Reverse like-kind exchange is afforded nonrecognition treatment

The Tax Court rejects the IRS's argument that a third-party facilitator never assumed ownership under a benefits-and-burdens test.
By Maria M. Pirrone, CPA, LL.M.

The Tax Court held that a non—safe-harbor, reverse like-kind exchange qualified for nonrecognition treatment under Sec. 1031. The Tax Court rejected the IRS's argument that the third-party exchange facilitator in the transaction must acquire the benefits and burdens of ownership of the property for the transaction to qualify for nonrecognition treatment.

Facts: In 1999, Bartell Drug Co., a family-owned drugstore chain in Washington state, entered into a purchase agreement with the owner of real property for a site for a future drugstore in Lynnwood, Wash. (replacement property). In anticipation of entering into a like-kind exchange, Bartell Drug executed a second agreement with a third-party exchange facilitator. The exchange facilitator obtained financing from a bank that was guaranteed by Bartell Drug. Under the agreement with the facilitator, Bartell Drug would also pay all taxes and indemnify and hold harmless the facilitator for any loss or claims, except for gross negligence. The facilitator would have no obligation for any expenditures beyond the amount borrowed and no responsibility for the construction of the drugstore beyond disbursing the borrowed funds. The closing took place on Aug. 1, 2000, with the facilitator taking title to the property. Bartell Drug managed construction of the new drugstore and, upon its substantial completion in June 2001, leased it from the facilitator until the relinquished property was disposed of and title to the replacement property was transferred to Bartell Drug.

Bartell Drug identified its property to be relinquished, another drugstore in Everett, Wash., but many developments delayed its sale. In September 2001, Bartell Drug entered into a contract to sell the relinquished property, and the sale closed, with the facilitator as intermediary, the following December. That month, the facilitator transferred the title to the new drugstore to Bartell Drug, and the exchange was completed.

Upon an examination of Bartell Drug's 2001 corporate return, the IRS disallowed Sec. 1031 deferral of approximately $2.8 million realized in the transaction. This caused an increase in the income passed through to the company's shareholders, and the IRS issued them notices of deficiency. They challenged the IRS's determination in the Tax Court, and after the death of the primary shareholder, George Bartell Jr., in 2009, his estate was substituted for him in the case.

Issues: Sec. 1031 provides that no gain or loss is recognized on the exchange of like-kind property held for productive use in a trade or business or for investment. The rationale for the nonrecognition treatment is that the newly acquired property is a continuation of the old or relinquished property. There is a change in form, not substance, of the investment.

The IRS issued Rev. Proc. 2000-37 in October 2000 to provide guidance when replacement property is acquired prior to the transfer of the relinquished property. It provides a 180-day safe harbor to effectuate the exchange. However, this transaction predated the effective date of the revenue procedure, and, in any event, since it took 17 months, it would not have met the safe harbor's time limit.

The IRS asserted that the transaction failed to qualify as an exchange entitled to nonrecognition treatment pursuant to Sec. 1031 because, under a benefits-and-burdens analysis, the taxpayer was the true owner of the replacement property. The exchange facilitator, according to the IRS, was not the owner because Bartell Drug's agreement with the facilitator effectively insulated the facilitator from the benefits and burdens of ownership. In support of its argument, the IRS noted that the Tax Court had applied a benefits-and-burdens test to deny like-kind exchange nonrecognition treatment in DeCleene, 115 T.C. 457 (2000).

The plaintiffs argued that case law in both the Tax Court and the Ninth Circuit, to which an appeal would lie in this case, had rejected the benefits-and-burdens test, citing Alderson, 317 F.2d 790 (9th Cir. 1963). In that case, the Ninth Circuit stated that "one need not assume the benefits and burdens of ownership in property before exchanging it but may properly acquire title solely for the purpose of exchange and accept title and transfer it for other like property, all as part of the same transaction with no resulting gain."

Holding: The Tax Court rejected the IRS's argument that a benefits-and-burdens test should be applied. The court distinguished DeCleene from the current case because in the former case, the taxpayer acquired the replacement property outright. Specifically, the Tax Court stated that case law has established that "where a section 1031 exchange is contemplated from the outset and a third-party exchange facilitator, rather than the taxpayer, takes title to the replacement property before the exchange, the exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for section 1031 purposes before the exchange." Accordingly, the court held that the exchange transaction qualified for nonrecognition treatment pursuant to Sec. 1031.

  • Estate of Bartell, 147 T.C. No. 5 (2016)

—By Maria M. Pirrone, CPA, LL.M., assistant professor of accounting and taxation, St. John's University, Queens, N.Y.

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