Tax issues

IRS Clarifies Reverse Exchange Qualifications

The Internal Revenue Service's recent Revenue Procedure providing a safe harbor for reverse like-kind exchanges adds clarity to what has been a hazy situation.

In the past, many taxpayers have been hesitant to enter into reverse exchanges due to the Internal Revenue Code's ambiguous treatment of these transactions. In a reverse exchange, a taxpayer receives the replacement property before transferring the relinquished property. The IRS often challenged reverse exchanges and treated them as recognized taxable transactions.

To avoid uncertainty, many taxpayers opted for parking transactions, in which a third party, an accommodator, acquires and holds the replacement property until the taxpayer can dispose of the relinquished property. When the taxpayer is ready to sell the relinquished property, the taxpayer enters into a simultaneous exchange with the accommodator. Thus, the taxpayer receives the replacement property, whereas the accommodator receives the relinquished property and distributes it to a third party.

However, in parking exchanges, determining which party has the benefits and burdens of ownership of the replacement property has been unclear. It has been uncertain whether the taxpayer could guarantee any debt of the accommodator, provide services to the property, or lease the property from the accommodator without looking more like the beneficial owner, which would jeopardize the tax status of the exchange transaction.

To clear up the confusion, the IRS issued Rev. Proc. 2000-37, providing a safe harbor for reverse like-kind exchange transactions. Under this ruling, the IRS will not challenge the qualification of property as either replacement property or relinquished property or the treatment of the exchange accommodation titleholder as the property owner for federal income tax purposes if the property is held in a qualified exchange accommodation arrangement.

Clarifications In a recent U.S. Tax Court case, DeCleene v. Commissioner, a business owner attempted to structure a transaction as a like-kind exchange to achieve a tax break. The business owner purchased unimproved land on which he planned to relocate his business. Subsequent to the purchase, a third party expressed an interest in the business owner's former commercial property.

The business owner quitclaimed the unimproved property to the third party, who conveyed the property back to the business owner after a new building had been constructed on it in exchange for the commercial property. The business owner sought like-kind exchange treatment under IRC Section 1031, but the Tax Court concluded that the transaction resulted in a taxable sale of the commercial property because the third party never acquired beneficial ownership of the unimproved property.

The court indicated that the third party did not acquire the benefits and burdens of ownership of the unimproved property during the three months that it held title to it. The third party acquired no equity interest in the property, and his holding of title had no economic significance. The third party had no exposure to real estate taxes during the three months, and the new construction was financed by the business owner, who was at risk at all times with respect to the new property.

Due to these facts, the court found that the transaction merely was a parking transaction with the third party, and reconveying the new property was not part of a like-kind exchange because the business owner never had relinquished beneficial ownership.

To avoid such confusion, Rev. Proc. 2000-37 clarifies several issues for investors.

For example, it establishes that the exchange accommodator is deemed to be the beneficial owner of the property. According to the safe-harbor qualifications, legal title to the property must be held by an exchange accommodator, who is subject to federal income tax. If the exchange accommodator is treated as a partnership or corporation, more than 90 percent of its interest or stock must be owned by partners or shareholders who are subject to federal income tax. The title must be held by the exchange accommodator until the transfer of the replacement property.

Because Rev. Proc. 2000-37 makes this relationship clear, the taxpayer now can guarantee a portion or all of the debt as well as advance funds to the exchange accommodator. The taxpayer also can enter into a net lease and provide services to the property. The taxpayer will not be treated as the beneficial owner of the property if the exchange accommodator leases property to the taxpayer. Additionally, the taxpayer can manage, supervise improvements, or act as contractor with respect to the property.

The taxpayer and exchange accommodator also can enter into agreements or arrangements relating to the purchase or sale of the property, including puts and calls. The taxpayer will not be considered the beneficial owner of the property effective for a period of 185 days from the date that the exchange accommodation titleholder acquires the property.

Qualifications A transaction must meet five requirements to be considered a qualified exchange accommodator agreement under Rev. Proc. 2000-37.

First, the exchange accommodator must hold legal title to the property until the transfer of the replacement property. Also, at the time of the transfer of legal title to the exchange accommodator, the taxpayer must have a bona fide intent to enter into a qualified exchange under IRC Section 1031.

This intent and the accommodator's role as beneficial owner in the exchange must be put into a written agreement within five business days of the title transfer.

As with deferred exchanges, the taxpayer must identify the replacement property within 45 days of the transfer of the relinquished property.

Finally, the total combined time that the replacement property and the relinquished property are held cannot exceed 180 days.

If the requirements of Rev. Proc. 2000-37 are not satisfied, then the safe-harbor rules under this revenue procedure will not apply to a transaction. If the transaction falls outside the scope of the safe harbor, the normal reverse exchange rules would apply.

Consult with your tax adviser before undertaking an exchange transaction.

Steven M. Friedman and Steven J. Szymanski

Steven M. Friedman is a tax partner and Steven J. Szymanski is a tax manager in the McLean, Va., office of Ernst & Young. Contact them at (703) 747-1000 or and