IRS Issues Reverse Exchange Guidance
[November/December, 2000]

by Louis S. Weller

Since 1921, the Internal Revenue Code (IRC) has allowed taxpayers who engage in "like-kind" exchanges葉rading business or investment property葉o not recognize either gain or loss realized on disposition of "relinquished properties." This is the rule of current IRC Section 1031. Since 1984 the IRC has imposed limitations on "deferred" like-kind exchanges, requiring that "replacement property" be identified and acquired within specific time limitations in order to qualify as like-kind to relinquished property in an exchange. Now the Internal Revenue Service has issued rules which, for the first time, provide guidance on how to complete "reverse" like-kind exchanges葉hose when a taxpayer acquires replacement property before, rather than following or simultaneous with, the disposition of relinquished property. In releasing Revenue Procedure 2000-37 on September 15, 2000, IRS took a giant step towards solving some of the most vexing problems associated with these types of like-kind exchanges.

Safe Harbors

Fundamentally, Revenue Procedure 2000-37 sets up a safe harbor for so-called "parking" transactions. These transactions allow a property owner who wants to utilize Section 1031 to defer gain on a future sale or property to avoid concurrent ownership of both replacement and relinquished properties. To accomplish this, an accommodation party takes ownership of one of these properties during the period of time between acquisition of replacement property and disposition of relinquished property. In an "Exchange First" transaction, a taxpayer transfers a relinquished property to an accommodation party in exchange for the accommodation party's concurrent acquisition and transfer of a replacement property to the taxpayer. In an "Exchange Last" transaction, the accommodation party purchases the taxpayer's intended replacement property, but retains it until sale of the relinquished property occurs. Then, a simultaneous exchange or a later deferred exchange is undertaken. These structures have been developed because tax advisors were unable to conclude that a valid exchange occurs if the exchanger directly acquires a replacement property while still holding the relinquished property.

The IRS chose to adopt an approach, which builds on current practice. Unlike a so-called "pure" reverse exchange擁n which an owner acquires replacement property before transferring relinquished property葉he taxpayer/exchanger does not own more than one property at a time in either "Exchange First" or "Exchange Last" transactions. The key issue for these transactions was whether the IRS would respect the independent status of the accommodation owner, or treat the accommodator as a surrogate of the exchanger because the accommodator did not possess sufficient benefits and burdens of ownership. Revenue Procedure 2000-37 has set out rules which, if followed, guarantee that an accommodation parking arrangement won't be attacked due to lack of economic substance.

Rules applicable to parking arrangement exchanges under Revenue Procedure 2000-37 parallel those applicable since 1991 to deferred exchanges. To qualify for the favorable treatment established by this new rule, accommodation arrangements must last no longer than 180 days. The "qualified exchange accommodation arrangement" (QEAA) must be reflected in a written agreement. The "exchange accommodation titleholder" must not be a "disqualified person"葉he same restriction is applicable to qualified escrow holders, qualified trustees and qualified intermediaries in deferred exchanges. Finally, the relinquished property transferred in a reverse exchange must be identified within 45 days of the time the accommodating party acquires a replacement property. The familiar 3-property/200 percent limitation rule does apply to identification in these exchanges. Finally, the taxpayer must have a bona fide intent to complete an exchange at the time the QEAA is created.

On the Bright Side

The good news here is that so long as the requirements of the safe harbor are met, the IRS will not review the economic relationship between the exchanger and the accommodator to determine whether it is an "arm's length" arrangement or whether the accommodator has benefits and burdens of ownership under general tax law principles. This means the terms of financing the purchase of the replacement property, operating it during the QEAA period and limiting the accommodator's possible profit or loss on transfer of the property to the exchanger do not matter.

The IRS also specifically provided that creation of the safe harbor requirements does not create a presumption that parking arrangements which do not meet the tests of Revenue Procedure 2000-37 would result in the accommodator being treated as the exchanger's agent.

Some Difficulties Remain

Despite the generally good news associated with this IRS action, two requirements of the new rule mean that institutional real estate owners such as REITs may find the Revenue Procedure less useful than they hoped.

First, and most importantly, the 180-day limitation on duration of a QEAA means that safe harbors are not available in many (if not most) exchanges involving construction of replacement property. Despite lobbying by industry groups to obtain a longer period for safe harbors, the IRS elected to create a period parallel with the one applicable to deferred exchanges. When construction of replacement property takes longer than six months, reverse exchanges will have to be structured outside the safe harbor period.

Second, the identification requirement may affect situations when more than three properties are being marketed at the time of a replacement property acquisition. As a result of the identification requirement, it is necessary to limit the potential relinquished property associated with a specific parked replacement property.

Some increased conservatism in the structuring of build-to-suit reverse exchanges will likely result in the REIT industry. In addition we will probably see increased use of these techniques in portfolio realignment planning when purchases of property in a market a REIT wants to enter or consolidate must precede sales of property in a market from which a REIT wants to exit.

A Step Forward

In spite of these shortcomings from the REIT perspective, Revenue Procedure 2000-37 represents a significant step forward. It recognizes the validity of reverse exchange parking arrangements. It takes away tax uncertainty from many of the elements of parking arrangements, so long as they constitute safe harbor arrangements. It specifically provides that non-safe harbor arrangements can work if appropriately structured. REITs and their advisors should welcome the new rules and add reverse exchanges to their list of techniques available for tax effective disposition and acquisition of properties.