THIS ARTICLE PROVIDES SUMMARY GUIDANCE ONLY CONCERNING THE REVERSE LIKE-KIND EXCHANGE RULES OF SECTION 1031 OF THE INTERNAL REVENUE CODE. THESE RULES AND THEIR INTERPRETATIONS CHANGE CONSTANTLY, AND THE APPLICATION OF THESE RULES TO PARTICULAR FACTS REQUIRES CAREFUL SCRUTINY. ALWAYS CONSULT WITH YOUR ATTORNEY OR TAX ADVISOR.
On September 19, 2000, the Internal Revenue Service announced (in Revenue Procedure 2000-37) that it would recognize the validity of certain so-called "reverse" like-kind exchanges. The IRS thus greatly expanded the practical utility of the like-kind exchange, one of the most important tax savings tools available to investors and businesses.
1. Background. An ordinary forward like-kind exchange involves the sale of the taxpayer's old property, followed by the acquisition of new property within 180 days of the sale of the old property. Under the ordinary forward exchange rules, the taxpayer must identify the target replacement property within 45 days of the sale of the old property.
2. The Dilemma. The strict timing rules mentioned above often make it difficult for taxpayers to complete a like-kind exchange. Thus, many taxpayers begin the search for new property before the old property is sold. Clearly a wise step. But what if the seller of the new replacement property will not wait until the taxpayer's sale of the old property? Prior to the IRS Announcement, the IRS had indicated that the deferred exchange rules of Internal Revenue Code Section 1031(a)(3) did not apply if the taxpayer purchased new property before the old property was sold.
3. The Parking Intermediary. Even before the IRS Announcement, a limited number of exchange companies began to offer services as "parking intermediaries." Unlike the ordinary forward qualified intermediary (whose role is more or less limited to holding proceeds of sale of an old property pending reinvestment in new property), the parking intermediary would actually take title to the new property, hold it, lease it to the taxpayer and then sell it to the taxpayer after the taxpayer's old property was sold. Thus, it was made to appear as if the taxpayer was doing an ordinary forward exchange--the new property was conveniently "parked" with the special parking intermediary until the old property was sold, when the parking intermediary would sell it to the taxpayer.
The parking intermediary did not mind being patient--holding the new property awaiting the sale of the taxpayer's old property--because that is what the parking intermediary was paid to do. The agreed profit or fees earned by the parking intermediary usually ran between $5,000 to $25,000, depending upon the type, value and holding period of the new property parked with the parking intermediary.
4. Timing Requirements. Under the IRS Announcement, a parking intermediary can hold new replacement property for up to 180 days. By that time, the new property must be transferred to the taxpayer as part of an ordinary forward exchange, otherwise the parking arrangement will not qualify for safe-harbor treatment. Moreover, the taxpayer must identify the old property that would eventually be exchanged for the new parked property within 45 days of the time that the parking intermediary acquired the new property.
Prior to the IRS Announcement, parking intermediaries might hold the target property for a longer period of time. Indeed, the IRS Announcement said that it is not passing judgment on parking arrangements undertaken prior to the announcement, or on future parking arrangements that fall outside of rules contained in the IRS Announcement. Prudence dictates, however, that taxpayers in a reverse exchange situation comply with the requirements of the IRS Announcement, in addition to the ordinary forward exchange rules.
5. Do I Still Need A Qualified Intermediary? A qualified intermediary serves the purpose of "safe-harboring" a forward like-kind exchange. Compliance with the IRS Announcement on reverse exchanges does not create safe-harbor treatment for the forward exchange, and since complying with any IRS safe-harbor reduces the risk of challenge, it makes sense to pay the modest fees charged by forward qualified intermediaries.
6. Who Are These Parking Intermediaries? Prior to the IRS Announcement, most parking intermediaries were exchange companies who knew like-kind exchanges, inside and out. Whereas a forward qualified intermediary's services are relatively simple to administer (the primary role of a forward qualified intermediary is to sign the documents necessary to safe-harbor the transaction and to hold proceeds of sale pending re-investment), a reverse parking intermediary eventually becomes an integral part of the exchange itself, as the parking intermediary actually holds title to the new replacement property. The parking intermediary is not on the side of the transaction; it is part of the transaction. Watch out for parking intermediaries who have a set of documents but do not really understand the rules; when it comes time to deal with a lender financing the acquisition of the new property, closing on the acquisition of the new property or selling the new property to the taxpayer, parking intermediaries without experience can create more problems than they solve. While many forward intermediaries are rushing into the reverse exchange business, there are a few parking intermediaries that have been around for years and whose reputation, experience and reliability are known.
7. Step By Step Mechanics of a Reverse Exchange. In simple terms, this is what happens:
(a) The taxpayer signs a Qualified Exchange Accommodation Agreement with the parking intermediary. This is the blanket document that the IRS Announcement requires.
(b) The parking intermediary takes title to the new property, taking a loan from a bank and/or the taxpayer. If the loan is from a bank, the taxpayer will generally be asked to (and may) give a guaranty.
