Like-Kind Exchanges | Norton Rose Fulbright
In today’s energy market, companies are looking to sell assets and use the sales proceeds to pay down debt and maintain liquidity, not to acquire new assets. In the rush to do this, tax-saving strategies involving like-kind exchanges are often overlooked.
The combination of a like-kind exchange with other financing techniques can be used not only to generate tax savings, but also to create capital to purchase new property, reduce debt, enhance credit ratings and prevent tax bills from being passed on to ratepayers and investors.
Tax-deferred exchanges have been in use for more than 80 years. Most property held for productive use in business, including office buildings, power plants, factories, mineral interests, and other real estate, equipment like aircraft, trucks, tractors, railcars, and transmission and distribution lines, and intangible assets like patents, contracts, trademarks, customer lists, and licenses can be a candidate for a like-kind exchange.
Taxpayers can create substantial savings by doing a three-way like-kind exchange where an intermediary acts as a go-between between the seller of the asset and the eventual buyer. Two kinds of entities may be involved: a “qualified intermediary” and an “exchange accommodation titleholder.”
There are two basic types of transactions: forward exchanges and what the tax lawyers call a “parking arrangement” under Revenue Procedure 2000-37.
A forward exchange requires that existing property be relinquished first and that replacement property thereafter be identified within 45 days and purchased within 180 days. Taxpayers that acquire replacement property of equal or greater value to the relinquished property and invest all equity in the replacement property are generally able to defer federal tax fully on any gain, as well as avoid any “recapture”of depreciation claimed to date on the property being sold. If the transaction qualifies as a like-kind exchange, then the basis of the relinquished property will be carried over into the replacement property, and any gain from the sale of the relinquished property will be deferred until the replacement property is sold. However, where the relinquished property is considered equipment for tax purposes (rather than real property), special rules will apply and need to be considered.
Companies often have trouble finding suitable replacement property and scheduling closings to comply with the tax code’s requirement to sell first and buy second. However, in September 2000, the IRS issued Revenue Procedure 2000-37. It created creates a “safe harbor” permitting taxpayers to make a sale of property through an “exchange accommodation titleholder,” or “EAT.” This allows the seller more control over the timing of the disposition and replacement in order to complete a tax-deferred exchange. Under the parking safe harbor, the parked property must be conveyed from the EAT to the taxpayer (if replacement) or from the EAT to a third party buyer (if relinquished) within 180 days of parking. Further, although for most taxpayers it is a mere formality, the intended relinquished property must be identified within 45 days of parking a replacement.
The greatest benefit of the parking safe harbor is its flexibility in permitting various arrangements concerning the property during the parking period. For example, an EAT can acquire property and lease it back to the taxpayer or any other party. This allows the taxpayer to manage and operate the property while it is owned by the EAT. Additionally, the taxpayer can either lend money directly to the EAT to acquire the target property, or the taxpayer can be the guarantor of third-party loans obtained by the EAT.
As long as a taxpayer meets the requirements of the parking safe harbor, including keeping the parking arrangement from exceeding the time limit of 180 days, the IRS will not challenge the arrangement on grounds that the taxpayer failed to dispose of the relinquished property before acquiring the replacement.
The intricacies and pitfalls associated with entering into like-kind exchanges are best illustrated by two examples.
Example 1: Using credit tenant lease property to create capital.
An investor-owned utility plans to sell $2 billion of non-core real estate. Its goal is to defer the capital gains taxes on the sale of the real estate by acquiring like-kind replacement property of a type consistent with its desire to maintain liquidity.
The utility purchases replacement real estate that is already leased to an investment grade, single tenant (often called a credit tenant lease, or “CTL”) which has a term of 20 years or longer. Much of the appeal for these properties stems from their high financeability: they are often packaged with 90% loan-to-value non-recourse debt. In this example, the taxpayer’s advisors have concluded that this CTL also has certain characteristics that will allow leveraged lease accounting treatment.
