Reverse Exchange Variations
Articles from The Massachusetts Focus
Newsletter of Stewart Title Guaranty Company, Massachusetts Offices
Fall 2002, Volume 1, Number 3
Reverse Exchange Variations
Comparison of Two Different "Parking Arrangement" Fomats
by Robert HB Buckner and Todd R. Pajonas Esq. of Asset Preservation Inc, a subsidiary of Stewart Title Company
Since 1991 when the IRS defined the role of a "Qualified Intermediary" and streamlined the exchange process, many real estate investors and their counsel have become increasingly aware of the benefits of an IRC §1031 tax deferred exchange. Properly structured, a tax deferred exchange allows a "taxpayer" to defer the capital gain tax realized upon the sale of business or investment property if the taxpayer acquires property of like-kind which is also held for business or investment purposes.
To obtain the benefit of tax deferral, taxpayers must adhere to a strict schedule of identifying and purchasing replacement property. These requirements sometimes leave taxpayers scrambling and, on occasion, unable to complete an exchange. Taxpayers must identify potential replacement property (one or more) within 45 calendar days and acquire the replacement property within 180 calendar days, both periods running from the date of closing the relinquished property. IRC §1031(a)(3)(A)-(B). In addition, to obtain a complete deferral of the capital gain tax, the taxpayer must acquire replacement property of equal or greater value, obtain equal or greater debt on the replacement property, reinvest all the net proceeds realized from the sale of the relinquished property, and acquire only like-kind property. Treas. Reg. §1.1031(d)-2 and IRC §1031(a)(1).
Often in a "sellers market," where recently listed properties are quickly under contract with a buyer, Exchangers need to purchase a replacement before they are ready to sell their relinquished property. When confronted with this situation Exchangers need to perform what is commonly known as a "reverse exchange," or more properly termed, a "parking arrangement." Revenue Procedure 2000-37 provides guidelines for Exchangers to perform a "parking arrangement" exchange.
An Overview of "Parked" Property Arrangements
Prior to the release of Revenue Procedure 2000-37, (the "Rev. Proc.") many Exchangers were reluctant to proceed with reverse or improvement exchange variations, both of which required the Qualified Intermediary to be "parked" on title to either the replacement or relinquished property. One of the primary concerns was the problem of "constructive ownership." Many tax and legal advisors were concerned that the Exchanger was both responsible for, and entitled to, the burdens and benefits of ownership while legal title was held by the Qualified Intermediary. If the Exchanger retained all the benefits and burdens of ownership, and only legal title was "parked," the structure could be collapsed because the IRS would look at the Exchanger as actually owning both the relinquished property and replacement property at the same time. In addition, there were many potential problems such as the management of the "parked" property, loan arrangements, advances to fund the purchase of the replacement property, puts and calls, and which entity was entitled to receive the tax benefits of ownership while the property was "parked."
Revenue Procedure 2000-37: A Summary
Finally, the IRS has provided guidance for these "parked" arrangements. As a result, Exchangers can now work with an experienced Qualified Intermediary and confidently proceed with a wider array of exchange alternatives. Revenue Procedure 2000-37, enacted on September 15, 2000, applies to exchanges where title to either a relinquished or replacement property is "parked" with the Qualified Intermediary. The revenue procedure creates a "safe harbor" for transactions that are within the following parameters:
- Title to either the relinquished or the replacement property must be parked with the "Exchange Accommodation Titleholder" (EAT);
- The EAT must hold legal title, referred to as the "Qualified Indicia of Ownership" (QIO);
- The Exchanger and the EAT must enter into a written agreement known as the "Qualified Exchange Accommodation Arrangement" (QEAA) within five days of the EAT's purchase of the "parked" property;
- The Exchanger must have a "bona fide intent" that the parked property will either be the relinquished or replacement property in an exchange;
- The EAT cannot be the Exchanger or a "disqualified person";
- The EAT must report the property on its income tax return;
- The Exchanger must identify the relinquished property within 45 calendar days;
- The Exchanger must complete the exchange within 180 calendar days from the date the property is transferred to the EAT.
