Guidance from Revenue Procedure 2000-37 *

Even though Reverse tax-deferred like-kind exchanges have been structured by legal and tax advisors for many years, there has been little to no guidance from the Department of the Treasury or the Internal Revenue Service and legal precedent on the proper structure and documentation. Until September 2000, Investors had to rely on the educated guesses of their legal and tax advisors on how to properly structure a Reverse tax-deferred like-kind exchange transaction.

The Department of the Treasury finally provided guidance on the issue in the form of Revenue Procedure 2000-37 on September 15, 2000. Revenue Procedure 2000-37 provides a number of safe harbor rules for structuring Reverse tax-deferred like-kind exchange transactions, and has resulted in a significant increase in the number of Reverse tax-deferred like-kind exchange transactions since that time. These guidelines have clarified issues surrounding Reverse tax-deferred like-kind exchanges and provided a much higher comfort level than before.

It is important to point out that Revenue Procedure 2000-37 is not a Reverse tax-deferred like-kind exchange Revenue Procedure; it merely provides guidelines on how to properly structure a Reverse tax-deferred like-kind exchange using a “parking structure.”

* Private Letter Ruling 2001-11205.

Safe Harbor versus Non-Safe Harbor Reverse Exchanges:

Reverse tax-deferred like-kind exchange transactions structured pursuant to Revenue Procedure 2000-37 are referred to as “safe harbor” Reverse tax-deferred like-kind exchange transactions. It is possible to structure Reverse tax-deferred like-kind exchange transactions outside of these guidelines, which are referred to as “non-safe-harbor” Reverse tax-deferred like-kind exchange transactions. Investors should consult with their legal and tax advisors prior to structuring a Reverse tax-deferred like-kind exchange transaction to determine which strategy is best for them. The proper structure must be selected before proceeding: Reverse tax-deferred like-kind exchange transactions can not be converted from one structure to another once the form of the transaction has been selected.

Components of a Reverse Exchange

In a Reverse tax-deferred like-kind exchange, the legal title to either the Investors relinquished or replacement property is transferred to and held or “parked” by an Exchange Accommodation Titleholder (EAT) on behalf of the Investor. A Qualified Intermediary then facilitates the 1031 tax-deferred, like-kind exchange. While the Exchange Accommodation Titleholder and the Qualified Intermediary could be the same entity, it is not advisable: one entity should function as the Qualified Intermediary and a separate entity should function as the Exchange Accommodation Titleholder.

The easiest way to understand the structure of a Reverse tax-deferred like-kind exchange is to view it as two separate component parts: both stages of the transaction are distinct from each other, but both are then contractually integrated to complete a Reverse tax-deferred like-kind exchange.

A “Reverse tax-deferred like-kind exchange” is actually a misnomer: the transaction itself actually consists of a “parking” transaction, where legal title to either the relinquished or replacement property is acquired and “parked” by the Exchange Accommodation Titleholder, and then a simultaneous tax-deferred like-kind exchange occurs either at the beginning (Exchange First) or at the end (Exchange Last) of the Reverse tax-deferred like-kind exchange process. This parking/exchange scenario is commonly called a Reverse tax-deferred like-kind exchange because, as previously mentioned, it allows the Investor to acquire his like-kind replacement property first and then dispose of the relinquished property at a later date, not because it is the transactional opposite of a Forward tax-deferred like-kind exchange.

Exchange Accommodation Titleholder (EAT)

The Exchange Accommodation Titleholder is (or should be) a separate legal special purpose entity/limited liability company set up for the express purpose of conducting a Reverse tax-deferred like-kind exchange transaction in order to ensure proper liability protection for both the Qualified Intermediary and the Investor. Although it is possible for the Qualified Intermediary to function as the Exchange Accommodation Titleholder, it is highly undesirable: having the Qualified Intermediary hold thousands of Investors’ tax-deferred like-kind exchange funds and hundreds of Investors’ real property exposes the Qualified Intermediary and the Investor’s assets to all of the real property held by the Qualified Intermediary to potential liability from liens, judgments, toxic waste contamination or other liabilities and risks involving real property.

In order for an entity to qualify and serve as the Exchange Accommodation Titleholder it must meet all of the following requirements:

  • Hold Qualified Indicia of Ownership (customarily the legal title) at all times from the date of acquisition of the property until the property is transferred.
  • May not be a disqualified entity or the Investor.
  • Must be subject to federal, and if applicable, state income tax. If the Exchange Accommodation Titleholder is treated as a partnership or S corporation, more than 90% of its partnership interests or shareholders must be owned by partners or shareholders who are subject to federal income tax.
  • Must report the acquisition, holding and ultimate disposition of the property on its Federal and state income tax returns.

Qualified Indicia of Ownership

Qualified Indicia of Ownership are defined as any of the following:

• Legal title to the property.
• Other indicia of ownership of the property that are treated as beneficial ownership of the property under principles of commercial law (i.e. a contract for deed).
• Interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes, such as a single-member limited liability company, and this entity must hold either legal title to the property or other Qualified Indicia of Ownership.

