Law Offices of David L. Silverman, J.D., LL.M.

© 2011 David L. Silverman, J.D., LL.M. (Taxation)
Law Offices of David L. Silverman
2001 Marcus Avenue, Suite 265A South
Lake Success, NY 11042 (516) 466-5900
http://www.nytaxattorney.com
nytaxatty@aol.com

April 15, 2011

TABLE OF CONTENTS

I. REPRESENTATION -1-

II. CONCILIATION CONFERENCE -2-

III. THE DIVISION OF TAX APPEALS -3-

IV. ANALYZING A SALES TAX CASE -3-

V. MOTIONS FOR SUMMARY DETERMINATION -5-

VI. TAX APPEALS TRIBUNAL -6-

VII. ARTICLE 78 REVIEW OF TAX APPEALS TRIBUNAL DECISIONS -7-

VIII. APPEALS TO COURT OF APPEALS -10-

IX. DECLARATORY RELIEF AGAINST DEPARTMENT OF TAXATION -11-

New York State
Tax Litigation

April 15, 2011
I. REPRESENTATION

Lincoln’s adage that “he who is his own lawyer has a fool for a client” appears particularly apt for those taxpayers who represent themselves in tax disputes, since not only are they often unfamiliar with the procedural aspects of the litigation process, but they are also often unfamiliar with the tax law. Although administrative law judges make every effort to accommodate pro se taxpayers, proceedings at the Division of Tax Appeals are governed by the Tax Law and the CPLR. Pro se taxpayers with little knowledge in these statutory areas generally fare poorly, frequently making arguments that have been rejected countless times in the past by other taxpayers. In addition, they often create a hearing record so decidedly adverse that a later appeal to the Tax Appeals Tribunal becomes extraordinarily difficult.
The Department of Taxation, on the other hand, is represented by skillful and experienced lawyers who are conversant with the cases and with the system. The Department’s counsel are also adept at defusing the actions of auditors who have deviated from established audit procedures during the audit. Taxpayers not representing themselves at the Division of Tax Appeals or the Tax Appeals Tribunal may be represented by an accountant or by an attorney. Taxpayers appealing an adverse decision of the Tax Appeals Tribunal via an Article 78 proceeding to the Appellate Division may only be represented by an attorney.

II. CONCILIATION CONFERENCE

A taxpayer who disagrees with audit finding will be given the opportunity to participate in a mediation conference with the auditor. This conference is held under the under the auspices of the Bureau of Mediation and Conciliation Services (BCMS), which is a separate operating bureau within the Department of Taxation reporting directly to the Commissioner of Taxation and Finance. The goal of the Conciliation Conferee is to resolve tax disputes without the necessity of a formal hearing before the Division of Tax Appeals. A request for a Conciliation Conference must generally be made within 90 days after the issuance of a Notice of Determination. The taxpayer who deems the Conciliation Order issued by the Conferee following the Conference unacceptable, may request a formal hearing before the Division of Tax Appeals within 90 days after the Conciliation Order is issued.
A taxpayer who wishes to bypass the Conciliation Conference may do so by filing a request for a formal hearing before the Division of Tax Appeals within 90 days after the issuance of a Notice of Determination. These time periods are jurisdictional; a taxpayer who fails to timely file a request for a hearing before the Division of Tax Appeals will lose all appeal rights in the administrative tax tribunals. (Relief may still be sought in some cases by bring a declaratory judgment action in state supreme court challenging the constitutionality or the applicability of the statute or assessment. However, this path is perilous at best.)

III. THE DIVISION OF TAX APPEALS

The Division of Tax Appeals, in contrast to BCMS, is an autonomous unit of the Department of Taxation and is independent of the Commissioner of Taxation and Finance. The Administrative Law Judges who preside over hearings at the Division of Tax Appeals are experienced and impartial. Still, the Department of Taxation has an advantage in the Division of Tax Appeals, since tax laws are construed narrowly and in favor of the government. Hearings are held at the offices of the Division of Tax Appeals, located at 500 Federal Street, in Troy. The majority disputes with the Department of Taxation heard today involve sales tax. Decisions of the Tax Appeals Tribunal, the Appellate Division, Court of Appeals, or United States district or appeals courts sitting in New York may be cited as authority for the taxpayer’s case. However, the doctrine of staré decisis has no application to cases decided by Administrative Law Judges. Accordingly, those determinations have no precedential value and may not be cited as authority in any brief. In the 2009-2010 fiscal year, Administrative Law Judges sustained 80.2 percent of the deficiencies or other action asserted by the Department of Taxation; they cancelled 9.4 percent of the deficiencies or other action; and they modified 10.4 percent of the deficiencies or other action. New York State Division of Tax Appeals, Annual Report Fiscal Year 2009-2010.

