- The Super Rev Proc 2000-37 Reverse Exchange
- May 2, 2003
- Law Firm: Miller Nash LLP - Portland Office
When Rev Proc 2000-37, 2000-2 CB 308, was first released by the Internal Revenue Service, it was hailed as a significant breakthrough in structuring reverse tax-free exchanges. Rev Proc 2000-37 provides a safe harbor for anyone structuring a reverse tax-free exchange. There is only one catch, and it is a whopper -- Rev Proc 2000-37 requires that any reverse exchange must be completed in 180 days. As described in this article, a Super Rev Proc 2000-37 reverse exchange will allow 1) the benefits of Rev Proc 2000-37 to be available if the transaction can be completed within 180 days or 2) the conversion of the transaction to a classic reverse exchange.
Most taxpayers investigating a reverse exchange are in one of two situations. First, a taxpayer may be completing an improvement exchange that requires that the replacement property cannot be received until it has costs equal to the sales price of the relinquished property. In many cases this may be difficult or impossible to do. Construction delays are a normal risk in completing a project and can create a tax disaster if the time deadline cannot be met. Second, a taxpayer may not have found a buyer for the relinquished property, or, if a buyer is found, the sale might not close by the date on which the replacement property must be purchased. The taxpayer can never be sure that the sale of the relinquished property can be consummated within the fairly short timelines required under Rev Proc 2000-37.
If Rev Proc 2000-37 is not used, then a reverse exchange must be structured under the "classical" approach, in which the exchange accommodation titleholder ("EAT") who is holding title to the parked property must be considered the owner of the property for federal income tax purposes. To be considered the owner for tax purposes, the EAT must possess a majority of the benefits and burdens of ownership. If the EAT does not, the taxpayer is considered to own the parked property for tax purposes, and the exchange fails.
Under the classical approach, to be treated as the true owner of the parked property the EAT must have the right to income from the parked property, the potential to receive capital appreciation, and perhaps the ownership of equity in the parked property. Any leases, options, or other arrangements should be based on arm's-length market arrangements. Under Rev Proc 2000-37, arm's-length market arrangements are not required.
So how can a Super Rev Proc 2000-37 be structured? First, the transaction must be structured to meet all the technical requirements of Rev Proc 2000-37. A discussion of these requirements is beyond the scope of this article, but except for the 180-day time limits, they are not very onerous. Second, the transaction must also be structured so that it meets the criteria for a classical reverse exchange. This means that the leases, options, and other arrangements must be as close to arm's length as possible. If there is a lease, the EAT must have lease income (over and above its expenses) so that it can be argued that the EAT received income from the property. For example, a triple-net lease can be structured so that there is $100-per-month cash flow over and above underlying debt payments with a minimum annual lease income of at least $1,200. After each year the rents could increase by 6 percent. The EAT must also have the potential to have capital appreciation. To achieve this result, the EAT can grant the taxpayer an option to purchase the parked property for cost plus $1,000. Both the $1,200 of lease income and the $1,000 of appreciation profit can be part of the EAT's income for its services. In addition, to make the transaction very difficult for the IRS to attack, the EAT can actually invest its own money into the transaction. A minimum 3 percent investment is considered in other tax motivated transactions to make the EAT the owner of the property for tax purposes.
If, near the end of the 180-day period for holding property by the EAT, it appears that the EAT must hold the parked property for longer than 180 days, the EAT and the taxpayer can amend the option agreement and lease to extend the period to a year (or even two years). The option price can be changed to fair market value with a presumption that if the option is exercised during the first year, the fair market value is equal to the EAT's cost plus $1,000. The agreement thus amended, the taxpayer -- using a Super Rev Proc 2000-37 -- will have a year (or two years) to complete the exchange. After that, the EAT's lease income will go up by 6 percent and the option price will change to fair market value. The EAT thus has both real prospects for income and capital appreciation from the parked property. The only risk the taxpayer might have is that the EAT can theoretically refuse to amend the option agreement, but as a practical matter this risk is minimal.
A Super Rev Proc 2000-37 gives the taxpayer the best of both worlds: the safety and security of knowing that the transaction will be tax-free if accomplished within the 180-day period, as well as the option to take on the additional risks of a classic reverse exchange if the transaction cannot be completed within 180 days.