ALI-ABA Course of Study Creative Tax Planning for Real Estate Transactions. October 11-13, 2007 Atlanta, Georgia

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1 223 ALI-ABA Course of Study Creative Tax Planning for Real Estate Transactions October 11-13, 2007 Atlanta, Georgia Recent Developments Affecting Real Estate and Pass Through Entities By Stefan F. Tucker Venable LLP Washington, D.C.

2 224 TABLE OF CONTENTS I. LEGISLATIVE DEVELOPMENTS...6 A. Tax Relief and Health Care Act of Extensions of Income Tax Credits Extensions of Deductions Extension of Fifteen-Year Straight-Line Cost Recovery for Qaulified Leasehold Improvements and Qualified Restaurant Property Modification of Excise Tax on Unrelated Business Taxable Income of Charitable Remainder Trusts Premiums for Mortgage Insurance... 7 B. Pension Protection Act of Contributions of Fractional Interests in Tangible Personal Property Charitable Easements... 9 II PRIORITY GUIDANCE PLAN...10 A. Financial Institutions and Products...10 B. General Tax Issues...10 C. Gifts, Estates and Trusts...10 D. Partnerships...11 E. Subchapter S...11 F. Tax Accounting...12 G. Tax Administration...12 III. PROPOSED, TEMPORARY AND FINAL REGULATIONS...12 A. Sections 72 and 1001 (Exchanges of Appreciated Properties for Annuities)...12 B. Sections 83 and 721 (Partnership Equity for Services)...13

3 225 C. Section 168 (Depreciation of MACRS Property Acquired in a Like-Kind Exchange or Involuntary Conversion)...15 D. Sections 168(k) and 1400L(b) (Special Depreciation Allowances)...16 E. Section 263 (Treatment of Payments to Acquire, Produce or Improve Tangible Property)...22 F. Section 752 (Treatment of Disregarded Entities under Section 752)...25 G. Sections 1361 and 7701 (Employment and Excise Taxes for Disregarded Subchapter S Subsidiaries and other Single Owner Disregarded Entities)...27 IV. ANNOUNCEMENTS AND NOTICES...27 A. Notice , I.R.B B. Notice , I.R.B C. Notice , I.R.B D. Notice , I.R.B V. REVENUE PROCEDURES...29 A. Rev. Proc , I.R.B B. Rev. Proc , I.R.B VI. REVENUE RULINGS...29 A. Rev. Rul , I.R.B B. Rev. Rul , I.R.B C. Rev. Rul , I.R.B D. Rev. Rul , I.R.B VII. LETTER RULINGS...33 A. Priv. Ltr. Rul (May 26, 2006)...33 B. Priv. Ltr. Rul (February 8, 2006)...34 C. Priv. Ltr. Rul (March 6, 2006)

4 226 D. Priv. Ltr. Ruls and (March 1, 2006)...34 E. Priv. Ltr. Rul (March 16, 2006)...34 F. Priv. Ltr. Rul (May 24, 2005)...35 G. Priv. Ltr. Rul (April 13, 2006)...35 H. Priv. Ltr. Rul (July 26, 2006)...36 I. Priv. Ltr. Rul (July 31, 2006)...36 J. Priv. Ltr. Ruls , and (September 8, 12 and 13, 2006)...37 K. Priv. Ltr. Rul (September 19, 2006)...37 L. Priv. Ltr. Rul (September 29, 2006)...38 M. Priv. Ltr. Rul (October 6, 2006)...38 N. Priv. Ltr. Rul (October 10, 2006)...38 O. Priv. Ltr. Rul (October 3, 2006)...39 P. Priv. Ltr. Rul (September 29, 2006)...39 Q. Priv. Ltr. Rul (September 29, 2006)...40 R. Priv. Ltr. Rul (October 31, 2006)...40 S. Priv. Ltr. Rul (November 28, 2006)...41 T. Priv. Ltr. Rul (November 20, 2006)...41 U. Priv. Ltr. Rul (December 13, 2006)...41 V. Priv. Ltr. Rul (February 5, 2007)...42 W. Priv. Ltr. Rul (March 6, 2007)...42 X. Priv. Ltr. Rul (February 21, 2007)...42 Y. Priv. Ltr. Rul (March 27, 2007)...43 Z. Priv. Ltr. Rul (April 12, 2007)...43 AA. Priv. Ltr. Rul (April 5, 2007)...43 BB. Priv. Ltr. Rul (March 27, 2007)

5 227 CC. Priv. Ltr. Rul (April 4, 2007)...44 DD. Priv. Ltr. Rul (April 17, 2007)...45 EE. Priv. Ltr. Rul (April 26, 2007)...45 FF. Priv. Ltr. Rul (May 11, 2007)...46 GG. Priv. Ltr. Rul (May 9, 2007)...46 VIII. CHIEF COUNSEL AND FIELD ATTORNEY ADVICE...46 A. Chief Counsel Advice (July 7, 2006)...46 B. Chief Counsel Advice (June 30, 2006)...47 C. Chief Counsel Advice (September 2, 2005)...47 D. Chief Counsel Advice (August 25, 2006)...47 E. Chief Counsel Advices and (October 6, 2006)...48 F. Chief Counsel Advice (April 27, 2007)...49 G. Technical Advice Memorandum (March 31, 2006)...50 H. Technical Advice Memorandum (August 17, 2007)...50 IX. CASES...51 A. Dallas v. Comm'r, T.C. Memo (September 28, 2006)...51 B. District of Columbia v. Bender, D.C. Ct. App., No. 06-TX-255 (August 2006)...53 C. Estate of Erickson v. Comm r, T.C. Memo D. Gleason v. Comm r, T.C. Memo E. Goldsby v. Comm'r, T.C. Memo (December 27, 2006)...55 F. Hahn v. Comm'r, T.C. Memo G. Hubert Enterprises, Inc. v. Comm'r, 2007 U.S. App. LEXIS (6th Cir. 2007)...57 H. Korby v. Comm'r, 98 AFTR 2d (8th Cir. 2006)

