The IRS's Long Awaited Guidance on Parking Arrangements to Facilitate Like-Kind Exchanges
On September 15, 2000, the IRS released Rev Proc 2000-37(1), providing a safe harbor for so called "parking arrangements" that can be used by taxpayers in connection with like-kind exchanges under Search7RH1031 to cause the acquisition of replacement property prior to having disposed of the relinquished property. This Revenue Procedure was the culmination of almost ten years of review and consideration and while there are some who will say it does not go far enough, and others who will say it went too far, it is revolutionary in its purpose and scope.
Background
The Preamble(2) to the final Search7RH1031 deferred exchange regulations, which was issued on April 25, 1991, stated that the deferred exchange rules under Search7RH1031(a)(3) do not apply to so called "reverse exchanges" (i.e., exchanges where the replacement property is acquired before the relinquished property is transferred). This statement clearly seems to be correct since, by its terms, the only property that could be identified and received under Search7RH1031(a)(3) is the replacement property.
Nevertheless, this does not mean that Search7RH1031(a) could not apply to reverse exchanges. The argument in favor of such an interpretation is that since Search7RH1031(a)(3) technically only applies to forward exchanges, the law before the 1984 amendments that brought in Search7RH1031(a)(3) would still apply, including the extremely liberal decision of the Ninth Circuit in Starker v United States.(3) Moreover, there have been a few cases in which Search7RH1031 treatment was allowed even though the replacement property was acquired first, although the IRS did not appear to make an argument that a reverse exchange had occurred.(4)
The argument against allowing reverse exchanges seemed to center on the notion that congress intended Search7RH1031(a)(3) to be the exclusive means by which a non simultaneous exchange could be accomplished. This argument had somewhat of a hollow ring and in fact even the Preamble went on to say that the IRS and Treasury would continue to study the applicability of the general rule of Search7RH1031(a)(1) to reverse exchanges.
The failure of the IRS to issue guidance led the ABA Tax Section members to submit a report on reverse exchanges ("1993 Report"), together with a proposed revenue procedure, which set forth a reverse exchange safe harbor.(5) The safe harbor would have permitted the taxpayer to directly receive the replacement property provided that the relinquished property was transferred before the due date of the return for the year in which the replacement property was received (this effectively would have allowed anywhere from nine to a twenty one month period before the relinquished property had to be transferred). The 1993 Report appears to have required the relinquished property to have been identified in a written agreement at the time of the receipt of the replacement property. The beneficial qualified intermediary rules of Reg.Search7RH1.1031(k)-1(g)(4) would have applied.
In the absence of guidance from the National Office, practitioners and taxpayers attempted to avoid the reverse exchange issue by utilizing so called "parking arrangements". These are generally described in Rev Proc 2000-37, but essentially took two forms. In one case, the replacement property would be acquired and "parked" with a friendly party or a "qualified intermediary ("QI"), as defined in Reg.Search7RH1.1031(k)-1(g)(4), or more likely, an affiliate of a QI, particularly because there may have been some concern that a QI cannot technically hold onto the property it receives. The funding for the property would typically come from taxpayer (or from entities related to the taxpayer) guarantees or loans. There would typically be indemnifications against liabilities and losses, and often puts and calls so that the parking entity would not get stuck with the property, or that the parking entity could refuse to transfer the property to the taxpayer. The replacement property would be net leased to the taxpayer and there would be offsets of rentals against debt service on the loan. In a typical negotiation between the parking entity and the taxpayer, the former would attempt to limit its risk as much as possible and the latter would insist that there needs to be some risk on the part of the parking entity to make it work form a Federal tax viewpoint. The overall arrangements might vary significantly from arm's length arrangements. The issue of concern, of course, is whether from a Federal tax viewpoint, the parking entity would be treated as the agent of the taxpayer. In situations where the taxpayer negotiated with the seller of the replacement property, there might also be a Court Holding(6) issue.
Alternatively, the taxpayer might currently transfer the relinquished property to the parking entity in exchange for the replacement property, with the parking entity holding the relinquished property until such time as a buyer could be found. In addition to the substantive issues discussed above, the parties would typically have non arm's length fixed purchase price puts and calls (which could also exist in the first alternative), which might raise concerns about whether a current transfer of the relinquished property has occurred, although if properly structured, there is analogous favorable authority.(7)
The situation became even more complicated if the replacement property was a "build-to-suit." If the parking entity was acquiring vacant land on which an improvement was to be constructed, the taxpayer would want to oversee and manage construction, and the parking entity would be concerned about construction financing and limitation of liability. In addition, the parking entity would have to hold onto the property to complete construction, even though a buyer may have been found.
