The Bartell Case

In Bartell, the Tax Court was asked to decide whether a reverse exchange that did not fall within the safe-harbor provisions of Revenue Procedure 2000-37 still qualified as a valid LKE. In the case, Bartell Drug Co. (“Bartell Drug”), an S-corporation, entered into an agreement to purchase a property in Lynnwood, Washington. To facilitate the purchase through a LKE transaction, Bartell Drug engaged a third party Section 1031 exchange facilitator (the exchange accommodation titleholder or “EAT”) to take title to the Lynnwood property until it could sell another property (relinquished property). As part of the exchange transaction and in accordance with its agreement with Bartell Drug, the EAT obtained bank financing to purchase the Lynnwood property and construct a new drug store which Bartell Drug guaranteed. The agreement also permitted Bartell Drug to manage the construction of the new drug store and upon completion, required the EAT to triple net lease the drug store to Bartell Drug. When a buyer for the relinquished property was found, Bartell Drug assigned its right to sell the property to a Section 1031 qualified intermediary who subsequently sold the relinquished property to the buyer, used the sales proceeds to purchase the Lynnwood property from the EAT and transferred the Lynnwood property to Bartell Drug to complete the LKE. The entire LKE transaction took approximately 17 months to complete. On audit, the IRS rejected the tax deferral treatment under Code Section 1031 and assessed an income tax deficiency against the Bartell Drug shareholders relating to the transaction.

The principal issue in Bartell was whether Bartell Drug or the EAT should have been considered the true owner of the Lynnwood property for federal income tax purposes prior to the EAT's conveyance of the Lynnwood property to Bartell Drug. If Bartell Drug was the owner for federal income tax purposes at some time prior to its acquisition of title, a LKE would not be deemed to have occurred because a taxpayer cannot use property that it already owns as replacement property in a LKE. The IRS took the position that Bartell Drug already owned the Lynnwood property under the “benefits and burdens” test because it had the capacity to benefit from any appreciation in the property's value, the risk of loss from any diminution in its value, and other burdens of ownership such as taxes and liabilities arising from the property. By contrast, the IRS also contended that the EAT possessed no benefits and burdens of ownership of the Lynnwood property; it had no equity interest in the property, it had no economic outlay to acquire the property, it was not at risk with respect to the property because all of the financing was nonrecourse to it, it paid no real estate taxes, the construction was financed and directed by Bartell Drug and Bartell Drug had possession and control of the property for the entire time the EAT held title. The shareholders argued that the case law in the Tax Court and Ninth Circuit, to which an appeal of the case would ordinarily lie, had expressly rejected the proposition that a person who takes title to the replacement property for purposes of effecting a LKE must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement under Code Section 1031.

Based on this case law, the Tax Court agreed with the shareholders and held that the transaction qualified for nonrecognition treatment as a LKE. Importantly, the Tax Court emphasized that the case law established that where a Code 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 exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for Code Section 1031 purposes before the exchange. However, the Tax Court also limited its holding to reverse exchange transactions that did not extend beyond the time periods at issue in existing case law (including the 17-month period in Bartell).

Conclusions

The Tax Court's holding in Bartell is significant because it substantially increases the flexibility that taxpayers have in structuring Section 1031 non-safe harbor reverse exchanges and reduces the related risks associates with these transactions. For example, it may no longer be necessary for the titleholder (i.e., EAT) to use its own lines of credit to finance construction or go partially recourse on the acquisition or construction financing to evidence the burdens of ownership until the project was conveyed to the taxpayer. Nevertheless, taxpayers seeking to implement a reverse exchange should continue to structure the exchange in accordance with Revenue Procedure 2000-37, if possible, to avoid any questions regarding the treatment of the transaction as a LKE. However, for construction (i.e., “build-to-suit”) reverse exchanges that cannot be completed within the 180 day limit imposed by the revenue procedure, the Bartell decision represents a major victory because it makes nonrecognition treatment possible without the additional challenge of demonstrating that the EAT obtained the substantial benefits and burdens of ownership. This is especially true in the jurisdictions in which the case law upon which the Tax Court based its decision would be controlling.

Taxpayers should be aware, however, that the IRS may appeal the Tax Court's decision and that there is a risk of an IRS challenge to reverse exchanges that are not effected in compliance with the safe-harbor. Therefore, it is important for taxpayers to consult with their tax advisors to structure their reverse exchange transactions in compliance with Revenue Procedure 2000-37 or if this cannot be done, as closely as possible to the facts in Bartell.

Withers Bergman

In a long awaited decision (almost 10 years following the initial trial), the United States Tax Court held in Estate of George H. Bartell, Jr. v. Commissioner, 147 T.C. 5 (2016) that the taxpayer's non-safe harbor reverse exchange of real property for like-kind replacement property affected through a third party exchange facilitator qualified for nonrecognition treatment under Internal Revenue Code Section 1031. So says Marc Finer, special counsel in the wealth planning and tax group at Withers Bergman. “In so holding, the Tax Court rejected the IRS's argument that the taxpayer should have been treated as the owner of the replacement property at the time of the exchange because it had already assumed the benefits and burdens of ownership. The Tax Court's holding in Bartell is significant because it substantially increases the latitude that taxpayers have in structuring Code Section 1031 non-safe harbor reverse exchanges and reduces the attendant risks.”

Read his full guest commentary below for more on the subject. The views expressed in the column are the author's own.

