On Sept. 15, 2000, the Internal Revenue Service issued Revenue Procedure 2000-37, which provided guidelines to qualify for reverse tax deferred exchanges under Section 1031 of the tax code. Under a reverse deferred exchange of real estate, the taxpayer first arranges to have a third party purchase and hold real estate, which the taxpayer wishes to acquire in exchange for real estate the taxpayer owns. This is followed by an ultimate sale of the taxpayer’s real estate by the third party obtained by the taxpayer. Afterwards, the replacement real estate is transferred to the taxpayer, which is intended to qualify as exchange under Section 1031 of the tax code on which taxable gain is deferred. This type of exchange is often referred to as a “reverse-Starker exchange” based on a case called Starker vs. United States that involved a more traditional deferred exchange.
Previously, the treasury issued regulations under Section 1031 of the tax code to facilitate the more common type of deferred exchange, which is the transfer of the real estate or a contract to sell real estate owned by the taxpayer to a third party qualified intermediary. The third party uses the proceeds of sale to acquire replacement real estate identified by the taxpayer, which is transferred to the taxpayer in order to qualify for deferral of gain under Section 1031 of the tax code. While a taxpayer may still qualify for tax deferred exchange treatment on a reverse-Starker exchange without satisfying the requirements of Revenue Procedure 2000-37, the revenue procedure provides a safe harbor to qualify for a reverse tax-deferred exchange. The failure to satisfy these requirements does not disqualify the exchange for tax deferral under Section 1031, which the revenue procedure make quite clear.
Section four of Revenue Procedure 2000-37 provides that property qualifies as being held in a qualified exchange accommodation arrangement, which would allow an exchange to be qualified for tax deferral if six requirements are satisfied. They are as follows:
“Qualified indicia of ownership” of the property is held by an exchange accommodation title holder, which is not the taxpayer or a disqualified person. The person is either subject to federal income tax, or a flow through entity with more than 95 percent of its interests or stock owned by partners or shareholders who are subject to federal income tax. A qualified indicia of ownership means legal title to the real estate, or other indicia of ownership of the real estate that are treated as beneficial ownership of the real estate.
Taxpayers must have a bona fide intent that the qualified indicia of ownership of the real estate transferred to the exchange accommodation title holder represents either the replacement real estate or the relinquished real estate owned by the taxpayer in an exchange that is intended to qualify under Section 1031 of the tax code.
No later than five business days after the transfer of the qualified indicia of ownership, the taxpayer and such title holder must enter into a qualified exchange accomodation arrangement, which provides the exchange accommodation title holder is holding the real estate for the benefit of the taxpayer in order to facilitate an exchange under Section 1031. The agreement must specify that the exchange accommodation titleholder will be treated as the beneficial owner of the real estate for all federal income tax purposes and that treatment must be reflected on the income tax returns filed by both parties.
No later than 45 days after the transfer of the qualified indicia of the ownership of the replacement real estate to the exchange accommodation titleholder, the relinquished property must be properly identified in a manner consistent with the principles described in Regulation Section 1.1031(k)-1(c) of the tax code. Under the regulations, the taxpayer must promptly report alternative and multiple properties to be sold, up to three. Ordinarily, the taxpayer will be able to identify which real estate it owns, which is to be used in the exchange within the 45-day period. This is because ordinarily he would not have more than one parcel of real estate that he would wish to exchange for the real estate acquired by the exchange accommodation title holder.
No later than 180 days after the transfer of qualified indicia of ownership, the replacement real estate is transferred to the taxpayer as replacement real estate or the real estate is transferred to a person who is not the taxpayer or a qualified person as relinquished real estate.
The combined time period that the relinquished real estate and the replacement real estate are held under a QEAA does not exceed 180 days.
The revenue procedure also lists a number of permissible agreements that may be entered into in order to facilitate a deferred exchange, which will not disqualify qualified exchange accommodation arrangements. These are important as they are often required in order to facilitate the tax-deferred exchange.
The taxpayer or a disqualified person may guarantee some or all of the obligations of the exchange, or it can indemnify the exchange accommodation titleholder against costs and expenses. Thus, the taxpayer can provide a personal guarantee on mortgage debt used to acquire the replacement real estate identified by the taxpayer in order to facilitate reverse deferred exchange.
The taxpayer or a disqualified person can loan or advance funds to the exchange accommodation title holder or guarantee a loan or advance to the exchange accommodation title holder again for the purposes of acquiring the replacement real estate identified by the taxpayer. The replacement real estate will be transferred to the taxpayer in exchange for the taxpayer’s real estate pursuant to the reverse deferred exchange.
In order to provide funds to satisfy mortgage indebtedness identified by the taxpayer or in order to permit the taxpayer to begin using the real estate before it effects the reverse deferred exchange, the taxpayer may lease the real estate acquired by the exchange accommodation title holder in order to begin using for the purpose intended.
The taxpayer or disqualified person may manage the replacement real estate, supervise the improvement of the replacement real estate, act as a contractor or provide services to the exchange accommodation title holder with respect to the real estate which the taxpayer intends to acquire.
It is important to be aware of the requirements to satisfy the non-taxability of the exchange. In order to be fully non-taxable, if real estate owned by the taxpayer is subject to mortgage indebtedness, the unpaid principal amount of the indebtedness cannot exceed the amount of the mortgage indebtedness against the replacement real estate received in exchange for the taxpayer’s real estate. To the extent that the mortgage debt on the real estate owned by the taxpayer is in excess of the mortgage debt against the replacement real estate, there is taxable gain on the amount of the excess. Accordingly, the amount of any mortgage debt should not exceed the amount of the mortgage debt against the real estate owned by the taxpayer to be used in the exchange. This may require a principal payment by the taxpayer of the mortgage debt against the taxpayer’s real estate in order to avoid an unintended gain
Robert C. Zinnershine specializes in real estate law at Seyfarth Shaw (www.seyfarth.com), a law firm in Boston.
Robert J. Paley specializes in tax law at Seyfarth Shaw in Chicago.
