Construction Exchanges: A Tale of Two Letter Rulings

By Richard A. Goodman[1]


Introduction

            Although this may be the worst of times in many places, it surely is the best of times in the world of construction exchanges.[2] Although the courts have approved construction exchanges for many years,[3] the IRS repeatedly contested them until 1991.[4] In that year, the IRS issued regulations providing safe harbors for standard deferred exchanges.[5] These regulations (the “Deferred Exchange Regulations”)[6] explicitly approved the use of construction exchanges[7] as long as certain identification and receipt requirements were met.[8]

For economic reasons, construction exchanges usually can be structured only as reverse exchanges and not as standard deferred exchanges. Therefore, the guidance provided by the Deferred Exchange Regulations was limited. In 2000, however, the IRS issued Rev. Proc. 2000-37,[9] approving reverse exchanges, including reverse construction exchanges, as long as they met certain requirements. As helpful as is that revenue procedure, it, too, left questions unanswered.

            Thus, the recent issuance by the IRS of two private letter rulings[10] is very welcome.  These rulings are Ltr. Rul. 200251008 (“Ruling 1”)[11] and Ltr. Rul. 200329021 (“Ruling 2”).[12]  Taken together, they provide insight into exchanges in which improvements are constructed on leasehold interests acquired from related parties.

Ruling 1

The facts presented in Ruling 1 are as follows.[13] A married couple (“Owner 1”) owns an S Corporation (“Taxpayer 1”), which, in turn, owns improved real property (“Relinquished Property 1”) upon which it operates its business.[14] Taxpayer 1 has entered into a purchase agreement (“Purchase Agreement 1”) to sell Relinquished Property 1 to an unrelated third party (“Buyer 1”). Taxpayer 1 wishes to relocate its business operations to a certain parcel of raw land (“Raw Land 1”) [15] upon which certain improvements (“Improvements 1”) will be constructed. In substance, Taxpayer 1 wishes to exchange Relinquished Property 1 for Raw Land 1, as improved by Improvements 1, using a qualified intermediary ( “QI 1”) in the exchange.

This exchange cannot be structured as a standard deferred exchange for several reasons:

  • Taxpayer 1 is unable or unwilling[16] to purchase Raw Land 1, which currently is leased by its owner, Seller 1, for a 32-year term under a “Lease and Development Agreement.”[17] The lessee is another S corporation owned by Owner 1 (“Corp 1”). Corp 1, in turn, subleases Raw Land 1 to a limited liability company (“LLC 1”), 90% of which is owned by Owner 1. Therefore, Taxpayer 1 proposes subleasing Raw Land 1 from LLC 1 for its fair rental value, thereby acquiring a leasehold interest (“Leasehold Interest 1”) in it.[18]
  • Since fair market rents are being charged, Leasehold Interest 1 has no value. Therefore, Taxpayer 1 would be receiving boot if Relinquished Property 1 simply was exchanged for Leasehold Interest 1. In order for Taxpayer 1 not to receive boot, Improvements 1 must be constructed before, rather than after, Leasehold Interest 1 is transferred to Taxpayer 1.[19]
  • If Improvements 1 were constructed while LLC 1 owns Leasehold Interest 1, the IRS might well contend that the related party rules are triggered and violated.[20] Therefore, the exchange is being structured as a parking transaction in which Leasehold Interest 1 will be transferred by LLC 1 to an exchange accommodation title holder (“EAT 1”) pursuant to a  qualified exchange accommodation agreement (“QEAA 1”).[21] The sublease between LLC 1 and EAT 1 will be at market rents.
  • EAT 1 is unwilling to take legal title to Leasehold Interest 1, presumably because of the liability risks arising from construction. EAT 1 insists that title to Leasehold Interest 1 be taken by its subsidiary, a newly created limited liability company disregarded for tax purposes (“Titleholder 1”). Improvements 1 will be constructed while Leasehold Interest 1 is owned by Titleholder 1.
  • This exchange is a hybrid deferred/reverse exchange: Taxpayer 1 will transfer Relinquished Property 1 after EAT 1 acquires Leasehold Interest 1 and constructs at least a portion of Improvements 1 but before Taxpayer 1 receives Replacement Property 1.[22]
  • Since Titleholder 1 has no assets, it will be unable to secure construction financing (“Construction Loan 1”) from the proposed lender ( “Bank 1”).[23] Therefore, a creditworthy maker and guarantors will be needed.
  • Even though Titleholder 1 will be the nominal owner of Leasehold Interest 1, Taxpayer 1 wishes a reliable party to control both the construction of Improvements 1 and the disbursement of Construction Loan 1.
  • Even after construction is complete, Taxpayer 1 will be unwilling to take title to Leasehold Interest 1 or to Improvements 1.[24] Instead, it proposes acquiring Titleholder 1 from EAT 1 and treating Titleholder 1 itself as replacement property.
  • Owner 1, Taxpayer 1, Corp 1 and LLC 1 are related parties, necessitating compliance with the related party rules.[25]

