HOT LIKE-KIND EXCHANGE ISSUES. Robert D. Schachat, EY February 5, 2016

Transcription

1 HOT LIKE-KIND EXCHANGE ISSUES Robert D. Schachat, EY February 5, 2016

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3 Page 3 Section 1031 General Rules

4 General Rules To qualify as tax-free under 1031: relinquished ( old ) property must be exchanged for replacement ( new ) property of like kind held for investment or use in a trade or business. Can be viewed as three separate requirements: Exchange. Like kind. Held for investment or use in a trade or business. Page 4

5 Computation of Gain and Basis Gain realized in a like-kind exchange is still recognized (taxable) to the extent taxpayer receives cash or other property that is not of a like-kind ( boot ). Any excess of debt on relinquished property over debt on replacement property is boot. Boot from debt relief is offset by cash given. Replacement property takes a substituted basis. Adjusted for difference in debt on relinquished property v debt on replacement property and other boot. Page 5

6 Los Disallowance Loss is disallowed in a section 1031 exchange. Section 1031 is not elective. Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5 th Cir. 1968). Page 6

7 Exchange Requirement An exchange is a direct exchange with one party. Sale for cash followed by reinvestment of cash in likekind property does not qualify under Crandall v. Commissioner, T.C. Summary Opinion (failure to use qualified intermediary or qualified escrow, discussed below, resulted in actual receipt). Buyer of relinquished property is unlikely to hold property that taxpayer wishes to acquire. Long ago, taxpayers began to use a straw to perform the exchange. Page 7

8 Qualified Intermediary The exchange party cannot be the agent of the taxpayer. If property is exchanged through an agent, the agent s receipt of cash from sale of relinquished property is imputed to the taxpayer. Taxpayer s receipt of cash will generally bust the exchange. Regulations issued in 1991 provide a safe harbor for exchanges through a qualified intermediary ( QI ). Certain security or guarantee arrangements, a qualified escrow account or qualified trust are also permitted and can be combined with QI arrangement; Reg (k)-1(g). Page 8

9 Qualified Intermediary Taxpayer s receipt of cash may bust the exchange. But see Peter Morton v. U.S., 98 Fed. Cl. 596 (Ct. Fed. Cl. 2011) (accidental actual receipt by taxpayer through no fault of taxpayer). Taxpayer could not prove like-kind exchange. Zurn v. Commissioner, T.C. Memo Program exchanges. Non-docketed service advice review (NSAR) F. Line of credit paydown approved. CCA Page 9

10 Qualified Intermediary Under the safe harbor regulations, the QI cannot be a disqualified person. Reg (k)-1(k): A disqualified person is one who: has been taxpayer s employee, attorney, accountant, investment banker or broker, or real estate agent or broker in the two years before transfer of first relinquished property; or Is related to the taxpayer or any service provider prohibited above using 10% test under 267(b) or 707(b). Taxpayer s son was a disqualified person even though son was an attorney. Blangiardo v. Commissioner, TC Memo Page 10

11 Qualified Intermediary Rulings on disqualified person. Intermediary LLC is not a disqualified person although managed by another LLC in which exchanging taxpayer s son is an individual manager. PLR Bank is not a disqualified person by reason of QI and controlled group members providing investment advisory, brokerage, private planning, insurance, trust and retail banking services. PLRs and PLR Page 11

12 Qualified Intermediary More rulings on disqualified person. Subsidiary activities as manager of operations of a financing company or commercial paper issuance and shareholder loan program. PLR Provision of software designed to assist in like-kind exchanges. PLR Exchange accommodation titleholder ( EAT ) performing state sales tax trade-ins for a vehicle/equipment lessor that replaced its used vehicles through like-kind exchanges was not a disqualified person. PLR Page 12

13 Like-Kind Real Estate Definition of like kind for real estate is very broad: In general, real estate is of like kind to all other real estate: E.g., vacant rural land for office building. Generally look to state law definition. Compare to federal tax definition: 48, 512, 856. State law property classification does not control whether exchanged properties are considered of like kind for purposes of Section Rather, federal income tax law controls, and requires consideration of all facts and circumstances, including state law and federal tax law classifications, as appropriate. ILM Page 13

14 Like-Kind Real Estate Lease Exchanges - fee title for 30-year leasehold. Reg (a)-1(c); example in PLR Renewal options count toward 30 years. Rev. Rul , CB 258. Exchange of tenant s interest in lease with remaining term of less than 30 years can be exchanged for tenant s interest in another lease with remaining term of less than 30 years. Rev. Rul , CB 241. Exchange of leasehold interest in real property with 21 years remaining for fee interests in real property did not qualify as a like-kind exchange. VIP's Industries Inc. v. Commissioner, T.C. Memo Page 14

15 Like-Kind Real Estate Other examples of lease exchanges. Tenant s interest in building on land already owned by taxpayer was replacement property of like kind under Rev. Rul , CB 338. Tenant s interest in newly-issued lease may qualify as replacement property. PLR See also Rev. Rul , CB 299. Consider impact of 467. Page 15

16 Like-Kind Real Estate Other examples of like kind for real estate. Coal supply contracts were covenants running with real property under New Mexico law; coal mine (subject to the supply contracts) is "like-kind" to gold mining property. Peabody Natural Resources Co. v. Commissioner, 126 TC 261 (2006). Exchange of old-growth timberlands for reproduction timberlands. Approved in PLR : Citing Rev. Rul , age, quality and species of timber do not change class or kind of property being exchanged. Page 16

17 Like-Kind Real Estate Other examples of like kind for real estate. Development rights for fee interest in real property. Approved in PLR Approved again in PLR Development rights vary widely under state and local law. Page 17

18 Not Like-Kind Real Estate Not all real estate is of like kind Construction of new building on land already owned by taxpayer. Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F.2d (7 th Cir. 1951) Rev. Rul Fee title for 50-year water rights not of like kind. Wiechens v U.S., 228 F.Supp. 2d 1080 (D.C. Arizona 2002). U.S. and foreign real property are not of like kind. 1031(h)(1). Page 18

19 Held for Requirement Section 1031 also requires that both relinquished and replacement properties are: Held for investment; or Used in a trade or business. Thus, held for requirement is violated if either relinquished or replacement property is: Ordinary income (dealer) property. Personal use property. Held for requirement may be jeopardized if relinquished or replacement property is transferred to an affiliate or unrelated party soon before or after the exchange. Page 19

20 Interplay with Section 121 Gain generally can be excluded under 121 if property was owned and used as taxpayer s principal residence for at least two of the five years preceding the sale. Exclusion generally limited to $250,000 ($500,000 for certain joint returns). Exclusion allowed even if property converted to investment or business use for up to three years before sale. Sale of such property may qualify for 1031 deferral. 121(d)(10) denies exclusion for five years after property acquired fully or partially tax-free under If transaction qualifies under both 121 and 1031, boot received in 1031 exchange is allocated first to 121 exclusion. Only the amount beyond 121 exclusion is taxable boot. Basis step-up permitted for amount excluded under 121. Favorable result; Rev. Proc Page 20

21 Vacation and Personal Use Real Property Personal use real property. Page 21 Court looked to primary purpose in holding the property. The mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence. Failure to offer for rent or sale. No claim of investment interest deductions or maintenance expenses on tax returns. Moore v. Commissioner, T.C. Memo Goolsby v. Commissioner, T.C. Memo Yates v. Commissioner, T.C. Memo Rev. Rul Safe harbor - Revenue Procedure Adopts personal use/fair rental value test of 280A for 24 months before and after exchange. Change from Rental to Personal Use after Exchange. Reesink v. Commissioner, T.C. Memo Lease at Fair Rental to Son. Adams v. Commissioner, T.C. Memo

