IRS Establishes A Safe Harbor For
"Reverse" Tax-Deferred Exchanges

The Internal Revenue Service (“IRS”) has issued Revenue Procedure 2000-37 which sets forth requirements that, if followed, will provide a “safe harbor” for "reverse" tax-deferred exchanges.

While the requirements for a conventional Internal Revenue Code Section 1031 tax-deferred exchange are well settled, the tax treatment of a “reverse exchange” has been in question. This type of exchange is called a “reverse exchange” because the taxpayer typically will acquire the replacement property prior to the sale of his or her relinquished property.

In Revenue Procedure 2000-37, the IRS states that it will not challenge the tax-deferred status of any reverse exchange that is structured in compliance with the safe harbor guidelines contained in the Revenue Procedure. Most Section 1031 delayed exchanges are structured where the taxpayer transfers its exchanged or relinquished property to a "qualified intermediary" in the first leg of the exchange. The qualified intermediary completes the tax-deferred transaction by acquiring replacement property and transferring it to the taxpayer in the second leg of the exchange. Revenue Procedure 2000-37 removes the require- ment that the transfers take place in this order and in fact allows for the exchange to be completed in the reverse order.

This flexibility potentially can be very important to a taxpayer who needs to acquire the replacement property before he or she is able to sell the relinquished property.

Requirements for Reverse Exchange:

In order to qualify under Revenue 2000-37, the taxpayer must enter into a “qualified exchange accommodation arrangement” with a third party. This arrangement has the following requirements:

In order to qualify as a reverse exchange, the taxpayer must enter into an agreement with an “exchange accommodation titleholder” under a written “qualified exchange accommodation agreement” (a “QEA Agreement”). The QEA Agreement must provide that the Exchange Accommodation Titleholder is holding title to the property for the benefit of the taxpayer in order to facilitate a tax-free exchange under Section 1031 and Revenue Procedure 2000-37. The QEA Agreement requires the Exchange Accommodation Titleholder to report the acquisition, holding and disposition of the property as provided in the Revenue Procedure, and the Exchange Accommoda-tion Titleholder must be treated as the beneficial owner of the property for all federal income tax purposes.

Revenue Procedure 2000-37 also imposes strict timing requirements for completion of the transaction. The taxpayer must identify the relinquished property to be exchanged for the replacement property within 45 days of the transfer of the replacement property to the Exchange Accommodation Titleholder. In addition, the Qualified Exchange Accommodation transaction with the Exchange Accommoda-tion Titleholder must be completed within 180 days. This means, in the case where the taxpayer is using the QEA Agreement to "park" the replacement property, the exchange must be completed by transfer of replacement property (either directly or through a qualified intermediary) to the taxpayer within 180 days from the date of transfer of the property to the Exchange Accommodation Titleholder. These timing requirements, together with the other requirements contained in Revenue Procedure 2000-37, must be strictly adhered to in order to qualify for the "safe harbor" offered by the Revenue Procedure.

Tax reporting consistency is a key requirement of Revenue Procedure 2000-37 and the taxpayer must have a bona fide intent that the property held by the Exchange Accommodation Titleholder will either be the replacement property or the relinquished property in an exchange and that it is intended to qualify for non-recognition of gain under Revenue Code Section 1031.

The Revenue Procedure requirements make a reverse exchange more burdensome from a tax-reporting standpoint. In addition, the timing requirements imposed by Revenue Procedure may make the safe harbor for reverse exchanges suitable primarily for those taxpayers who have either already agreed to sell the relinquished property but were unable to close before being required to acquire the replacement property, or for taxpayers who are willing to take the risk that they may have to purchase the replacement property with funds other than the net proceeds of the sale of the relinquished property. However, the 180-day requirement to complete the exchange (which is similar to the 180-day requirement for receipt of replacement property in the ordinary exchange) may make the reverse exchange procedure unsuitable for people wanting to do a “build-to-suit” exchange where new improvements will be built and delivered as part of the replacement property. In these cases, the completion of the improvements may take longer than 180 days.

There are a number of additional detailed rules and requirements in order to qualify for the reverse exchange “safe harbor” under Revenue Procedure 2000-37. The application to any specific transaction should be reviewed in detail with your attorney or tax advisor. However, these new rules should provide a useful tool to taxpayers who wish to trade out of property they own without having to pay taxes on the gain, but for whatever reason are unable to sell their relinquished property before they need to acquire the replacement property.