 

Ruling 2

The facts in Ruling 2 are as follows. Taxpayer 2 is a corporate subsidiary of a parent corporation (the “Parent”). Taxpayer 2 owns improved real property (“Relinquished Property 2”) which its leases to the Parent[26] and upon which the Parent operates its business.[27] Taxpayer 2 will enter into a purchase agreement (“Purchase Agreement 2”) to sell Relinquished Property 2 to an unrelated third party (“Buyer 2”). The Parent wishes to relocate its business operations to a certain parcel of raw land (“Raw Land 2”) after certain improvements (“Improvements 2”) have been constructed upon it. In substance, Taxpayer 2 wishes to exchange Relinquished Property 2 for Raw Land 2, as improved by Improvements 2.

Taxpayer 2 faces similar but not identical issues to those confronting Taxpayer 1:

  • Taxpayer 2 is unable or unwilling to purchase Raw Land 2, which currently is being leased by its owner (“Owner 2”) to the Parent for a term of 20 years with four (4) five-year renewal options. Instead, the Parent will assign the lease creating the leasehold interest in Raw Land 2 (“Leasehold Interest 2”) to EAT 2. The Parent will receive no consideration except for reimbursement of certain planning costs paid by it to third parties.
  • As in Ruling 1, the exchange will be a hybrid deferred/reverse exchange: Taxpayer 2 will transfer Relinquished Property 2 concurrently with  the acquisition by EAT 2 of  Leasehold Interest 2 but before EAT 2 constructs any of Improvements 2 and before Taxpayer 2 receives Replacement Property 2.
  • As in Ruling 1, Improvements 2 will not be constructed on Leasehold Interest 2 while it is owned by the Parent. Therefore, Taxpayer 2 will utilize a parking transaction in which Leasehold Interest 2 will be acquired and held by an exchange accommodation title holder (“EAT 2”) pursuant to a  qualified exchange accommodation agreement (“QEAA 2”).[28]In this case, however, EAT 2 will be the same entity as QI 2.
  • Like EAT 1, EAT 2 is unwilling to take title to Leasehold Interest 2 and insists that title to Leasehold Interest 2 be taken by its subsidiary, a newly created limited liability company (“Titleholder 2”). Improvements 2 will be constructed while Leasehold Interest 2 is owned by Titleholder 2.
  • Although Titleholder 2 will obtain construction financing (“Construction Loan 2”), Ruling 2 does not provide any details concerning its terms, the identity of the lender or as to guarantors.
  • The Parent will oversee the construction of Improvements 2, and, presumably, the disbursement of Construction Loan 2.
  • When construction is complete, EAT 2 will cause Titleholder 2 to transfer to Taxpayer 2 Leasehold Interest 2 and Improvements 2.
  • In Ruling 2, there are only two related parties, the Parent and Taxpayer 2.

 

Do the Exchanges Meet the “Like Kind” Requirement?

A threshold requirement for any tax deferred exchange is that the properties must be of “like kind.” In Ruling 1, Taxpayer 1 will acquire Titleholder 1 as replacement property, raising the question of whether Titleholder 1, a limited liability company, is “like kind” to Relinquished Property 1, which is real property. Although, in general, an interest in an entity is deemed to be personal property, which is not “like kind” to real property,[29] there is one exception: ownership of a single member limited liability company disregarded for federal income tax purposes is deemed to be equivalent to the ownership of its assets.[30] Since Titleholder 1 meets this requirement, the replacement property here will be deemed to consist of its assets, namely, Leasehold Interest 1.

In both rulings, the respective taxpayers propose exchanging outright ownership in one property for a leasehold interest in another property. Generally, ownership of real property is not “like kind” to a leasehold interest. Again, however, there is an exception: a leasehold interest having a remaining term of at least 30 years (including renewal option periods) is “like kind” to real property.[31] Since the term of the leasehold interest in each ruling exceeds 30 years if renewal options are included, this aspect of the “like kind” requirement is satisfied in both cases.

