A reverse 1031 exchange is a tax deferral strategy created in Section 1031 of the Internal Revenue Code providing a mechanism for taxpayers to enter into an exchange of property in lieu of a traditional sale. A Section 1031 exchange is an attractive option for taxpayers because when a transaction qualifies for Section 1031 treatment any capital gains taxes that would otherwise be due are deferred. Over the last century, the Section 1031 rules and regulations have evolved to meet the increasingly complex demands of taxpayer transactions. A number of safe harbor provisions have been built in to Section 1031 exchanges in order to facilitate the transactions. For example, Revenue Procedure 2000-37 provides a safe harbor provision for parking a title during a reverse 1031 exchange.
Revenue Procedure 2000-37
Prior to the existence of Revenue Procedure 2000-37, taxpayers who utilized an exchange accommodator titleholder, or EAT, to park a title during an exchange had to be concerned about whether the EAT had enough of the benefits and burdens relating to the property to be treated as the owner of the property for federal income tax purposes. In order to make tax administration simpler, the Internal Revenue Service, or IRS decided to provide a clear method by which an EAT will be considered to be the owner of property involved in a reverse 1031 exchange for the purpose of federal income tax.
In order for the safe harbor provisions of Revenue Procedure 2000-37 to apply, the property in question must be held pursuant to a Qualified Exchange Accommodation Arrangement, or QEAA. Title to either relinquished or replacement property may potentially qualify under the safe harbor provisions.
The safe harbor provisions of Revenue Procedure 2000-37 can be extremely beneficial in a reverse 1031 exchange when a taxpayer has identified a replacement property that needs to be purchased but has yet to identify a property to be relinquished. For example, if a property is particularly desirable and the taxpayer wishes to get it officially off of the market then parking it with an EAT under the terms of a QEAA can be an attractive option. The same applies if a taxpayer stands to lose earnest money on a replacement property if the property is not purchased, but the taxpayer has yet to identify a property to relinquish. In that case, parking the title through the use of a reverse 1031 exchange is the taxpayer’s best option.
If you choose to take advantage of the safe harbor provision, be certain that you comply with all of the rules regarding a QEAA. If your agreement does not satisfy the requirements of a QEAA then your transaction will not qualify for the safe harbor provision.
Reverse 1031 exchanges are relatively straight forward in theory but complex in the series of supporting interdependent 1031 exchange documentation. Additional consideration must be given to states and localities that impose real estate transfer taxes. Business aircraft will often use a reverse 1031 exchange to park the relinquished or old aircraft, while the taxpayer acquires the new aircraft. A taxpayer will also use a reverse 1031 exchange when improvements to the replacement property are needed.
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