The tax court recently issued a decision involving a built-to-suit reverse 1031 exchange which may provide taxpayers more flexibility in completing non-traditional exchanges. In the case of Estate of George H. Bartell Jr. et al. v. Commissioner, 147 T.C. No. 5, the Tax Court approved a reverse section 1031 exchange where the safe harbor tests under Revenue Procedure 2000-37 (“Rev. Proc. 2000-37”) were not met. The case and the court’s reasoning may support alternatives for structuring reverse exchanges that cannot meet the safe harbor.
A 1031 exchange provides potential deferral of gain on what would otherwise be a taxable sale of property. Under a typical ‘forward’ exchange, a taxpayer would sell a property, and the funds would be held temporarily by a qualified intermediary (QI) until the closing of a replacement property occurs. Under a ‘reverse’ exchange, the purchase of a replacement property occurs before the sale of the relinquished property. The QI holds title to the replacement property until the sale of the relinquished property occurs. Rev. Proc. 2000-37 was issued on September 18, 2000 to provide guidance and a safe harbor for reverse exchanges.
Rev. Proc. 2000-37 Safe-Harbor
IRC Section 1031 allows non-recognition of gain only to the extent that the replacement property is “like-kind” to the relinquished property (for example: real property must be exchanged for other real property). If all or part of the replacement property is not of a like-kind, gain will be recognized in the amount of non like-kind property received. Therefore, in order to fully defer the gain realized on the disposition of relinquished property, the taxpayer must acquire like-kind replacement property of equal or greater value.
Improvements constructed on real property already owned by a taxpayer are not like-kind to other property and do not qualify as like-kind to relinquished property transferred by the taxpayer. Therefore, if a taxpayer uses proceeds from the sale of relinquished property for the construction of improvements on land already owned by the taxpayer, the amount used would create recognized gain.
In order to complete these so-called “build-to-suit” exchanges, it is necessary to ensure that the taxpayer is not the owner of the replacement property until construction is complete. Rev. Proc. 2000-37 provides a safe harbor that allows a taxpayer to treat a QI as the owner of the property for federal income tax purposes, thereby allowing the taxpayer to accomplish a qualifying like-kind exchange where proceeds from the sale of relinquished property will be used to fund construction of the replacement property.
Under the Revenue Procedure, a party that holds bare legal title to the property (referred to as an “exchange accommodation titleholder” or “EAT”) will be treated as the owner of the property for federal income tax purposes.
One of the requirements of the safe harbor under Rev. Proc. 2000-37 is that the taxpayer must receive title to the property within 180 days of the original transfer of title to the EAT. Given the nature of a build-to-suit exchange transaction, it is often difficult to complete construction within this 180-day time limit. However, the Revenue Procedure specifically provides that “the Service recognizes that ‘parking’ transactions can be accomplished outside of the safe harbor provided in this revenue procedure.” Unfortunately, the IRS has provided no guidance describing when such a non-safe harbor transaction could still qualify as a section 1031 like-kind exchange.
Based on the Tax Court’s opinion in Bartell, taxpayers may be able to successfully complete a built-to-suit like-kind exchange transaction where the EAT holds bare title for a period exceeding 180 days.
Estate of George H. Bartell Jr. Et Al. V. Commissioner
In this case, Bartell Drug entered into an agreement to purchase property in Lynnwood, WA, in 1999. The sale agreement contained a clause stating that both the buyer and seller agreed to reasonably cooperate with each other to accomplish an exchange under section 1031. Bartell Drug engaged a QI for section 1031 exchanges, agreeing that EPC Two, a single member LLC formed for the exclusive purpose of providing services to Bartell Drug, would take title to the Lynnwood property in order to effect the section 1031 exchange. A loan was obtained in order to fund the acquisition of the Lynnwood land as well as the construction of a new drug store on the property. The loan was made to EPC Two, but was nonrecourse to the entity and was guaranteed by Bartell Drug.
