Section 1031 of the Internal Revenue Service (IRS) code is one of the last remaining tax shelters. A taxpayer can avoid recognizing capital gain on the sale of qualified relinquished property by reinvesting in like-kind property within the limitations of the code. Since 1921, tax-deferred exchanges have evolved from restrictive, two-party swaps of properties to strategic, sophisticated exchanges.

In 1991, when the final regulations on deferred exchanges were issued, the Treasury specifically stated that the regulations did not apply to a reverse exchange situation where a taxpayer acquired replacement property before selling relinquished property. In the preamble to these regulations, Treasury stated that it would continue to analyze reverse exchanges in a 1031 setting. During the following decade, deferred exchanges, where the taxpayer enters into an exchange agreement, sells relinquished property through a qualified intermediary and acquires replacement property within 180 days, have become routine. These exchanges are generally referred to as "straight" or "standard" deferred exchanges, and are the most common type of 1031 transactions.

Finally, in September 2000, the IRS published the long awaited guidelines for reverse exchanges as "Revenue Procedure 2000-37" (Rev. Proc. 2000-37). Even before 2000, many taxpayers found themselves in situations where the replacement property was available before the relinquished property was sold. And, unless the taxpayer could extend the contract to purchase this replacement property after the relinquished property was sold, the taxpayer had to structure a reverse exchange using a "parking intermediary" or close the transaction without taking advantage of 1031 benefits. Most exchange companies offered to acquire and hold or "park" the replacement property until the taxpayer sold the relinquished property. At the closing of the relinquished property, the exchange company would swap or simultaneously exchange the relinquished property for the replacement property.

Because the 1991 regulations specifically did not address reverse exchanges, there was no certainty that these parking structures would qualify for favorable 1031 treatment. The 45-day identification period and the 180-day acquisition period for straight deferred exchanges did not apply to reverse exchanges. In the absence of published guidelines for required or permitted holding periods, many parking intermediaries did not feel compelled to follow the 45-day and 180-day periods. There were also no guidelines on criteria necessary to establish that the parking intermediary was the true or "beneficial owner" of the parked property and not the taxpayer's agent. In the absence of formal guidelines on these two critical issues (holding periods and ownership determinations), many taxpayers followed a conservative approach and simply avoided structuring reverse exchanges.

Rev. Proc. 2000-37 provides a safe harbor for completing reverse 1031 exchanges. Under the Rev. Proc., a parking intermediary (known as an Exchange Accommodation Titleholder or "EAT" under the Rev. Proc.) can hold either the new replacement property or the taxpayer's relinquished property for up to 180 days. At that time, the "parked" property must either be transferred to the taxpayer (if the replacement property is parked) or to a third-party buyer (if the relinquished property is parked) if the transaction is to qualify for 1031 treatment. Rev. Proc. 2000-37 provides a safe harbor where the IRS will not challenge either the qualification of the property as a replacement property or a relinquished property as defined and used within Treasury Regulation Section 1.1031(k). Nor will the IRS challenge that the "parking intermediary" (Exchange Accommodation Titleholder) is the beneficial owner of the property.

In order to receive safe harbor treatment, a reverse exchange must satisfy all formal requirements of the Revenue Procedure. The five formal requirements under Rev. Proc. 2000-37 are summarized as follows.

1. "Qualified Indicia of Ownership" of the relinquished property or the replacement property must be held by an Exchange Accommodation Titleholder (EAT), who is not the taxpayer or a disqualified person, as defined under Treasury Regulation 1.1031(k), and who is subject to federal income tax. Although the most common examples of "qualified indicia of ownership" are either a deed or a lease, the Rev. Proc. does not specifically define "qualified indicia of ownership."

2. The taxpayer must have a bona fide intent to do a reverse 1031 exchange. This intent must be evident at the time that the qualified indicia of ownership -- of either the replacement or the relinquished property -- is transferred to the Exchange Accommodation Titleholder.

3. Within five (5) days after qualified indicia of ownership on the replacement or the relinquished property transfers to the Exchange Accommodation Titleholder, the taxpayer and Exchange Accommodation Titleholder must enter into a written Qualified Exchange Accommodation Agreement (QEAA)

4. If the Exchange Accommodation Titleholder acquires qualified indicia of ownership of the replacement property, then within 45 days thereafter, the taxpayer must identify the relinquished property. The same rules of identification for straight deferred exchanges apply.

