Reverse Exchanges After Revenue Procedure 2000-37
By Gene Aalseth
First American Title Insurance Company
Your client wants to accomplish a tax-deferred exchange pursuant to Internal Revenue Code Section 1031. Several months ago your client found an investment property and entered into a contract to acquire it. Since that time your client has been actively marketing five investment properties, but has had little success attracting buyers. The contract for the acquisition of the replacement property will expire soon and the seller has told your client that the contract will not be extended. Your client doesn't want to lose this replacement property, but still wants to accomplish a tax-deferred exchange. The solution is to enter into a Qualified Exchange Accommodation Agreement (QEAA) pursuant to IRS Revenue Procedure 2000-37 (Rev. Proc. 2000-37) in order to accomplish a reverse exchange.
Under Rev. Proc. 2000-37 reverse exchanges are accomplished by "parking" either the replacement property or the relinquished property with a third party until the actual exchange of properties can take place. In the situation described above, your client would locate a third party willing to act as an Exchange Accommodation Titleholder (EAT) and assign the replacement property purchase contract to the EAT. The EAT, using funds advanced from your client or from a lender, would acquire title to the replacement property and would hold title to the replacement property until your client was able to sell one of the investment properties (relinquished property). The contract for the sale of the relinquished property would be assigned to a Qualified Intermediary (QI) and pursuant to that agreement title would be transferred to the QI who would transfer it to the buyer. The QI would then use the sale proceeds to acquire the replacement property from the EAT and would transfer the replacement property to your client to complete the exchange.
THE SAFE HARBOR UNDER REV. PROC. 2000-37
Revenue Procedure 2000-37, which became effective September 15, 2000, provides a safe harbor under which the IRS will not challenge:
The qualification of property as either replacement property or relinquished property for purposes of 1031 of the Internal Revenue Code and the regulations thereunder, or the treatment of the Exchange Accommodation Titleholder as the beneficial owner of the replacement property or relinquished property for federal income tax purposes, if the property is held in a Qualified Exchange Accommodation Arrangement, as defined in the revenue procedure.
Section 4.02 of Rev. Proc. 2000-37 sets forth six requirements that must be met for property to be held in a Qualified Exchange Accommodation Arrangement. Those requirements can be summarized as follows:
QUALIFIED EXCHANGE ACCOMMODATION ARRANGEMENTS
- The property is held by an Exchange Accommodation Titleholder (EAT) - a person who is not the taxpayer or a disqualified person and who is subject to federal income tax. (If this person is a partnership or an S corporation 90% of partners or shareholders must be subject to federal income tax.)
- The Taxpayer must have a bona fide intent that the property be held as either replacement property or relinquished property in a qualifying exchange when transferring it to the EAT.
- A written agreement must be entered into within five business days after the transfer of the property to the EAT that provides that:
a) Property is held for the benefit of the Taxpayer in order to facilitate an exchange under 1031 and Rev. Proc. 2000-37;
b) Taxpayer and EAT agree to report the acquisition, holding, and disposition of the property as provided in Rev. Proc. 2000-37; and
c) EAT will be treated as the beneficial owner of the property for all federal income tax purposes.
- No later than 45 days after the transfer of the replacement property to the EAT, relinquished property must be identified in a manner consistent with the principles for identifying replacement property found in 1.1031(k)-1(c)(4) of the Treasury Regulations.
- No later than 180 days after the transfer of the property to the EAT, the property is transferred to the Taxpayer as replacement property or to a person other than the Taxpayer or a disqualified person as relinquished property.
- The combined time period that the relinquished property and the replacement property are held does not exceed 180 days.
As a consequence of requirement four, the client in the example must, within 45 days, identify three potential relinquished properties, or any number of potential relinquished properties, so long as the aggregate fair market value of the identified relinquished properties does not exceed the 200% of the value of the replacement property, or any number of potential relinquished properties no matter what their value, provided 95% of the identified relinquished properties are transferred in connection with the exchange. If the client identifies three potential relinquished properties, the client can transfer one, two or all three of the identified relinquished properties to complete the exchange.
Several practical issues must be addressed in order for an EAT to be able to acquire, hold and manage property. For instance, a lender may not wish to lend money to the EAT without a guarantee from the Taxpayer. The EAT may not be qualified to manage the property or to oversee construction if construction is to take place during the hold period. Section 4.03 of Rev. Proc. 2000-37 permits the taxpayers and EATS to enter into certain agreements to address these issues. In summary, these agreements may contain one or more of the following provisions:
- An Exchange Accommodation Titleholder may serve as Qualified Intermediary;
- The Taxpayer or a disqualified person may guarantee some or all of the obligations of the EAT, including secured or unsecured debt incurred to acquire the property, or may indemnify the EAT against costs and expenses;
- The Taxpayer or a disqualified person may loan or advance funds to the EAT or guarantee a loan or advance to the EAT;
- The property may be leased by the EAT to the Taxpayer or a disqualified person;
- The Taxpayer or a disqualified person may manage the property, supervise improvement of the property, act as a contractor, or otherwise provide services to the EAT with respect to the property;
- The Taxpayer and EAT may enter into agreements or arrangements relating to the purchase or sale of the property, including puts and calls at fixed or formula prices, effective for a period not in excess of 185 days from the date the property is acquired by the EAT; and
- The Taxpayer and the EAT may enter into agreements or arrangements providing that any variation in the value of a relinquished property from the estimated value on the date of the EAT's receipt of the property be taken into account upon the EAT's disposition of the relinquished property through the Taxpayer's advance of funds to, or receipt of funds from, the EAT.
EXCHANGE FIRST AND EXCHANGE LAST TRANSACTIONS
Either the relinquished property or the replacement property can be parked in a QEAA. Transactions where the relinquished property is parked are known as 'exchange first' transactions. In an exchange first transaction, the Taxpayer transfers the relinquished property to the QI who in turn transfers it to the EAT. At the same time, the seller of the replacement property" transfers it to the qualified intermediary who transfers it to the Taxpayer to complete the exchange. The EAT holds title to the relinquished property until the Taxpayer has found a buyer for it, and then transfers it to the buyer. The proceeds from the sale of the relinquished property are then used to repay the Taxpayer or the lender who advanced the funds to acquire the replacement property.
In the 'exchange last' transaction, the seller of the replacement property transfers it to the EAT who holds it until the relinquished property" has been sold, or, in the case of a reverse construction exchange, until construction has been completed, and then the exchange takes place.
Revenue Procedure 2000-37 provides a safe harbor for some, but not all "parking" transactions. It applies only to transactions after the effective date, September 15, 2000, and will not apply to an exchange that does not meet all six requirements found in Section 4.02. However, in Section 3.02 the IRS indicated that they recognize that "parking" transactions can be accomplished outside the safe harbor of Rev. Proc. 2000-37 and that those transactions may still qualify for tax-deferred treatment. A transactions where improvements to be constructed on the replacement property" will take longer than 180 days to complete would be an example of an exchange that will need to be structured as a "parking" arrangement outside the safe harbor of Rev. Proc. 2000-37.