United States

IRS takes stricter view than Tax Court on reverse like kind exchanges

IRS explains why it disagrees with Tax Court

TAX ALERT  | 

The IRS has issued guidelines creating a safe-harbor to allow certain “reverse” like kind exchanges to be effected on a tax-free basis, even though the relinquished property is given up after the benefits and burdens of ownership of the replacement property are acquired. Even where the strict guidelines for such “reverse” exchanges are not followed, the Tax Court may nevertheless allow tax-free treatment. However, the IRS is trying to hold the line and insist that its own safe-harbor standards must be followed. Taxpayers that want to avoid controversy in a potential IRS examination should follow the IRS procedures, even if they are stricter than the rules that might apply if they went to Tax Court to contest a proposed deficiency.

In an Action on Decision issued Aug. 14, 2017, the IRS indicated it would not acquiesce in the holding of Estate of George H. Bartell Jr., et al. v. Commissioner, 147 T.C. 140 (2016). The IRS issued its memo explaining the nonacquiescence on Thursday, Aug. 24.

In Bartell, the taxpayer sought like-kind exchange treatment under IRC §1031 for a sale and acquisition of business property involving a third-party exchange facilitator (EF) who acquired the replacement property 17 months prior to the exchange date.[1] That is a longer period of time than is permitted by IRS safe-harbor procedures. The IRS accordingly argued that general tax principles should apply to examine whether the taxpayer had acquired the benefits and burdens of ownership of the property held by the EF before the purported exchange of the taxpayer’s “relinquished” property for the property being held by the EF. Under those standards, the IRS argued, the transaction should not be viewed as an exchange of one property for another, since the taxpayer effectively acquired tax ownership of the “new” property held by the EF, and then independently disposed of the “old” property. The IRS’s position relied on a benefits and burden analysis under Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981).

The Tax Court disagreed. The Tax Court quoted its own opinion in the earlier case of Barker v. Commissioner, 74 T.C. 555, 561 & 565 (1980), stating:

“In a sense, the substance of a transaction in which the taxpayer sells property and immediately reinvests the proceeds in like-kind property is not much different from the substance of a transaction in which two parcels are exchanged without cash. . . . [T]he conceptual distinction between an exchange qualifying for section 1031 on the one hand and a sale and reinvestment on the other is largely one of form.”

The Tax Court found for the taxpayer, holding that in situations where a third-party EF takes title to the replacement property before the exchange, the third-party may be treated as the replacement property’s owner for section 1031 purposes regardless of where the benefits and burdens of ownership lie prior to the exchange.

Despite the taxpayer’s victory in that case, the IRS will continue to litigate the issue. The IRS explained its position in a memo discussing its “nonacquiescence” to Bartell. As a legal matter, the IRS explained, the Tax Court improperly relied on case law decided before the issuance of Treas. Reg. § 1.1031(k)-1 (the deferred exchange regulations). Although those regulations do not expressly address “reverse” exchanges, they do impose time limits for “deferred exchanges” that the IRS later insisted be followed in reverse exchanges under its “safe-harbor” procedures. Apparently the IRS concluded that the Tax Court did not give sufficient deference to those time limits.

The IRS explained in its memo that Bartell was a reverse exchange, in which the replacement property was “parked” with an exchange accommodation titleholder (EAT) before the transfer of the relinquished property, and therefore could have been allowed if it had complied with the safe harbor rules established in Rev. Proc. 2000-37, 2000-2 C.B. 308, modified by Rev. Proc. 2004-51, 2004-2 C.B. 294. However, section 3.04 of Rev. Proc. 2000-37 provides that if the requirements of the revenue procedure are not met, the determination of who owns the property at the time of the purported exchange will not take the revenue procedure into account. The IRS view, in such a case, is that there is no “exchange” if the benefits and burdens of ownership have already been transferred to the taxpayer before the purported exchange. In that event, the purported acquisition of the “new” property from the EAT is merely a change in legal title, not a change in tax ownership, and thus cannot be part of an “exchange” in which other property is relinquished “in exchange” for the property, title to which is transferred by the EAT.

Because of its view that the Bartell holding improperly rested on case law that was decided prior to the issue of the deferred exchange regulations and Rev. Proc. 2000-37, the IRS will not follow case law that allows an EF to be treated as the owner of property, without regard to whether the EF, or the taxpayer, truly holds the benefits and burdens of ownership before the purported exchange. That is, the IRS will inquire as to whether the EF is effectively a mere nominee or accommodation party. The IRS further stated that a taxpayer that uses an accommodation party without relying on Rev. Proc. 2000-37 should not be treated as having engaged in an exchange if the taxpayer, rather than the accommodating party, acquires the benefits and burdens of ownership of the replacement property before the taxpayer transfers the relinquished property.

The IRS’s refusal to follow Bartell underscores the importance of form in like-kind exchange transactions. The IRS appears more likely to scrutinize reverse exchanges, making it crucial that reverse exchanges be structured to clearly qualify for the safe harbor provisions of Rev. Proc. 2000-37. It is strongly recommended that one consult a tax professional to navigate the rules of like-kind exchanges.

[1] Unless otherwise indicated by the context, references herein to “section” are to provisions of the Internal Revenue Code of 1986 (“Code”), and references applicable Treasury Regulations.

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