James R. Browne Dallas TX 72505 Real Estate Sales and Exchanges
Speaker Strasburger & Price, LLP 901 Main Street, Suite 4400 Dallas, Texas 75202.3794 Tel: 214.651.4420 Fax: 214.659.4019 jim.browne@strasburger.com JAMES R. BROWNE Jim is a partner in the Dallas office of Strasburger & Price, LLP law firm, specializing in general tax planning. He has over 35 years of experience in the area of taxation, having served as lead counsel in matters involving federal, state, and foreign taxes. He regularly advises clients on the U.S. income tax aspects of domestic and international business transactions involving a diverse range of industries, including healthcare, manufacturing, energy, real estate, and financial services. Prior to joining Strasburger in 2005, Mr. Browne served as chief tax officer for several large publicly traded multinational companies, was a partner in a "Big 4" accounting firm, and was a partner in a nationally prominent law firm. He earned his law degree from Vanderbilt University (1981) and his undergraduate degree in business administration from the University of Michigan (1978). He is a licensed lawyer and certified public accountant in Texas. Strasburger & Price, a full-service law firm with seven offices, is one of Texas largest and most respected firms. Strasburger serves as a trusted adviser to publicly and privately held companies, entrepreneurs, executives, governmental entities and individuals. Since the firm s founding in 1939, Strasburger attorneys have been privileged to represent more than half of the Fortune 500 companies. For more information, visit www.strasburger.com. 2
Disclaimer This document is not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors. Any tax advice contained in this document was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or taxrelated matter. 3
Agenda Part 1 Dispositions Other Than Like-Kind Exchanges Base case: sale for cash Installment sales Other tax-deferred sale options Self-directed installment sale Structured sale Partnership transactions Other deferred sales Part 2 Like-Kind Exchanges For a narrative discussion of the matters covered in Part 1, see Browne, Tax Considerations for Real Estate Sales at www.strasburger.com 4
Sale for Cash 5
Sale for Cash Amount of gain or loss realized Gain (loss) = amount realized - basis Selling expenses reduce amount realized Liabilities assumed increase amount realized Amount of gain or loss recognized General rule: all gain or loss is recognized Exceptions Gain from sale of a principal residence Involuntary conversion Loss disallowance and deferral rules Personal use property Sales to related persons Other 6
Sale for Cash Character of recognized gain or loss Capital assets vs. dealer property Section 1231 gains and losses Depreciation recapture (sections 1245 and 1250) Unrecaptured section 1250 gain Sale to related party (section 1239) Subdivided investment property (section 1237) Holding period(s) Timing (period in which gain or loss is recognized) Source (foreign versus domestic) 7
Installment Sales 8
Installment Sales Installment method Applies to sale of property at a gain in which at least one payment is due after the close of the taxable year of sale Calculation: Gain recognized = payment received x gross profit ratio ( GPR ) GPR = (selling price basis and selling expenses) contract price Selling price = amount realized (including assumption of debt) without reduction for selling expenses Contract price = selling price lesser of (a) qualifying indebtedness assumed or encumbering the property, or (b) basis Effect: allocate basis to assumed debt, then proportionately to remaining payments 9
Installment Sales Example T/P sells land subject to a $20 nonrecourse debt for $100 cash, with $80 to be paid at closing and $20 to be paid one year later. The property has a basis of $50. Inputs: Selling price (SP) = $120 ($100 cash + $20 debt) Contract price (CP) = $100 (SP - $20 debt) Gross profit ratio (GPR) = 70% (($120 SP - $50 basis) $100 CP) Result: Gain at closing = $56 ($80 payment x 70% GPR) Gain in year 2 = $14 ($20 payment x 70% GPR) Effect: $50 basis first allocated to $20 of assumed debt, and then remaining basis ($30) is allocated to the cash payments in proportion to their relative amounts 10
Installment Sales Installment method not available for Publicly traded securities Dealer dispositions and inventory Special rules for farm property, residential lots, timeshares, and campgrounds Trade receivables Most sales to controlled entities Depreciation recapture Election out of installment method Closed transaction method Open transaction method 11