(c) The new property (now owned by the parking intermediary) is leased to the taxpayer on a triple-net basis. Rent under the lease is generally equal to the carrying costs of the new property, including any debt service.
(d) On the day that the parking intermediary acquires the new property, the parking intermediary and the taxpayer sign a contract by which taxpayer agrees to acquire the new property from the parking intermediary within the next 180 days.
(e) The taxpayer begins to market the old property. Prior to selling the old property, the taxpayer signs a forward exchange agreement with a qualified intermediary.
(f) When a contract to sell the old property has been executed, the taxpayer's rights under that contract are assigned to the qualified intermediary pursuant to the ordinary forward exchange rules. The buyer of the old property is given notice of this assignment. Most forward qualified intermediaries have forms for this.
(g) When the sale of the old property closes, proceeds of sale are deposited with the forward qualified intermediary.
(h) The taxpayer contacts the parking intermediary and advises that it is ready to acquire the new property from the parking intermediary to close out the taxpayer's exchange.
(i) The taxpayer assigns its rights under contract with the parking intermediary (see paragraph (d), above), to the forward intermediary. Because most reverse exchanges are closed out within 45 days of sale of the old property, a separate notice of identification need not be filed with the forward qualified intermediary, but the taxpayer must keep this 45 day identification requirement in mind.
(j) The new property is conveyed to the taxpayer in exchange for the funds in the taxpayer's forward exchange account. The parking intermediary uses these funds to repay all or part of the loan that the parking intermediary received from the taxpayer or the bank to finance the acquisition.
(k) The lease from the parking intermediary to the taxpayer is cancelled (because the taxpayer is now both the owner and the tenant of the property).
(l) The exchange (forward and reverse) is now complete, except for special reporting on the taxpayer's annual tax return for the year of the exchange.
8. Mechanics--Additional Details. As you can see, a reverse exchange has the parking intermediary acting as if it were a bona fide owner of the new property. Thus, the parking intermediary leases the property to the taxpayer. The parking intermediary and taxpayer sign a contract to sell the new property to the taxpayer. And if the parking intermediary borrows any money from the taxpayer to buy the new property, the parking intermediary gives the taxpayer a promissory note, mortgage and/or security agreement.
Although the IRS now recognizes certain reverse exchanges, we believe it is prudent to use long form documents to evidence these legal relationships. Thus there is a written lease, a written real estate purchase agreement, a proper promissory note and a mortgage and/or security agreement to evidence and secure any loan from the taxpayer. Some parking intermediaries avoid these ancillary documents and rely only upon a short form blanket agreement which explains the legal relationships but does not create them. Why is this important? Although the IRS Announcement does not explicitly require detailed documentation of legal relationships, the taxpayer has real dollars invested in the new property and an expectation of using it and eventually owning it. These expectations should be in customary legally enforceable documents.
9. Build To Suit Exchanges. So-called "build to suit" exchanges can be done forward or reverse. A reverse build to suit exchange is one in which the parking intermediary buys new property and begins construction of improvements on that property before the old property is sold. When the taxpayer sells his old property, the new property is acquired and the improvements constructed to the date of acquisition of the new property from the parking intermediary can be included in the like-kind exchange as replacement property. A forward build to suit involves the sale of the taxpayer's old property, followed by a purchase of the new property. Under IRS regulations, the taxpayer cannot own the new property while improvements are being constructed. So the parking intermediary holds title to the new property until the earlier of 180 days after the sale of the old property or completion of construction. In either a forward or reverse build to suit exchange, the parking intermediary must be sufficiently familiar with the construction issues to properly interface with the lender and, if necessary, the construction trades.
10. About Non-Real Estate Property. While we have written about property generally, most taxpayers are of the impression that like-kind exchanges apply only to real estate. But there is an active market in reverse exchanges for a host of other types of property, from jet aircraft to oil drilling rigs, from fleets of trucks to metal fabricating machines, from franchise rights to broadcast licenses. In the case of aircraft exchanges, a good parking intermediary will be able to assist the taxpayer's counsel in working with the FAA to obtain proper registration and clearance for a reverse exchange.
11. Working with Lenders. In a reverse exchange, the taxpayer is looking to acquire new property before the old property is sold. Although the parking intermediary will be taking title to the new property, the parking intermediary does not use its own funds to acquire the property. The parking intermediary will use a combination of bank financing and/or an equity loan from the taxpayer. Some lenders have difficulty understanding reverse exchanges and will be reluctant to lend to a parking intermediary. But that is because of a failure to understand that the bank can get to exactly the same place with a mortgage against the new property and a guaranty from the taxpayer. A good parking intermediary will be able to help the lender understand a reverse exchange and understand why loaning to the parking intermediary should be as straight-forward as a loan to the taxpayer. From the taxpayer's perspective, the loan documents need only a couple of small tweaks, the most important of which is allowing the transfer from the parking intermediary to the taxpayer without triggering a due on transfer premium or acceleration of the loan.
