Reverse exchanges often strike fear in the hearts of legal and tax professionals trying to protect clients who are determined to use this technique to pay as little tax as possible. This is because there has been no formal acknowledgement of reverse exchanges by the Service until now.

In simple terms, a reverse exchange happens when you want to buy the new property before you've sold your old. There might be a million reasons why you want to do this, but if you don't want to pay tax on the sale of your old property in a reverse exchange you have to carefully structure the purchase of the new property so that you don't take title to it until after you've closed on the sale of your old property. Typically, in a reverse exchange, the qualified intermediary takes title to the new property and holds it for you until your old property closes.

For the last several years, senior members of Branch 5 of the IRS, the branch which oversees Section 1031, have verbally told us that the IRS does not have a problem with the concept of reverse exchanges. They acknowledge that they are tremendously complicated and state that the reason they have not issued a ruling on them is because no one has asked for one. Now someone has, and the ruling is favorable.

I have to admit that I missed the reverse exchange angle when Private Letter Ruling 98-23045 first came out. I noted its issuance, but IRS approval of an exchange of powerline easements hardly seemed noteworthy. I didn't dig deep enough for this little nugget.

The pertinent facts of the ruling are that the taxpayer, a utility, wanted to move some of its powerlines. They proposed that "Company F", an unrelated company, would acquire the new easements while the utility built and tested the transmission structures. Once the transmission network was working, Company F would transfer the new easements and transmission structures to the taxpayer in exchange for the old easements and transmission structures.

The really important part of the ruling is paragraph 17 where the IRS states: "The facts of this case present a reverse exchange transaction between two parties, in which the conveyance of the new easement to the Taxpayer is to be followed by relinquishment to Company F of the old easement." They then go on to state in paragraph 19 that the exchange qualifies as a 1031 exchange.

This is actually a classic form of reverse exchange we call a "reverse/construction exchange." In a reverse/construction exchange the qualified intermediary acquires the new property and builds a new structure on it. When the new structure is completed, the old property is sold and the new property and structure are acquired by the exchanger from the qualified intermediary in a straight exchange. The exchanger typically arranges the financing for acquisition and construction of the new property, and also is actively involved in the construction process. The point during the construction in which the new property is transferred to the taxpayer in completion of the exchange differs from transaction to transaction, but usually happens before a certificate of occupancy is issued.

For me, the most exciting aspect of the ruling is the total understatement by which the IRS deals with their first acknowledgement of reverse exchanges. They don't define the term. They don't explain the concept. They don't mention the steps the utility will take to create the reverse exchange relationship. They don't comment on the active involvement by the utility in the construction process, and they don't imply that the presence of the reverse exchange had any significance in the transaction. The ruling thus represents a tacit approval of the concept and use of reverse exchanges in general.

While I doubt that this ruling will open any great flood gates for reverse exchanges, the understated way that the IRS deals with it in this ruling gives us assurance that reverse exchanges are not the potentially fearsome monster that many believe them to be.