Installment Sales What constitutes a payment? Buyer note Receipt of buyer s note is generally not a payment Exceptions: Buyer s note is payable on demand Buyer s note is readily tradable or secured by cash or cash equivalents Receipt of a note or other payment obligation of a person other than the buyer generally is a payment Exception for bona fide escrow obligations Exception for receipt of a buyer note from a qualified intermediary in a like-kind exchange Buyer s assumption of seller qualified indebtedness is not a payment except to the extent the debt exceeds basis 12
Installment Sales Contingent Payments Maximum selling price Use maximum selling price (if applicable) to compute gross profit ratio If maximum is subsequently reduced, adjust gross profit ratio for payments received in that year and future years Loss allowed for excess unrecovered basis over redetermined maximum selling price Fixed period If there is no maximum selling price, but there is a maximum period over which payments are to be made: Allocate basis ratably to each year in the period Excess basis in any year is carried forward until expiration of the period 13
Installment Sales Contingent Payments (con t) No maximum selling price or fixed period Allocate basis ratably over 15 years Excess basis in any year is reallocated ratably to the remaining 15-year period, and at end of 15-year period is carried forward from year to year until basis is fully recovered or the contingent payment obligation becomes worthless Alternative methods T/P can request alternative method of basis recovery if normal rules substantially and inappropriately defer recovery of basis IRS can impose alternative method of basis recovery if normal rules substantially and inappropriately accelerate recovery of basis Alternative method can be requested or imposed midstream Income forecast method 14
Installment Sales Interest charge for large sales Applies if: Obligation arose from an installment sale involving a sales price > $150,000, and Face amount of all such obligations arising that year and outstanding at the close of the year > $5,000,000 Effect is tax is deferred until cash is received, but interest is imposed for the privilege of deferral of tax on amount deferred in excess of $5,000,000 Exceptions for personal use property and farms 15
Installment Sales Other special rules Anti-pledging rules Related party transactions Dispositions Liquidating distributions of installment obligations Qualifying indebtedness Liabilities in excess of basis and wrapped indebtedness Seller expenses 16
Installment Sales Purchase price allocation Where multiple properties are sold and a portion of the purchase price is deferred, can the deferred payments be specially allocated exclusively to property eligible for installment sale reporting? Probably, if (1) documented, (2) supported by substantial non-tax business purposes, and (3) otherwise in accordance with the residual allocation method. 17
Installment Sales Election out of installment method - closed transaction method Elect out of installment method by reporting all gain realized from the transaction in the year of sale All forms of taxable consideration are valued and included in Seller s amount realized as of the sale date Value of fixed deferred payments = imputed principal amount Value of contingent deferred payments = fair market value If fair market value is not reasonably ascertainable, defer recognition until payments are ascertained, and impute interest on the amount so determined Amounts received in excess of fair market value = interest and collection gain 18
Installment Sales Election out of installment method - open transaction method Applies in those rare and extraordinary cases in which the value of all or a portion of the consideration is not reasonably ascertainable Clear Congressional intent to limit circumstances in which the open transaction method applies, but method was not invalidated Gain recognized only at the time and to the extent cumulative payments exceed basis This rule also applies to recapture income No interest charge on large sales, anti-pledging rules, etc. Interest must be imputed on deferred payments (unless the deferred payments provide for adequate stated interest) 19
Installment Sales Section 1031 (like-kind exchange) overlap A qualified intermediary s obligation to deliver replacement property and boot (if any) is not a payment for installment sale purposes (even though secured) Gain on boot recognized only when received Installment note issued by QI s buyer of relinquished property is not a payment for installment sale purposes (even though issued by a person other than the QI) 20
Other Tax-Deferred Sale Options 21
Other Tax-Deferred Sale Options Self-directed installment sale Risks: business purpose and economic substance; agency/independent economic interest, constructive receipt 22
Other Tax-Deferred Sale Options Structured sale Risks similar to those for a self-directed installment sale 23
