Like-Kind Exchanges, Reverse Exchanges, and the Safe Harbor

Overview

Generally, an exchange of property for other property is treated as a sale with gain or loss being recognized on the transaction.  I.R.C. §§61(a)(3); 1001.  However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like-kind to be held either for productive use in a business or for investment.  I.R.C. §1031.  Federal and state income tax is not avoided, it is simply deferred until the replacement property is sold (except that gain is immediately recognized to the extent of any boot or unlike property received in the exchange). The rationale is that the replacement property is viewed as causing no material change in the taxpayer’s economic position.  It’s just a continuation of the original property. 

Like-kind exchanges are popular in agriculture for various reasons.  Those reasons can include the facilitation of an estate or business plan, Medicaid asset preservation planning, or simply for tax deferral reasons.  Sometimes an exchange is straightforward as a direct, two-party exchange.  Other times it is a “deferred” exchange or a “reverse” exchange.  When an exchange is other than a direct, two-party exchange, special rules must be followed.  Several years ago, the IRS established a “safe harbor” for such exchanges, but recently the U.S. Tax Court said that a transaction that wasn’t within the confines of the safe harbor still qualified for tax deferral.

The implications of the Tax Court decision on deferred or like-kind exchanges is our focus today. 

Like-Kind Exchange Details

With respect to the trade of tangible personal property, such as farm machinery, the Treasury Regulations determine if property is like-kind by reference to being within the same product class.  Also, property is of a like-kind to property that is of the same nature or character.  Like-kind property does not necessarily have to be of the same grade or quality.  In addition, for intangible assets, the determination of like-kind must be made on an asset-by-asset basis.  Thus, a like-kind trade can involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.

With respect to real estate, a much broader definition of like-kind applies.  Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment.  Even water rights, if they are not limited in duration, can be like-kind to a fee interest in land.  See, e.g., Priv. Ltr. Rul. 200404044 (Oct. 23, 2003).  Thus, agricultural real estate may be traded for residential real estate.  See also Treas. Reg. §1.1031(a)-(1)(c).  However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise.  Many farm depreciable buildings and structures are I.R.C. §1245 property.  For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate.  If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property.  IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in exchange. 

Deferred exchanges.  An exchange may qualify for the like-kind exchange treatment even if the replacement property is received after the relinquished property has been given up.  I.R.C. §1031(a)(3) and Treas. Reg. §1.1031(k)-1.  This is known as a deferred exchange, and a qualified intermediary (Q.I.) is to be used to facilitate the exchange.  The Q.I. is a party unrelated to the taxpayer that, pursuant to a written agreement with the taxpayer, holds the proceeds from the sale of the relinquished property in trust or an escrow account.  The Q.I. takes title to the property that is sold (the relinquished property) and receives the sales proceeds.  This is done to ensure that the taxpayer is not in constructive receipt of the sale proceeds.

After the relinquished property is transferred, replacement property must be identified within 45 days after the date of the transfer of the relinquished property, and the replacement property must be received before the earlier of 180 days or the due date of the income tax return, including extensions, for the tax year in which the relinquished property is transferred.  Treas. Reg. §1.1031(k)-1(b). 

Reverse exchanges.  With a reverse exchange, the taxpayer receives the replacement property before the transfer of the relinquished property.  Often, a reverse exchange is facilitated by a “parking” transaction or a “build-to-suit” transaction where the replacement property is “parked” with an exchange facilitator that holds title to the replacement property, usually until improvements to the property are completed.

Safe Harbor.  While the Code doesn’t address reverse exchanges and regulations haven’t been developed to provide guidance, the IRS did issue a safe harbor in 2000 for such transactions.  Rev. Proc. 2000-37, 2000-2, C.B. 308.  Under the safe harbor, the Q.I. must hold the property for the taxpayer’s benefit and be treated as the beneficial owner for federal tax purposes.  In addition, for the safe harbor to apply, the IRS said that the 45-day and 180-day requirements must be met.  The IRS made no comment on the tax treatment of “parking” transactions that don’t satisfy the safe harbor.  But, a major difference between the safe harbor and the Treasury Regulations governing deferred exchanges is that, under the safe harbor, the Q.I. must take title and beneficial ownership of the replacement property.  In a deferred exchange, the Q.I. only need “facilitate” the exchange.  That doesn’t require taking legal title.  Later, in 2004, the IRS tightened the safe harbor so that it didn’t apply to taxpayers who acquire replacement property that the taxpayer or a related party owned before the exchange.  Rev. Proc. 2004-51, 2004-2, C.B. 294. 