IV. ANALYZING A SALES TAX CASE

In fiscal year 2009-10, sales tax cases represented 59 percent of the cases heard in the Division of Tax Appeals. This is not surprising. With the lure of interest, penalties, and large revenues upon which the sales tax is based, the Department of Taxation aggressively pursues sales tax revenue through audit. To emerge victorious in a sales tax dispute, the taxpayer should be conversant with some important principles involving sales tax litigation. First, auditors often attack the adequacy of the taxpayer’s books and records. Should the Division find these records inadequate, it may resort to “external indices,” one of which is a “test period” audit, in which an extrapolation could be made over a lengthy term. Since penalties will also be extrapolated, this is a dangerous position for the taxpayer to be in.
The first question is whether the Division was justified in resorting to external indices. The Division must make an explicit request for books and records for the entire audit period. If only a “weak and casual” request is made for records (Matter of Christ Cella, 477 NYS2d 858), the taxpayer may be excused from having failed to provide records. If the auditor failed to conduct a sufficient examination of the records, the use of a test period audit has been held improper. Does the audit report actually document a finding of inadequacy of records? Matter of King Crab, 522 N.Y.S.2d 978. If not, the Division may be unable to establish inadequacy of records. Resort to a test period audit is not justified unless it is “virtually impossible” to determine tax based upon available records. Matter of Chartair, 411 NYS2d 41. Did the auditors fail to review books and records because they were “too voluminous”? Matter of Names in the News, 429 NYS2d 755. The Division may not employ an “economic feasibility” test in resorting to a test period audit. The taxpayer has a right to a detailed audit under Tax Law §1138. Matter of Chartair, supra.
Did the taxpayer or his representative actually consent to a test period audit? Merely complying with a request to provide records for a test period does not, without more, evidence a waiver of the taxpayer’s right to a complete audit. Matter of James G. Kennedy, 509 NYS2d 199. Did the Division “deliberately overlook” records which were helpful to the taxpayer? Matter of Merrick Discount Center, DTA No. 800362. Was there a change in auditors? Did the original auditor appear at the hearing or at least provide an affidavit? If not, the evidence may not be sufficient to justify resort to external indices. Matter of Kenneth Schuck Trucking, DTA No. 816129. If the audit period was extended, were those records requested? Was an independent review of records relating to the extended audit period made? If adequate records exist for the extended audit period, the Division “cannot ignore them.” Matter of Adamides, 521 NYS2d 826.
Even if the taxpayer failed to comply with the Division’s record keeping regulations, it may not “prescribe the type of proof that a taxpayer must provide at hearing”” in order to prevail. Matter of John G. Avildsen, DTA No. 809722. If the amount of tax paid was “easily ascertainable” from records provided, a denial of credit by the Division was held to constitute the “mindless elevation of form over substance” and could not be considered “anything other than an arbitrary and capricious exercise of power.” Matter of Riluc, 565 NYS2d 265. Did the Division request records not typically kept by persons involved in the taxpayer’s line of business? If so, the taxpayer has the right to substantiate the proper collection of tax due through supporting documents. Matter of Raemart Drugs, 555 NYS2d 458.
Assuming resort to estimate procedures was warranted, did those procedures lack a “rational basis,” or did an extrapolation yield a grossly inaccurate estimate the tax liability? Matter of Yonkers Plumbing, 403 NYS2d 792. Was the Division’s method “reasonably calculated” to reflect the taxes due? Matter of W.T. Grant Company, 2 NY2d 196, cert denied 355 US 869. Was the audit methodology founded upon the auditor’s “experience” without any indication that the experience relates to the present audit? Matter of Grecian Square, 119 AD2d 948. Was the method chosen by the Division to estimate sales arbitrary and capricious? Matter of King Crab, supra.
Was the imposition of penalties proper? Did the taxpayer make a “reasonable effort” to ascertain tax liability? Matter of Northern States Contracting, Inc., DTA 806161. Was any understatement of tax unintentional? Matter of G & R Machinery, DTA 804590. As these cases demonstrate, knowledge of the taxpayer’s substantive rights constitutes the best insurance against an unfavorable result. Having a meritorious case may unfortunately be insufficient to prevail at hearing unless the proper legal arguments are advanced.

