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I. Acquisition of All Partnership Interests Takes Exchange Out of IRC § 1031(a)(2)(D)
PLR 200909008 concluded that an Exchange Accommodation Titleholder (“EAT”) may acquire a 50% partnership interest as replacement property for the taxpayer’s exchange where the taxpayer owns the other 50%. Although §1031(a)(2)(D) precludes the exchange of a partnership interest, under Rev. Rul. 99-6, the acquisition by a partner of all of the remaining interests of a partnership is treated as the acquisition of a pro rata share of the underlying property, rather than the acquisition of a partnership interest.
II. “Qualified Use” Requirement Relaxed Where Trust Funds LLC Which Engages in Swap
In PLR 200812012, under the terms of decedent’s will, Trust A was established to administer estate assets. The trust owned real property in various states which were held for investment. Pursuant to a termination plan formulated by the trustees, Trust A assets were contributed to an LLC. The issue raised was whether the LLC could thereafter engage in a like kind exchange. The IRS ruled favorably, noting that Trust A terminated involuntarily by its own terms after many years in existence. The ruling also noted that there was no change in beneficial ownership of the LLC, or the manner in which it holds or manages the replacement property. The ruling distinguished Rev. Rul. 77-337, which involved “voluntary transfers of properties pursuant to prearranged plans.”
III. QI Status Not Affected By Conversion of S Corps to C Corps
In PLR 200908005, the IRS ruled that the conversion of three subchapter S corporations, which engaged in the business of acting as qualified intermediaries for like kind exchanges, to C corporations, would not be considered a change in the qualified intermediaries, despite the formation of three new taxpayer entities. The IRS reasoned that although the C corporation would no longer be a disregarded entity under federal tax law, the three entities would be the same for state law purposes, and there would be no change in the manner in which the corporations conducted business. This ruling leaves open the question of how the IRS would view the acquisitions of a bankrupt or insolvent qualified intermediary by another entity.
IV. Acquisition of All Interestsin Partnership Results in Good Like Kind Exchange
In PLR 200807005, taxpayer, a limited partnership, intended to form a wholly-owned LLC which would be a disregarded entity for federal tax purposes. It would then acquire 100 percent of the interests of the partners in a partnership in a like kind exchange. After the exchange, the LLC would be a general partner and the taxpayer a limited partner in the partnership.
The ruling raised two issues: First, does the exchange qualify for nonrecognition under IRC § 1031? The ruling answered this in the affirmative. Pursuant to Rev. Rul. 99-6, the partnership is considered to have terminated under IRC §708(b)(1)(A), and made a liquidating distribution of its real property assets to its partners, and the taxpayer is treated as having acquired those interests from the partners, rather than from the partnership, for federal tax purposes. Accordingly, the transaction is a like kind exchange, rather than an exchange of partnership interests.
The second issue raised was whether the taxpayer may hold the replacement property in a newly-created state law partnership that is disregarded for federal income tax purposes. Since the LLC is disregarded for tax purposes, and the taxpayer, who owns 100 percent of the partnership following the exchange, is considered as owning all of the real estate owned by the partnership, the ruling concluded that the taxpayer may hold the replacement property in a newly-created state law partnership that is disregarded for federal income tax purposes without violating the requirement of IRC § 1031 that replacement and relinquished property both must be held by the [same] taxpayer.
V. Development Rights Are Real Property For Purposes of IRC § 1031
PLR 200901020 ruled that development rights qualified as real property for purposes of Section 1031. In the facts of the ruling, property owner contracted to sell (relinquish) certain parcels of property. The contract contained a put option, which entitled the seller to transfer some or all of its residential development rights under a phased development plan. If the option was exercised, the buyer was required to sell certain hotel development rights back to the seller. After determining that the development rights constituted real property under state law, the PLR then stated that the development rights would qualify as like kind property if the rights were in perpetuity, and were directly related to the taxpayer’s use and enjoyment of the underlying property. The ruling concluded that the taxpayer had met these criteria.
