Tax-Free Exchanges of Aircraft Under Section 1031
Under Section 1031
© 1999 KEITH G. SWIRSKY
There may be situations where it is necessary for a taxpayer to receive the replacement property before the transfer of the relinquished property. This structure would not constitute a deferred exchange, because the Regulations define a deferred exchange as one in which the taxpayer transfers property and subsequently receives qualifying property in exchange. The IRS has, in the past, taken the position that a "reverse" exchange structure, whereby the replacement property is received by a taxpayer before the transfer of the relinquished property, does not qualify as a like-kind exchange under § 1031. Notwithstanding the IRS opposition, there is no judicial authority denying tax-free treatment to a reverse exchange.
In response to widespread public criticism of its position limiting Section 1031 to simultaneous and deferred exchange, the IRS has recently fashioned a special safe-harbor procedure under which it will recognize a reverse exchange (i.e. an exchange where the replacement property is received first) as a qualified tax free exchange. Revenue Procedure 2000-37 (Sept. 15, 2000). The safe harbor has more procedural requirements than a deferred exchange. In particular, it requires the cooperation of a special purpose shell or parking company, but it allows taxpayers to close replacement property purchase transactions earlier, without fear of adverse tax consequences.
Effective for transactions occurring on or after September 15, 2000, the IRS will respect a reverse exchange accomplished through the use of a qualified exchange accommodation arrangement ("QEAA") involving a "parking company." There are three basic variants of reverse exchange, under the QEAA safe-harbor. First, in a "back end" reverse exchange, the replacement property is transferred to a parking company. The parking company holds the replacement property until a buyer for the relinquished property is found. At this point, the parking company exchanges title to the replacement property for title to the relinquished property. Second, in a "front end" reverse exchange, the replacement property is acquired by the parking company, and the taxpayer immediately enters into an exchange with the parking company: exchanging the relinquished property for the replacement property. The parking company holds the relinquished property for sale until a buyer is found. Finally, in a "hybrid" reverse exchange, the relinquished property is first transferred to the parking company. The parking company later acquires the replacement property and transfers it to the taxpayer. The parking company continues to hold the relinquished property until a buyer is found.
All QEAAs have six elements:
1. title to the replacement aircraft and the relinquished aircraft must be transferred to and held by an "exchange accommodation title holder" (the parking company)
2. at the time the parking company acquires title to either the replacement property (front end or back end) or the relinquished property (hybrid), the taxpayer has a "bona fide intent" to enter into a like kind exchange
3. within five (5) days of the parking company acquiring title to either property, the taxpayer enters into a written "qualified exchange accommodation agreement" that makes reference to Rev. Proc. 2000?37 and the intent of the parties to enter into an exchange
4. within forty five (45) days of the first transfer in a back-end exchange, the taxpayer properly identifies the relinquished aircraft (alternative and multiple aircraft may be identified)
5. within one hundred and eighty (180) days, one of the following occurs: (i) the replacement aircraft is transferred to the taxpayer (back end), or (ii) the relinquished aircraft is sold by the parking company to an unrelated party (front end or hybrid)
6. the combined period of time that the relinquished aircraft and the replacement aircraft are held in a QEAA does not exceed one hundred and eighty (180) days.
There are several additional requirements regarding the parking company. It must hold "qualified indicia of ownership" in the aircraft, meaning legal title or other beneficial ownership under applicable principles of commercial law. The parking company cannot be related to the taxpayer or exempt from federal income tax either because it is a foreign corporation or a U.S. based non profit. If the parking company is partnership or an S corporation, it must be 90 percent owned by partners or shareholders who are subject to federal income tax. Lastly, the parking company must hold title continuously during the time between its acquisition of the replacement property and the expiration of the QEAA. The parking company may be a single member limited liability company that is disregarded for federal tax purposes, as long as the LLC's owner is not a related party or exempt from federal income tax.
Revenue Procedure 2000?37 specifically endorses certain techniques commonly used to enable the parking company to acquire the property or to shift risk to the taxpayer and away from the parking company. Prior to the Revenue Procedure, these techniques were subject to challenge on the theory that they made the taxpayer ? ? not the parking company ? ? the true owner of the replacement property or the relinquished property. In particular, the IRS will allow the taxpayer to loan purchase money funds directly to the parking company, to guarantee a purchase money loan, and to lease the property from the parking company. Additionally, the taxpayer and the parking company may agree to fixed formula prices or puts and calls ? ? effective not more than 185 days ? ? that are designed to assure that changes in the value of the replacement property or the relinquished property held by the parking company do not adversely affect the parking company's interests. Finally, in front end reverse exchanges, the written agreement governing the QEAA may specify that the taxpayer will advance its own funds or receive funds to equalize any variation from the estimated value of the relinquished property on the date of the exchange.
This Revenue Procedure is not intended to be the exclusive means of accomplishing a reverse exchange. It is, in effect, a safe harbor, and the IRS makes clear that it does not intend any inference to be drawn that reverse exchange transactions completed prior to September 15, 2000 are suspect if they did not follow the new requirements.