The long-awaited Tax Court decision in Estate of George H. Bartell, et al. v. Commissioner (briefs were filed in 2007) was issued recently (147 T.C. No. 5). The court held that property to which an exchange “facilitator” engaged by a taxpayer takes legal title from a third party, but in which the facilitator does not hold burdens and benefits of ownership, is property the taxpayer can acquire to complete an exchange under Internal Revenue Code Section 1031.
Briefly stated, the principal facts of the case are that the taxpayer held appreciated real property (i.e., property having a value in excess of its tax basis) it wanted to transfer in a nonrecognition transaction under Section 1031 (such property, “relinquished property”). The taxpayer located land on which it wanted to construct improvements, and then use in its business (such land and improvements, together, the “project”). The taxpayer wanted to exchange the relinquished property for the project under Section 1031. (The petitioners were the shareholders of an S corporation, Bartell Drug Co. (“Bartell Drug”), which was the subject of the tax examination; for convenience, references below to “taxpayer” are generally to Bartell Drug.)
To plan the exchange, the taxpayer worked with two companies (related to each other) in the business of providing exchange accommodation services. A limited liability company (the “SPE”), all of the membership interests of which were held by one of those companies, acquired title to the land, and held title while the improvements were constructed on it. An institutional lender financed the purchase of the land and cost of the improvements. The loan was guaranteed by the taxpayer. The SPE did not hold assets other than the project or have significant risks, or enjoy significant “upside”, with respect to the project. The taxpayer transferred the relinquished property (actually, a relinquished property other than the one it initially expected to transfer in the exchange), employing the typical qualified intermediary safe harbor provided for in the deferred exchange regulations, and subsequently acquired the project to complete the transaction it reported as an exchange.
Section 1031 generally requires, among other things, an exchange of property by a taxpayer for other property which is “like kind”. While real property held for use in a trade or business is generally considered like kind to other real property held for such purposes, improvements made to land already owned by a taxpayer are not like kind to other real property, such as real property a taxpayer wants to transfer under Section 1031.
Thus, a taxpayer cannot transfer property in exchange for land and then use, or cause another to use, the remaining proceeds from the transfer of the taxpayer’s property to pay for construction of improvements. Instead, in the typical situation, a third party acquires the land and makes sufficient improvements to it so that, given the relative values of the property the taxpayer seeks to transfer and the improved property the taxpayer seeks to acquire, an exchange in which the taxpayer transfers and receives only like kind property can be structured. In such “build to suit” exchanges, the third party must be recognized as the owner of the property for income tax purposes until the property is conveyed by it to the taxpayer to complete the exchange (such holding of tax ownership by a third party is commonly but inaptly referred to as a “reverse exchange”; the property held by the third party is typically transferred to a taxpayer as replacement property to complete what is sometimes referred to as a “forward” exchange, and the holding of the property by the third party is often referred to as a “parking” arrangement).
The issue in Bartell was whether the arrangements among the various parties should be so described for tax purposes; i.e., whether the SPE, as opposed to Bartell Drug, “owned” the project for federal income tax purposes prior to the time at which title to the project was transferred by it to the taxpayer. The taxpayer asserted that the SPE’s holding of legal title until that time was sufficient, and that the court need only determine that the SPE (the court referred to it as a “facilitator”) was not the taxpayer’s agent under applicable federal income tax authority. The IRS asserted that Bartell Drug already “owned” the project at the time the SPE transferred title to it because it then already held the “burdens and benefits” of ownership to the project. (The taxpayer’s brief included the alternative argument that if a burdens and benefits test was appropriate, the SPE held those while it was in title.)
Obviously, because the case is subject to potential appellate review, and for the reasons discussed below and others with respect to matters a reviewing court might consider, advisors and taxpayers will not rush to rely on the Bartell opinion in planning “non safe harbor” build to suit exchanges. (See Sikora article “Structuring the Build-to-Suit Like-Kind Real Estate Exchange”, 1st Quarter 2011 Real Estate Taxation, for extensive discussion of build to suit exchanges.) And, because the decision was perhaps based in some measure on the lenient approach (regarding exchange matters) of the Ninth Circuit, to which appeal in the case would be taken, the case may not provide significant planning comfort to all even should a reviewing court agree with the Tax Court’s decision.