VI. Leasehold Interests Are of “Like Kind” to other Leasehold Interests; Basis of Property in Multiple Property Exchanges
In PLR 200842019, the taxpayer exchanged an existing leasehold interest for a new lease. The ruling stated that a leasehold interest with permanent improvements is of like-kind to another leasehold interest with permanent improvements. Variations in value or desirability relate only to the “grade or quality” of the properties and not to their “kind or class.” Depreciable tangible personal property is of like kind to other depreciable tangible personal property in the same General Asset Class. In this case, all of the depreciable personal property to be exchanged, i.e., office furniture, fixtures and equipment, is in the same General Asset Class.
Treas. Regs. § 1.1031(k)-1(e)(1) provides that the transfer of relinquished property will not fail to qualify for nonrecognition under § 1031 merely because replacement property is not in existence or is being produced at the time the property is identified as replacement property. Treas. Regs. §1.1031(j)-1(c) sets forth the exclusive method of basis computation for properties received in multiple property exchanges. In such exchanges, the aggregate basis of properties received in each of the exchange groups is the aggregate adjusted basis of the properties transferred by the taxpayer within that exchange group, increased by the amount of gain recognized by the taxpayer with respect to that exchange group, with other adjustments. The resulting aggregate basis of each exchange group is allocated proportionately to each property received in the exchange group in accordance with its fair market value. Therefore, the basis of property received by the taxpayer will be determined on a property-by-property basis beginning by first ascertaining the basis of each property transferred in the exchange and adjusting the basis of each property in the manner provided in Treas. Regs. § 1.1031(j)-1(c). Even if no cash is received in an exchange involving multiple properties, it is possible that boot will be produced, because property acquired within an exchange group may be of less value than property relinquished within that exchange group.
VII. Properties Can Be of “Like Kind” Without Being of “Like Class”
In PLR 200912004, taxpayer operated a leasing business, in which the taxpayer purchases and sells vehicles as the leases terminate. The taxpayer implemented a like kind exchange program pursuant to which the taxpayer exchanges vehicles through a qualified intermediary under a master exchange agreement. The taxpayer proposes to combine into single exchange groups all of its cars, light-duty trucks and vehicles that share characteristics of both cars and light duty trucks, arguing that all such vehicles are of like kind under Section 1031.
Ruling favorably, the IRS noted that although the taxpayer’s cars and light duty trucks are not of like class, Treas. Regs. § 1.1031(a)-2(a) provides that an exchange of properties that are not of like class may qualify for non-recognition under Section 1031 if they are of like kind. Moreover, Treas. Regs. § 1.1031(a)(2(a) provides that “in determining whether exchange properties are [of] a like kind no inference is to be drawn from the fact that the properties are not of a like class.” Thus, properties can be in different asset classes and still be of like kind.
VIII. IRS Finds Trademarks Qualify as Like Kind Property
The IRS recently reversed its long held position that intangibles such as trademarks, trade names, mastheads, and customer based intangibles could not qualify as like kind property under Section 1031. Chief Counsel Advisory (CCA) 20091106 stated that these intangibles may qualify as like kind property provided they can be separately valued apart from a business’s goodwill, and that except in “rare or unusual circumstances” they should be valued apart from goodwill. Even so, the “nature and character” requirements of Treas. Regs. § 1.1031(a)(2)(c)(1) must still be met. Thus, not all trademarks, trade names and mastheads are of like kind to other trademarks, trade names and mastheads.
CCA 20091106 opens up new planning opportunities for business owners seeking to swap similar businesses. Business owners may now defer gain not only with like-kind or like-class tangible assets, but also with like-kind non-goodwill intangibles disposed of in an exchange. Utilizing a “reverse exchange,” taxpayers may “park” non-goodwill intangibles with an EAT, and use the parked property as part of a like-kind exchange within 180 days.
