October 30, 2000

Cite this Page: 2000 LWUSA 933


News Story

Real Estate Lawyers Can Do More Tax-Free Exchanges
By James L. Dam

Tax-free exchanges of real estate and other property are now much easier in many cases as a result of an IRS revenue procedure approving "reverse" exchanges, in which new property is purchased before old property is sold, experts tell Lawyers Weekly USA.

The IRS announced that such exchanges will be allowed under Sect. 1031 of the Tax Code so that the gain from the sale of old investment or business property can be "rolled over" into similar new property if certain requirements are met.

People often need to do an exchange "in reverse" because they are unable to sell their old property before purchasing the new property. In the past, however, it was very unclear when the exchanges would be allowed, which made planning them both risky and extremely complicated.

"Many, many lawyers across the board avoided doing them," says Washington tax attorney Howard Levine, the author of a "Tax Management Portfolio" on tax-free exchanges.

Now, with "safe harbor" requirements clearly stated in the revenue procedure, "It's possible to do these transactions with far less complexity and tax structuring input," says Louis Weller, a San Francisco tax attorney who headed an ABA task force that helped the IRS draft the revenue procedure.

Unlike in the past, "You don't have to spend thousands of dollars hiring a tax expert to structure the transaction," says Phoenix tax attorney Ronold Platner, who was also on the ABA task force. As a result, "many more small transactions" can be done as reverse exchanges, he says.

The revenue procedure "provides a safe harbor to help people who aren't real estate moguls," says an IRS spokesperson.

Exchanges in general "are hot, hot, hot," says Daniel Borinsky, a real estate attorney in Woodbridge, Va. Now, reverse exchanges may become popular as well, he says.

For a discussion of the growing popularity of regular exchanges, see 2000 LWUSA 498; Search terms for LWUSA Archives: Bowden and Galley.

Fond du Lac, Wis., real estate attorney Louis Andrew says he has been doing regular exchanges for years but has never done a reverse one. Based on how often he has had clients who could have benefited from one, however, he expects that about 20% of the exchanges he does from now on will be "reverses."

Seattle tax attorney Mary Foster, who is the author of a book on tax-free exchanges and chairs an ABA committee on them, expects that, as in the past, about 10% of her exchanges will be "reverses."

Typically, clients need to do an exchange in reverse when they have found new property they want to buy and either the seller is requiring that they close the deal quickly or they are having a problem selling their old property, lawyers say.

In some cases, a client will still be running its business and needs to move out of that property and into new property before selling it, says Edward Miller, a real estate attorney in Lancaster, Pa.

Clients sometimes solve the problem by using "creative ways to tie up the new property short of taking title to it," such as a lease with an option to purchase the property, says Gregg Nathanson, a real estate attorney in Farmington Hills, Mich.

However, such an approach often isn't feasible, lawyers agree.

The 'Safe Harbor' Requirements

Under the new revenue procedure, as in the past, reverse exchanges will generally be done in one of two ways. Both methods use a third-party "accommodator" to hold property for a period of time so that, technically, the client still does a regular exchange, in which he or she sells the old property before purchasing the new property, or the sale and purchase are simultaneous.

In one method, the accommodator first purchases the new property and holds it while the client finds a buyer for the old property. Once the client finds a buyer, the client does a regular exchange in which the old property is sold to the buyer and the client purchases the new property from the accommodator.

In the other method, the client first does a regular exchange in which the old property is sold to the accommodator and the client purchases the new property from the seller. The accommodator later sells the old property to a buyer.

Critical to the success of these approaches is that the accommodator, while holding the property, be regarded by the IRS as the true owner rather than an agent of the client.

What has been uncertain in the past are the circumstances in which the IRS will regard the accommodator as the true owner. As a result, it has been difficult to structure the agreements so as to satisfy the IRS and also meet the various needs and demands of the parties.

For instance, there is often a need for the client to fund the accommodator's purchase of property. But it's been unclear whether a loan from the client to the accommodator, or a guarantee by the client of a bank loan to the accommodator, would cause the IRS to view the accommodator as the client's agent.

Also, the client may need some assurance that an accommodator holding new property will sell it to the client at a certain price. But it's been uncertain whether the client and the accommodator can agree to this in advance.

