by George G. Jones and Mark A. Luscombe

Like-kind exchanges have come a long way over the years, from simple swaps of one business or investment property for another, to forward exchanges, reverse “Starker” exchanges, and even four-way exchanges, with or without cashouts.

They give businesses and investors important flexibility to revamp operations or get rid of nonproductive assets without being taxed. In fact, the business and investment communities have put tremendous pressure on Washington to keep interpretation of the like-kind tax break as broad as possible.

Nevertheless, some practitioners have been pushing the envelope lately on creative manipulation of the like-kind rules, causing some push-back by the Internal Revenue Service and the Treasury Department. Understanding where the lines are being drawn is essential to maximizing a business’ use of the like-kind exchange provisions without running afoul of examination problems.

Some of the positions recently taken by the IRS eventually might be proven wrong in the courts. However, a taxpayer who takes an aggressive position is more likely now than ever to have its exchange-transactions scrutinized.

Two like-kind exchange issues have taken center stage recently in IRS guidance. One is pro-taxpayer, one is not. One brings good news, while the other creates bad precedents for structuring future exchanges.

Delaware Statutory Trusts
Rev. Rul. 2004-86 enables a Delaware Statutory Trust to be classified as a trust for tax purposes and secure like-kind treatment in a package more likely to bring a deal together than outright individual ownership.

Basically, property owned by an individual or business can be placed in a DST in exchange for an interest in the DST (tax-free), followed by a like-kind exchange (tax-free) by that individual or business of its interest in the DST for property similar to the property held in the DST. If all other like-kind exchange qualifications fall into place, tax-free treatment is allowed not only for the party trading the DST interest but also for the party receiving it in the exchange.

Delaware law as it applies to the terms of the trust agreement must be examined in determining whether a DST will work for like-kind treatment. If a power does not exist under the trust agreement to vary the investment of the certificate holders, it would indicate that the DST is an investment trust to be classified as a trust for federal tax purposes and, therefore, is an entity that will work for like-kind treatment.

Under the terms of the trust agreement in the hypothetical situation posed by Rev. Rul. 2004-86, the trustee could collect and distribute income; purchase very limited short-term investments; and make minor structural changes to the property. The trustee could not accept additional contributions; renegotiate the terms of the loan; or renegotiate the terms of the lease. These attributes, the IRS concluded, indicated that the trustee had no power to vary the investment.

The IRS specifically distinguished Rev. Rul. 92-105, which examined an Illinois land trust. The trustee there was an agent for the taxpayer, and a genuine trust was not created. The taxpayer retained direct ownership of the property for federal tax purposes.

No ‘parking’
Rev. Proc. 2004-51 puts the brakes on businesses twisting the like-kind exchange rules to allow use of one property to fund the improvement of another property. Before this recent guidance, taxpayers were operating under the most liberal like-kind rules seen in years, thanks to Rev. Proc. 2000-37’s safe-harbor rules.

As long as those safe-harbor rules were followed, the IRS promised not to challenge (1) the qualification of property as either “replacement property” or “relinquished property,” or (2) the treatment of the “exchange accommodation titleholder” as the beneficial owner of such property for tax purposes, if the property is held in a “qualified exchange accommodation arrangement.” Rev. Proc. 2004-51 explains that the safe-harbor went too far and, in effect, has eliminated (1), above, from its promised blind eye.

Taxpayers had been using the safe harbor for parking transactions to take proceeds from the sale of real estate to pay for improvements to other real estate owned by the same taxpayer or a related party. Taxpayers were claiming like-kind exchange treatment when they transferred property to the third party and received the same property back “as replacement property in a purported exchange for other property of the taxpayer.” The IRS believed that this result was not intended by Code Section 1031 or by its Rev. Proc. 2004-37 safe harbor.

Parking safe harbor limited
The regulations on deferred like-kind exchanges, first introduced in 1993, do not allow “reverse” Starker exchanges. In a reverse exchange, the property acquired in the exchange is obtained before the taxpayer relinquishes its own property. In Rev. Proc. 2000-37, the IRS provided a safe harbor that allows taxpayers to “park” the acquired asset with a third-party titleholder.

In the meantime, the taxpayer finds another company that is willing to purchase the asset and make an exchange. The taxpayer then relinquishes its property by exchanging assets tax-free with the titleholder. This had to occur within 180 days of the “parking” transaction. The titleholder then transfers the relinquished property to the second company.

In some parking transactions, the taxpayer and the titleholder exchange properties before the taxpayer has found another company to participate in the exchange.

Under Rev. Proc. 2004-51, the safe harbor for parking transactions is no longer available to taxpayers who use property that they owned before the exchange as replacement property. The guidance applies to parking transactions after July 19, 2004.

Rev. Proc. 2004-51 appears to bar transactions in which like-kind property and a loan figure prominently. In one typical arrangement, a taxpayer transfers its own property to the titleholder, lends it money that is used to improve the property, then exchanges the improved property for another “like-kind” asset. The titleholder then sells the asset in a sale arranged by the taxpayer, and repays the taxpayer’s loan with the proceeds.

Tip of the iceberg?
Time will tell whether the removal of the safe-harbor for a taxpayer’s previously owned property will stop build-to-suit exchanges. Remember that the IRS is only removing the safe harbor. The exchange still works if the taxpayers can establish that the exchange accommodation titleholder bears the economic benefits and burdens of ownership so that the accommodation party can be treated as the owner of the property. Rev. Proc. 2000-37 itself stated that, “the service recognizes that ‘parking’ transactions can be accomplished outside of the safe harbor provided in this revenue procedure.”

For example, what if the taxpayer or a related party acquires unimproved property first to go through the time-consuming process of obtaining building permits before starting the 180-day holding-period clock running on improvements by the exchange accommodation titleholder? Some argue that allowing a like-kind exchange under those facts remains true to the intent of the statute.

Second, members of the American Bar Association Tax Section and others have advised the IRS that leasehold improvement exchanges (in which the replacement property includes improvements constructed on land owned by a taxpayer and leased to an accommodation party) satisfy both the purpose and the technical requirements of Section 1031. They maintain further that related-party leasehold improvement exchanges also can be structured to avoid abuse of the related-party relationship and fulfill the requirements of Section 1031.

Finally, the Treasury and the IRS appear a bit uncertain about how far they should go in denying safe-harbor treatment. They end Rev. Rul. 2004-51 by stating that they are studying other parking transactions and may issue further guidance. In particular, they report looking at related-party transfers of leasehold interests to a titleholder, which makes improvements to the land and transfers the improved property to the taxpayer for other real estate.


George G. Jones, J.D., LL.M., is the managing editor of Federal and State Tax, and Mark A. Luscombe, J.D., LL.M., CPA, is the principal analyst of Federal and State Tax, at CCH Inc., in Riverwoods, Ill.

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