6 228 I. Estate of Langer v. Comm r, T.C. Memo J. Lee v. Comm r, T.C. Memo (September 11, 2006)...59 K. Maloof v. Comm r, 98 AFTR 2d (6th Cir. 2006)...60 L. Estate of McCord v. Comm r, 461 F.3d 614 (5th Cir. 2006)...61 M. Peabody Natural Resources Co. v. Comm r, 126 T.C. No. 14 (May 8, 2006)...62 N. Estate of Rosen v. Comm r, T.C. Memo O. Senda v. Comm r, 433 F.3d 1044 (8th Cir. 2006)...64 P. Stone v. United States, 2007 U.S. Dist. LEXIS (N.D. Cal. 2007)...65 Q. Toth v. Comm r, T.C. Memo

7 229 I. LEGISLATIVE DEVELOPMENTS A. Tax Relief and Health Care Act of The Tax Relief and Health Care Act of 2006 ("the Act"), signed into law on December 20, 2006, included extensions for many tax credits and deductions, and retroactively restored certain tax cuts that had expired. 1. Extensions of Income Tax Credits. The Act contains extensions of credits for (i) residential energy efficient property, (ii) electricity produced from certain renewable resources and (iii) new energy efficient homes. a. Residential energy efficient property. The Act extended by one year the income tax credits under Section 25D for the purchase of residential energy efficient property placed in service after December 31, Under the extension, the property must be placed in service no later than December 31, This provision became effective on the date of enactment. b. Electricity produced from certain renewable resources. The Act extended by one year the income tax credit under Section 45 for the production of electricity from renewable resources at qualified facilities. Under the extension, qualified facilities must be placed in service before January 1, This provision is effective for facilities placed in service after December 31, c. New energy efficient homes. The Act extended by one year the income tax credit under Section 45L for qualified new energy-efficient homes constructed by eligible contractors and acquired by a person from such eligible contractor for use as a residence. Under the extension, the new energy efficient home credit does not apply to homes acquired after December 31, This provision became effective on the date of enactment. 2. Extensions of Deductions. The Act contains extensions of the deduction for energy efficient commercial buildings and the bonus depreciation deduction for certain qualified Gulf Opportunity Zone ("GO Zone") property. a. Energy efficient commercial buildings. The Act extended by one year the deduction under Section 179D for the cost of energy efficient commercial building property placed into service during the taxable year. Under the extension, the property cannot be placed in service after December 31, This provision became effective on the date of enactment. b. Bonus depreciation for certain qualified GO Zone property. The Act extended the placed in service deadline for the additional first year depreciation deduction for specified GO Zone extension property. Under the extension, non-residential real property or residential rental property, substantially all of the use of which is in one or more specified portions of the GO Zone, must be placed in service by the taxpayer on or before December 31, The extension also applies to property described in Section 168(k)(2)(A)(i) if (i) substantially all of the use of such Section 168(k)(2)(A)(i) property is in a building that is a non- 6

8 230 residential real property or residential rental property placed in service on or before December 31, 2010, substantially all of the use of which is in one or more specified portions of the GO Zone, (ii) and such Section 168(k)(2)(A)(i) property is placed in service by the taxpayer not later than 90 days after the building is placed in service. (1) Section 168(k)(2)(A)(i) property. Section 168(k)(2)(A)(i) property is MACRS property with a recovery period of 20 years or less, which is (i) certain computer software, (ii) water utility property or (iii) qualified leasehold improvement property. (2) Effective Date. This provision is effective for property placed in service on or after August 28, 2005, in taxable years ending on or after such date. This provision is applied as if it were included in Section 101 of the GO Zone Act of Extension of Fifteen-Year Straight-Line Cost Recovery for Qualified Leasehold Improvements and Qualified Restaurant Property. The Act extended by two years the 15-year property classification of qualified leasehold improvement property and qualified restaurant property. Under the extension, the property must be placed in service before January 1, This provision is effective for property placed in service after December 31, Modification of Excise Tax on Unrelated Business Taxable Income of Charitable Remainder Trusts. The Act imposed an excise tax on 100 percent of the unrelated business taxable income (the UBTI ) of a charitable remainder trust. a. No loss of income tax exemption. This provision replaces the old rule that caused a charitable remainder trust that had UBTI in a tax year to lose its income tax exemption for that tax year. b. Excise tax treated as imposed by Chapter 42. The 100 percent excise tax imposed on charitable remainder trusts with UBTI is treated as if it was imposed by Chapter 42 (Private Foundations; and Certain Other Tax-Exempt Organization) for purposes of this title other than subchapter E (Abatement of First and Second Tier Taxes in Certain Cases) of Chapter 42. paid from the trust corpus. (1) Tax paid from corpus. The excise tax is treated as if it was (2) UBTI is considered income of the trust. The UBTI is considered to be income of the charitable remainder trust for the purpose of determining the character of the distribution made to the beneficiary. c. Effective date. This provision is effective for taxable years beginning after December 31, Premiums for Mortgage Insurance. The Act added Section 163(h)(3)(E), which provides that mortgage insurance premiums paid or accrued for qualified mortgage insurance by a taxpayer during the taxable year in connection with acquisition indebtedness with respect to a qualified residence of the taxpayer is treated as interest which is qualified residence interest, and is thus deductible under Section 163(h)(3)(A)-(D). 7

