Benefits and Burdens Test Does Not Apply in Case of Reverse §1031 Exchange

Since its original enactment, the like kind exchange provisions IRC §1031 has been allowed to apply to transactions for which there is not a direct exchange between parties of property.   Initially such transactions were expanded, first by judicial holdings and then explicitly by Congress [IRC §1031(a)(3)] to include deferred “forward” exchanges where the taxpayer does not simultaneously receive the replacement property from the party that acquires the relinquished property, but rather, with the use a qualified intermediary, acquires property from another party with the proceeds of the sale.

Later case law allowed for reverse deferred exchanges (referred to as reverse Starker exchanges in reference to a major Ninth Circuit case on the original forward exchanges) where the replacement property is acquired first and then the relinquished property is later sold.

While we have law and regulations implementing forward exchanges, there was nothing equivalent for reverse exchanges—they were judged on a facts and circumstances basis.  In 2000 the IRS finally issued safe harbor guidance for reverse exchanges in Revenue Procedure 2000-37. That imposed certain requirements to obtain safe harbor treatment for a reverse exchange that were similar to those imposed on a forward exchange. 

However this is merely a safe harbor and, as the IRS noted in the Revenue Procedure:

…[T]he Service recognizes that “parking” transactions can be accomplished outside of the safe harbor provided in this revenue procedure. Accordingly, no inference is intended with respect to the federal income tax treatment of “parking” transactions that do not satisfy the terms of the safe harbor provided in this revenue procedure, whether entered into prior to or after the effective date of this revenue procedure.

In the case of Estate of George H. Bartell Jr. et al. v. Commissioner, 147 TC No. 5 the Tax Court was asked to look at a reverse exchange case that would not have met the safe harbor tests in Revenue Procedure 2000-37 and which the IRS was arguing failed to qualify for §1031 deferral.

In this case the taxpayer had entered into an agreement to acquire property in Lynnwood in 2000, with title held by the facilitator under an agreement that would allow the taxpayer to manage construction on the property and lease the property once construction was finished in order to operate a drug store in the property.  The taxpayer intended from the outside to enter into a §1031 exchange transaction. Due to various developments, the sale of the relinquished property did not close until December of 2001, well outside the time frame allowed in the safe harbor under Revenue Procedure 2000-37 and the identical time periods for a forward exchange.  In the interim, construction had been completed and Bartell Drug had begun operating its drug store in the Lynnwood location.

The key question before the Court was whether the S corporation which reported the exchanges had actually been the true owner of the replacement property prior to the sale of the relinquished property.  If the corporation (Bartell Drug Co.) was actually the owner of the replacement property prior to sale of the relinquished property it would be exchanging property with itself—not a transaction that would qualify for §1031 gain deferral. 

The IRS argued that a “benefits and burdens” test, used often in many contexts under the IRC, should determine if Bartell Drug was the true owner of the property.  The IRS notes:

…Bartell Drug already owned the Lynnwood property at the time of the disputed exchange because Bartell Drug—not EPC Two—had all the benefits and burdens of ownership of the property; namely, the capacity to benefit from any appreciation in the property's value, the risk of loss from any diminution in its value, and the other burdens of ownership such as taxes and liabilities arising from the property. By contrast, respondent contends, EPC Two did not possess any of the benefits and burdens of ownership of the property; it had no equity interest in the property, it had made no economic outlay to acquire it, it was not at risk with respect to the property because all the financing was nonrecourse as to it, it paid no real estate taxes, and the construction of improvements on the property was financed and directed by Bartell Drug. Moreover, respondent contends, Bartell Drug had possession and control of the property during the entire period EPC Two held title, first by virtue of the REAECA provisions giving it control over the construction of site improvements and then possession through a lease that EPC Two was obligated under the REAECA to extend to it, for rent equal to the debt service on the KeyBank loan plus EPC Two's fee for holding title.

In fact, the position that Bartell was in would generally have met the “benefits and burdens” test in other contexts—but the taxpayer argued that the “benefits and burden” test is not relevant in the context of a reverse §1031 exchange.

Petitioners point out, however, that both this Court and the Court of Appeals for the Ninth Circuit, to which an appeal in this case would ordinarily lie, see sec. 7482(b), have expressly rejected the proposition that a person who takes title to the replacement property for the purpose of effecting a section 1031 exchange must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement. As the Court of Appeals for the Ninth Circuit pointed out in Alderson v. Commissioner, 317 F.2d at 795:

[O]ne 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 in exchange for other like property, all as a part of the same transaction with no resulting gain which is recognizable under Section 1002 of the Internal Revenue Code of 1954.