           

Do the Exchanges Meet the Requirements for Deferred Exchanges?

            The requirements for a deferred exchange are detailed in the Deferred Exchange Regulations. A major focus of these regulations is to prevent the taxpayer’s “constructive receipt” of proceeds from the sale of the relinquished property. In order to comply, a taxpayer cannot have control over or access to those proceeds before receiving the relinquished property. The Deferred Exchange Regulations provide several “safe harbors” to assist the Taxpayer in complying with those rules,[32]  the most common widely used being the “qualified intermediary” safe harbor.[33]

In both of these rulings, the taxpayers are relying on the “qualified intermediary” safe harbor. In each case, the taxpayer will enter into an exchange agreement (the “Exchange Agreement”) with a QI. Then, the taxpayer will assign the purchase agreement to the QI, and will give written notice of the assignment to all parties.[34] Subsequently, the taxpayer will transfer its relinquished property by “direct deed” to the buyer. The buyer will pay the purchase price to the QI, which will use the net proceeds of sale to purchase the replacement property,[35] which will be transferred directly to the taxpayer.[36]

Since each taxpayer is complying with the requirement of the “qualified intermediary safe harbor,” both exchanges comply with the deferred exchange requirements.

 

Do these Construction Exchanges Meet the Requirements for Parking Transactions?

            Rev. Proc. 2000-37 provides that if certain requirements are met, the IRS will not challenge the treatment of an EAT as the beneficial owner of the property held by the EAT, thereby eliminating agency as a factual issue.[37] Rev. Proc. 2000-37 generally is utilized in structuring reverse exchanges. However, nothing prevents it from being used in other types of construction exchanges. As discussed below, both Ruling 1 and Ruling 2 involve hybrid deferred/reverse construction exchanges.

In each ruling, the taxpayer intends construction decisions and disbursement of construction funds to be made an entirely reliable party, LLC 1 in Ruling 1 and the Parent in Ruling 2. However, since, in each case, the leasehold interest in question will by owned by a titleholder during the course of construction, it is crucial for each taxpayer that the titleholder not be treated as its agent. Compliance with Rev. Proc. 2000-37 will enable each taxpayer to accomplish that objective.

Rev. Proc. 2000-37 requires that a taxpayer enter in a written “qualified exchange accommodation agreement” with an EAT,[38] pursuant to which the EAT, directly or through a wholly owned entity disregarded for tax purposes, acquires the Leasehold Interest[39] and agrees to be treated as its owner for all federal income tax purposes.  It further requires that, no later than 45 days after transfer of the Leasehold Interest to the EAT, the Relinquished Property must be identified, and, no more than 180 days after such transfer, the Replacement Property must be transferred to the Taxpayer. [40]

As long as these requirements are met, great latitude is allowed in structuring a construction exchange as a parking transaction. A taxpayer or a disqualified person may loan funds to the EAT, guarantee loans to the EAT and indemnify the EAT. The replacement property may be leased to or from the taxpayer or a disqualified person. Finally, the taxpayer or a disqualified person may manage the property, supervise improvement of the property, act as a contractor and/or otherwise provide services to the EAT.[41]

In Ruling 1, construction of Improvements 1 will be supervised by LLC 1, which will be paid for its services.[42] LLC 1 also will enter into construction contracts and pay the subcontractors. Bank 1 will make Construction Loan 1 to Taxpayer 1, which will sign a promissory note to Bank 1, and this note will be guaranteed by the Husband, the Wife and by LLC 1. Taxpayer 1, in turn, will loan these funds to Titleholder 1, which will execute its own note back to the Taxpayer (the “Titleholder Note”). [43] 

In Ruling 2, construction of Improvements 2 will be supervised by the Parent. Since Ruling 2 does not specify the borrower of  Construction Loan 2 or whether it will be guaranteed, that information is clearly immaterial to the determination that the parking transaction requirements have been met.

 

Does the Exchange Meet the Requirements for an Exchange Between “Related Parties”?

