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Non-Safe-Harbor Reverse Exchanges

In the section describing Hybrid Exchanges, several methods of combining safe-harbor exchanges were described and these may provide up to 360 days to deal with exchanges involving multiple properties, either New or Old. There are situations in which this approach will not work and for which it may be necessary to venture outside of the reverse exchange safe harbor. The primary benefit of doing so is the removal of the 45-day identification deadline and the 180-day deadline for completion of the exchange.

General Non-Safe-Harbor Structure

In the safe-harbor world, EATs are typically LLCs formed and structured by the Accommodator to be disregarded for tax purposes and held for no more than 180 days. Moreover, the EAT will have a set of arrangements with the Exchangor that are not at arm’s length. These usually include an interest-free loan, a rent-free lease and, for improvement exchanges, a construction management agreement with no fees. In the non-safe-harbor world, while the structure of the exchange is similar, the nature and character of the LLC must be completely different and all the arrangements must be at arm’s length.

For our purposes, the LLC used to hold title to the parked property will be referred to as a Non-safe-harbor Exchange Titleholder (“NET”) in order to distinguish it from the typical safe-harbor EAT. Similarly, we’ll refer to the agreement between the QI and the Exchangor as the Exchange Cooperation Agreement (“ECA”) instead of the QEAA.

The typical non-safe-harbor parking arrangement has structure similar to an Exchange Last:

  • A NET is formed which will acquire title to one or more New Properties.
  • There may be loans between the NET and one or more lenders, including the Exchangor.
  • The ECA between the Accommodator and the Exchangor describes the intentions, mechanisms, purchase option, representations and warranties.
  • There will be a Lease giving access to the New Property to the Exchangor and there may be a Construction Management Agreement if improvements are being made.
  • Once the Old Property has been sold, the standard deadlines apply and the sale of the New Property, with any improvements, to the Exchangor by the NET must occur within 180 days.

There are two critical differences:

  • First, to operate successfully outside the safe harbor, the NET must demonstrate legitimate burdens and benefits of ownership during the period it holds the New Property.
  • Secondly, all of the arrangements between the NET and the Exchangor must be at arm’s length and have associated consideration (i.e. interest on purchase money, rent payments, management fees) at market rates.

This may sound simple but considerable planning and skilled execution are required to make a non-safe-harbor structure able to withstand IRS scrutiny “more likely than not”. Achieving a higher level of confidence, as we’ll see below, requires even greater commitment in the formation and funding of the EA.

In order to pass the burdens and benefits test, the NET must be carefully structured. It should be formed as a separate tax-paying entity. It should be equipped to manage cash flow from operations such as the collection of rent, the payment of interest on loans, the payment of property taxes and other normal and customary expenses. It should keep detailed financial records and file its own tax returns. Most importantly, the NET must have the ability to make or lose money from the operations and ultimate sale of the assets. The NET must have financial risk and reward potential in order to satisfy the burdens and benefits test. A critically important aspect of this requirement is that the NET must acquire a meaningful equity interest in the parked assets. In most cases, this means that there must be at risk capital supplied by the one or more Members of the NET for the purpose of acquiring the parked assets and, perhaps, making improvements to them. This is a crucial difference from the safe-harbor approach in which the Exchangor can lend all of the purchase money for a New Property to an EAT. The provider of this capital must be genuinely at risk of a loss or have the potential of a gain.

The “capital stack” of the NET – that is, the funds it mobilizes in order to acquire and, perhaps, improve its assets – typically has the following composition: at-risk capital from a third-party Investor, a loan from a third-party Lender and a loan from the Exchangor or an Affiliate of the Exchangor. Standard practice is that the minimum at-risk equity investment from the Investor is between 5% and 20% of the total value of the parked assets at any point in time. Confidence in the ability of the NET to pass the burdens and benefits tests will increase with the size of both the contribution of the Investor and the size of the loan from the Lender. So, an NET that has 5% at-risk capital and a 95% loan from the Exchangor will not be as likely to pass the test as an NET that has, for example, a 10% at-risk capital contribution, a 50% loan from a Lender and a 40% loan from the Exchangor.

There are significant changes to the other arrangements that result from this structure. The loan agreement between the NET and the Exchangor will require that interest be paid at a market rate. The Lease giving the Exchangor access to the parked property will require the payment of rent at a market rate. The Lease will also call for steep rent increases as a way of motivating, without compelling, the Exchangor to exercise its purchase option. There are other differences as well, all contributing to the notion that the NET is the beneficial owner of the assets and all are necessary for increasing confidence in the ability of the NET to pass the burdens and benefits test and thereby withstand scrutiny from tax authorities.

