 provides an administrative safe harbor for reverse
exchanges that are parking transactions and use either the exchange last
or exchange first method. The property must be held in a “qualified
exchange accommodation arrangement” (QEAA). Section 4.02 of the
Rev. Proc. spells out six formalistic requirements for a QEAA, including
(1) title or other qualified indicia of ownership to the parked property
must be held by a person qualified to be an exchange accommodation titleholder
(EAT); (2) the taxpayer must have a bona fide intent that the parked property
qualify as replacement or relinquished property under Section 1031; (3)
the taxpayer and the EAT must enter a written qualified exchange accommodation
agreement that contains specified provisions within five (5) business
days after the EAT acquires the parked property; (4) if the exchange last
method is used, the taxpayer must identify the relinquished property within
45 days after the EAT acquires the replacement property; (5) the parked
property must be transferred by the EAT and the transaction must be completed
within 180 days after the EAT acquires the parked property; and (6) the
combined time period that the relinquished property and the replacement
property are held in a QEAA must not exceed 180 days.
The inflexible 180-day time limitation is the key to qualifying a reverse
exchange under the safe harbor. Within 180 days after the EAT acquires the
parked property, the EAT must transfer the parked property. The parked property
must be transferred to the taxpayer if the EAT holds the replacement property
under the exchange last method, or to the buyer if the EAT holds the relinquished
property under the exchange first method. A “safe harbor” reverse
exchange necessarily means a parking transaction with an EAT that is completed
within 180 days. Parking transactions that are not completed in 180 days
(or otherwise do not meet the requirements of the Rev. Proc.) are referred
to as “non-safe-harbor” reverse exchanges. Section 3.04 of the
Rev. Proc. provides that if the requirements of the safe harbor are not
met (for example, the parked property is not transferred by the EAT in 180
days), the Rev. Proc. does not apply. In that event, the determination of
whether the taxpayer or the EAT is the owner of the parked property for
tax purposes and the proper treatment of the transactions between the parties
is made under general tax principles and without regard to the liberal rules
of the Rev. Proc.
Section 4.03 of the Rev. Proc. allows many “permissible agreements” between
the taxpayer and the EAT even though the agreements do not contain arms-length
terms, including loans, guarantees, indemnities, leases, management, contractor
or other service agreements. Section 4.03 also allows puts and calls at
fixed or formula prices effective not more than 185 days after the EAT acquires
the parked property, and arrangements that account and compensate for variations
between the actual and estimated value of the relinquished property if the
exchange first method is used. These permissible agreements are crucial
to allow the EAT to hold bare legal title to the parked property and effectively
shift all or substantially all of the benefits and burdens of ownership
to the taxpayer. Further, the parked property will still qualify as being
held in a QEAA even though the accounting, regulatory, or state, local or
foreign tax treatment of the arrangement differs from the treatment required
by the Rev. Proc.
The Rev. Proc. is simply a statement of the Service’s administrative
procedures. It is not a regulation with the force and effect of law.
If the terms of the Rev. Proc. are met, the Service will not challenge
(a) the qualification of the parked property as replacement property
or relinquished property under Section 1031 or (b) the treatment of
the exchange accommodation titleholder (EAT) as the beneficial owner
of the parked property for federal income tax purposes. While the Service
will not disallow on audit an exchange that falls within this administrative
safe harbor, the Rev. Proc. and the statements made therein are not
binding on any court.
The Rev. Proc. favors parking arrangements by providing a safe harbor for
transactions completed in a 180-day period. It does not address a true reverse
exchange. The Rev. Proc. recognizes reverse exchanges using both the exchange
first and exchange last methods and provides a special reverse identification
rule for the exchange last method. Within 45 days after the EAT acquires
the replacement property, the relinquished property must be identified consistent
with Reg. Section 1.1031(k)-1(c), including the identification of alternative
and multiple properties.
The Rev. Proc. states that, as a general rule, the party that bears the
economic burdens and benefits of ownership is considered the owner of property
for federal income tax purposes, citing Rev. Rul. 82-144, 1982-2 C.B. 34.
But the Rev. Proc. itself eschews a “benefits and burdens” analysis
for parking arrangements that meet the requirements for a QEAA (Section
4.02). The Rev. Proc. explicitly allows agreements and other arrangements,
including guarantees, indemnification, loans, leases, management agreements,
put and call options, and the shifting of gain or loss, even though the
agreements contain terms that might not otherwise result from arm’s
length bargaining between unrelated parties (Section 4.03).
The reference to a “benefits and burdens” test in general and
Rev. Rul. 82-144 in particular has caused concern for non-safe-harbor reverse
exchanges, such as build-to-suit exchanges that cannot be completed in 180
days. Rev. Rul. 82-144 held that a taxpayer was the owner of tax-exempt
obligations notwithstanding the fact that the taxpayer shifted the risk
of loss of the obligations through the simultaneous purchase of a “put.” The
ruling notes that two significant factors of ownership are: (1) which party
has the right to dispose of the property and (2) which party bears the risk
of profit or loss with respect to the property. The taxpayer in the ruling
met both tests and was entitled to the full benefit of any appreciation
in the value of the obligations. The ruling distinguished situations in
which the taxpayer was holding obligations as security on a loan or for
the benefit of another party (including cases where the other party had
rights to purchase or reacquire the property at a fixed price). The ruling
also noted that, while the “puts” limited the taxpayer’s
risk of loss, an arm’s length price was paid for the “puts”,
their primary purpose was to increase liquidity for the taxpayer’s
portfolio rather than to shift risk of loss, and the “puts” had
a short, fixed duration that was substantially less than the life of the
obligations. Many commentators question whether this line of cases and rulings
should apply to a typical non-safe-harbor reverse exchange. How relevant
are these authorities to parking arrangements under Section 1031? The Rev.
Proc. cites Rev. Rul. 82-144 while PLR 2000111025 (discussed below) ignores
it in analyzing a non-safe-harbor reverse exchange.