22 Dealer Real Property Dealer property does not qualify for like-kind exchange treatment. Definition of dealer property is somewhat broader under 1031 than under standard definition under 1221(a). Neal T. Baker Enterprises, Inc. v. Commissioner, T.C. Memo See also ILM (dual use property held for rental and for sale ruled held primarily for sale). Page 22

23 Fragmentation Taxpayer enters into a sale agreement for the sale of multiple properties. Can taxpayer exchange some properties and sell other properties for cash? The sale agreement provides a clear allocation of the sale prices of the individual properties; The exchange properties are not physically or functionally integrated with, or geographically adjacent to, the cash sale properties; and The sale agreement permits an assignment of the rights to sell the exchange properties to a QI with no assignment of the cash sale properties. Page 23

24 Timing of Exchanges Simultaneous Exchange. Deferred Exchange: old property transferred first, new property received later; 1031(a), enacted in response to Starker v US. 45-day identification requirement. 180-day closing requirement. Reverse exchange. New property is received before old property is transferred. Case law is generally unfavorable. See discussion of parking transactions below. Page 24

25 Typical Steps in a Deferred Exchange Taxpayer enters into a contract to sell relinquished property. Taxpayer enters into an exchange agreement with a QI pursuant to which the QI agrees to facilitate an exchange of the relinquished property for other replacement property pursuant to the QI safe harbor in Treas. Reg (k)-1(g)(4). On or before the closing on the sale of the relinquished property, taxpayer assigns its rights in the sale contract to the QI and notifies the buyer in writing of the assignment. Page 25

26 Typical Steps in a Deferred Exchange At the closing on the sale of the relinquished property, taxpayer deeds the relinquished property directly to the buyer and the proceeds of the sale (net of any paydown of relinquished property debt) are transferred by the buyer directly to the QI. Within 45 days after the closing on the sale of the relinquished property, taxpayer identifies potential replacement properties in a written document that is delivered to the QI. Taxpayer enters into a contract to purchase replacement property. Page 26

27 Typical Steps in a Deferred Exchange On or before the closing on the purchase of the replacement property, taxpayer assigns its rights in the purchase contract to the QI and notifies the seller in writing of the assignment. Page 27

28 Typical Steps in a Deferred Exchange No later than 180 days after closing on the sale of the relinquished property (and before the expiration of the due date, including valid extensions, of the taxpayer s tax return for the year in which the relinquished property was transferred), taxpayer closes on the purchase of the replacement property. At the closing on the purchase of the replacement property, the QI transfers the balance of the exchange funds (supplemented, as necessary by proceeds from new debt incurred to acquire the replacement property or other cash provided by the taxpayer) to the seller and the seller direct deeds the replacement property to taxpayer. Page 28

29 45-Day Identification Requirement Replacement property must be identified within 45 days of transfer of the relinquished property. No extension for week-ends or holidays. Number and value of replacement property identification. Three replacement properties with any value. Unlimited number, but fair market value no more than 200% of relinquished property. Unlimited number and value; taxpayer actually acquires 95% by value. Property acquired within 45-day identification period. Unambiguous description of each replacement property. Notice must be delivered to seller or certain other nondisqualified parties to the transaction. Reg (k)-1(c). Page 29

30 180-Day Closing Requirement Replacement property must be acquired by the taxpayer within 180 days of transfer of the relinquished property. If sooner, extended due date for tax return No extension for week-ends or holidays. Taxpayer must acquire replacement property that is substantially the same as identified. Reg example: acquisition of only 75% of vacant land that was identified. Reg (k)-1(d). Page 30

31 Additional QI Requirements QI agreement must require that QI cannot transfer any exchange funds or other boot to taxpayer unless and until: Expiration of 45-day identification period, if taxpayer has not identified any replacement property at that time; or Taxpayer has received all replacement property to which taxpayer is entitled. Reg (k)-1(g). In general, taxpayer cannot change QI mid-exchange. PLR IRS rules that change of ownership of QI does not invalidate pending exchange. Page 31

32 Interest on Exchange Funds Taxpayer can obtain the benefit of an interest factor under QI agreement. Taxpayer must include such interest in income, even if taxpayer receives the benefit in the form of additional replacement property. Reg (k)-1(h). Page 32

33 Interest on Exchange Funds - Who is Taxed? Proposed regs issued under 1.468B-6 in January 1999: Addressed taxation of income earned in a qualified escrow account or qualified trust used in a deferred 1031 exchange. Interest income taxed to exchanging taxpayer unless exchange facilitator ( QI ) has all the beneficial use and enjoyment of the funds. Page 33

34 Interest on Exchange Funds Who is Taxed? Proposed 1.468B-6 regs issued February 2006: Substantially revise 1999 proposed regs. Taxpayer generally be treated as loaning funds to QI. No deemed loan if all earnings are payable to taxpayer. Proposed reg governs below-market loans associated with like-kind exchanges. If taxpayer loan to QI, interest imputed at 182-day Tbill rate. Regs would be effective when issued in final form. Grandfather for reasonable, consistently applied method for transfers before regs are finalized. Page 34

35 Interest on Exchange Funds Who is Taxed? Final 1.468B-6 and regs. Issued July 2008: Generally follow Feb proposed regs. Taxpayer generally be treated as loaning funds to QI. No deemed loan if all earnings are payable to taxpayer. Final regs permit lower imputed interest rate. If taxpayer loan to QI, interest imputed at lower of AFR or 91- day Tbill rate. Page 35

36 Interest on Exchange Funds Who is Taxed? Final 1.468B-6 and regs (continued). New exceptions to treatment as loan to QI. Exchange funds are less than $2,000,000. Exchange funds are held in separate sub-accounts. Fees paid by banks to QIs. Effective for transfers of relinquished property on or after October 8, IRS will not challenge a reasonable, consistently applied method for transfers before that date. Page 36

37 Depreciation Calculations Final regulations concerning depreciation of replacement property acquired in: a like-kind exchange under 1031 or involuntary conversion under General approach. Step-in-the-Shoes to extent of substituted basis. Restart depreciation to extent of additional basis. Treas. Reg (i)-6. Page 37

38 Codification of Economic Substance Doctrine Transaction must change in a meaningful way (apart from Federal income tax effects) the taxpayer s economic position, and the taxpayer must have a substantial purpose (apart from Federal income tax effects) for entering into such transaction. Applies only if economic substance doctrine is relevant. Potential application to structuring for a like-kind exchange? Non-safe harbor parking transactions? Other transactions? Page 38

39 Page 39 Proposed Legislation

40 Proposed Legislation Administration Proposal. Released February 2, 2015 (same as February 2014 proposal). Limit deferral of gain from real property exchanges under section 1031 to $1,000,000 (indexed for inflation) per taxpayer per year. House Ways and Means Committee Proposal. Ways and Means Committee Chair Dave Camp (R-MI) released a tax reform proposal on February 26, Includes proposal to repeal section Senate Finance Committee proposal. Then Senate Finance Committee Chair Max Baucus (D-MT) released a series of proposals in November Includes proposal to repeal section Ernst & Young LLP study of impact of repeal on the economy.