9 231 a. Phaseout. The amount of the premiums treated as deductible interest is reduced (but not below zero) by 10 percent of such amount for each $1,000 (or fraction thereof) that the taxpayer s adjusted gross income for the taxable year exceeds $100,000. For a married individual filing a separate return, the phaseout is a reduction of the amount of the premiums treated as deductible interest by 10 percent for each $500 (or fraction thereof) that the taxpayer s adjusted gross income for the taxable year exceeds $50,000. b. Qualified mortgage insurance definition. The Act added Section 163(h)(4)(E), which defines qualified mortgage insurance as (i) mortgage insurance provided by the Veterans Administration, the Federal Housing Administration or the Rural Housing Administration, and (ii) private mortgage insurance (as defined in section 2 of the Homeowners Protection Act of 1998, as in effect on the date of the enactment of this provision). c. Prepaid qualified mortgage insurance. The Act added Section 163(h)(4)(F), which provides that any amount paid for qualified mortgage insurance that is properly allocable to future tax years is treated by the taxpayer as paid in the tax year to which it is allocated. The Section also provides that no deduction shall be allowed for the unamortized balance if the mortgage is fully paid before the end of its term. Section 163(h)(4)(F) does not apply to amounts paid for qualified mortgage insurance provided by the Veterans Administration or the Rural Housing Administration. d. Effective date. This provision is effective for amounts paid or accrued after December 31, B. Pension Protection Act of The Pension Protection Act of 2006 ("PPA"), enacted on August 17, 2006, deals primarily with technical pension plan issues. However, it does contain provisions relating to charitable giving incentives, including charitable gifts of fractional interests in tangible personal property and charitable easements. 1. Contributions of Fractional Interests in Tangible Personal Property. In general, a taxpayer is not allowed a deduction for a contribution of a fractional interest in tangible personal property unless the taxpayer holds all of the interest in such property, alone or together with the donee, prior to the contribution. The PPA provides that the Secretary may issue Regulations providing an exception to this general rule where all current owners of such property make proportional contributions. a. Subsequent gifts. The value of subsequent fractional contributions is based on the lesser of (i) the fair market value of the tangible personal property at the time the taxpayer made the initial contribution, or (ii) the fair market value of the tangible personal property at the time the taxpayer makes the subsequent contribution. (1) Initial fractional contribution. The PPA defines "initial fractional contribution" as a taxpayer s first charitable contribution, subsequent to August 17, 2006, of an undivided portion of the taxpayer s entire interest in any tangible personal property. (2) Additional contribution. The PPA defines "additional contribution" as any charitable contribution by the taxpayer of any interest in property with respect to which the taxpayer has previously made an initial fractional contribution. 8

10 232 b. Recapture. The taxpayer must recapture the deductions if the taxpayer does not transfer his or her remaining interest in the tangible personal property to the same donee (or, if such donee is no longer in existence, to any donee described in Section 170(c)) before the earlier to occur of (i) the date that is ten years after the date of the initial fractional contribution or (ii) the date of the death of the taxpayer. Recapture will also occur if the donee fails to take "substantial physical possession" of the contributed item, and use the contributed item in connection with its exempt function, within the requisite period starting on the date of the initial fractional contribution. (1) Recapture amount. The taxpayer must recapture the amount of any deductions taken, plus interest. (2) Addition to tax. In any taxable year for which there is a recapture, the amount owed by the taxpayer in the year of recapture is increased by ten percent of the amount recaptured. c. Effective date. The provisions added by the PPA regarding contributions, bequests and gifts of fractional interests of tangible personal property are effective after August 17, Charitable Easements. In general, a taxpayer may take a charitable deduction for a contribution, for conservation purposes, of a qualified real property interest to a qualified organization. Qualified real property interests include conservation and facade easements. The PPA provides additional tax benefits for certain easements granted before In addition, the PPA restricts the availability of the deduction for charitable easements in certain circumstances. a. Allowed deductions. A taxpayer who makes a qualified conservation contribution, prior to January 1, 2008, is allowed to deduct up to 50 percent of the taxpayer s contribution base. Excess deductions may be carried forward for the following 15 years. If the taxpayer is a qualified farmer or rancher, the taxpayer may generally deduct up to 100 percent of his or her contribution base, for qualified conservation contributions made prior to January 1, Excess deductions may be carried forward for the following 15 years. b. Additional requirements for buildings in registered historic districts. A contribution of a facade easement will not lead to a charitable deduction unless the easement includes a restriction preserving the entire exterior of the building. In addition, the contributing taxpayer and the donee must enter into a written certification agreement. Finally, for any such contributions made in any taxable year subsequent to the date of enactment of the PPA, there are additional reporting requirements to be included with the taxpayer s tax return for the taxable year of the contribution. These additional requirements are a qualified appraisal, photographs of the building s exterior, and a description of any restrictions on the development of the building. The definitions for "qualified appraisal" and "qualified appraiser" are provided in new Section 170(f)(11)(E)(i), as added by the PPA and interpreted in Notice (see below). 9

