The Dreaded Reverse Starker Exchange
Planning Ahead Is the Best Way to Avoid It.
In 1991, when the Treasury Department issued reams of new regulations on how to structure an acceptable tax-deferred exchange, many thought that nearly every conceivable exchange question had been addressed.
Not so. The regulations provide extensive detail on deferred exchanges, but leave a large gap when it comes to a reverse Starker exchange.
What Is a Starker Exchange?
The term Starker exchange comes from a series of 1970s court cases involving Starker family members who bravely went where no one had gone before in a tax-deferred exchange. The Starkers conveyed timber land in return for a promise that the buyer would provide a suitable replacement property within five years. To motivate the buyer, the agreement included a 6 percent annual growth factor.
Surprising to many, the court granted exchange status to this long-deferred trust arrangement, giving birth to the "Starker exchange." Of course, that liberal attitude was tempered under the 1991 regulations, specifying the 45-day identification period and the 180-day exchange period.
For purists, a Starker exchange is still one in which the taxpayer's acquisition of the replacement property is secured by a trust agreement, binding the person who acquires the relinquished property subsequently to provide a replacement property to the taxpayer. Due to the inherent risks to which a Starker trust subjects the exchanging taxpayer and because of the ease of implementing the safe harbor provisions in the 1991 regulations, true Starker exchanges have pretty much gone the way of the capital gains deduction. Starker exchange, 1031 exchange, Starker trust, and deferred exchange have all come to mean the same thing: a tax-deferred exchange in which the taxpayer first relinquishes property and then acquires replacement property.
Is a Reverse Exchange Possible?
Even Internal Revenue Service (IRS) regulations refer to a Starker exchange in their preamble, which (unfortunately) states: "The proposed regulations do not apply to transactions in which the taxpayer receives the replacement property prior to the date on which the taxpayer transfers the relinquished property (so-called 'reverse Starker' transactions)." The preamble goes on to say: "However, the Service will continue to study the applicability of the general rule of Section 1031(a)(1) to these transactions." Well, it's been more than five years and still no word.
In the meantime, investors are occasionally confronted with situations that do not fit the traditional tax-deferred exchange mold of relinquishing property and then replacing it. What can be done for the client who is faced with a reverse Starker exchange-acquiring the replacement property before transferring the relinquished property?
The rare court cases addressing this dilemma provide few answers. One of the key elements of a successful tax-deferred exchange is that there was an exchange. In fairness to the IRS, taxpayers who have attempted reverse Starker exchanges and subsequently argued their cases in court have failed to establish even the most elementary evidence that the series of transactions were "...interdependent parts of an overall plan, the result of which was an exchange of like-kind properties." Consequently, the "exchanges" were deemed to be purchases followed by sales that resulted in recognized capital gains.
Eventually it may be possible for an exchanging taxpayer to structure a true reverse Starker with the requisite documentation and interdependence to pass the IRS's test for tax-deferral treatment. In the meantime, whenever someone claims to have discovered a way to execute a reverse Starker exchange, what is really being proposed is a way to avoid a reverse Starker exchange. This article is no exception.
The Cornered Taxpayer
Fred the taxpayer has an investment property that he hopes to exchange in a 1031 tax-deferred exchange for a replacement property currently owned by Betty. Fred has negotiated a purchase agreement withBetty that provides for the closing to occur no more than 30 days later. Barney has agreed to buy Fred's relinquished property, but Barney cannot come up with the cash for at least 90 days. Subsequently, Fred is facing a classic reverse Starker exchange if he acquires Betty's property before transferring his relinquished property to Barney.
Avoiding the Dilemma
The most effective method of avoiding a reverse Starker exchange is to ensure that the problem is not created in the first place. All sales contracts for relinquishing the property and all purchase agreements for acquiring the replacement property should contain language that clearly demonstrates the taxpayer's intent to execute a tax-deferred exchange. There are two types of notices:
- a "1031 Exchange Notice" that makes it clear to the other party (and the IRS) that the taxpayer is either relinquishing or acquiring property as part of a tax-deferred exchange; or
- a "1031 Contingency Notice" that clearly indicates the taxpayer's intent to exchange and makes the taxpayer's performance in the transaction subject to his or her ability to execute the exchange fully.
