Sooner or later, most owners of pricey corporate jets and turboprops realize they cannot sell their aircraft without incurring a substantial income tax liability. As one client recently put it: “Buying an airplane is like getting married — once you’re in, you’re in. If you want out, it will cost you dearly.”

The problem arises because many makes and models of corporate aircraft tend to hold their values relatively well in the market but, for tax purposes, the aircraft are rapidly depreciated. The “gap” between an aircraft’s fair market value and its adjusted tax basis represents potential taxable income that generally must be recognized when the aircraft is sold — usually at ordinary income tax rates.¹

Fortunately, Congress has left in place § 1031, one of the last opportunities for tax deferral under the Internal Revenue Code. Originally enacted in 1921, this section permits a taxpayer to “exchange” qualifying business or investment property with property of “like kind” without incurring an income tax liability. The theory behind the statute is that, in an exchange, the taxpayer is merely changing the form of its business or investment property, and has not yet “cashed out.” Technically, the statute does not avoid tax — it defers the recognition of tax until the property acquired in the exchange (the “replacement property”) is later disposed of in a taxable transaction. Since the replacement property may be sold in yet another § 1031 exchange, income tax may be deferred well into the future.

Transactions under the statute are usually structured as either a simultaneous exchange of qualifying properties or a deferred exchange in which (using a “qualified intermediary”) the sale of the old or “relinquished” property is followed by the purchase of the replacement property. In a deferred exchange, the purchase of the replacement property generally must occur within 180 days after the sale of the relinquished property. Under § 1031’s usual ordering of events, taxpayers having a need to purchase the replacement first — say, to take advantage of favorable pricing or bonus depreciation — traditionally have been unable to rely safely upon provisions of § 1031.²

In September of 2000, however, after years of discussion and debate over how taxpayers might structure a so-called “reverse exchange” under § 1031, the Internal Revenue Service released Rev. Proc. 2000-37 (the “Revenue Procedure”). In it, the Service created a safe harbor that now allows taxpayers to “purchase” before “selling” and still take advantage of § 1031 on the sale of the relinquished property.

For companies and others that want or need to purchase a new or used replacement aircraft but are unable, because of market or other conditions, to sell beforehand their existing aircraft (which has substantial “trapped” or “built-in” gains), the Revenue Procedure and its safe harbor may be just the answer.³

An Overview of §1031

Section 1031 provides that no gain or loss will be recognized on an exchange of qualifying properties, if the following requirements are met: (1) the taxpayer who sells the relinquished property and purchases the replacement property must be the same person;⁴ (2) the taxpayer must have a bona fide intent to effect an exchange of qualifying properties; (3) the relinquished property and the replacement property must each be “held either for the productive use in a trade or business or for investment;”⁵ (4) there must be a qualified “exchange” of property, meaning that the sale of the relinquished property and the purchase of the replacement property must be part of an integrated, mutually dependent transaction, as opposed to a separate “sale” of the old property and a separate “purchase” of the new property; and (5) the relinquished and the replacement properties must be of “like-kind.” When depreciable tangible personal properties are exchanged, such as aircraft, the properties must be “like-kind” or, as provided in the regulations, “like-class.”⁶

If the statutory criteria are met — and so long as the only property received by the taxpayer in the exchange is qualifying replacement property — the taxpayer will incur no gain or loss on the disposition of the relinquished property, even though the value of the relinquished property far exceeds its tax basis for federal income tax purposes.

It should be noted that a taxpayer may (and oftentimes does) receive property other than qualifying replacement property in a § 1031 exchange. The taxpayer’s receipt of cash or other “boot” does not disqualify the transaction under § 1031. It may, however, create taxable income that must immediately be recognized by the taxpayer.

Net Taxable Boot and the Basis Rules

Generally there are two categories of boot — “cash” boot and “mortgage” boot. Cash boot is cash and any other property (other than qualified replacement property) received by the taxpayer in the exchange. Mortgage boot is any debt relief received by the taxpayer on the sale of the relinquished property. Mortgage boot is received when the purchaser of the relinquished property agrees to “assume” the taxpayer’s debt on the property, or when the purchaser buys the relinquished property “subject to” the taxpayer’s debt on the property.

Boot received, whether cash or mortgage in nature, can be netted (or offset) against boot paid. Although the boot netting rules are somewhat involved,⁷ generally no taxable boot will be recognized (in an otherwise qualified exchange) so long as (i) the fair market value of the replacement property is equal to or greater than the fair market value of the relinquished property, and (ii) the taxpayer’s equity in the replacement property is equal to or greater than its equity in the relinquished property. This simple “value up — equity up” test is a quick way to determine whether a proposed exchange may result in net taxable boot.

