Tax-Free Exchange Advisor

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1 miller nash llp Winter 2012 brought to you by the tax law practice team Tax-Free Exchange Advisor Related-Party Exchanges Can Sometimes Be Tax-Free Congress passed the related-party exchange rules to prevent a taxpayer from exchanging out of low-basis property and acquiring high-basis property from a related party. There are a number of significant exceptions to the general rule. One of the most important exceptions is available if either the disposition of the relinquished property or the acquisition of the replacement property did not have as one of its principal purposes the avoidance of federal income taxes (the No Tax Avoidance Exception ). IRC 1031(f) (2) (C). This exception has expanded over the years and provided quite a number of different ways to avoid the related-party rules. These exceptions are discussed more fully below. But a note of caution: This exception has an additional requirement that the application of the exception must be established to the satisfaction of the IRS. What follows is a laundry list of the exceptions to related-party rules: Two-Year Wait. The taxpayer may convey the relinquished property to a related party and receive in exchange replacement property from the related party if both parties wait two years before disposing of either property. The disposition of either the relinquished property or the replacement property following the death of the taxpayer or the related party is an exception to the two-year rule. IRC 1031(f)(2)(A). A disposition of either property as a result of a condemnation or threat of condemnation of the property is also an exception to the two-year rule. IRC 1031(f)(2)(B). Sell Relinquished Property to Related Party. The taxpayer may sell the relinquished property to a related party and buy the replacement property from an unrelated party, even if the related party plans to sell the relinquished property within two years. See Priv Ltr Rul (Nov. 28, 2006); Priv Ltr Rul (Nov. 20, 2006); Priv Ltr Rul (Apr. 12, 2007). The IRS has taken the position that that there was no basis swap and neither party cashed out of its investment in real estate. Undivided Interests Exchanged. If the taxpayer and its related parties own undivided interests in multiple properties, the parties may complete exchanges, even if the parties will not all hold their interests in the properties for an additional two years, provided that at the end of the exchange each party owns an entire property or owns a larger undivided interest in a property than it owned before the exchange. See Priv Ltr Rul (Apr. 26, 2007); Priv Ltr Rul (Oct. 31, 2006). See also Priv Ltr Rul (June 29, 2005); Priv Ltr Rul (Apr. 2, 1999). No Net Tax Savings From Exchange. If the net tax paid as a result of the exchange is greater than the tax that the taxpayer would have paid, the exchange is permissible because there will have been no tax-avoidance purpose. For example, if the taxpayer were to complete an exchange by which he acquired the replacement property from his sister (deferring $300,000 of taxable income), the exchange would be tax-free as long as inside this issue (continued on page 5) 2 Exchange Tossed Replacement Property Was Really Taxpayer s Residence 3 How Long Must I Hold It? 4 Taxpayer Caught Completing Indirect Related-Party Exchange 5 Goodwill Can Be Exchanged if Treated as Real Estate

2 Exchange Tossed Replacement Property Was Really Taxpayer s Residence The Tax Court had no trouble tossing out an attempted tax-free exchange because the replacement property was determined to be the taxpayer s residence. The taxpayer in Goolsby, TC Memo , sold investment property and exchanged it into a replacement-property home located in Fayetteville, Georgia, which the Court referred to as the Pebble Beach property. For an exchange to be effective, both the relinquished and the replacement property must be held for investment or for productive use in a trade or business. the homeowner covenants governing the property. The taxpayer even started remodeling the property s basement within a few weeks after purchasing the property. A really scary fact was that the accommodator s staff was called to the witness stand. Testimony revealed that the taxpayer had asked the accommodator if the taxpayer could move into the Pebble Beach property if no one could be found to rent it. The Court found that this showed intent to move into the property. What lessons does the Goolsby case teach us? First, a court will see through window-dressing attempts to pretend that the property was not intended for personal use. Second, be careful what you say to anyone about your intent (with the exception of your lawyer) because it could end up in court. Finally, and perhaps most importantly, this case once again proves that one can be too aggressive. The taxpayer should