Nothing further occurred until 1997 when the IRS issued LTR 98114019 (December 23, 1997), permitting a two party reverse exchange of easements. While this was generally thought to be a positive sign, it did not provide much help since the ruling did not apply to a multi party exchange. Practitioners thought the time may be right and again made submissions to the IRS in an attempt to get guidance. The ABA Tax Section also made a second submission in 1999 (although it was not officially submitted until July, 2000, and therefore is referred to herein as the "2000 Report"), in which a very broad parking arrangement safe harbor was requested. The 2000 Report provided for a two year period to complete the exchange, with further extensions possible, and no required identification of the relinquished property. The taxpayer would also be permitted to transfer its rights under the parking accommodation arrangement to a related party. This presumably was intended to reflect the concerns that certain accounting firms and members of the real estate industry had that any safe harbor provide maximum flexibility to allow build to suit projects.
Revenue Procedure 2000-37
While the good news is that the Rev Proc is helpful and does provide much needed guidance, it appears that the demands made on Treasury and the IRS may have resulted in a safe harbor that, as far as build to suits is concerned, is more limited than even the safe harbor proposed in the 1993 Report.
1. Simply stated, an "exchange accommodation titleholder" ("EAT"), who must be an unrelated party, can acquire the replacement property, hold onto it for up to 180 days until a buyer is found for the relinquished property, and then transfer it to the taxpayer in a 1031 exchange. Alternatively, the taxpayer can currently acquire the replacement property in a 1031 exchange and the EAT can hold the relinquished property up to 180 days until a buyer is found.
2. Although it is not necessary for the EAT to hold legal title, he must have "indicia of ownership of the property that are treated as beneficial ownership under principles of commercial law (e.g., a "contract for deed"). Since the Rev Proc does not apparently permit an actual reverse exchange (i.e., the EAT could not enter into a contract to purchase the property and assign the contract to the taxpayer who closes on the property), there is some uncertainty as to whether this could apply to any situation other than perhaps where legal title is held by the lender as security. If it means a contract to purchase or an option with a lease (which is doubtful), this will not likely be helpful from a practical viewpoint since there will presumably be pressure to close on the replacement property. Query, however, whether the taxpayer could hold legal title as security for the loan made to the EAT to acquire the property, so that legal title never has to pass through the EAT.
3. Sec 4.02 of the Rev Proc states that at the time the EAT obtains legal title, the taxpayer must have a "bona fide" intent that the property held by the EAT represent either replacement property or relinquished property in a 1031 exchange. There is no indication of how the bona fide intent is proved but this is probably insignificant since within five days thereafter, the taxpayer and the EAT must enter into a written qualified exchange accommodation agreement ("QEAA").
4. The EAT cannot hold the relinquished and or the replacement property, pursuant to a QEAA, for an aggregate period in excess of 180 days.
5. The relinquished property must be identified within 45 days from the EAT's obtaining legal title. However, the taxpayer can identify alternative and multiple properties as described in Reg.Search7RH1.1031(k)-1(c)(4). Query how the 95% and 200% rules will mechanically work.
6. Sec 4.03 permits all kinds of dealings between the taxpayer and the EAT (e.g., loans, guarantees, leases, management of the property) on non arm's length basis. Specifically, one or more of the following can be accomplished, irrespective of the arm's length nature of the relationship:
a. The taxpayer or a "disqualified person" can guarantee some or all of the obligations of the EAT, including secured or unsecured debts or indemnify the EAT against costs and expenses.
b. The taxpayer or a disqualified person can loan or advance funds to the EAT or guaranty a loan or advance to the EAT. Presumably, it does not matter whether any interest is charged or whether Search7RHSearch7RH7872 or 482 might otherwise be deemed to apply. Query whether the OID rules of Search7RH1271-1274 could nevertheless apply?
c. The property is leased by the EAT to the taxpayer or a disqualified person. Again, presumably it does not matter whether any rental is charged at all.
d. The taxpayer or a disqualified person manages the property, supervises improvement of the property, acts as a contractor or otherwise providers services to EAT with respect to the property.
