In Appeal of Patricia Bragg (SBE, November 2012), the California State Board of Equalization (SBE) determined that the taxpayer had failed in its attempt to complete a reverse like-kind Section 1031 exchange. In a reverse exchange, the taxpayer locates a property he wishes to purchase before he locates a buyer for the property he currently owns and wishes to sell. To ensure that the property the taxpayer wishes to purchase will not be sold in the interim, the taxpayer needs to find a friendly party or exchange intermediary to purchase the new property on his behalf and hold it until he can sell his current property. When he locates a buyer for his current property, he can sell it through the exchange intermediary and receive the replacement property from the intermediary to complete his exchange.

Naturally, the exchange intermediary does not want to incur any economic risk in connection with the purchase and holding of the real property that the taxpayer eventually wishes to acquire. The lack of risk creates the tax problems inherent in these transactions. Under the tax law, the like-kind exchange does not work if the taxpayer is considered to be the economic owner of the replacement property prior to the time he sells his current property. The exchange intermediary normally wants to transfer all of the risks and burdens and benefits of ownership of the replacement property to the taxpayer immediately through their contractual arrangement.

In the Bragg case, the intermediary did a good job of transferring these burdens to the taxpayer. The agreement between the taxpayer and the intermediary provided, first, that the intermediary would sell the replacement property to the taxpayer at the intermediary’s cost to purchase the property plus the costs it incurred while it owned the property. The property was purchased with a loan that was guaranteed by the taxpayer, and the intermediary was not likely to make or lose any money by owning the property beyond the fee it charged. Second, the taxpayer was required to insure the property and pay the property taxes and other expenses of the property during the period the intermediary owned the property. Third, the taxpayer leased the property from the intermediary, but all rent that was paid by the taxpayer was credited to the purchase price when the taxpayer purchased the property from the intermediary. Fourth, the intermediary agreed that it would not further encumber the property during its period of ownership. Fifth, the taxpayer agreed to indemnify the intermediary against any loss or expense related to the purchase, ownership, or sale of the property; and sixth, if the taxpayer did not purchase the property from the intermediary after one year, the intermediary could terminate the exchange agreement and compel the taxpayer to purchase the property. Based on the above, the SBE determined that the taxpayer was the economic owner of the property from the date of the intermediary’s acquisition, so the taxpayer did not receive this property in exchange for his current property.

While reverse exchanges are difficult, they are not impossible, and the IRS has established a safe-harbor procedure through which a taxpayer can accomplish a reverse exchange. The safe-harbor rules are contained in Rev. Proc. 2000-37, as later modified by Rev. Proc. 2004-51. As with a regular exchange through an exchange intermediary, the intermediary must be unrelated to the taxpayer. The key criterion is that the intermediary must transfer the property to the taxpayer within 180 days after it acquires the property — in effect, the same 180-day period the taxpayer has to acquire replacement property in a regular exchange after it sells its property. The taxpayer did not observe the 180-day limit in the Bragg case, so the taxpayer could not rely on the safe harbor.

If a taxpayer observes the 180-day limit, most of the factors that caused the taxpayer’s exchange in Bragg to fail would be permitted. For example, the taxpayer can guarantee the loan the intermediary uses to purchase the property or can even loan the intermediary the purchase funds. The taxpayer can lease the property from the intermediary or manage the property. The price the taxpayer will pay to purchase the property can be fixed in the agreement. Rev Proc. 2004-51 imposes the additional restriction that the taxpayer cannot own the replacement property before it is owned by the exchange intermediary.

While a reverse exchange can be done outside of the safe harbor, it is much more difficult because few intermediaries are willing to take the risks necessary to make them the economic owner for tax purposes.