41 Distressed Property Exchanges and Related Issues Page 41

42 QI Failures and Defalcations QI Failures in Recent Years. Bankruptcy and otherwise. LandAmerica 1031 Exchange Services, Inc. Case No KRH, E.D. Va., Richmond Division Replacement property can still be acquired with additional taxpayer funds. IRS has informally indicated general approval. Legal counsel must be consulted to advise of risks in routing cash through a bankrupt or insolvent QI.

43 QI Failures and Defalcations Mid-Exchange Change in QI. IRS view: in general, no change in QI is permitted. PLR permits change in QI. Allowed change in QI from disregarded entity to C corporation. Unusual facts. See also PLR Even with no change in QI, replacement property can still be acquired with additional taxpayer funds.

44 QI Defalcations IRS considering the issue: IRS letter August 24, 2007 IRS suggests bad debt deduction: IRS letter June 6, TIGTA Report (August 27, 2008). IRS Business Plan guidance may be forthcoming on: Joint accounts requiring signature of both QI and taxpayer. Mid-exchange change in QI. Sale or liquidation of QI. Other substitution of new QI. PLR permits change in QI from disregarded entity to C corporation.

45 QI Defaults Revenue Procedure Safe harbor method of reporting gain or loss for taxpayers who initiate a deferred like-kind exchange but fail to complete the exchange because the QI defaults (due to bankruptcy or receivership proceeding) on its obligation to acquire and transfer replacement property to the taxpayer. Generally, gain not recognized until payment is received. Exception for liabilities in excess of basis. Effective for taxpayers whose like-kind exchanges fail due to a QI default occurring on or after January 1, Also may amend returns for prior years. Page 45

46 Exchange of Underwater Real Property Can relinquished property held subject to nonrecourse debt in excess of its fair market value qualify for exchange treatment? PLR Analogous authority for tax-free transfer of property without equity. Does such relinquished property qualify as property? See, e.g., 351. Clearly preferable in context of deed in lieu transfer rather than actual foreclosure transaction. Lender cooperation.

47 Exchange of Underwater Real Property: Other Issues There is no sales contract in foreclosure. Can property be deeded directly to lender? Regs permit a direct deed. But can transferor s rights be assigned to a QI? Perhaps property can be first deeded to QI. But transfer to QI may raise other issues. Bad boy loan covenants: does unauthorized transfer convert to recourse loan? Transfer taxes.

48 Exchange of Underwater Real Property: Other Issues In exchange of underwater property, the taxpayer receives no exchange proceeds to fund cash portion of purchase price of replacement property. To minimize cash portion of replacement property, taxpayer may acquire credit net lease property. Debt on replacement property should equal or exceed debt balance on relinquished property. Loan fees? Lease terms should be reviewed to confirm true ownership issue.

49 Exchange of Underwater Real Property: Timing What is the date of the transfer for federal income tax purposes? General Rule: sale occurs when benefits and burdens of ownership pass to buyer. State law redemption period for foreclosure. Is debt recourse or nonrecourse? R. Odell & Sons Co. v. Comm r, 169 F.2d 247 (3d Cir. 1948): transfer occurs upon expiration of redemption period. Form 1099-B instructions.

50 Acquisition of Underwater Real Property Can replacement property subject to nonrecourse debt in excess of property value qualify for like-kind exchange treatment? No depreciation or interest deductions allowed: Estate of Franklin v. Comm r, 544 F.2d 1045 (9 th Cir. 1976). Odend hal v. Comm r, 748 F.2d 908 (4 th Cir. 1984). Nonrecourse debt recognized as debt of the taxpayer to the extent of the fair market value of property: Pleasant Summit Land Corp. v. Comm r, 863 F.2d 263 (3d Cir. 1989).

51 Acquisition of Underwater Real Property Acquiring property out of foreclosure. Redemption period timing issue discussed above. Pleasant Summit treats liabilities in excess of value as contingent liabilities. Do contingent liabilities qualify as liabilities that reduce taxable boot from net debt relief? Reduction of debt encumbering property in connection with sale of property generally treated as reduction in debt before sale. Treas. Reg (b).

52 Failure to Acquire Replacement Property Many taxpayers are unable to acquire replacement property in the current market. Acquisition of replacement property from a related seller generally flunks anti-abuse rule of 1031(f)(4). Teruya Bros., Ltd. v. Comm r, 124 T.C. 45 (2005), aff d 580 F.3d 1038 (9 th Cir. 2009). Ocmulgee Fields, Inc. v. Comm r, 132 T.C. 105 (2009), aff d 613 F.3d 1360 (11 th Cir. 2010). North Central Rental & Leasing, LLC v. Comm r, DCND (9/3/13), aff d 115 AFTR 2d (8 th Cir. 2015). Possible exceptions if no basis shifting. Failure to acquire replacement property will result in taxable sale treatment.

53 Installment Sales and Busted Exchanges Taxpayer can report installment note from buyer of the relinquished property under 453 installment method. Special rule overrides general rule that installment method is allowed only for indebtedness of the buyer, which would otherwise be the QI under the fiction of the (k) regs. Reg (k)-1(j).

54 Installment Sales and Busted Exchanges If sale and receipt of cash from QI straddle two taxable years, Reg (k)-1(j) permits taxpayer to report taxable gain under 453 installment method. See Rev. Rul Assumes taxpayer transfers property through a QI and still has a bona fide intention to complete a likekind exchange at end of year one.

55 Installment Sales and Busted Exchanges Installment gain is generally taxable in year cash is received. However, gain is triggered in year one to extent of: Liabilities in excess of basis. Depreciation recapture under 1245, 1250 and 291(a)(1). Interest charge under 453A(c). Applies at partner level. Announcement

56 Loss Disallowed in Section 1031 Exchanges Taxable loss is disallowed in a 1031 exchange. Section 1031 is not elective. Regardless of presence or absence of boot. Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5 th Cir. 1968). Taxpayer sought to recognize gain to obtain basis step-up at capital gain rates for gain before enactment of 1245.

57 Loss Disallowed in Section 1031 Exchanges To avoid loss disallowance under 1031: Use different taxpayers to transfer and receive property. Did not work in Redwing Carriers. Separate agreements. No cross default provisions. Better yet, no cross references. Separate closing dates.

58 Page 58 Reverse Exchanges and Parking Transactions

59 Reverse Exchanges True reverse exchange. Taxpayer receives new property before relinquishing old property. Situation typically arises when: Seller of new property will not postpone sale; or No buyer has been located for old property. Page 59

60 Reverse Exchanges True reverse exchange. Statute and regulations are silent. Preamble to regulations are unfavorable. Case law is unfavorable: Many cases have held reverse exchange is taxable. Few favorable cases: Rutherford, TC Memo (exchange of heifers). In Re Exchange Tiles, bankruptcy court, unusual facts. Private rulings are not helpful: PLR : direct reverse exchange was tax-free. TAM : failed parking transaction. Advisable to avoid true reverse exchange. Page 60

61 Parking Transactions Alternative to a true reverse exchange: First, new property is acquired by (parked with) accommodator, which later completes a simultaneous exchange ( Park First ); or Simultaneous exchange first, then old property parked with accommodator until sale ( Park Last ). Park First is more common; lender may require Park Last. Park First: Less risk ownership imputed to taxpayer. Park Last: Allows more new property. Page 61

62 Parking Transactions Two alternative types of parking transactions: Safe harbor parking. Rev. Proc Modified by Rev. Proc , discussed below. Parking outside the safe harbor. Based on general income tax principles. Page 62