Other Tax-Deferred Sale Options Leveraged partnership See Canal Corp. v. Comm r, 135 T.C. 199 (2010), for an example of a failed leveraged partnership transaction 24
Other Tax-Deferred Sale Options Unleveraged partnership 25
Other Tax-Deferred Sale Options Other Lease with options Seller leases property to buyer on 11/1/16 for < 80% of property s economic life Seller can require buyer to purchase the property (put option) anytime between 2/1/17 and 3/31/17 at 100% of 11/1/16 FMV Buyer has option to purchase the property (call option) exercisable anytime between 11/1/18 and 12/31/18 at 100% of 11/1/16 FMV Realistic possibility that neither option will be exercised Variable prepaid forward Rev. Rul. 2003-7: variable prepaid forward contract is not a present sale Can a total return swap be used in lieu of sale of real property? Notice 2008-2: IRS studying proper accounting for derivatives 26
Other Tax-Deferred Sale Options Like-kind exchange See Part 2 27
Summary Part 1 28
Summary Part 1 Sale for cash Numerous and sometimes complex rules govern the amount, character, timing, and source of gain or loss Consider effect of timing of sale on estimated tax payments and any non-recognition rules Installment sales Many exceptions and special rules Receivables, inventory, and recapture not eligible Contingent payments (basis allocation) Interest charge for large sales Allocation of mixed purchase price in a sale of multiple assets Election out (closed transaction method or open transaction method) 29
Summary Part 1 Other tax-deferred sale options Generally involve complexity and IRS hostility Might work in the right fact pattern 30
Real Estate Sales and Exchanges Part 2 31
Agenda Part 2 Like-Kind Exchanges Overview Exchange Requirement Like-Kind Requirement Held for Business or Investment Requirement Partnerships and Disregarded Entities 32
Overview of Like-Kind Exchanges 33
Overview General rule - 1031(a) 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. Three requirements: Exchange of properties Properties are like-kind Properties are held for use in a business or for investment 1031 is not elective (e.g., sale leaseback; trade in) 34
Overview Broad application Exchange requirement can be satisfied by properly structured sale and purchase transactions Value balancing allowed Liberal like-kind definition for real property (but not for personal property) Common uses Tax deferred reinvestment Individual assets or mass assets (e.g., leasing inventory) Diversification 35
Overview Tax consequences Gain realized is recognized (taxable) to the extent of any cash or non like-kind property ( boot ) received Note to the extent of boot, not in proportion to boot Any excess of debt on relinquished property over debt on replacement property (net debt transferred) is treated as boot received, but is offset by boot transferred Net debt assumed does not reduce any boot received; instead, treated as boot paid and offsets realized gain Basis of replacement property = basis of relinquished property (including boot paid), minus boot received, plus gain recognized. Loss is not allowed, but is preserved in carryover basis 36
Overview Tax consequences (con t) Recapture (including intangible drilling costs, depletion, and equipment depreciation) is recognized to the extent recapture property is exchanged for non-recapture property Multiple properties require complicated calculations involving exchange groups and residual groups (1.1031(j)-1) 37
Overview Illustration of a basic like-kind exchange Property Value Basis Debt Net Value Relinquished Property 100 65 30 70 Replacement Property 90 20 70 A s realized gain = $35 ($90 replacement property received, plus $10 net debt transferred, minus $65 basis) Boot received = $10 (net debt transferred) A s recognized gain = $10 (lesser of $35 gain realized or $10 boot received). A s basis in the replacement property = $65 ($65 basis of the relinquished property, less boot of $10, plus recognized gain of $10). Deferred gain = $25 ($90 value - $65 basis). 38
Overview Borrowing Against relinquished property before exchange Can reduce boot received (to extent debt assumed would otherwise exceed debt transferred) IRS might characterize loan proceeds as disguised boot (PLR 8434015) Probably OK if business purpose (Garcia) Against replacement property after exchange Risk that proceeds treated as boot received from Seller; cannot be netted against boot paid Probably OK if not effected or binding prior to receipt of replacement property 39
Exchange Requirement 40
Exchange Requirement Direct exchange two party transaction Taxpayer Replacement Property Relinquished Property Buyer 41
Exchange Requirement Indirect exchange three party transaction Taxpayer Replacement Property Relinquished Property Buyer Cash Seller 42