11 233 c. Effective dates. The allowed deductions apply to qualified conservation contributions made in taxable years beginning on January 1, The additional requirements for buildings in registered historic districts apply to qualified conservation contributions made after July 25, I PRIORITY GUIDANCE PLAN A. Financial Institutions and Products 1. Guidance for RICs and REITs concerning the application of Section 1(h) to capital gain dividends. 2. Guidance addressing the correction of minor errors by RICs and REITs. 3. Final Regulations under Section 1221 regarding capital asset exclusion for accounts and notes receivable. Proposed Regulations were published on August 7, B. General Tax Issues 1. Revenue Ruling addressing the consequences of certain transactions on the treatment of arrangements as leases for Federal income tax purposes. 2. Regulations under Section 170 regarding substantiation and reporting requirements for cash and noncash charitable contributions to reflect amendments made by the American Jobs Creation Act of 2004 and the Pension Protection Act of Interim guidance was issued as Notice Final Regulations under Section 199, as amended by the Tax Increase Prevention and Reconciliation Act of 2005, on the deduction for income attributable to domestic production activities. activities. 4. Guidance under Section 469 involving grouping and regrouping of C. Gifts, Estates and Trusts 1. Guidance regarding the consequences under various estate, gift and generation-skipping transfer tax provisions of using a family-owned trust company as the trustee of a trust. 2. Guidance under Section 2036 regarding the tax consequences of a retained power to substitute assets in a trust. 10

12 234 D. Partnerships 1. Proposed Regulations under Section 108(e)(8), as amended by the American Jobs Creation Act of 2004, regarding debt satisfied by a partnership interest. 2. Guidance under Sections 465, 704(b) and 752 concerning the interaction of the at-risk provisions, deficit restoration obligations and the partnership liability rules. 3. Regulations under Sections 704 and 737 regarding partnership mergers. Interim guidance was issued as Notice Proposed Regulations under Sections 704, 743, and 755, as amended by the American Jobs Creation Act of 2004, regarding the disallowance of certain partnership loss transfers and no reduction of basis in stock held by a partnership in a corporate partner. Interim guidance was issued as Notice Guidance under Section 704 involving remedials and related parties. 6. Final Regulations under Section 704(b)(2) regarding whether partnership allocations have substantial economic effect. Proposed Regulations were published on November 18, Proposed Regulations under Section 706(d) regarding the determination of distributive share when a partner s interest changes. 8. Final Regulations under Section 707 regarding disguised sales. Proposed Regulations were published on November 26, Final Regulations under Sections 721 and 83 regarding partnership equity issued in connection with the performance of services. Proposed Regulations were published on May 24, Final Regulations under Section 721 for the tax treatment of noncompensatory options and convertible instruments issued by a partnership. Proposed Regulations were published on January 22, Proposed Regulations under Section 751 regarding unrealized receivables and inventory items of a partnership. 12. Final Regulations regarding the application of Section 1045 to certain partnership transactions. Proposed Regulations were published on July 15, E. Subchapter S 1. Revenue ruling on S corporation losses/reduction in tax attributes under Section 108(b) for discharge of indebtedness income that is excluded from gross income. 11

13 Guidance under Sections 1366 and 1367(a)(2) regarding the amount of deduction, and adjustments to basis of S corporation stock, for charitable contributions of property by S corporations made after the Pension Protection Act of 2006 amendments. 3. Final Regulations under Section 1367 regarding adjustments in basis of indebtedness. Proposed Regulations were published on April 12, loans. 4. Guidance under Section 1367 regarding S corporations and back-to-back F. Tax Accounting. 1. Regulations under Sections 162 and 263 regarding the deduction and capitalization of expenditures for tangible assets. 2. Regulations under Sections 195, 248 and 709, as amended by the American Jobs Creation Act of 2004, regarding the elections to amortize start-up and organizational expenditures. 3. Proposed Regulations under Section 263(a) regarding the treatment of capitalized transaction costs. annuity. 4. Guidance under Section 453 addressing the exchange of property for an 5. Guidance regarding the application of Section 453A to contingent payment installment sales. contracts. 6. Regulations under Section 460 providing rules for home construction G. Tax Administration. 1. Guidance concerning patented transactions. III. PROPOSED, TEMPORARY AND FINAL REGULATIONS A. Sections 72 and 1001 (Exchanges of Appreciated Properties for Annuities). 1. Overview: On October 17, 2006, the Treasury issued Proposed Regulations that would stop the avoidance or deferral of gain on exchanges of highly appreciated property for annuity contracts, both private and commercial. The preamble to the Proposed Regulations explain that a private annuity contract can be valued at the time of the exchange. Therefore, application of the new rules will clearly reflect the income of the transferor, and taxpayers should no longer use (i) the open transaction approach of Lloyd v. Comm r, 33 BTA 903 (193), or (ii) the ratable recognition approach of Rev. Rul , C.B

