Financial Resource

requirements).

8. EAT will use the proceeds received from QI to pay Construction Manager and to pay the construction loan in full; QI will direct EAT to transfer its interest in Titleholder directly to exchanger.

One of the key elements to this structure is the long-term lease of the replacement property to the Titleholder. Treas. Reg. § 1.1031(a)-1(c)(2) provides that a fee interest in land is of like-kind to a leasehold of land if said leasehold has a remaining term of 30 years or more, including renewal options as yet unexercised. Accordingly, when the Titleholder leases the land for this period of time, and thereafter adds value to the property through these tenant improvements, the subsequent transfer of the interest in the Titleholder to the exchanger as replacement property, which now includes the value of the improvements, causes the exchanger to receive like-kind property in compliance with IRC § 1031 (a)(1).

Structuring a real estate transaction as a parking arrangement, however, of which an improvement exchange is one example, creates certain land title issues that should be addressed by a title insurance company. Additionally, a parking arrangement starts out with an acquisition of either the relinquished or replacement property by the EAT, which later transfers title to the property, or the ownership interest in the EAT entity, to the exchanger in completion of the exchange. Accordingly, a determination as to any transfer tax due upon the disposition of the parked property by the EAT to the exchanger, and whether title insurance coverage is obtained during the EAT’s period of ownership, needs to be made.

Title Insurance Considerations

Although the EAT is generally the subsidiary of a Qualified Intermediary, no title insurance benefits will be available for the parked property unless a title insurance policy is purchased with the EAT as the named insured. This situation creates a possible burden on the exchanger to purchase two separate title insurance policies: one for the EAT during its period of ownership, and an additional title policy when the exchanger takes title from the EAT.

The rate manual issued by the Title Insurance Rate Services Association, Inc.  (TIRSA) controls, by the authority and approval of the Superintendent of Insurance of the State of New York, the premiums charged and the continuation of coverage of a policy upon certain events (among other things). Unfortunately, for a direct transfer of title from the EAT to the exchanger there are no exceptions contained within Section 32 – Continuation of Coverage of the TIRSA rate manual, nor are there currently any endorsements available that would allow the title insurance coverage to continue onto the exchanger after the disposition by the EAT.

There are, however, several ways to provide a title insurance solution for the exchangers who are concerned with this issue. Firstly, if the property to be parked is the relinquished property, which means that the exchanger is transferring title to the property it currently owns to the EAT, a full covenant and warranty deed can be used to continue most of the benefits of title coverage to the EAT entity during its period of ownership. Since the exchanger has presumably been on title for an appreciable period of time, it is reasonable to believe that any potential title insurance issues might have been discovered already. Thus, the period of ownership by the EAT without the direct benefits of a title insurance policy may be within the reasonable risk tolerance of most exchangers. However, the unfortunate reality is that most exchanges are structured as the replacement parked variant due to certain financing and structuring issues.

Conversely, as an EAT is usually a special purpose entity formed for the sole purpose of holding title to the property during the period of the exchange, and normally dissolved immediately thereafter, there is not as much benefit to the EAT transferring title with a full covenant and warranty deed to the exchanger. The difficulty of commencing an action against a dissolved entity, and potential statute of limitation issues, make this an imperfect solution.

A structure that provides for title insurance coverage during the EAT’s period of ownership, as well as a continuation of that coverage once the exchange is complete, involves transferring ownership of the EAT entity to the exchanger, instead of title to the real property.

Normally, in order to have a valid exchange, the exchanger must dispose of and acquire only real property in order to have a valid exchange. IRC § 1031(a)(1). In addition, the entity that disposes of the relinquished property must be the same entity that takes title to the replacement property. However, a limited liability company with only one owner will be classified either as a disregarded entity or a corporation, whereas an entity with two or more members will be classified as a partnership or a corporation. Accordingly, an entity with only one member that does not elect to be treated as a corporation will be treated as a disregarded entity. This allows an exchanger to take title to the replacement property by purchasing the interest of the EAT, as long as the exchanger treats it as a pass-through entity, without jeopardizing the viability of the exchange. Treas. Reg. § 301.7701-2(c). By purchasing the interest of the EAT, the title insurance coverage continues without the need of a second policy.

