Reverse Like-Kind Exchanges - Form Over Substance?

The Tax Court recently held in a division opinion that the form of the taxpayer’s transaction was determinative instead of the substance of the transaction. The court held in Bartell et al. v. Commissioner, 147 T.C. No. 5 (Aug. 10, 2016) that a taxpayer’s reverse like-kind exchange was a qualified §1031 transaction where the taxpayer carefully structured the exchange using a qualified intermediary (third-party) to hold property titles while the taxpayer retained the benefits and burdens of ownership.

Reverse Exchanges

In a reverse like-kind exchange, also known as a “Starker Exchange” (named after Starker v. Commissioner, 602 F.2d 1341 (9th Cir. 1979)), a taxpayer receives the replacement property before disposing of the relinquished property. There has been no question that forward exchanges were contemplated by §1031. However, in Starker, courts expanded the scope and allowed deferred exchanges (now codified in §1031(a)(3)) and the IRS promulgated regulations to allow deferred forward exchanges. Following litigation the IRS released guidance in a safe harbor allowing for “parking arrangements” aka reverse exchanges, where a taxpayer uses a third-party to “park” title and ownership of the replacement property while deferring disposition of the relinquished property. Rev. Proc. 2000-37, 2000-2 C.B. 308. Bartell took place before the safe harbor was released, making it an interesting fact pattern because it allows reverse exchanges outside of the safe harbor.

Taxpayer’s Reverse Exchange Structure

The taxpayer is a drug store chain which identified a potential retail location to open another store. At the time the taxpayer was not clear on which property it would relinquish in the §1031 exchange. To facilitate a qualified §1031 exchange and acquire parcel L before relinquishment of parcel E, the taxpayer engaged with a qualified third-party intermediary (QI). QI formed an LLC special purpose entity (SPE) that would take title and “own” L while in substance giving the taxpayer full use, benefits, and burdens of the property via contractual arrangements and lease-back. Taxpayer provided insurance and indemnity to SPE on L. During construction of L, taxpayer found a suitable buyer for E. Taxpayer engaged in a purchase and sale agreement for E, assigning its rights and proceeds to QI. QI in turn applied the proceeds to an exchange with SPE, receiving L in return and completing the transaction by deeding L to taxpayer in a pre-arranged contract. Taxpayer deferred the proceeds from E on its return and the IRS disallowed the purported §1031 treatment.

Taxpayer’s Form Over Substance

The Tax Court distinguished the facts in Decleene v. Commissioner, 115 T.C. 457 (2000), stating that the taxpayer in Bartell did not engage in a self-exchange unlike the transaction in Decleene. In Decleene, the taxpayer had obtained the replacement property a year before engaging in a like-kind exchange and transferred title directly to the purchaser of the relinquished property. The court explained that the facts in that case weighed heavily against the taxpayer as it appeared a §1031 exchange was contemplated after acquiring the replacement property instead of carefully using a third-party intermediary to engage in a deliberate §1031 exchange. In contrast, the taxpayer in Bartell went to great lengths to properly structure the transaction and use a QI to hold title and contractual arrangements to be afforded use of the land in the meantime. These factors led the Tax Court to hold for the taxpayer.

The court noted that taxpayers are traditionally given widelatitude to structure their transactions to comply with §1031. The IRS and the taxpayer disagreed whether the legal standard of ownership in a like-kind exchange is a pure “title” standard or the benefits and burdens test that is generally used to determine ownership in tax law. Under the benefits and burdens standard, the taxpayer “owned” the property because it directed its use, overseeing construction, obtaining permits, paying insurance, and otherwise enjoying full use of L.

The Tax Court held that the legal standard is more form than substance. The 9th Circuit (taxpayer would appeal to this circuit) had expressly rejected the benefits and burdens test in the §1031 context. Alderson v. Commissioner, 317 F.2d 790 (9th Cir. 1963). Under the Golsen rule the court is obligated to follow the precedent of the circuit which this case would be appealable to. Additionally, the court noted that its own precedent afforded taxpayers discretion in the form of their affairs in these kinds of transactions.

Final Thoughts

Also of note is the timeframe of the reverse exchange. The taxpayer identified the replacement property and SPE took title to it 17 months before the taxpayer disposed of the relinquished property. This is well outside of the time frame afforded under the safe harbor. While the Tax Court specifically held the reverse exchange was qualified within the time period in this case, the favorable outcome to taxpayers in Bartell should give some comfort to practitioners who may be outside of the safe harbor. Carefully structuring and purposefully intending a §1031 exchange seems to have carried the day in Bartell. How the IRS views this decision, heavily dependent on its facts, is to be determined. The rarity of taxpayer’s form over substance carrying the day is something to closely follow...

Stay tuned for more!