Under Section 1031 of the Internal Revenue Code, a taxpayer may exchange one real estate property for another and defer capital gains on the transaction. This is called a “1031 exchange.” A “reverse like-kind exchange” or a “reverse 1031” is where the taxpayer acquires the replacement property prior to selling the current property (also called the “relinquished property”). In a reverse 1031, the new property is held by, or, as referred to by tax professionals, “parked with” a third party (the qualified intermediary or “QI”) until the relinquished property is sold. Simultaneously with the sale of the relinquished property, the QI transfers the newly acquired property to the taxpayer.
Will there be a second Maryland transfer tax or recordation tax on the transfer of the replacement property to the taxpayer from the QI?
Whether the transfer of the newly acquired property is by deed (or through an assignment of the membership interests in the LLC that the QI forms to own the property in order to avoid personal liability), it will be tax exempt.
The transfer which is highlighted in the question refers to the last step of a series of transactions that are designed as a “reverse like-kind exchange.” See generally Rev. Proc. 2000-37, 2000-2 C.B. 308. In the first step, the new property was purchased by the Company, and the Company paid the full Maryland state and local recordation taxes on that purchase. At the time of that acquisition, the deed named the QI as grantee, and the QI is essentially acting as a straw man for the taxpayer. In the final step, the QI, as exchange accommodation title holder (“EAT”), transfers its interest in the property to the taxpayer to close out the like-kind exchange and end the straw man ownership. This conveyance is exempt from Maryland state and local recordation and transfer taxes because this transfer was from a straw man to the taxpayer, the true beneficial owner of the replacement property. 49 Op. Att’y Gen. 508 (1964), 42 Op. Att’y Gen. 126 (1957), and 24 Op. Att’y Gen. 965 (1939).
A similar transaction was ruled as exempt from recordation and transfer taxes in an opinion drafted by Bruce Benshoof, Assistant Attorney General, in his letter dated October 24, 2004 (the “Benshoof Letter”). The Benshoof Letter addresses a situation where the actual property was transferred from a straw man to the beneficial owner as the last part of a reverse like-kind exchange. The Benshoof Letter states that the transfer of property is deemed to be a transfer with no consideration when conveying the replacement property from the QI to the taxpayer. This is due to the QI merely being a “nominee” or “straw man” who is holding the replacement property for the benefit of the taxpayer. Because this transfer is merely a transfer of legal title to the true beneficial owner, it is exempt from any transfer or recordation tax in Maryland.
Instead of taking title to the new replacement property by deed in a 1031 transaction, a taxpayer may choose to acquire all of the equity interests in the entity that owns the property. In this scenario, the QI typically forms a related LLC (an EAT) that takes title to the replacement property until the relinquished property is sold. The last step in the reverse 1031 transaction would include having the QI assign all of the membership interests in the EAT to the taxpayer. As with a direct deed to the taxpayer, this assignment of the membership interests in the LLC similarly does not trigger liability for transfer or recordation taxes.
Under the so-called “controlling interest” provision of the State’s transfer and recordation taxes (Section 12-117(c)(1) of the Tax-Property Article of the Maryland Code), “[t]he transfer or a controlling interest in a real property entity is not subject to recordation tax if the transfer of the real property by an instrument of writing between the same parties and under the same circumstances would have been exempt under Section 12-108 of this title.” As noted above, pursuant to the Benshoof Letter and current Maryland law, a transfer from a QI to the taxpayer for whom the property was held by such QI would be exempt. As noted above, the transfer if performed as a conveyance by deed would be exempt. Therefore, the transfer of membership interests is similarly exempt from these taxes.
For questions, please contact Jeff Spatz (410-576-4124).