Another major aspect of an exchange is calculating the tax basis of the replacement property. Under § 1031(d), the basis of the replacement property is equal to the tax basis of the relinquished aircraft, increased by any additional consideration given, and any gain recognized, by the taxpayer on the exchange (i.e., net taxable boot received to the extent of realized income), and decreased by the amount of any money received by the taxpayer. In effect, the basis formula reduces the price paid by the taxpayer for the replacement property by the amount of unrecognized gain on the sale of the relinquished property. This basis rule effectively “shifts” the unrecognized or “trapped” gain from the relinquished property to the replacement property. That gain will be recognized by the taxpayer when the replacement property is later sold in a taxable transaction (unless, of course, the replacement property is sold under § 1031).⁸

Qualified Aircraft Exchanges

Aircraft can be exchanged under § 1031 in several different ways. Perhaps the most basic exchange is a trade-in of the relinquished aircraft for a new aircraft from the manufacturer or for another used aircraft from a third-party owner.

Many aircraft are exchanged on a deferred (forward) basis under Treas. Reg. § 1.1031(k)-1, in which the relinquished aircraft is sold by the taxpayer before the replacement aircraft is purchased. This ordering of events (that is, a “sale” followed by a “purchase”) is a critical part of the regulations.

In a deferred transaction, the taxpayer typically enters into a sales contract with a buyer for the relinquished aircraft. The taxpayer also engages the services of a middleman, known as a qualified intermediary (QI), to effect the intended exchange. The QI may be any person other than a “disqualified person” as defined under the regulations.⁹ The two parties then enter into an exchange agreement, under which the QI, among other things, agrees to (i) accept an assignment of the sales contract from the taxpayer, (ii) acquire, and transfer to the ultimate buyer, beneficial title to the relinquished aircraft, and (iii) receive and hold the net proceeds on the sale of the relinquished property until the replacement aircraft is purchased. Under no circumstances may the taxpayer receive or have control over the net sales proceeds; otherwise, the money held by the QI may constitute taxable boot received by the taxpayer.¹⁰

In the meantime, the taxpayer identifies the replacement aircraft and enters into an aircraft purchase agreement for the purchase of that property. The purchase agreement is assigned to the QI as contemplated in the exchange agreement. The QI then closes the purchase transaction by obtaining beneficial title to the replacement aircraft and by paying the net sales proceeds to the seller of the replacement aircraft (and any other consideration needed to complete the transaction, which is provided or arranged by the taxpayer). In effect, the taxpayer, through the QI, has exchanged one aircraft for the other, even though the “sale” and the “purchase” occurred at different times.

Although the QI accepts beneficial title to both aircraft involved in the exchange, “direct deeding” of the aircraft is permitted, thereby allowing title to pass directly between the taxpayer and the buyer of the relinquished property, and between the seller of the replacement property and the taxpayer.

Section 1031 places strict and absolute timing limits on the parties in a forward exchange. For example, the taxpayer must “unambiguously” identify the replacement property by giving written notice to the QI before midnight of the 45th day after the transfer of the relinquished property.¹¹ Also, the properly identified, replacement aircraft must be purchased within 180 days after the sale of the old property or, if sooner, not later than the due date (determined with regard to extensions) of the taxpayer’s income tax return for the year in which the relinquished property is sold.¹²

The Commercial Need for Reverse Exchanges

The market for corporate aircraft over the past four years or so has been tumultuous. Demand for many makes and models of jets and turboprops has been seriously hampered by an economic slowdown and doubts about the timing of a turnaround, 9/11, corporate scandals and a shrinking lender base. On the other hand, demand for other makes and models, especially new or newer aircraft, has been enhanced as the result of bonus depreciation, efficient and well-run fractional aircraft programs, and continuing delays at commercial airports and the consequent waste of executive time.

With varying pockets of strength and weakness in the market, proper timing of an aircraft purchase is critical. Many aircraft owners may see an immediate need for obtaining replacement aircraft — to take advantage of favorable pricing or the availability of bonus depreciation — but are unwilling or unable to quickly sell their existing aircraft. For them, a traditional trade-in or a deferred (forward) exchange simply will not work. Instead, what they need is the ability to effect a tax-deferred exchange, by placing the “purchase” of the replacement aircraft before the “sale” of the relinquished aircraft — a so-called “reverse exchange.”

