I have previously noted in my blog some of the practical benefits of the use of the “reverse exchange” allowed for deferral of gain under Internal Revenue Code Section 1031. For those of you who may not recall the specifics of this technique, in a reverse exchange, the taxpayer acquires the “replacement property” first before selling the “relinquished property”; contrast this form of transaction with a standard exchange, where a taxpayer sells the relinquished property and then buys the replacement property to complete the exchange.
As pointed out in my blog, this tax deferral strategy can be particularly useful for real estate investors facing the challenge of working in a market in which the supply of high-quality commercial property is tight. In these circumstances, where it can be problematic to identify and acquire replacement property within the strict 45- and 180-day time limits of the standard exchange, a reverse exchange affords additional flexibility to a taxpayer with the means to buy property without first selling other property.
Thus, when the chance to purchase suitable replacement property presents itself, a taxpayer can move forward on that opportunity by first acquiring the replacement property through an intermediary and “parking” it there pending the disposition of relinquished property. If the transaction is then handled in accordance with the IRS’s “safe harbor” rules issued in 2000, the IRS will not challenge the tax-deferred treatment of the transaction. Under those rules, the taxpayer must identify the relinquished property within 45 days of the purchase of the replacement property through the intermediary, and must take title to the replacement property within 180 days of that purchase.
As such, a reverse exchange carried out in conformity with the safe harbor rules will satisfy IRS scrutiny, and most reputable exchange accommodators will structure their reverse exchanges in full compliance with those rules to ensure favorable tax treatment. But what happens with reverse exchanges that fall outside of the safe harbor rules? A recent ruling by the U.S. Tax Court has provided taxpayers with some flexibility in this regard, making it a little less difficult to take advantage of this gain-deferral strategy.
In Estate of George H. Bartell, Jr. v. Commissioner, 147 T.C. No. 5 (2016), the U.S. Tax Court held that a parking arrangement that failed to satisfy the safe harbor rules nonetheless qualified for deferral of gain as a Section 1031 reverse exchange. In that case, involving events that occurred before the safe harbor rules were issued, the taxpayer parked the replacement property with an intermediary for 17 months, well outside the 180-day safe harbor time limit, during which time the intermediary was the borrower on a construction loan guaranteed by the taxpayer and the property was improved and leased by the intermediary at the direction of the taxpayer.
The IRS challenged the transaction and asserted the position that it did not qualify as an exchange for deferral of gain under Section 1031 on the ground that, notwithstanding the parking arrangement, the taxpayer was the owner of the replacement property because the benefits and burdens of the property remained with the taxpayer. The Tax Court rejected this approach, noting that, while the safe harbor rules were inapplicable, the transaction was otherwise structured in a manner consistent with the safe harbor rules, except for the 180-day requirement for taking title. As such, and in view of the fact that decisions in other cases where the intermediary took title to the property in a Section 1031 exchange did not require the intermediary to assume the benefits and burdens of ownership, the court took the position that applying that analysis was inappropriate to the case at hand, and ruled for the taxpayer.
The Bartell case is significant for property investors because it means that reverse exchanges that fall outside of the safe harbor rules may qualify for tax deferral and may be less likely to be litigated, even when the intermediaries do not maintain the benefits and burdens of ownership, as long as title to the property remains in the name of the intermediary, not the taxpayer. As a result, taxpayers who may need more time to complete a reverse exchange than allowed under the safe harbor rules may still be able to enjoy the benefits of Section 1031.
The U.S. Tax Court’s opinion in Estate of George H. Bartell, Jr. v. Commissioner can be found here.