By Laura Michaels, CPA, and Patricia Brandstetter, J.D., LL.M.

The Tax Court's recent decision in Estate of Bartell, 147 T.C. No. 5 (2016), alleviates some of the uncertainty that taxpayers and practitioners face when structuring a reverse like-kind exchange intended to qualify for nonrecognition treatment under Sec. 1031. To date, the statute and regulations do not address reverse exchanges; however, a safe harbor for these transactions was established in Rev. Proc. 2000-37.

In its decision, the Tax Court rejected the IRS's position that a third-party "exchange facilitator" the taxpayer engaged to take legal title to the replacement property was required to assume the benefits and burdens of ownership of the property to facilitate a valid Sec. 1031 exchange. Moreover, the Tax Court held that existing case law did not limit the time a third-party exchange facilitator may hold title to the replacement property before the exchange must occur.

Citing previous decisions, the Tax Court held that where a Sec. 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. The court distinguished this result from its decision in DeCleene, 115 T.C. 457 (2000), where a taxpayer was held to have merely engaged in an exchange with himself because, rather than using a third-party exchange facilitator, the taxpayer made an outright purchase of the replacement property (unimproved land) prior to the exchange, then conveyed title to a third party for the period during which improvements were constructed, followed by the reconveyance of the improved property to the taxpayer to complete an exchange for other property owned by the taxpayer. According to the Tax Court, DeCleene did not address the circumstances where a third-party exchange facilitator is used from the outset in a reverse exchange.

Bartell arguably signifies one of the most important like-kind exchange developments in the past decade, particularly for contemplated exchanges where construction needs to be made on the replacement property. The Tax Court affirmed that Rev. Proc. 2000-37 only establishes a safe harbor and does not place restraints on "parking" arrangements that do not satisfy its conditions. (In a parking transaction, replacement property is "parked" with an exchange facilitator that holds title to the replacement property, usually until improvements to the property are completed to allow for an exchange "solely for property of like kind.") Thus, the decision could be good news for taxpayers who wish to build or modify replacement property in a reverse exchange, as it is typically difficult to complete property construction within the 180-day safe-harbor time frame.

It is noteworthy that the IRS did not appeal the Tax Court's holding, likely because the decision cited taxpayer-favorable precedent in the Ninth Circuit, which would have heard the case on appeal. However, given that the IRS continues to study parking arrangements, it is possible that congressional action could be sought similar to the limitations enacted in Sec. 1031(a)(3) and Regs. Sec. 1.1031(k)-1 in the wake of Starker, 602 F.2d 1341 (9th Cir. 1979), which first allowed nonsimultaneous exchanges. In addition, while not explicitly addressed by the Tax Court, the principles of equity were in Bartell's favor: Rev. Proc. 2000-37 had not been published, and the taxpayer had structured the reverse exchange carefully and in accordance with established legal precedent at the time. Therefore, taxpayers and advisers should exercise caution and structure reverse exchanges in close alignment with the facts of the taxpayer-favorable case law cited in Bartell.

For a detailed discussion of the issues in this area, see "Tax Clinic: Tax Court Upholds Non-Safe-Harbor Reverse Like-Kind Exchange," in the May 2017 issue of The Tax Adviser.
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