Revenue Procedure 2000-37: Permissible Agreements
Revenue Procedure 2000-37 provided for the following permissible agreements regardless of whether or not they contain terms which may typically destroy an arms-length relationship between the EAT and the Exchanger:
- The EAT may act as both the Qualified Intermediary and the EAT, provided the Exchanger may guarantee all or part of the obligations of the EAT including debt and incurred expenses;
- The Exchanger may loan or advance funds to the EAT;
- The EAT may lease the property to the Exchanger;
- The EAT may enter into a management agreement with the Exchanger;
- The Exchanger may act as contractor and/or supervisor with respect to the property;
- EAT and Exchanger may enter into agreements using puts and calls at fixed or formula prices for subsequent dispositions, provided that they satisfy the Qualified Intermediary safe harbor provisions in Section 1.1031(k)-1(g)(4).
The safe harbor and permissible agreements cited above provide the Exchanger with much needed clarification and guidance on many issues that have concerned tax and legal advisors who have reviewed "parked" arrangements in the past. For the most part, the requirements of Rev. Proc. 2000-37 provide Exchangers great latitude in these transactions. However, the Rev. Proc. did narrow the time requirements considerably and this may create problems on larger commercial exchanges. Obtaining the necessary approvals and construction improvements within the 180-day time limit can be challenging when proceeding with an improvement exchange on commercial property.
A key to the reverse exchange is that the Exchanger cannot own both the relinquished property and the replacement property at the same time. An Exchange Accommodation Titleholder (EAT) is the entity, prescribed by the IRS, which holds title to the property during the reverse exchange (180-day) period. And while Exchangers have the option of "parking" either their relinquished or replacement property with the EAT, there are significant differences in each of these structures.
"Replacement Property Parked"
The EAT acquires title to the replacement property with funds the Exchanger loans to the EAT. Within 180 days the Exchanger sells the relinquished property through the "delayed exchange" format and the EAT transfers the replacement property to the Exchanger. The equity from the sale of the relinquished property pays down the loan and/or pays back the Exchanger.
Positives of the "Replacement Property Parked"
- Since the net proceeds from the sale of the relinquished property are available prior to the Exchanger purchasing the replacement property, the equity in the replacement property will be sufficient for the equity requirements for the tax deferred exchange. (For a fully tax deferred exchange, Exchangers should acquire property of equal or greater value and use all of the net sales proceeds in the purchase.)
- If there are extra funds the Exchanger can still purchase additional replacement property, other than the "reverse property," as a delayed exchange.
- A "replacement property parked" arrangement allows for multiple relinquished properties. In fact, using the 200 percent rule, this format allows an Exchanger to identify many potential relinquished properties, allowing for tremendous flexibility. Under the 200 percent rule, the Exchanger can identify an unlimited number of properties, whose total aggregate value does not exceed 200 percent of the value of the replacement property or properties. For example, if the Exchanger were to purchase a five million dollar property ($5,000,000), he could identify up to ten million dollars ($10,000,000) of potential relinquish properties.
Negatives of the "Replacement Property Parked"
- Loan issues - some smaller, unsophisticated lenders may have issues lending to the EAT. A solution may be to use a portfolio lender or to borrow funds secured by other real estate.
- Potential for higher costs - in certain states there is the potential for higher costs due to double transfer taxes and title insurance fees. In some states, the LLC can be transferred to the exchanger to avoid extra taxes.
"Relinquished Property Parked"
The Exchanger conveys the relinquished property to the EAT and then the Exchanger acquires the replacement property under a "simultaneous exchange" format. During the 180 days, the EAT remains on title to the relinquished property until it is sold to a purchaser.
Positives of the "Relinquished Property Parked"
- Purchase and financing of replacement property is easier since the Exchanger is taking title directly instead of the EAT.
- The arrangement allows Exchanger to have all the benefits of ownership immediately.
- It is safer for EAT and Exchanger to hold title.
Negatives of the "Relinquished Property Parked"
- In order to have a fully tax deferred exchange the Exchanger must be able to finance the acquisition of the replacement property without taking out more debt on the replacement property than was in place on the relinquished property.
- There can be lender issues on relinquished property when transferred to EAT (due on sale clause and prepayment penalties).
While each of these structures offers its own set of positives and negatives, neither should be contemplated without the advice of competent tax and legal professionals. For additional information contact Asset Preservation at (877) 845-1031; (800) 282-1031 or http://www.apiexchange.com.