14 New Rules: The Proposed Regulations provide that, if a taxpayer receives an annuity contract in exchange for property, other than money, then (i) the amount realized is the fair market value of the annuity contract at the time of the exchange, (ii) any gain or loss is recognized at the time of the exchange, and (iii) in determining the initial investment in the annuity contract, the aggregate amounts of premiums or other consideration paid for the annuity contract equals the fair market value of the contract at the time of the exchange. a. The Proposed Regulations provide that the fair market value of the annuity contract is determined under Section b. The Proposed Regulations apply equally to (i) secured and unsecured annuity contracts and (ii) annuity contracts issued by an insurance company and those issued by a person that is not an insurance company. c. The Treasury intended that a transferor of highly appreciated property will be taxed in the same manner as if he or she sold the property and used the sale proceeds to purchase an annuity. The new rules apply regardless of whether the exchange produces a gain or loss. 3. Effective Date: The Proposed Regulations would apply for most transactions that are not completed by the effective date of October 18, For certain transactions that pose a low likelihood of abuse, the effective date is proposed to be April 18, B. Sections 83 and 721 (Partnership Equity for Services). 1. Overview: On May 24, 2005, the Treasury issued Proposed Regulations addressing the treatment of a transfer of partnership equity in connection with the performance of services. Concurrently with the issuance of the Proposed Regulations, the IRS issued Notice , I.R.B. 1221, announcing a proposed revenue procedure that provides a safe harbor election for determining the value of the transferred partnership interest. 2. New Rules: The Proposed Regulations introduce the following new rules: a. The Proposed Regulations apply Section 83 to all partnership interests, without distinguishing between partnership capital interests and partnership profits interests. Hence, a partnership capital or profits interest is Section 83 property, and the transfer of a partnership interest in connection with the performance of services is subject to Section 83. b. The partnership recognizes no gain or loss on the transfer of a partnership interest in exchange for the performance of services. c. In the case of a transfer of a substantially non-vested partnership interest, if a Section 83(b) election is made, the transferee is treated as a partner for Federal income tax purposes. If no Section 83(b) election is made, then the holder of the partnership interest will not be treated as a partner until the partnership interest becomes substantially vested. These rules differ from Rev. Proc , C.B. 191, which provides that the holder of a 13

15 237 partnership profits interest may be treated as a partner under certain circumstances, even if no Section 83(b) election is made. d. The rules of Section 83(h) govern the timing and amount of any compensation deduction to the partnership. e. The amount includible in income by the transferee and the amount deductible by the partnership generally is equal to the fair market value of the transferred partnership interest. f. Upon receipt of the partnership interest, the service provider s capital account is increased by the amount taken into income plus any amounts paid for the transferred partnership interest. g. In determining the value of the transferred partnership interest, the partnership and its partners can elect to treat the fair market value of the partnership interest as equal to its liquidation value pursuant to a safe harbor procedure provided in Notice Valuation Safe Harbor: Notice provides the safe harbor procedure because of the difficulties in valuing partnership interests and so that partnership capital accounts can be properly maintained. Notice is in the form of a draft revenue procedure that describes the rules and conditions relating to the safe harbor election. 4. Required Conditions for Safe Harbor Election. a. Prepare and file election statement. The partnership must prepare a statement, executed by a partner who has responsibility for Federal income tax reporting by the partnership, stating that the partnership is electing, on behalf of the partnership and each of its partners, to have the safe harbor apply irrevocably with respect to all partnership interests transferred in connection with the performance of services while the safe harbor election remains in effect. Prop. Reg (l)(1)(i). This statement must specify the effective date of the election, which may not be prior to the date this document is executed. The partnership must attach this statement to its tax return for the taxable year that includes the effective date of the safe harbor election. b. Partner approval. The partners may approve of the partnership s election to use the safe harbor in one of two ways: (1) include a provision in the partnership agreement providing that (i) the partnership is authorized and directed to elect the safe harbor and (ii) the partnership and each of its partners (including any person to whom a partnership interest is transferred in connection with the performance of services) agrees to comply with all requirements of the safe harbor with respect to all partnership interests transferred in connection with the performance of services while the election remains effective; or (2) if the partnership agreement does not contain the provisions described above, each partner in a partnership that transfers a partnership interest in connection with the performance of services must execute a document containing provisions that are legally 14