Once this replacement property is located, the utility sells its original piece of real estate. The qualified intermediary takes an assignment to the rights in the purchase contract, but does not take title to the relinquished property. The utility transfers title to the buyer directly, and the sales proceeds are placed in an escrow account to which the qualified intermediary also signs. The utility then identifies its replacement property within 45 days, and enters into a purchase agreement with the seller of the replacement property.
The proceeds from the sale of the relinquished property (held in escrow) are used within 180 days to purchase the replacement property. The replacement property is transferred to the utility using the qualified intermediary in a manner similar to the first transaction. The type of CTL property and the duration of its lease allow the utility both to defer its tax liability through a like-kind exchange and maintain liquidity. Potentially, the utility may not pay any state or federal capital gains taxes or depreciation recapture on the sale. At some point in the future, the utility may sell the CTL property and purchase core property.
Example 2: Using parking arrangements to bring projects online. An investor-owned utility plans to sell $350 million in assets and intends to develop a greenfield power plant. The utility’s development cycle for a new plant is typically 36 months or longer. The utility also desires to purchase equipment and other personal property for plants already under construction before disposing of its non-core assets.
The utility sets up two EATs: EAT 1 acquires and holds title to the future plant site, and EAT 2 acquires and holds new transmission and distribution assets. The utility guarantees the entire amount of a third-party loan granted to EAT 1 to acquire the new plant’s site. EAT 1 holds title to the new plant’s site and leases the site to the utility to manage the construction work at the new site.
The utility lends money to EAT 2 to purchase all new transmission and distribution equipment for both the new plant and for use by plants that are already in operation. The utility ensures that the new equipment being purchased is of a “like kind” to the equipment being sold.
Once each EAT acquires replacement property, the utility will have 45 days to identify the property it is selling and 180 days to purchase the replacement property from the EATs. The utility sells the relinquished property and all sale proceeds are directed into an escrow account through an unrelated third party known as a “qualified intermediary.”
The utility exercises its option in the lease agreements to acquire the replacement property from EAT 1 and EAT 2. The intermediary sends proceeds from the escrow account to each EAT to purchase the replacement property. The intermediary transfers the replacement property held by each EAT to the utility and each EAT then pays off the loans used to acquire the replacement property.
The utility is able to sell its non-core property and defer all the gains taxes from the sale into new strategic property that will grow its business. The flexibility of the EAT structure gives the utility the ability to develop its parked property while maintaining the use of its relinquished property.
Longer Parking Arrangements
For transactions that take longer than 180 days to complete, Revenue Procedure 2000-37 says the IRS “recognizes that ‘parking’ transactions can be accomplished outside the safe harbor provided in this revenue procedure. Accordingly, no inference is intended with respect to the federal income tax treatment of ‘parking’ transactions that do not satisfy the terms of the safe harbor provided in this revenue procedure.” However, many of the arrangements into which taxpayers enter with an EAT in anticipation of completing safe harbor parking within 180 days appear problematic from the perspective of, if not wholly inconsistent with, a parking transaction intended to satisfy the IRS. Strategic ownership structures are being developed to address instances when a property needs to be parked for an extended period of time. In the meantime, prior to parking, taxpayers should do their best to determine whether they will be able to find a buyer within 180 days of parking, and they should pay particular attention to its time constraints.
Dispelling the Myth
Like-kind exchanges are becoming essential for companies that want to defer capital gains taxes or depreciation recapture on their dispositions. The assumption that power plant and infrastructure exchanges are difficult or have no place in the energy sector is proving false. Comprehensive and flexible like-kind structures can be successfully executed. With proper planning and the assistance of an experienced and knowledgeable intermediary, like-kind exchange structures can be used to acquire new core assets or generate cash.
Given the current marketplace, companies need to continue incorporating like-kind exchanges into their planning. With restrictive capital markets, such transactions can allow companies to recycle capital, maintain liquidity, and move toward financial solvency.