have either given up trying to complete an exchange or made an earnest and meaningful attempt to lease the property. In determining whether the replacement property s use qualifies for tax-free treatment, the courts have always looked at the intent of the taxpayer on the day the replacement property is acquired. The Tax Court determined that the Pebble Beach property was not qualified replacement property on the day it was acquired. Why did the Court make this determination? The evidence showed that the taxpayer actually moved into the house just two months after it was acquired. The taxpayer made the purchase of the Pebble Beach property contingent on the sale of the taxpayer s existing personal residence. There were some attempts to rent the property, but the Court found them to be rather pathetic. An ad was placed in a newspaper for a few months, but the taxpayer failed to research rental transactions in the Pebble Beach area and did not even know whether a rental violated Estate Planning Seminar Engaged Guidance, Exceptional Counsel. For those in the Portland area, Miller Nash invites you to a complimentary one-hour program on estate planning. The program will answer the following questions: What is a probate? Who gets my assets if I don t have a Will? How are trusts set up and what are their uses? Will my estate be subject to estate taxes? What are some approaches we can use if we have children from prior marriages? Can a Will avoid probate? How do I plan for jointly owned property, 401(k) accounts, and life insurance benefits? What must I consider when passing property to children and grandchildren? What are the basic strategies used to minimize estate taxes? What should business owners consider when planning their estates? In addition to these topics, we invite other estate planning questions that you may have. The program is appropriate for business owners, retirees, and executives. Spouses and adult children are welcome to join. You can register by sending an to marika.giers@millernash.com or by calling When: January 31 (9:00-10:00 a.m.) Where: Miller Nash LLP (111 S.W. Fifth Avenue, Suite 3400, Portland, Oregon 97204) Continental breakfast provided. Parking will be validated. If the date above does not work for you, we will be hosting similar programs on March 6 and March 20. Find more information online at 2 miller nash llp Tax-Free Exchange Advisor

3 How Long Must I Hold It? How a Taxpayer s Intentions for Its Property Affect the Taxpayer s Ability to Complete a 1031 Exchange by Jeneé Hilliard jenee.hilliard@millernash.com Talking about holding it always makes me think of family road trips when I was a kid. In the case of 1031 exchanges, messing up the holding it part can be equally disastrous. Internal Revenue Code Section 1031(a)(1) provides that a taxpayer may complete a 1031 exchange only if both the relinquished property and the replacement property are held for productive use in a trade or business or for investment. Additionally, Code Section 1031(a)(2)(A) provides that property held primarily for sale is not eligible to serve as relinquished property or replacement property, and of course, property held for personal use is not eligible either. It can be difficult to determine when the holding requirement has been met because the Code, regulations, and case law do not provide clear standards about what it means to hold it. There are no bright line rules with respect to the holding requirement; instead, whether property was held for the required purpose (investment or in a trade or business, and not for resale) is a fact-specific inquiry that focuses on the taxpayer s intended use of the property. Because only the taxpayer knows what he or she intended, although taxpayer testimony about intent is relevant, courts typically find the taxpayer s outward actions more compelling than self-serving testimony about his or her actual intent. The taxpayer s outward actions that are commonly persuasive are the length of time that the taxpayer owned the property and the taxpayer s actual use of both the relinquished property and the replacement property. Length of ownership is relevant because immediately reselling property after it is acquired often shows intent to hold the property primarily for sale and not intent to hold the property for investment, especially if the property is not income-producing property. Owning property for at least two years should be long enough to show that the property was not held primarily for resale. Owning property for even one year is probably long enough, but the longer the relinquished property Owning property for at least two years should be long enough to show that the property was not held primarily for resale. is owned before the exchange and the longer the replacement property is owned after the exchange, the better. A taxpayer who owns property for less than one year and