Before speculating a bit regarding potential review of the decision and possible implications of the opinion, as an aside and though not significant with respect to the principal issue in Bartell, the facts set forth in the opinion may lead a reader to ask whether the requirements of the deferred exchange regulation the taxpayer employed, specifically Reg. 1.1031(k)-1(g)(4), were satisfied, as the opinion is somewhat unclear regarding whether the assignment of the purchase agreement for the project to the taxpayer’s qualified intermediary occurred before or after the conveyance of the project to the taxpayer. See Reg. 1.1031(k)-1(g)(4)(iv)(C) and -1(g)(4)(v), and indications in the opinion that was timely done (if the assignment was included in the exchange agreement, which was executed prior to the replacement property deed) or perhaps not timely done (if executed on January 3, 2002, which was after the replacement property deed was recorded).
Leaving aside that matter and moving to the central, important holding in the case, the opinion states that “Alderson and Biggs establish that where a section 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 of the replacement property in order to be treated as the owner for section 1031 purposes before the exchange”.
Speculating regarding potential appellate review of the case, one wonders whether, quite aside from whether an exchange facilitator must “assume the burdens and benefits of ownership” in a project, the Ninth Circuit might consider more important and devote greater attention to Bartell Drug’s holding of significant burdens and benefits of ownership for an extended period prior to the facilitator’s transfer of title to it. In that regard, the court might question whether Alderson, which held that the other party to an exchange transaction need not acquire a “real” interest in the replacement property by “assuming the benefits and burdens of ownership”, is strong support for the proposition that a taxpayer’s prior holding of significant “real” interests and burdens and benefits of ownership in replacement property for more than a transitory pre-closing period is of no consequence.
Further, the Ninth Circuit might view Biggs differently. For example, it might ask if the court of appeals in Biggs specifically considered whether a burdens and benefits test should be applied to the facts, which involved the use of a parking entity (a title company, Shore, owned by Biggs’ lawyer and others) to own the replacement property for a period of time, or whether the facts of the case, including that, according to the opinion, Shore “assumed” certain debt (including obligations to the seller of the property it held) and that the other exchanging party (Powell) did so as well suggest the court did not focus much attention on the matter or perhaps that the matter was not effectively argued (the Biggs opinion suggests the court’s principal focus was whether the fact that Powell never acquired legal title to the replacement property mattered).
Advisors may also debate whether a reviewing court will ask if use of a third party title-holding intermediary in structuring a transaction satisfactorily explains the difference between the Bartell decision and the reasoning in DeCleene, a 2000 Tax Court decision in which a taxpayer conveyed title to land to another for the period of time during which improvements were constructed on it, followed by the reconveyance of the improved property to the taxpayer to complete a purported exchange for other property owned by the taxpayer. The Bartell opinion states that the burdens and benefits analysis was proper in DeCleene and that its application showed that DeCleene’s “purported exchange of the relinquished and replacement properties was … no more than an exchange with himself”. While there are differences between the Bartell situation and the facts in DeCleene, the DeCleene decision would not be binding on the court of appeals in a potential review of Bartell, and considerations of whether an integrated exchange plan and early or initial exchange intent existed have been highlighted in a number of 1031 cases, a reviewing court might still find the reasoning in DeCleene, and the test used there, applicable.
While not relevant to evaluation of the Tax Court’s opinion, if its reasoning is affirmed (and, obviously, assuming no future changes to Section 1031) the advice of some exchange practitioners and advisors will change markedly as, if mere title holding by a third party facilitator (for perhaps up to 17 months, as in Bartell) is sufficient under applicable case law, Rev. Proc. 2000-37 and its 180 day time limit will become less significant for taxpayers in jurisdictions in which such a holding would be controlling. Though the Tax Court suggested that the “inapplicability of Rev. Proc. 2000-37 … to the transaction at issue” (because the SPE acquired title to the land prior to the effective date of the revenue procedure) influenced its decision, the revenue procedure only establishes a safe harbor and not law or limitations regarding parking arrangements which do not satisfy its conditions, and, therefore, the distinction between exchange structures within and outside the parking arrangement safe harbor will (if the reasoning in the Bartell opinion ultimately carries the day) be of lesser consequence for such taxpayers and their advisors, and transactions and transaction documents will be structured differently.
Until more is said about Bartell or parking arrangements in general by relevant authorities, however, that distinction will continue to be significant as advisors and clients plan build to suit and other exchanges. In light of advisor speculations about what a reviewing court might do or consider, including those of the kind referred to above and others, Bartell is unlikely to significantly influence planning of build to suit exchanges in the near term.