SECTION 1031 EXCHANGES

Transcription

1 SECTION 1031 EXCHANGES TEXAS LAND TITLE INSTITUTE December 4-5, 2008 Michael L. Cook Winstead PC 401 Congress Avenue Suite 2100 Austin, Texas FAX

2 SECTION 1031 EXCHANGES Table of Contents I. INTRODUCTION....1 Page II. III. STARKER AND FORWARD...2 A. Starker The First Judicial Approval of Non-Simultaneous Exchanges...2 B. Multi-Party Exchange...2 C. Holding Purpose; Conveyance of Exchange Property Before or After the Exchange IRS Rulings Wagenson Magneson Bolker Mason Chase Maloney...5 D. Partnership Exchanges and Exchanges of Undivided Interests Partnership Interests Undivided Interests in Real Estate Rev. Proc E. Business Swaps...10 F. Related Party Restrictions Background True v. United States TAMs, FSAs and Rev. Rul I.R.B Teruya Brothers, Ltd. v. Commissioner...12 G. Deferred Exchanges The Regulations...13 H. Deferred Exchanges and Installment Sales...14 DEFERRED LIKE KIND EXCHANGE REGULATIONS...14 A. Overview...14 B. The Intermediary The Qualified Intermediary Limitation on Right to Receive Boot Qualified Intermediary Cannot Be a Disqualified Person Written Exchange Agreement Disposition Requirement...17 C. Security Arrangements Permitted Security Arrangements Pledges of Property Standby Letters of Credit...18

3 4. Guarantee Right to Receive Money Qualified Escrow Accounts Qualified Trusts Early Distributions by an Intermediary...23 D. Specification of Replacement Property Property Acquired By 45th Day Identification Notice Recipient of Identification Notice Transmission of Identification Notice Mailed Notices Telecopied Notices Hand Delivered Notices Description of Real Property Identification of Incidental Items of Property Revocation of Identification Alternative and Multiple Properties Three-Property Rule Percent Rule Percent Rule...30 E. Direct Deeding Assignment of Sales Agreement to Qualified Intermediary Taking Title...31 F. Build to Suit Identification Acquisition of Substantially the Same Replacement Property That was Designated Achieving the Burdens and Benefits of Ownership...34 G. Deferred Exchanges and Installment Sales Prior to the Regulations Constructive Receipt Intent to Exchange Examples Effective Date of Proposed Regulations The Computation of Gain When the Relinquished Property is Encumbered Conclusion...42 IV. DEALING WITH THE PRACTICAL PROBLEMS OF DEFERRED EXCHANGES...43 A. Picking a Qualified Intermediary...43 B. Concerns of the Intermediary Intermediary s Gain Intermediary s Fee FIRPTA Withholding Closing Agent Reporting Interest Reporting...45

4 6. State Taxation of Intermediary Sales and Use Tax Documentary Transfer Tax Liability Concerns CERCLA Liability Liabilities to Parties to the Exchange Intermediary as Agent Resignation of Intermediary...48 C. Payment of Boot; Deposits and Earnest Money Deposits Earnest Money Deposit...49 D. Matching Liabilities; New Financing...49 E. Transaction Expenses...50 F. The Reverse Starker Deferred Exchanges Authority to Undertake Reverse Deferred Exchanges Parking the Replacement Property Use of Options The Fact Patterns and the Solutions Case Law Dealing with Reverse Deferred Like Kind Exchanges Revenue Procedure TAM Rev. Proc , I.R.B (Aug. 16, 2004)...58 G. The Dealer Issue...58 H. Interest and Growth Factors...59 I. Deferred Exchanges Using an Installment Note...60 J. Exchanges of Leasehold Estates with Less than Thirty Years of Duration...61 K. Real Estate Loan Workout Problems and Deferred Exchanges Exchange Prior to Foreclosure Standstill Agreement and Related Party Exchange...62 L. Exchanges by Partners and Partnerships The Problem ABA Tax Section Project TAM TAM TAM M. LLCs for Acquisition of Replacement Properties...66

5 SECTION 1031 EXCHANGES: UPDATE AND PRACTICAL APPROACH TO DEFERRED EXCHANGE STRUCTURES I. INTRODUCTION. by Michael L. Cook IRC 1031 is one of those opportunity provisions of the Internal Revenue Code that is in a constant state of change resulting from activity in the area at all levels -- judicial, legislative and regulatory. In its most simplistic form the like kind exchange allows a taxpayer who desires to dispose of an investment or an asset used in a trade or business (with certain exceptions) to exchange such property for a property of like kind of equal or greater value without recognizing the gain or loss which would otherwise be reportable on the disposition of the original property. The gain or loss is deferred until another day. This provision has led to a long history of tension between the IRS and taxpayers who constantly challenge the boundaries imposed by the IRS. The most recent expansion of the benefits of the like kind exchange treatment of 1031 has occurred in the deferred exchange area and is the subject of this paper. Section II of this outline describes the evolution of current law which has resulted from the longstanding tug-of-war between the government and the taxpayer, including the now recognized practice of nonsimultaneous or deferred exchanges. Section III sets forth the operating rules for deferred exchanges under the safe harbor regulations and Section IV discusses the practical problems practitioners face when structuring a deferred exchange. The general rule of 1031(a) provides as follows: (a) Nonrecognition of Gain or Loss From Exchanges Solely in Kind. (1) In General. No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. (2) Exception. This subsection shall not apply to any exchange of sale, (A) (B) stock in trade or other property held primarily for stocks, bonds, or notes, -1-