In the revenue procedure, the IRS says that it will regard the accommodator as the true owner of the property for purposes of qualifying for a tax-free exchange as long as certain requirements are met.

The most important of these is that the property must be held by the accommodator for no more than 180 days meaning that the client must find a buyer and sell the old property in that period of time.

The other requirements are:

* The accommodator must receive either (a) legal title to the property, (b) a contract for the deed or other "beneficial ownership of the property," or (c) interests in a single-member LLC or other "disregarded" entity that has legal title to or beneficial ownership of the property.

For the period in which the accommodator holds the property, it must file federal income tax returns that reflect its ownership.

Within five days after the accommodator receives the property, the client and the accommodator must enter into a written agreement that the accommodator is holding the property for purposes of an exchange and that the accommodator will be treated as the property's owner for federal tax purposes.

The client must have a "bona fide intent" to qualify for a tax-free exchange.

If the accommodator holds new property, then within 45 days after it receives the property, the client must identify the old property to be sold.

The revenue procedure says that if these requirements are met, the accommodator will be regarded as the true owner rather than the client's agent even if there are arrangements between the accommodator and the client that do not result from "arm's length bargaining."

It give examples of such arrangements, including:

A loan or advance from the client to acquire the property, or a guarantee by the client of a debt incurred by the accommodator.

A lack of any equity interest by the accommodator in the property.

An indemnification of the accommodator by the client against any costs and expenses associated with the transaction.

A lease of the property by the accommodator to the client.

Management of the property by the client while it is held by the accommodator.

A "call" option allowing the client to buy the property from the accommodator at a fixed price, or a "put" option allowing the accommodator to sell it to the client at a fixed price.

A provision that if the accommodator sells the old property for more than expected, the accommodator will pay the difference to the client, and that if it sells it for less than expected, the client will pay the difference to the accommodator.

If all the requirements are met, the revenue procedure "allows you to disregard what otherwise would be evidence that the [accommodator] is the agent of the taxpayer," says Platner.

"There was lots of attention in the past on providing the [accommodator] with sufficient burdens and benefits of ownership to satisfy the tax test for ownership," says Weller. "Now you don't have to worry about those things if you complete the transaction in 180 days."

"The only risk the accommodator has to take is the risk of holding title," says Levine.

Less Need for a Specialist

Because the revenue procedure's requirements are relatively easy to meet, there is less need for tax expertise, and real estate attorneys can rely to a greater extent on the knowledge of "professional accommodators," experts say.

There are a rapidly growing number of companies providing services as accommodators around the country, says Weller. Many are companies that have long provided services as "qualified intermediaries" in regular exchanges, he says.

Many are affiliated with title and escrow companies, and some with banks, says Adam Handler, a tax attorney in Los Angeles.

It's generally better to use such a professional accommodator rather than a friend or relative of the client to hold property in a reverse exchange for a number of reasons, experts say.

Using a friend or relative may be cheaper, "but as a legal matter it's never prudent," says Weller. An individual might die, in which case "all hell can break loose," and there may also be a greater danger of bankruptcy, he says.

In addition, professional accommodators generally are very familiar with the rules for regular exchanges and over time should become familiar with the rules for reverse exchanges, says Weller. As a result, in garden variety exchanges, people will often be able to rely on them without bringing in a tax expert, he says.

"They know what they are doing and help monitor the situation and the transaction and get it on the right track," says Levine.

"In the small transaction area, attorneys do rely on them," says Foster, who is general counsel to an accommodator.

Experts caution, however, that at least while the revenue procedure is still new, real estate lawyers who aren't tax experts may still want either a CPA or tax attorney to be involved in most cases.

"It's no different from any other matter motivated largely by taxes," says Levine. "Unless a real estate lawyer has significant experience in the tax area, it's a mistake not to consult [a specialist]."

The specialist "should review the transaction and documentation to make sure you are complying with the revenue procedure's requirements," says Platner.

Use Specialists in 'Dangerous' Cases

In many cases, a lawyer may want help from a specialist because there is a danger that the revenue procedure's 180-day deadline for completing the exchange transaction will not be met.

Where this danger exists, the reverse exchange should be planned just as it would be in the past, because if the deadline isn't met, "It's as if the safe harbor doesn't exist," says Weller.