V. MOTIONS FOR SUMMARY DETERMINATION

NYCRR § 3000.9(b)(1) provides that ““summary determination” may be granted “if, upon all of the papers and proofs submitted, the administrative law judge finds . . . no material and triable issue of fact is presented and that the . . . judge can, therefore, as a matter of law, issue a determination in favor of any party.” A motion for summary determination forces the Department to “lay bare”” its proof at an earlier stage. In that sense, the motion serves as a proxy for discovery. It can also provide an effective means of presenting the case to the ALJ prior to the hearing in a light most favorable to the taxpayer. Most evidence, which often consists of auditor’s testimony, his logs and other documentary evidence, is typically presented for the first time at the hearing before the ALJ in Troy.
A motion for summary judgment may eliminate the undesirable element of surprise. Surprise at hearing may derail even the strongest of cases. Once served with a motion for summary determination, the Department must respond by proving the existence of a genuine issue of triable fact. Facts not controverted in opposing papers are deemed admitted. Fair v. Stanley Fuchs, 631 N.Y.S.2d 153 (1st Dept. 1995) held that a party opposing a motion for summary judgment “must produce evidentiary proof in admissible form sufficient to require a trial of material questions of fact . . . mere conclusions, expressions of hope or unsubstantiated allegations or assertions are insufficient.” Accordingly, affirmations of counsel would be insufficient to defeat the motion. Affidavits by the auditor as well as other evidence in admissible form would seemingly be required to oppose to such a motion.

VI. TAX APPEALS TRIBUNAL

Following a hearing at the Division of Tax Appeals, any party may appeal all or part of the Determination to the Tax Appeals Tribunal, provided a Notice of Exception is filed within 30 days after service of the Determination on the parties. The Tax Appeals tribunal sits as the final administrative tax tribunal in the state. In the 2009-2010 fiscal year, the Tax Appeals Tribunal sustained the deficiency or other action asserted by the Department of Taxation in 71.7 percent of cases; it cancelled the deficiency or other action asserted in 13.0 percent of the cases; it modified the deficiency or other action asserted in 8.7 percent of the cases, and it remanded the case to the Administrative Law Judge in 6.5 percent of the cases.
A brief may be filed within 30 days after the filing of the Notice of Exception. 30-day extensions for filing a Notice of Exception may be granted “for cause.” In practice, such extensions are granted as a matter of course, provided a letter requesting the extension is received by the Division of Tax Appeals within the 30-day period for filing the Notice of Exception. The Tax Appeals Tribunal, also located in Troy, has three Commissioners who serve nine-year terms and who may be removed only for cause. Tax procedure in the administrative tax tribunals is governed by rules promulgated by the Tax Appeals Tribunal. In many respects, these rules resemble procedural rules found in the CPLR. Oral argument may be requested before the Tax Appeals Tribunal, and is routinely but not automatically granted.