6 (C) interest, (D) (E) (F) other securities or evidences of indebtedness or interests in a partnership, certificates of trust or beneficial interests, or chooses in action. For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership. II. STARKER AND FORWARD A. Starker The First Judicial Approval of Non-Simultaneous Exchanges. Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979), is the first circuit court decision which directly considered the question of delayed exchanges in the context of In that case, Mr. Starker transferred his property to Crown Zellerbach in May, 1967 pursuant to a contract under which the corporation agreed to acquire other real property in the future and convey the property to Mr. Starker. Crown Zellerbach had up to five years to find suitable exchange property, or pay any outstanding credit balance (which included an annual growth factor equal to 6% of the outstanding balance) in cash to Mr. Starker. In 1968, in partial satisfaction of its obligation, Crown conveyed to Mr. Starker a contract right to purchase property from a third party. This property was subject to a life estate and legal title could not pass to Mr. Starker until the life estate expired. However, Mr. Starker had immediate possession of the property, subject to certain restrictions. The IRS argued that the transaction did not qualify under 1031, first, because the transfers were not simultaneous and, alternatively, because the taxpayer had received, in 1967, a contract right which was not of a like kind with the real property he had transferred in the exchange. The Ninth Circuit held that a simultaneous exchange is not required in a 1031 exchange and, in response to the IRS like-kind argument, stated: A contractual right to assume the rights of ownership should not, we believe, be treated as any different than the ownership rights themselves. Even if the contract right includes the possibility of the taxpayer receiving something other than ownership of like-kind property, we hold that it is still of a like-kind with ownership for tax purposes when the taxpayer prefers property to cash before and throughout the executory period, and only like-kind property is ultimately received. 602 F.2d B. Multi-Party Exchange. As the Starker case was making its way through the judicial process, the IRS was also challenging the ability of the taxpayer to structure multi-party -2-

7 exchanges and to actually bypass the transfer of title to certain of the parties (originally called facilitators, now referred to as intermediaries ), sometimes through the use of an escrow. For the most part, the legislative changes allowing deferred exchanges (1984 Tax Reform Act) and the regulations that followed have rendered the multi-party, escrow and deed bypass cases nothing more than interesting history. The principal cases are: Rutland v. Commissioner, 36 T.C.M. (CCH) 40 (1977); Everett v. Commissioner, 37 T.C.M. (CCH) 274 (1978); Biggs v. Commissioner, 632 F.2d 1171 (5th Cir. 1980) aff d 69 T.C. 905 (1978); Garcia v. Commissioner, 80 T.C. 491 (1982) acq C.B. 1; Barker v. Commissioner, 74 T.C. 555 (1980); Allen v. Commissioner, 43 T.C.M. (CCH) 1045 (1982). C. Holding Purpose; Conveyance of Exchange Property Before or After the Exchange. For a period of time the IRS displayed significant tenacity with regard to its narrow interpretation of the 1031 holding purpose requirements. It argued that a property acquired by the exchanging taxpayer immediately preceding the exchange from a related entity could not have been held for investment or trade or business purposes by the taxpayer; similarly, the IRS argued that property transferred to a related entity immediately after the exchange should not be treated as held for investment or trade or business purposes for purposes of For the most part, the courts have disagreed, and on balance, the IRS has to be considered the loser in this struggle. 1. IRS Rulings. Rev. Rul , C.B. 333, considered a situation where the taxpayer exchanged his exchange property for replacement property, and immediately afterwards transferred the replacement property to a controlled corporation. The ruling held that the transaction does not qualify as a nontaxable exchange, since the taxpayer, after the exchange, did not hold the replacement property for a qualified use. Rev. Rul , C.B. 305, reversed the sequence of facts of Rev. Rul In Rev. Rul , a corporation liquidated pursuant to 333 (IRC 333 was repealed by the 1986 Tax Reform Act) distributed investment property to its shareholder, and the shareholder (who took the property with a low carryover basis) exchanged that property for replacement property. The ruling held that the new property did not qualify as replacement property and that the exchange transaction did not qualify for nonrecognition under 1031, since the taxpayer did not hold the exchange property prior to the exchange for a qualified use. The analyses of Revenue Rulings and were based on a straightforward, literal interpretation of the requirements of By its terms, 1031 requires the taxpayer to hold both the exchange property and the replacement property for a qualified use. In the view of the Service, this qualified use requirement was violated by the preceding or succeeding nontaxable transfers. 2. Wagenson. Wagenson v. Commissioner, 74 T.C. 653 (1980), considered an exchange followed by a gift of the replacement property within 9 months after the exchange; the Tax Court held that the subsequent transfer did not violate the qualified use requirement. However, in Click v. Commissioner, 78 T.C. 225 (1982), the Tax Court held that an exchange failed to qualify under 1031 where, at the time of the exchange, the taxpayer intended to give away the replacement property. The taxpayer in fact gave away the property within seven months of the exchange and his children lived in the replacement property until the gift. -3-

