Recent Rulings Provide Guidance for Improvement Exchanges on Exchanger-Owned Land

Written by admin on May 10th, 2011

HISTORICALLY, Americans have never had a great affection for being taxed. The great author and political commentator Mark Twain, once stated that the difference between a tax collector and a taxidermist is that a taxidermist only takes your skin. Thus, it usually sparks great interest whenever the Internal Revenue Service may appear willing to allow a new avenue to avoid paying capital gain taxes.

Recently, the IRS issued two Private Letter Rulings that permitted  “exchangers” to complete an IRC § 1031 tax-deferred exchange where the replacement property consisted of improvements made to real property that the taxpayer or an affiliate owned prior to starting the exchange. These rulings provide useful guidance to tax and legal advisors, as they are a clear departure from previous rulings wherein the IRS disallowed these structures.

Before discussing these new rulings, however, some background is in order on  § 1031 exchanges in general, so-called “parking arrangements,” and the concept of “related parties.’

A properly structured tax-deferred exchange under § 1031 of the Internal Revenue Code of 1986, as amended (IRC), allows an owner of real property, the “exchanger,” to defer the recognition of capital gain taxes normally recognized upon the sale of real property. In order to complete a fully tax-deferred exchange, an exchanger must:

• acquire a property that is equal or greater in value to that of the relinquished property;

• reinvest all of the net proceeds from the sale of the relinquished property in the replacement property;

• obtain financing on the replacement property that is equal to or greater than the financing that was paid off on the relinquished property; and

• receive nothing except “like-kind” property.

A valid partially deferred exchange can be structured even if an exchanger does not fully comply with one of these rules, such as purchasing a replacement property for 0,000 less than the relinquished property was sold for, as the exchanger will only be taxed on the difference.

Since the value of the replacement property is the acquisition price, an exchanger wishing to include the value of improvements made to the replacement property in its total value (paid with exchange funds) must structure the exchange as a “parking arrangement,” discussed below. A parking arrangement in this situation allows an exchanger to have a separate entity acquire the replacement property, and to then have real property improvements made to that property using exchange funds.

The exchanger obtains a greater level of deferral since the replacement property has now been improved. Again, though, even if the improved replacement property falls short of being equal to or greater in value to the relinquished property, the exchanger can still obtain the benefit of a partial tax-deferred exchange for the value of the replacement property at the time it is transferred in completion of the exchange.

In order to qualify for exchange treatment, both the relinquished and replacement properties must be of “like-kind.” Like-kind property is defined as property held for productive use in a trade or business, or for investment purposes, that is exchanged for property that is also held for productive use in a trade or business, or for investment purposes. IRC § 1031 (a)(1). Like- kind refers to the nature or character of the property, and “[t]he fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.” Treas. Reg. § 1.1031 (a) 1(b). Any property conforming to this definition will be considered like-kind.

Parking Arrangements

While most exchanges are structured as “forward” or “delayed” exchanges, where the relinquished property is sold and the replacement property is then acquired within 180 calendar days, parking arrangements are structured much differently. A parking arrangement is necessary (a) when an exchanger wishes to acquire the replacement property before selling the relinquished property, (b) the exchanger needs to make improvements on the replacement property before taking title to it; or (c) a combination of these two exchanges, where the exchanger acquires and improves the replacement property prior to selling the relinquished property. These are the reverse, improvement, and reverse- improvement exchanges, respectively.

Whereas in a delayed exchange, title to the relinquished and replacement properties passes between the exchanger and the buyer and seller, respectively, in a parking arrangement, an entity known as an Exchange Accommodation Titleholder (EAT) takes title to the “parked property.” The need for the EAT to hold title to either the relinquished or replacement property is driven by the fact that an exchanger may not own both the relinquished and replacement properties at the same time. Thus, one of the properties must be “parked.’

It is only within the last few years that there has been reliable guidance on the structure of a parking arrangement. On Sept. 15, 2000, the IRS released Rev. Proc. 2000-37, which provided a safe harbor for structuring parking arrangements. In order to fall within the safe harbor provisions the exchanger must, among other things, have an EAT hold title to the parked property; identify the relinquished property within 45 days of the acquisition of the replacement property by the EAT; and complete the exchange within 180 days.

The IRS also stated that a parking arrangement did not necessarily have to comply with Rev. Proc. 2000-37 in order to be valid. A parking arrangement structured as a “non-safe harbor” parking arrangement allows a taxpayer to go beyond the 180-day date necessary to complete a safe harbor exchange. Although this can provide some exchangers with much-needed flexibility, it also comes at the price of being considerably more risky, since there is little guidance from the IRS in this area. Accordingly, most parking arrangement exchanges are structured as safe harbor exchanges.

Improvement Exchanges

In a “normal” improvement exchange, an exchanger disposes of the relinquished property; the EAT purchases replacement property from a third- party seller utilizing a portion of the exchange funds; and thereafter, the EAT uses the remaining exchange funds to improve the property. The exchanger gets the dual benefit of having the replacement property improved to its specifications while obtaining a greater tax deferral than if it had acquired the replacement property at a lower value and performed construction after taking title.

In the past, the IRS issued rulings that were not in favor of taxpayers making improvements to property they already owned, sometimes due to the “related party” rules (see below). The IRS has not, and still does not, look favorably upon acquisitions of replacement property from a related party. See Private Letter Ruling 9748006, wherein the IRS disallowed a tax deferral to an exchanger who purchased his mother’s property. The agency’s chief concern appears to stem from the facts that it looks at the exchanger and the related party as a single economic unit, that exchange funds will be paid from a related party to acquire the replacement property, and that thereafter the related party has the potential to return the money to the exchanger. Although the exchanger is now on title, the transaction allows the related party the continued benefit of the property, through the related exchanger, while having received the money in what amounts to a tax-free exchange.

A “related party” is any person bearing a relationship to the exchanger as defined in IRC § 267(b) or § 707(b). Some examples of related parties are family members, two corporations of the same control group, or a corporation or partnership in which the exchanger owns a 50 percent or more interest. Accordingly, the ultimate related party is the exchanger itself. So, for example, if the exchanger owned a 50 percent or more interest in an entity that owned the replacement property, the IRS would consider it a related party transaction, and possible disallow it. In addition, the exchanger’s federal tax return for the tax year in which the exchange was completed must include Form 8824, which asks the exchanger if there were any related parties to the exchange.

The New Rulings

On Sept. 11, 2002, and April 7, 2003, the IRS released Private Letter Rulings 2003329021 and 200251008, respectively which, although not identical, set forth the following general structure for an improvement exchange on exchanger-owned land:

1. The exchanger will enter into a Qualified Exchange Accommodation Agreement  (QEAA) with the EAT, and will enter into an exchange agreement with a Qualified Intermediary (QI).

2. The exchanger will lease the replacement property to Titleholder, a disregarded entity wholly owned by EAT, at a fair market rental, for 32 years, as part of a QEAA as defined in Rev. Proc. 2000-37.

3. Exchanger (or a third-party bank where the exchanger gives its personal guaranty) will lend Titleholder the funds necessary to construct the improvements on the leased property.

4. Exchanger will assign its rights to the sale agreement to the relinquished property to the QI.

5. Exchanger will transfer title to the relinquished property through the QI, and the QI will receive the sale proceeds.

6. Exchanger will assign its position in the QEAA to the QI.

7. QI will use proceeds from the sale of the relinquished property to pay EAT for its interest in Titleholder (which holds all of the replacement property, consisting of leased property and newly constructed improvements to suit the exchanger’s

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