wants to use the property as relinquished property in a 1031 exchange may still be able to do so, but should evaluate the situation more carefully than someone who has owned a rental property for 25 years before using it as the relinquished property in a 1031 exchange. In an IRS evaluation of whether a taxpayer s actual use of the property meets the holding requirement, the taxpayer s actions to achieve his or her stated purpose can support a finding of the required intent, even if those actions were unsuccessful. For example, a taxpayer who owns a vacant office building for six months and the entire time aggressively markets space for rent and interviews and hires brokers to find tenants for the building can be found to have an investment intent for the property even if the efforts to procure tenants are unsuccessful. On the flip side, a taxpayer who buys a 50 percent occupied office building, completes substantial renovations, fills the vacancies, and sells the office building nine months later might have a more difficult time proving that the property was acquired for investment purposes and not primarily for sale. Even legitimate transfers of property or changes in use of property immediately before or after an exchange can increase the risk that an exchange will be treated as invalid. For example, a taxpayer s receipt of rental property as a gift or in connection with the liquidation of a partnership could cause the IRS to challenge the exchange. Similarly, by gifting replacement property or contributing replacement property to a partnership immediately after an exchange, a taxpayer might fail to meet the holding requirement. When it comes to the holding requirement, our advice is to keep things as simple as possible and recommend that the ownership of the relinquished property not change for at least two years before the exchange, that the ownership of the replacement property remain unchanged for at least two years after the exchange, and that during these periods the property be used in a trade or business or be income-producing property. Of course, many exchanges that don t fall neatly within these parameters can still be valid. But in those cases, we recommend that the facts be carefully evaluated before commencing an exchange so that the likelihood of a successful exchange can be enhanced. 3

4 Taxpayer Caught Completing Indirect Related- Party Exchange Taxpayers (and sometimes their advisors) often believe that for any rule there is some way to get around it. This is sometimes true, but Congress and its staff read all the tax journals and often quickly close up any known loopholes. So it is with related-party exchanges. In order to prevent a taxpayer from exchanging low-basis property via a sale to an unrelated party in exchange for a purchase of high-basis property from a related party, Congress in IRC 1031(f) prohibited such exchanges. Congress also prohibited in Section 1031(f)(4) exchanges structured to manipulate the basic related-party rules. The law says that Section 1031 is not available to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. In Ocmulgee Fields, Inc. v. Comm r, 106 AFTR2d (11th Cir 2010), the taxpayer tried to get around the related-party rules by interposing an accommodator in the transaction. Thus, instead of completing an exchange with a related party, technically the exchange was completed using an exchange accommodator or qualified intermediary. In effect, the taxpayers were attempting to complete a tax-free exchange they could not do directly, by completing the exchange indirectly by using an accommodator. The Court did not have much trouble in upholding the IRS s assessment against the taxpayer. Related-Party Exchanges Taxpayer Low-Basis Property High-Basis Property Accommodator Low-Basis Property $ Buyer High-Basis Property $ Related Party Seller Tax-Free Exchange Advisor miller nash llp 4

5 Goodwill Can Be Exchanged if Treated as Real Estate When attempting to exchange a business, exchanging the goodwill component is often a dead end. Goodwill of two different businesses may never be of like kind. Treas Reg (a)-2(c)(2). Goodwill associated with real estate, however, can generally be treated as real estate and exchanged tax-free for other real estate. Certain types of real estate essentially constitute businesses in and of themselves. Examples of these are shopping centers, motels, hotels, quarries, and golf courses. In these types of transactions, it is easy to separate the real property from the tangible personal property, such as the furniture and bedding used in a motel. It is very difficult, however, to separate the real estate from its goodwill, including the value of the above-market leases, name, telephone number, and workforce in place. It is probably not necessary to allocate goodwill from real estate of this nature. Under IRC 197, goodwill can be amortized over 15 