Clearly, with Rev. Proc. 2004-51, the IRS didn’t want taxpayers to use reverse exchanges to reinvest proceeds from the sale of one property into improvements to other real estate that the taxpayer had previously owned.  For example, assume that a farmer owns a tract of land that is not in close proximity to his primary farming operation and has become inconvenient to operate.  Thus, the farmer wants to sell the tract and use the proceeds to build a livestock facility on other land that he owns that is adjacent to his farming operation.  In an attempt to structure the transaction in a manner to qualify as a tax-deferred exchange, the farmer transfers title to the land where the livestock facility will be built to a Q.I.  The farmer provides the financing and the Q.I. has the livestock facility built.  The farmer then transfers the tract that he desires to dispose of to the Q.I. and the Q.I. sells it and uses the sale proceeds to retire the debt on the livestock facility.   Because the farmer owned the land on which the livestock facility was built before the exchange occurred, Rev. Proc. 2004-51 would operate to bar the transaction from tax-deferred treatment. 

2016 Case

In Estate of Bartell v. Comr., 147 T.C. No. 5 (2016), a taxpayer (a drugstore chain) sought a new drugstore while it was still operating an existing drugstore that it owned.  The taxpayer identified the location where the new store was to be built, and assigned its rights to the purchase contract in the property to a Q.I. in April of 2000.  The taxpayer then entered into a second agreement with the Q.I. that provided that the Q.I. would buy the property, with the taxpayer having the right to buy the property from the Q.I. for a stated period and price. The taxpayer, in June of 2001, leased the tract from the Q.I. until it disposed of the existing drugstore in September of 2001.  The taxpayer then used the proceeds of the existing drugstore to buy the new store from the intermediary, with the transaction closing in December of 2001.  Because the new store was acquired before the existing store was disposed of, it met the definition of a reverse exchange.  However, the safe harbor did not apply because the exchange was undertaken before the safe harbor became effective.  If the safe harbor had applied, the transaction would not have been within it because the Q.I. held title for much longer than 180 days.  Despite that, the IRS nixed the tax deferral of the exchange because it viewed the taxpayer as having, in substance, already acquired the replacement property.  In other words, it was the taxpayer rather than the Q.I. that held the burdens and benefits of ownership before the transfer which negated income tax deferral.  An exchange with oneself is not permissible.    As a result, eliminated was the deferral of about $2.8 million of gain realized on the transaction in 2001.

The Tax Court noted that existing caselaw did not require the Q.I. to acquire the benefits and burdens of ownership as long as the Q.I. took title to the replacement property before the exchange.  The Tax Court noted that it was important that the third-party facilitator was used from the outset.  While the safe harbor didn’t apply to the transaction, the Tax Court noted that 45 and 180-day periods begin to run on “the date on which the taxpayer transfers the property relinquished in the exchange,” and that the taxpayer satisfied them.  The Tax Court also noted that caselaw does not impose any specific time limits, and supported a taxpayer’s pre-exchange control and financing of the construction of improvements on the replacement property during the time a Q.I. holds title to it.  The taxpayer’s temporary possession of the replacement property via the lease, the court reasoned, should produce the same result.      

Conclusion

What impact does the court’s decision have on the safe harbor?  For starters, even though the safe harbor didn’t apply in the case, the court’s decision certainly illustrates that the safe harbor only applies with respect to reverse exchanges.  Another point is that because the facts of the case involved pre-2004 years, the Tax Court did not need to address Rev. Proc. 2004-51 and how the IRS tightened the screws on the safe harbor at that time.  That means that Estate of Bartell probably shouldn’t be relied too heavily upon and a reverse exchange transaction should be structured to come within the safe harbor, as modified by Rev. Proc. 2004-51.  But, the safe harbor is just that – a safe harbor.