16 238 binding on that partner stating that (i) the partnership is authorized and directed to elect the safe harbor, and (ii) the partner agrees to comply with all requirements of the safe harbor with respect to all partnership interest transferred in connection with the performance of services while the election remains effective. Prop. Regs (l)(1)(ii)-(iii). 5. Effective Date: The Proposed Regulations would apply to transfers of property on or after the date Final Regulations are published in the Federal Register. C. Section 168 (Depreciation of MACRS Property Acquired in a Like-Kind Exchange or Involuntary Conversion). 1. Overview: On February 26, 2007, the Service issued Final Regulations for computing depreciation on MACRS property acquired in a like-kind exchange under Section 1031 or as a result of an involuntary conversion under Section 1033 where both the acquired and relinquished property are subject to MACRS in the hands of the acquiring taxpayer. The Final Regulations remove the Temporary Regulations that were issued on February 27, The Service had noted in the Temporary Regulations that it had become aware of inconsistent depreciation treatment by taxpayers of such property. Some taxpayers had been depreciating property using the same depreciation method, recovery period and convention as the exchanged or involuntarily converted property (i.e., relinquished property), while other taxpayers had been depreciating the replacement property as if it were newly placed in service. 2. General Rule: For exchanges or conversions occurring after February 27, 2004, the exchanged basis is depreciated over the remaining recovery period of, and using the depreciation method and convention of, the relinquished MACRS property. Reg (i)- 6(c)(3). Exchanged basis is determined after the depreciation deductions for the year of disposition are determined and is the lesser of (i) the basis in the replacement MACRS property, as determined under Section 1031(d) and the Regulations under Section 1031(d) or Section 1033(b) and the Regulations under Section 1033(b); or (ii) the adjusted depreciable basis (as defined in Reg (b)-1(a)(4)) of the relinquished MACRS property. Reg (i)- 6(b)(7). The general rule applies if the replacement property has the same or shorter recovery period or the same or more accelerated depreciation method than the relinquished property. Reg (i)-6(c)(4). 3. Special Rules a. Deferred Exchanges: Taxpayers may not recognize depreciation on the relinquished MACRS property during the period between the disposition of the relinquished property and the acquisition of the replacement MACRS property. Reg (i)- 6(c)(5)(iv). b. Acquisition Prior to Disposition: Taxpayers may depreciate the unadjusted depreciable basis of the replacement MACRS property until the time of disposition of the relinquished MACRS property. Reg (i)-6(d)(4). Such taxpayers, however, must include in taxable income in the year of disposition of the relinquished MACRS property the excess of the depreciation allowable on the unadjusted depreciable basis of the replacement MACRS property over the depreciation that would be allowable on the excess basis of the 15

17 239 replacement MACRS property from the date the replacement MACRS property was placed in service by the taxpayer to the time of disposition of the relinquished MACRS property. Reg (i)-6(d)(4). c. Transactions Involving Nondepreciable Property: If MACRS property and land are acquired in a like-kind exchange or involuntary conversion for land or other nondepreciable property, the basis of the replacement MACRS property that is attributable to the relinquished nondepreciable property is considered property placed in service by the acquiring taxpayer in the year of replacement. Reg (i)-6(d)(2)(ii). 4. Opt Out Election: Realizing that under certain circumstances the general rule could adversely affect taxpayers, the Final Regulations provide an election not to apply the Final Regulations and to treat the replacement MACRS property as MACRS property placed in service by the acquiring taxpayer at the time of replacement. Reg (i)-6(i)(1). For example, a taxpayer should make the election to opt out when the replacement property has a shorter recovery period than the relinquished property. 5. Election to Treat Certain Replacement Property as MACRS Property: Under the Final Regulations, if the taxpayer acquires replacement property to replace tangible depreciable property for which the taxpayer made a valid election under Section 168(f)(1) to exclude it from the application of MACRS, the taxpayer may elect to treat, for depreciation purposes only, the sum of the exchanged basis and excess basis of the replacement property as MACRS property that is placed in service by the taxpayer at the time of replacement. Reg (i)-6(i)(2). 6. Effective Dates: In general, the Final Regulations apply to a like-kind exchange or an involuntary conversion of MACRS property for which the time of disposition and the time of replacement both occur after February 27, The election to treat certain replacement property as MACRS property, Reg (i)-6(i)(2), applies to such relinquished property and replacement property for which both the time of disposition and the time of replacement (both as determined under Reg (i)-6(i)(2)) occur after February 26, D. Sections 168(k) and 1400L(b) (Special Depreciation Allowances). 1. Overview: On August 31, 2006, the Service issued Final Regulations that provide detailed rules regarding the type of property that qualifies for the additional first-year bonus depreciation deductions under Sections 168(k) and 1400L(b) and the computation thereof. These Final Regulations amend and clarify Proposed Regulations issued in September Qualified Property: To qualify for the additional first-year bonus depreciation deduction, the Final Regulations provide the following four requirements: (a) the depreciable property must be of a specified type; (b) for 30% additional first-year depreciation property, the original use must commence with the taxpayer after September 10, 2001, and for 50% bonus depreciation property, the original use must commence after May 5, 2003; (c) the taxpayer must acquire the depreciable property within a specified time period; and (d) the depreciable property must be placed in service by a specified date. 16