A taxpayer who has not yet identified a replacement property should be protected by a 1031 Contingency Notice in the relinquished property sales contract. Likewise, a taxpayer who is negotiating to acquire a replacement property should be protected by a 1031 Contingency Notice in the purchase agreement until the relinquished property is transferred.
Fred's contract with Betty should have contained language making Fred's performance contingent on his ability to first dispose of the relinquished property. It is one thing to have a client who must delay an exchange while locating a different replacement property; it is quite another matter to have a client who is forced to purchase a property without cash proceeds or exchange benefits or who is sued for nonperformance under either contract.
Alternatives to a Reverse Starker
Assuming that Fred either has no 1031 Contingency Notice in his contract to purchase Betty's property or chooses to waive the contingency, how can this exchange be structured so that Fred relinquishes before replacing?
One of the safe harbors provided under the 1991 regulations in a deferred exchange is the use of a qualified intermediary. With proper documentation, the taxpayer's qualified intermediary does not actually take title to relinquished replacement properties, but acts as a statutory "strawperson" whose primary role is to take receipt of any proceeds during the interim of a deferred exchange and to provide the mandatory exchange paperwork. However, a more aggressive use of a qualified intermediary can provide possible solutions to an imminent reverse Starker exchange.
Using funds borrowed from Fred, the qualified intermediary acquires the replacement property from Betty and immediately swaps with Fred for the relinquished property. The qualified intermediary then holds title to the relinquished property until Fred's buyer, Barney, is able to take title from the qualified intermediary. Regardless of when the qualified intermediary reconveys the relinquished property to Barney, from Fred's perspective, this is an acceptable exchange: Fred has simultaneously swapped his property for Betty's.
This scenario raises two issues. First, can Fred obtain the funds to loan to the qualified intermediary to acquire Betty's property? Second, is the qualified intermediary willing to hold title to Fred's relinquished property, subject to the inherent risks of property ownership (environmental and liability being the most obvious) until Barney can take title?
Using funds borrowed from Fred, the qualified intermediary acquires Betty's property, the replacement property, and holds it until Barney can take title to Fred's relinquished property; Fred then acquires the replacement property from the qualified intermediary. Once again, the issues of availability of funds for Fred and liability for the qualified intermediary are obvious. And assuming Fred can finda qualified intermediary willing to do so, what are Fred's risks in having the qualified intermediary hold title to his replacement property for an extended period of time?
The Qualified Intermediary
The options outlined in Alternatives 1 and 2 assume that the qualified intermediary is truly qualified. The terms qualified intermediary, intermediary, and accommodator often are used interchangeably. In many cases that does not present a problem, but for reverse Starker exchanges, the distinction is critical. Under the rules, a qualified intermediary cannot be the agent of, nor related to, the taxpayer. For that test, the relationship is any person who is a member of the taxpayer's immediate family or who has more than a 10 percent common interest with the taxpayer. For example, a corporation in which the taxpayer holds an 11 percent interest cannot act as the taxpayer's qualified intermediary in a four-way exchange.
However, when the qualified intermediary is actively involved as an accommodator, as in Alternatives 1 and 2, another type of "related person" issue arises under the 1984 IRS Code, because a taxpayer is either transferring property to or receiving property from such a related person.
In that case, a related person is defined as a member of the taxpayer's immediate family or an entity in which the taxpayer has common ownership of more than 50 percent. For example, a taxpayer and a partnership in which the taxpayer holds a 51 percent interest would be considered related persons. Such rules were devised to discourage "basis shifting" by taxpayers who convey to or receive property from a related person in an exchange.
By involving a related person as an accommodator in an exchange, the property received from the related person (whether by the related person or by the taxpayer) is subject to a minimum two-year holding period. In the event that a related person does dispose of an acquired property within the two-year period, the exchange executed previously will be treated as a sale, with taxes due on the realized gain. (Death and condemnation are two exceptions to this rule.)