The Rev. Proc. acknowledges that taxpayers have engaged in parking transactions
to facilitate reverse exchanges and that they attempt to structure the transaction
so that the accommodation party has “enough of the benefits and burdens” relating
to the parked property to be treated as the owner for federal income tax
purposes. The Rev. Proc. explicitly states that parking transactions can
be accomplished outside of the safe harbor provided in the revenue procedure.
PLR 2000111025 confirms this recognition by approving a parking arrangement
in which the accommodator had minimal, but apparently “enough”,
of the benefits and burdens of ownership. The key to the PLR was not benefits
and burdens of ownership, however, but rather the taxpayer’s intent
to exchange, the structure of the transaction as an integrated exchange,
and the fact that the accommodator was not the taxpayer’s agent.
The principles set forth in the Rev. Proc. have no application to any federal
income tax determinations other than the particular issues presented under
Section 1031 and determinations that involve a QEAA. For example, the Service
may recast amounts paid as a fee to an EAT to the extent necessary to reflect
the true economic substance of the arrangement. Other federal income tax
issues implicated, but not addressed, in the Rev. Proc. include the treatment
of payments that shift gain or loss after the relinquished property is sold,
and whether an EAT may be precluded from claiming depreciation deductions
(e.g., as a dealer).
The EAT cannot be the taxpayer or a “disqualified person” under
Reg. Section 1.1031(k)-1(k). An EAT may be an affiliate or division of a
QI since services as an EAT are disregarded in determining status as a QI.
See PLR 2000111025 (accommodator was a single-member LLC treated as a division
of an exchange company for federal income tax purposes). The EAT must be
subject to federal income tax. Thus, the safe harbor cannot be used as a
means to generate tax-exempt income or similar tax benefits.
The Rev. Proc. spells out what must be contained in a QEAA agreement:
a. The agreement must state that the EAT is holding the property for the
benefit of the taxpayer in order to facilitate an exchange under Section
1031 and the Rev. Proc.
b. The taxpayer and EAT must agree to report the acquisition, holding and
disposition of the property as provided in the Rev. Proc.
c. The agreement must specify that the EAT will be treated as the beneficial
owner of the property for all federal income tax purposes. (Among other
things, this implies that only the EAT, and not the taxpayer, may be able
to claim depreciation deductions with respect to the parked property.)
d. Both parties must agree to and actually report the federal income tax
attributes of the property on their federal income tax returns in a manner
consistent with this agreement.
A well-drafted QEAA agreement will contain other things:
a. A statement of the taxpayer’s bona fide intent that the property
held by the EAT represents either replacement or relinquished property in
an exchange intended to qualify under Section 1031, and provisions for an
integrated and contractually interdependent exchange between the taxpayer
and the EAT or the taxpayer and a QI. If the exchange is between the taxpayer
and a QI, the EAT will simply be seller of the replacement property under
the exchange last method, or the buyer and future seller of the relinquished
property under the exchange first method.
b. Provisions concerning the financing of the property, including any down
payment by the EAT, any loan by the taxpayer or a related party, and third-party
financing issues (the terms of the note, the deed of trust, any requirements
for a special purpose bankruptcy-remote entity, any environmental or other
indemnities, any guarantee by the taxpayer or a related party). The parties
must also consider the impact of a transfer of the relinquished property
to an EAT under the exchange first method, including triggering due-on-transfer
provisions in the existing financing.
c. Title insurance issues, including review and approval of a preliminary
title report, the title policy and endorsements, and arranging for a binder
or discount on the subsequent transfer of the property.
d. Provisions concerning the interim operation of the property, including
the leasing, management and any improvements to be constructed, including
selection of contractors and the supervision, approval and financing of
construction.
e. A representation and warranty of the EAT, guaranteed by a parent company
or other responsible person, that the ownership, management and structure
of the EAT will be maintained; the property will be operated by the EAT
in a prudent and commercially reasonable manner; no new liens or encumbrances
of the EAT will attach to the property except as otherwise agreed by the
parties; title will be transferred to the taxpayer (exchange last) or to
the buyer (exchange first) subject only to the agreed liens and exceptions;
the EAT will transfer the property as provided in the agreement and not
otherwise dispose of it; and the EAT will disburse the consideration received
from the transfer of the property in accordance with the agreement, including
payment of closing costs, EAT fees or other income, return of any down payment
of the EAT, repayment of any loans made by the taxpayer or a related person
(including any interest thereon), and payment of all third-party financing
(including interest thereon).
f. Under the exchange first method, provisions for the sale or other disposition
of the relinquished property by the EAT, including listing agreements, approval
of terms of sale, real estate transfer disclosures, representations and
warranties of the seller, and appropriate indemnifications. Also provisions
for any variations in the value of the relinquished property from the estimated
value on the date of the EAT’s acquisition, including future payments
to or from the taxpayer on account of such variations and the treatment
of such payments.
g. Provisions for insurance, including the amount and type of insurance,
the insured parties, and payment of the premiums. Insurance may also be
addressed under a net lease of the property to the taxpayer.
h. Provisions for real estate and other taxes, including property tax reassessment
upon the transfer of the relinquished property to the EAT under the exchange
first method. A supplemental assessment may not be made until after the
EAT sells the relinquished property. The supplemental assessment may then
become an unsecured debt of the EAT. The EAT will want to pass that cost
to the taxpayer under a net lease or other provision of the agreement. The
parties will also want to consider sales tax on any personal property and
gross receipt taxes and other taxes and fees imposed upon the EAT, including
EATs that are LLCs.
i. Provisions for environmental studies, representations, warranties and
indemnities concerning the property.
j. Provisions for tax and other indemnifications, releases and guarantees,
including costs of defense and reasonable attorney’s fees.
