In the last post, we began to examine the problem of what to do when a taxpayer needs to buy an IRC Section 1031 like-kind exchange replacement property before the relinquished property in that exchange can be sold. This is called a “reverse exchange” because it proceeds in the opposite direction from the common forward exchange where the relinquished property is sold first. The reverse exchange process creates a special problem in that the taxpayer cannot simultaneously own both the relinquished property and the replacement property. 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.
We also examined why traditional non-safe harbor reverse exchanges are expensive, risky and rare. On the other hand, traditional non-safe harbor exchanges have the substantial advantage that there is no theoretical limit to how long a potential replacement property could be parked. In order to inject some certainty into the reverse exchange process and in order to encourage reasonable time limits on that process, the IRS has offered an alternative by creating a safe harbor in Revenue Procedure 2000-37.
A Safe Harbor Reverse Exchange
Here is a rough sketch of how a safe harbor reverse exchange works under the Rev. Proc. 2000-37. Either the relinquished property or the replacement property is “parked” in a manner similar to what we discussed above, but, instead of parking with an “accommodation party”, the property is parked with a person or business entity that the revenue procedure calls an “exchange accommodation titleholder” or “EAT”. An EAT is similar to an accommodation party in a traditional non-safe harbor reverse exchange. It holds legal title (or something that is equivalent to legal title) to the parked property during the exchange period. Unlike an accommodation party, an EAT need not have any financial interest in the parked property nor any investment in the property nor any risk from owning the property. In short tax jargon, an EAT needs “indicia of ownership,” but does not need “substantial indicia of ownership.” The EAT can act as the taxpayer’s agent for all purposes except for federal income tax purposes. The taxpayer can have the full use and benefit of owning the parked property during the exchange period with only one exception: The taxpayer cannot depreciate the parked property while it is owned by the EAT. There can be a formal lease between the EAT and the taxpayer during the exchange period. However, a lease is not required. It is acceptable (and often preferable) for the parking agreement simply to authorize the taxpayer to use, to improve and/or to benefit from the parked property.
In return for these important leniencies, the IRS requires that the taxpayer and EAT must enter into a “qualified exchange accommodation agreement” (a “QEAA”), and the taxpayer must have a current bona fide intention to exchange property. The QEAA must provide that a mirror image of the normal forward exchange rules will apply to the reverse exchange. The taxpayer’s relinquished property must be identified within the same 45-day period that would be required for the identification of replacement property in a forward exchange. The number of relinquished properties that the taxpayer can identify is limited in a safe harbor reverse exchange to the same extent that the number of relinquished properties would be limited in a forward exchange. That is, (a) the taxpayer can identify any three relinquished properties, regardless of their value (the “3-property rule”); or (b) the taxpayer can identify any number of potential relinquished properties, so long as their aggregate value is not more than two times the value of the replacement property (the “200-percent rule”); or (c) the taxpayer can rely on the fact that the relinquished property is actually exchanged during the first 45 days of the reverse exchange period (the “45-day rule”); or (d) if the taxpayer has identified too many relinquished properties, the exchange can still be valid if the taxpayer relinquished 95% of the property that was identified as relinquished property in this exchange (the “95-percent rule”). The entire transaction must be completed within the same 180-day exchange period that applies to a forward exchange.
There are some important differences between parking a replacement property and parking a relinquished property. We will take a look at some of those differences in the next post.