VII. ARTICLE 78 REVIEW OF TAX APPEALS TRIBUNAL DECISIONS

Taxpayers wishing to contest adverse determinations of the Tax Appeals Tribunal generally have only one choice: an Article 78 proceeding to review the determination of a “state body” (i.e., the Tax Appeals Tribunal), pursuant to CPLR §7804. Article 78 review must be commenced within 4 months following an adverse decision by the Tax Appeals Tribunal. A CPLR Article 78 proceeding is the “dotted line” in the flowchart that brings the tax dispute out of administrative tribunal system and into the New York judicial court system. From a tax petitioner’s standpoint, Article 78 is far from perfect: it possesses treacherous statutes of limitations, it is inherently capable of providing only narrowly circumscribed relief, and it imposes onerous bonding requirements. Still, like the Spirit of St. Louis, Article 78 will at least take the taxpayer into the courtroom of the Appellate Division, where counsel may be able to convince the Court of reversible error below.
An Article 78 petition is returnable to the Appellate Division, 3rd Department, in Albany. If corporate sales tax is in issue, the taxpayer must deposit the tax or post an undertaking. No undertaking is required to seek review of personal income and corporate tax determinations, including responsible person determinations; however, assessment and collection of these taxes may proceed during the pendency of an Article 78 proceeding.
The actual Article 78 proceeding is commenced by service of a Notice of Petition and Petition upon the parties described above made returnable to the Appellate Division, 3rd Department, on at least 20 days’ notice. At least five days before the return date of the Petition, the Commissioner must appear by serving an answer, or otherwise moving to dismiss. (A motion to dismiss could be based upon a lack of jurisdiction for failing to properly serve all parties or for failing to obtain the required bond, or dismissal could result from failing to state a cause of action.)Judicial review is limited to the record before the agency — no new evidence may be submitted. The stipulated record and a brief must be filed within 9 months after the date of commencement of the proceeding.
CPLR § 217 provides that “a proceeding against a body . . . must be commenced within four months after the determination to be reviewed becomes final and binding.” Tax Law §2016 provides that the four-month period commences after notice of the Tax Appeals Tribunal is served. The statute then provides that “service by certified mail shall be complete upon deposit of such notice . . . in a post office.” Therefore, the taxpayer actually has less than four months from receipt of the notice in which to commence an Article 78 proceeding. The Department of Taxation keeps meticulous records, including affidavits by clerks, concerning the manner in which certified copies of decisions are mailed.
Arguments made by the taxpayer concerning either the taxpayer’s own timely mailing, or the Department’s failure in this regard, will in all likelihood fail. One might presume that only the Department of Taxation need be served with an Article 78 petition. This presumption would be erroneous: Tax Law § 2016 provides that “[t]he petitioner shall designate the tax appeals tribunal and the commissioner of taxation and finance as respondents in the proceeding for judicial review.” (The Tax Appeals Tribunal does not, however, participate in the proceeding.) Section 2016 continues, providing that “[i]n all other respects the provisions and standards of article seventy-eight of the [CPLR] shall apply.” CPLR §7804(c) provides that “notice of petition must be served upon the attorney general by delivery of such order or notice to an assistant attorney general.”
Therefore, the Department of Taxation, the Tax Appeals Tribunal and the Attorney General must all be served in an Article 78 proceeding. One might also assume that since the taxpayer may be served with notice of the Tax Appeals Tribunal decision by certified mail, the taxpayer could, similarly, commence an Article 78 proceeding by serving the three required recipients by certified mail. This is not the case: Although CPLR §307(2) does provide that personal service may be effected upon a state agency (i.e., Department of Taxation and Tax Appeals Tribunal) by certified mail, § 307(1) appears to require personal delivery by a process server upon the Attorney General.
Additionally, one more trap awaits the unwary regarding service of process by certified mail: CPLR §307(2) provides that such service is not effective unless “the front of the envelope bears the legend “URGENT LEGAL MAIL.” Given the tangle of statutory provisions governing service, it would appear far preferable to serve all parties personally by process server, rather than to serve by certified mail and hope that all statutory requirements have been met. Although the taxpayer may have contested the deficiency to the Tax Appeals Tribunal without paying any disputed tax, this courtesy of the New York Legislature ends at the filing of the Article 78 petition, at least with respect to some types of tax.
Thus, a jurisdictional prerequisite to instituting an Article 78 proceeding involving, inter alia, sales tax or real property transfer gains tax, is the filing of a bond to cover contested amounts and court costs. Although a bond is not required in order to initiate an Article 78 proceeding based upon deficiency relating to income tax, the Department may nevertheless assess and collect a deficiency during the pendency of such an Article 78 proceeding. If the Department decides to assess tax during the proceeding, the taxpayer must either pay the deficiency or file a bond (a letter of credit may also be acceptable to the Department) pending ultimate disposition of the case.
Although it may seem unjust for the Appellate Division to dismiss meritorious cases on procedural grounds such as the failure to serve the Article 78 petition in the proper manner — and perhaps it is unjust — a body of case law has evolved which makes it virtually impossible for a court to entertain a petition which suffers from jurisdictional defects. The petition must be verified (CPLR §7804) and must comply with all provisions of the CPLR which govern pleadings.
Thus, it must make factual allegations in separately numbered paragraphs and must state a legally cognizable cause of action, or the action will be susceptible to a motion to dismiss. The Court of Appeals held in Spodek v. New York State Com’r. of Taxation and Finance, 628 N.Y.S.2d 256 (1995), that the commencement-by-filing provisions in CPLR §304 apply to proceedings originating in the Appellate Division. Thus, before service of the Article 78 petition on the required recipients, the Petition must be filed (and an index number purchased) from the Clerk of the Appellate Division.
After purchasing the index number, personal service (preferably by a process server) must be made on the recipients. After such service is complete, proof of such service must be filed with the Appellate Division “not later than 15 days after the date on which the [four-month] statute of limitations expires.” CPLR § 306(b) Pursuant to Tax Law § 2016, the taxpayer must include as part of the petition (1) the determination of the Administrative Law Judge (ALJ), (2) the decision of the Tax Appeals Tribunal, (3) the transcript of the hearing (if any) before the ALJ, and (4) any exhibit or document submitted into evidence at any stage in the proceeding. Judicial review of the agency determination will be limited to a review of the record.
After issue has been joined (i.e., the Department has served an answer or moved to dismiss), and within nine months of the date of the Notice of Petition, the taxpayer must file with the Appellate Division an original and nine copies of a reproduced full record, as well as ten copies of the taxpayer’s brief. In reviewing the determination of the Tax Appeal Tribunal, CPLR §7803 provides that the determination will be upheld if it is supported by “substantial evidence.” In addition, the burden of proof is generally on the taxpayer to show that the agency determination was arbitrary or capricious, or not supported by the evidence. This includes responsible person determinations made under the income and sales tax laws for corporate officers and employees.
After submission of the record and brief, oral argument is scheduled. Taxpayer’’s counsel is generally allowed 15 minutes for oral argument. Approximately six weeks later, the Court will render a full opinion or memorandum decision. The prevailing party will then draft a proposed order for execution by the Appellate Division Clerk. After service of this order with Notice of Entry, the nonprevailing party will then have 30 days in which to seek leave (permission) to appeal to the Court of Appeals. The Court of Appeals seldom grants leave to appeal in tax cases.