k. Provisions for an exit strategy, including puts and calls, the consideration
to be paid for the option, the strike price (fair market value or fixed
or formula amount), the effect of a party not exercising an option, and
any required post-sale payments (e.g., if the EAT would otherwise incur
a loss of sale). The Rev. Proc. allows puts and calls at fixed or formula
prices effective for a period not in excess of 185 days from the date the
parked property is acquired by the EAT. This implies that such options cannot
be effective after 185 days in order to be a permissible arrangement under
the Rev. Proc.
l. Provisions that spell out the EAT’s fees or other income, including
set-up and entity fees, lease income, sale profit, construction fees, financing
fees, option fees, etc. Also provisions that require reimbursement for the
EAT’s out-of-pocket costs.
m. Provisions that address the ownership, management and structure of the
EAT, assignment rights, and potential savings on title insurance and transfer
tax.
n. Provisions that evidence the taxpayer’s intent to comply with
the 180-day time limitation of the safe harbor, and the effect of the transaction
and actions to be taken if the property is not transferred in the 180-day
period. Do the parties proceed with a non-safe-harbor exchange or is the
transaction terminated? If the transaction is terminated, how do the parties
account for and report the transaction? Does this depend on whether or not
the EAT is the taxpayer’s agent?
Unlike the deferred exchange regulations, the Rev. Proc. does not say whether
or not the EAT may act expressly as the taxpayer’s agent, but there
is nothing in the Rev. Proc. to indicate that the EAT would be disqualified
if it was the taxpayer’s agent under state law. See PLR 200148042
(IRS approved the inclusion of an express agency statement, making the EAT
an agent of the customer for all purposes except federal income tax purposes,
in a QEAA). In fact, the QEAA agreement must provide that the EAT is holding
the property for the benefit of the taxpayer in order to facilitate a Section
1031 exchange. If the EAT is the taxpayer’s agent under state law
but the parties nevertheless comply with all of the provisions of the Rev.
Proc. (including treatment of the EAT as the beneficial owner for all federal
income tax purposes and consistent tax reporting), the Service should not
challenge the exchange. The spirit of the Rev. Proc. is that an EAT under
the safe harbor should be treated in the same way as a QI under the deferred
exchange regulations. If the EAT is the taxpayer’s agent, the EAT
would receive the legal protections of its principal, additional transfer
tax may be avoided on the transfer of the property, and the tax treatment
of a transaction that terminates because it is not completed in the 180-day
period would be more certain. However, if the EAT is the taxpayer’s
agent, the exchange may not qualify for state income tax purposes. The Rev.
Proc. is only a statement of the Service’s procedures for federal
income tax purposes.
The 180-day time limit of the safe harbor may encourage a market niche
for “white knights” to purchase the relinquished property and
allow the transaction to close in time. No later than 180 days after the
transfer of parked property to the EAT: (i) the property must be transferred
(either directly or indirectly through a QI) to the taxpayer as replacement
property (exchange last method), or (ii) the property must be transferred
to a person who is not the taxpayer or disqualified person as relinquished
property (exchange first method). Further, the combined time period that
the replacement and relinquished properties are held in a QEAA cannot exceed
180 days. The 180-day time period for the safe harbor appears to be fixed
in the same way as for a deferred exchange under Section 1031(a)(3). The
Rev. Proc. states that it only applies when the exchange is accomplished “within
a short time” after the property is transferred to the EAT. Under
the exchange last method, the EAT must transfer the replacement property
to the taxpayer in the 180-day period. But there is no prohibition on the
transfer of the relinquished property to a “white knight” (who
is not the taxpayer or a disqualified person) in order to complete an exchange
within 180 days.
Comparing Safe Harbor vs. Non-Safe-Harbor Transactions
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Safe harbor and non-safe-harbor reverse exchanges are distinguished by
three main characteristics: (1) a safe harbor transaction must be completed
in 180 days while a non-safe-harbor transaction does not and theoretically
has no time limitation; (2) the EAT or other party holding title to the
parked property need not have any benefits and burdens of ownership in
a safe harbor transaction but should have enough benefits and burdens
to be considered the owner in a non-safe-harbor transaction; and (3) apparently
the EAT may act expressly as the agent of the taxpayer in a safe harbor
transaction (at least for all purposes other than federal income tax purposes)
but the EAT cannot be the taxpayer’s agent in a non-safe-harbor
transaction. Obviously, taxpayers would like to avail themselves of the
benefits and protection of the safe harbor if they can. But sometimes
the transaction cannot be completed in 180 days. For example, in some
build-to-suit exchanges, the entitlements, plans, permits and construction
may take years. It also may not be possible to sell the relinquished property
at its best price in 180 days. These situations require a non-safe-harbor
transaction, assuming the taxpayer still desires to attempt an exchange
after all the risks, costs and headaches are disclosed.
Section 2.03 of Rev. Proc. 2000-37 indicates that a “benefits and
burdens” test applies as a general rule to determine ownership for
federal income tax purposes. This may imply that the IRS believes that such
a test applies to non-safe-harbor transactions. In DeCleene v. Commissioner,
115 T.C. 457 (2000), the court applied a “benefits and burdens” test
to a parking transaction with the intended buyer of the relinquished property.
DeCleene is cited in Rev. Proc. 2004-51 which amends Rev. Proc. 2000-37.
But the court applied this test in a very special case. In DeCleene, the
replacement property was previously owned by the taxpayer and purportedly
sold to the buyer three months prior to the exchange.
