he long-standing debate is over. With the advent of revenue procedure 2000-37, the IRS has finally endorsed what are commonly called “reverse” exchanges on real estate and other investment property. Effective September 15, 2000, this pronouncement established a safe harbor for these types of IRC section 1031 tax-deferred exchanges and provided a relatively clear road map for CPAs to help clients execute them safely.
Real estate investors have long recognized the benefits of section 1031 exchanges, which include postponing the tax due on the transfer until the taxpayer sells the replacement property. Most exchanges today are done on a delayed basis, meaning the sale of the existing property and the acquisition of a new one take place at different times. Under a reverse or “parking” exchange, an unrelated third party (sometimes called a parking entity or qualified intermediary) acquires and “warehouses” the replacement property until the investor sells the original property and is free to purchase the parked property from the third party. Reverse exchanges have no special tax benefits; they simply offer taxpayers a transaction option they might otherwise lose because of timing. (For a primer on deferred exchanges, see “Beyond Section 1031,” JofA , Jul.00, page 61. ) With the IRS signaling its desire that parking exchanges be clearly documented, executed and reported, it’s important that CPAs understand the new rules found in revenue procedure 2000-37.
A HISTORY OF PARKING EXCHANGES
Although delayed exchanges are more popular, simultaneous exchanges are still done on rare occasions if all the steps fall into place. With the delayed method, a taxpayer first sells the so-called relinquished property and then acquires a replacement property within 180 days. A qualified intermediary does the required paperwork and holds the sale proceeds. Although the IRC does not specifically mention this forward order, it certainly is implied. The expanded section 1.1031 regulations the Treasury Department issued in 1991 neither endorsed nor condemned reverse exchanges; rather, the prelude simply stated the regulations did not apply to reverse exchanges, with no further comment.
In the past, some taxpayers attempting section 1031 exchanges abandoned the process when unforeseen events made a forward exchange (where the relinquished property is sold first) impossible. This was mostly because CPAs saw few safe options for completing the transaction if the taxpayer acquired the replacement property before selling the relinquished property. This dearth of options led to the development of reverse or parking exchanges. See exhibit 1, below, for an example.
Historically, the concerns some CPAs had about parking arrangements were twofold:
A lack of direct IRS approval.
Doubts about whether the parking entity really had the full “burdens and benefits” of property ownership that make for a real-world transaction.
Although the IRS showed no interest in attacking these exchanges, some CPAs initially felt uncomfortable giving assurance about their validity. Because the taxpayers involved in parking exchanges often lent money directly to the third-party parking the property or offered personally guaranteed loans to fund the acquisition, some CPAs were concerned about whether the transactions were truly arms-length. If the exchange lacked true substance, the IRS might have a good reason to consider it a tax avoidance scheme or could argue the parking entity was really the taxpayer’s agent, invalidating the exchange.
Over time, when the IRS didn’t question parking exchanges, more CPAs became comfortable with the approach. Yet despite their increased use and popularity, parking exchanges remained questionable. In an attempt to give some direction, the IRS published revenue procedure 2000-37 in September 2000. The ruling outlines appropriate steps and requirements taxpayers must follow to complete a parking exchange.
WHY A PARKING EXCHANGE?
Parking exchanges have become popular for a number of reasons. (See exhibit 2, below, for a detailed list.) Most involve the timing of the transaction. Typically, either the current owner of the targeted replacement property wants to close before the client can sell the relinquished property or a planned closing is delayed. Investor preference also makes this type of exchange popular. By using a parking exchange, a taxpayer who is uncertain of whether to sell an attractive property can take more time to look for and secure a desirable replacement. This added flexibility appeals to investors in today’s fast-paced real estate market.
Parking exchange methods. There are two ways to structure a parking exchange. The first and most common is the “exchange last” technique. It addresses the need to gain possession of the desired replacement property first and sell it to the taxpayer later. The second and less common method is the “exchange first” technique whereby the taxpayer temporarily parks the relinquished property. Although this technique is more difficult, it can sometimes be used to satisfy lender concerns.
Example. Susan Andrews has scheduled her replacement property closing for one week after closing on the property she is giving up. Due to a financing problem, the sale of the relinquished property cannot be completed as planned. Andrews has spent considerable time and money in due diligence and has nonrefundable earnest money at risk on her replacement property. Her bank loan on the new property is not subject to selling the old property. What can Susan do to protect her investment? The exchange last technique, in which a parking entity acquires and warehouses her targeted replacement property would be one option, but a new problem arises when the bank refuses to substitute the parking entity for the original borrower, given the short time until closing.
