Reverse Like-Kind Exchange Qualifies For Section 1031 Non-Recognition Treatment

In Bartell v. Comm’r,[1] the Tax Court held that a reverse like-kind exchange made by a drug store chain which did not qualify for the safe harbor under Rev. Proc. 2000-37,[2] still qualified for non-recognition treatment under Section 1031. The Revenue Procedure was inapplicable because the replacement property was purchased before the publication of the safe harbor set forth in Rev. Proc. 2000-37 and the court noted that the replacement property in the case was held for 17 months rather than the 180-day time limit under the safe harbor set forth in Rev. Proc. 2000-37.

Facts

Bartell Drug, Co., an S corporation, owned and operated a chain of retail drug stores during the years at issue and had been doing business in Seattle, Washington, and the surrounding areas for more than 100 years. Most of Bartell Drug’s retail drug stores were located in strip shopping centers anchored by grocery stores.

In the late 80’s and 90’s, however, two key developments affected the business model for retail drug stores. First, grocery stores began including pharmacies within their stores. Second, Walgreen, Co. introduced on a massive scale with great success a store format that shifted the paradigm for drug retailing to free-standing corner locations with drive-through pharmacies.

In reaction to this change in business climate, Bartell Drug undertook development of new sites in order to open its own free-standing stores. Because the existing properties owned by Bartell Drug generally had very low bases so that an outright sale would produce significant taxable gain, Bartell Drug pursued a strategy of entering into like-kind exchanges and utilized the services of Section 1031 Services, Inc. (“Section 1031 Services”) to update the company’s real estate portfolio.

In executing the Section 1031 exchanges, Bartell Drug worked with Section 1031 Services and a related company, Exchange Structures, Inc., which in turn set up wholly-owned limited liability companies to serve as the exchange intermediary in such transactions. One such limited liability company was EPC Two (“EPC Two”), a Washington state entity having Exchange Structures as its sole member. As discussed below, EPC Two served as the exchange intermediary in the transaction at issue in the case.

Replacement Property

On May 7, 1999, Bartell Drug executed a real estate purchase and sale agreement (the “Purchase Agreement”) with Mildred Horton for real property located in Lynnwood, Washington (the “Lynwood Property”). The Purchase Agreement contained a provision providing that the buyer and seller would reasonably cooperate with each other in order to accomplish an exchange under Section 1031, including the assignment of the Purchase Agreement to an exchange facilitator. Bartell Drug later assigned its rights in the Purchase Agreement to the Lynnwood Property to the third-party exchange facilitator, EPC Two, and entered into a second agreement, the Real Estate Acquisition and Exchange Cooperation Agreement (“REAECA”) for EPC Two to purchase the Lynnwood Property and for Bartell Drug to have a right to acquire the Lynnwood Property from EPC Two for a stated period and price. EPC Two purchased the Lynwood Property on 8/1/2000, with financing from KeyBank National Association (“KeyBank”) that was negotiated by and fully guaranteed by Bartell Drug. The loan was in the amount of $4 million and was completely nonrecourse with respect to EPC Two. At such time, EPC Two acquired legal title to the Lynnwood Property. Following the acquisition of the Lynnwood Property by EPC Two, Bartell Drug managed the construction of the drug store on the Lynnwood Property using proceeds from the KeyBank loan and, upon substantial completion of the store in June 2001, leased the store from EPC Two from that time until 12/31/2001, when title to the Lynnwood Property was transferred from EPC Two to Bartell Drug. Both the REAECA and the subsequent lease agreement from EPC Two to Bartell Drug contained indemnification clauses in favor of EPC Two, one general indemnification clause and one specifically focused on environmental liabilities.

As construction progressed, periodic payments for the construction work on the new drug store were made in the following manner:

1. the contractor would send an invoice to Bartell Drug;
2. a Bartell Drug employee would send written authorization to EPC Two requesting a construction draw from the KeyBank loan in the amount of the invoice;
3. EPC Two would send written authorization to KeyBank for disbursement of funds from the construction loan to be paid by wire transfer to the contractor;
4. KeyBank would pay the contractor the amount specified in the EPC Two authorization.