The essential facts of DeCleene are as follows: The taxpayer (T) purchased
unimproved property in 1992 and the acquisition was not part of an integrated
plan to effect an exchange. In September 1993, a buyer (B) wished to acquire
T’s relinquished property (a property on which T operated his business
since 1977). B agreed instead, at T’s request, to acquire the unimproved
property (replacement property), subject to a reacquisition agreement. The
parties agreed that the properties were of equal value ($142,400) and T
quitclaimed title to the replacement property to B for a deferred cash consideration
of $142,400 to be paid at a second closing. No interest accrued on the deferred
cash consideration. B agreed to build a building on the replacement property
to T’s specifications. B also agreed to reconvey the property to T,
with the substantially completed building on it, in exchange for the relinquished
property that B wanted to buy. The transactions closed as agreed in December
1993. While B held title to the replacement property, T retained beneficial
ownership thereof. B had no equity interest in the replacement property
and made no economic outlay to acquire it. T was responsible for all transaction
and closing costs, including accrued property taxes. B paid no amounts and
was not obligated to pay any amounts with respect to the replacement property,
including the improvements constructed thereon, until it received the relinquished
property and paid the $142,400 to T. Construction was financed by a note
and mortgage guaranteed by T that were non-recourse as to B. No interest
accrued or was paid on the non-recourse note. T assumed personal liability
for the note at the second closing. Through his guaranty and reacquisition
obligation, T was at all times at risk with respect to the replacement property.
B had no potential for any economic gain or loss on its acquisition and
disposition of title to the replacement property. The reacquisition agreement
did not take into account any value added to the replacement property by
reason of the building constructed on it in the interim. T did not use a
third party facilitator to acquire the replacement property either in 1992
(when the land was acquired, which was a year or more before T was ready
to transfer the relinquished property and relocate his business to the replacement
property) or in 1993 when the property was transferred to B, subject to
the reacquisition agreement.
On these special facts, the court held that T remained the beneficial owner
of the replacement property during the 3-month period that B held bare legal
title and the building was constructed. Thus, no tax significance attached
to the transfer of legal title to B in September 1993. Since T remained
the beneficial owner of the replacement property for income tax purposes,
the $142,400 payment received by T was deemed to be the sales price for
the relinquished property. The court noted that “a taxpayer cannot
engage in an exchange with himself; an exchange ordinarily requires a ‘reciprocal
transfer of property, as distinguished from a transfer of property for a
money consideration.’” (Citing Reg. Section 1.1002-1(d).) DeCleene
reminds one of Chase v. Commissioner, 92 T.C. 874 (1989). The taxpayers
in both cases did so many things wrong that it is hard to determine which
particular facts were fatal. The court stated that the taxpayers “lost
sight of the cumulative adverse effect on their position of all the facts
in the case at hand.” (Emphasis added.)
DeCleene could have simply ended there. But the opinion contains other
language, such as (i) the transaction “amounted to nothing more
than a parking transaction,” (ii) the reference to “risks
of ownership” that the accommodating parties had in PLR 7823035
(March 9,1978) and PLR 9149018 (September 4, 1991), and (iii) footnote
7 of the opinion which cites Rev. Rul. 82-144 and related cases. Thus,
the court in DeCleene cites the same potentially disturbing line of cases
and rulings as Section 2.03 of Rev. Proc. 2000-37. Many non-safe-harbor
reverse exchanges could be regarded as mere parking transactions with
little or no economic substance and disallowed under a strict “benefits
and burdens” test. But many commentators believe that the appropriate
test under Section 1031 is and has always been whether the facilitator
is the taxpayer’s agent, not whether the facilitator has a requisite
amount of “benefits and burdens” of ownership. Importation
of alien authorities (which apply a “benefits and burdens” test
to resolve entirely different tax issues) arguably flies in the face of
one of the earliest cases under Section 1031. See Mercantile Trust Company
v. Commissioner, 32 B.T.A. 82 (1935) (title company facilitated 4-party
simultaneous exchange and was not taxpayer’s agent). The court made
it clear that an intermediary need not have the benefits and burdens of
ownership before exchanging property but may acquire title solely for
the purpose of the exchange. See also Barker v. Commissioner, 74 T.C.
555 (1980) (a party can have transitory ownership of exchange property
solely for purposes of effecting the exchange); Biggs v. Commissioner,
69 T.C. 905 (1978), aff’d. 632 F.2d 1171 (5th Cir. 1980) (replacement
property parked with facilitator for several months before the exchange).
Fortunately, the IRS has issued PLR 200111025 which analyzes a non-safe-harbor
reverse exchange based on existing Section 1031 authorities. While Section
6110(k)(3) provides that it may not be used or cited as precedent, the PLR
is well-reasoned and written like a court opinion. The ruling applies the
authorities under Section 1031 and does not muddy the waters with foreign
authorities (such as Rev. Rul. 82-144 which applies a “benefits and
burdens” test in a totally different context than Section 1031).
In PLR 200111025, the taxpayer (T) owned relinquished property (the Park)
and granted an option to a conservation organization (B) to acquire the
property for public parkland. The exercise of the option and consummation
of the purchase was subject to a variety of conditions, including public
agency approvals. T located its desired replacement property in the interim
and arranged for it to be parked with an accommodating party (A). A acquired
the replacement property (Property) and paid the related transaction costs
by borrowing from a bank and additional funds from T pursuant to a full
recourse line of credit. The bank loan was signed by A, secured by the Property,
and bore interest. T signed a payment guaranty and environmental indemnification
in favor of the bank. A agreed to pay T a loan guaranty fee. T’s loan
to A was unsecured, bore interest and was due on the earlier of the sale
of the Property or a fixed maturity date. Apparently, A put none of its
own funds into the acquisition of the Property. A leased the Property to
T under a standard triple net lease, providing for monthly base rent plus
additional rent equal to all taxes, insurance and maintenance costs with
respect to the Property. The lease had an initial one-year term with an
optional one-year extension of the term. The amount of rent exceeded all
costs of operating the Property, including debt service. A also assigned
its interest in certain leases and contracts to T. As long as A owned the
Property, A and T agreed to report the transactions for federal income tax
purposes in accordance with their form, with A as the owner and master lessor
and T as the master lessee and as the sublessor under the subleases.