IX. Ninth Circuit Affirms in Teruya
The Ninth Circuit upheld the Tax Court’s decision in Teruya. No. 05-73779 (9/8/09). The Court of Appeals found that Teruya had “decreased their investment in real property by approximately $13.4 million, and increased their cash position by the same amount.” Therefore, Teruya had effectively “cashed out” of its investment. Noting that Teruya could have achieved the same property disposition through “far simpler means,” the court concluded that the transactions “took their peculiar structure for no purpose except to avoid § 1031(f). The presence of the QI, which ensured that Teruya was “technically exchanging properties with the qualified intermediary . . . served no purpose besides rendering simple – but tax disadvantageous – transactions more complex in order to avoid § 1031(f)’s restrictions.” The exception in § 1031(f)(2)(C) was inapplicable since “the improper avoidance of federal income tax was one of the principal purposes.”
X. Ocumulgee Fields Further Restricts Exchanges Between Related Parties
In Ocumulgee Fields v. Com’r., T.C. No. 6 (2009), the taxpayer transferred appreciated property to a qualified intermediary under an exchange agreement, whereupon the QI sold the same property to an unrelated party and used the sale proceeds to purchase like kind property from a related person that was transferred back to the taxpayer to complete the exchange. The IRS assessed a deficiency, arguing that the exchange was part of a series of transactions designed to avoid IRC § 1031(f) and that the taxpayer had not established the “lack of tax avoidance” exception under § 1031(f)(2)(C). Citing Teruya Bros., Ltd., the Tax Court agreed with the IRS, noting that the immediate tax consequence of the exchange would have been (i) to reduce taxable gain by $1.8 million, and (ii) to substitute a 15% tax rate for a 34% tax rate.
After Ocumulgee, and the Ninth Circuit decision in Teruya, it may be difficult to find a more likely than not basis to proceed with an exchange involving a related party in instances where the related party already owned the replacement property. The Tax Court came perilously close to holding that basis shifting virtually precludes, as a matter of law, the absence of a principal purpose of tax avoidance.
XI. Related Party Rules Not Violated Where Equalizing Transfers of TIC Interests Made By Trust Beneficiaries
In PLR 20091027, the taxpayer, the taxpayer’s sibling, and a trust were tenants in common of real property. The trustees of the trust wished to sell their interest in the real property. To increase the marketability of the interests sold, the three owners each agreed to exchange their undivided 1/3 interest in the property for 100 percent fee simple interests in the same property. The proposed division would split the property into three parcels of equal value.
The taxpayer sought a ruling regarding the applicability of IRC § 1031(f) to the proposed exchange. The ruling held that while the taxpayer and the taxpayer’s sibling were related, neither intended to sell their property within two years. Furthermore, the taxpayer was not related to the trust within the meaning of IRC § 1031(f)(3); (i.e., the trust did not bear a relationship to the taxpayer described in IRC §267(b) or §707(b)(1)). Accordingly, the ruling concluded that with respect to the taxpayer and the trust, there was no exchange between related persons for purposes of IRC §1031(f).
XI. IRS Counsel Opines that Same Property May be Relinquished for Reverse Exchange and for Forward Deferred Exchange
In CCA 200836024 the taxpayer, pursuant to Rev. Proc. 2000-37, first structured an “exchange last” reverse exchange. In the reverse exchange, Greenacre was acquired by the EAT as replacement property, and parked until the taxpayer identified property to be relinquished. Thirty-three days after Greenacre was acquired by the EAT, the taxpayer identified three properties to potentially serve as relinquished property for Greenacre. Redacre was one of those properties. On the 180th day following the EAT’s acquisition of Greenacre, Redacre was relinquished in the reverse exchange, and that exchange was unwound. However, since the value of Redacre far exceeded the value of Greenacre, the taxpayer structured a second like kind exchange to defer the gain that remained after the exchange of Redacre for Greenacre. Accordingly, 42 days after the sale of Redacre to cash buyer, the taxpayer identified three additional properties intended to be replacement properties for the relinquishment of Redacre in a deferred exchange.
The issue was whether the taxpayer could utilize Redacre both as the relinquished property in a reverse exchange, and also as the relinquished property in a deferred exchange. The answer was yes. Reasoning that the taxpayer had complied with identification requirements for both a reverse and a deferred exchange, the advisory concluded that the taxpayer could properly engage in both a reverse exchange and a deferred exchange with respect to the same relinquished property.