Various other expenses, including those incurred after the $4 million was depleted, were paid by Bartell Drug directly. A promissory note was executed by EPC Two in favor of Bartell Drug with respect to a portion of the expenses directly paid by Bartell Drug.

Relinquished Property

On or about 9/21/2001, Bartell Drug entered into a purchase agreement to sell one of its existing properties (the “Everett Property”) to William and Teresa Eng. The transaction was structured as a sale-leaseback and among other provisions, the purchase agreement contained a Section 1031 cooperation provision. On 12/17/2001, Bartell Drug, as “Exchangor” and Section 1031 Services as “Intermediary,” executed an exchange agreement for the exchange of relinquished property, identified as the Everett Property, for replacement property identified as the Lynnwood Property, in a transaction intended to qualify for tax-deferred treatment under Section 1031. The Exchange Agreement provided for the purchase agreement with the Engs and for Bartell Drug’s rights under the REAECA to be assigned to Section 1031 Services. Section 1031 Services would then transfer the relinquished property to the Engs, acquire the replacement property from EPC Two, and transfer the replacement property to Bartell Drug. These transfers were to be accomplished through a direct deeding mechanism. The purchase price for the relinquished property would be paid to Section 1031 Services and used by Section 1031 Services to acquire the replacement property from EPC Two. Bartell agreed to indemnify Section 1031 Services from any and all loss in general and specifically from any claims related to hazardous materials.

Closing of the Exchange

Finalization of the transfers of the Lynnwood and Everett Properties took place between 12/26/2001 and 1/3/2002. Bartell Drug executed a special warranty deed conveying the Everett Property to entities managed by the Engs which was recorded on 12/28/2001. On 12/27 or 12/28/2001, EPC Two executed a statutory warranty deed conveying the Lynnwood Property to Bartell Drug which was recorded on 12/31/2001, and on 1/3/2002, Bartell Drug executed an assignment of the REAECA to Section 1031 Services.

On its tax return, Bartell Drug treated the acquisition of the Lynnwood Property and the sale of the Everett Property as a like-kind exchange, and as such, the gain realized from the sale of the Everett Property was not reported by the shareholders of Bartell Drug. In early 2004, the IRS commenced an examination of Bartell Drug’s 2001 corporate return and disallowed tax deferred treatment under Section 1031 for the $2,804,863 gain reported as realized in the like-kind exchange involving the Lynnwood Property and the Everett Property.

Contentions of the Parties

Bartell Drug argued that the transaction involving the Lynnwood Property was properly treated as a like-kind exchange, thus permitting deferral of the income realized upon the disposition of the Everett Property. The IRS, conversely, asserted that the transaction in question failed to qualify for Section 1031 treatment. The differences of the parties centered on whether an exchange for purposes of Section 1031 occurred. It has been observed that the “very essence of an exchange is the transfer of property between owners, while the mark of a sale is the receipt of cash for the property.”[3] A corollary of the requirement that there be a reciprocal transfer of property between owners is that the taxpayer not have owned the replacement property before the exchange occurs. If the taxpayer has acquired the replacement property before the exchange has occurred, he is in essence engaging in a non-reciprocal exchange with himself not qualifying for tax deferred treatment under Section 1031.

The IRS maintained that Bartell Drug already owned the Lynnwood Property long before the December 2001 disposition of the Everett Property, thereby precluding any exchange as of that date. Bartell Drug contended that it was not the owner of the Lynnwood Property but rather, EPC Two was the owner of the Lynnwood Property prior to the exchange. Bartell Drug argued that an agency analysis is the appropriate standard and that such analysis should be employed in a manner consistent with the wide latitude historically permitted in the context of like-kind exchanges. The IRS, on the other hand, advocated application of the “benefits and burdens” analysis as the test that should apply in a myriad of situations raising questions of tax ownership of property.

Section 1031(a) sets forth the general rule that no gain or loss will be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of a like-kind which is to be held either for productive use in a trade or business or for investment. Any gain not recognized as a result of Section 1031 is deferred through the operation of Section 1031(d), under which the basis of the replacement property in a like-kind exchange generally equals the basis of the relinquished property.