18 240 a. Property of a Specified Type (Reg (k)-1(b)(2)): Pursuant to the Final Regulations, the depreciable property must be one of the following: less; (1) MACRS property that has a recovery period of 20 years or (2) computer software; (3) water utility property; or 1.168(k)-1(c)). (4) qualified leasehold improvement property (defined in Reg. b. Original Use (Reg (k)-1(b)(3)): The Final Regulations provide that, generally, original use means the first use to which the property is put, whether or not that use corresponds to the use of the property by the taxpayer. (1) Reconditioned or Rebuilt Property: Additional capital expenditures incurred to recondition or rebuild property previously acquired or already owned by the taxpayer satisfy the original use requirement. Capital expenditures to acquire reconditioned or rebuilt property, however, do not satisfy the original use requirement. The Final Regulations provide a safe harbor for determining whether property that contains used parts will be considered reconditioned or rebuilt. If the cost of the used parts is more than 20% of the total cost of the property, whether acquired or self-constructed, the property will be treated as reconditioned or rebuilt for purposes of the original use test. (2) Conversion to Business or Income-Producing Use: Under the Final Regulations, new property initially used by a taxpayer for personal use, or initially held by a taxpayer as inventory, and then subsequently used in that taxpayer s trade or business satisfies the original use requirement. New property that is held by the original owner as inventory, and later acquired by a taxpayer for use in its trade or business, satisfies the original use requirement. However, new property that is personal use property to the original owner, but that another taxpayer later acquires for use in its trade or business, does not satisfy the original use requirement, because the second owner is not considered the original user of the property. (3) Sale-Leaseback Transaction: The Final Regulations provide that, if a person places new property in service during the appropriate time periods specified in Section 168(k) and later sells the property to another party, which then leases the property back to the seller within three months after the date the seller-lessee put the property in service, the buyer-lessor is considered the original user of the property. (4) Syndication Transaction: If new property is originally placed in service by a lessor after September 10, 2001 (30% bonus depreciation) or May 5, 2003 (50% bonus depreciation), and is sold by the lessor or any subsequent purchaser within three months after the lessor originally placed the property in service, and the user of the property after the last sale during the three-month period remains the same as when the property was originally placed in service by the lessor, the purchaser of the property in the last sale during the threemonth period is considered the original user of the property. 17

19 241 (5) Fractional Interests in Property: The Final Regulations provide that, if, in the ordinary course of business, a taxpayer sells fractional interests in property to unrelated third parties, each first fractional owner of the property is considered the original user of its proportionate share of the property. The purchaser of a fractional interest shall be considered the original user even if the seller used the property before the sale, provided the seller held the property primarily for sale after its use began. c. Acquisition of Property (Reg (k)-1(b)(4)): (1) Qualified Property (a) 30% bonus depreciation: The Final Regulations provide that, for purposes of the 30% additional first-year depreciation deduction, depreciable property will qualify if the property is: (i) acquired by the taxpayer after September 10, 2001, and before January 1, 2005, but only if no written binding contract for the acquisition of the property was in effect before September 11, 2001; or (ii) acquired by the taxpayer pursuant to a written binding contract that was entered into after September 10, 2001 and before January 1, (b) 50% bonus first-year depreciation: Depreciable property must be acquire after May 5, 2003 and before January 1, 2005, but only if no written binding contract for the acquisition of the property was in effect before May 6, 2003; or acquired by the taxpayer pursuant to a written binding contract that was entered into after May 5, 2003 and before January 1, (2) Binding Contract (a) The Final Regulations define a binding contract as any contract that is enforceable under state law against the taxpayer or a predecessor and that does not limit damages to a specified amount. The fact that there may be little or no damages because the contract price does not significantly differ from fair market value will not be taken into account in determining whether a contract limits damages. (b) The Final Regulations provide that a contract is binding even if it is subject a condition so long as the condition is not within the control of either party or a predecessor. (3) Non-binding Contracts: The Final Regulations provide the following examples of contracts that are not binding contracts for purposes of Section 168(k): (a) an option to acquire or sell property; (b) a supply or similar agreement, if the amount and design specifications of the property to be purchased have not been specified; and 18

20 242 (c) a binding contract to acquire one or more components of a larger property will not be treated as a binding contract to acquire the larger property. (4) Self-Constructed Property: (a) General Rule: The Final Regulations provide the property acquisition requirement is met if a taxpayer manufactures, constructs or produces qualified property for its own use and such activity began after either September 10, 2001 (for 30% bonus depreciation property) or May 5, 2003 (for 50% bonus depreciation property) and before January 1, (b) Beginning of Construction: Under the Final Regulations, construction, production or manufacture begins when physical work of a significant nature begins, which is measured as the time when the taxpayer incurs or pays more than 10% of the total cost of the property. Physical work does not include preliminary activities, such as planning or designing, securing financing, exploring or researching. (c) Components of Self-Constructed Property: A binding contract to acquire one or more components of a larger self-constructed property does not preclude the larger self-constructed property from satisfying the property acquisition requirement. Thus, the unadjusted depreciable basis of the larger self-constructed property that is eligible for the 30% or 50% bonus first-year depreciation does not include the unadjusted depreciable basis of the nonqualifying, smaller components. The Final Regulations also provide for a bifurcation of components for purposes of qualifying for the bonus depreciation. For example, if a taxpayer enters a binding contract to acquire a smaller component after September 11, 2001 (30% bonus depreciation) or May 6, 2003 (50% bonus depreciation), and before January 1, 2005, but the manufacture, construction or production of the larger self-constructed property does not begin before January 1, 2005, the smaller component qualifies for the additional first-year depreciation deduction, but the larger self-constructed property does not. (5) Disqualified Transactions: (a) Binding Contracts: The Final Regulations provide that the property acquisition requirement is not met if the user of the property as of the date on which the property was originally placed in service, or a related party to the user, acquired, or had a written binding contract in effect for the acquisition of, the property at any time before September 11, 2001 (30% bonus depreciation) or before May 6, 2003 (50% bonus depreciation). (b) Self-Constructed Property: Such property does not satisfy the property acquisition requirement if the self-construction began at any time before September 11, 2001 (30% bonus depreciation) or May 6, 2003 (50% bonus depreciation). d. Placed-in-Service Date (Reg (k)-1(b)(5)) (1) General Rule: The Final Regulations provide that qualified property is property placed in service before January 1, The placed-in-service date for certain property with longer production periods is January 1,