Exchange Requirement Intermediary exchange Buyer Taxpayer Replacement Property Relinquished Property Cash Intermediary Cash Seller 43
Exchange Requirement Deferred exchange Deferred exchange = disposition of relinquished property before receipt of replacement property 45-day identification period Taxpayer must identify the replacement property within 45 days after the disposition date Detailed rules for identifying the replacement property, alternative and multiple replacement properties, property to be produced, etc. 180-day exchange period Taxpayer must receive the replacement property by the earlier of (a) 180 days after the disposition date or (b) the due date (including extensions) of the Taxpayer s return for the year of the disposition 44
Exchange Requirement Constructive receipt issue If taxpayer is in constructive receipt of proceeds of sale of relinquished property, the sale is fully taxable. Four safe harbors in Reg. 1.1031(k)-1(g) Security or guarantee arrangements Qualified escrow accounts and qualified trusts Qualified intermediary ( QI ) Interest and growth factors Disqualified persons can t serve as QI Employee, accountant, attorney, banker, or broker within two years, or related to taxpayer (10% ownership test) 45
Exchange Requirement Parking transactions / reverse exchanges Parking transaction (a/k/a reverse exchange) = acquisition of replacement property before disposition of relinquished property Typical structures: Parked replacement property: An exchange accommodation titleholder ( EAT ) acquires the replacement property and holds it until a contract for sale of the relinquished property is executed Parked relinquished property: EAT acquires replacement property and immediately exchanges it for Taxpayer s relinquished property, which is held by the EAT until it can be sold 46
Exchange Requirement Parking transactions (con t) Rev. Proc. 2000-37: IRS won t argue that EAT is acting as Taxpayer s agent if the property is held under a qualified exchange accommodation arrangement EAT cannot be a disqualified person Intent to effect a like-kind exchange Written agreement referencing RP 2000-37 Relinquished property is identified within 45 days after the date the EAT acquires the replacement property, and the exchange and sale are completed within 180 days of that acquisition date The EAT s combined holding period for the replacement and relinquished property cannot exceed 180 days OK for Taxpayer to lease and maintain the parked property, and for Taxpayer to have the economic risk and opportunity for profit on the parked property 47
Exchange Requirement Parking transactions (con t) If the value of the relinquished property exceeds the value of the parked replacement property, an additional 180-day period can be obtained for additional (non-parked) replacement properties (CCA 200836024) Safe harbor does not apply to replacement property previously owned by taxpayer within 180 days of its acquisition by the EAT. Rev. Proc. 2004-51. Non safe-harbor transactions are not precluded, but EAT must have some real economic ownership of the property to avoid being treated as taxpayer s agent 48
Exchange Requirement Build to suit transactions Buyer (or EAT) funds improvements on replacement property Allows Taxpayer to fund improvements using tax deferred proceeds from sale of relinquished property Buyer cannot be taxpayer s agent (Rev. Rul. 75-291) EAT not viewed as taxpayer s agent; but limits construction period to 180 days Taxpayer should not own the replacement property; might be viewed as exchanging relinquished property for services (DeCleene; cf. Rev. Proc. 2004-51) Ownership by affiliate under study by IRS (cf. PLR 200251008) 49
Exchange Requirement Lease versus exchange (mineral interests) Sale of a working interest or lease with a retained overriding royalty interest is a lease (sublease) rather than a sale Receipt of like-kind replacement property is treated as a lease bonus rather than a like-kind exchange (Crooks) Planning Carve out retained overriding royalty prior to sale/exchange Hybrid lease (sale with retained production payment and contingent royalty) Economics are similar to a traditional lease (with a retained royalty), but qualifies as a sale and is eligible for a like-kind exchange See Browne, Tax Aspects of Acquisitions and Dispositions of Oil and Gas Properties: Part 1 - Individual Properties, 28 Petroleum Acct. & Fin. Mgmt. J. 39 (Fall/Winter 2009) 50