The purpose of Section 1031 and its predecessor has been identified by the courts as resting on the lack of any material change in taxpayer’s economic position. The replacement property is substantially a continuation of the taxpayer’s investment in the relinquished property, still unliquidated, and the taxpayer’s funds remain tied up in the same kind of property, and as such, the taxpayer should not be forced to recognize gain at such time.[4] Based on this rationale, courts have frequently interpreted the requirements of Section 1031 liberally, exhibiting a lenient attitude toward taxpayers’ attempts to come within its terms.[5]

Deferred Like-Kind Exchanges

There has never been any question that Section 1031 as originally enacted covered simultaneous exchanges between two parties. However, later cases found a broader reach for Section 1031 so that the statute itself and regulatory directives explicitly address various deferred exchanges (where the exchange of properties is not simultaneous) and multi-party transactions (where third-party exchange facilitators are used to effect the exchange). Following Starker v. U.S.,[6] Section 1031 was amended to expressly provide that if the relinquished property was identified within 45 days after the date on which the taxpayer transferred the relinquished property in the exchange and the relinquished property was received on the earlier of the day which is 180 days after the date on which the taxpayer transferred the relinquished property in the exchange or the due date (determined with regard to extension) of the transferor’s tax return for the taxable year in which the transfer of the relinquished property occurred, such exchange would qualify as a like-kind exchange.[7] Following enactment of Section 1031(a)(3), comprehensive regulations were issued under Reg. 1.1031(k)-1 to facilitate deferred “forward” exchanges (i.e., where the taxpayer receives replacement property after the date of the transfer of the relinquished property) within the prescribed time limits. At the time of issuance of these regulations, the IRS declined to provide guidance with respect to deferred reverse exchanges (i.e., where the taxpayer receives replacement property prior to the date of his transfer of the relinquished property). Such transactions are sometimes referred to as “reverse exchanges” or “reverse-starker transactions.”

Rev. Proc. 2000-37

The IRS eventually issued Rev. Proc. 2000-37,[8] addressing specific parking arrangements to provide a safe harbor under which the IRS would not challenge the qualification of property as either “replacement property” or “relinquished property” for purposes of Section 1031 or the treatment of the “exchange accommodation titleholder” as the beneficial owner of such property for federal income tax purposes, if the property was held in a qualified exchange accommodation arrangement (“QEAA”).

Rev. Proc. 2000-37 was effective for QEAAs entered into by an exchange accommodation titleholder on or after 9/15/2000 and specifically provided that no inference was intended by issuance of the revenue procedure with respect to the federal income tax treatment of arrangements similar to those described in the revenue procedure that were entered into prior to the effective of the revenue procedure. Additionally, the revenue procedure provided that the IRS recognized that “parking” transactions can be accomplished outside of the safe harbors provided in the revenue procedure. As such, no inference was intended with respect to the federal income tax treatment of “parking” transactions that do not satisfy the terms of the safe harbor provided in the revenue procedure, whether entered into prior to or after the effective date of the revenue procedure.

Rev. Proc. 2000-37 observed that in the years since the deferred forward exchange regulations were published, taxpayers had attempted to structure a wide variety of reverse “parking” transactions “so that the accommodation party has enough of the benefits and burdens relating to the property” to be treated as the owner. The revenue procedure then imposed time limits paralleling those for deferred forward exchanges (45 and 180 days) and enumerated specific contractual provisions and/or relationships that would not be considered fatal to the treatment of the “exchange accommodation titleholder” as the owner of the replacement or relinquished property for federal income tax purposes.

Application of the Law to the Bartell Drug Exchange

The Tax Court first noted that because Bartell Drug undertook the transaction involving the Lynnwood Property before Rev. Proc. 2000-37 was published, Rev. Proc. 2000-37 was inapplicable. EPC Two acquired title on 8/1/2000, before the revenue procedure’s effective date, and the complete transaction consumed 17 months, well beyond the 180 dates allowed for closing the transaction under the revenue procedure.