21 243 (2) Special Rules (a) Sale-Leaseback Transactions: If qualified property is originally placed in service after the appropriate date (i.e., September 10, 2001 or May 5, 2003) by a person who sells the property to the taxpayer, who then leases the property back to the seller within three months after the date the seller-lessee put the property in service, the property is treated as originally placed in service by the buyer-lessor no earlier than the date on which the seller-lessee uses the property under the leaseback. (b) Syndication Transactions: If a lessor places qualified property in service after the appropriate date (i.e., September 10, 2001 or May 5, 2003), and the lessor or subsequent purchaser later sells the property within three months after the date the lessor originally placed the property in service, and the user of the property after the last sale during the three-month period remains the same as when the property was originally placed in service by the lessor, the property is treated as originally placed in service by the purchaser of the property in the last sale during the three-month period but not earlier than the date of the last sale. (c) Technical Termination of a Partnership: Qualified property placed in service by the terminated partnership during the taxable year of termination is treated as originally placed in service by the new partnership on the date the qualified property is contributed by the terminated partnership to the new partnership. (d) Step-in-the-Shoes Transactions: Qualified property transferred in a step-in-the-shoes transaction described in Section 168(i)(7) in the taxable year the qualified property is placed in service by the transferor is treated as originally placed in service on the date the transferor placed the qualified property in service. 3. Computation of Depreciation Deduction for Qualified Property (Reg (k)-1(d)) a. Additional First-Year Depreciation Deduction (1) The Final Regulations provide that the allowable additional first-year depreciation deduction for qualified property (other than 50% bonus depreciation property) or Liberty Zone property is equal to 30% of the property s unadjusted depreciable basis. The allowable additional first-year depreciation deduction for 50% bonus depreciation property is equal to 50% of the unadjusted depreciable basis. (2) Unadjusted Depreciable Basis: The Final Regulations define unadjusted depreciable basis as cost basis reduced by the percentage of the taxpayer s non-business use of the property, less any portion of the basis the taxpayer properly elects to expense under Section 179, and less any adjustments to basis provided in other provisions of the Code (e.g., reduction in basis by the amount of the disabled access credit under Section 44(d)(7)). Reg (k)-1(a)(2). (3) The Final Regulations provide that the additional first-year depreciation deduction is allowed for both regular tax and alternative minimum tax purposes. 20

22 244 b. Otherwise Allowable Depreciation (1) After calculating the additional first-year depreciation deduction, the taxpayer must reduce the unadjusted depreciable basis of the property by the greater of the allowed or allowable additional first-year depreciation. (2) The remaining unadjusted depreciable basis forms the basis for determining the amount of depreciation otherwise allowable in the current and following tax years under the applicable method of depreciation. 4. Special Rules (Reg (k)-1(f)) a. Property Placed in Service and Disposed of in the Same Taxable Year: The Final Regulations provided that the additional first-year depreciation deduction is not allowed for qualified property placed in service and disposed of during the same taxable year. b. Technical Termination of a Partnership: As noted above, qualified property placed in service by a partnership in which a technical termination occurs in the same taxable year qualifies for the additional first-year depreciation deduction. In this case, the new partnership, not the terminated partnership, claims the additional first-year depreciation deduction. c. Section 1245 and 1250 Depreciation Recapture: The Final Regulations provide that, for purposes of Section 1245, the additional first-year depreciation deduction is an amount allowed or allowable for depreciation and thus subject to recapture. Further, for purposes of Section 1250, the additional first-year depreciation deduction is not a straight-line method. Accordingly, the additional first-year depreciation deduction is an accelerated depreciation method for purposes of determining recapture under Section New York Liberty Zone Property (Reg L(b)-1) a. Scope: The Final Regulations provide that New York Liberty Zone Property includes the same property that is described as qualified property under Section 168(k) and nonresidential real property or residential rental property to the extent such property is a part of the rehabilitation of real property damaged or replaces real property destroyed or condemned, as a result of the terrorist attacks on September 11, Thus, for example, if certain structural components of a building were damaged or destroyed, but the entire building itself was not destroyed or condemned, only the costs related to replacing the damaged or destroyed structural components qualify as New York Liberty Zone Property. b. Property Not Eligible for Additional Depreciation under Section 1400L(b): The Final Regulations provide that property that qualifies for an additional first-year depreciation deduction under Section 168(k) is not also eligible for the additional firstyear depreciation deduction under Section 1400L(b). c. Substantially All Test: For purposes of Section 1400L(b)(2)(A)(ii), which requires substantially all use of the property to be in the New York Liberty Zone, the Final Regulations define substantially all to mean 80% or more. 21