            In each ruling, the most serious risk facing the taxpayer is that the exchange will be disqualified by application of the related party rules. Tax-deferred exchanges between related parties are not prohibited but they are restricted so as to prevent their use for “basis shifting” purposes.[44] In particular, a taxpayer’s exchange with a related party is disallowed if, within two years of the exchange, either the taxpayer or the related party disposes of the property received in the exchange.[45]

            In Ruling 1, the Husband, the Wife, the Taxpayer and LLC 1 all are related parties. The first question, therefore, is whether the exchange is between any of these related parties. The position of the IRS is that the use of a QI does not insulate an exchange from being treated as one between related parties. To the contrary, the IRS would view each of these exchanges as being one between the taxpayer and a related party (LLC 1 in Ruling 1 and the Parent in Ruling 2).[46]

In Ruling 1, since the exchange must be re-characterized as one between Taxpayer 1 and LLC 1, Taxpayer 1 is deemed to be transferring Relinquished Property 1 to LLC 1 in exchange for Raw Land 1 and LLC 1 is deemed to be selling Relinquished Property 1. Similarly, in Ruling 2, the exchange must be viewed as one between Taxpayer 2 and the Parent, in which Taxpayer 2 is transferring Relinquished Property 2 to the Parent in exchange for Raw Land 2 and the Parent is selling Relinquished Property 2. In each ruling, therefore, it appears that the related party has disposed of the property it received by the conclusion of the exchange, which is to say, well before the end of the two-year period.

Nonetheless, in each ruling, the IRS concludes that the related party rules do not trigger the recognition of gain. Neither ruling clearly articulates its reasoning. Ruling 1 simply states that application of the related party rules, “…is not a concern for this transaction unless and until Taxpayer or the related party dispose of their interests in the exchange property within two years after the last transfer that was part of the exchange.”[47] Ruling 2 explains that, “…since both Taxpayer and Parent continue to be invested in exchange properties…gain recognition is not triggered… .”

            Apparently, the position of the IRS is that if a related party is not receiving any compensation for the replacement property, it is not cashing out of that property and no gain recognition is triggered.[48] Although this reasoning is debatable, the conclusion unquestionably is correct, as the related party rules do not apply unless income tax avoidance is a principal purpose of the taxpayer.[49] In neither ruling is there any evidence of a tax avoidance scheme. To the contrary, the related party transfers in both cases have unimpeachable business purposes. Even if basis shifting could be shown to occur, the magnitude of the construction projects inescapably demonstrates that economic considerations clearly dominate over tax motives.

Conclusion

            These rulings provide guidelines in structuring a construction exchange in which improvements are constructed on raw land originally owned or leased by a related party. Although they increase the utility of construction exchanges, the difficulty of completing construction of improvements within 180 days remains an obstacle in most situations.

 


 

[1] Richard A. Goodman is a partner in the law firm of Goodman & Levine LLP with offices in Oakland, California. He is the author of Real Property Exchanges (First Edition, California CEB 1982) and of numerous articles relating to tax-deferred exchanges. As part of his transactional real estate practice, Mr. Goodman represents taxpayers and qualified intermediaries in tax-deferred exchanges. His web address is: www.the1031attorney.com.

[2] A construction exchange is one in which improvements are constructed on the replacement property before that property is transferred to the taxpayer.

[3] See e.g., Coastal Terminals, Inc. v. United States, 320 F.2d 333 (4th Cir. 1963); Alderson v. Commissioner, 317 F.2d at 790 (9th Cir. 1963); Coupe v. Commissioner  52 TC 394 (1969); J. H. Baird Publishing Co. v. Commissioner 39 TC 608 (1962); and 124 Front Street, Inc. v. Commissioner 65 TC 6 (1975). See also Borden, From the Ground Up: An In-Depth Analysis of Build-to Suit and Related Party Exchanges, included in the materials for the Federation of Exchange Accommodators Annual Meeting, October 4, 2003, slightly revised from the version set forth in Tax Management Memorandum, January 27, 2003.

[4] In Rev. Rul. 75-291, 1975-2 Cum Bull 332, the IRS approved a construction exchange where one party purchased raw land and constructed improvements on it before exchanging it with the taxpayer for the relinquished property. The IRS concluded that the buyer was not acting as the taxpayer’s agent in constructing the improvements, a debatable conclusion upon which most taxpayers have been unwilling to rely.

[5] A standard deferred exchange is one in which the relinquished property is disposed of before the replacement property is acquired.

[6] Reg. §1.1031(k)-1.

[7] Reg. §1.1031(k)-1(e)(1).