8 3. Magneson. Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985), considered an exchange of real property by the taxpayer (a tenancy-in-common interest), followed by a contribution of the replacement property to a limited partnership for a general partnership interest. The Ninth Circuit determined that the taxpayer satisfied the qualified use requirement. According to the court, the underlying property of the general partnership was of like kind to the taxpayer s pre-exchange tenancy-in-common interest in real property. The court determined that there was merely a change in the taxpayer s form of ownership of the property which did not significantly affect the taxpayer s control of or the nature of the property. The court s analysis seemed to be grounded on an aggregate rather than an entity view of partnerships. The court rejected the Commissioner s position that a taxpayer must intend to keep the replacement property indefinitely in his own name. Rather, the court ruled that the holding requirement is satisfied when the taxpayer does not intend to liquidate or use the replacement property for personal purposes. The key factual element in the case was that the taxpayer intended to and did continue to hold the replacement property and that the contribution to a partnership was a mere change in his form of ownership. Significantly, this decision predated the enactment of the partnership interest exclusion of 1031(a)(2)(D) (see II.D. below). To the extent Magneson could be read to hold that a partnership interest could be like kind to a tenancy-in-common interest in real property, it is no longer good authority. 4. Bolker. Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985), involved a distribution of exchange property by a corporation liquidating under 333 to its shareholder, followed by an exchange of the property by the shareholder for replacement property. The facts in Bolker were almost identical to the transaction on which the Service had ruled unfavorably in Rev. Rul Nevertheless, the court held that the transaction did not violate the qualified use requirement of The court identified two distinguishing facts. First, the Bolker liquidation was planned before the taxpayer formed his intention to exchange the properties. Second, the taxpayer actually held the exchange property for three months after the liquidation. As in Magneson, the Bolker court did not consider the law subsequent to the adoption of 1031(a)(2)(D). Furthermore, it is significant that Bolker involved a corporation and not a partnership. It is easy to terminate the corporate ownership of property by merely deeding the property to the shareholders, but it may be more difficult to terminate partnership ownership, since the partnership ownership of property characterizes the business relationship of the partners and is not limited to the form of holding title to the property. 5. Mason. Mason v. Commissioner, 55 T.C.M. (CCH) 1134 (1988), involved a distribution of real property by a partnership to its partner, followed by an exchange by the partner. This case is the partnership analog of Bolker. In a memorandum decision with very little analysis, the Tax Court determined that the property was held for a qualified use and therefore that the transaction qualified for nonrecognition treatment. The court did not discuss whether the distribution effectively terminated the partnership relationship; the court appeared merely to assume that it did. Although Mason implicitly presented one of the fundamental issues in exchanges involving partnerships, the court did not address the issue at all. It also neglected to explore the significance of the 1984 amendments to See II.D. below. -4-

9 6. Chase. Chase v. Commissioner, 92 T.C. 874 (1989), on its face looks like a reprise of Mason. Nevertheless, the taxpayer in Chase seems to have done just about everything wrong. As a rare taxpayer defeat in the 1031 arena, Chase is worth reviewing in detail if a taxpayer is planning a partnership distribution followed by an exchange of the distributed property. Unfortunately, it is difficult to say whether Chase stands for some broad tax principle or whether it should be limited to its facts. In a word, the taxpayer lost because of careless form and execution; the distribution/exchange would be better described as wishful thinking by the taxpayer as opposed to a structure that was fully agreed to by all of the parties and executed pursuant to the agreement. 7. Maloney. Maloney v. Commissioner, 93 T.C. 89 (1989), undoubtedly will be cited as authority by more taxpayers than the Chase case. Maloney also may be read to imply that taxpayers are better advised to undertake exchanges at the partnership level, followed by a distribution to the partners rather than to distribute partnership property to be followed by an exchange. The partnership-level exchange does not generally involve the same question of whether the distribution could terminate the partnership relationship. The Tax Court in Maloney found a corporate exchange followed by a distribution of the replacement property qualified for nonrecognition treatment under The taxpayer in Maloney was the controlling shareholder of a corporation. On December 28, 1978, the corporation traded its real estate for replacement real estate. On January 2, 1979, the corporation liquidated under 333 and distributed the replacement property to the taxpayer. Afterwards, the taxpayer used the replacement property in the operations of several of his corporations. The question before the court in Maloney was whether the corporation s subsequent liquidation violated the qualified use requirement with respect to the replacement property. The Maloney court, citing Bolker, stressed that 333 recognizes a taxpayer s continuing investment in property notwithstanding the interposition of a corporate form. Based on Magneson, the court found that the transaction qualified as a nonrecognition exchange. Further, the court found that a trade of like kind property may be preceded by a tax-free acquisition of the property at the front end or succeeded by a tax-free transfer of property at the back end. The court also stressed that, in a 333 liquidation, the shareholder continues to have an economic interest in essentially the same investment, although there has been a change in the form of ownership. Furthermore, the court found that the corporation s purpose was equivalent to the shareholder s purpose. Presumably, the proper taxpayer was the corporation and not the shareholder. Nevertheless, Maloney should be even stronger as authority when a partnership undertakes an exchange, since the aggregate view of partnerships is considerably stronger than an aggregate view of corporations implied by the Maloney court. Maloney may indicate that it is reasonably safe for the partnership to exchange its property and then to distribute the replacement property to its partners. Nevertheless, there are significant lapses in the analysis of Maloney. Most significantly, Maloney appears to stress the holding purpose of the shareholder rather than the holding purpose of the corporate taxpayer who effected the exchange. Correspondingly, where a partnership undertakes an exchange, it should be the holding purpose of the partnership and not the holding purpose of the partner that is relevant to ACHIEVING A TAX FREE EXCHANGE UNDER See Section IV.L hereafter. -5-

