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Articles : IRS Expands Tax-Free Exchanges of Real Estate

IRS Expands Tax-Free Exchanges of Real Estate

By: Stephen M. Breitstone

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By Stephen M. Breitstone

In our practice and in the real world, it is usually easier to purchase real estate than to sell real estate. This often presents real world difficulties for businesses seeking to take advantage of the “like-kind” exchange provisions under section 1031 of the Internal Revenue Code. Typically, a corporation will identify a site suitable for its expanding business operations before it will commence efforts to sell the headquarters or manufacturing facility it has outgrown. However, because the new site often requires modifications to suit the expanding business or is to be built from the ground up, it is usually impractical to even consider selling an existing site until the new site is up and running. Until the recent issuance of Revenue Procedure 2000-37, 2000-40 IRB xxx, one of the huge tax issues facing an expanding business in this situation was whether it was possible to purchase the new site prior to relinquishing ownership of the old site and still receive tax-free “like-kind” exchange treatment under Section 1031.

“Like-kind” exchanges under Section 1031 of the Internal Revenue Code provide one of the most viable methods of disposing of real estate without paying income tax on accrued gains. However, it is often difficult to arrange a straightforward exchange under Section 1031 in the real world because of the difficulty, if not impossibility, of matching two parties who are both seeking an exchange of real estate and who own real property which is suitable for the other party’s needs. Fortunately, the statute, regulations and case law have evolved to permit a wide variety of arrangements that are designed to allow tax-free, “like-kind” exchange treatment to be obtained through the use of various types of accommodation party arrangements. For example, pursuant to the statute and regulations, a so-called “qualified intermediary” may be used to effectuate an exchange, provided that both the identity of the property to be acquired in the exchange and the actual exchange meet certain time restrictions. However, notwithstanding this considerable latitude and certainty the IRS has not, until the recent publication of Revenue Procedure 2000-37, 2000-40 IRB xxx, condoned the so-called “reverse exchange.”

“Like-kind” exchanges under Section 1031 of the Internal Revenue Code provide one of the most viable methods of disposing of real estate without paying income tax on accrued gains. However, it is often difficult to arrange a straightforward exchange under Section 1031 in the real world because of the difficulty, if not impossibility, of matching two parties who are both seeking an exchange of real estate and who own real property which is suitable for the other party’s needs. Fortunately, the statute, regulations and case law have evolved to permit a wide variety of arrangements that are designed to allow tax-free, “like-kind” exchange treatment to be obtained through the use of various types of accommodation party arrangements. For example, pursuant to the statute and regulations, a so-called “qualified intermediary” may be used to effectuate an exchange, provided that both the identity of the property to be acquired in the exchange and the actual exchange meet certain time restrictions. However, notwithstanding this considerable latitude and certainty the IRS has not, until the recent publication of Revenue Procedure 2000-37, 2000-40 IRB xxx, condoned the so-called “reverse exchange.”

In order to bring this type of transaction within the parameters of Section 1031, taxpayers have arranged for an accommodation party to acquire the replacement property and hold it until the point in time when the relinquished property is ready to be transferred. When this occurs, the transfer is documented as an exchange with the accommodation party of the replacement property for the relinquished property followed by a resale of the relinquished property to a third party.

Until the recent publication of Rev. Proc. 2000-37, there were always concerns that the IRS would not treat this type of transaction as a like-kind exchange under section 1031, especially when the accommodation party could be viewed as a de facto agent of the transferor. With the publication of Rev. Proc. 2000-37, taxpayers can be assured that, by following certain safe harbors provided within Rev. Proc. 2000-37, such transactions will be treated as a section 1031 exchange.

In addition to these safe harbors, taxpayers must continue to follow certain technical requirements and fairly limited time frames relating to all section 1031 exchanges. It is not clear whether transactions falling outside these requirements will still qualify for Section 1031 exchange treatment. However, the Rev. Proc. 2000-37 does not necessarily infer that they would not.

The safe harbor requirements of Rev. Proc. 2000-37 are briefly summarized as follows:

1) Qualified indicia of ownership (i.e., legal title) must be held by a person who is not the taxpayer or a disqualified person (i.e., taxpayer’s agent) and either such person is subject to federal income tax, or if such person is a partnership or S corporation, more than 90% of its interests or stock are owned by partners or shareholders who are subject to federal income tax.

2) At the time the qualified indicia of ownership of the property is transferred to the accommodation party, it is the taxpayer’s intent that the property represents either replacement or relinquished property.

3) No later than five days after the transfer to the accommodation party, the taxpayer and the accommodation party enter into a written agreement providing that the accommodation party is holding the property in order to facilitate a Section 1031 exchange under this revenue procedure and that the taxpayer and accommodation party agree to report the entire transaction as provided in the revenue procedure.

4) The relinquished property is identified within 45 days after the transfer of the replacement property to the accommodation party.

5) Within 180 days after the transfer to the accommodation party, the property is transferred to the taxpayer as replacement property, or the property is transferred to a person who is not the taxpayer or disqualified person as relinquished property.

6) The combined time period that the relinquished property and the replacement property are held by the accommodation party not exceeding 180 days.

With the publication of Rev. Proc. 2000-37, the IRS has provided taxpayers with a suitable means of qualifying their transactions under Section 1031 where the taxpayer has a genuine intent to accomplish a “like-kind” exchange at the time the taxpayer arranges for the acquisition of replacement property and actually accomplishes the exchange within a short time thereafter