The Tax Court framed the fundamental question as whether what happened should be deemed a self exchange, such that Bartell Drug would be considered the owner of the Lynnwood Property for tax purposes before acquiring legal title to the Lynnwood Property in December 2001.

The IRS contended that Bartell Drug already owned the Lynnwood Property at the time of the disputed exchange because Bartell Drug, rather than EPC Two, had all the benefits and burdens of ownership of the property; namely, the capacity to benefit from any appreciation in the property’s value, the risk of loss from any diminution in its value, and the other burdens of ownership such as taxes and liabilities arising from the property. The IRS argued that EPC Two did not possess any of the benefits and burdens of ownership of the property because it had no equity interest in the property and it had made no economic outlay to acquire it, it was not at risk with respect to the property because all of the financing was nonrecourse as to EPC Two, it paid no real estate taxes, and the construction of improvements on the property were financed and directed by Bartell Drug. Additionally, the IRS argued that Bartell Drug had possession and control of the property during the entire time EPC Two held legal title by virtue of the REAECA provisions giving it control over construction of site improvements and the possession to a lease that EPC Two was obligated under the REAECA to extend to it for rent equal to the debt service on the KeyBank loan plus EPC Two’s fee for holding title. In short, the IRS’s position was that the benefits and burdens test, which is used in many contexts to determine ownership of property for federal tax purposes,[9] should be applied in the context of Section 1031 to determine who owns replacement property as between a third-party exchange facilitator who takes legal title to the property to facilitate an exchange and the taxpayer who ultimately receives the replacement property at the time of the exchange.

On the other hand, the taxpayer argued that both the Tax Court and the Court of Appeals for the Ninth Circuit, to which an appeal in this case would ordinarily lie, had expressly rejected the proposition that a person who takes title to the replacement property for the purpose of effecting a Section 1031 exchange must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement. Citing Alderson v. Comm’r,[10] Bartell Drug pointed out that the Ninth Circuit expressly stated that “[O]ne need not assume the benefits and burdens of ownership in property before exchanging it but may properly acquire title solely for the purpose of exchange and accept title and transfer it in exchange for other like property, all as part of the same transaction with no resulting gain which is recognizable.…”[11]

The Tax Court went on to provide that it had followed Alderson according Section 1031 treatment in a variety of transactions where the taxpayer used a third-party exchange facilitator to take title to the replacement property to effect an exchange of property in form, who was contractually insulated from any beneficial ownership of the replacement property, citing Garcia v. Comm’r,[12] Barker v. Comm’r[13] and Biggs v. Comm’r[14]. In all these cases, the Tax Court pointed out that the third-party exchange facilitator was contractually excluded from beneficial ownership of the property pursuant to the agreement under which it held title to the replacement property for the taxpayer, and that beneficial ownership necessarily resided with the taxpayer once title had been obtained from the seller of the replacement property. The Tax Court observed that in each of these cases, the third-party exchange facilitator was nevertheless treated as the owner of the replacement property at the time of the exchange.

In support for its contention that a third-party exchange facilitator must hold the benefits and burdens in the replacement property in order to be treated as the owner of the property at the time of the exchange, the IRS relied on the Tax Court’s more recent decision in DeCleene v. Comm’r[15], in which the Tax Court employed the benefits and burdens analysis in rejecting the taxpayer’s claim of Section 1031 treatment. In DeCleene, the Tax Court concluded that the taxpayer had beneficial ownership of the replacement property at the time of the exchange even though the taxpayer had arranged for the transfer of legal title of the replacement property to the purchaser of the relinquished property. The Tax Court concluded in the DeCleene case that the purported exchange of the relinquished and replacement properties was therefore an exchange with the taxpayer himself (a “self exchange”) not qualifying for tax-deferred treatment under Section 1031.

The Tax Court, in rejecting the IRS’s argument, found that the IRS interpreted the DeCleene case too broadly. In the DeCleene case, the taxpayer made an outright purchase of the replacement property and only later transferred the property to a third-party exchange facilitator. The Tax Court stated that its decision in DeCleene made explicit and repeated emphasis on the taxpayer’s failure to use a third-party exchange facilitator so that the DeCleene case did not address the circumstances where a third-party exchange facilitator is used from the outset in a reverse exchange. The Tax Court then went on to provide that the Alderson and Biggs cases established that where a Section 1031 exchange is contemplated from the outset and a third-party exchange facilitator, rather than the taxpayer, takes title to the replacement property before the exchange, the third-party exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for Section 1031 purposes before the exchange.