5. Within 180 days after the Exchange Accommodation Titleholder acquires qualified indicia of ownership, the replacement property must be transferred to the taxpayer or the relinquished property must be transferred to a third-party buyer.

In addition to these five formal requirements, the written QEAA may contain, but is not required to include, additional terms and provisions that would permit the taxpayer to lease, guarantee financing and other obligations, manage, and contract to sell or purchase the property. These additional provisions permit a taxpayer to structure a reverse exchange within realistic business parameters that accommodate third-party financing and the taxpayer's use of the parked property.

Most reverse exchanges that are structured to meet the safe harbor requirements are set up with the taxpayer entering into a written QEAA, loaning acquisition funds to the Exchange Accommodation Titleholder to acquire the property, entering into a triple net lease, marketing and selling the relinquished property to a third-party buyer within 180 days and satisfying the "acquisition" loan to the Exchange Accommodation Titleholder with the proceeds from the sale of the relinquished property.

Just as the revenue service reserved ruling on reverse exchanges in the initial 1991 regulations, Rev. Proc. 2000-37 specifically recognizes and states that many reverse exchanges will fail to meet the formal requirements, and will thus fall outside the safe harbor. The Rev. Proc. states the IRS recognizes that both pre- and post-2000-37 parking arrangements can be structured outside the safe harbor, and that no inference is intended with respect to the federal income tax treatment of "parking" transactions that do not satisfy the safe harbor. This "non-inference" language simply means that, in an audit or review situation, the IRS will not assume or infer the transaction fails to qualify for 1031 treatment if the reverse exchange is a non-safe harbor structure.

If a parking arrangement does not fall within the safe harbor, it is clear that the parking intermediary must be able to provide evidence that it has the burdens and benefits of ownership of the parked property. These burdens and benefits will not be assumed, as they are under safe harbor treatment. Therefore, a non-safe harbor parking intermediary must necessarily incur risks of ownership in the parked property. The parking intermediary cannot be deemed to be the agent of the taxpayer. In order to avoid being treated as the taxpayer's agent, a parking intermediary must evidence a true equity risk. Most non-safe harbor reverse exchanges are significantly more expensive than straight deferred exchanges or safe harbor reverse exchanges. A transaction that is initially structured as a safe harbor reverse exchange, which must be completed within 180 days, cannot be converted mid-stream into a non-safe harbor transaction. Most safe harbor QEAA would not satisfy the benefits and burdens test for a non-safe harbor parking intermediary.

The transaction costs incurred in a reverse exchange are significantly greater than the transaction costs in a straight deferred exchange. Unlike straight deferred exchanges, the Exchange Accommodation Titleholder must actually enter into the chain of title on either the replacement or the relinquished property. The Exchange Accommodation Titleholder will always incur potential environmental risks. Most Exchange Accommodation Titleholders require that any third-party lender financing for acquisition of the replacement property be non-recourse and fully assumable, without penalty, to the taxpayer. Many non-savvy commercial lenders do not understand an Exchange Accommodation Titleholder's limited role in a reverse exchange and are unable or unwilling to structure loan documents to accommodate both the taxpayer's and the Exchange Accommodation Titleholder's interests.

Many reverse exchange transactions will also result in dual conveyance taxes, the first when the Exchange Accommodation Titleholder takes title, and the second when the Exchange Accommodation Titleholder transfers title, to the third-party buyer in the case of relinquished property or to the taxpayer in the case of replacement property. In some states, dual conveyance taxes can be avoided under statutory exemptions or by forming a single member limited liability company, with the Exchange Accommodation Titleholder as the sole member. When it is time to transfer title, the Exchange Accommodation Titleholder simply withdraws as the member and the taxpayer is substituted. Many states, however, have a controlling interest transfer tax, which is equivalent to the conveyance tax.

Whether structured as a safe harbor or non-safe harbor, reverse exchanges should be considered as an alternative method of exchanging to be used only if it is not possible to structure a simultaneous or straight deferred exchange. Reverse exchanges are far more complex, with more requirements and greater costs. Reverse exchanges require careful planning. Although significant tax benefits are the goal of a successful 1031 transaction, a taxpayer should always consult a tax advisor to determine if a tax-deferred exchange is appropriate and compatible with overall investment goals. First and foremost, structuring a sale as a 1031 straight deferred, reverse safe harbor or reverse non-safe harbor exchange is a business decision.

Linda J. Rehak serves as underwriting counsel for LandAmerica Exchange Company.

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