Commercial Real Estate Blog by Madison

Parking Arrangements in Reverse Exchanges – Part 1

IRC §1031 like-kind exchanges are popular, reliable, IRS-approved transactions that allow taxpayers to defer paying taxes on profits when property (usually real estate) that is held for productive use in trade or business or for investment is exchanged for like-kind property (e.g., real estate exchanged for real estate) that will also be held for productive use in trade or business or for investment.

In a typical IRC §1031 exchange, the taxpayer sells relinquished property through a qualified intermediary (a “QI”) and later acquires replacement property through the same QI. If the process is handled in accordance with Treasury Regulations, it is considered as if the taxpayer exchanged the relinquished property for the replacement property. This process is commonly referred to as a “forward” exchange because it proceeds in the normal direction – sell first, buy second. Sometimes it is referred to as a “delayed exchange” because there is usually a delay between the sale of the relinquished property and the purchase of the replacement property.

However, sometimes a taxpayer needs to buy the replacement property before the relinquished property can be sold. This is called a “reverse exchange” because it proceeds in the opposite direction from a forward exchange. A reverse exchange poses a special problem. The taxpayer cannot simultaneously own both the relinquished property and the replacement property. That would make it impossible to exchange one property for the other. Therefore, in a reverse exchange, either the relinquished property or the replacement property must be “parked” with some relatively friendly third-party until the relinquished property is sold.

An “Accommodation Party”

That third-party (let’s assume it is a limited liability company, and therefore gender neutral) is sometimes referred to by the IRS and by tax practitioners as an “accommodation party” because it is accommodating the taxpayer to structure the exchange. In a traditional reverse exchange, the IRS insists that the accommodation party must not be acting as the agent of the taxpayer. It must act on its own account and for its own benefit. In addition, an accommodation party must have “substantial indicia of ownership” in the parked property. That means the accommodation party must have a financial stake in the property, that is, some significant benefit if the property appreciates in value and/or if the property makes money from operations, and/or it must have some significant risk if the property loses value and/or loses money from operations. The IRS and the courts have not given much help in clarifying what the limits are for an accommodation party to act as the taxpayer’s agent and what the minimum financial interest is that the accommodation party must have in the parked property. For this reason, traditional reverse exchanges are, for the most part, expensive, risky and rare.

The IRS has a particular interest in keeping the rules murky for traditional reverse exchanges. If those rules were easy to comply with, a taxpayer could park a property with an accommodation party for an unlimited period of time and use it some day in the future as replacement property for an exchange that the taxpayer has not yet even thought about doing. That is more flexibility than the IRS wants to give. However, the IRS has not been heartless. It has given a substantial amount of flexibility and a tremendous amount of certainty in reverse exchanges by creating a safe harbor in Revenue Procedure 2000-37.

We will explore how a safe harbor reverse exchange works in the next part of this post.

Tags: , , , , , , , , , , , , , , , Comments Off

Comments are closed.

WordPress Appliance - Powered by TurnKey Linux