The Non-Safe-Harbor Improvement Exchange

Suppose that a car Dealership badly needs a new facility (showroom, service bays and parking lots) in order to grow its business. The old showroom has been heavily depreciated and it would be both expensive and disruptive to do the work necessary to modernize it the way target clientele find most attractive. A suitable vacant lot has been located and plans have been drawn up. Preliminary discussions with the local authorities suggest that the necessary zoning work, permits and infrastructure installation are feasible. However, there is no possibility any significant portion of this project can be finished in 180 days. The Dealership can therefore engage a skilled 1031 Accommodator to establish a non-safe-harbor improvement exchange. The Accommodator helps the dealership identify a source of capital (the Investor) and brokers an agreement for “return on equity” to be paid by the NET to the Investor for its 10% investment. The Dealership has a very good relationship with a local bank and convinces them to make a construction loan of 40% of the anticipated cost of both the land and the new facility. The Accommodator forms the NET with the Investor as a Member and executes loan documents with both the bank and the Dealership. The initial funds are used to acquire the land, pay for permits, zoning work, architecture, initial construction and so on. Once the initial funds are spent, the NET will make draws against the construction loan with the bank. The NET will establish a bank account for receiving and disbursing funds as required by its operations. The NET will enter into a Lease with the Dealership for the completed facility and assign the Lease as security for its loan. The NET will also hire the Dealership to manage the construction of the new facility and pay a fair market management fee. The NET will make interest payments pursuant to the two loans. And, the NET will provide a return on investment to the Investor. Naturally, the rental income from the Lease should be sufficient to manage the affairs of the NET with very slight positive cash flow.

When the construction is nearing completion, the Dealership will start the process of selling its old facility (the Old Property). Once it is sold, the 180-day exchange period will begin. The 45-day identification requirement is easy to satisfy in this case. When the sale concludes, the QI will facilitate a transfer of the title to the New Property from the NET to the Dealership and also transfer title of the Old Property to its ultimate buyer. The NET will use the sale proceeds to pay off its loans and retain the balance. The transfer of title to the New Property to the dealership will likely be done by assigning 100% of the interests in the NET to the dealership. This will maintain the continuity of the construction loan, title insurance policy, property insurance policy and may, in some states, eliminate a second real estate transfer tax.

The Non-Safe-Harbor Parking Arrangement

Suppose the Exchangor is a corporation that has owned a piece of land (the “Old Property”) for many years that is currently used to store vehicles and idle manufacturing equipment. They have engaged a local law firm to secure a rezoning of the Old Property that will substantially increase its potential value (estimated at $60million) for a contemporary multi-use development project. The Exchangor expects the rezoning effort to take between two and two and a half years. In the meantime, they know that they will acquire several new pieces of real estate (the New Property) over the same period. Since the depreciated basis of the Old Property is very low, the capital gains tax will be enormous unless the Old Property is exchanged for something similar in value.

The Exchangor will therefore establish a non-safe-harbor parking structure that will acquire and own the potential New Properties over a 2-3 year period. When the Old Property is sold, a QI will perform a delayed or simultaneous exchange in which the Exchangor relinquishes the Old Property and acquires all of the New Property held by the NET. If all other provisions are in order, the tax deferral will be 100% if the total value of the New Property exceeds that of the Old Property. If the New Property is valued at less than the sale price of the Old Property, then there will be taxable boot.

In this case, the NET will have to have capital infusions that increase as each New Property is acquired. The Exchangor has engaged a major accounting firm to render an opinion on how to achieve a “should” level of confidence in the structure and is expecting at-risk capital of 20% of the purchase price for each New Property. In addition, they have secured an agreement with a Lender (with whom they evidently have quite a bit of leverage!!) to supply 40% of the purchase money for each New Property. The Lender will, of course, be in “first position” as reflected in the loan documents between it and the NET. The Exchangor will supply the remaining 40% via a series of loans subordinated to the NET that bear interest at a market rate for this type of loan.

When the Old Property is finally sold, a standard simultaneous exchange will be executed with the seller of the New Property being the NET. During the settlement process, title to the New Property will transfer to the Exchangor and title to the Old Property will transfer to its ultimate buyer. Loans will be repaid and the balance of the purchase price will go to the Investor as its return.

The Safe-Harbor Reverse Extension

This technique is applicable in cases where an Exchange Last is in danger of failing because the Old Property will not be sold to an ultimate buyer within the 180-day exchange period. This structure is sometimes referred to as a “white knight” structure since the Accommodator literally saves the day for an Exchangor in danger of losing a deferment. In essence, the Accommodator will “extend” the reverse by forming a special LLC to make a bona fide acquisition of the Old Property before the 180th day and thereby allow the Exchangor to complete its original safe-harbor reverse. The LLC will be formed so that it can satisfy the same burdens and benefits test described above. The requirement for at-risk capital from an Investor unrelated to the Exchangor is still applicable.

Instead of an exchange agreement, the extension arrangement is completely described in the LLC’s operating agreement and includes, among other things, a description of the responsibilities of the members, treatment of capital contributions, the required put/call structure and provisions for dissolution of the LLC.

The Exchangor, therefore, is still required to find an ultimate buyer for the Old Property. The rent paid as a result of a lease of the Old Property to the Exchangor is used to pay any interest due, make payments of return on equity to the Investor and so on. The NET will operate as a fully-functional business – collecting rent, paying interest, paying property taxes, keeping a set of books, filing tax returns and so on. Once a buyer for the Old Property is found and a sale consummated, the purchase money will be held in the account of the LLC and disbursed according to the terms in the operating agreement.


¹ Extending an Exchange First may be possible but a careful assessment of the facts and circumstances is required due a subtle restriction on Old Property transfers to disqualified parties found in Rev. Proc. 2000-37. Contact an experienced Accommodator if this is your situation.