The Tax Court's decision in Estate of Bartell, 147 T.C. No. 5 (2016), alleviates some of the uncertainty that taxpayers and practitioners face when structuring a reverse like-kind exchange intended to qualify for nonrecognition treatment under Sec. 1031.
The Bartell case
In its decision, the Tax Court rejected the IRS's position that a third-party "exchange facilitator" the taxpayer engaged to take legal title to the replacement property was required to assume the benefits and burdens of ownership of the property to facilitate a valid Sec. 1031 exchange. Moreover, the Tax Court held that existing case law did not limit the time a third-party exchange facilitator may hold title to the replacement property before the exchange must occur.
The Bartell Drug Co., a family-owned S corporation operating drug stores in Washington state, entered into a sales agreement to acquire property in Lynnwood, Wash. The sale agreement expressly stated that Bartell intended to enter into a Sec. 1031 exchange. Bartell held appreciated property in Everett, Wash., that it wanted to transfer in a nonrecognition transaction under Sec. 1031 for the Lynnwood replacement property, on which a new store was to be constructed for use in Bartell's business.
To execute the transaction, in April 2000, Bartell transferred its rights under the contract for sale of the Everett property to Section 1031 Services Inc., a company in the business of providing exchange accommodation services, which formed a special-purpose limited liability company treated as a disregarded entity for federal income tax purposes (the exchange facilitator) to effect the Sec. 1031 exchange. The exchange facilitator was formed to acquire and hold title to the Lynnwood property during the construction period. The exchange facilitator also acted as the borrower on a construction loan guaranteed by Bartell and initiated construction on the Lynnwood property based on specifications and contractors approved by Bartell, but was otherwise contractually insulated from responsibility concerning the Lynnwood property.
When construction was nearing completion in June 2001, Bartell leased the Lynnwood property from the exchange facilitator. The sale of the Everett property closed in September 2001, and the exchange facilitator transferred title to the Lynnwood property to Bartell in December 2001, which completed the exchange.
The IRS, upon examination of Bartell's 2001 tax return, disallowed deferral under Sec. 1031 of approximately $2.8 million of gain realized in the transaction, arguing that no exchange occurred in December 2001 because Bartell held the burdens and benefits of ownership prior to the transfer (i.e., the ability to benefit from appreciation in the property's value, risk of loss, and taxes and liabilities arising from the property). The issue before the Tax Court was whether a person who takes title to replacement property for the purpose of effecting a Sec. 1031 exchange must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement.
Generally, taxpayers must recognize gain or loss on the sale or other disposition of property pursuant to Secs. 61(a)(3) and 1001. Sec. 1031 provides an exception, permitting taxpayers to defer the recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged in a reciprocal transfer between owners "solely for property of like kind." The term "like kind" refers to the property's nature and character rather than its grade or quality. Thus, real property held for productive use in a trade or business is generally considered of like kind as other real property held for such purposes. If all or part of the replacement property is not of like kind, gain will be recognized to the extent of the consideration attributable thereto. Therefore, to fully defer gain realized on the disposition of the relinquished property, the taxpayer must acquire like-kind replacement property of equal or greater value. A successful like-kind exchange defers federal and state income taxes on the taxable gain until the replacement property is sold. Nonrecognition of gain treatment under Sec. 1031 is based on the rationale that there is no material change in the taxpayer's economic position, as the replacement property is essentially a continuation of the taxpayer's investment in the relinquished property.
Over time, practical application of the like-kind exchange provision of Sec. 1031 brought an expansion from direct two-party exchanges to "deferred exchanges" and "reverse exchanges." In a deferred exchange, the replacement property is received after the transfer of the relinquished property, typically with involvement of a third-party exchange facilitator.
Sec. 1031(a)(3) and Regs. Sec. 1.1031(k)-1 impose two primary limitations on deferred exchanges, enacted in response to the decision in Starker, 602 F.2d 1341 (9th Cir. 1979), which first allowed nonsimultaneous exchanges. First, the replacement property must be identified within 45 days after the date of transfer of the relinquished property, and, second, the identified property must be received before the earlier of (1) 180 days after the transfer of the relinquished property or (2) the tax return due date for the tax year in which the relinquished property is transferred (Regs. Sec. 1.1031(k)-1(b)). These rules, however, do not address reverse exchanges.
In a reverse exchange, the taxpayer receives the replacement property before the transfer of the relinquished property. Taxpayers have used so-called parking transactions or "built-to-suit" transactions to facilitate reverse exchanges, whereby replacement property is "parked" with an exchange facilitator that holds title to the replacement property, usually until improvements to the property are completed to allow for an exchange "solely for property of like kind." This type of transaction was at issue in Bartell. To date, the statute and regulations do not address reverse exchanges; however, a safe harbor for these transactions was established in Rev. Proc. 2000-37.