If the safe harbor provision doesn't apply, the revenue procedure says the accommodator can still be regarded as the owner of the property.

And the lawyer would "have to win the case on general principles of law," which would be hard to do in a transaction that "fully takes advantage of the flexibility of the revenue procedure," says Los Angeles tax attorney Terence Cuff.

"If you've put in all the bells and whistles that the safe harbor permits, you would have a real uphill struggle at that point arguing that the accommodator is anything other than an agent," says Philadelphia tax attorney David Shechtman.

In some cases, if the danger of missing the deadline is small, you might want to change the agreements only slightly to increase the odds that the exchange would be approved by the IRS outside the safe harbor, Shechtman says.

For instance, you might decide not to include a fixed price "put" option or not to have the client provide 100% of the financing for the accommodator's purchase of the new property, he says. Instead of a "put" option, you might draft an accommodator's lease of property to the client to include escalating rents that give the client an incentive to exercise an option to purchase the property, he says.

The idea is "not to take advantage of every non-arm's length term to the fullest extreme, because you want to give yourself a shot at saying that the accommodator is not the client's agent if it falls apart," says Levine. "It's a balancing act," he says.

However, Weller disagrees with this approach. If there's any danger, he says, you need to change the agreements "not just a little, but a lot. If there is any possibility that [the deadline won't be met], then you ought to structure things as if the safe harbor did not exist."

For instance, he says, you might try to have as much third-party financing as possible, maybe without a guarantee from the client. If the accommodator leases the property to the client, you might try to set the rent at fair market value. And you might limit the time during which there is a cap on the price the client must pay to purchase the new property from the accommodator.

There frequently will be at least a small risk that the 180-day deadline won't be met, lawyers agree.

Clients generally can meet the deadline by lowering the price of the old property enough to sell it on time, but that would offset some of the tax savings from doing the exchange.

One situation where the risk of not meeting the deadline will generally be great is where construction is done on the new property while it is held by the accommodator in order to increase the value of the property up to or above the value of the old property, so that there can be a full Sect. 1031 rollover of the gain from the old property.

"180 days is not a long time to build an apartment complex or shopping center," says tax and real estate attorney Desmond Sheridan of Greensboro, N.C.

A client might meet the deadline by purchasing the property with the construction only partially completed, but that would diminish the tax savings from doing the exchange.

Lower Cost

By reducing the difficulty and complexity of the planning, the revenue procedure should reduce the cost of attorneys and accountants in reverse exchanges, experts agree.

If the number of accommodators and the number of reverse exchanges that are done increase, the fees charged by accommodators may also go down, says Foster.

The accommodators "will build a cottage industry and streamline things," says Nathanson.

However, their charges could also go up because of increased accounting costs they will incur in complying with the revenue procedure's requirement that they be treated for their own income tax purposes as the owners of the property they hold.

"This is a complication accommodators are struggling with," says Platner. "In the past, they normally would not report on their own return that they owned the property, just the fees they received."

Currently, it appears that accommodators typically charge about $2,500.

To determine whether a reverse exchange is worth doing, the costs must be weighed against the potential benefits of a postponement of the tax on the gain from the sale of the old property.

Generally, to be worthwhile, the amount of postponed tax should be at least $10,000, "and probably more, when you look at all the rigmarole you have to go through," says Foster.

A consideration is whether some or all of the gain could be offset against passive losses, says Washington real estate attorney Benny Kass.

Another consideration is that it may be possible to not just postpone the tax but eliminate it. This can be done if the client owns the new property until death, when there is a "step-up" in the property's tax basis.

It can also be done if the new property qualifies under Sect. 1031 as "investment or business property," but two or more years after the exchange the client moves into the property and turns it into his or her personal residence. If the client continues to live there for at least two years and then sells it, up to $500,000 of gain might be excluded under Sect. 121 of the Code, says Shechtman.

The revenue procedure is effective for written agreements with accommodators entered into on or after Sept.15, 2000.

It is Rev. Proc. 2000-37, issued on Sept. 15 and published on Oct. 2, 2000, in Revenue Bulletin 2000-40.

You can read, print or download the full text in the "Important Documents" section of Lawyers Weekly USA's Internet site:


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