63 Non-Safe Harbor Parking Accommodator recognized if tax owner of the parked property. Tax ownership is based on benefits and burdens of ownership. Generally requires accommodator to have some real upside and downside. Weigh factors discussed below. DeCleene v. Commissioner, 115 T.C. 457 (2000). FAA F. Page 63

64 Non-Safe Harbor Parking Formalistic (optimistic) view: sufficient that accommodator is not the agent of the taxpayer. PLR IRS would not necessarily grant another such PLR. Pending Tax Court Decision: George Bartell, TC Docket # Trial October Page 64

65 Non-Safe Harbor Parking Relationship of accommodator to owner. Cannot be agent of exchanger. Case law deferred exchange safe harbor for a qualified intermediary may not apply. Agency would result in true reverse exchange. Should not be related to exchanger. Legislative history to 1031(f)(4) apparently prohibits acquisition through a QI from related party. Page 65

66 Non-Safe Harbor Parking Financing purchase of parked new property. Direct loan by exchanger to intermediary. Repayment of loan may be boot. Third party loan on commercially reasonable terms. Intermediary will require nonrecourse loan. Lender will require exchanger guarantee. Exchanger lease may provide lender assurance. Seller financing is best, if available. Page 66

67 Non-Safe Harbor Parking Operation of parked property. Net lease to exchanger. True lease required to avoid true reverse exchange. Minimizes upside and downside to accommodator. Exchanger manages parked property. Easier to avoid tax owner status. Exposes accommodator to upside and downside. Accommodator, as property owner, reports property income and deductions. Page 67

68 Non-Safe Harbor Parking Transfer of parked property between exchanger and accommodator. Exchanger desires call option. Beware of possible recast as ownership by exchanger if exercise of option is economically compelled. Accommodator desires protection. Put option, with exchanger s call option, would create major pressure on tax ownership. Accommodator may be satisfied with increasing rents. Must avoid long-term lease subject to 467. Page 68

69 Non-Safe Harbor Parking Bottom line. Accommodator tax ownership requires real upside and downside in parked property operations or value. Conversely, taxpayer does not wish to give accommodator upside, and accommodator does not wish to assume downside. Thus, it is generally difficult to structure non-safe harbor parking arrangement for which tax advisor can opine at any high level of comfort. As a result, a group of private practitioners requested Treasury and IRS to grant a safe harbor for parking. Page 69

70 Safe Harbor Parking In Rev. Proc , the IRS announced that, for parked property held in a qualified exchange accommodation arrangement ( QEAA ), it will not challenge: Qualification of the property as replacement or relinquished property; or Treatment of the exchange accommodation titleholder as beneficial owner. Effective for transactions after 9/14/00. No inference for parking outside safe harbor. Page 70

71 Safe Harbor Parking Safe Harbor Requirements: Title held by EAT: Not the taxpayer or disqualified person. At least 90% held by taxable holders. Bona fide intent for like-kind exchange. Written QEAA within 5 business days. Relinquished property identified within 45 days. Transfer to taxpayer or third party within 180 days. EAT cannot hold property for more than 180 days. Page 71

72 Safe Harbor Parking Safe Harbors Permitted: EAT may also serve as QI. Taxpayer can provide/guarantee financing. Taxpayer may lease/manage parked property. Puts/calls at fixed/formula prices may be used. Taxpayer can use contrary treatment for regulatory, GAAP, state, local or foreign tax purposes. PLR permits statement that EAT is taxpayer s agent for all purposes other than federal income tax purposes. Page 72

73 Safe Harbor Parking Timing traps: identification and holding periods. 5 days to enter into QEAA. Must identify specific taxpayer and EAT. In PLR , the Service ruled that the QEAA is valid even though a related party also entered into a QEAA for the same property. PLR : same ruling for two related parties. 45 days to identify. 3 properties or 200% value tests under the regulations. Relinquished property sold within but identified outside 45 day-period: approved in PLR , but reliance unclear. 180 days to close. If not complete, transfer of partially completed building. Must decide at inception whether parking will be within or outside safe harbor. Page 73

74 Safe Harbor Parking Combined reverse and deferred exchange. IRS approved exchange into two replacement properties: One replacement property parked under safe harbor; Second replacement property acquired in deferred exchange. ILM IRS refers to the transaction as two separate exchanges. Page 74

75 Safe Harbor Parking Rev. Proc. permits parking only for direct interest in replacement property. Parking of 50% interest in real estate partnership permitted where exchanging taxpayer held the other 50% partnership interest PLR REIT stock acquired by EAT, which soon thereafter liquidates the REIT and conveys the assets to the taxpayer? Page 75

76 Safe Harbor Parking The safe harbor was modified by the IRS in Rev. Proc : Rev. Proc will not apply if the parked replacement property was previously owned by the taxpayer at any time in the 180 days before the transfer to the EAT. Rule clearly applies to transfer of fee title by exchanging taxpayer to EAT. Rule is intended to apply to ground lease of land by exchanging taxpayer to EAT ( disappearing lease ). Rule does not apply to lease from related party to EAT (IRS now studying the issue). Effective for transfers on or after 7/20/04. Page 76

77 Page 77 Exchanges into Build-to-Suit Property

78 Build-to-Suit Replacement property can be build-to-suit. Construction cannot be performed by taxpayer. Construction by affiliate is vulnerable to anti-abuse rule of 1031(f)(4) unless direct exchange. Thus, construction must be performed by sellerdeveloper, QI or EAT. Because of greater restrictions on a taxpayer s dealings with a QI, use of an EAT is generally preferred if unrelated party is not used. Page 78

79 Build-to-Suit (cont d) Building on Land Owned by Taxpayer or Affiliate. IRS view: land and building cannot be exchanged for new building built on land already owned by taxpayer. Rev. Rul Transfer of taxpayer s land to another party for construction period followed by transfer back to taxpayer may be disregarded. DeCleene v. Comm r, 115 T.C. 457 (2000). Taxpayer generally cannot acquire land from affiliate as replacement property through QI. 1031(f)(4). Teruya Bros., Ltd. v. Comm r, 124 T.C. 45 (2005), aff d 580 F.3d 1038 (9 th Cir. 2009). Ocmulgee Fields, Inc. v. Comm r, 132 T.C. 105 (2009), aff d 613 F.3d 1360 (11 th Cir. 2010). Rev. Rul Page 79

80 Build-to-Suit (cont d) Building on Land Owned by Taxpayer or Affiliate (cont d) Thus, if new building is to be built as replacement property on land already owned by taxpayer or affiliate, preferred approach is to use a ground lease to the EAT during construction, which is later transferred to taxpayer in the exchange. The law is undeveloped on this approach; still may be vulnerable to disregard of lease grant and transfer. Page 80

81 Build-to-Suit (cont d) Building on Land Owned by Taxpayer or Affiliate (cont d) IRS has approved exchanges into build-to-suit property on land leased from an affiliate of exchanging taxpayer. PLR PLR PLR Page 81

82 Build-to-Suit (cont d) Facts Taxpayer enters into QEAA with EAT. EAT enters into (acquires) > 30 ½ year lease in land owned (or leased) by affiliate and pays no consideration for leasehold interest. EAT constructs improvements. Within 180 days of EAT s acquisition of the leasehold interest: Taxpayer sells relinquished property through a QI and Taxpayer acquires leasehold interest and partially/fully constructed building from EAT through the QI. Page 82