The Tax Court went on to reject the IRS’s argument that Alderson and Biggs were distinguishable because they concerned forward exchanges rather than reverse exchanges. First, the Tax Court found that although Biggs is sometimes characterized as involving a forward exchange, it was actually a reverse exchange. Second, the Tax Court found that even forward exchange cases, including Alderson, analyze the relationship to the replacement property of the taxpayer versus a third-party exchange facilitator, and treat the latter as the owner before the exchange, notwithstanding the utterly transitory and nominal nature of that ownership. In the Tax Court’s view, the analysis of the relationship of the taxpayer to the replacement property, as compared to the third-party exchange facilitator holding bare legal title, is equally applicable in a reverse exchange.

Finally, the Tax Court acknowledged that while the transaction at issue spanned a greater period (17 months) than those in Alderson and Biggs (3 months and 4-1/2 months, respectively), case law provides no specific time limitation on the period during which a third-party exchange facilitator may hold title to the replacement property before the title to the relinquished property and replacement properties are transferred in a reverse exchange.

The Tax Court concluded that Bartell Drug’s disposition of the Everett Property and the acquisition of the Lynnwood Property in 2001 qualified for nonrecognition treatment under Section 1031 as a like-kind exchange since EPC Two was treated as the owner of Lynnwood Property during the period it held legal title to the Lynnwood Property.

Observations

At a District of Columbia Bar Taxation Section luncheon in Washington, DC, John Lovelace, Branch 5 Attorney, IRS Office of Associate Chief Counsel (Income Tax and Accounting), said that the question of whether to appeal the Bartell case is “under active consideration [and] no decision has been reached.” Lovelace stated that because Bartell would be appealable to the Ninth Circuit, the unfavorable opinion in Alderson will be an issue in the consideration of whether to appeal, but that case might not necessarily support the Tax Court’s decision in Bartell. Lovelace specifically stated that “it’s going to come down to whether we are comfortable with the Ninth Circuit precedent, and I think Alderson is a case that we would look at pretty strongly and if we felt like we could distinguish it, we might move forward.” “If not, we probably would not.”[16]

Subsequently, speaking at the Sales, Exchanges and Basis Section of the American Bar Association Section of Taxation meeting in Boston, Mr. Lovelace reiterated that the IRS is considering appealing Bartell to the Ninth Circuit and that “we are unlikely to walk away from a benefits and burdens analysis.”[17]

About the Author:
Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at slooney@www.deanmead.com.

[1] 147 TC No. 5 (2016).

[2] 2000-2 C.B. 308.

[3] Carlton v. U.S., 385 F.2d 238 (CA-5 1967).

[4] See, e.g., Comm’r v. P.G. Lake, Inc., 356 U.S. 260 (1958); and Koch v. Comm’r, 71 TC 54 (1978).

[5] See, e.g., Starker v. U.S., 602 F.2d 1341 (CA-9 1979).

[6] Id.

[7] Section 1031(a)(3).

[8] 2002-2 C.B. 308.

[9] See e.g., Grodt & McKay Realty, Inc. v. Comm’r, 77 TC 1221 (1981).

[10] 317 F.2d 790 (CA-9 1963), reversing 38 TC 215 (1962).

[11] Id. at 795.

[12] 80 TC 491 (1983).

[13] Barker v. Comm’r, 74 TC 555 (1980).

[14] Biggs v. Comm’r, 632 F.2d 1171 (CA-5 1980).

[15] 115 TC 457 (2000).

[16] IRS Considering Appeal on Like-Kind Exchange Case, 2016 TNT 184-7 (Sep. 22, 2016).

[17] IRS Sticking with Benefits and Burdens Despite Loss in Bartell, TNT 192-14 (Oct. 4, 2016).