Background on Like-Kind Exchanges

Code Section 1031 provides for the nonrecognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment for like-kind property (commonly referred to as a “like-kind exchange”). While the statute was originally intended to cover simultaneous exchanges, the Treasury Regulations promulgated under Code Section 1031 expanded the scope of permissible like-kind exchanges to include “forward exchanges” – exchanges in which the taxpayer receives the replacement property after the date on which the taxpayer disposes of the relinquished property. However, reverse exchanges or so-called “parking arrangements” whereby the replacement property is purchased before the taxpayer disposes of the relinquished property were not specifically addressed until the IRS issued Revenue Procedure 2000-37, 2000-2 CB 308. The Revenue Procedure provides a safe-harbor under which the IRS will not challenge the qualification of property as either replacement property or relinquished property for purposes of Code Section 1031, or the treatment of the third party facilitator (i.e. a person other than the taxpayer who holds legal title to, or other indicia of ownership of, the property to be exchanged) as the beneficial owner of the property for tax purposes if the property is held in a qualifying exchange accommodation arrangement. Importantly, the Revenue Procedure is effective for exchanges on or after September 15, 2000 and was therefore, inapplicable to the like-kind exchange (“LKE”) in Bartell which commenced prior to this effective date.

The Bartell Case

In Bartell, the Tax Court was asked to decide whether a reverse exchange that did not fall within the safe-harbor provisions of Revenue Procedure 2000-37 still qualified as a valid LKE. In the case, Bartell Drug Co. (“Bartell Drug”), an S-corporation, entered into an agreement to purchase a property in Lynnwood, Washington. To facilitate the purchase through a LKE transaction, Bartell Drug engaged a third party Section 1031 exchange facilitator (the exchange accommodation titleholder or “EAT”) to take title to the Lynnwood property until it could sell another property (relinquished property). As part of the exchange transaction and in accordance with its agreement with Bartell Drug, the EAT obtained bank financing to purchase the Lynnwood property and construct a new drug store which Bartell Drug guaranteed. The agreement also permitted Bartell Drug to manage the construction of the new drug store and upon completion, required the EAT to triple net lease the drug store to Bartell Drug. When a buyer for the relinquished property was found, Bartell Drug assigned its right to sell the property to a Section 1031 qualified intermediary who subsequently sold the relinquished property to the buyer, used the sales proceeds to purchase the Lynnwood property from the EAT and transferred the Lynnwood property to Bartell Drug to complete the LKE. The entire LKE transaction took approximately 17 months to complete. On audit, the IRS rejected the tax deferral treatment under Code Section 1031 and assessed an income tax deficiency against the Bartell Drug shareholders relating to the transaction.

The principal issue in Bartell was whether Bartell Drug or the EAT should have been considered the true owner of the Lynnwood property for federal income tax purposes prior to the EAT's conveyance of the Lynnwood property to Bartell Drug. If Bartell Drug was the owner for federal income tax purposes at some time prior to its acquisition of title, a LKE would not be deemed to have occurred because a taxpayer cannot use property that it already owns as replacement property in a LKE. The IRS took the position that Bartell Drug already owned the Lynnwood property under the “benefits and burdens” test because it had the capacity to benefit from any appreciation in the property's value, the risk of loss from any diminution in its value, and other burdens of ownership such as taxes and liabilities arising from the property. By contrast, the IRS also contended that the EAT possessed no benefits and burdens of ownership of the Lynnwood property; it had no equity interest in the property, it had no economic outlay to acquire the property, it was not at risk with respect to the property because all of the financing was nonrecourse to it, it paid no real estate taxes, the construction was financed and directed by Bartell Drug and Bartell Drug had possession and control of the property for the entire time the EAT held title. The shareholders argued that the case law in the Tax Court and Ninth Circuit, to which an appeal of the case would ordinarily lie, had expressly rejected the proposition that a person who takes title to the replacement property for purposes of effecting a LKE must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement under Code Section 1031.

Based on this case law, the Tax Court agreed with the shareholders and held that the transaction qualified for nonrecognition treatment as a LKE. Importantly, the Tax Court emphasized that the case law established that where a Code 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 exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for Code Section 1031 purposes before the exchange. However, the Tax Court also limited its holding to reverse exchange transactions that did not extend beyond the time periods at issue in existing case law (including the 17-month period in Bartell).

Conclusions

The Tax Court's holding in Bartell is significant because it substantially increases the flexibility that taxpayers have in structuring Section 1031 non-safe harbor reverse exchanges and reduces the related risks associates with these transactions. For example, it may no longer be necessary for the titleholder (i.e., EAT) to use its own lines of credit to finance construction or go partially recourse on the acquisition or construction financing to evidence the burdens of ownership until the project was conveyed to the taxpayer. Nevertheless, taxpayers seeking to implement a reverse exchange should continue to structure the exchange in accordance with Revenue Procedure 2000-37, if possible, to avoid any questions regarding the treatment of the transaction as a LKE. However, for construction (i.e., “build-to-suit”) reverse exchanges that cannot be completed within the 180 day limit imposed by the revenue procedure, the Bartell decision represents a major victory because it makes nonrecognition treatment possible without the additional challenge of demonstrating that the EAT obtained the substantial benefits and burdens of ownership. This is especially true in the jurisdictions in which the case law upon which the Tax Court based its decision would be controlling.

Taxpayers should be aware, however, that the IRS may appeal the Tax Court's decision and that there is a risk of an IRS challenge to reverse exchanges that are not effected in compliance with the safe-harbor. Therefore, it is important for taxpayers to consult with their tax advisors to structure their reverse exchange transactions in compliance with Revenue Procedure 2000-37 or if this cannot be done, as closely as possible to the facts in Bartell.