83 Build-to-Suit (cont d) IRS Rulings Taxpayer satisfies QI and Rev. Proc safe harbors. Exchange involves a related party, but no gain recognized under 1031(f) unless taxpayer or affiliate disposes of interest in the property within 2 years. Affiliate did not cash out its interest in the property. Reimbursement of certain affiliate costs may be permitted. Page 83

84 Build-to-Suit (cont d) Implications. Road map for build-to-suit exchange on land owned by related person. Holding does not extend to build-to-suit exchanges on land owned by taxpayer. IRS will not rule favorably if land is owned by the exchanging taxpayer within 180 days before transfer to EAT. See Rev. Proc Page 84

85 Build-to-Suit (cont d) Rev. Proc : Rev. Proc will not apply if the parked replacement property was previously owned by the taxpayer at any time in the 180 days before the transfer to the EAT. Rule clearly applies to transfer of fee title by exchanging taxpayer to EAT. Rule is intended to apply to ground lease of land by exchanging taxpayer to EAT ( disappearing lease ). Rule does not apply to lease from related party to EAT (IRS now studying the issue). Effective for transfers on or after 7/20/04. Page 85

86 Build-to-Suit (cont d) Construction of replacement real property need not be complete. Completion of identified property in deferred exchange is required only for personal property. Reg (k)-1(e)(3). Safe harbor parking limited to 180 days. Post-exchange construction costs do not count toward value of replacement property. Prepaid construction costs: weak position. Page 86

87 Page 87 Related Party Exchange Issues

88 Background Benefits of related party exchanges: Shift basis to property to be sold earlier. Shift basis to depreciable property. Historically, tax-free like-kind exchange treatment has been permitted for exchanges between related parties. IRS ruled that 1239 does not override 1031, but only applies to gain recognized under PLRs and : tax-free exchanges between taxpayers and wholly-owned corporations. In 1989, Congress Enacted 1031(f). Page 88

89 General Rule Basic related party exchange limitation: deferred exchange gain is triggered upon a transfer (a second disposition ) within two years of a tax-free related party exchange. 1031(f)(1). Gain is triggered to both parties upon a second disposition by either party: taxpayer disposition of replacement property; or related party disposition of relinquished property. Page 89

90 General Rule What if Taxpayer (T) exchanges property with related party B and, within 2 years thereafter, T sells property? B sells property? These are the standard applications of the general rule. In either case, the sale triggers gain to the non-selling related party. Page 90

91 General Rule What if T exchanges low basis property for related party B s high basis property and, in the following year, T has an NOL so B sells its property to related party C? The sale by B appears to trigger T s gain, even though the sale is to a related party. Page 91

92 Related Person Defined by 1031(f)(3). Incorporates 267(b). Affiliated and commonly controlled entities. Family includes spouse, ancestors, issue, siblings. Also incorporates 707(b)(1). Partnership and person owning >50% interest. Two partnerships owned >50% by same persons. Capital or profits. Section 267 attribution of indirect ownership. Page 92

93 Related Person Private rulings on related person status under 1031(f)(3). PLR IRS rules that seller of replacement property is not related to the exchanging taxpayer so that the exchange does not violate the antiabuse rule of 1031(f)(4), discussed below. PLR IRS rules that Trust is not a related party to taxpayer under 267 or 707(b). Page 93

94 When is the Relationship Tested? What if T exchanges property with his brother B s S Corporation (S), 18 months later B sells the S stock to a Third Party X and S then sells its exchange property? Relationship is tested at time of exchange. Sale by S triggers T s gain, even though S is unrelated to T at time of sale by S. Same result for S if T sells his property. PLR implies that the parties can become unrelated soon before the exchange to avoid 1031(f). Page 94

95 When is the Relationship Tested? What if T exchanges low basis property for Third Party X s high basis property, 18 months later T purchases X and has X sell its exchange property? Subject to anti-abuse rule and assuming no integrated plan, T and X were unrelated at date of exchange so T should not have gain under 1031(f). Page 95

96 Suspension of Two-Year Period The two-year period is suspended under 1031(g) while the holder s risk of loss is substantially diminished by: Holding a put. Another person holding a right to acquire. Short sale or any other transaction. Similar to 453(e)(2)(B). Page 96

97 Suspension of Two-Year Period What if T exchanges property with related party B; 18 months later B acquires an option to put the property to Third Party X; put expires unexercised after 12 months; and B sells property 5 months later (35 months after exchange)? 2 year period is suspended so long as B holds put option; thus, B s sale is within 2 years and T s gain is triggered. Page 97

98 What is a Disposition? Section 1031(f)(1) applies to a second disposition of property. However, the term disposition is not defined. A sale or exchange is generally a disposition. Lease of property should not be a disposition. Provided it qualifies as a true lease for tax purposes. Nontaxable transfers, e.g., under 351, 721, 731? Gifts? Demolition of property? Disposition of a portion of property? Cutting and disposition of timber is not a disposition of the underlying land. PLR Citing Rev. Rul (not a disposition for purposes of 1374 tax under 337(d)). Page 98

99 Exceptions to General Rule Section 1031(f)(2) permits exceptions for: Death of either taxpayer or related party. Compulsory or involuntary conversion. As defined in If exchange occurred before threat or imminence of such conversion. it is established to the satisfaction of [the IRS] that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax. Legislative history permits exchanges of undivided interests to consolidate ownership in a single property. See PLR Advance IRS ruling required? Page 99

100 Exceptions to General Rule Originally, IRS position apparently was that private rulings would not be issued under 1031(f)(2)(C) exception for non-tax avoidance. However, the IRS has granted such rulings: PLR PLR Page 100

101 Lack of Tax Avoidance Purpose What if T exchanges property with related party B and, 18 months later, B contributes property to partnership (P) for a 99% interest? For a 1% interest in P? In either case, B s contribution triggers gain to T under the general rule, but nontaxable if T can establish that Federal tax avoidance was not a principal purpose of either the exchange or B s contribution. Page 101

102 Application of Two-Year Rule Two-year rule seems to impose a mechanical limitation. If so, taxpayers can plan for dispositions two years and one day after initial exchange. PLRs under 708(b)(1)(B) permit taxpayers to avoid technical termination of a partnership through transfers separated by one year and one day. See anti-abuse rule discussed below. But no abuse if related party sells exchange property more than two years after original exchange, even if intended at time of exchange. FSA Beware of premature transfer of benefits and burdens of ownership. Page 102

103 Anti-Abuse Rule Deferred exchange treatment is denied under 1031(f)(4) anti-abuse rule if the exchange: is a part of a transaction (or series of transactions) structured to avoid the purposes of [section 1031(f)]. Legislative history example: Replacement property acquired through QI from owner related to taxpayer who receives cash. If anti-abuse rule applies, the entire exchange is fully taxable. Page 103

104 Anti-Abuse Rule In general, the acquisition of replacement property from a related party through a QI will violate the anti-abuse rule of 1031(f)(4). Page 104 TAM ; FSA ; Rev. Rul Teruya Brothers Ltd. v. Comm r, 124 T.C. 45 (2005), aff d 580 F.3d 1038 (9 th Cir. 2009). Ocmulgee Fields, Inc. v. Comm r, 132 T.C. 105 (2009), aff d 613 F.3d 1360 (11 th Cir. 2010). Tax Court holds that, in general, the acquisition of replacement property from a related party through a QI will violate the anti-abuse rule of 1031(f)(4). Court rejects penalties on ground that Teruya Brothers decision had not yet been issued. Leaves door open if taxpayer can show, e.g., no basis shifting. North Central Rental & Leasing, LLC v. Comm r, DCND (9/3/13), aff d 115 AFTR 2d (8 th Cir. 2015).