With her replacement property financing in question, Andrews opts to try the exchange first technique. Almost simultaneously, she conveys the relinquished property to the parking entity and then acquires the replacement property, completing the exchange. The parking entity then has 180 days to sell the relinquished property to complete the transaction. Because of the additional market and valuation risk, this is usually not the preferred way to structure a parking exchange.
REVENUE PROCEDURE 2000-37
With this guidance, the IRS created a safe harbor for parking transactions. The revenue procedure added new terminology (see exhibit 3, below), offered specific requirements and approved a number of steps on the road to a successful parking exchange.
Mandatory written elements. To be covered under the safe harbor protections, the taxpayer must enter into a written agreement—referred to as the qualified exchange accommodation agreement or QEAA—within five business days of the date the exchange accommodation title holder (AT) first acquires the parked property. This agreement must state that the
Taxpayer has a bona fide intent to use the parked property to complete a section 1031 tax-deferred exchange.
AT holds title or qualified indicia of ownership (QIO) to the property to facilitate a section 1031 tax-deferred exchange and to comply with revenue procedure 2000-37.
AT will be treated as the beneficial owner of the parked property for all federal income tax purposes.
Other requirements. The IRS guidance also requires that
The exchange must be completed within 180 days to receive the automatic safe-harbor protection. The clock begins either when the AT receives the target replacement property (in the exchange last technique) or when the taxpayer transfers the relinquished property to the AT (in an exchange first scenario).
An identification letter is due within 45 days of the initial closing. If the replacement property is being warehoused, the taxpayer must identify the relinquished property to be sold within 45 days of the date the AT took title to the parked property.
A tax return must be filed. Although most professional service providers have taken the position the entity providing the parking function must file the returns, the revenue procedure makes this step mandatory. In addition, the AT may have to depreciate certain parked properties even if it acquired and transferred the properties in the same tax year.
The AT cannot be the taxpayer or a “disqualified person” as defined in Treasury regulations section 1.1031. (See the sidebar at the end of this article for guidance on selecting an AT.)
OTHER APPROVED ACTIONS
With revenue procedure 2000-37, the IRS took a rather liberal approach in answering some lingering questions about the “burdens and benefits” of ownership and the “agency” issues that had long troubled CPAs (see exhibit 4, below, for a list.) The IRS specifically said the entity performing the parking service may be the same as the entity performing the qualified intermediary function. With this measure, the IRS effectively dispelled any remaining concerns about agency—whether the qualified intermediary is acting as the taxpayer’s agent.
Previously, certain qualified intermediary companies set up a separate entity (either an LLC or a corporation) to perform the parking function. This newly formed company acted as the warehousing entity, while the established company performed the QI function independently. Besides answering the agency concern, this technique protected the taxpayer from any unrelated litigation or other actions that might affect the intermediary. (For the same reason, it’s still important for the professional service provider not to use the same entity to hold property for different exchanges or even to recycle a holding entity once a parking exchange is complete.)
Parking exchanges outside the safe harbor. While the new pronouncement expanded exchange possibilities by providing a safe harbor for a specific parking technique, it also limited the time frame for completion to 180 days. This limitation is particularly important for hybrid non-safe-harbor “reverse construction” exchanges. In this type of transaction, the parking entity acquires a lot on which the taxpayer makes improvements. Typically the time necessary to build the needed improvements (particularly in large commercial transactions) easily exceeds 180 days and falls outside the safe harbor. The IRS addressed this concern clearly in revenue procedure 2000-37, stating that it “recognizes that parking transactions can be accomplished outside the safe harbor provided in this revenue procedure.” While the IRS underscored this fact, it did not list specific standards. If the parking exchange is not complete in 180 days (and consequently falls outside the safe harbor), what might lead the IRS to conclude the parking entity is actually the taxpayer’s agent, invalidating the exchange? Lacking a clear answer, the troubling issues of agency and the burdens and benefits of ownership arise again and CPAs should consider them for transactions that fall outside the safe harbor.
STEP BY STEP
Although the safe-harbor guidelines for parking exchanges are more liberal than expected, the IRS is clear in its desire to have the steps in such exchanges documented, executed and reported. By blessing certain steps in these types of exchanges, the IRS has quelled the uncertainty and given taxpayers more flexibility when executing a tax-deferred exchange. Despite the 180-day time limit to complete the transaction from start to finish, the fact that the IRS now sanctions reverse exchanges should increase their popularity.