e. The taxpayer and the EAT enter into agreements or arrangements relating to the purchase or sale of the property, including puts and calls at fixed or formula prices, effective for a period not in excess of 185 days from the date the property is acquired by the EAT.(8)
f. The accounting, regulatory or state, local or foreign tax treatment of the relationship between the taxpayer and the exchange accommodation titleholder is different from the treatment required by the Revenue Procedure. There was some concern previously as to how the accounting firms would treat the parking arrangements. If the EAT had to reflect ownership of the property and the debt as its own, that might preclude EAT's who are affiliated with publicly held corporations (or who require certified financial statements) from being in the business. The Rev Proc would appear to alleviate this concern since it is understood that the EAT's might not, from a financial accounting viewpoint, have to reflect the property or the debt.
7. Sec 4.03 also permits the agreement to take variation in the value of the relinquished property from the estimated value into account upon the EAT's disposition of the relinquished property through the taxpayer's advance of funds to or receipt of funds from the EAT. While it is not entirely clear what this means, it is presumably intended to further permit the risk of appreciation or depreciation to remain with the taxpayer.
8. Query whether the QEAA can expressly provide that the EAT is acting as an agent for the taxpayer for all purposes other than Federal income tax purposes. While this express agency is presumably permitted in connection with the Qualified Intermediary safe harbor, and may be acceptable for purposes of the QEAA, there would appear to be some risk in the absence of a ruling. Moreover, taxpayers will not generally be willing to allow such a statement since it is possible that the relinquished property will not be able to be sold within 180 days and the safe harbor will not apply. As explained below, the taxpayer may still be able to qualify his exchange, depending on the circumstances.
9. The Rev Proc states that if the exchange is not completed within the time period, the transaction will or will not qualify under Search7RH1031 as if the Rev Proc simply were not applicable. This may suggest there is little downside in structuring a parking arrangement to fit within the Rev Proc, even if the relinquished property cannot be sold within 180 days (or any construction will not be completed within 180 days). However, if there is any concern about being able to sell the relinquished property within 180 days, taxpayers will not want to have a QEAA that provides for all the permissible non arm's length circumstances so as to preserve the ability to contend that the exchange still qualifies.(9)
Moreover, it is not clear how a transaction could be structured that contains a put or call in which it is intended that the exchange still qualify under the pre - Rev Proc rules if the EAT has to hold the property beyond the 185 day. This would seem on its terms to violate the Rev Proc, unless the parties agree to a later amendment (although the parties may not be comfortable with this since this will not be in writing upfront).
10. Although the expectation early on was that the Rev Proc would be in proposed form, it came out in final form and is effective for QEAA's entered into with respect to an EAT that acquires qualified indicia of ownership of property on or after September 15, 2000.
11. In several places, the Rev Proc refers to acquisition of "property", and in other places it refers to acquisition of "qualified indicia of ownership." Presumably it is the latter phrase that is significant throughout.
12. It is clear that the EAT can be a QI, which eliminates the existing concern as to whether an entity will fail to qualify as a QI if it does not immediately dispose of the relinquished and replacement properties.(10) Alternatively, a QI can be used in conjunction with a related EAT, which is likely to be the more common approach to minimize concerns in the marketplace about bankruptcy of the EAT or perhaps for state tax reasons.
13. Sec 3.03 states that there are other tax issues not addressed int the Rev Proc, such as whether the EAT can be precluded from claiming depreciation deductions with respect to the relinquished or the replacement property as a dealer. This could produce a positive tax liability for the EAT if there is a net lease rental for six months. While the rental could be for $1, the payment of the debt service will likely be treated as rent. One needs to run numbers. Moreover, if the property is held by the EAT for less than a year, there will be recapture.
14. It is permissible for legal title to be owned through a single "member" LLC owned by the EAT. This presumably includes a two member LLC in which the EAT owns the entire economic interest.(11) Query whether the taxpayer can be the member who owns no economic interest?
15. As indicated above, Sec 3.04 sates that if the requirements of the Rev Proc are not met, the Rev Proc does not apply. So, despite the good faith intent language, and unlike the installment sale Regs, this presumably will require an amendment of tax returns (for both taxpayers and EAT's) for failed exchanges that straddle two taxable years.