VIII. APPEALS TO COURT OF APPEALS

Appeals to the Court of Appeals may be taken either by permission or as of right. In either case, no oral argument on the motion is permitted. Appeals as of right may be taken where (i) two justices dissented on a question of law in favor of the taxpayer; or (ii) the issues in dispute directly involve a constitutional question. With respect to (i), it is not enough that there have been two dissenting judges; each must have advocated judgment in favor of the taxpayer based on questions of law. With respect to (ii), even where a constitutional question is presented, the appeal will be dismissed if the decision could have been decided on other grounds. Thus, a constitutional question cannot be raised solely to obtain jurisdiction.
A motion seeking permission to appeal may be based upon three grounds: (i) the decision conflicts with a prior Court of Appeals decision; (ii) a novel question is presented; or (iii) a question of substantial public importance is presented. Permission is typically sought under (ii) or (iii). The motion must include (a) a concise statement of facts; (b) a statement of the procedural history and a showing that the motion is timely; (c) a showing that the Court has jurisdiction; (d) an argument as to why the case merits review; and (e) an identification of portions of the record where the questions sought to be reviewed were preserved for appellate review. Within 10 days taking an appeal by right or by permission, the petitioner must “perfect” the appeal by filing a jurisdictional statement. The petitioner must then file and serve his brief, with the record and original exhibits. Leave to appeal to the Court of Appeals, rarely granted, may be sought if the taxpayer in the Appellate Division. In recent years, the U.S. Supreme Court has granted certiorari to relatively few petitioners involving substantive state tax issues.
The Appellate Division will affirm if it finds the decision was (i) supported by “substantial evidence” and was not (ii) erroneous, arbitrary or capricious. Following submission of the record and briefs, oral argument before five judges will be scheduled in the Appellate Division. Within 4 to 6 weeks, a decision will be handed down. An appeal to the Court of Appeals from an adverse decision of the Appellate Division must be taken within 30 days after being served with a notice of entry. Failure to timely take an appeal is a fatal jurisdictional defect that will foreclose all further relief. The Court of Appeals generally reviews only questions of law. However, it may also review the Appellate Division’s reversal of the administrative tribunal’s finding of fact or exercise of discretion.

IX. DECLARATORY RELIEF AGAINST DEPARTMENT OF TAXATION

Although the administrative dispute mechanism is fairly administered by competent judges, tax disputes often result in manifest unfairness to the taxpayer, since protest and filing deadlines are strictly enforced, notices are unclear, and unintended forfeiture of rights frequently occurs. Taxing statutes are narrowly construed and administrative tribunals have little or no equitable jurisdiction. Moreover, Article 78 proceedings are procedurally and substantively weighted against the taxpayer, the standard of review being the difficult to surmount “arbitrary and capricious” formulation. In the federal arena, suits against the IRS may proceed in federal courts only if the taxpayer has paid the tax and then sues for a refund; otherwise the taxpayer must litigate in Tax Court. The doctrine of sovereign immunity will, with few exceptions, pose an impenetrable bar resulting in dismissal of most actions brought by the taxpayer in federal court, except when expressly authorized by statute.
Yet, the doctrine of sovereign immunity exerts less pull in New York state courts. In fact, the Court of Appeals has expressly recognized that administrative remedies are not the sole method of contesting the validity of a taxation statute: “A tax assessment may be reviewed in a manner other than that provided by statute where the constitutionality of the statute is challenged or a claim is made that the statute by its own terms does not apply…” Slater v. Gallman, 377 N.Y.S.2d 448. Thus, even a taxpayer who has contested — and lost — in the administrative tribunals, may seek another “day in court” in state supreme court, a naturally more hospitable venue. Moreover, once in supreme court, the Department’s own counsel will mostly likely transfer the file to the Attorney General’s office to litigate the matter. Since the Attorney General may not have the same institutional loyalty to the Department, a satisfactory accord may be reached even where none was possible the Department’s counsel at the administrative tribunals stage.
Challenging the constitutionality of a taxing statute is difficult, as is succeeding in an argument that a taxing statute is unconstitutional or by its terms inapplicable. Nonetheless, the legislature is by no means incapable of enacting vague or unconstitutional statutues, and a serious challenge in supreme court may in the end vindicate the taxpayer’s interests. Thus, in Tennessee Gas Pipeline Company v. Urbach, 96 NY2d 124 (2001), a declaratory judgment action, the Court of Appeals reversed the Appellate Division and declared the gas import tax unconstitional as violative of the Commerce Clause.
In practice, a declaratory judgment action in state supreme court is commenced by filing a summons and complaint as in any other civil action. The usual rules of procedure as provided in the CPLR apply. Often, a complaint is brought on by an order to show cause (OSC) seeking injunctive relief and a stay of collection until a hearing has been held. The Department does not like to litigate outside of its administrative tribunal forum. Nevertheless, a taxpayer who seeks a declaratory judgment and alleges that a statute is unconstitutional or inapplicable is entitled to a judgment declaring the parties’ rights. The appellate division has held that it is improper to ““dismiss’ a complaint seeking a declaratory judgment, since the proper action is to declare that the statute is — or is not — constitutional. If there is a real question as to whether the statute is unconstitutional or inapplicable, the Attorney General, on its client’s — the Department’s — instruction, may seek to resolve the dispute without forcing the court to render a decision on the merits, which could further impede the Department’s efforts to collect tax against other similarly situated taxpayers if the Department were to lose and the statute were held to be inapplicable or unconstitutional.
Even if the taxpayer seeking a declaratory judgment appears unlikely to succeed on the merits, the mere presence of the taxpayer and his attorney in state supreme court with a Summons and an OSC against the Department and the Commissioner will more likely elicit the attention of an attorney or official with the power and inclination to settle the dispute than would the taxpayer on the receiving end of a telephone call from a collection agent. The declaratory judgment action can be an extremely useful device, especially where other viable options appear few.

