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Reverse Like-Kind Exchanges

(Acquiring the replacement Property before the old Property is sold)

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The like-kind exchange is a popular strategy for deferring capital gain taxes on the transfer of business or investment property. Section 1031 of the Internal Revenue Code permits taxpayers to exclude from taxable income any gain recognized on the transfer of most types of property (other than securities, partnership interests and similar property) if that property is exchanged for other property of like kind. The statute does not require that the disposition and acquisition of property occur simultaneously; e.g., exchanges that occur within a 180-day period, known as Starker exchanges because of the U.S. Supreme Court case that engendered them, are expressly authorized. Regulations finalized in 1991 established rules and procedures for accomplishing a tax-deferred exchange when the disposition of the "relinquished property" precedes the acquisition of the "replacement property." The 1991 regulations left open the question of whether and how it is possible to execute a successful "reverse Starker" exchange; i.e., one in which the replacement property is acquired before the relinquished property is transferred.

Safe Harbor Established

On October 2, 2000, the IRS answered this question through the publication of Rev. Proc. 2000-37, 2000-40 I.R.B. 308 (the "Procedure"). The Procedure establishes a safe harbor for the qualification under Section 1031 of reverse Starker exchanges which involve the use of an accommodation party and meet a number of other technical requirements. To fall within the safe harbor, a "qualified exchange accommodation arrangement," involving either the relinquished property or the replacement property, or both, requires the following:

The accommodation party must hold legal title to the property and other indicia of ownership that are treated as beneficial ownership.

At the time the accommodation party acquires the property, the taxpayer must intend to involve the property in a like-kind exchange.

Within 5 days after the transfer of the property to the accommodation party, the taxpayer and the accommodation party must enter into a written agreement which references the Procedure and contains a number of required provisions.

Both parties must treat the accommodation party as the owner of the property for federal income tax purposes for the period during which it owns the property.

The taxpayer must identify the relinquished property, in the manner set forth in existing regulations, within 45 days of the transfer of the replacement property to the accommodation party.

Within 180 days after the transfer of the property to the accommodation party, the property must be transferred (directly or indirectly through a qualified intermediary) to the taxpayer as replacement property.

The maximum combined amount of time that the replacement property and the relinquished property may be held in a qualified exchange accommodation arrangement must not exceed 180 days.

Reverse exchanges in accordance with the latest IRS regulations are much more complicated than a regular 1031 Exchange and the cost for such an exchange will range between $3,500.00 and $5,000.00, depending upon the circumstances.

Other Transactions May Qualify

The IRS has acknowledged that the Procedure is not the exclusive route to qualification of a reverse Starker transaction as a like-kind exchange. For transactions which cannot qualify for the safe harbor, e.g., due to failure to meet a 5, 45, or 180-day time limit, it still may be possible to structure an arrangement which will qualify as a like-kind exchange under case law and rulings in existence prior to publication of the Procedure.

Like-kind exchanges can be an effective means of deferring tax liabilities but require careful adherence to technical requirements. For more information, contact us.

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