10 8. PLR In PLR , the IRS rule favorably for the taxpayer. Here a testamentary trust which had systematically engaged in like-kind exchanges throughout its existence was scheduled to terminate according to its terms. Prior to termination the trust entered into two contracts to sell some of its real property with the intent to complete a like-kind exchange pursuant to During the term of the contracts and prior to closing, the trust terminated and distributed all of its property to an LLC of which it was the sole member. The LLC desired to complete the like-kind exchange and therefore sought a ruling from the IRS as to whether it would meet the holding requirements of The IRS indicated that the LLC would satisfy the holding requirements of 1031 despite having received the relinquished property subject to a contract. The IRS distinguished this case from Rev. Rul by highlighting the fact that the LLC would continue the current business practices of the trust as a functional continuation of the trust and that the exchanges were independent of the impending termination of the trust. These facts were enough for the IRS to bless this transaction as one which satisfies the holding requirements of D. Partnership Exchanges and Exchanges of Undivided Interests. 1. Partnership Interests. The exchange of a partnership interest for an interest in another partnership has always been a problem for the IRS and with the emergence of the judicial liberalization of the holding purpose standard in Magneson, Bolker and the other related cases discussed in II.C. above, the IRS could eliminate partnership interest exchanges definitively only by requesting a change to 1031 through legislation. In the 1984 TRA, 1031 was amended to exclude from the like kind exchange rules an exchange of interests in different partnerships, although the legislative history made it clear that [t]his rule (excluding interests in different partnerships from 1031(a) treatment) is not intended to apply to an exchange of interest in the same partnership (emphasis added) H.R. Rep. No , 98th Cong., 2d Sess., pt. 2 (1984), pp Undivided Interests in Real Estate. a. The History. Generally, exchanges of undivided interests are exchanges of real property are not exchanges of partnership interests but relationships between tenants in common may constitute the creation of a partnership. In PLR six related parties divided co-ownership in 23 separate parcels of farm land and the IRS extended 1031 treatment to the transaction. But, in PLR the IRS ruled that two brothers (A and B) who owned 10 rental properties together were actually partners and their division of the 10 rental properties was in effect an exchange of real property for a partnership interest. Management of the properties was performed by a property management corporation of which A and B were equal stockholders. A and B represented that they have never executed any partnership agreement or considered themselves to be anything other than equal owners of the properties but for five consecutive tax years all net income and losses relating to the properties have been reported on Form 1065, a partnership return. The PLR noted that (a) provides that a joint undertaking merely to share expenses is not -6-

11 a partnership. For example, if two or more persons jointly construct a ditch to drain surface water from their properties, they are not partners. Mere coownership of property that is maintained, kept in repair, and rented or leased does not constitute a partnership. For example, if an individual owner, or tenants in common, of farm property lease it to a farmer for cash rental or a share of the crops, they do not necessarily create a partnership thereby. Tenants in common, however, may be partners if they actively carry on a trade, business, financial operation, or venture and divide the profits thereof. For example, a partnership exists if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent. In Rev. Rul , C.B. 261, two parties each own an undivided one-half interest in an apartment project. A management company retained by the co-owners manages the building. Customary tenant services such as heat and water, unattended parking, trash removal, normal repairs, and cleaning of public areas are furnished at no extra charge. Additional services, such as attendant parking, cabanas, and gas and electricity are provided by the management company for a separate charge. The ruling holds that the furnishing of customary services in connection with the maintenance and repair of an apartment project will not render coownership a partnership. The furnishing of additional services by the owners or through an agent will render a co-ownership a partnership. The revenue ruling concludes that since the management company is not an agent of the owners and the owners did not share the income earned from the additional services, the owners were not furnishing services. Therefore, the owners are to be treated as co-owners and not partners under section 761. The PLR further noted, citing Estate of Levine, 72 T.C. 780, 785 (1979), that a crucial test under case law of whether the co-owners of property intended to create a partnership, as evidenced by their actions, notwithstanding the lack of characterization of their relationship. The IRS concluded that Taxpayer s filing of partnership tax returns for several tax years indicates an intention to be taxed as a partnership. b. Divisions of Property. The issue of tenancy in common versus partnership relationships do not arise in divisions of contiguous or single parcel property. A partition or division of contiguous property is not a sale or exchange. See PLRs , , , , and c. Tenancies in Common. In the 1990s taxpayers, on a widespread basis, began to avail themselves of convenient replacement property availability through managed tenancies in common (TIC). Generally, the TIC agreements had all of the substantive elements of a partnership. In 2000 the IRS announced that it would not rule on the application 1031 where the replacement property is an undivided interest. Rev. Proc However, in 2002 the IRS published a safe harbor Revenue Procedure (Rev. Proc , CB 733) that outlines the requirements to be met to obtain a favorable advance ruling for a tenancy in common ( TIC ) syndication. -7-

