Like Kind Exchange Decisions & Rulings of 2010
[Note:Excerpted from Like Kind Exchanges of Real Estate Under IRC. §1031 (3rd Ed., 1/11) . View treatise at nytaxattorney.com]
I. Use of Replacement Property as Personal Residence Negates Like Kind Exchange Treatment
Finding that the “use of property solely as a personal residence is antithetical to its being held for investment,” the Tax Court, citing objective factors indicating that the taxpayer had little if any actual intention to hold replacement property for productive use in a trade or business or for investment, but rather intended to live in the property, denied exchange treatment. Goolsby v. CIR, T.C. Memo 2010-64.
The taxpayer’s attempt to rent the replacement property was “minimal” and amounted to nothing more than an advertisement in a local newspaper for a few months. The taxpayer moved into the acquired property “within 2 months after they acquired it,” and prior to the exchange discussed with the QI the feasibility of moving into the property if renters could not be found. Moreover, the taxpayer “failed to research rental opportunities” in Pebble Beach and “failed to research whether the covenants of the homeowners association would allow for the rental of the Pebble Beach property.” The Tax Court also upheld accuracy-related penalties imposed by the IRS pursuant to IRC § 6662.
II. Properties May be of “Like Kind” Without Being of “Like Class”
In PLR 200912004, taxpayer operated a leasing business, in which the taxpayer purchased and sold vehicles as the leases terminated. The taxpayer implemented a like kind exchange program pursuant to which the taxpayer exchanged vehicles through a qualified intermediary under a master exchange agreement. The taxpayer proposed 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.
III. Volatile Organic Compound Credits and Nitrogen Oxide Credits are of Like Kind
PLR 201024036 stated that Parent may exchange NOx Credits (achieved by installing air emission reduction equipment) obtained from subsidiary for VOC credits which it will need to offset its anticipated emissions of Volatile Organic Compounds. The Ruling noted that Rev. Proc. 92-91, Q & A 5 states that emission allowances may qualify as like-kind property for purposes of IRC § 1031. NOx Credits and VOC Credits are of the same “nature and character” since both are “part of [the government’s] program to control air pollution.” The Ruling then noted that although Nitrogen Oxide and Volatile Organic Compounds are “different chemical compounds” both are used to control nitrogen emissions. Therefore, the differences between the two compounds should be considered as differences in “grade or quality,” rather than “nature or character,” and are therefore of like kind.
IV. Ninth Circuit Upholds TaxCourt Decision in Teruya
Teruya Brothers Ltd. v. Com’r, 124 T.C. No. 4 (2005) illustrates the danger of using a QI where the related party rules could apply. Teruya, in a series of transactions, transferred several properties to a QI, who sold them to unrelated parties. The QI used the proceeds to purchase replacement properties from a corporation related to the taxpayer. The Tax Court held that the transaction constituted a taxable sale rather than a deferred exchange, since it had been structured to avoid the purpose of Section 1031(f). Although the corporation recognized more gain on its sale than the taxpayer deferred, it had large net operating losses (NOL) which offset its gain. The court rejected the argument that the non-tax-avoidance exception of Section 1031(f)(2)(C) applied.
The Ninth Circuit in late 2010 upheld the Tax Court’s decision in Teruya. 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 observed 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 found in § 1031(f)(2)(C) was inapplicable since “the improper avoidance of federal income tax was one of the principal purposes behind these exchanges.” (No. 05-73779; 9/8/09).
V. Eleventh Circuit Affirms Ocmulgee Fields
In Ocmulgee Fields, 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 § 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 consequences resulting from the exchange would have reduced taxable gain by $1.8 million, and would have resulted in the substitution of a 15 percent tax rate for a 34 percent tax rate. The Tax Court came close to holding that basis shifting virtually precludes, as a matter of law, the absence of a principal purpose of tax avoidance.
The Eleventh Circuit in 2010 affirmed the Tax Court, concluding that “the substantive result of Ocmulgee Fields’ series of transactions supports an inference that Ocmulgee Fields structured its transactions to avoid the purposes of § 1031(f). . .” The court reasoned that even if Ocmulgee had not interposed a qualified intermediary, the transaction would fail because it could not establish the “lack of tax avoidance” exception in § 1031(f)(2)(C). The court found no “persuasive justification” for the complexity of its transaction other than one of “tax avoidance.” Although Ocmulgee argued on appeal that tax avoidance was not a “principal purpose” of the exchange, the court found that the basis-shifting, reduction in immediate taxes, and shifting of the tax burden to the party with the lowest tax rate all justified negative “inferences” against the taxpayer. Finally, although Ocmulgee argued that it had a legitimate business purpose for the exchange, it failed to establish clear error. Moreover, the “mere existence of legitimate business purposes does not preclude a finding that Ocmulgee Fields’ principal purpose for the exchange was tax avoidance.” Ocmulgee Fields, Inc., v. CIR, No. 09-13395 (2010). After the Eleventh Circuit decision in Ocmulgee, 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.
