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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. |