Safe Harbor for Reverse Exchanges of Real Property

• Publication year: 2001
• Pages: 75
• Citation: Vol. 30 No. 1 Pg. 75

30 Colo.Law. 1 Colorado Lawyer 2001.

2001, February, Pg. 75. Safe Harbor for Reverse Exchanges of Real Property

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75

Vol. 30, No. 1, Pg. 1

The Colorado Lawyer
February 2001
Vol. 30, No. 2 [Page 75]

Specialty Law Columns
Real Estate Law Newsletter
Safe Harbor for Reverse Exchanges of Real Property
by Sander Slatkin

The rising value of real estate in Colorado has resulted in an increased interest in methods of deferring capital gains taxes on the transfer of real properties that have increased substantially in value above their low tax bases. This interest also has been fueled by a healthy economy and new expanding businesses looking for a location to accommodate such expansion. Section 1031(a)(1) of the Internal Revenue Code of 1986, as amended ("Code"), provides a method for deferring capital gains taxes on exchanges of real properties held for productive use in a trade or business or for investment for like-kind real properties to be held for the same purposes.1 This article discusses deferred like-kind exchanges where the taxpayer arranges for the purchase of replacement property prior to the sale of property presently owned

Background

Taxpayers often wish to defer payment of a capital gains tax when they have an opportunity to sell their real property at an attractive price, but may not able to locate a like-kind, replacement property immediately. Legislatively enacting the holding of the Ninth Circuit Court of Appeals in Starker v. United States,2 Congress has provided taxpayers a method of selling property on one day and acquiring a replacement property on a subsequent day, qualifying for tax-deferred, like-kind exchange status under Code § 1031. Such deferred exchanges, embodied specifically in Code § 1031(a)(3), often are referred to as "Starker exchanges."

For a deferred exchange to qualify as a statutory Starker exchange, (1) any proceeds allocated to the selling taxpayer from the sale of property ("relinquished property") must be deposited with a qualified intermediary who bears no relationship to the taxpayer; (2) the selling taxpayer must identify the exchange property to be acquired ("replacement property") within forty-five days of the transfer of the relinquished property; and (3) the taxpayer must acquire an identified replacement property prior to the earlier of (a) 180 days from the date of transfer of the relinquished property or (b) the due date (determined with regard to extensions) for the taxpayer's federal income tax return for the year the relinquished property is transferred.3

Alternatively, taxpayers often find suitable replacement property to acquire before they are able to sell their presently owned property. In structuring the purchase of replacement property to fall within the context of a like-kind, Starker exchange, such a taxpayer might: (1) seek an extension of the closing of the replacement property until after transfer of the relinquished property; (2) acquire an option to purchase the replacement property so the option is exercised at a time after the taxpayer has transferred the relinquished property; or (3) negotiate a lease option for the replacement property, thereby permitting the taxpayer to have current use of the replacement property and providing the taxpayer with an option to purchase that property following the taxpayer's transfer of the relinquished property.4

However, in a sellers' real estate market, as currently being experienced in Colorado, structuring a like-kind, Starker exchange (in the event the taxpayer has located a suitable replacement property prior to transferring the relinquished property) may be difficult. Sellers may be unwilling to wait for the sale of their properties or to accommodate a buyer's desire for a like- kind exchange.

Because of this difficulty, parties have resorted to what has been termed a "reverse-Starker exchange." A reverse-Starker, like-kind exchange takes place when a taxpayer's acquisition of a replacement property occurs prior to the closing on the sale and transfer of the relinquished property. In publishing regulations governing the proper structuring of statutory Starker exchanges, the Internal Revenue Service ("Service") specifically provided in its preamble that those Treasury Regulations do not apply to reverse-Starker exchanges.5 Consequently, in the absence of controlling Treasury Regulations or guidance with regard to reverse exchanges, such reverse exchanges have been open to attack from the Service.

Apparently because of this lack of guidance, some practitioners have become reluctant to structure reverse-Starker exchanges. For example, in DeCleene v. Commissioner,6 a recent decision of the Tax Court, the Court disqualified a transaction structured as a like-kind exchange. In that case, the petitioner-taxpayers owned a repair business located on commercial property they also owned. The petitioners were looking for land on which to move their business and subsequently purchased unimproved real property.

After the petitioners acquired the real property, a third party expressed interest in the petitioners' commercial property. The petitioners' accountant suggested the petitioners structure a like-kind exchange in which the petitioners would quitclaim the unimproved property to the third party. In exchange for the commercial property, the third party would convey back to the petitioners the unimproved property with a new structure built to the petitioners' specifications.

The Service determined that the subject transaction did not qualify for like-kind treatment under Code § 1031(a)(1), and the Tax Court upheld the Service's decision. The Court held that the subject transactions resulted in a taxable sale of the commercial property to the third party because the third party never acquired beneficial ownership of the unimproved, "replacement" property.7

In a recent Technical Advice Memorandum ("Tech. Adv. Mem."),8 the Service addressed a deferred, like-kind exchange. The taxpayer in that Tech. Adv. Mem. intended to exchange his relinquished property for an accommodator's replacement property. The taxpayer's plan was to assign a contract of sale of his relinquished property to an accommodator who would sell the relinquished property and use the proceeds to acquire replacement property. The taxpayer would then have the accommodator transfer the replacement property to the taxpayer to complete the exchange.

The attempted sale of the relinquished property did not close as planned. Nevertheless, the seller of the replacement property demanded that closing on the...