12. An Alternative--Parking the Old Property. Most parking arrangements involve parking the new property pending the sale of the old property. But it is possible (and the IRS Announcement permits) the taxpayer to sell the old property to the parking intermediary, triggering an ordinary forward exchange. This is somewhat more complex to structure, since the parking intermediary can only give the taxpayer a promissory note for the purchase price rather than cash, and the taxpayer's ability to use the parking intermediary's note to buy the new property is of course limited. There are ways of allowing the taxpayer to convert the note to cash and use that cash to buy the new property, but the cost of structuring a reverse exchange by parking the old property rather the new property would be higher. Examples of situations where the old (rather than new) property may be parked: where the new property has environmental issues and the parking intermediary is reluctant to take title; where the second transfer of the old property (to the ultimate buyer) will involve lower real estate transfer taxes or sales or use taxes than a second transfer of the new property; and where the lender on the new property simply will not consent to a parking arrangement.
13. Using Single Member LLCs. The IRS has ruled that a taxpayer may take title to new property through a single member limited liability company and the taxpayer will be treated for like-kind exchange purposes as having acquired property even though the property is not owned by the taxpayer directly. Often a parking intermediary will offer to set up a single member limited liability company (sometimes a grantor trust) to take title to the property. This is useful for several reasons. First, the property is now held in an entity separate from other properties owned by the qualified intermediary. This will facilitate financing, particularly securitized or conduit financing described below. Second, the subsequent transfer of the property from the parking intermediary to the taxpayer can occur by way of an assignment of the interests in the company. This could be useful in avoiding a second level of real estate transfer taxes or sales and use taxes.
14. Conduit/Securitized Loans. With larger real estate properties, lenders may initiate a loan for resale into the secondary market. These loans become part of a securitized pool. These securitized or conduit loan programs often require that title to the new property be taken through a bankruptcy remote special purpose entity, usually a limited partnership or limited liability company. A good parking intermediary can take title through a bankruptcy remote special purpose entity in a way that accommodates the requirements of the conduit lender, although some conduit lenders remain inflexible for fear that the rating agencies may down-grade the quality of the loan for resale purposes.
15. Synthetic Leases. A synthetic lease is a sophisticated accounting and tax technique that allows a company to own an asset for tax purposes but have the asset (and more importantly, its related debt) "off balance sheet" for financial accounting purposes. In most synthetic lease transactions, the taxpayer will be the tax owner of the property, and there are no special complications that should arise from either a forward or reverse exchange. But even the best of lawyers and parking intermediaries are thrown for a loop because in a synthetic lease, none of the customary purchase and sale documents can be found. The taxpayer is not signing a purchase agreement--it is signing a lease. The parking intermediary is not buying and selling new property--it is leasing it. The key to a successful synthetic lease in terms of an exchange is having counsel understand that the legal documentation (which is in the form of a lease) will be viewed, for tax purposes, as if it were purchase documentation, and to structure the exchange accordingly.
16. Transfer, Sales and Use Taxes. In a reverse exchange, there are two sales, and two transactions in respect of which taxing authorities may apply taxes. The parking intermediary is buying the new property from the original owner. That is one transaction. Then the parking intermediary later sells the new property to the taxpayer. That is the second transaction. In many jurisdictions, real estate transfer taxes, sales taxes and use taxes could be applied at both levels, causing substantial additional costs. Prior to the IRS Announcement, it was considered prudent to pay the double transfer taxes; otherwise, the IRS could argue that the taxpayer was not truly an owner; payment of a second level of transfer taxes was sort of an insurance premium for the integrity of the parking arrangement. Under the IRS Announcement, inconsistent positions will not be fatal for Federal income tax purposes. In other words, it is possible to take the position that the parking intermediary is the true owner for Federal tax purposes (as is required under the IRS Announcement), but take the position that second level transfer taxes should not apply. Indeed, in Private Letter Ruling 200148042, the IRS indicated that a qualified intermediary could be explicitly designated as the taxpayer's agent for all purposes other than income tax; language to this effect facilitates the position that the reverse exchange should attract only one level of transfer, sales or use tax. Of course the IRS is not sanctioning non-compliance with state and local transfer, sales and use tax rules, but non-compliance with these rules will not be fatal to the Federal tax treatment of a reverse exchange.
17. More Information. For more information regarding exchanges, contact the author of this article, Michael Tuchman (312-476-7550). A senior partner at Levenfeld Pearlstein in Chicago, Tuchman represents numerous forward and reverse exchange intermediaries and has developed exchange programs for institutional and entrepreneurial clients, including one of the earliest reverse exchange programs, mass asset exchanges for leasing companies, sale-by-auction exchanges, partnership exchanges, synthetic lease exchanges and securitized finance exchanges. Lawyers should feel free to call as well, as we regularly back-stop other counsel involved in exchanges with due regard for existing client relationships.
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