105 Anti-Abuse Rule What if T enters into exchange with QI, which sells relinquished property to Third Party X and uses cash to purchase replacement property from related party B? Exchange is taxable under standard application of anti-abuse rule. No different than exchange with B followed by sale by B. X s cash stays in the related party group. Teruya Brothers; Ocmulgee Fields, Inc.; Rev. Rul What if related party B is a dealer? IRS ruled that there is no exception to the anti-abuse rule by reason of related party seller status as a dealer. ILM Page 105

106 Anti-Abuse Rule: Exceptions Presumably anti-abuse rule applies to replacement property acquired from a related person through a QI only if the related party receives cash or other non-like kind property. Otherwise, there appears to be no abuse whether or not transfers are made through a QI. Group has no more cash after the exchange than before. Page 106

107 Anti-Abuse Rule: Exceptions Purchase of replacement property through QI from related party as part of like-kind exchange by the related party itself approved by IRS. PLRs , , , , and Each party agreed not to sell for more than two years. Boot up to 5% of gain realized permitted in PLRs and Two successive related party exchanges allowed under PLRs , and Separate identification and replacement periods allowed under PLR Page 107

108 Anti-Abuse Rule: Exceptions Another possible exception: Related party has taxable gain that exceeds the gain exchanging taxpayer is seeking to defer. In effect, no shifting of basis. PLR : Exchange of undivided interests between brothers and trust for niece followed by sale by niece and one brother does not invalidate exchange of the other brother. Selling brother had lower tax basis than exchanging brother. IRS also cited legislative history under 1031(f)(2)(C) permitting exchanges of undivided interests to consolidate ownership in a single property. Teruya Brothers: Exception did not apply because related party taxable gain was partially sheltered by NOL. Thus, little or no tax benefit allowable under this approach. What if selling affiliate is subject to a lower tax rate? Page 108

109 Anti-Abuse Rule Sale to Related Party What if T sells relinquished property through a QI to related party B for cash and QI uses the cash to buy replacement property from unrelated party X? IRS has ruled privately that this transaction does not trigger gain under 1031(f)(4). No different from exchange with B for property purchased by B. Cash leaves the related party group. Applies even if related party B resells relinquished property within two years. PLRs , , and Page 109

110 Anti-Abuse Rule Sale to Related Party PLRs , , and Taxpayer (REIT) sells relinquished property to related person (TRS) through a QI as part of a 1031 exchange even if the related person resells that property within two years. General related party rule of 1031(f)(1) does not apply because exchange was through an unrelated QI. Anti-abuse rule of 1031(f)(4) does not apply because IRS found no tax avoidance purpose. Page 110

111 Anti-Abuse Rule Sale to Related Party Sale to related party must qualify as a true sale. Fair market value pricing and terms. Buyer adequately capitalized. Transfer of benefits and burdens of ownership. Potential uses and benefits: Condominium conversion ordinary income. Bramblett planning: freeze inherent gain as nondealer gain. May permit parking outside safe harbor of Rev. Proc Page 111

112 Pre-Exchange Disposition What if related party B sells high basis Property 1 to Third Party X for cash and 18 months later X exchanges Property 1 for T s low basis Property 2? This may be caught by anti-abuse rule. Transaction merely rearranges steps of basic prohibited exchange under anti-abuse rule. Result probably depends on whether there was an integrated plan. Page 112

113 Consolidated Returns Exchange Between Members of a Consolidated Return Group. Section 1031 tax-free treatment is denied under Reg (f). Instead, gain or loss on the exchange is deferred under the rules of Reg for deferred intercompany transactions. By its terms, Reg (f) applies only to direct exchanges between group members. But perhaps could be extended to indirect exchanges, e.g., through a QI, under the anti-abuse rule of Reg (h). Parent treated as holding property (emission allowances) for productive use in its trade or business acquired from subsidiary to complete like-kind exchange with unrelated buyer. PLR (no analysis of the issue). Page 113

114 Page 114 Single-Member LLC Exchange Issues

115 Non-Tax Reasons to Use Separate Entity Acquisition of new property via a single-asset entity. Minimize certain potential liabilities. E.g., environmental or construction risks. Lender may require bankruptcy-remote entity ( BRE ). Transfer of entity may avoid transfer taxes. Page 115

116 Same Entity Must Acquire New Property Exchange is tax-free only if the new property acquired by the owner of the old property. Acquisition of new property in separate tax entity fails IRS victory in Redwing Carriers, replacement property acquired by subsidiary of exchanging taxpayer. Statute prohibits 1031 swaps of partnership interests or corporate stock. Despite court losses, IRS may challenge swaps closely followed/preceded by transfer to/from separate entity: Magneson, Bolker, Mason. Page 116

117 Disregarded single-member LLC ( SMLLC ) Page 117 Replacement property acquired directly by SMLLC: PLRs , , Relinquished property sold and replacement property acquired by separate disregarded SMLLCs: PLR Second LLC member owned by lender with no economic interest disregarded; LLC thus qualifies as disregarded LLC: PLR Acquisition of 100% of interests in disregarded SMLLC is treated as acquisition of underlying SMLLC asset: PLR Transfer to disregarded SMLLC after acquisition: PLR

118 Same Entity Must Acquire New Property (cont d) Corporate successor in 381 transaction can acquire replacement property to complete a 1031 exchange. PLRs , , , , IRS will not grant such a ruling for a partnership merger between two legs of a deferred exchange. Sub K has no analog to 381. Page 118

119 Disregarded Entities Certain entities disregarded for like-kind exchange purposes: Grantor trusts. Illinois land trusts. SMLLC (alter ego of owner). Qualified sub S subsidiaries. Qualified REIT subsidiaries. Delaware statutory trusts (conditions discussed below). Page 119

120 Transaction Structures Acquire new property through SMLLC to avoid transfer tax or create BRE. SMLLC acquires new property. See PLRs above Owner acquires all interests in SMLLC. PLR Sell old property through SMLLC to avoid transfer tax. First contribute old property to new SMLLC. Then transfer 100% of the interests in the SMLLC. Transfer of LLC interests by merger. Partnership transactions, discussed below. Sale of partial interest in SMLLC (Rev. Rul. 99-5). Acquisition of 100% of partnership interests (Rev. Rul. 99-6). Page 120

121 State Tax Treatment Most states have adopted the federal check-the-box ( CTB ) classification regulations. Most follow federal CTB rules (e.g., CA, NY). Some are unclear or silent (e.g., KY, PA). Some states generally tax LLCs as corporations (e.g., TX). Some states impose LLC net worth tax. Page 121

122 State and Local Transfer Taxes Most states impose transfer taxes. Combined state/local rate ranges up to 4%. E.g., Philadelphia, PA. Transfer tax generally imposed only on transfers of direct real estate interests. Some states impose transfer tax on transfers of 50% or greater interests in entities. E.g., NJ, NY, CT, DC. Page 122

123 Non-Tax State Law Treatment LLC legislation has now been adopted in all 50 states and DC. Most states permit a SMLLC. Page 123

