Brandt Nicholson, JD, Principal
Taxpayers would like to do reverse exchanges - an exchange in which you receive the new property before you get rid of the old one. But reverse exchanges are not authorized explicitly in the Internal Revenue Code or in any court decision, regulation, or ruling.
Wouldja settle for an audit? They say that in the Land of the Blind, the one-eyed man is king. By the same token, in the Land of the Tax Blind, an audit may be all the authority you can get.
There are no statistics on who the number one practitioner of reverse exchanges is, but I suspect it’s Brandt Nicholson of Sausalito, CA (415) 332-9116, (www.starkerexchanges.com). He has done around 50 since 1990. At present, he does two or three a month. Many main line exchange facilitator firms that do not want to try a reverse exchange refer clients to Nicholson when those clients ask about a reverse.
One of the benefits of doing so many reverse exchanges (he also does the normal kind) is that Nicholson has seen over four dozen exchangers work out the practical problems associated with them - like where do you get the cash to buy the new property if you have not yet sold the old one? Another benefit, is that he was eventually going to see one of his clients audited on the reverse exchange. That happened in 1996 on a deal he did in 1994.
A man who wanted to do a reverse exchange out of four San Francisco condos was referred to Nicholson by a Realtorâ . The exchanger, I’ll call him Irv Browner, wanted to acquire land in the San Francisco Bay Area, upon which was to be built a store that would be occupied by a well-known national chain store. The chain had already signed the deal to have the store built at the location in question. Browner was negotiating with the developer who had the land and the agreement with the chain.
Browner had not yet sold his condos. It was a slow market, which seems the constant condition with condos. But the chain was ready to go now and their agreement with the builder had deadlines so it had to be a reverse exchange or none.
So this exchange involved not one but two complications:
Browner owned the condos free and clear. So he raised the cash needed to buy the land and assignment of the construction-and-lease agreement by refinancing the condos. Refinancing in anticipation of an exchange can be scary legally. A proposed IRS regulation [1.1031(b)-1©], which claimed to be a "clarification of existing law," said the proceeds of "anticipatory mortgaging" before an exchange would be taxable. Fortunately, the proposed reg was not adopted. But the fact that the IRS characterized the proposed, reg as a "clarification of existing law" is worrisome.
To avoid having the anticipatory refinancing proceeds become taxable, experts like Nicholson say they must go directly into the delayed exchange escrow from the refinancing escrow. The exchanger must not have "unfettered access" to those funds.
Can’t exchange into property you already own
Nicholson created the Browner Exchange Trust and had the refinancing proceeds put there. In April 1994, the Trust acquired the land and an assignment of the build-to-suit contract from the developer. At this point, the Browner Exchange Trust, not Browner, owned the chain-store site.
That’s key. Although there is no legal authority on point regarding the legal viability of a reverse exchange, it appears to be rather well settled that you cannot exchange into property you already own. (Bloomington Coca Cola Bottling Company, 189 F2d 14)
Some lawyers worry that the Trust would be deemed to be Browner’s agent, which means he actually is the owner. But a court decision once said that in exchanges, it is necessary to turn the doctrines of substance over form and step-transaction on their heads, because the exchange is by definition all form and no substance and it is by definition a multi-step transaction. So they are not likely to say that Browner owns the land in substance as long as the form of ownership is the trust.
After the Trust took title to the land, it had the developer proceed with the construction and it was completed in early 1995. (See my article "Can you exchange into to-be-constructed buildings" in the 9/92 issue)
In the meantime, Browner had put his condos up for sale. The first sold in September of 1994. That’s important because that first sale starts the 45 and 180-day clocks. In order for the exchange to be tax-free, the exchanger must identify the property to be acquired within 45 days of the sale of the first property and must acquire all of the properties that are part of the exchange within 180 days. (If you sell the first one in the last quarter of the year, you have to file an automatic extension of your income tax return to get the full 180 days.)
The deal involved six closings from Browner’s perspective:
1995 tax return
Browner reported this deal on his 1995 federal income tax return. He saved approximately $500,000 in taxes by doing it as an exchange.
With the requirement that you red flag any exchange with IRS Form 8824, and given the amount of tax avoided, it is not surprising that IRS audited Browner’s exchange. Doing an exchange does not automatically trigger an audit, but the IRS is generally interested in unusual transactions involving lots of potential tax revenue.
IRS’s Bay Area people told Browner that they were referring the matter to Washington DC headquarters because of it’s importance and unprecedented nature. That informal statement is comforting because it suggests that whatever decision was made is indicative of what the IRS policy would be nationwide rather than just in the Bay Area.
After considering the matter for three months, IRS approved Browner’s tax return with no change.
It should be noted that as with most well-done reverse exchanges, this really was not a reverse exchange. Browner sold condos then, when they were all gone, received the chain-store property. That’s a normal sequence delayed exchange.
True, his trust owned the property before he sold the condos, but as long as the trust is not considered to be Browner’s legal alter ego, that should not be a problem.
Whenever someone owns property, they need to manage and insure it. In this case, Browner Exchange Trust contracted with Browner for him to manage the property. In addition, the Trust insured the property in normal fashion. Those policies were assigned to Browner when he took title to the chain-store property. It should be noted that vacant property, like the under-construction chain store, is far less likely to trigger a liability lawsuit than occupied property.
John T. Reed’s Real Estate Investor’s Monthly (ISSN: 0887-1922) Published by John T. Reed, 342 Bryan Drive, Alamo, CA 94507 FAX, (510) 820-1259 Web Site: www.johntreed.com, (510) 820-6292, E-mail Johnreed@johntreed.com $125/year. Copyright 1997 John T. Reed. All rights reserved.
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