Reverse Section 1031 Exchanges

• August 21, 2023
• Carey M. Heyman, CPA

I must be excited for this week’s complimentary webinar presented by CLA and First American Exchange Company, as I have Section 1031 exchanges on the brain. Loyal subscribers will know that we have covered this topic extensively over the years. And for our less loyal readers, here are a couple blog posts to get you up to speed: Related-Party Rules for Section 1031 Exchanges, The Nuances of Section 1031 Exchanges (Parts One, Two and Three) and The Proposed Elimination of the Section 1031 Exchange, which due to a significant lack of creativity in Washington D.C., may be something that we need to re-package and re-post each election cycle.

A subject that we haven’t spent too much time on within the Section 1031 universe, is the reverse exchange. Situations may occur where it is necessary for a taxpayer to receive an exchange property prior to the transfer of the taxpayer’s property to the exchangor. The final regulations, like the proposed regulations that preceded it, defined a deferred exchange as one where a taxpayer transfers property and subsequently receives qualifying property in exchange. Many court cases over the years have been referenced in support of reverse Section 1031 exchanges such as Starker (1975), Rutherford (1978), Lee (1986), Bezdjian (1988), In re Exchanged Titles (1993), DeCleene (2000) and the Estate of Bartell (2016) vs. the Commissioner.

In the absence of definitive guidance from the Internal Revenue Service (IRS), taxpayers and advisors have attempted to avoid reverse Section 1031 exchange issues by utilizing “parking arrangements.” These types of agreements are generally described in a 1993 Report on the Application of Section 1031 to Reverse Exchanges and IRS Revenue Procedure 2000-37. In general, parking arrangements take two forms:

• The replacement property is acquired by a qualified intermediary, or an affiliate thereof. The taxpayer will facilitate the acquisition of the replacement property through some type of funding, such as guarantees or loans. The replacement property is then net leased to the taxpayer, with negotiated offsets of rental income to debt service.
• The taxpayer transfers the relinquished property to the qualified intermediary in exchange for the replacement property. The qualified intermediary will hold the relinquished property until a buyer can be secured.

Whether an intermediary would even qualify in these transactions may depend on whether certain functions can be completed. There include acquiring the relinquished property from the taxpayer, transferring the relinquished property, acquiring the replacement property, and transferring the replacement property to the taxpayer.

In our research and our experience, there are two matters of significance that should be highlighted:

1. The order in which the above functions are required to occur are not explicitly stated in the regulations, and
2. It is recommended that efforts to substantiate an arm’s length transaction, or something relatively close to that, be exhausted. Anything that could make the parking agent viewed as an agent of the taxpayer should be avoided.

A big thanks to Jake Caelwaerts and Jim Milliken for their assistance with this blog post! They are going to do an impeccable job with Janna Perret, Vice President/Regional Manager of First American Exchange Company, on Thursday’s webinar. Please be sure to register and tune in!

Source: Bloomberg Tax, Journal of Accountancy

Tags: 1031, 1031 Exchange, Real Estate, Reverse, Reverse Exchange, Reverse Sec 1031 Exchange, Reverse Section 1031 Exchange, Sec 1031 Exchange, Section 1031 exchange, Federal and state taxation, including proposed regulations, Industry best practices, Industry trends/analysis, Year-end tax planning | Comments Off on Reverse Section 1031 Exchanges