Posted in New York State Tax Litigation, NYS Tax Litigation, Treatises | Tagged Article 78 Review Tax Appeals, BCMS Conciliation Conference, Matter of Chartair, New York State Division of Tax Appeals, New York State Tax Audits, NYS Sales Tax, NYS Sales Tax Disputes, NYS Tax Audits, tax appeals tribunal, Tax Appeals Tribunal Rules of Practice & Procedure | Leave a comment

Revision of New York Power of Attorney Law Takes Effect

Posted on April 2, 2013 by David L. Silverman, J.D., LL.M. (Taxation)

Revision of New York Power of Attorney Law Takes Effect

Effective 9/1/09, NY General Obligations Law §5-1501, which governs the content and execution of powers of attorney, was revised and amended. Powers executed prior this date remain valid, but are subject to the amended statute.

A power of attorney grants an agent appointed by the principal the authority to make legally binding decisions on the principal’s behalf. This instrument is invaluable should the principal later become incapacitated, since the appointment of a legal guardian, who can also make those decisions, requires plenary court proceedings.

The POA must now be signed, dated and acknowledged not only by the principal, but also by the agent. Under the new law, a POA is durable (i.e., not affected by later incapacity) unless it specifically provides otherwise. If a guardian is later appointed, the agent will account to the guardian rather than to the principal. The new POA contains an optional provision whereby the principal can appoint a “monitor” who may request records of transactions by the agent. The statute also provides for a special proceeding to compel an agent to produce records of receipts. Provisions relating to health care billing should allow the agent access to health care records in accordance with HIPPA privacy requirements.

A new “Statutory Major Gifts Rider” (SMGR), if executed simultaneously with the power of attorney, authorizes the agent to make legally binding major gifts on behalf of the principal. The SMGR must be executed simultaneously with the power of attorney, and with the same formalities governing the execution of a Will. The SMGR may also authorize the agent to “create, amend, revoke, or terminate an inter vivos trust.” The authority of the agent to create joint accounts or to modify a “Totten trust” may also be included in the SMGR. Small gifts ($500 or less) in a calendar year may be made by the agent without a SMGR. The SMGR may be modified to supplement or eliminate the default provisions provided by new law, provided they are not inconsistent with the default SMGR provisions. A conveyance of real property to a bona fide purchaser for less than adequate consideration would require a SMGR, since the conveyance would be in part a gift.

Under GOL §5-1504, acceptance of the statutory “short form” POA by banks and other third parties is now mandatory. A third party may not refuse to honor the power or SMGR without reasonable cause. The statute provides that it is unreasonable for a third party or bank to require its own form, or to object to the form because of the lapse of time between execution and acknowledgment. (Banks had sometimes insisted that their own powers be used, which created a problem where the principal had become incapacitated.) An attorney may certify that a photocopy of a duly executed power is a true copy, and banks must now accept that copy.

The statute requires that the agent, a fiduciary, observe a “prudent person standard of care,” and imposes liability for breaches of fiduciary duty. Fiduciary duties are imposed on agents appointed under all powers of attorney, including those executed prior to the effective date of the new law. The agent must maintain records and must make those records available within 15 days to a monitor, co-agent, certain governmental entities, a court evaluator, a guardian, or a representative of the principal’s estate. The statute expressly provides that the agent is entitled to compensation for his work. A mechanism is provided by which the agent may resign.

