April 28, 2017

Reverse Tax-Deferred Exchange: You can do that?

The short answer is “Yes you can.”  The actual use of this tax deferral approach under IRC Sec. 1031 has limited application but important benefits for those taxpayers that are in a position to use it.  A recently decided Tax Court case illustrates how this can work.  The Tax Court’s Opinion in the Estate of George H. Bartell, et al. v. Commissioner was issued August 10, 2016.  The events that started this case date back to May 7, 1999.  The Tax Court deciding this case is in the 9th District Court for Appeals, so the judges in the case were mindful of prior decisions in the 9th District in particular.  (The 9th District covers California and several other western states.)

This tax deferral approach, sometimes referred to as a “parking transaction”, has limited application because the taxpayer must have the ability to purchase the replacement property through an accommodator or exchange facilitator before selling the property to be exchanged.  Most taxpayers need the funds from the sale of their property to fund the purchase of the replacement property.  This tax deferral really does favor the well heeled over the merely well off.

Here is a very brief summary of the case:

The taxpayer, Bartell, purchased land known as Lynnwood in May 1999 through a facilitator, also known as a third party accommodator, to build a retail store, in this case a pharmacy in Washington State.   Bartell then arranged for bank financing for the construction. The construction loan was managed by the facilitator, although Bartell made the construction decisions.  The acquisition of the land had a closing date of August 1, 2000.  Construction was completed in July 2001. The facilitator leased the property to Bartell for several months while the sale of the property to be exchanged was completed.  Bartell entered a sale agreement through a facilitator on September 21, 2001 to sell Everett, the property to be exchanged.  The sale of Everett was to an unrelated party in a sale and leaseback arrangement. Everett included an existing pharmacy location.  The facilitator closed the sale of Everett on December 28, 2001 and the exchange escrow for Lynnwood was closed on December 31, 2001.  

After all of the transactions and construction was completed, Bartell was able to sell one existing pharmacy property but retain its operations at that location through a lease, and Bartell was able to open a new pharmacy location that it now owns.  The loan from the bank to fund construction was paid off from the proceeds of the sale of Everett.  

The IRS issued Revenue Procedure 2000-37 which explains the reverse exchange process after the Bartell transactions were initiated in 1999. The IRS guidance in this Revenue Procedure provides taxpayers with “safe harbor” guidelines to follow to avoid any controversy with reverse exchange transactions. One of the guidelines requires the exchange of the relinquished property and the replacement property to be completed within 180 days. This is in contrast to the 17 month gap between the purchase of Lynnwood (8/1/2000) and the sale of Everett (12/31/2001) in the Bartell case.

The IRS argument with the result in the Bartell case centered on the degree of control that Bartell had over the financing and construction process as well as the pre-exchange possession of the property through a lease for the Lynnwood property from the facilitator.  In effect, Bartell “owned” the Lynnwood property the IRS argued.

The Tax Court followed prior case law where the intent of the taxpayer to enter into a tax-deferred exchange is clear from the beginning and the taxpayer uses a third party facilitator to take title of the property in the exchange, the facilitator did not have to assume the benefits and burdens of ownership to be treated as the owner for the purposes of the exchange under IRC Section 1031.  The temporary possession of the property by Bartell through a lease with the facilitator and the long holding period did not change their conclusion.

The Tax Court made a point of the importance of using a facilitator in the Bartell case.  This case cites other cases where taxpayers had not used a facilitator and those when a facilitator was used.  The use of a facilitator is essential to a successful reverse tax-deferred exchange or any tax-deferred exchange.  The Bartell case opens the door to reverse exchange transactions that are outside the IRS safe harbor guidelines.