Safe harbor in Rev. Proc. 2000-37
Rev. Proc. 2000-37 provides a safe harbor for accomplishing reverse and built-to-suit exchanges effective on or after Sept. 15, 2000. The revenue procedure provides that the treatment of the exchange facilitator as the owner of the property for purposes of Sec. 1031 will not be challenged if the property is held in a qualified exchange accommodation arrangement (QEAA). A QEAA exists if the requirements in the revenue procedure are met, which include that the parties have a written agreement stipulating that (1) the exchange facilitator is holding the property for the benefit of the taxpayer for purposes of a Sec. 1031 exchange and (2) the facilitator is treated as the beneficial owner of the property for all federal income tax purposes. Both parties must report the federal income tax attributes of the property on their income tax returns in a manner consistent with this agreement.
In addition, the time limitations of Regs. Sec. 1.1031(k)-1(b) must be met, i.e., the replacement property must be identified within 45 days and exchanged for the relinquished property no later than 180 days from the transfer of title to the exchange facilitator. Moreover, the combined period that the relinquished property and the replacement property are held in a QEAA must not exceed 180 days. However, the revenue procedure expressly states that parking transactions can be accomplished outside the safe harbor and that no inference is intended with respect to the federal income tax treatment of parking transactions that do not satisfy the safe harbor. The IRS reiterated in Rev. Proc. 2004-51 that it continues to study these transactions.
The Tax Court's opinion in Bartell
The Tax Court noted that Rev. Proc. 2000-37 did not apply in this case, as Bartell undertook the exchange prior to its effective date. In any event, Bartell would not have met the safe-harbor requirements because the exchange facilitator held title for approximately 17 months, far beyond the 180-day QEAA period. The Tax Court highlighted that an exchange can be structured to qualify under Sec. 1031 as a "non-safe harbor" reverse exchange based upon existing case law, which has permitted taxpayers great latitude in structuring like-kind exchanges.
Citing previous decisions in Biggs, 69 T.C. 905 (1978), aff'd, 632 F.2d 1171 (5th Cir. 1980), and Alderson, 317 F.2d 790 (9th Cir. 1963), the Tax Court held that where a Sec. 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. The court distinguished this result from its decision in DeCleene, 115 T.C. 457 (2000), where a taxpayer was held to have merely engaged in an exchange with himself because, rather than using a third-party exchange facilitator, the taxpayer made an outright purchase of the replacement property (unimproved land) prior to the exchange, then conveyed title to a third party for the period during which improvements were constructed, followed by the reconveyance of the improved property to the taxpayer to complete an exchange for other property owned by the taxpayer.
According to the Tax Court, DeCleene did not address the circumstances where a third-party exchange facilitator is used from the outset in a reverse exchange. As for the 17-month period during which the exchange facilitator in Bartell held the replacement property, the Tax Court reiterated that Rev. Proc. 2000-37 did not apply and noted that the 45- and 180-day periods in which a taxpayer must identify the replacement property and receive it as prescribed in Sec. 1031(a)(3) begin to run on "the date on which the taxpayer transfers the property relinquished in the exchange" and were thus satisfied in the Bartell transaction. The Tax Court further noted that case law provides no specific time limits and held that Bartell's reverse exchange should qualify for nonrecognition treatment pursuant to Sec. 1031.
Bartell arguably signifies one of the most important like-kind exchange developments in the past decade, particularly for contemplated exchanges where construction needs to be made on the replacement property. The Tax Court affirmed that Rev. Proc. 2000-37 only establishes a safe harbor and does not place restraints on parking arrangements that do not satisfy its conditions. Thus, the decision could be good news for taxpayers who wish to build or modify replacement property in a reverse exchange, as it is typically difficult to complete property construction within the 180-day safe-harbor time frame.
It is noteworthy that the IRS did not appeal the Tax Court's holding, likely because the decision cited taxpayer-favorable precedent in the Ninth Circuit, which would have heard the case on appeal. However, given that the IRS continues to study parking arrangements, it is possible that congressional action could be sought similar to the limitations enacted in Sec. 1031(a)(3) and Regs. Sec. 1.1031(k)-1 in the wake of Starker. In addition, while not explicitly addressed by the Tax Court, the principles of equity were in Bartell's favor: Rev. Proc. 2000-37 had not been published, and the taxpayer had structured the reverse exchange carefully and in accordance with established legal precedent at the time. Therefore, taxpayers and advisers should exercise caution and structure reverse exchanges in close alignment with the facts of the taxpayer-favorable case law cited inBartell.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
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