years. When Congress passed IRC 197, it was concerned that taxpayers would attempt to divide goodwill from its associated real estate and amortize the goodwill over a very short 15 year period versus the much longer depreciation periods available for real estate. The regulations provide that for tax purposes, goodwill is not a separate asset from real estate: Section 197 intangibles do not include any interest in land. For this purpose, an interest in land includes a fee interest, life estate, remainder, easement, mineral right, timber right, grazing right, riparian right, air right, zoning variance, and any other similar right, such as a farm allotment, quota for farm commodities, or crop acreage base. Prop Treas Reg (c) (3). Section 197 assets also do not include the value of leases. For example, (continued on page 6) Related-Party Exchanges Can Sometimes Be Tax-Free Continued from page 1 the sister had to pay tax on her sale of at least $300,000. No one knows what would happen if the sister had to pay tax on $280,000 of taxable income, but it would probably work. At some point, if the sister s tax liability were substantially less than her brother s savings in taxable income, the IRS could treat the transaction as taxable. This exception would not apply if the sister s $300,000 in taxable income did not generate a tax liability or generated a lesser tax liability than expected (e.g., she had a net operating loss carryover that sheltered the gain or her tax bracket was substantially lower than her brother s). See Teruya Bros. v. Comm r, 104 AFTR2d (9th Cir 2009); Ocmulgee Fields, Inc. v. Comm r, 106 AFTR2d (11th Cir 2010). No Cash-Out. The IRS has held that if neither the taxpayer nor the related party cashed out (i.e., neither party received any cash in the exchange transactions), the No Tax Avoidance Exception applies. In Priv Ltr Rul (Sept. 11, 2002), the taxpayer completed an improvement exchange. The replacement property was a building constructed on a ground lease from a related party. Even so, since the related party did not receive any cash in the transaction, it was held that the relatedparty rules were not violated and that the exchange was tax-free. Taxpayer and Related Party Both Exchange. The taxpayer may acquire the replacement property from a related party and sell the relinquished property to an unrelated third party as long as the related party also does its own 1031 exchange. See Priv Ltr Rul (Dec. 22, 2005); Priv Ltr Rul (June 14, 2004). This exception applies even if the related party receives some taxable boot in its exchange. Priv Ltr Rul (Feb. 7, 2008); Priv Ltr Rul (Dec. 6, 2007). Family Feud. The No Tax Avoidance Exception has been applied to an exchange to resolve a family dispute. In Priv Ltr Rul (Dec. 21, 1999), the IRS permitted a series of circular taxfree exchanges between related parties followed by a spin-off of a corporation when the purpose of the spin-off was not to avoid taxes, but rather to resolve disagreements between shareholders as to the management of the corporation. Additional Tax-Free Transaction. The No Tax Avoidance Exception has also been applied to dispositions of the replacement property in a second tax-free transaction (e.g., using the property as a capital contribution to a limited liability company). Priv Ltr Rul (Dec. 22, 2005). If an exchange involves a related party, it may be taxable under the applicable rules. But don t stop there. A number of significant exceptions to the related-party rules allow those exchanges to be structured as tax-free exchanges. 5 miller nash llp Tax-Free Exchange Advisor

6 Goodwill Can Be Exchanged if Treated as Real Estate Continued from page 5 purchasing a shopping center does not include a separate allocation for the value of the leases, even if the value of the real estate is increased because of the existence of a favorable lease. Prop Treas Reg (c)(8). A much different problem is raised when real estate is a mere component of a business. In this situation, the real estate must be separately valued, including any goodwill component. If possible, the allocation should be included in the purchase and sale agreement. The allocation of the value of each component of a business will be controlled by the provisions of IRC Engaged Guidance, Exceptional Counsel. Tax-Free Exchange Advisor is published by Miller Nash LLP. This newsletter should not be construed as legal opinion on any specific facts or circumstances. The articles are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and any specific legal questions you may have. To be added to any of our newsletter or event mailing lists or to submit feedback, questions, address changes, and article ideas, contact Client Services at or at clientservices@millernash.com U.S. Bancorp Tower 111 S.W. Fifth Avenue Portland, Oregon Presorted First-Class Mail US Postage PAID Portland, OR Permit #11