12 3. Rev. Proc Rev. Proc lists fifteen conditions that must be satisfied for a taxpayer to receive a favorable ruling as to whether a TIC arrangement will not be treated as a partnership. The IRS has published Rev. Rul , I.R.B. 191 allowing a Delaware statutory trust to hold real estate and be disregarded for tax purposes. The conditions specified in Rev. Proc and Rev. Rul are as follows: a. Tenancy-in-common ownership. Each co-owner must hold title to the underlying property directly or indirectly through an entity disregarded for federal income tax purposes and must be a tenant-in-common under local law. For asset protection purposes, some TIC arrangements require that each TIC interest be owned in a single-asset entity. b. Limited number of co-owners. The number of co-owners per TIC arrangement is limited to no more than 35 persons. c. Co-ownership not an entity. The co-ownership may not (i) file a partnership or corporate tax return; (ii) conduct business under a common name; (iii) execute an agreement identifying any or all of the co-owners as partners, shareholders, or members of a business entity; or (iv) otherwise hold itself out as a partnership or other form of business entity. d. Co-ownership agreement. The co-owners may enter into a coownership agreement that runs with the land. Under Rev. Proc , a coownership agreement may provide that a co-owner must offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair market value before exercising his right to partition or transferring his interest to a third party. e. Voting. The co-owners must unanimously approve (i) the hiring of any manager, (ii) the sale or other disposition of the property, (iii) leases of any portion or all of the property, or (iv) the creation or modification of a blanket lien. With respect to all actions on behalf of the co-owners, other than those requiring unanimous consent, the co-owners may agree to be bound by the vote of those holding more than 50% (or some higher percentage) of the undivided interests in the property. Co-owners may not, however, provide the manager or another person with a global power of attorney or proxy to make decisions for them. f. Right to alienate. Each co-owner generally must have the right (which may be subject to a right of first offer granted to another co-owner, the sponsor, or the lessee) to transfer, partition, or encumber the co-owner s interest in the property without agreement or approval of any other person. Co-owners are also allowed to place certain restrictions on the right to transfer, partition, or encumber an interest in the property, if such restrictions are required by a lender and are consistent with customary commercial lending practices. g. Split on property sale. If the property is sold, any debts secured by a blanket lien must be satisfied and the remaining sales proceeds must be -8-

13 distributed to co-owners. This condition prohibits arrangements between coowners that are designed to have perpetual existence following the disposition of the property, perpetual existence being an indication of a partnership. h. Proportionate sharing of profits and losses. Each co-owner must share n all revenues generated by the property and in all costs associated with the property in proportion to the owner s undivided interest in the property. Any advances to a co-owner by another co-owner, the sponsor (as defined in Rev. Proc , the word sponsor includes a syndicator ), or the manager to meet expenses associated with the co-ownership interest must be recourse to the co-owner receiving such advance and cannot exceed a 31-day period. If the coowner is a disregarded entity, the advance must be recourse to the owner of the disregarded entity. i. Proportionate sharing of certain debt. The co-owners must share in any debt secured by a blanket lien in proportion to their undivided interests. j. Options. As discussed above in connection with voting, a coowner may issue a call option with respect to a TIC interest. The exercise price for a call option is required to reflect the fair market value of the property determined at the time the option is exercised. For this purpose, the fair market value of an undivided interest is equal to the co-owner s percentage interest in the property multiplied by the fair market value of the whole property, thereby precluding minority discounts. The Rev. Proc. prohibits an owner from acquiring a put option to sell the property to the sponsor, the lessee, another co-owner, the lender, or any person related to the sponsor, the lessee, another co-owner, or the lender. k. No business activities. The Rev. Proc. limits the activities that a co-owner may participate in to those customarily performed in connection with the maintenance of rental property. Rev. Rul , 1975 CB 261, defines those customary activities, which include heat, air conditioning, hot and cold water, unattended parking, normal repairs, trash removal, and cleaning public areas. Activities will be treated as customary activities for this purpose if the activities would not prevent an amount received by an organization described in 511(a)(2) from qualifying as rent under 512(b)(A) and the regulations thereunder. l. Management and brokerage agreements. The co-owners may enter into management or brokerage agreements with an agent, but the activities of the agent, sponsor, or co-owner, acting as manager, may not exceed the activities allowed under the above condition. A management or brokerage agreement must be renewable no less frequently than annually, and while the sponsor or a co-owner may fill such capacity, a lessee may not. Co-owners are allowed to agree to authorize the manager to perform nominal accounting and clerical functions such as (i) maintaining a bank account before dispersing each co-owner s share of net revenues; (ii) preparing profit/loss statements for the co- -9-

