While taxpayers may generally feel comfortable gleaning tax planning guidance from tax court decisions, especially the taxpayer friendly ones, it’s critical to be aware that the IRS can limit the reach of those decisions for other taxpayers. This recently occurred with the tax court’s decision in the Estate of George H. Bartell et al v. Commissioner (147 TC 140) — and signals taxpayers to proceed with caution when considering a reverse 1031 exchange.
In this particular instance, Bartell sought a lengthy window for a reverse 1031 exchange. The tax court agreed, given there was no published guidance stating otherwise. While the case was pending, the IRS finally released guidance, Revenue Procedure 2000-37, which essentially reversed the Bartell decision with respect to any taxpayer other than Bartell. To make its position abundantly clear, the IRS published its non-acquiescence to the court’s decision on August 11, 2017 (AOD 2017-6).
This article details the importance of following the provisions of Revenue Procedure 2000-37 when considering a reverse 1031 exchange to receive safeguarded benefits and protect yourself from potential IRS scrutiny.
IRC Section 1031 Explained
Under Section 1031, there is no gain or loss recognized on the like-kind exchange of business or investment property that meets certain criteria. Both the relinquished property you sell and the replacement property that you buy must be held for use in a trade or business or for investment. In some 1031 exchanges, there is a delay in time in completing the exchange. In a “forward IRC 1031 deferred exchange” the taxpayer sells his or her property (the relinquished property) first and has 45 days from the date of sale to identify the replacement property and 180 days to complete the exchange. When properly met, such an exchange is benign in terms of risk of audit.
However, issues can arise when the taxpayer enters into a “reverse IRC 1031 exchange” if the taxpayer takes ownership of the replacement property before the exchange occurs. In a reverse 1031 exchange the replacement property is identified and acquired before the sale of the relinquished property. To effectuate an IRC 1031 exchange, there must be a reciprocal transfer of property between owners who do not have previous ownership over the property being exchanged. The key concept here is that a taxpayer cannot enter into an exchange with him or herself. This became the essence of the parties’ contentions and the court’s analysis in the Bartell Case.
Unpacking the Case
In the Bartell case, the taxpayer owned family run pharmacies with locations primarily in rundown strip malls, making it difficult to compete with competitors such as Walmart opening up stores nearby. The taxpayer saw an opportunity to acquire a new location and wanted the benefits of the like-kind exchange treatment. The taxpayer entered into a purchase agreement with the property owner, obtained financing and engaged an exchange facilitator, known as EPC Two, to facilitate the 1031 exchange. The transaction took seventeen months to complete.
Upon completion of the transaction, the IRS concluded that a proper 1031 exchange did not occur and challenged the transaction in the Tax Court. The following details the IRS's arguments:
- EPC Two never took ownership over the property since it did not obtain the benefits and burdens of ownership; therefore the taxpayer was really the owner of the property before the exchange—negating the tax-free exchange.
- The argument was consistent with Revenue Ruling 82-144, which held that the party that bears the economic benefits and burdens of ownership is the owner of the property.
However, the taxpayer argued that EPC Two was its agent that facilitated the exchange and that EPC Two was not required to have the benefits and burdens of ownership in such a scenario.
The tax court agreed with the taxpayer and concluded the following:
- From the outset, the taxpayer contemplated the use of the exchange facilitator to take possession of the replacement property for purposes of facilitating a 1031 exchange, which the exchange facilitator did immediately after closing.
- The court contrasted this with DeCleene v. Commissioner (115 TC 469), a case which the IRS relied upon, in which the taxpayer took possession of the property first and then decided to enter into the 1031 exchange.
- When structuring the transaction with the exchange facilitator taking the property from the outset in contemplation of a 1031 exchange occurring, the taxpayer is deemed to avoid engaging in an exchange with itself.
- Therefore, the 1031 exchange was found to have been properly executed, even though the exchange facilitator did not have the benefits and burdens of ownership.
Safe Harbor for Reverse 1031 Exchanges
Months after the Bartell transaction was completed, Revenue Procedure 2000-37 established a safe harbor for reverse 1031 exchanges. This safe harbor applies when there is a qualified exchange accommodation agreement in place and the completed exchange occurs within a six-month period. When defining a qualified exchange accommodation arrangement, the Revenue Procedure provisions were similar to the holding of the tax court in the Bartell case, with one major exception: the exchange accommodation titleholder is required to be treated as the beneficial owner of the property for all federal income tax purposes. Section 4 of the Revenue Procedure states that property is deemed to be held in a qualified Exchange Accommodation arrangement when:
- The qualified indicia of ownership of the property must be held by a person (the exchange accommodation titleholder) who is not the taxpayer or a disqualified individual who is either subject to federal income tax or a partnership or S Corporation with more than 90% of its interest or stock owned by partners or shareholders who are subject to federal income tax.
- The exchange accommodation titleholder must hold the property at all times from the date of acquisition by the exchange accommodation titleholder until the property is transferred in completion of the exchange.
- A written agreement is executed no later than 5 business days after title to the property is transferred to the exchange accommodation titleholder. The agreement must state that the taxpayer has a bona fide intent that the property held by the exchange accommodation titleholder represents either replacement property or relinquished property in an exchange that qualifies under IRC Section 1031.
- The agreement must also state that the exchange accommodation titleholder be treated as the beneficial owner of the property for all federal income tax purposes. Both parties must report the federal income tax attributes of the property on their federal income tax return in a manner consistent with the agreement.
- No later than 45 days after the property is transferred to the exchange accommodation titleholder, the relinquished property must be properly identified. The exchange of properties must also occur within 180 days after title is transferred to the exchange accommodation titleholder.
- The combined time period that the relinquished property and the replacement property are held in the qualified accommodation arrangement cannot exceed 180 days.
Given the scope of the safe harbor provisions in Revenue Procedure 2000-37, if the transaction in the Bartell case occurred after Revenue Procedure 2000-37, the tax court may have decided differently given that the relinquished property was transferred after the six-month window and the exchange facilitator was not deemed to be the beneficial owner of the replacement property. With the provisions of the Revenue Procedure firmly in place, it is not surprising that the IRS non-acquiesced to the Bartell decision. Interestingly though, it did not appeal the ruling, possibly viewing it as a one off.
Few, if any, transactions that have exceeded the Revenue Procedure 2000-37 safe harbor period have been challenged by the IRS since the Revenue Procedure was published. Therefore, uncertainty looms over how the IRS would view such transactions.
For more information on the reverse 1031 exchange and the necessary steps to follow which would help ensure safe harbor protection as outlined in the Revenue Procedure, contact Andrew Cohen at 212.842.7649 or firstname.lastname@example.org, or your Friedman LLP professional.