124 Page 124 Partnership Exchange Issues

125 Partnership Planning General rules. A partnership is an entity. The same entity generally must transfer the old property and receive the new property. Exceptions Disregarded entities, e.g., SMLLCs. Successor in corporate transactions under (a)(2)(D) generally prohibits 1031 swaps of partnership interests. Page 125

126 Partnership Planning In general, 1031(a)(2)(D) provides that a partnership interest is not of like kind to any other property. However, Rev. Rul treats the acquisition of a partnership interest as the acquisition of an undivided interest in the underlying assets of the partnership. Seller is treated as selling partnership interest. IRS ruled in PLR (discussed below) that a partnership interest can serve as replacement property under Rev. Rul by looking through to the underlying partnership assets. PLR extends PLR to permit safe harbor parking under Rev. Proc of a partnership interest that will serve as replacement property under Rev. Rul Page 126

127 Partnership Planning Technical Termination under 708(b)(1)(B). Is the new partnership the same taxpayer as the old partnership for 1031 purposes? Same taxpayer rule. Held for requirement. Long v. Commissioner footnote. PLR Favorable ruling: technical termination of partnership did not violate However, IRS would limit favorable ruling to highly unusual facts; termination of testamentary trust. Page 127

128 Partnership Planning Exchange of Cash Proceeds Received in Part- Contribution, Part-Sale. Taxpayer contributes property to partnership in exchange for partnership interest plus cash treated as disguised sale consideration under 707(a). Can taxpayer take the cash through a QI and treat the cash as proceeds from the sale of relinquished property in a like-kind exchange? Apparently yes - see Reg (a)(2) (second sentence). Page 128

129 Simultaneous Partnership Exchange Caveat: gain possible if shift in liabilities. E.g., nonrecourse debt on old property is replaced with recourse debt on new property. Partners with no economic risk of loss on new debt face: Constructive distribution under 731. Minimum gain chargeback under Reg Possible solution: bottom dollar guarantee. Page 129

130 Deferred Exchanges by Partnerships Debt on old property relieved before debt taken on new property. 752 gain from excess of liabilities over basis? 1031 and regs silent. Rev. Rul : excess liabilities taxable in 1033 context. Reg (f): debt can be netted if one transaction. Complete in single year - also avoid Reg issue. Rev. Rul : net debt under 1031 regs. Is gain triggered under 465(e)? Generally no 465(e) recapture if old and new properties are treated as held in a single activity. Page 130

131 Partnership Exchange of Contributed Property for Boot Partnership acquires real property in tax-free 704(c) contribution. Partnership later exchanges the contributed real property for replacement property plus cash boot. Is the boot 704(b) or 704(c) gain? PLR IRS rules that taxable boot from a partially taxable likekind exchange by a partnership can be treated as 704(b) gain allocable to all partners with only the balance of such gain treated as 704(c) gain or reverse 704(c) gain. IRS permits partnership to order the boot gain as: First 704(b) gain. Then post-contribution (reverse) 704(c) gain. Then pre-contribution 704(c) gain. Page 131

132 Partnership Split-Ups Often some partners wish to exchange property and others wish to take cash. Partnership (P) exchanges for property plus cash; P distributes cash to redeem exiting partners interests. P distributes undivided interests in property to partners, who then sell or exchange at the individual partner level. P first redeems interests of exiting partners, then exchanges property at P level. P exchanges for property plus note, then distributes note to redeem exiting partners interests. Page 132

133 Partnership Exchange and Distribution to Exiting Partners Partnership exchanges property for new like-kind property plus cash. Partnership specially allocates taxable boot gain solely to exiting partners. Partnership distributes cash to exiting partners in complete redemption of their partnership interests. Page 133

134 Partnership Exchange and Distribution to Exiting Partners Does allocation of boot to exiting partners have substantial economic effect? Position has facial appeal if exiting partners capital accounts before the exchange are zero. Otherwise, allocation may lack economic effect. Beware of capital account revaluation. Substantiality - Reg (b)(2)(iii). Page 134

135 Partnership Distribution, Then Sale or Exchange by Partners Base case: Partnership distributes a tenancy-in-common interest in the partnership real property to one (or all) partners. Then the partnership and/or some (or all) partners do their own exchanges. Some partners may sell for cash. If the transaction is respected, the (former) partners can go their own ways: The taxable gain to the cashing out partners cannot be allocated to the exchanging partners. Partners can acquire their own replacement properties. Page 135

136 Partnership Distribution, Then Sale or Exchange by Partners Is property treated as held by a partnership for tax purposes? Reg (a): key is level of services. Powell. Rev. Rul : all services must be customary. Net leased property should be OK. Avoid partnership characteristics: Confirm right of partition, no restriction on transfer. Rev. Proc : ruling policy on undivided fractional interests. Does not apply because the property had previously been held by the partnership. Nevertheless, Rev. Proc may serve as a useful checklist. Page 136

137 Partnership Distribution, Then Sale or Exchange by Partners Held for requirement of statute. Magneson v. Commissioner, 753 F2d (9 th Cir. 1985). Bolker v. Commissioner, 760 F2d (9 th Cir. 1985). Mason v. Commissioner, TC Memo Maloney v. Commissioner, 93 T.C. 89 (1989). Former partners should hold separate interests in old property as long as possible before exchange. Exchanges completed before termination of testamentary trust approved in PLR IRS viewed as special situation. Period of time remaining before trust termination was not disclosed. Page 137

138 Partnership Distribution, Then Sale or Exchange by Partners Transfer of old property imputed to partnership. Court Holding Company, 324 U.S. 331 (1945). Chase, 92 T.C. 874 (1989). TAM Observe formalities. Notify mortgage lenders. Record separate deed for each former partner. Pay any applicable transfer tax. Obtain updated title insurance. Negotiate transfers at partner level after distribution of old property. Former partners should hold interests in old property as long as possible before transfer. Page 138

139 Partnership Distribution, Then Sale or Exchange by Partners Partnership Division s PLR allowed partnership to divide into two partnerships, with each partnership then doing its own separate exchange. Reg (d), issued thereafter, appears to preclude this approach. Page 139

140 Partnership Distribution, Then Sale or Exchange by Partners IRS May Increase Scrutiny. Form Two questions concerning like-kind exchanges. See questions 13 and 14: IRS is seeking information related to like-kind exchanges, e.g., distribution of tenancy-in-common interests in partnership assets. Page 140

141 Redemption of Exiting Partners Before Partnership Exchange Safest approach for tax purposes but increases requisite reinvestment in replacement property. Partnership may not have sufficient cash. Source of funds? Continuing partners must replace the entire gross sale price of the partnership relinquished property. Continuing partners assume risk that the exchange does not close. Page 141

142 Redemption of Exiting Partners Before Partnership Exchange Tax issues Debt incurred in anticipation of exchange. Proposed Reg (b)-1(c) held taxable boot. Final regulations silent - but result unclear. Case law favorable on good facts. Fredericks v. Commissioner, T.C. Memo Solution: Partnership retains liability for new debt, exchanging property free and clear of new debt. Page 142

143 Redemption of Exiting Partners Before Partnership Exchange Tax issues Redemption for partnership note. 736, not 453, governs. Delayed 734 inside basis step-up. Rev. Rul : not true debt, no basis step-up. Disguised sale under 707(a)(2). Purchase of exiting partners interests with funds supplied by continuing partners may be recast as disguised sale of partnership interests. Technical termination may result in new entity ineligible to complete the exchange. Page 143