In general, such a related person could act as a taxpayer's accommodator, depending on the accommodator's role. In Alternative 1, however, a related person acting as Fred's accommodator would not be able to reconvey the relinquished property to Barney within the two-year holding period. In Alternative 2, the minimum two-year holding period need not act as a deterrent to Fred as the recipient of the property, because he should already have the intent to indefinitely hold the replacement property he received in the exchange from any person, related or not.
If the taxpayer chooses a related person as an accommodator, a qualified intermediary also should be engaged to overcome the issue of constructive receipt of proceeds and to provide exchange documentation.
As just illustrated, using a related person is one way to overcome the obstacle of a reverse Starker exchange. Any exchanging taxpayer who has interests in other entities can use that financial strength to his or her advantage by having the related person acquire the relinquished property in place of a stranger. However, the taxpayer must understand that the acquiring related entity will have to live with the minimum two-year holding period.
For example, suppose Fred owns a 51 percent interest in Fred, Inc. Then Fred, Inc., could acquire Fred's relinquished property, allowing Fred to acquire Betty's property in a timely manner.
Since the IRS definition of related implies only those relationships in which the taxpayer has a controlling interest, an entity that is close to the taxpayer but not related also can be useful in an exchange. For instance, a partnership in which Fred has a 50 percent interest is not a related person under the IRS Code. That means that Fred can use his partnership with his best friend, Ed (Fred 'n' Ed), to buy the relinquished property and hold it pending Barney's acquisition, without Fred 'n' Ed being subject to a two-year holding period.
Keep in mind that when using a qualified intermediary or unrelated person to act as the taxpayer's accommodator, there is usually no tax liability to the accommodator, since the property is reconveyed without gain. When a related party acts as the accommodator and acquires the property with the intent of holding it for investment or business property, the related party can choose to exchange the property in the future and defer any capital gains after the two-year holding period.
Using a qualified intermediary or a related person to avoid a reverse Starker exchange can ensure a timely closing for the benefit of the seller of the replacement property. Depending on the motives of that seller, other approaches to this problem can instead eliminate the reverse Starker effect by delaying the acquisition of the replacement property.
For example, Fred could suggest to Betty that he lease the replacement property from her, which temporarily gives Betty the return she seeks and allows Fred the time necessary to relinquish his property to Barney. However, if all benefits and burdens of ownership already have passed to the exchanging taxpayer, such arrangements can lead the IRS to conclude that the taxpayer is essentially the equitable title holder of the property, which implies a reverse Starker exchange (the replacement property is "acquired" prior to relinquishment).
In a similar vein, the exchanging taxpayer may offer to purchase an option on the replacement property, therefore holding his or her place in line, while awaiting the transfer of the relinquished property. Once again, arrangements that provide for possession of the property may result in the IRS finding that the taxpayer has "acquired" the property, just short of taking legal title.
If Betty is willing to act as Fred's accommodator, she could swap properties with Fred and hold onto Fred's relinquished property until Barney can buy it from her. There would be no taxable event to Betty, since the property would be reconveyed without gain. This allows Barney to achieve a simultaneous exchange, but is acceptable only to a seller who wishes to transfer title but is willing to wait for all cash proceeds.
A Blessing and a Burden
Many investors have discovered the benefits of exchanges since the IRS first allowed them in 1921. For the few taxpayers who are faced with a reverse Starker exchange, the burdens of exchanging may seem to outweigh the blessings. The wheels of tax law turn slowly, and those who wish to structure an acceptable reverse Starker exchange may conclude that "you can't get there from here." Although an authentic reverse Starker exchange is truly a journey into uncharted waters, there are viable alternatives for the exchanging taxpayer.
Proper documentation is the key to any successful tax-deferred exchange. Remember, the burden is always on the taxpayer to show that an exchange has occurred within the meaning of Section 1031 of the IRS Code. Documentation becomes even more critical in any exchange that involves extraordinary methods or participants.
When related persons do business, parties may be tempted to lower their guard, based on a false sense of security. To the contrary, avoiding reverse Starker exchanges by any method requires exceptionally well memorialized transactions that show arms-length negotiations and the intent to exchange. A taxpayer confronted with a potential reverse Starker exchange should make a decision concerning his or her options only after receiving extensive tax and legal counsel.