As the Court continues:

When the third-party exchange facilitator has been contractually excluded from beneficial ownership pursuant to the agreement under which he holds title to the replacement property for the taxpayer, that beneficial ownership necessarily resides with the taxpayer once title has been obtained from the seller of the replacement property. And yet the third-party exchange facilitator, rather than the taxpayer, has been treated as the owner of the replacement property at the time of the exchange in the cases cited above. Otherwise, a disqualifying self-exchange could be said to have occurred.

The opinion goes on to note that this is one of those rare cases in the IRC where form controls over substance—that is, in a traditional forward exchange there’s not any real economically substantial difference between the exchange with a facilitator and the sale of property by the taxpayer who then takes the proceeds and a few days later buys replacement property.  But the tax difference is significant, all because of the form of the transaction.

The Court goes on to note that the Courts have granted great latitude to taxpayers in having transactions qualify for like kind treatment. 

The IRS argued that the Tax Court had, in fact, endorsed the “benefits and burdens” test for reverse exchanges in the case of DeCleene v. Commissioner, 115 T.C. No. 34 when it found the transaction in question failed to qualify.  But the Tax Court distinguished that case, holding the facts there were unique:

Given the DeCleene Opinion's explicit and repeated emphasis upon the taxpayer's failure to use a third-party exchange facilitator, it must be said that DeCleene did not address the circumstances where a third-party exchange facilitator is used from the outset in a reverse exchange. Moreover, the taxpayer in DeCleene had acquired the purported replacement property outright, and held title to it directly without any title-holding intermediary, for more than a year before transferring title to WLC. This feature also distinguishes DeCleene from the myriad of cases where taxpayers seeking section 1031 treatment were careful to interpose a title-holding intermediary between themselves and outright ownership of the replacement property. In sum, DeCleene does not dictate a result for respondent here.

The Tax Court then goes on to note:

Alderson and Biggs establish 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.

The Court also rejected the IRS’s objection that those cases shouldn’t apply because they involved forward exchanges and this is a reverse exchange.  The Court pointed out that by the IRS’s own definition the transaction in Biggs was a reverse exchange, even if had features that lead some to refer to as a forward exchange case.  In any event, the Court noted that the specific question before the court (ownership of property) has application to forward exchanges, stating:

…[E]ven forward exchange cases, including Alderson and those that permit “great latitude” to taxpayers in structuring section 1031 transactions, Starker, 602 F.2d at 1353 n.10, analyze the relationship to the replacement property of the taxpayer versus the third-party exchange facilitator, and treat the latter as the owner before the exchange, typically notwithstanding the utterly “transitory”, Barker v. Commissioner, 74 T.C. at 565, and nominal nature of that ownership. In our view, this analysis of the relationship of the taxpayer to the replacement property, as compared to an exchange facilitator holding bare legal title, is equally applicable in a reverse exchange, as the holding in Biggs confirms. See also DeGroot v. Exchanged Titles (In re Exchanged Titles, Inc.), 159 B.R. 303 (Bankr. C.D. Cal. 1993) (“[T]he transfer of legal title is sufficient to effectuate a reverse I.R.C. § 1031 exchange involving an accommodator[.]”).

The Court found that the analysis applied even though the accommodator was obligated to and did lease the property to Bartell Drug and that the time span in question was significantly longer than the time periods in the cases cited above.

The Court notes:

Given the inapplicability of Rev. Proc. 2000-37, supra, to the transaction at issue, the caselaw provides no specific limit on the period in which a third-party exchange facilitator may hold title to the replacement property before the titles to the relinquished and replacement properties are transferred in a reverse exchange. We express no opinion with respect to the applicability of section 1031 to a reverse exchange transaction that extends beyond the period at issue in these cases. In view of the finite periods in which the exchange facilitator in these cases could have held, and in fact did hold, title to the replacement property, we are satisfied that the transaction qualifies for section 1031 treatment under existing caselaw principles.

Although the Court notes that it is limiting the application of this holding to the facts before it here, the Revenue Procedure in question is merely a safe harbor and, in its text, grants that structures other than those found in the safe harbor may qualify for deferral in a reverse exchange context.

Advisers still should likely advise taxpayers that, if at all possible, a reverse exchange should be structured to comply with the requirements of the Revenue Procedure to avoid any question regarding the status of the gain.  But if things don’t go quite as expected and the transaction no longer fits within the requirements for the safe harbor this case raises the possibility that a gain deferral may still be possible—but the taxpayer needs to be aware that the IRS may very well challenge that treatment.