Qualified Exchange Accommodation Agreement

In order to conduct a tax-deferred like-kind exchange, the Exchange Accommodation Titleholder and the Investor must enter into a written Qualified Exchange Accommodation Agreement (Qualified Exchange Accommodation Agreement). The terms of the Qualified Exchange Accommodation Agreement must include the following terms:

• The Exchange Accommodation Titleholder is holding the property for the Investor’s benefit in order to facilitate an exchange pursuant to Section 1031 of the Internal Revenue Code and Section 1.1031 of the Treasury Regulations and Revenue Procedure 2000-37.
• The Exchange Accommodation Titleholder and the Investor agree to report the acquisition, holding and disposition of the property on each of their respective income tax returns in a manner consistent with the agreement.
• The Exchange Accommodation Titleholder will be treated as the beneficial owner of the property for all federal and state income tax purposes.

Legal and Contractual Arrangements

Revenue Procedure 2000-37 allows the Exchange Accommodation Titleholder and the Investor to enter into a number of operating agreements in order to complete a successful Reverse tax-deferred like-kind exchange transaction utilizing the parking structure while eliminating certain risks for both the Exchange Accommodation Titleholder and the Investor. These agreements may include:

• Loan, funds advanced or line of credit agreement
• Triple net lease back to investor
• Property management agreement
• Contractor and/or supervisor agreement
• Put and Call provisions are permissible

The Investor is responsible for any capital gains or losses incurred by the operating agreements and will receive any net operating profits or losses generated from the property during the parking or holding period. The Investor can retain control of the parked property either by leasing the property from the Exchange Accommodation Titleholder under a triple-net lease or by entering into a property management agreement, under which the Investor assumes all management responsibilities of the property, including the retention of an outside property management firm if they so desire.

Deadlines for Reverse Exchanges

Despite the difference in the structure of the transaction, the Reverse tax-deferred like-kind exchange transaction has the same transfer and identification requirements as a Forward tax-deferred like-kind exchange.

In an “Exchange Last” Reverse tax-deferred like-kind exchange parking arrangement the relinquished property must be identified within 45 calendar days after the transfer of the replacement property to the Exchange Accommodation Titleholder in a manner consistent with the principles of identifying property in a forward (delayed) 1031 tax-deferred, like-kind exchange.

In an Exchange First parking arrangement, no identification is required since the actual tax-deferred like-kind exchange is completed at the beginning of the transaction as a simultaneous exchange.
After a successful identification, the relinquished property must be sold and transferred to the buyer within 180 calendar days after the transfer of the parked property to the Exchange Accommodation Titleholder in either an Exchange First or Exchange Last structure.

Typical Reverse Exchange Structures

The Exchange Accommodation Titleholder can park title to either the replacement property or relinquished property, depending on a number of complicated factors within each individual transaction.

The preferred and most common method involves having the Exchange Accommodation Titleholder acquiring and holding title to the Investor’s replacement property in an Exchange Last structure. However, there are times when parking title to the replacement property with the Exchange Accommodation Titleholder is not practical and title to the relinquished property must be held by the Exchange Accommodation Titleholder in an Exchange First structure.

Exchange Last Structure: Replacement Property Parking

The “Exchange Last” structure is the most common form of Reverse tax-deferred like-kind exchange. In the “Exchange Last” structure, the Investor enters into a Qualified Exchange Accommodation Agreement with the Exchange Accommodation Titleholder. The Exchange Accommodation Titleholder then forms a limited liability company or other special purpose entity (“SPE”), into which the Investor assigns the Purchase Contract and/or the Escrow Instructions for the replacement property.

The Investor will then either loan funds to and/or arrange for third-party financing for the Exchange Accommodation Titleholder for the acquisition of the replacement property. Third-party lenders still base the decision to lend on the credit worthiness of the Investor, even though the Exchange Accommodation Titleholder is the entity executing the loan documents. After the financing is arranged, the Exchange Accommodation Titleholder acquires and parks title to the replacement property, and typically leases the replacement property to the Investor under an absolute triple net lease or enters into a property management agreement with the Investor, as authorized by the Qualified Exchange Accommodation Agreement. The lease payments to the Exchange Accommodation Titleholder are offset by the loan payments due from the Exchange Accommodation Titleholder, and may cover any debt service owed on outside financing, resulting in a tax neutral position for the Exchange Accommodation Titleholder.

