The taxpayer then has certain time periods to identify and acquire replacement property. In order to defer the entire gain, a taxpayer must reinvest all of the funds received from the disposed property. To the extent that the relinquished property was encumbered by debt, the replacement property must be encumbered by an amount of debt that equals or exceeds the debt of the disposed property.
While this is the typical order for most like kind transactions, there are times when a taxpayer has to acquire the replacement property before the relinquished property is disposed of. These transactions are commonly known as reverse exchanges. Prior to guidance being issued by the Internal Revenue Service, taxpayers used a wide variety of methods to execute these transactions.
A common method used to accomplish a reverse like kind exchange is the so called “parking transaction”. In this transaction, the replacement property is “parked” with an accommodation party until the taxpayer arranges for the transfer of the relinquished property. Once the transfer of the relinquished property is arranged, the taxpayer transfers it to the accommodation party in return for the replacement property. The accommodation party transfers the relinquished property to the ultimate transferee.
In Revenue Procedure 2000-37, the Internal Revenue Service provided a safe harbor so the taxpayers can have assurance that the reverse exchange will qualify as a like kind exchange under Section 1031. Generally, the replacement property is transferred to a Qualified Exchange Accommodator and the taxpayer enters into a Qualified Exchange Accommodation Arrangement. Again, assuming certain time periods are met with regard to identifying and transferring the relinquished property, the Internal Revenue Service will treat the transaction as qualifying for non-recognition under Section 1031.
In structuring a reverse like kind exchange, taxpayers have tried to use their own property to qualify as replacement property. For example, a taxpayer may transfer their vacant land to a Qualified Exchange Accommodator Titleholder (EAT). The taxpayer then finds a purchaser for the intended relinquished property. The proceeds from the relinquished property are used by the EAT to improve the vacant land. Within the time periods, the improved real estate is transferred back to the taxpayer. In effect, taxpayer has transferred relinquished property for replacement property that it already owned.
The Internal Revenue Service addressed this transaction in Revenue Procedure 2004-51. In order to prevent the taxpayers from transferring their property to an EAT and receiving that same property back as replacement property, the Revenue Procedure provides that property owned by the taxpayer within 180 day period ending on the date of transfer to an EAT will not qualify as replacement property. Thus, the vacant land held by the taxpayer in the example will not qualify as replacement property since it was held by the taxpayer within 180 days prior to the exchange.
However, the Treasury Department held open the possibility that if a party related to the taxpayer previously owned the replacement property, then the exchange will qualify under Section 1031. Thus, a taxpayer may be able to structure a reverse exchange where the replacement property was owned by a related party.
In Private Letter Ruling 201408019, a related party to the taxpayer owned vacant land. The related party leased the vacant land to an EAT for more than a thirty year term, and the taxpayer advanced funds to the EAT to finance construction of a new building on the vacant land. The construction was to be overseen by the taxpayer, but the EAT would hold the qualified indicia of ownership. As part of a like kind exchange, the taxpayer identified the lease and the improvements as replacement property. Within a 180 days after entering the lease, the EAT conveyed the lease and the improvements to the taxpayer. The IRS ruled that the transaction qualified for non-recognition under Section 1031 because the lease was transferred to the EAT from a party related to the taxpayer, not from the taxpayer directly. The IRS stated that Rev. Procedure 2004-51 did not prevent non-recognition treatment because the replacement property had not previously been owned by the taxpayer.
Our real estate group has advised clients on these types of transactions.
Deferred like kind exchange transactions have become common and routine in the real estate world. However, this private letter ruling shows that there is still room for creativity in planning Section 1031 transactions, especially when planning a reverse exchange.
|Robert E. Demmett, CPA, MS, Partner
T (212) 829 3210
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.