[8] For example, the Deferred Exchange Regulations state that the identification notice must contain a legal description of the land and as much detail on the construction of the Improvements as is practicable when the identification is made. Reg. §1.1031(k)-1(e)(2).

[9] 2000-40 I.R.B. 308. In a revenue procedure (abbreviated as Rev. Proc.), the IRS provides administrative guidance as to procedural matters in obtaining a ruling from the IRS.

[10] A private letter ruling is one issued in response to a request made by a taxpayer based upon a proposed set of facts. A private letter ruling is binding on the IRS with regard to the taxpayer to whom it is issued unless material facts turn out to be different than those stated. A private letter ruling is not binding on the IRS with regard to any other taxpayer. Nonetheless, private letter rulings are carefully scrutinized by tax practitioners since they usually provide insight into the IRS current position.

[11] Issued September 11, 2002, released December 20, 2002.

[12] Issued April 7, 2003, released July 18, 2003.

[13] In the interest of clarity, the facts in both rulings have been slightly simplified.

[14] The nature of the business is not identified.

[15] Actually, the Raw Land is part of a larger parcel referred to in the Ruling as “A-Acres.” However, the balance of this acreage is not involved in the exchange.

[16] The unwillingness, if any, may arise from a desire to avoid paying compensation to a related party, as discussed below.

[17] The title of that document indicates that development of the Raw Land has been envisioned at least from the time that it was negotiated.

[18] Compare the facts in Ruling 2, below, in which the Leasehold Interest was assigned to the EAT.

[19] Reg. §1.1031(k)-1(e)(1).

[20] See discussion below.

[21] See Rev. Proc. 2000-37, discussed below.

[22] However, see Borden, supra at 30-31, which unequivocally characterizes this as a reverse exchange.

[23] Not to be confused with Bank One, an actual bank.

[24]  This reluctance may relate to liability issues or to property tax or transfer tax implications.

[25] IRC §1031(f).

[26] Ruling 2 does not use the term lease but the relationship clearly entails an implicit lease.

[27] The nature of the business is not identified.

[28] See Rev. Proc. 2000-37, discussed below.

[29] Rev. Rul. 59-229, 1959-2 CEB 180.

[30] Reg. §301.7701-3(b)(1)(ii).

[31] Reg. §1.1031(a)-1(c).

[32] An exchange may qualify a valid deferred exchange even if it does not fall within a safe harbor. However, to avoid uncertainty, the vast majority of deferred exchanges are structured to meet one of the safe harbors.

[33] Reg. §1.1031(k)-1(g)(4).

[34] As required by Reg. §1.1031(k)-1(g)(4)(v).

[35] It should be recalled that in Ruling 1, the Replacement Property is the Titleholder.

[36] Both the Relinquished Property and the Titleholder are being transferred directly rather than being transferred first to the QI. This structuring frequently avoids the imposition of double transfer taxes and is specifically approved by Reg. §1.1031(k)-1(g)(4).

[37] As was the case in Rev. Rul. 75-291, supra.

[38] The fact that the EAT is related to the QI (both are subsidiaries of the same parent) does not adversely affect the exchange.

[39] Rev. Proc. 2000-37 specifically permits title to be taken by a subsidiary which is disregarded for federal income tax purposes.

[40] See Rev. Proc. 2000-37, §4.03(6).

[41] Rev. Proc. 2000-37, §4.02(2)-(5).

[42] Such supervision is specifically authorized by Rev Proc. 2000-37, §4.03(5) Because the Titleholder is a pass-through entity, the contracts which it enters into will be deemed to be made by the EAT.

[43] Its terms are not set forth but presumably they mirror those of the Bank Note.

[44] “Basis shifting” occurs when one party (“Party A”) wishes to sell real property with a low basis and a high value (“Property A”). If Party A sells Property A, he will incur a substantial gains tax. However, if he exchanges it with a related party (“Party B”) who owns high basis real property (“Property B”) and Party B then sells Property A, taxation of most or all of the capital gain can be avoided.

[45] IRC §1031(f)(1).

[46] See TAM 9748006 (8/25/1997) and FSA 199931002 (4/12/1999)

[47] Ruling 1, footnote 5.

[48] In Ruling 2, the “planning costs” for which the Parent is being reimbursed are explicitly stated to be expense reimbursement rather than as consideration for the assignment. Ruling 2, footnote 1.

[49] IRC §1031(f)(2).