The reverse exchange: is it a further liberalization of Sec. 1031 deferred exchanges of real estate?

• Author: Bengel, Ross

Recently issued regulations under Sec. 1031 represent a step forward in the safe structuring of deferred like-kind exchanges. The regulations are applicable to both real and personal property. However, the focus of this article is on deferred exchanges of real estate, the area where these regulations are likely to receive their most significant application.

The regulations are applicable to only one of the two types of deferred exchanges--the one in which the taxpayer acquires the replacement property after the transfer of the taxpayer's own property (relinquished property). By definition, they do not cover deferred exchanges in which the taxpayer acquires the replacement property before the transfer of the relinquished property.(1) These latter exchanges represent a significant number of deferred real estate transactions. In fact, many legal and real estate professionals advertise to serve as intermediaries in "reverse exchanges" or "reverse Starkers," despite knowing that their legal validity is unsettled.

Evolution of the Deferred Exchange

The nontaxable exchange provisions of Sec. 1031 represent a well-established planning technique for deferral of taxable gains on real estate. Under Sec. 1031, gains can be deferred when the taxpayer's property is exchanged for other property in a transaction that meets three basic requirements.

1. The reliquished and replacement properties must be held for productive use in trade or business or for investment.

2. The properties exchanged must be like kind.(2)

3. There must be a legitimate exchange of properties, as opposed to a sale and a separate unrelated purchase.(3)

   Over the past 30 years, the courts have permitted increasingly greater latitude in meeting the third requirement. This period has seen like-kind real estate exchanges evolve from strictly two-party simultaneous transactions to include complex exchanges involving multiple parties and multiple properties packaged in a series of transactions that close at different times.

   Legal precedent for deferred exchanges was first established in the Ninth Circuit case of Starker.(4) In Starker, the court recognized that the transactions involving the relinquished and the replacement properties could close at different times. Despite this legal recognition that a deferred exchange was an acceptable tax deferral technique, uncertainty followed the Starker decision on the form, structure and timing of these exchanges.

   The Starker decision was codified by the Deficit Reduction Act of 1984 (DRA), which also resolved some of the timing questions left by the case.(5) The DRA required that the potential replacement properties be identified within 45 days and that the exchange be completed within 180 days after the transfer of the relinquished property.(6) By enacting these rules, the DRA limited statutory authorization of deferred exchanges to those in which the taxpayer transfers property and subsequently receives replacement property. This type of exchange is commonly known as a Starker exchange. The DRA did not specifically address the status of reverse exchanges.

   The regulations answer many questions about the form and structure of Starker exchanges but continue to be silent on reverse exchanges. There remains today no clear, direct congressional, administrative or judicial support for deferred reverse exchanges. There is also nothing to prohibit them.

   This lack of guidance has resulted in contrary views among tax professionals regarding the legal validity of reverse exchanges. Some practitioners argue that a reverse exchange can never qualify a like kind under Sec. 1031. They conclude that the purchase of replacement property and the subsequent sale of the taxpayer's own property are two distinct transactions, each having its own separate tax consequence. They interpret the definition of deferred exchanges in the DRA as an attempt by Congress to exclude the reverse exchange and further argue that the IRS had the opportunity to approve of such exchanges in the regulations, but declined. The IRS position is that "the deferred exchange rules of section 1031(a)(3) do not apply to reverse-Starker transactions. Therefore, the final regulations . . . do not apply to reverse-Starker transactions. However, the Service will continue to study the applicability of the general rule of section 1031(a)(1) to these transactions."(7)

   Other practitioners believe that a reverse exchange is valid like-kind exchange. However, among these practitioners there are two arguments as to why these exchanges are viable. One view holds that the basic validity of reverse exchanges flows from the principle of the Starker holding--that title to the relinquished property can pass to the buyer at a different time than title to the replacement property passes to the seller. Proponents of this view argue that even though the order of the transactions in Starker is different, there is no language in the case that excludes application of the holding to a properly structured reverse exchange. They further contend that providing administrative or judicial sanctioning of reverse exchanges is consistent with the general attitude of the courts that "[t]axpayers have been allowed wide latitude in structuring . . . [these] transactions."(8)

   The authors concur with this view and also believe that the reasoning of cases involving simultaneous and Starker-type deferred exchanges provide a model for determining when an exchange, including a reverse exchange, is a valid like-kind exchange. There is, however, a second view of reverse exchanges that holds they are not deferred but, rather, are simultaneous exchanges. This article will discuss both practitioner viewpoints.

   Types of Reverse Exchanges

   A reverse exchange occurs when the taxpayer intends to make a like-kind exchange but, for some reason, acquires the replacement property before selling the relinquished property. The taxpayer may fear that replacement property vital to his business will be sold to another party. Perhaps the reverse exchange is the result of the buyer backing out of a previously arranged simultaneous exchange or the seller forcing a premature closing on the replacement property. In any event, the taxpayer completes the replacement leg of the exchange first. This is accomplished by using the buyer of the relinquished property or an outside party, known as an accommodator or intermediary, to purchase and hold title to the replacement property. At a later date in a separate transaction, the relinquished property is transferred to the buyer and the taxpayer receives the replacement property.

   The taxpayer typically provides a loan to the accommodator to fund the down payment on the replacement property. The property is usually financed with an assumable mortgage. When the taxpayer receives the replacement property, he assumes the mortgage.

   There are three types of reverse exchanges:

   * Type 1: "Reverse regs." exchange.

   * Type 2: "Biggs"(9) reverse exchange.

   * Type 3: "Simple" reverse exchange.

   The first two types rely on an accommodator or intermediary who is hired to complete the exchange. The first transaction under these two approaches is the same. It is the separation in time between the first and second transaction that creates the deferred exchange.

   The transactions for the "reverse regs." exchange (Type 1) are:

   * First transaction: The accommodator acquires the replacement property from the seller. The accommodator holds title to the replacement property while the taxpayer seeks a buyer for his relinquished property.

   * Second transaction: At a later...