IRS Gives OK to Non-Safe-Harbor Reverse Exchange

In January, the IRS issued a Private Letter Ruling (PLR 200901004) approving a reverse improvement exchange under §1031 that did not comply with Revenue Procedure 2000-37 (the “safe harbor” exchange guidelines issued by the IRS).

There were two unusual features to this exchange –

• It is a “non-safe-harbor” reverse exchange, and
  
  
• The replacement property is an improvement built on property (easements) owned by the taxpayer.

These are issues for which no specific guidance or approval had been previously issued by the IRS. Usually, like-kind replacement real estate has been thought to require ownership of real property as distinguished from an improvement constructed on land already owned by the taxpayer.

As described in the PLR, the taxpayer proposed to exchange “Old Facility” for “New Facility.” Old Facility was to be sold to an unrelated third party. Taxpayer was to hire a contractor (Accommodator) to build New Facility on easements already owned by Taxpayer or acquired by Taxpayer prior to the exchange. The contractor would initially own and finance the construction of the New Facility independently of the Taxpayer. Following completion of New Facility, the contractor would transfer ownership of New Facility to Taxpayer (presumably using the exchange cash to service debts of the contractor).

This is the substance of the proposed exchange described by the PLR. However, there are more complicated relationships in the transaction which can be summarized as follows –

• The contractor was a domestic subsidiary of a foreign corporation which also owned the Taxpayer. However, the contractor is not a related party to Taxpayer because the parent is a foreign corporation which is excluded from the definition of a related party.
  
  
• The contractor had no equity in the project other than funds from its parent foreign corporation.

Unlike the DeCleene Case, the ruling does not examine whether the contractor acting as Accommodator possessed the benefits and burdens of ownership, whether it was acting as Taxpayer’s agent or whether the exchange is a step transaction resulting in the Taxpayer acquiring improvements on its own property. The ruling does imply that an exchange can be structured using an accommodator for property in which the taxpayer has a substantial ownership interest or over which it otherwise exercises control.

As with all PLRs, this opinion was issued as a private letter ruling to the taxpayer requesting a ruling, and therefore it cannot be cited as precedent. The Internal Revenue Service has the right to change its position on this matter without notice. If you have questions about structuring your improvement or reverse exchange, please give us a call at 888-367-1031.

Transferable Development Rights are 1031 Like Kind to Real Estate

Transferable Development Rights (TDRs) are a relatively modern land use planning tool that are encountered in many jurisdictions. Where they are authorized, governments can grant TDRs in order to limit or to entirely prevent development in special zoning districts. When properly structured, governments can accomplish these land use goals without having to pay for what might otherwise constitute costly partial – or even total – condemnations. TDR programs can also be used to reduce political and legal opposition to a restrictive zoning plan. In a TDR program, a governmental entity grants owners of property in the special use zone TDRs in exchange for either voluntary or compulsory new restrictions on the development of property within the zone. These TDRs can be sold on the open market to owners of other real property in a receiving zone, permitting development of the property in the receiving zone beyond what would otherwise have been permitted.

In a recent IRS Letter Ruling (2008-05012), a taxpayer proposed to sell a fee interest in relinquished property and use the proceeds to acquire TDRs. Those TDRs would be used to enhance construction on property the taxpayer already owned within a designated receiving zone. The taxpayer sought a ruling that the TDRs were like-kind to a fee interest in real property.

The IRS ruled that the TDRs could be like-kind to a fee interest under section 1031, despite the fact that the taxpayer intended to use the them to enhance real property it already owned, as long as the TDRs were acquired in an arm’s length transaction. They cited a prior Revenue Ruling from 1968 that said a leasehold with more than 30 years left to run on the property the taxpayer already owned was like-kind to a fee interest under section 1031 as long as the taxpayer acquired the leasehold in an arm’s length transaction.

Next, relying almost entirely on their classification under state and local law, the ruling held that the TDRs are like-kind to a fee interest in real property. While TDRs may not be treated identically to real property for all purposes, they are treated like real property in a number of important ways including: a) the fact that their grant is not discretionary; b) they appear to be permanent; c) they are transferred in a manner similar to the transfer of a deed or an easement; and d) they are recorded and indexed against the granting and receiving sites. Further, the state where the taxpayer was located had a tax statute and transfer tax provisions that seemed to define TDRs as real estate.

Because TDR programs vary considerably from one state to another, it is by no means certain that the laws of a particular jurisdiction will comply sufficiently with the standards presented in this letter ruling. As is always the case with private letter rulings, the ruling itself cannot be cited as precedent, and the IRS has the right to rule differently on subsequent occasions. However, the ruling is useful for the purpose of demonstrating the current thinking on this important subject. To receive a copy of the PLR involving TDRs, give us a call at 888-367-1031 or send us a message at 1031@1031cpas.com.

Basic types of 1031 exchanges

A Simultaneous Exchange is an exchange in which the closing of the relinquished property and the replacement property occur on the same day. Ideally, these closings are scheduled back-to-back so there is essentially no time interval between sale and purchase. This type of exchange is covered under the safe harbor regulations established by the IRS in 1991.

A Delayed Exchange is an exchange where the replacement property is closed at a date after the closing of the relinquished property. The exchange is not simultaneous or on the same day. This type of exchange is sometimes referred to as a "Starker Exchange" after the well known Supreme Court case that is the grandfather of a delayed exchange. In 1991, section 1031 of the Internal Revenue Code provided guidelines and strict time frames for completion of a delayed exchange.

A Reverse Exchange (Title-Holding Exchange) is an exchange in which the replacement property is purchased before the relinquished property is sold. Usually the Intermediary takes title to the replacement property and holds title until the taxpayer can find a buyer for his relinquished property. Subsequent to the closing of the relinquished property (or simultaneous with this closing), the Intermediary conveys title to the replacement property to the taxpayer.

An Improvement Exchange (Title-Holding Exchange) is an exchange in which a taxpayer desires to acquire a property and arrange for construction of improvements on the property before it is received as replacement property. The improvements are usually a building on an unimproved lot but could also include enhancements made to an already improved property. This type of exchange is completed in order to create adequate value to close on the exchange so that a trade down in value does not occur. The Code and Regulations do not permit a taxpayer to construct improvements on a property as part of a 1031 Exchange after he has taken title to property as exchange replacement property. Therefore, it is necessary for the Qualified Intermediary to close on, take title, and hold title to the property until the improvements are constructed. Once sufficient value has been added, the QI conveys title to the taxpayer as replacement property. Improvement Exchanges may be done in combination with either a delayed exchange and reverse exchange, depending on the circumstances. In 2000, the IRS issued safe harbor guidance on Reverse Exchanges (including title-holding exchanges for construction or improvement).