Posted in Estate Planning, Powers of Attorney | Tagged durable power of attorney, estate attorney, health care proxy, living will, new york revised power of attorney, power of attorney, revised power of attorney, tax attorney, tax lawyer | Leave a comment

Post Mortem Estate Tax Planning

Posted on April 2, 2013 by David L. Silverman, J.D., LL.M. (Taxation)

Post Mortem Estate Planning

Calculation and remittance of federal and NYS estate tax is of primary concern in administering an estate. An estate tax return must generally be filed within nine months of the decedent’s death, and payment must also accompany the Form 706. IRC § 6075. A request for an automatic six-month extension may be made on Form 4768. Such request must include an estimate of the estate tax liabilities. An extension of time to file does not expand the time in which the tax must be paid. However, a request for an extension of time to pay the estate tax may be made under IRC § 6161 or IRC § 6166.

New York State imports most of the information contained on the federal 706 onto its own estate tax return, Form ET-706. Since the New York State exemption amount is only $1 million, an estate must complete and submit a federal Form 706 along with the ET-706 whether or not the federal Form 706 is required to be filed with the IRS.

Under IRC § 6161, the IRS may, for “reasonable cause” or “undue hardship,” grant an extension of up to ten years to pay the estate tax. Treasury regulations provide examples of what may constitute reasonable cause or undue hardship. Under IRC §6166, an election may be made to pay estate tax in installments over 14 years, provided a “closely held business” interest exceeds 35 percent of the estate.

A failure-to-file penalty of 5 percent per month is imposed for each month the failure causes the return to be filed past the due date (including extensions). The penalty may not exceed 25 percent of the tax, and it may be waived for reasonable cause.

New York imposes a similar penalty under Tax Law § 685(a)(1), which may also be abated for reasonable cause. See 20 NYCRR § 2392.1(a)(1); § 2392.1(d)(5), and § 2392.1(h); and Matter of Northern States Contracting Co., Inc., DTA No. 806161, Tax Appeals Tribunal (1992), (“in determining whether reasonable cause and good faith exist, the most important factor to be considered is the extent of the taxpayer’s efforts to ascertain the proper tax liability”); and Matter of AILS Systems, Inc., DTA No. 819303, Tax Appeals Tribunal (2006), (the Tribunal took notice of the “hallmarks of reasonable cause and good faith,” which included “efforts to ascertain the proper tax liability.”

A failure-to-pay penalty of 0.5 percent per month is imposed for each month the failure causes payment to be made past the due date (including, if applicable, extensions for time to pay). The penalty may not exceed 25 percent of the tax, and it may be waived for reasonable cause. New York State imposes a similar penalty. Tax Law § 685(a)(2), which may also be abated for reasonable cause.

This penalty applies to all tax returns, including gift and estate tax returns. The penalty imposed is $1,000 or, if greater, one-half of the fee derived (or to be derived) by the tax return preparer with respect to the return. An attorney who gives a legal opinion is deemed to be a non-signing preparer. The fees upon which the penalty is based for a non-signing preparer could reference the larger transaction of which the tax return is only a small part.

Under IRC § 6321, a general tax lien may be imposed on all property owned by any person liable to pay any tax who neglects or refuses to pay such tax after a demand has been made. The general tax lien applies not only to all property owned by the taxpayer at the time the lien comes into effect, but also to all after-acquired property. Under IRC § 6322, the lien commences when the tax is assessed and continues until it becomes unenforceable by lapse of time. Under IRC § 6502, the period of collection is ten years.

Under IRC § 6324, a special estate tax lien attaches to all property which comprises part of the decedent’s estate at death. No formal assessment need be made in order to create this special lien. The special lien for estate taxes differs from the general tax lien under IRC § 6322 in that it expires 10 years from the date of death.

An executor is a fiduciary. If an estate possesses insufficient assets to pay the deceased’s debts, the government will have first priority in proceedings under Chapter 11. The IRS also has the power to proceed directly against a fiduciary for the payment of estate taxes if any assets of the estate have been distributed before the executor has obtained a release from liability. In correspondence from the IRS to an executor which the IRS seeks to hold liable for unpaid estate taxes, the IRS may reference 31 U.S.C. § 3713. This statute, which creates fiduciary liability, provides that the government must be paid first out of estate funds. The statute provides that “[a] representative of a person or an estate . . . paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment of unpaid claims of the Government.”

Although the statute does not create a lien per se, it does set forth a priority of payment. The statute would prevent the executor from paying any debts to others while debts are owing to the United States. The case law, though not uniform, has held that the distribution by an executor of assets would subject the executor to personal liability.

On the other hand, if no assets are distributed, the fiduciary does not bear personal responsibility for the payment of estate taxes. If the fiduciary distributes assets or sells assets and distributes the proceeds while estate tax liability exists, the IRS may hold the fiduciary liable for the payment of estate taxes.

The same procedures used by the IRS when collecting taxes from an estate are available in enforcing the personal liability of a fiduciary. Under IRC § 6901(c)(3), the IRS may assess taxes against a fiduciary until the expiration of the period for collection of the estate tax. Although the Code does not specifically provide for a collection period against a fiduciary, presumably the ten year collection period would be applicable.