Comparing an exchange scenario to that of an IDA leaseback scenario could provide a more definite and less cumbersome solution to this problem. Currently there is available for entities taking advantage of Industrial Development Authority (IDA) financing and endorsements to the title issuance policy. When an entity purchases a property in conjunction with the IDA, it is the IDA that acquires the property on behalf of the entity, with construction and/or improvements being financed by the IDA. Typically, the property is then “triple net” leased to the entity for approximately 20-30 years, after which time the property is acquired by the entity for nominal consideration. And although the IDA entity has legal title to the real property, the court in Davidson Pipe Supply Co. v. Wyoming County Industrial Development Agency, 85 N.Y.2d 281, 624 N.Y.S.2d 92 (1995) cited the following:

The conveyance of legal title to the agency with simultaneous lease back to the company is structured merely as a mechanism to facilitate financing and is not a genuine allocation of ownership in the agency. The economic benefits and burdens of ownership are reserved to the company and the agency serves only as a conduit for the tax benefits provided by such an arrangement ….

Accordingly, an IDA endorsement to a title insurance policy provides a continuation of the benefits of the title insurance policy to the beneficiary of the financing after the IDA entity transfers title to the property upon completion of the IDA financing term.

In a completely analogous situation, an EAT takes legal title to a property in order to effectuate a parking arrangement tax-deferred exchange pursuant to IRC § 1031, and in the case of a safe harbor parking arrangement, Rev. Proc. 2000-37. However, although the EAT has legal title to the property, it is, in effect, being held for the benefit of the exchanger, and title to the replacement property will vest in the exchanger upon completion of the exchange. Since a parking arrangement and IDA financing are structured in much the same way, it makes sense to assume that an endorsement providing for a continuation of the title policy once title is vested in the exchanger for parking arrangements would be permitted. Unfortunaly there is not an endorsement of this nature for § 1031 exchanges.

Transfer Tax Considerations

The State of New York imposes a transfer tax on a conveyance of real property where the consideration exceeds 0. N.Y. Tax Law § 1402. In addition, there can be additional transfer taxes due in various areas, such as New York City and the Peconic Bay. The question is whether a transfer tax is due when the EAT transfers title to the exchanger in completion of the exchange.

When a replacement property is parked with an EAT, a transfer tax is levied upon that purchase. It is the transfer tax that would normally be due with the subsequent transfer of the parked property to the exchanger that is in issue.

N. Y. Tax Law § 1405(6) exempts from payment of the real estate transfer tax

[c]onveyances to effectuate a mere change of identity or form of ownership or organization where there is no change in beneficial ownership, other than conveyances to a cooperative housing corporation of the real property comprising the cooperative dwelling or dwellings …

Although the EAT must have qualified indicia of title to satisfy the provisions stated in section 4.02(1) of Rev. Proc. 2000-37, the EAT is holding the property for the benefit of the exchanger to complete an IRC § 1031 tax deferred exchange. The Peconic Bay transfer tax, which is levied upon buyers of real property, contains the same exception. Accordingly, exchangers should feel comfortable invoking this section of the tax law to avoid paying a duplicate transfer tax.

In addition, a “conduit” exception was found under similar circumstances for exchangers wishing to park property located in the City of New York. In the Matter of 46 West 55th Street Corp., New York City Tax Appeals Tribunal, Decision no. 92-0408, June 3, 1999. Although a portion of the ruling had to do with agency issues that were cleared by the amendments to IRC § 1031 in 1986, “the tribunal stated that its duty is to apply the transfer tax based on the record before it and to determine the ‘true nature of the transaction’ as derived

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