A and T also entered into a Real Estate Acquisition Agreement (Agreement)
pursuant to which A entered into the lease with T, the purchase agreement
with the seller of the Property, the bank loan and T’s loan. Under
the Agreement, T had an option to purchase (or acquire through a tax-deferred
exchange) all or a portion of the Property for an amount equal to its fair
market value. For this purpose, the fair market value was deemed to be equal
to A’s cost of purchasing the Property if T acquired the Property
within 18 months of A’s acquisition. If the option was terminated,
upon the occurrence of certain events, A may sell the Property in accordance
with certain procedures set forth in the Agreement. If A did not do so,
it had the potential for exposure to economic loss. However, A was not obligated
to sell the Property and could retain the Property and thus had the potential
to realize economic gain. If A elected to sell the Property, T must reimburse
A for a certain portion of the net sales proceeds as compared to all of
A’s costs. If the net proceeds exceed such costs, A may retain the
excess. If the Property could not be sold despite A’s good faith efforts,
the net sales proceeds were deemed to be a certain amount and T must also
reimburse A for costs incurred.
Since the inception of the transaction, T intended to exchange the Park
for all or a portion of the Property under Section 1031. As soon as B exercised
its option and is in a position to acquire the Park, T will assign its rights
and transfer the Park to a QI. The QI will then sell the Park to B and receive
the sales proceeds. Within 45 days after the transfer of the Park by T to
QI, T will identify all or a portion of the Property as replacement property.
QI will acquire the Property from A pursuant to an assignment of T’s
rights under the Agreement and transfer the acquired Property to T within
the time limit of Section 1031(a)(3). Thus, the transaction was structured
both as a non-safe-harbor reverse exchange (using the EAT to acquire and
hold the replacement property under the exchange last method) and as a deferred
exchange (using a QI to sell the relinquished property and acquire the replacement
property).
The PLR contains a detailed discussion of the relevant Section 1031 authorities.
The safe harbor of Rev. Proc. 2000-37 did not apply because A’s acquisition
predated the effective date and A’s acquisition of the Property will
be more than 180 days after the transfer of the Property to T. Accordingly,
the ruling squarely addressed a non-safe-harbor parking transaction. The
ruling first cited the plethora of cases under Section 1031 permitting taxpayer’s “significant
latitude” in structuring tax-deferred exchanges. The ruling noted
that case law authority exists for a true reverse exchange, citing Rutherford.
The ruling then analyzed the facts and holdings of Biggs and Baird in detail.
It concluded that “an agency analysis, therefore, underlies the determination
of whether or not an exchange occurred.” To flesh out the agency test
under Section 1031, the PLR noted and applied the Supreme Court’s
agency analysis as set forth in Commissioner v. Bollinger, 485 U.S. 340
(1988) and National Carbide Corp. v. Commissioner, 336 U.S. 442 (1949).
This agency analysis has four factors and two requirements as follows: (1)
Whether the party in question operates in the name and for the account of
the principal; (2) binds the principal by its actions; (3) transmits money
received to the principal; and
(4) whether receipt of income is attributable to the services of employees
of the principal and to assets belonging to the principal; (5) the agency-principal
relationship cannot be founded solely on the fact that the principal owns
the agent; and (6) the business purpose of the party in question must be
the carrying on of the normal duties of an agent.
The ruling concluded its thorough discussion and analysis of the law by setting
forth the applicable test under Section 1031. The ruling states: “The
foregoing authorities present three general requirements for an exchange to
be recognized as a like-kind exchange under Section 1031 in similar situations
[to a non-safe-harbor transaction]:
1. the taxpayer must demonstrate its intent to achieve an exchange and
the properties to be exchanged must be of like kind and for a qualified
use [“intent to exchange”];
2. the steps in the various transfers must be part of an integrated plan
to exchange the relinquished property for the replacement property [“integrated
plan”]; and
3. the party holding the replacement property must not be the taxpayer’s
agent [“no agency”].”
On the facts of the ruling, this test was met. First, T demonstrated a
clear intent to exchange the Park for the Property from the inception of
the transaction. Second, all of the steps in the transactions, including
the various transfers and agreements, were interdependent and integrated
parts of a single overall plan to achieve an exchange by T. Finally, the
PLR applied the six National Carbide factors. The ruling noted that, under
the Section 1031 case law, merely facilitating an exchange is not tantamount
to being the taxpayer’s agent. Based on these authorities, the PLR
concluded that A was not T’s agent. In finding no agency relationship,
the PLR discussed these key facts: (1) A conducted all business, held title
and entered into all agreements in its own name and for its own account
and was never referred to as T’s agent; (2) T did not contractually
authorize A to bind T by A’s actions; (3) A did not simply transmit
money that A received for its account to T; (4) the receipt of income by
A was not attributable to the services or assets of T but rather the receipt
of income by each party was based on lessor-lessee relationships; (5) A
and T were separate and unrelated legal entities, and A will report A’s
rental income and expenses on its own tax returns; and (6) A’s business
purpose was not to carry on the normal duties of an agent.
Except for situations in which the accommodating party acts expressly as
the taxpayer’s agent in a safe harbor exchange under Rev. Proc. 2000-37,
this agency test should be satisfied in most non-safe-harbor parking transactions.
The role of the accommodating party will be to facilitate an exchange on
its own and for its own account, and not to act as the taxpayer’s
agent. If the legal analysis contained in the PLR is correct, non-safe-harbor
parking transactions should be successful, provided that all of the proper
formalities are observed (written agreements, leases, promissory notes,
actions and tax reporting consistent with the legal form of the transaction,
and no express indications of an agency relationship). This will be the
case even though the accommodating party has minimal benefits and burdens
of ownership. However, the facts of the PLR also indicate that the EAT had
some benefits and burdens of ownership, however small or remote. The EAT
apparently did not put any of its own funds into the acquisition of the
replacement property and had no equity investment. See DeCleene. But the
financing was stated to be pursuant to a full recourse line of credit. If
the EAT (presumably a single-asset limited liability company) had no other
major assets, however, the full recourse nature of the financing would have
much more significance to T as guarantor than to the EAT as signer of the
loan. The EAT also received rental income under the master lease in excess
of all costs and debt service (arguably a benefit of ownership of the fee).
