Form 8824, used to report like kind exchanges, requires (i) a description of the relinquished and replacement properties; (ii) identification of related parties to the exchange; and (iii) calculation of realized gain, recognized gain, and the basis of replacement property received. Form 8824 now requires detailed information to ensure compliance with the 45-day identification and 180-day exchange periods, which are jurisdictional (i.e., cannot be extended). Sales or exchanges of business property must also be reported on either Schedule D or Form 4797 (“Sales of Business Property”).
Form 8824 requires the taxpayer to state whether the replacement property was acquired directly or indirectly from a related party. The instructions state that indirect related party exchanges include (i) an exchange made with a related party through an intermediary (such as a QI or EAT) or (ii) an exchange made by a disregarded entity (i.e., a single-member LLC) if the taxpayer owns the entity. Form 8824 must be filed for two years following the taxable year of the related party exchange.
The issue of whether or not an exchange qualifies under Section 1031 is often not clear. If “substantial authority” exists for a position taken on a return, neither the return nor the preparer will be subject to accuracy-related penalties for under reporting under IRC §6662, even if the IRS successfully challenges the position taken. By contrast, if a position is not supported by “substantial authority,” penalties may be imposed unless the position has been adequately disclosed and a “reasonable basis” supports the position. Substantial authority exists if the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.
Whether to make disclosure is often a question of judgment. A tax opinion letter may state that a transaction “should” result in the tax consequences predicted if it possesses at least an eighty percent chance of success. Disclosure would not be required in this instance. However, if the tax treatment has only a “reasonable possibility of success,” disclosure should be made. Some tax advisors consider a forty percent chance of success the threshold below which disclosure should occur. Some transactions, although generating clear and favorable conclusions from a tax standpoint, will not have substantial authority solely because IRS never issued guidance. Those transactions would presumably not require disclosure.
New York imposes few special reporting requirements for like kind exchanges involving New York residents. New York imposes no withholding tax on exchange proceeds. Nonresidents, who must generally make estimated payments, are required to check a box on Form IT-2663 and state that the transaction is a Section 1031 exchange.
A single-member LLC (SMLLC) that is ignored for federal income tax purposes is also ignored for New York income tax purposes. However, since an LLC is a “person” as defined in Tax Law §1101(b)(4), it may have an obligation to pay sales tax if it engages in a like-kind exchange. New York imposes no special licensing, bonding or registration requirements on “qualified intermediaries” or “exchange accommodation titleholders” providing exchange services in New York. Finally, the acquisition of replacement property outside of New York should not affect the tax-deferred nature of the exchange for New York tax purposes.
Non-California residents should be be aware of California’s “clawback” rule, which encourages only “one way” investments in California realty. Although California does allow exchange treatment to nonresidents, deferred gain must continue to be reported indefinitely if out-of-state replacement property is acquired. If that out-of-state property is ever sold in a taxable sale, California will “claw” its way back, and impose tax on the initial deferred gain, which may have occurred many years earlier. New York and other states are said to be considering such a rule. The “clawback” rule may not be unconstitutional, since no state is required to provide like-kind exchange treatment as an initial matter.