14 owners; (iii) obtaining or modifying insurance on the property, subject to the approval of the co-owners; and (iv) negotiating modifications of the terms of any lease or any debt encumbering the property, subject to the approval of the coowners. The manager must disburse to the co-owners their share of net revenues within three months from the date of receipt of those revenues; therefore, the TIC arrangement probably cannot accumulate earnings to maintain a maintenance or other type of reserve. m. Leasing agreements. All leasing agreements must be bona fide leases for federal tax purposes. Thus, rents paid by a lessee must reflect a fair market value for the use of the property. This means that the determination of the amount of rent must not depend, in whole or in part, on income or profits derived by any person from the leased property (other than an amount based on fixed percentages of receipts or sales). n. Loan agreements. Any person related to any co-owner, the sponsor, the manager, or any lessee of the property is prohibited from being a lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire an undivided interest in the property. o. Payments to sponsor. Except as otherwise provided in Rev. Proc , any payment to the sponsor for the acquisition of the co-ownership interest (and the fees paid to the sponsor for services) must reflect the fair market value of the acquired ownership interest (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the property. E. Business Swaps. In the 1980s, taxpayers again tested the resolve of the IRS in the personal property exchange area. Taxpayers took the position that an exchange of one business for another business of the same type was nontaxable under 1031 notwithstanding that the mix of assets employed in the respective businesses involved in the exchange were not like kind. The taxpayers found significant comfort in Rev. Rul , C.B. 181 (assets of one television station for the assets of another) and subsequent private letter rulings such as PLR (June 1, 1989); PLR (June 1, 1989) and PLR (August 14, 1989). In an action in which the timing would strongly imply a communication problem within the IRS, it then reversed field in a published opinion. See Rev. Rul , C.B. 203, where the business for business application of 1031 was rejected, and Rev. Proc , C.B. 783, wherein the IRS announced it would no longer rule on a transaction involving the exchange of the assets of similar or identical businesses. F. Related Party Restrictions. 1. Background. Prior to 1989, taxpayers developed a simple procedure that in the right circumstances artificially transferred basis from one asset to another. For example, if Taxpayer owned two tracts, Whiteacre and Blackacre, which had bases of $100 and $1,000, respectively, and received an offer to purchase Whiteacre for $2,000, Taxpayer could move Blackacre s $1,000 basis to Whiteacre, thereby deferring the tax on -10-

15 $900 gain until the time Blackacre is sold. How? Taxpayer would form two S corporations and convey Whiteacre to S Corporation I and Blackacre to S Corporation II. S Corporations I and II would then exchange Whiteacre and Blackacre S Corporation II, the new owner of Whiteacre, which then had Blackacre s old $1,000 basis, would complete the sale. Blackacre, now owned by S Corporation I, has a $100 basis. This example seems too good to be true, and it is. The Commissioner elected not to win by litigation, but instead, the transaction was defeated by legislation. Section 1031(f), passed by Congress in OBRA 1989, provides that in the event of an exchange between related parties and a subsequent sale of either of the exchanged properties within two years following the exchange (normally there will only be one with a low basis), the original exchanging party that transferred the subsequently disposed property must recognize the otherwise deferred gain. Therefore, in the above example, S Corporation I must recognize the $900 gain and in such event its basis in Blackacre would be stepped back to $1,000. The relationship that triggers the recognition of gain in the event of a subsequent sale of property exchanged between related parties is controlled by the Code s primary attribution rule provisions, 267(b) and 707(b)(1). 2. True v. United States. The IRS has applied theories from other areas of the tax law to frustrate purported like kind exchanges between related parties. In True v. United States, 190 F.3d 1165 (10th Cir. 1999), the Tenth Circuit held that the IRS properly recharacterized a family s transactions in ranchland through passthrough entities, finding that the various steps were the means to reach a particular result and, thus, should be treated as a single transaction. Jean and Henry True and their children operated businesses through partnerships or S corporations, including ventures in ranching and in oil and gas production. The ranching venture is through True Ranches. Smokey Oil Co. is one of the oil and gas companies. During the 1980s the Trues purchased five new ranch properties. Smokey Oil purchased the real property while True Ranches acquired the operating assets. Smokey Oil then transferred the land to True Oil Co. in exchange for certain oil and gas leases. The Trues treated that exchange as a taxfree like-kind exchange. True Oil immediately distributed the ranchlands to familymember partners as tenants in common. The partners then contributed their undivided interests in the land to True Ranches. The Trues treated the distributions as nonrecognition transactions under sections 721 and 731. Under those transactions, Smokey Oil received depletable oil and gas leases with the same cost basis it had in the ranchland, allowing Smokey Oil to claim cost depletion deductions on its tax returns. True Oil received the nondepreciable ranchland with a zero basis because the oil and gas leases it exchanged were fully cost depleted. The Trues paid the deficiencies under protest and sought refunds. The district court granted the government summary judgment. The Tenth Circuit affirmed only as to the ranchland transactions. The appeals court concluded that those transactions failed to satisfy the end result test, because the evidence established that the Trues intended all along to place the ranch properties in the hands of True Ranches. The Trues asserted that the steps had economic substance because they wanted Jean and Henry to bear a greater percentage of the acquisition costs. Collapsing the steps, they insist, will deprive Jean and Henry of any compensation for the additional amount they contributed to the purchase price, and their greater share of profits from Smokey Oil s ownership of the oil -11-