If T did not exercise its option to purchase or exchange into the Property,
the EAT was not obligated to sell and could retain the Property. Thus, the
EAT had potential exposure to gain or loss if it did not elect to sell the
Property in accordance with the termination sale procedures set forth in
the Agreement. Any risk of loss of the EAT was unclear except in the case
that it did not elect to sell the Property. The reimbursement provisions
of the Agreement appeared to protect the EAT against any loss and may have
guaranteed a profit to the EAT if the EAT could not sell the Property despite
its good faith efforts to do so.
Accordingly, the facts of the PLR may be distinguished from DeCleene where
the court held that the accommodating buyer had no (zero) benefits and burdens
of ownership with respect to the replacement property. Taxpayers proceeding
with non-safe-harbor parking transactions would be wise to have some benefits
and burdens of ownership vested in the accommodating titleholder. While
taxpayers may still rely on Section 1031 case law and the agency test, these
cases involve relatively short periods of ownership by the accommodating
party (e.g., a few months, not a year or more). The courts might find a
long-term parking transaction too abusive, irrespective of prior Section
1031 cases. The courts may apply a “benefits and burdens” test
and traditional substance-over-form principles to cases where the accommodating
party simply holds bare title, earns a fee and has no benefits and burdens
of ownership whatsoever.
On the flip side of PLR 200111025 (a non-safe-harbor transaction in which
the EAT was not and could not be the taxpayer’s agent) is PLR 200148042
(a safe harbor transaction in which EAT acted expressly as the taxpayer’s
agent for all purposes other than federal income tax purposes). In PLR 200148042,
the IRS ruled that the inclusion of an express agency statement, making
the EAT an agent of the customer for all purposes except federal income
tax purposes, will not adversely affect a QEAA agreement under Rev. Proc.
2000-37. Thus, according to this ruling, an EAT can be the express agent
of an exchange customer for all purposes except federal income tax purposes
and still be within the safe harbor provided by the revenue procedure. But
if the parties stray one step outside of the safe harbor, an express agency
statement will be fatal to the exchange. Thus, in addition to the 180-day
time limitation, the issue of agency is a key factor distinguishing between
safe harbor and non-safe-harbor transactions.
Even under the safe harbor, an EAT cannot be the agent of the customer
for all purposes. The EAT cannot be the agent of the customer for federal
income tax purposes under the provisions of Section 4.02(3) of the revenue
procedure. Section 4.02(3) provides that a QEAA agreement must specify that
the EAT will be treated as the beneficial owner of the property for all
federal income tax purposes. Further, both parties must report the federal
income tax attributes of the property on their federal income tax returns
in a manner consistent with this agreement. If the EAT were also the agent
of the customer for federal income tax purposes, the provisions of Section
4.02(3) could not be satisfied because the customer as principal, and not
the EAT as agent, would be treated as the beneficial owner of the property.
Accordingly, the express agency statement in the ruling is limited and had
to be limited so that the EAT acts as an agent of the customer for all purposes
except federal income tax purposes.
An express agency statement may help the parties avoid additional transfer
tax. Transfer tax may be avoided on the transfer of replacement property
by the EAT to the customer or on the transfer of the relinquished property
by the customer to the EAT. For state and local purposes, the transfer of
title would be from agent to principal or principal to agent with no change
in beneficial ownership. Such transfers of title should be exempt from transfer
tax in most state and local jurisdictions. In addition, an EAT acting as
agent would be entitled to all of the immunities and protections of an agent
under state and local law, including indemnification by the principal, provided
that the EAT acts within its authority. A principal would be protected from
actions by the agent outside of the agent’s actual or ostensible authority.
An agent may also be accountable as a fiduciary to the principal under state
and local law. The principal would be regarded as the beneficial owner of
the property if the EAT died (assuming the EAT was an individual), dissolved
or became bankrupt. Accounting, financing and regulatory treatment of the
transaction may also be simplified if the EAT is merely the agent of the
customer for all purposes except for federal income tax purposes.
The main disadvantages to an agency relationship include the potential
legal risks to the principal of being bound by the acts of his agent. The
principal may incur liabilities to third parties due to the acts or omissions
of an agent. Further, the exchange may be subject to income tax under state
law. States are not bound by the administrative safe harbor provided in
Rev. Proc. 2000-37 for federal income tax purposes. In general, the tax
consequences of property held by an agent are attributed to the principal
so that the principal is treated as the beneficial owner of the property.
An exchange involving such an agent would be meaningless. The principal
may be treated under state law as “exchanging” for replacement
property that he already owns through his agent under the exchange last
method (i.e., not exchanging for anything), or as selling relinquishing
property through his agent under the exchange first method (i.e., making
a taxable sale). Perhaps this result could be mitigated if the express agency
statement is modified to provide that the EAT is acting solely as the agent
of the customer for all purposes except federal and state income tax purposes.
But that modification may work only in a state that follows the principles
of Rev. Proc. 2000-7 for state income tax purposes. Otherwise, state income
tax authorities are likely to question (as anyone with common sense would)
how someone can be an agent for all purposes “except federal and state
income tax purposes”? Outside of Rev. Proc. 2000-37, this statement
may not make any sense.
The other big tax disadvantage is that the exchange presumably will not
qualify under Section 1031 if the parties go one inch outside of the safe
harbor. This could occur if any of the requirements for a QEAA are not met
(e.g., the EAT is a disqualified person, the parties do not report transaction
in a manner consistent with the QEA agreement, or the transaction is not
completed within 180 days after the EAT acquires title). Further, an express
agency statement would likely preclude the parties from converting a safe
harbor transaction into non-safe-harbor transaction if that became necessary.
