IRS OKs use of one property to engineer a reverse and forward like-kind swap Chief Counsel Advice 200836024
In Chief Counsel Advice (CCA), IRS has given its blessing to the use of one property to engineer both a completed reverse like kind exchange and an attempted forward like kind exchange. The forward exchange was necessary because the value of the relinquished property far exceeded the value of the replacement property that the taxpayer received. Because the forward exchange couldn’t be completed within the statutory time limits, however, the taxpayer wound up paying tax on the net cash it received.
Observation: The new CCA is noteworthy because it shows how far the like-kind exchange rules can be stretched, with IRS‘s approval, to accommodate complex conditions.
Background. In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. (Code Sec. 1031) Like-kind treatment is barred if the property to be received is not identified (e.g., by being specified in the contract) on or before 45 days after the transfer, or isn’t received within 180 days after the transfer or by the due date (with extensions) of the return for the year of transfer if earlier. (Code Sec. 1031(a)(3))
Qualified intermediaries (QIs) may be used to structure like-kind exchanges using qualified exchange accommodation arrangements (QEAAs). (Reg. § 1.1031(k)-1(g)(4)) Under established rulings policy, IRS will treat an exchange accommodation titleholder () as the beneficial owner of property for federal income tax purposes if the property is held in a qualified exchange accommodation arrangement (QEAA).
A like-kind exchange can be set up in “forward” or “reverse” mode:
- In a “forward” (or regular) deferred like-kind exchange using a QI, the taxpayer transfers the relinquished property to the QI, who will sell the property to a buyer. The QI then takes the proceeds of the sale of the relinquished property, buys the replacement property, and transfers the replacement property to the taxpayer.
- In a “reverse” deferred like-kind exchange, the replacement property is acquired first by the QI (typically using money borrowed from the taxpayer). The taxpayer then identifies relinquished property and transfers it to the QI, who sells it to an outside buyer. Finally, the QI transfers the replacement property to the taxpayer.
Rev Proc 2000-37, 2002-2 CB 308, tailors the 45-day and 180-day statutory periods to the specific situation of QEAAs holding title to property involved in a multiparty exchange.
Facts. A taxpayer we’ll call Hotels, Inc., wanted to acquire a building in Phoenix, Arizona. However, instead of buying it, Hotels wanted to engineer the acquisition as an exchange for one of the buildings it owned elsewhere. To that end, Hotels entered into a QEAA with EAT, an affiliate of QI. The deal called for EAT to facilitate a parking arrangement and acquire the Phoenix property in a like-kind exchange. EAT agreed to take title to the Phoenix property through a wholly-owned single member limited liability company called RPLLC. Hotels loaned RPLLC funds to buy the Phoenix property, for which RPLLC gave Hotels a promissory note obligating EAT to repay the loan to Hotels if the latter subsequently acquired the Phoenix property from EAT.
The following transactions took place:
- On Date 1, RPLLC acquired the Phoenix property from Seller, financing the $21 million purchase price by assuming an existing $12 million mortgage on the property and borrowing the $9 million balance from Hotels.
- On Date 2, thirty-three days after the acquisition of the Phoenix property by EAT through RPLLC, Hotels identified in writing to EAT three like-kind properties it owned to potentially serve as relinquished property for the Phoenix property. One of these properties was a building in Houston.
- On Date 3, Hotels entered into a written exchange agreement with QI to facilitate the exchange of the Houston building. Hotels assigned to QI the right to receive the net sales proceeds for the Houston building from the company interested in buying it (Buyer).
- On Date 4, QI, acting on behalf of Hotels, transferred the Houston building to Buyer for a total purchase price of $50 million. The net sales proceeds of $41 million (i.e., $50 million less a $9 million mortgage) were deposited with QI. Also on Date 4, which was 180 days from the acquisition of the Phoenix building by EAT, QI directed EAT to transfer the Phoenix building to Hotels as replacement property for the Houston building for a total of $9 million from the sale of the Houston building and an assumption of a mortgage of $12 million. EAT transferred its 100% membership interest in RPLLC to Hotels, thereby transferring the Houston property to Hotels. In addition, Hotels received $9 million in repayment of EAT‘s obligation under the note.
- On Date 5, which was 42 days after the sale of the Houston property, Hotels identified in writing to QI three additional properties, which were intended by Hotels to be additional replacement properties for the exchange of the Houston property. However, although Hotels had a bona fide intent to enter into a deferred exchange on Date 4, it failed to acquire any other replacement property in the 180-day period subsequent to Date 4.
Hotels later received the remaining proceeds from the sale of the Houston building from QI. Since the attempted deferred exchange transaction spanned two separate tax years, Taxpayer reported the remaining $32 million gain from the sale of the Houston building in the tax year that included the date it received the remaining proceeds in accordance with the installment sale rules of Code Sec. 453 and Reg. § 1.1031(k)-1(j)(2).
Observation: Although the CCA doesn’t explain the derivation of the “remaining $32 million gain,” it’s apparently the $41 million cash from the sale of the Houston building net of the $9 million cash used to buy the Phoenix building.
Observation: Under Code Sec. 453(a) and Code Sec. 453(b)(1), the installment sale rules must (unless the taxpayer elects out) be used to report gain on the disposition of nondealer property where at least one payment is to be received after the close of the tax year in which the disposition occurs. The installment method may be elected even though no payments are received in the year of sale. Here, although Hotels wound up paying tax on the “cash boot” it received because the forward exchange failed, it nonetheless wound up deferring that tax to a year following the year in which the Houston building was disposed of.
Potential problem. The examiner looking at Hotels’ transactions thought that they violated Congressional intent because (1) there could be up to 360 days between the day on which replacement property is parked with an exchange titleholder at the inception of the reverse exchange and the day the deferred exchange is completed, and (2) Hotels is entitled to two separate 45 day identification periods for the forward and reverse exchanges. The argument, in essence, was that the transactions were contrary to the identification and replacement provisions in Code Sec. 1031(a)(3).
Transactions pass muster. The CCA pointed out that Hotels planned on making two exchanges, not one. A taxpayer has 45 days to identify replacement property in a deferred exchange and 45 days to identify relinquished property once replacement property is parked. Hotels satisfied the identification requirement in both instances. Moreover, a taxpayer may park property with an EAT for 180 days or less. Also, in a deferred exchange, a taxpayer must close its exchange by acquiring replacement property within the exchange period, which is the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or the due date (determined with regard to extension) for the taxpayer’s return for the tax year in which the transfer of the relinquished property occurs. The CCA said Hotels stayed within all of these guidelines.
The CCA conceded that neither Code Sec. 1031 and its regs, nor Rev Proc 2002-37 expressly allow the same relinquished property to be used in both a reverse exchange and a forward deferred exchange. However, it concluded that nothing in these authorities prohibits this coupling in the use of the same relinquished property. Also, taxpayers using the revenue procedure are not constrained to exclusively acquire as replacement property only the property parked with the EAT. It also pointed to a long history of the courts giving significant latitude in structuring like-kind exchanges under Code Sec. 1031.
As a result, the CCA concluded that if the statutory and regulatory guidelines were followed (i.e., time limitations, the avoidance of constructive receipt, etc.) and if Hotels stayed within IRS‘s administrative guidelines, the gain it realized on the reverse exchange is deferred under Code Sec. 1031 and the gain on the intended deferred exchange is to be recognized in the tax year that includes the date that Hotels received the remaining proceeds from the sale of the Houston property, in accordance with Reg. § 1.1031(k)-1(j)(2)(ii).
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