Non-Safe-Harbor Reverse Exchanges

There are several situations in which the standard forms of deferred and safe-harbor reverse exchange, together with combinations thereof, will not provide enough time sell the Relinquished Property (“RQ”) and/or make improvements to the Replacement Property (“RP”) having enough value to accomplish desired deferment objectives. In these situations, it is necessary to venture outside of the reverse exchange safe harbor, with the primary benefit of doing so being the removal of the 180-day deadline for completion of the exchange. The two primary forms of non-safe-harbor structure involve (1) dealing with a safe-harbor reverse exchange that is in danger of failing because the RQ may or will not sell in the 180-day exchange period and (2) non-safe-harbor “parking arrangements” in which it is known at the outset that more than 180 days will be needed to complete improvements to the RP and/or sell the RQ.

For many years, non-safe-harbor parking arrangements have been conducted by structuring the entity that would hold title to the parked property (the “EA”) so that it could satisfy the IRS’ test for having the burdens and benefits of ownership. The most challenging aspect of these arrangements has consistently been the injection into the EA of enough cash equity (as opposed to debt) from a third-party that is not related to the Exchangor, to be used for the acquisition of the parked property and/or making the improvements, to give the “investor” legitimate investment upside and downside potential. This type of structure is still used, as shown below, and – given that all other elements of the process are conducted correctly – can give the Exchangor confidence that the desired deferment of gain will be achieved.

However, a recent decision rendered by the US Tax Court - affectionately known as “Bartell” - has resulted in the ability to conduct non-safe-harbor parking arrangements in situations where the fact pattern is similar to that found in Bartell without the injection of 3rd-party capital. The Court agreed in Bartell that tax ownership by the EA of the parked property was established by a combination of intent to exchange and a lack of expressed agency relationship and that the burdens and benefits test did not apply. In Bartell, the EA built a new building on vacant land over a period of 17 months using funds supplied pursuant to a bank loan that was guaranteed by the Exchangor. All the operative arrangements between the Taxpayer and the EA (such as a loan, construction management agreement and a lease) were at market rates of consideration. The Taxpayer had an option to acquire the improved property “at cost” for 24 months and then at the appraised value thereafter.

As shown below, non-safe-harbor options for saving an existing safe-harbor reverse and for new parking arrangements using both “burdens and benefits” and Bartell provide a useful set of options that can satisfy most Exchangors’ requirements while providing different cost and certainty options.

Safe-Harbor Reverse Exchange with the “White Knight” Rescue Option

If the Exchangor intends to conduct a reverse exchange and has high confidence that the RQ will sell within 180 days of close of the purchase of the RP and that the cost of any improvements to be made to the RP during that time will be sufficient to meet the pertinent deferment objectives, then a safe-harbor reverse/improvement exchange is preferable because the process is simpler, less expensive and will not be challenged by the IRS if all the requirements of Rev. Proc. 2000-37 are met.

If, for any reason, the RQ will not timely sell, the Accommodator and/or other investors can form a “White Knight” entity (typically a LLC) to acquire the RQ from the Exchangor prior to the expiration of the 180-day period following the acquisition of the RP by the EAT, allowing the reverse exchange to conclude successfully. In the “rescue” agreement, the Exchangor agrees to find a 3rd-party Buyer and consummate the sale of the “parked” property, which is the original RQ, within a predetermined time period, for example, twelve months.
The following are basic characteristics of the “white knight rescue” arrangement:

In some jurisdictions, the lack of an agency relationship between the Exchangor and the EA may result in real estate transfer taxes when ownership of the RP is conveyed to the Exchangor at the conclusion of the process. This is a function of local law and should be investigated prior to determining the cost/benefit profile of an exchange.

• There should be an equity contribution of >=5% of the acquisition price coming from a third-party “Investor” that is not related to the Exchangor
• The Exchangor may own an interest of up to 10% in the White Knight and may serve as its Manager
• The White Knight can use financing from an outside lender and/or the Exchangor, in addition to the Investor’s equity contribution, to acquire the RQ
• The Exchangor will have a fixed-price option to buy out the Investor for a predetermined period of time following the purchase of the RQ by the White Knight
• When the parked property is sold, the sale proceeds are used to retire debt and return the Investor’s equity

Extensible Reverse Exchange Strategy

• Any and all agency language has been changed or removed.
• The Exchangor is given a fixed-price option for the acquisition of the RP but the Accommodator does not have the “put option” normally found in a safe-harbor reverse/improvement exchanges.
• If more than 180 days are needed to complete the Exchange, the parties amend the exchange documents to extend the exchange period, employing a structure similar to that used in Bartell.

Non-Safe Harbor Reverse Exchanges

If the required improvements will definitely take more than 180 days to complete or if the time needed to sell the RQ after the acquisition of the RP will definitely be more than 180 days, then the Exchangor and Accommodator can conduct a non-safe harbor reverse exchange from the outset.

There are two options for structuring the exchange, each having a different cost as well as different degrees of “safety” in terms of their ability to successfully withstand scrutiny by federal and state tax authorities:

• Safe option: follows Bartell, i.e., tax ownership by the EA is based on the lack of an agency relationship with the Exchangor:
• The parked property may be acquired using a combination of outside lender financing along with equity and additional debt from the Exchangor. No 3rd-party capital is required.
• The Exchangor has a fixed-price call option, for up to 18 months, by which the parked property can be acquired however the EA does not have a "put option”.
• The parked property is leased by the EA to the Exchangor with rent escalation provisions after 18 months.
• Safer option: follows proven non-safe-harbor parking arrangements in which tax ownership of the parked property by the EA is based on the ability to satisfy the IRS’ “burdens and benefits” of ownership test:
• A capital contribution of >=5% of the funds needed by the EA to buy the parked property and finance any improvements must come from a third-party Investor that is not a related-party vis-à-vis the Exchangor.
• The remaining funds can be derived from debt from a combination of the Exchangor and an outside lender.
• The Exchangor has a fixed-price call option, for a pre-determined period of time, by which the parked property can be acquired and the EA has a "put option” enabling it to sell the property if not acquired by the Exchangor as contemplated.
• There will be a Lease between the EA and the Exchangor with rent escalation provisions which go into effect after a fixed time period.

In both cases, once the RQ is sold, the exchange can complete within the ensuing 180 days, usually – although not always - concluding with the acquisition of the membership interests in the EA by the Exchangor.