Although Rev. Proc. 2000-37 does not expressly state that an EAT may be
the taxpayer’s agent for purposes other than federal income tax purposes,
PLR 200148042 and Sections 3.03, 4.03 and 5.04 of the revenue procedure,
together with the analogy to a QI under the deferred exchange regulations,
indicate that such an agency relationship should not adversely affect a
QEAA agreement. In the PLR, the IRS stated: “For Customer to obtain
the benefits of the safe harbor rules of the revenue procedure, the transaction
need only fit within the confines of the safe harbor rules. Assuming the
boundaries of the safe harbor rules are not exceeded, Customer is entitled
to enjoy the protection afforded to all compliant taxpayers by these rules,
notwithstanding inconsistent treatment or characterization under state or
local law.” But this treatment of an EAT as the taxpayer’s agent
only applies to and within the formalistic world created by the safe harbor.
Only in that world does it make sense to have an agent for all purposes “except
for federal income tax purposes.” The world in which the safe harbor
of Rev. Proc. 2000-37 operates is a strange world indeed ----a world in
which Humpty Dumpty is king and words mean no more and no less than what
he says they mean. The world in which non-safe-harbor transactions operate
is an entirely different world in which the EAT cannot be the taxpayer’s
agent.
Structuring and Planning Reverse Exchanges
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
The most important structuring and planning issues affecting reverse exchanges
were detailed above: (1) pure reverse exchange versus parking transaction;
(2) exchange last versus exchange first method; (3) safe harbor versus non-safe-harbor
transaction; and (4) whether or not the EAT should be an express agent in
a safe harbor transaction. Another issue that should be considered upfront
is whether a safe harbor transaction can be converted into a non-safe-harbor
transaction (e.g., if the 180-day time limitation is not met). Some commentators
believe that the transaction must be structured in advance as either a safe
harbor transaction or a non-safe-harbor transaction. Others believe that
the transaction can be structured so that it is not mutually exclusive, and
that it should be possible to convert a safe harbor into a non-safe-harbor
transaction. To be able to convert the transaction, the QEAA agreement would
have to meet the requirements of the safe harbor and not have provisions
that would disqualify a non-safe-harbor exchange. This would rule out any
express agency statement in the QEAA agreement and may restrict the types
of otherwise “permissible agreements” that could be used under
Section 4.03 of Rev. Proc. 2000-37.
If the transaction may be converted to a non-safe-harbor transaction,
or if a non-safe-harbor transaction is contemplated all along, the parties
should properly document the non-agency status of the accommodator. Everything
possible should be done to avoid having the taxpayer held out as the owner
of the parked property to third parties. Tax reporting of the transaction
should be consistent with the accommodator’s ownership of the parked
property during the gap period. Further, in these situations, it is very
helpful if the accommodator has some “skin in the game.” Some
commentators believe that an equity interest of anywhere from 3% to 10%
of the cost of the parked property may be effective. The parties may wish
to review the accounting standards applicable to “synthetic leases,” although
they apply only for financial reporting purposes. See Financial Accounting
Standards Board (“FASB”) Statements of Financial Accounting
Standards 13 and 98 as well as Emerging Issues Task Force of FASB Release
EITF 90-15. If the accommodator puts some of its own funds into the transaction
and bears some risk of loss, it is more likely to be treated as an owner
for tax purposes.
Another planning issue is the entity structure used for the accommodator.
Advisors may consider using a single-member LLC as the accommodator. The
single-member LLC may be owned by a QI or its affiliates. The single-member
LLC is treated as a disregarded entity or tax “nothing” under
the default rule of Reg. Section 301.7701-3(b)(ii). In the exchange last
format, the taxpayer can acquire the 100% membership interest in the LLC
rather than direct title to the replacement property and still have it qualify
as the receipt of a like-kind asset. This potentially allows avoidance of
transfer tax applicable to a real property title transfer, at least in jurisdictions
where there is a distinction between entity ownership transfer and title
transfer. This technique also anticipates potential lender requirements
for a bankruptcy-remote single-purpose entity.
In planning for a reverse exchange, the value and equity of the relinquished
and replacement properties must be considered. Even if the sales price of
the relinquished property is not known, the exchanger should estimate the
value, structure financing accordingly, and anticipate any boot that will
be received. At the conclusion of the exchange, the exchanger must trade
even or up in both value and equity from the relinquished property to the
replacement property, or the exchanger will receive boot and must recognize
gain.
The retirement of debt created in reverse exchanges raises additional issues.
In the exchange last method, the debt is secured by the replacement property
and paid off with relinquished property sales proceeds. To the extent of
any deficiency in proceeds, the exchanger takes the replacement property
subject to the debt, assumes the debt or provides its own funds to retire
the debt. If the proceeds exceed the debt, further properties can be acquired
in the exchange or the exchanger receives boot. Under the exchange last
method, the time limit for additional properties under Section 1031(a)(3)
only begins to run when the exchanger receives the replacement property.
In the exchange first method, the debt is secured by the relinquished property.
If the debt is due to a third party, the exchanger will need to make up
any shortfall between the proceeds from sale and the amount of the debt
payoff. If the debt is due to the exchanger, it will generally be canceled.
If the proceeds of sale exceed the debt and are not retained by the accommodator,
the excess proceeds will be available for use in further acquisitions only
if the Section 1031(a)(3) time periods have not elapsed. Under the exchange
first method, the time limits begin to run when the exchange receives the
replacement property and the accommodator acquires the relinquished property,
not later when the accommodator sells the relinquished property.
Another planning issue is the exit strategy or “sunset provisions” if
the exchange is not timely consummated. In either the exchange last or exchange
first structure, the accommodator will not want to hold the parked property
indefinitely. What happens if the relinquished property is not sold? PLR
200111025 indicates the kind of “sunset provisions” that may
be used in a non-safe-harbor transaction using the exchange last method.
An option providing price protection to the exchanger was used for 18 months
(options under the safe harbor may only be effective for 185 days). If the
option was not exercised, a notice and sale procedure could be used so that
the accommodator could dispose of the parked property. A similar suggestion
is to create a short fuse option to purchase at a fixed price (i.e., exercisable
only between 12th and 18th month of the lease term), coupled with rental
escalations applying thereafter. Some accommodators structure the option
so that the parked property must be purchased after a certain time period
at appraised fair market value. The accommodator gets to keep any upside
but is not responsible for any downside. It is unclear how long fixed-price
call or put options may last in a non-safe-harbor transaction. Some practitioners
believe that an option lasting from 12 to 18 months should not, in and of
itself, undermine ownership of the parked property by the accommodator for
tax purposes.