Reverse Exchanges Under § 1031 — The Pure Reverse Exchange

A “pure” or “true” reverse exchange contemplates the taxpayer receiving the replacement property before it sells the relinquished property. In a reverse exchange, the taxpayer holds title to the replacement and the relinquished properties until the relinquished property is sold.

There is little judicial authority for the proposition that a pure reverse exchange may qualify for exchange treatment under § 1031. On the other hand, several cases have denied favorable “exchange” treatment in reverse transactions.¹³

The one case holding in favor of the taxpayer involved the exchange of some heifers (the replacement property) for a promise to deliver in the future some calves that did not yet exist.¹⁴ On the administrative side, the Service approved a pure reverse exchange of non-depreciable, non-income producing utility easements between two utility companies.¹⁵

In attempting to structure a reverse exchange, it is difficult to get much comfort from the existing authorities. Nonetheless, it may be possible to structure a pure reverse exchange under the statute. As one court pointed out, a reverse transaction under § 1031 would require that the taxpayer not operate, or keep the profits and losses from, both properties at the same time.¹⁶ In other words, it seems as though a taxpayer cannot own all of the “benefits and burdens” of the replacement property and the relinquished property at the same time — either directly or through an agent — and still claim an “exchange” under § 1031. Some of the benefits and burdens of one of the properties must belong to another person unrelated to the taxpayer.

Non-Safe Harbor Parking Transactions

As a refinement on the theory of a pure reverse exchange, so-called “parking” or “warehouse” arrangements have been devised over the past few years. In a parking transaction, the taxpayer uses a “friendly” third party to acquire title either to the replacement property or the relinquished property, and then to hold or “park” that property until the relinquished property is sold (the “parking period”). The idea here is to separate the ownership of the two properties, with one owned by the taxpayer and the other by a third-party titleholder.

A parking transaction also involves the use of an intermediary to effect a simultaneous exchange of the properties. The exchange may take place either at the beginning of the parking period, in a transaction known as a “front-end” exchange, or at the end of the parking period in a “back-end” exchange.

The mechanics of a parking transaction are somewhat detailed. However, in a back-end exchange, the third-party titleholder acquires and parks the replacement property. Typically, funds and/or financing for the acquisition of the property are arranged or provided by the taxpayer or an affiliate of the taxpayer. During the parking period, the third-party titleholder may lease the replacement property to the taxpayer under a triple net lease, with the taxpayer-lessee being responsible for all taxes, insurance and operating expenses. At the end of the parking period (i.e., when the relinquished property is sold), the replacement property is transferred to the taxpayer through the intermediary that transfers beneficial title in the relinquished property to the buyer.

In a front-end exchange, the third-party titleholder acquires the relinquished property from the taxpayer, through the intermediary that acquires, and transfers to the taxpayer, beneficial title in the replacement property. The relinquished property is then parked until it is sold to the ultimate buyer. Funding for the acquisition of the relinquished property by the titleholder is provided or arranged by the taxpayer or an affiliate of the taxpayer. During the parking period, the parked property is leased to, or managed by, the taxpayer, until it is sold.

Thus far, only one reported case, DeCleene v. Commissioner,¹⁷ has reviewed a modern parking transaction under § 1031, and in that case the taxpayer lost. Nevertheless, parking transactions are used, based primarily on favorable private letter rulings issued by the IRS.¹⁸ What the DeCleene case and the letter rulings point out is that the third-party titleholder must have some financial risk or obligations in the deal. Without having some of the burdens of ownership, the third-party titleholder most likely will be viewed as an agent of the taxpayer, thus disqualifying the transaction as an impermissible reverse exchange under the statute.

Whether a particular parking transaction will pass muster under § 1031 involves a facts and circumstances test. Just how much investment or risk a titleholder must have in the property is difficult to gauge. This uncertainty can be avoided in many instances, however, thanks to the IRS and the safe harbor parking transaction it created in Rev. Proc. 2000-37.

Safe Harbor Parking Transactions — Rev. Proc. 2000-37

In September 2000, the Service released Rev. Proc. 2000-37, which provides a safe harbor for parking arrangements — whether structured as a front-end or a back-end exchange — so long as certain requirements are met.¹⁹ The purpose of the Revenue Procedure is to provide relief for taxpayers who have a bona fide intent to enter into an exchange, but need some additional time — up to 180 days — to sell their relinquished properties. For aircraft owners, the safe harbor may be a valuable planning tool that, in appropriate situations, ought to be carefully considered.