16 and gas leases acquired in the exchange. The court rejected that argument, explaining that those financing considerations to not establish that the Trues intended an alternative end result. The court reached the same conclusion applying the interdependence test, finding that the steps involved lacked any reasoned economic justification standing alone. Noting that Smokey Oil is involved only in oil and gas exploration and production, Judge Brorby said unless Smokey Oil acquired the mineral rights underneath the ranchlands, that the company s purchase of the lands made no objective business sense. The holding in True is somewhat troubling to practitioners inasmuch as essentially all like-kind exchanges between related parties can be attacked under the step transaction doctrine. There is no prohibition of exchange between related parties. 1031(f) merely taxes both parties to an exchange if one of the related exchange parties sells the exchange property received within 2 years following the exchange. The goal was to step up the basis of depreciable property for the write off benefit. Section 1031(f) does not prevent the benefit of depreciation deductions following exchanges of related property. Does every 1031 exchange structured for tax savings fail? A more simplified example of the above the IRS seeks to eliminate here is where T owns X, a low basis rental property and Y, a high basis tract of unimproved property. T creates an S corporation and contributes X to S. T and S then exchange X and Y whereby T ends up with X with Y s old high basis. True would rearrange the steps and hold that T merely contributed Y to the S corporation and T got no basis step up. 3. TAMs, FSAs and Rev. Rul I.R.B The IRS has administratively attacked related party exchanges using an intermediary. In TAM S had a buyer for his property and he wanted to acquire property from his mother M with the proceeds. S sold the property and entered into an exchange agreement with an intermediary which used the sale proceeds to buy M s property. The IRS simply rearranged the steps of the transaction as the Tenth Circuit did in True. The IRS held that S and M made the exchange then M sold to the buyer, thus the exchange failed because of Section 1031(f). The IRS applied a similar approach in FSA and Rev. Rul Teruya Brothers, Ltd. v. Commissioner. In Teruya Brothers Ltd., et. al. v. Commissioner, 124 T.C. No. 4 (2005), the Tax Court held a like-kind exchange of property between related parties through a qualified intermediary was not entitled to nonrecognition treatment under 1031 because the transaction was structured to avoid taxes. Teruya Brothers Ltd. transferred two properties to a qualified intermediary (QI) that, in turn, sold the properties to unrelated third parties. The QI used the proceeds plus additional cash from Teruya to buy replacement properties from Times Super Market Ltd., a company in which Teruya was the majority stockholder. The replacement properties were then transferred from the QI to Teruya. The IRS acknowledged that the transactions met the general requirements for like-kind exchanges under 1031(a)(1). It argued, however, that Teruya was required to recognize more than $12 million in gains because it had violated 1031(f)(4), which prohibits nonrecognition treatment for transactions structured to avoid the purposes of 1031(f). The Tax Court determined that the transactions were economically equivalent to direct exchanges of properties between -12-

17 Teruya and Times (with boot from Teruya to Times), followed by Times sales of the properties to unrelated third parties. He inferred that Teruya s use of a QI was an attempt to circumvent the 1031(f)(1) limitation that applies to direct exchanges between related persons. G. Deferred Exchanges The Regulations. Congress amended 1031(a), effective for transactions occurring after July 18, 1984, by adding the following additional provision. (3) Requirement That Property Be Identified And That Exchange Be Completed Not More than 180 Days After Transfer of Exchanged Property. For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like kind property if (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (B) such property is received after the earlier of (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the due date (determined with regard to extension) for the transferor s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs. On April 25, 1991, the Treasury adopted regulations under the 1984 deferred exchange amendment. Although the final regulations address many questions about deferred exchanges, for most taxpayers the heart of the final regulations is the safe harbor provisions describing qualified intermediaries and security arrangements. It may be significant to note that the safe harbors are nothing more than safe harbors. Congress has not delegated to Treasury any authority to establish substantive rules; the final regulations merely interpret 1031 under the general interpretative authority granted by Where the taxpayer qualifies a transaction under the safe harbors, the taxpayer will not be, either directly or through an intermediary, escrow holder, or trustee that may be his agent, considered in actual or constructive receipt of money or other property for purposes of the final regulations. In theory, the taxpayer should be free to decide whether or not to take advantage of the safe harbors. Some commentators apparently had questioned whether the safe harbors were mutually exclusive. The regulations clarify that the taxpayer may use more than one safe harbor in the same deferred exchange, provided that the terms of each are satisfied. For example, many advisors will wish to combine the intermediary safe harbor with either the safe harbor for qualified escrows or the safe harbors for security. -13-