The CCA further noted that Rev. Proc. 2000-37 anticipated the use of a qualified intermediary in a reverse exchange. The advice also cited Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979) (transfers need not occur simultaneously); Coastal Terminals, Inc., v. U.S., 320 F.2d 333 (4th Cir. 1963) (tax consequences depend on what the parties intended and accomplished rather than the separate steps); and Alderson v. Com’r., 317 F.2d 790 (9th Cir. 1963) (parties can amend a previously executed sales agreement to provide for an exchange), for the proposition that courts have long permitted taxpayers “significant latitude” in structuring like-kind exchanges.
XII. IRS Declines to Regulate Qualified Intermediaries
Consolidation of qualified intermediaries has raised concerns regarding transfers of QI accounts during exchanges. There continues to be concern with respect to QI insolvencies as a result of several well-publicized failures, e.g., LandAmerica, November 2008. The Federation of Exchange Accommodators (FEA) has asked the Federal Trade Commission (FTC) and the IRS to regulate qualified intermediaries. Both have declined. Nevada and California do regulate qualified intermediaries. Under California law, the QI is required to use a qualified escrow or trust, or maintain a fidelity bond or post securities, cash or a letter of credit in the amount of $1 million. The QI must also have an errors and omissions insurance policy. Exchange facilitators must meet the prudent investor standard, and cannot commingle exchange funds. A violation of the California law creates a civil cause of action.
XIII. Build-to-Suit Rules Relaxed in PLR
In PLR 200901004, the IRS ruled favorable with respect to an exchange where taxpayer, engaged in the business of processing minerals in Old Facility, assigned easements to its wholly-owned LLC, which would then construct New Facility also for the purpose of processing minerals. The LLC would acquire funds for project financing through a syndicate of third party lenders, and the financing would be secured by the New Facility. Lenders would have the right to foreclose on the New Facility, including the rights of the LLC under the assigned easements. The ruling cautioned that the proposed exchange between the LLC and the taxpayer, though qualifying under Section 1031, constituted an exchange of multiple properties, both tangible and intangible, pursuant to Treas. Regs. § 1.1031(j)-1. This necessitated a property-by-property comparison to determine the extent of any boot present in the exchange.
XIV. Ruling Provides Flexibility in Two-Party TIC Exchanges
In three recent rulings, PLRs 200826005, 200829012 and 200829013, the IRS ruled that two 50% undivided fractional interests in real property did not constitute an interest in a business entity for purposes of qualification as eligible replacement property in a §1031 exchange. The rulings provide flexibility to two-party 50% tenancy-in-common ownership structures with regard to qualification as eligible replacement property. In approving a two-party 50% undivided interest structure for purposes of qualifying §1031 exchanges, the ruling modified several conditions specified in Rev. Proc. 2002-22:
¶ The Agreements between the two co-owners required the co-owners to invoke the buy-sell procedure prior to exercising their right to partition the property. Since Rev. Proc. 2002-22 provides that each co-owner must have the right to partition, the PLRs construed this requirement with great latitude. Although Rev. Proc. 2002-22 provides that each co-owner may encumber their property without the approval of any person, the Agreement in question allowed each co-owner the right to approve encumbrances. The IRS reasoned that since there are only two 50% owners, the restriction on the right of a co-owner to engage in activities that could significantly diminish the value of the other 50% interest without the approval of the other co-owner was consistent with the requirement that each co-owner have the right to approve an arrangement that would create a lien on the property.
¶ The PLRs modified a requirement within Rev. Proc. 2002-22 regarding proportionate payment of debt. While Rev. Proc. 2002-22 provides that each co-owner must share in any indebtedness secured by a blanket lien in proportion to their own indebtedness, the PLR approved an arrangement whereby an owner who paid more than 50% would have the right to be indemnified by the other co-owner. The Agreement provides a mechanism whereby the co-owners could pay an amount that deviates from their proportionate share of debt.
¶ While Rev. Proc. 2002-22 limits co-owners’ activities to those customarily performed in connection with the maintenance and repair of rental real property, the PLRs approved a provision allowing co-owners to lease the property to an affiliated entity. In each PLR, the properties were leased to an affiliate of one of the co-owners who conducts a business unrelated to the management and leasing of the property.