Tax Court Approves Non-Safe-Harbor “Reverse” 1031 Exchange Even Though Titleholder Had No Ownership Benefits or Burdens
A 1031 Exchange is a popular capital gains deferral strategy for business and investment property. Taxpayers use the strategy to defer capital gains tax on property “sold” by acquiring “like-kind” replacement property, usually in coordination with an intermediary or accommodation party.
After deliberating for a decade, the U.S. Tax Court has held that an accommodation party with no benefits or burdens of ownership can hold title to real property outside the established IRS “reverse” 1031 Exchange safe harbor without disqualifying the taxpayer’s 1031 Exchange. The case arose from transactions spanning from 1999 to early 2001 before the IRS issued its safe harbor ruling for such transactions. The accommodation party held the potential 1031 Exchange replacement property for over one year (longer than the 180-day period allowed by the IRS safe harbor) before transferring it to the taxpayer, following the taxpayer’s sale of its intended relinquished property. During this period, the taxpayer-funded all costs (including acquisition and construction costs) associated with the property, and entered into arrangements that constructively prevented the titleholder from realizing the benefits of owning the property.
The “owner” of property for federal income tax purposes usually is the party with the “benefits and burdens” of ownership, not legal title. Application of that standard would have disqualified the 1031 Exchange by treating the taxpayer as owning the replacement property before acquiring the relinquished property. But the Tax Court found that different rules apply in the 1031 Exchange context, such that the arrangement was acceptable to treat the temporary accommodation titleholder as the income tax owner until the taxpayer completed its 1031 Exchange.
The Tax Court’s reasoning relied heavily on a decision of the U.S. Court of Appeals for the Ninth Circuit, the appellate court with jurisdiction over California and other western states. While the Tax Court also relied on other precedent, there remains a risk cases in other geographic areas could have different outcomes. The case is nevertheless significant, bolstering the substantial flexibility taxpayers enjoy in structuring 1031 Exchanges.
Here is a link to the Tax Court opinion in Estate of Bartell v. Commissioner: http://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=10868.