Advisors should also properly structure and plan for the tax reporting
requirements applicable to an EAT (or other accommodator) and the taxpayer
in a typical parking transaction. Under both the exchange last and first
methods, the EAT must report activity associated with either the replacement
or relinquished property, including the receipt of income, payment of expenses,
capitalization of costs and claiming any depreciation deductions. The EAT
must also report any gain or loss on the sale or other disposition of the
property. Under the exchange first method, the taxpayer must currently file
Form 8824 and report the exchange of the relinquished property for the replacement
property. The taxpayer must also report the activity associated with the
replacement property that the taxpayer now owns and any income, expenses
or costs as a lessee or manager of the relinquished property after the exchange.
Under the exchange last method, the taxpayer must report the relinquished
property that the taxpayer continues to own and any income, expenses or
costs as a lessee or manager of the replacement property. The taxpayer must
subsequently file Form 8824 for the tax year in which the exchange under
the exchange last method occurs. Both parties must take into account rent,
interest, taxes, insurance and other accrued income or expenses in accordance
with their method of accounting.
Rev. Proc. 2000-37 provides that, in a safe harbor parking transaction,
the EAT must be treated as the beneficial owner of the property for all
federal income tax purposes. Further, the parties must report the transaction
and the tax attributes of the property on their respective tax returns consistently
and in accordance with the EAT’s beneficial ownership for federal
income tax purposes. Thus, in general, the EAT and only the EAT may claim
depreciation with respect to the replacement property under the exchange
last method or the relinquished property under the exchange first method.
The same goes for a non-safe-harbor parking transaction in which the EAT
must be respected as the owner of the property under general tax principles
and the authorities under Section 1031. The taxpayer must not claim depreciation
deductions or otherwise report the income, expenses and costs of the owner
of the property while the property is held by the EAT. Thus, tax reporting
for the EAT and the taxpayer may involve depreciation deductions, income
and expenses under leases or management agreements, interest income and
expenses under loans, taxes, construction and other capitalized costs, gain
or loss on the sale or other disposition of the property, and Form 8824
for reporting of the exchange. Further, the parties will need to show the
assets and liabilities arising out of the parking transaction on the balance
sheets of their respective tax returns. Various Forms 1099 may also need
to be filed in connection with the transactions.
The EAT may have to claim depreciation deductions if it holds depreciable
property used in a trade or business or held for the production of income.
Merely because the EAT intends to dispose of the property at a future date
does not necessarily mean that the property is inventory in the hands of
the EAT. Rental property, for example, may still be considered used in a
trade or business or held for the production of income in the interim period.
Since the depreciation allowance is mandatory, the EAT may be forced to
claim it or the Service could reduce the EAT’s basis on sale by the
amount of depreciation allowable but not claimed. However, this remains
unclear. Section 3.03 of Rev. Proc. 2000-37 indicates that the EAT may be
precluded from claiming depreciation deductions (e.g., as a dealer). What
is clear is that the taxpayer should not claim depreciation deductions as
the owner of the parked property while the EAT holds title.
The EAT and the taxpayer will need to take into account and report on their
respective tax returns the following items in accordance with their method
of accounting:
a. rent received and paid under the master lease, including base rent and
additional rent under a net lease for taxes, insurance, repairs and maintenance;
b. the EAT should report the gross rent received under a net lease and
deduct the taxes, insurance and other expenses paid;
c. the EAT should report the gross rent received from the property and
management fees paid to the taxpayer if a management agreement is used (the
EAT will deduct the management fees and the taxpayer will report the management
income);
d. rent received under subleases must be reported by the taxpayer and the
taxpayer will deduct the rent paid to the EAT under the master lease;
e. interest paid or accrued on the loans incurred by the EAT, including
loans from taxpayer or its affiliates, should be deducted by the EAT in
accordance with its method of accounting, and the taxpayer should similarly
report interest income;
f. other fees or income should be included in income, deducted or capitalized
as appropriate by the parties, including set-up or acquisition fees, exchange
fees, financing fees, guaranty fees, construction fees and option fees;
g. if the EAT is a new entity, the EAT will amortize its organizational
costs under Sections 248 or 709(b);
h. reimbursements of the EAT’s costs should be reported;
i. appropriate 1099 Forms may need to be issued by the EAT and the taxpayer,
including forms to third parties;
j. the EAT should account for deposits received from tenants, including
any deposits received under a master lease;
k. all capitalized costs, including construction expenditures, should be
shown on the EAT’s balance sheet;
l. all loans should be reflected in the EAT’s liabilities, including
loans from the taxpayer or its affiliates;
m. accrued expenses, including interest and taxes that are not deductible
in accordance with the EAT’s method of accounting, should be shown
as a current liability;
n. the capital and net worth of the EAT will be known from the balance
sheet (it would be useful for the EAT to have some capital and net worth
if a “benefits and burdens” test is applied).
Under the exchange first method, the taxpayer will currently report the
exchange of the relinquished property for the replacement property as a
simultaneous exchange on Form 8824. The current form has no special reporting
requirements or boxes to check for a parking transaction under Rev. Proc.
2000-37 or a reverse exchange. The EAT will report gain or loss from the
sale of the relinquished property in the tax year that it sells the relinquished
property. Under the exchange last method, the taxpayer will report the exchange
at a future date when the relinquished property is sold. The taxpayer will
then report the exchange as a simultaneous exchange on Form 8824. The EAT
will report gain or loss on the sale or exchange of the replacement property.
In summary, advisors should consider all of the tax reporting requirements
associated with a parking transaction. These reporting requirements may
add significantly to the costs of the transaction and should be taken into
account by the EAT in determining its fees or other income for facilitating
the exchange.
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