Exchange Requirement Related parties - 1031(f) 2-year holding period for exchanges between related parties Example: T wishes to sell low-basis property L with a value of $100 and basis of $20. T s corporation (C) owns property H with a value of $100 and a basis of $140. In lieu of T selling property L, T exchanges property L for property H, and C immediately sells property L for $100, nominally recognizing a $40 loss. Under 1031(f), T recognizes gain of $80 upon C s sale of property L. C s $40 loss on property H is also recognized, but is disallowed under 267. Disallowed loss offsets any gain subsequently recognized by T on sale of property H. Broad reach: applies to indirect dispositions (sale of entity), indirect exchanges (use of QI), constructive dispositions, and any transaction structured to avoid the purposes of 1031(f) Exception for dispositions where neither the exchange nor the disposition had a principal purpose of tax avoidance 51
Exchange Requirement Prior ownership of replacement property Example: T wishes to sell low-basis property L having a value of $100 and basis of $20. T also owns high-basis property H with a value of $100 and basis of $140. In lieu of selling property L, T sells property H to Buyer at a $40 loss. Buyer then exchanges property L for property H. T claims exchange is tax free and basis of property H is $20. Not specifically disallowed, but might be attacked under a variety of theories 52
Exchange Requirement Installment sale overlap In a QI deferred exchange that straddles year end, recognized gain is generally reported under the installment method Gain can be further deferred under the installment method to the extent boot consists of a buyer note Limitations on installment method: Recapture income not deferred Debt > basis Anti-pledging rules Interest charge on large sales 53
Exchange Requirement Structured installment sale Exchange agreement with QI specifies that QI will deliver a QI note to the extent of any excess cash QI will fund the note by depositing the excess cash with a financial institution in exchange for the financial institution s agreement to make payments on the note QI retains primary liability on the note Can Taxpayer report QI s note as a buyer deferred payment obligation under the installment method? 54
Exchange Requirement Failed exchanges Failure to close on relinquished property Return of relinquished property should have no tax consequences Failure to identify or close on replacement property Results in taxable sale of relinquished property See above regarding installment sale overlap Is a structured installment sale a viable backstop to immediate gain recognition on relinquished property? 55
Exchange Requirement QI defaults Chose QI wisely Well capitalized QI; segregated accounts; account controls Generally cannot change QIs mid-stream Rev. Proc. 2010-14 Gain is deferred and recognized under safe harbor gross profit method Similar to installment method, but recapture is deferred Loss recognized under 165 principles Imputed interest applies to payments received If relinquished debt > basis, consider completing exchange using supplemental funds = debt? 56
Like-Kind Requirement 57
Like-Kind Requirement Ineligible properties Inventory / dealer property Securities Partnership or trust interests (but see below) Choses in action (non-possessory rights to money or property) Like-kind Generally same kind or class Frequent litigation and ambiguous decisions Applied on a property by property basis (1.1031(j)-1) 58
Like-Kind Requirement General rules Personal property is not like-kind to real property U.S. assets are not like-kind to foreign assets The standard for real property is less restrictive than for personal property Goodwill of a business is not like-kind to goodwill of another business 59
Like-Kind Requirement Mineral interests Economic interest is classified as real property Qualifying exchanges Exchange of minerals rights for a city lot and hotel Exchange of producing mineral lease for a ranch Exchange of working interests for royalty interests Exchange of royalty interests for real property Unitization of mineral interests Fee interest exchanged for long-term leasehold interest (but not grant of lease for fee interest) 60
Like-Kind Requirement Mineral interests (con t) Production payment classified as a mortgage is not eligible property (chose in action) Working interest subject to a joint operating agreement may be classified a partnership interest (ineligible) Holders can elect out of partnership status ( 1.761-2) A valid election out of subchapter K is also respected for 1031 purposes ( 1031(a)) 61
Like-Kind Requirement Other oil and gas assets Equipment Not considered part of real property so exchange of producing well and equipment triggers application of complex multiple properties regulations (1.1031(j)-1) Generally must group equipment relinquished with equipment received according to asset classes or product classes (1.1031(a)-2) Incidental equipment allowed? Geological and geophysical (G&G) data Arguably constitutes like-kind property even where related to different mineral deposits 62