The safe harbor requires the use of an exchange accommodation titleholder (EAT), which can be any person or entity not related to the taxpayer. The EAT can be (and oftentimes is) an affiliate of the QI, and is usually set up as a single purpose entity, owning no property and having no debts, other than the taxpayer’s property and related debt. Such a structure can help to protect the taxpayer’s property held by the EAT in the event of bankruptcy by or against the owner of the EAT. It also can help to protect the owner of the EAT (and its other assets) from third-party liability in the event of an airplane crash or accident. The EAT may acquire and park either the replacement property or the relinquished property.

The Revenue Procedure allows the taxpayer and the EAT to accomplish an exchange through the use of a qualified exchange accommodation arrangement (QEAA). All QEAAs have five essential elements: (1) title to the “parked property” (whether it’s the replacement property or the relinquished property) must be transferred to and held by the EAT; (2) within five days after acquiring title to the parked property, the taxpayer and the EAT must enter into a “qualified exchange accommodation agreement,” or “QEA agreement,” that references Rev. Proc. 2000-37 and the intent of the parties to enter into an exchange; (3) in a back-end exchange, the taxpayer must properly identify the relinquished property within 45 days after the EAT acquires the replacement property (which, as a practical matter, usually is identified in the QEA agreement); (4) within 180 days after the day on which the EAT acquires title to the parked property, either one of the following must occur: (a) the replacement property must be transferred by the EAT to the taxpayer (in a back-end exchange); or (b) the relinquished property must be transferred by the EAT to the buyer (in a front-end exchange), who may not be the taxpayer or a “disqualified” person; and (5) under no circumstances may the EAT hold the replacement property and/or the relinquished property under the QEAA for more than a total of 180 days.

Importantly, the Revenue Procedure says that arm’s-length dealings between the taxpayer and the EAT are not required, and that the absence of such dealings will not cause the EAT to be viewed as the taxpayer’s agent for federal income tax purposes. This, of course, opens the door for a number of “friendly” transactions, such as non-interest bearing loans and rent-free lease agreements between the taxpayer and the EAT. Furthermore, the taxpayer may manage or service the parked property without regard to the financial terms surrounding those arrangements. And the taxpayer and the EAT may enter into agreements relating to the purchase and/or sale of the parked property, including puts and calls at fixed or formula prices covering a period of not more than 185 days after the EAT’s acquisition of the parked property.

Another important aspect of the safe harbor is that a transaction will not be disqualified if the taxpayer’s accounting, regulatory, or state, local or foreign tax treatment is different from the treatment under the Revenue Procedure. Thus, for instance, it is irrelevant if, under generally accepted accounting principles, the parked property and its related debt are required to be shown on the taxpayer’s financial statements or that, for state sales tax purposes, the EAT is treated as the taxpayer’s agent.

Undoubtedly one of the biggest risks facing a taxpayer under the safe harbor is the inability to sell the relinquished property within 180 days after the EAT acquires the parked property. The Revenue Procedure does not address this issue. It does say, however, that parking arrangements can be accomplished outside the safe harbor and that no adverse inference will be drawn from the fact that a transaction does not meet the safe harbor requirements. Despite those words, however, a transaction designed to meet the minimum criteria of the safe harbor — by placing none of the burdens or risks of property ownership on the EAT — will likely fail as a non-safe harbor parking arrangement given the absence of any real arm’s-length dealings between the taxpayer and the EAT. Therefore, during the initial planning stages of a parking transaction, the taxpayer needs to evaluate carefully the market for the relinquished aircraft and have confidence the aircraft can be sold at a reasonable price within the allowed time period. During this early process, the owner may consider negotiating a sales contract with its aircraft broker (who is involved in the purchase of the new aircraft) that would obligate the broker to purchase the old aircraft at a specified price within the 180-day period if another buyer cannot be located. Even though the safe harbor is available, careful and thoughtful tax planning in advance of the first “sale” or “purchase” is strongly recommended.

One of the Last Remaining Tax Deferral Provisions

Tax-deferred exchanges represent one of the last remaining tax deferral provisions in the Code. Parking transactions are an important part of § 1031, and Rev. Proc. 2000-37 provides much needed certainty in an otherwise nebulous area of tax law. For companies and others that may want to purchase a new or used replacement aircraft immediately, but need some time to sell their existing aircraft, a safe harbor parking transaction may provide a workable solution.

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