VI. Other Related Party Rulings
In CCM 20103038, the taxpayer, an auto dealer, attempted to structure a like kind exchange between itself and dealer, who were related parties under IRC § 267. Citing Teruya Brothers, Ocmulgee Fields, and Rev. Rul. 2002-83, IRS counsel concluded that the taxpayer “structured its transaction to achieve the impermissible result that Congress addressed in the legislative history.” It then concluded that the “no tax avoidance” exception of IRC §1031(f)(2)(C) was inapplicable, since qualification under the exception requires that tax avoidance not be “one” of its principal purposes. Therefore, even if other, non-tax avoidance purposes existed, the existence of any tax avoidance purpose would result in the inapplicability of the exclusion. The advisory concluded that “[a]s a matter of interpretation, the Service has consistently limited the §1031(f)(2)(C) exception to the situations Congress so specifically described in the legislative history. See Rev. Rul. 2002-83. We are not willing to expand the exception to cover the Taxpayer’s situation.”
PLR 201027036 involved an exchange among a group of companies with a common parent. The ruling blessed the transaction. No direct exchange between the parties occurred by reason of the interposition of a qualified intermediary. Therefore, IRC § 1031(f)(1) was by its terms inapplicable. In addition, the Ruling concluded that IRC § 1031(f)(4) was inapplicable since the related parties did not exchange high basis property for low basis property. Therefore, no “cashing out” occurred.
VII. Qualified Trust Account and Qualified Intermediary Safe Harbors May Both be Used in Single Exchange
PLR 201030020 corroborated the prevailing view that if all of the safe harbor requirements are satisfied for two safe harbors, both may be utilized in a single exchange. To provide an additional measure of safety to customer’s exchange funds, bank proposed to hold exchange funds in a qualified trust account pursuant to § 1.1031(k)-1(g)(3)(iii). Bank also proposed serving as a qualified intermediary pursuant to Regs. § 1.1031(k)-1(g)(4). The ruling concluded that “[t]he fact that Applicant serves in both capacities in the same transaction is not a disqualification of either safe harbor and will not make Applicant a disqualified person.” The Ruling also stated that the bank will not be a “disqualified person” with respect to a customer merely because an entity in the same controlled group performs trustee services for the customer. Finally, the Ruling concluded that a bank merger during the pendency of the exchange would not disqualify it as qualified intermediary for the exchange.
VIII. Rev. Proc. 2010-14 Approves Installment Method Reporting in
Revenue Procedure 2010-14 provides guidance concerning a failed exchange caused by the collapse or bankruptcy of a qualified intermediary. In this situation, the taxpayer will be unable to access the funds received by the QI from the relinquished property sale during the pendency of bankruptcy or receivership proceedings. While Rev. Proc. 2010-14 does not rehabilitate the failed exchange, it recognizes that the taxpayer “should not be required to recognize gain from the failed exchange until the taxable year in which the taxpayer receives a payment attributable to the relinquished property.” Accordingly, the taxpayer is put on the installment method of reporting gain, and “need recognize gain on the disposition of the relinquished property only as required under the safe harbor gross profit ratio method.”
IX. CCA 201025049 Addresses “Stock in Trade” Exclusion of § 1031(a)(2)(A)
“Stock in Trade” refers to property that would be included in inventory. Property held “primarily for sale” cuts a wider swath than property excluded from capital gain treatment under Section 1221(a)(1), which excludes only “property held for sale to customers in the ordinary course of trade or business.” This difference is significant. Some property that would generate capital gain if sold will not qualify for exchange treatment. The sale of a vacant lot purchased for investment would qualify for capital gain treatment if sold, and would qualify for exchange treatment if exchanged for other real estate. However, if the lot had been purchased with the intention of reselling it at a profit, while a sale would still generate capital gain (unless the taxpayer were a dealer), the transaction would not qualify for exchange treatment. Since the exclusion applies to both relinquished and replacement property (i.e., “this subsection shall not apply to any exchange of”) neither the relinquished property nor the replacement property may be held “primarily for sale.” Both must be held for productive use in a trade or business, or for investment.
CCA 201025049 interpreted the phrase “stock in trade or property held primarily for sale”. If an asset can function both as merchandise held for sale and as an asset used in a trade or business, the taxpayer’s primary purpose for holding the asset determines whether that asset is stock in trade. Temporarily withdrawing an asset from inventory for business use is not sufficient to imbue the property with the attribute of being used in the ordinary course of business operations. The advisory concluded that (i) since the corporation did not possess a “general or indefinite commitment” to use the equipment in its trade or business, the property is not depreciable under IRC § 167 and (ii) since the corporation held the equipment primarily for sale, the exchange will not qualify under IRC § 1031.