Like-Kind Requirement Recapture If relinquished property includes natural resource recapture property, receipt of less than equivalent value of natural resource recapture property will trigger recapture income notwithstanding 1031 ( 1.1254-2) Same rule for 1245 deprecation recapture ( 1245(b)(4)) 63
Held for Business or Investment Requirement 64
Held For Requirement Held for business use or investment Personal use property (e.g., personal residence or ranch) does not qualify; mere hope for sale at a gain does not cause property to be held for investment (Rev. Proc. 2008-16) Dealer property does not qualify (held for sale) Immediate transfers: Do transfers to affiliates/entities shortly after acquisition violate held for requirement? Rev. Rul. 75-292: transfer of property to a corporation followed by an exchange of the property (drop and swap) does not qualify for LKE treatment Case law more favorable Same considerations in transfers from an entity to its owners prior to exchange (distribute and swap); see below regarding partnership transactions Does recent construction on relinquished property qualify? 65
Held For Requirement Lack of profit motive Not fatal if legitimate business purpose CCA 201601011: airplane owned by special purpose LLC and leased to operating company at breakeven was held for use in a business because the below-market lease arrangement was a common arrangement motivated by non-tax considerations and airplane was used in the operating company s business Dual use property Cannot bifurcate a single asset Rev. Proc. 2008-16: rental residence qualifies if 10% personal use CCA 201605017: Airplane does not qualify if <50% business use Compare to CCA 201601011, where personal use by operating company executives disregarded because reported as part of their compensation If business use is >50% but <90%: no guidance 66
Partnerships and Disregarded Entities 67
Partnerships and DEs Property held by a partnership A partnership can effect a like-kind exchange of property Rev. Rul. 2003-56: In a deferred exchange, relief of debt on relinquished property is netted against debt assumed on replacement property for purposes of 752, even if transaction straddles year end Exchange of contributed property: for 704(c) purposes, recognized gain is treated first as post-contribution gain, then as pre-contribution gain (PLR 200829023) 68
Partnerships and DEs Partnership interests General rule: an exchange of partnership interests cannot qualify as a like-kind exchange, even if the partnerships own solely like-kind property Exceptions Acquisition of all of the partnership interests treated as an acquisition of the partnership property (Rev. Rul. 99-6 and PLR 200807005) QI s transfer of partnership interests to Taxpayer as replacement property treated as transfer of undivided interest in the partnership property where Taxpayer already owned all partnership interests not received from the QI (Rev. Rul. 99-6 and PLR 200909008) 69
Partnerships and DEs Partnership liquidations and split-ups If some partners want replacement property and other partners want cash or other replacement property: Distribute and swap: partnership distributes undivided fractional interests in its property to its partners and they then transfer their interests to a QI; partners can elect to receive cash or qualified replacement property from the QI Partial installment sale: partnership effects a like-kind exchange for replacement property plus a QI note, and then distributes note to exiting partners Other variations Numerous issues, including held for requirement, constructive partnership, validity of special allocations IRS will scrutinize (Form 1065, Sch. B, Lines 13 and 14) 70
Partnerships and DEs Disregarded entities Exchanges frequently structured as exchanges of 100% ownership interest in an LLC 100% owner of an LLC can exchange a partial ownership interest in the LLC for replacement property that is like-kind to the LLC property (Rev. Rul. 99-5) 71
Partnerships and DEs Undivided fractional interests Arises in connection with Partnership distributions and similar transactions Royalty trusts and other tenant-in-common structures Issue: is the arrangement a tax partnership? Rev. Proc. 2002-22 Ruling guidelines for UFI in rental real property 15 factors; difficult to satisfy all Does not apply to co-ownership in mineral property See also 1.761-2 (conditions for electing out of partnership status) ( 1031(a)) 72
Summary Part 2 73
Summary Part 2 Flexible LKE transaction structures allow tax savings with minimal non-tax impacts * Greatest benefit where: Relinquished property has low basis and debt relative to FMV Replacement property FMV relinquished property FMV (increased investment) Relinquished property debt replacement property debt Tax structuring and documentation ranges from routine to highly complex Start planning early * Assuming a desire or willingness to reinvest sale proceeds in like-kind property. 74