16. Presumably, an exchange can be accomplished utilizing both replacement property held by an EAT for 180 days and other replacement property to be acquired by the QI after the 180 day period, but within the QI safe harbor (i.e., where the value of the relinquished properties equals the aggregate value of both replacement properties).
17. The EAT should be concerned about state taxation. Query whether the EAT is doing business in each state it holds mere legal title? There are likely to be some aggressive states which might take this position. In other states, it might depend on whether actual rental income is received. There are also likely to be non tax issues of doing business that will be of concern (e.g., in the event of tort liability).
Technical Advice Memorandum ("TAM") 200039005 (May 31, 2000)
Prior to the issuance of Rev Proc. 2000-37, the IRS issued TAM 200039005(12), which involved a simultaneous exchange that went "bad" at the closing. At the last minute, the buyer of the relinquished property refused to close and the taxpayer nevertheless demanded that the closing on the replacement property proceed. The TAM states as a factual matter that the "taxpayer closed on the purchase of the replacement property," but directed that title be deeded to "A", an entity that apparently otherwise could have been a QI. The TAM also states that the taxpayer, of course, and not A, negotiated the purchase of the replacement property, the taxpayer provided the funds (although it does not state whether this was done by way of a loan), taxpayer was personally liable on the third party mortgage, while A was not, "there is no evidence that A would have been involved in the transaction but for taxpayer," and "a written exchange agreement did not exist at the time A acquired title to the replacement property." On the basis of these factors, the IRS concluded that A was acting as the taxpayer's agent.
There is some confusing language in the TAM concerning reverse exchanges. One could read the TAM to state that reverse exchanges are simply not permissible. We know from past experience that one cannot read adverse TAM's too literally, but this does seem to be what the TAM is saying. On the other hand, it is odd that the IRS would announce this conclusion concerning reverse exchanges (which, as stated above, was reserved in the Regulations) through a TAM. If that is their conclusion (this is not at all clear), how would they distinguish LTR 98114019, supra? It cannot be distinguished simply on the grounds the letter ruling involved a two party exchange.
The IRS was obviously working on the Rev Proc project at the time the TAM was considered by the National Office and this may have had an impact. The IRS may have felt compelled to take a somewhat harder line in a matter that would not factually have met all the technical requirements under the Rev Proc. This is understandable, given the generosity of the Rev Proc. However, since there has been no change in the law that prompted the Rev Proc, it would have been helpful for the IRS to clarify the substantive differences between the TAM and the factual setting of many pre-Rev Proc parking arrangements that have been in widespread use (not to mention the Rev Proc itself which by the end of May was presumably in its final stages). In any event the TAM is likely to be the subject of much discussion among practitioners, and IRS personnel will no doubt provide some clarification in future public forums and bar association meetings.
Conclusion
Despite the questions that most certainly will be raised concerning the TAM, Rev Proc 2000-37 provides much needed clarification and certainty to the area of like-kind exchanges. While the Rev Proc is not likely to please those who thought taxpayers should have maximum flexibility in designing build-to- suit exchanges, the Rev Proc is quite revolutionary in allowing a taxpayer to assume essentially all the risks and yet still treat the EAT as a principal in the transaction. In any event, the Rev Proc is likely to cause a sharp increase in the level of exchanges, which already has seen a significant upturn over the last few years.
FOOTNOTES_____________________
1. IRB 2000-40 (October 2, 2000)
2. T.D. 8346, 1991-1 CB 150, 151
3. 602 F.2d 1341 (9th Cir 1979). For a complete discussion and history of the Starker case, see Levine, 567-2nd T.M., "Taxfree Exchanges Under Section 1031", at A-37-A-38, (1997).
4. See, e.g., Rutherford v. Comr., T.C.. Memo 1978-505 (1978); Bezdjian v. Comr., 845 F2d 217 (9th Cir 1988); Lee v. Comr., T.C. Memo 1986-294 (1986).
5. "Report on the Application of Search7RH1031 to Reverse Exchanges", 21 J. of Real Estate Taxation 44 (Fall 1993).
6. Commissioner v. Court Holding Co, Inc., 324 US 331 (1945).
7. See Levine, supra at n.5
8. Query whether the reacquisition of the property must occur within 185 days or just that the put or call must be exercised within that time frame.
9. See the discussion on the TAM, infra.
10. See Levine, supra at n.5, p.48
11. See LTR 199911033 (December 18, 1998).
12. This TAM was not released to the public until September 29, 2000.