Last year on the blog, we reported a Tax Court decision approving “reverse” 1031 Exchanges in which a taxpayer acquires replacement property more than 180 days before disposing of relinquished property.
The IRS recently announced it will not follow the Tax Court decision, and may seek future challenges in other courts to overturn it. This limits the Tax Court decision’s impact until the courts establish more precedent.
The IRS announcement should not, however, deter all taxpayers needing more than 180 days to dispose of relinquished property from attempting 1031 Exchanges. In any reverse 1031 Exchange transaction, a person unrelated to the taxpayer must hold the replacement property or relinquished property until the ultimate buyer acquires the relinquished property. The Tax Court decision and IRS announcement only affect transactions in which an agent or straw man holds the replacement or relinquished property for the taxpayer in the interim period, without bearing risks normally associated with property ownership. Sometimes a taxpayer can find an unrelated person willing to bear some of the benefits and burdens of ownership for the property, differentiating the arrangement from an agent or straw-man structure. This opens the door to a taxpayer taking the position a longer holding period may exist, even if financing or other arrangements remain in place between the interim titleholder and the taxpayer.
The IRS announcement can be read at irs.gov.
E. John Wagner, II
A 1031 Exchange is a popular capital gains deferral strategy for business and investment property. Taxpayers use the strategy to defer capital gains tax on property “sold” by acquiring “like kind” replacement property, usually in coordination with an intermediary or accommodation party.
After deliberating for a decade, the U.S. Tax Court has held that an accommodation party with no benefits or burdens of ownership can hold title to real property outside the established IRS “reverse” 1031 Exchange safe harbor without disqualifying the taxpayer’s 1031 Exchange. The case arose from transactions spanning from 1999 to early 2001, before the IRS issued its safe harbor ruling for such transactions. The accommodation party held the potential 1031 Exchange replacement property for over one year (longer than the 180-day period allowed by the IRS safe harbor) before transferring it to the taxpayer, following the taxpayer’s sale of its intended relinquished property. During this period, the taxpayer funded all costs (including acquisition and construction costs) associated with the property, and entered into arrangements that constructively prevented the titleholder from realizing the benefits of owning the property.
The “owner” of property for federal income tax purposes usually is the party with the “benefits and burdens” of ownership, not legal title. Application of that standard would have disqualified the 1031 Exchange by treating the taxpayer as owning the replacement property before acquiring the relinquished property. But the Tax Court found that different rules apply in the 1031 Exchange context, such that the arrangement was acceptable to treat the temporary accommodation titleholder as the income tax owner until the taxpayer completed its 1031 Exchange.
The Tax Court’s reasoning relied heavily on a decision of the U.S. Court of Appeals for the Ninth Circuit, the appellate court with jurisdiction over California and other western states. While the Tax Court also relied on other precedent, there remains a risk cases in other geographic areas could have different outcomes. The case is nevertheless significant, bolstering the substantial flexibility taxpayers enjoy in structuring 1031 Exchanges.
Here is a link to the Tax Court opinion in Estate of Bartell v. Commissioner: http://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=10868.