Bartell Drug and EPC Two entered into an agreement where EPC Two was to construct a drug store on the Lynnwood property. After the bank loan proceeds were exhausted, the Bartell Drug loaned funds for the construction of the project. The agreement allowed Bartell Drug to manage the construction of the project and to lease the property once the construction was complete.
In December 2001, Bartell Drug executed an exchange agreement with the QI for the exchange of relinquished property for the Lynnwood Drug Store in a transaction intended to qualify for tax deferred treatment under section 1031. Because the length of time the property was held by EPC Two (17 months) was greater than 180 days, the safe harbor rules under Rev. Proc. 2000-37 would not have applied, even if Rev. Proc. 2000-37 had been effective prior to the initiation of the like-kind exchange.
The central issue between the taxpayer and the IRS in this case is whether Bartell Drug or EPC Two should be considered the owner of the Lynnwood property for Federal income tax purposes, prior to EPC Two’s exchange of the Lynnwood Drug Store to the taxpayer. If it were to be ruled that Bartell Drug was the owner of the Lynnwood property prior to the exchange, then the taxpayer would have been engaged in a non-reciprocal exchange with himself.
The IRS stated that under the benefits and burdens test, Bartell Drug already owned the Lynnwood property before the exchange occurred. The petitioners contended that EPC Two must be treated as the owner and that the agency analysis should be employed consistent with previously permitted like-kind exchanges. They point out that both the Tax Court and the Court of Appeals for the Ninth Circuit, to which an appeal in this case would ordinarily lie, have expressly rejected the proposition that a person who takes title to the replacement property for the purpose of effecting a section 1031 exchange must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement.
The Tax Court acknowledged that courts have historically exhibited a lenient attitude toward taxpayers’ attempts to come within the terms of section 1031, citing several relevant cases. The Court went on to state that it would put considerable emphasis on a taxpayer’s use of a third-party exchange facilitator rather than the benefits and burdens test. Citing previous case law, the Tax Court stated that it has been established that where a section 1031 exchange is contemplated from the outset and a third-party exchange facilitator, rather than the taxpayer, takes title to the replacement property before the exchange, the exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for section 1031 purposes before the exchange. The Tax Court concluded that the transaction qualified for section 1031 treatment under existing case law principles and that Bartell Drug’s disposition of the relinquished property and acquisition of the Lynnwood property in 2001 qualifies for non-recognition treatment pursuant to section 1031.
• Reverse exchange transactions offer taxpayers advantageous tax deferrals when structured correctly, particularly where the taxpayer wants to build or modify the replacement property. The findings in the Bartell case may allow taxpayers to take advantage of these tax deferrals even when they do not fall within the safe harbor limits of Rev. Proc. 2000-37.
• While meeting the requirements of the revenue procedure ensures that the transaction will avoid IRS challenge, the Tax Court’s decision opens up the possibility that if an exchange facilitator who takes bare legal title of the replacement property is properly utilized, the taxpayer can manage the construction of replacement property, guaranty acquisition and construction loans, lend funds to facilitate completion of the project, make other necessary arrangements and still successfully complete a reverse like-kind exchange even without meeting the safe harbor requirements.
• It is worth noting, however, that the Tax Court specifically stated that “we express no opinion with respect to the applicability of section 1031 to a reverse exchange transaction that extends beyond the period at issue in this case. In view of the finite period in which the exchange facilitator in this case could have held, and in fact did hold, title to the replacement property, we are satisfied that the transaction qualifies for section 1031 treatment under existing case law principles.” In light of this commentary, caution is warranted in structuring non-safe harbor exchange transactions that go beyond the facts of Bartell and the authorities described therein.
• An attorney from the IRS Office of Associate Chief Counsel (Income Tax and Accounting) recently stated that the IRS is considering appealing the Bartell decision to the Ninth Circuit. The IRS is considering the best strategy for supporting its legal analysis, which may or may not ultimately include an appeal. Regardless of its decision regarding an appeal, it appears the IRS is unlikely to give up on its position.