144 Partnership Exchange for Property Plus Buyer s Note Partnership exchanges for property plus boot but, in lieu of cash, partnership takes buyer s installment note. Buyer s note may qualify for deferral to the partnership under 453. Partnership takes zero basis in note. Partnership must allocate all carryover basis first to the replacement property, leaving no basis to be allocated to the note. Page 144

145 Partnership Exchange for Property Plus Buyer s Note Partnership later distributes buyer s installment note. Distribution of note is tax-free to partnership and exiting partners. See Reg (c)(2) and Prop. Reg B-1(c)(1)(i)(C). Exiting partner takes substituted basis in note. Section 734 inside basis step-down may be required. Elective or mandatory 754 election. To the extent the exiting partner takes stepped-up basis in note. Page 145

146 Partnership Exchange for Property Plus Buyer s Note Timing of partnership distribution of buyer s installment note. Distribution of note immediately or soon after exchange may be vulnerable to recast under step transaction doctrine. See, e.g., Gregory v. Helvering. Best to wait some period of time after sale before distribution. If recast, partnership receipt and distribution of note may be disregarded, so that note is taxable at partnership level. See substantiality issue discussed above. Page 146

147 Exchanges - Partnership Interests Rev. Rul. 99-5: if seller S owns 100% of the interests in a disregarded single-member LLC and sells an interest in the LLC to buyer B, S is treated as: Selling an undivided interest in each LLC asset to B followed by S (and B) contributing its undivided interest in each LLC asset to a new partnership P. Even though a sale of an LLC interest under state law, sale qualifies as a sale of an undivided interest in each LLC asset, including real property, under Page 147

148 Exchanges - Partnership Interests S owns 100% of interests in disregarded SMLLC. LLC owns nondealer real property as its sole material asset. S sells through a QI a 50% interest in the LLC to B, unrelated to S. S acquires replacement real property R through QI. S s exchange of 50% LLC interest for R can qualify under B s acquisition of its 50% LLC interest may fail 1031 under the held for requirement. Page 148

149 Exchanges - Partnership Interests Rev. Rul. 99-6: if B acquires 100% of the interests in a partnership P, apart from any P interests that may already be owned by B, B is treated as: Acquiring B s share of P assets in liquidation of P. Then purchasing undivided interests in P assets from the selling partners. Thus, even though a purchase of P interests under state law, the acquisition qualifies as a purchase of P assets, including real property, for 1031 purposes. Asymmetrical treatment: Sale of P interests by other partners is treated as such, and not recast as sale of assets, for 1031 purposes. Page 149

150 Exchanges - Partnership Interests B and S, unrelated, each own a 50% interest in P. P owns nondealer real property as its sole asset. B sells relinquished property through a QI. B acquires S s 50% interest in P through the QI. B s exchange of the relinquished property for the 50% P interest can qualify under S s sale does not qualify under Rev. Rul. 99-6: S is treated as selling its S interest in P. PLR T owned no P interest before exchange. PLR Parking of 50% interest in real estate partnership permitted where exchanging taxpayer held the other 50% partnership interest. Page 150

151 Page 151 REIT Exchange Issues

152 REIT Exchanges When REITs make distributions to shareholders well in excess of taxable income, REITs have less reason to structure sales and acquisitions as tax-free like-kind exchanges. Conversely, if a REIT is concerned that distributions to shareholders may not exceed taxable income, the REIT has strong reason to structure sales and acquisitions as tax-free like-kind exchanges. Page 152

153 REIT Exchanges If the exchange transaction qualifies under 1031: REIT maintains its capital base. Avoids taxable sale. Avoids distribution of proceeds. REIT status requires distribution of 90% of income other than capital gain. Corporate level income tax on undistributed REIT net income. The REIT can elect to treat shareholders as having paid their shares of the tax and having received their shares of the gain. Requires timely filed election. Exempt shareholders prefer not to file refund claims. Page 153

154 REIT Exchanges If 1031 treatment is disallowed upon audit: Taxable gain will be added to REIT taxable income. REIT is liable to pay tax itself on the gain. Such gain can be excluded from taxable income subject to the 90% REIT distribution requirement as excess non-cash income. 857(e)(2)(B). The REIT can elect to treat shareholders as having paid their shares of the tax and having received their shares of the gain. Requires timely filed election, generally unavailable in audit. Beware 453A interest charge on failed exchanges straddling year-end. Page 154

155 REIT Exchanges If 1031 treatment is disallowed upon audit: Generally the REIT will choose to distribute the gain. Such gain can be transferred to the shareholder level only through a deficiency dividend Such gain may qualify for capital gain treatment at the shareholder level. Capital gain designation for deficiency dividends is generally required within 120 days after the determination. Reg (f)(2). 25% tax rate under 1(h)(6), Notices and Page 155

156 Potential Dealer Status What if the exchange is taxable by reason of dealer status? REITs are subject to a tax on net income from prohibited transactions. Such income is gain from dealer sales. Tax rate is 100%. Small solace: this 100% tax is deductible under BIG tax. Reg (d)-7(b)(2)(i). Page 156

157 Potential Dealer Status Safe harbor from 100% tax is granted but only if, among other conditions: Property is held for more than two years. Four years for sales before July 31, Tacking permitted in PLR : the period the relinquished and replacement property was held counted for the 4 year (now 2 year) holding period under the safe harbor. Aggregate REIT sales for the year do not exceed seven sale transactions or 10% of total tax basis. 857(b)(6)(C). Ordinary income exempt from 100% tax under the safe harbor is still treated as ordinary income at REIT level. Page 157

158 Potential Dealer Status Are like-kind exchanges viewed as sales for prohibited transactions tax safe harbor? IRS has ruled favorably. PLR (exchange is not a sale under 857(b)(6)(C)). PLR (boot treated as sale of only a pro rata portion of exchanged property under 10% basis limitation). PLR (timber REIT). Beware more than de minimis boot. Page 158

159 Potential Dealer Status Law is still unclear as to whether a like-kind exchange is a sale in determining dealer status. Thus, attempted exchange of dealer property will fail 1031(a) and will count as a sale under 857(b)(6)(C). Resulting gain will be ordinary income and, if outside safe harbor, will be subject to 100% tax. Page 159

160 OP and OP Partner Exchanges Conventional corporation or trust. REIT owns some or all of its real property directly or through qualified REIT subsidiaries ( QRSs ), but not through partnerships. Umbrella or operating partnership. REIT owns all of its real properties through a partnership known as an operating partnership ( OP ) or an UPREIT partnership. DownREIT. REIT owns one or more (but not all) of its real properties through a partnership known as a downreit partnership. A taxable REIT subsidiary ( TRS ). A taxable C corporation owned up to 100% by a REIT: to hold nonqualifying REIT assets; to receive nonqualifying income or to perform nonqualifying services. Page 160

161 OP and OP Partner Exchanges Most REITs operate through an OP. REIT holds up to 99% interest in the OP. Other partners hold the remaining OP interests. Other OP partners also hold option to convert OP units into REIT stock. OP structure enables investors to contribute property to the OP tax-free. Contrast 721 with 80% control requirement under 351. Contribution directly to REIT would typically flunk control requirement for tax-free treatment under 351. OP structure permits tax-free property distributions. Beware 704(c)(1)(B), 707(a)(2), 731(c), 737 and 751(b). Page 161

162 OP and OP Partner Exchanges UPREIT Structure Public REIT Cash Limited Partners CONVERTIBLE UNITS OPERATING PARTNERSHIP Real Estate Assets Cash Page 162