18 The regulations do not contain a negative inference that a transaction should be presumed to be taxable if it does not qualify for the safe harbors. For example, the regulations do not either approve or disapprove of the use of a related party as an intermediary and they do not, as a substantive law matter, address receiving loans from an intermediary or premature disbursements from escrow. They merely set forth safe harbor rules. In appropriate cases (which would be rare), it seems that a taxpayer might later take the position that a transaction, blessed by a safe harbor, is fully taxable on account of constructive receipt. Someone considering this position, however, should first review the mitigation provisions contained in IRC and the effect of the various judicial doctrines such as consistency and estoppel. Nevertheless, it is possible that there are situations in which a taxpayer (or his successor) may determine that it is later advantageous to take the position that the safe harbors do not govern the substantive law and that a transaction within the safe harbors still is taxable. Considering the liberality of the safe harbors, it is entirely plausible that, in appropriate circumstances, this position could prevail. Section III describes the specific safe harbor rules. H. Deferred Exchanges and Installment Sales. The Starker decision raised an interesting question, academic in Starker but very real in those deferred exchanges that were crafted from Starker s broad principles. The question is: If, at the end of the five-year period, Crown Zellerbach had not replaced the property but paid Mr. Starker the required cash, how should Mr. Starker s gain on his property conveyed to Crown Zellerbach be reported? Should it have been reported in the year of the disposition as a nonqualifying like kind exchange or five years later as proceeds received pursuant to an installment sale? The 1984 amendment to 1031 did not resolve the question but merely shortened the potential installment period to two taxable years, since a deferred exchange must close, if at all, within 180 days following the date of closing of the conveyance of the relinquished property. IRC 1031(a)(3)(B). On November 2, 1992, the Treasury issued Prop. Reg (k)-1(j)(2) which made clear the effect of a failed deferred exchange entered into with a good intention. Such a failure would cause the otherwise deferred gain to be recognized in the year the consideration received from the disposition of the relinquished property would be treated as a payment on an installment note and taxed when received by the taxpayer from the intermediary, escrow or trust. See III.C. III. DEFERRED LIKE KIND EXCHANGE REGULATIONS. A. Overview. The 1031 regulations put flesh on the bare bones of the statute which provided only two basic rules: (i) that replacement properties must be identified within 45 days following the date of conveyance of the relinquished property (IRC 1031(a)(3)(A)), and (ii) that the replacement property must be acquired within 180 days following the date of conveyance of the relinquished property (IRC 1031(a)(3)(B)). The basic structural steps of a typical deferred exchange described in the broadest form are as follows: the taxpayer has a property with an inherent gain and the taxpayer receives a contract for purchase of his property; the taxpayer enters into an exchange agreement with an intermediary and then assigns the purchase contract to the intermediary; -14-

19 the purchase contract closes, the relinquished property is conveyed to the buyer and the consideration therefrom is paid over to the intermediary; the taxpayer identifies certain replacement property; the taxpayer selects the replacement property and contracts to buy it; the contract to acquire the replacement property is assigned to the intermediary; and the contract is closed whereby the intermediary transfers the cash consideration to the seller and the seller conveys the replacement property to the taxpayer, frequently through a direct deed. (See the diagram on Appendix 1.) The regulations expand the rules to cover all elements of a normal exchange which are discussed in detail in this Section III. B. The Intermediary. Almost all deferred exchanges structured under the regulations will utilize an intermediary although a good exchange does not require it. Generally, qualifying trusts and escrows are regarded as alternatives to the intermediary concept, but they are actually security concepts that should be utilized as a compliment to the qualified intermediary structure and not in lieu thereof. The intermediary safe harbor is sufficiently generous and the risks outside the safe harbor are sufficiently great that few will structure a deferred exchange with an intermediary who is not a qualified intermediary. Prior to the publication of the proposed 1031 regulations, taxpayers had no guidance concerning who could be used as an intermediary in completing a deferred exchange transaction. While some taxpayers used controlled or related persons, there was always an underlying concern that the transaction would result in constructive receipt. Other taxpayers used professional intermediaries, which frequently were shell corporations formed to provide intermediary services, usually for a fee. Some taxpayers were able to find friendly parties to act as intermediaries. The proposed regulations introduced a generous safe harbor that generally blessed the use of intermediaries, provided that the intermediary was not a party related to the taxpayer under broad attribution rules. The safe harbor under the final regulations is similar to the safe harbor under the proposed regulations. A qualified intermediary under the final regulations is not considered the agent of the taxpayer for purposes of applying The taxpayer s transfer of relinquished property and/or his subsequent receipt of like kind replacement property from a qualified intermediary is treated as an exchange. If the safe harbor requirements are met, the taxpayer will not be treated as being in actual or constructive receipt of money or other property held by the qualified intermediary. 1. The Qualified Intermediary. Reg (k)-1(g)(4) defines a qualified intermediary as a person who (i) is not the taxpayer or disqualified person, and (ii) enters into a written agreement with the taxpayer (the exchange agreement ) and, as required by the exchange agreement, acquires the rights to the relinquished -15-