An Investor in an “Exchange Last” scenario must identify the relinquished property or properties they intend to sell within 45 calendar days after the Exchange Accommodation Titleholder acquires title to the replacement property. Although the Investor will typically already know which relinquished property is going to be sold, it is important that the relinquished property be formally identified within the 45 calendar day deadline. After identifying the relinquished property, the Investor will then assign the Purchase and Sale Agreement and/or Escrow Instructions (if applicable) for their relinquished property to the Qualified Intermediary. Upon the sale of the relinquished property and transfer of title to the buyer, the Investor acquires title to the replacement property or the membership interest in the special purpose entity/limited liability company that holds title to the replacement property from the Exchange Accommodation Titleholder in a simultaneous exchange, and the Exchange Accommodation Titleholder uses the net proceeds received from the sale of the relinquished property to pay down the loan to the third-party lender and/or the Investor.

It is crucial that the Investor obtain the relinquished property lender’s approval prior to entering into an “Exchange Last” Reverse tax-deferred like-kind exchange transaction if he needs to secure conventional financing in order to avoid any due on sale clauses. The special purpose entity/limited liability company is the borrower on the loan, as it is the entity that holds title to the property and typically signs the loan documents on a non-recourse basis. The Investor can then guarantee the loan on a recourse or non-recourse basis depending on the flexibility of the lender. If the Investor fails to obtain the Lenders approval prior to the conveyance of the relinquished property to the Exchange Accommodation Title Holder, the Lender may elect to view the transfer as triggering the due on sale clause and may call the loan. These financing issues are one of the more difficult aspects when structuring a Reverse tax-deferred like-kind exchange.

When is it advisable to Use Exchange Last Parking Structure ?

Investors typically select the “Exchange Last” Reverse tax-deferred like-kind exchange structure when they have the ability to purchase the replacement property for cash or the seller is providing short-term financing (including seller-carry back financing).

Since the Investor’s net equity is temporarily tied up in the relinquished property, an “Exchange Last” transaction typically presents a liquidity problem. The “Exchange Last” structure allows the Investor to structure the Reverse tax-deferred like-kind exchange transaction without worrying about the reinvestment of the net equity upfront: the net equity can be reinvested at the back-end of the transaction by paying down the financing used to acquire the replacement property.

The “Exchange Last” structure also allows the Investor to combine a forward tax-deferred like-kind exchange at the back-end of the Reverse tax-deferred like-exchange transaction in the event there are excess tax-deferred like-kind exchange funds from the disposition of the relinquished property.

The “Exchange Last” is the easier of the Reverse tax-deferred like-kind exchange structures to construct and administer, especially when there is little lead time prior to the close of the replacement property transaction. This structure also provides the Investor with the most flexibility at the back-end of the Reverse tax-deferred like-kind exchange transaction.

Issues and Problems with the Exchange Last Structure


Cash Boot Potential: If the amount of the down payment (the money loaned to the Exchange Accommodation Titleholder) used to acquire the replacement property is less than the equity generated from the sale of the relinquished property, there is potential liability for taxable boot. (Note: To qualify for 100% tax deferral in a tax-deferred like-kind exchange, the equity in the replacement property must be equal to or greater than the equity in the relinquished property). If the equity from the relinquished property is greater than the down payment on the replacement property, the Investor may contribute additional cash to the Exchange Accommodation Titleholder to avoid a tax liability.

Financing Issues:

If seller financing is not available, the Investor must pay cash for the replacement property and/or arrange conventional or other third-party financing. Obtaining outside financing is often difficult with this structure because the lender is not always willing to lend to the Exchange Accommodation Titleholder. If outside financing is available, the Exchange Accommodation Titleholder will typically execute a non-recourse loan in favor of the lender guaranteed by the Investor.

If the Investor does not have sufficient liquidity and/or available financing to acquire the replacement property pursuant to an “Exchange Last” Reverse tax-deferred like-kind exchange structure, the “Exchange First” structure will be required.

Exchange First Structure: Relinquished Property Parking

In a Reverse tax-deferred like-kind exchange “Exchange First” transaction, the Investor completes a simultaneous exchange up front by conveying his relinquished property to the Exchange Accommodation Titleholder and acquiring and taking title to his replacement property.

The Investor then assigns the Purchase and Sale Agreement and/or Escrow Instructions (if applicable) for the relinquished property to the Qualified Intermediary, and enters into a Qualified Exchange Accommodation Agreement with the Exchange Accommodation Titleholder whereby the Exchange Accommodation Titleholder sets up a limited liability company or other special purpose entity to take title to the relinquished property. The Investor “sells” the relinquished property to the Exchange Accommodation Titleholder. A third party lender and/or the Investor will loan money to the Exchange Accommodation Titleholder and the Exchange Accommodation Titleholder executes a non-recourse note in favor of the lender or the Investor. The Exchange Accommodation Titleholder uses the “loan proceeds” to acquire the relinquished property from the Qualified Intermediary. The Qualified Intermediary uses the funds from the Exchange Accommodation Titleholder (“loan proceeds”) to purchase the replacement property on behalf of the Investor. The replacement property is direct deeded to the Investor and the exchange is completed. Once a buyer for the relinquished property is found, the net proceeds from the sale of the relinquished property are used to payoff any notes due to an outside lender or the Investor.


 
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