The executor may request a discharge from personal liability within nine months of making such request. An executor so discharged cannot be held personally liable for any deficiency in the estate tax.

Beneficiaries of an estate also bear personal liability for unpaid estate taxes with respect to both probate and nonprobate assets. IRC §§ 6901(a)(1) and 6324(a)(2). Transferee liability cannot exceed the value of the assets on the date of transfer. Com’r v. Henderson’s Estate, 147 F.2d 619 (5th Cir. 1945). Under IRC § 6901(c), the IRS may impose transferee liability for one year after the expiration of the period of limitations for imposing liability on the transferor.

Under IRC § 2032(a), an executor may elect to value estate assets six months after the decedent’s date of death. This election, made on the estate tax return, can be useful if estate assets have depreciated between the date of death and the “alternate valuation date.” If the election is made to value estate assets on the alternate valuation date, it will apply to all estate assets. Once made, the election is irrevocable. Any assets sold during the six month period preceding the alternative valuation date are valued as of the date of sale or distribution.

An accurate valuation of estate assets is essential in determining the estate tax and withstanding an audit. If the IRS or NYS determines on audit that the value of assets reported is incorrect, not only will the estate tax liability increase, but penalties may apply. Valuation discounts that are successfully challenged by the IRS may result in tax deficiencies of a magnitude sufficient to attract underpayment penalties.

The value of stocks traded on an established exchange or over the counter is determined by calculating the mean between the highest and lowest quoted selling price on the date of the gift. Treas. Reg. §25.2512-2(b)(1). Publicly traded stocks reference their market value and should include the CUSIP (Committee on Uniform Identification Procedure). Valuation services provide historical information for a fee. Historical stock quotes are also available on the internet. If no sales on the valuation date exist, the instructions state that the mean between the highest and lowest trading prices on a date “reasonably close” to the valuation date may be used. If no actual sales occurred on a date “reasonably close” to the valuation date, bona fide bid and asked prices may be used. Treas. Reg. §20.2031-2(e) provides that a blockage discount may be applied where a large block of stock may depress the sales price.

As surprising as it may sound, real estate requires no appraisal or formal valuation. Although not required, if an appraisal if obtained, it should be attached to the return. Contrary to what clients often surmise, Treas. Reg. §25.2512-1 provides that local property tax values are not relevant unless they accurately represent the fair market value. Even though not required, a date of death valuation is often obtained in the event an audit may be anticipated. Generally, the value of real property is the price paid in an arm’s length transaction before the valuation date. If none exists, comparable sales may be used.

Treas. Reg. §25.6019-4 provides that a legal description should be such that real property may be “readily identified.” This would include a metes and bounds description (if available), the area, and street address.) When determining the fair market value of real property, valuation discounts for (i) lack of marketability; (ii) minority interest; (iii) costs of partition; (iv) capital gains; and certain other discounts may be taken into consideration.

Lack of marketability and minority discounts may be available for gifts of closely held stock. Rev. Rul. 59-60, an often-cited ruling, sets forth a list of factors to be considered when valuing closely held businesses: (i) the nature of the business and the history of the enterprise; (ii) the economic outlook in general and the condition and outlook of the specific industry in particular; (iii) the book value of the stocks and the financial condition of the business; (iv) the earning capacity of the company; (v) the dividend-paying capacity of the company; (vi) goodwill and other intangible value; (vii) sales of stock and the size of the block of stock to be valued; (viii) the market price of stocks of a corporation engaged in the same or a similar line of business having their stocks actively traded in a free open market, either on an exchange or otherwise. If the decedent was a key person in the closely held business, an additional discount may be applicable. Furman v. Com’r, T.C. 1998-157, recognized a key man discount of 10 percent where the services of the decedent were important in the business.

Closely held stocks should be valued by an appraiser. The fair market value of closely held stock is determined by actual selling price. If no such sales exist, fair market value is determined by evaluating the “soundness of the security, the interest yield, the date of maturity and other relevant factors.” Treas. Reg. §25.2512-2(f). The gift tax instructions (by analogy) state that complete financial information, including reports prepared by accountants, engineers and technical experts, should be attached to the return, as well as the balance sheet of the closely held corporation for “each of the preceding five years.”

Despite persistent opposition by the IRS, courts have consistently held that the cost of an eventual capital gains tax reduces the value of the gross estate. Jelke v. Com’r, a typical case, allowed a full built-in capital gains discount. Discounts applicable to closely held corporations may well exceed those for partnerships or LLCs, since not only may built-in capital gains depress the value of the stock, but less of a market may exist for stock in a closely held family business compared to an interest in an LLC or partnership, which typically hold interests real estate.

No appraisal is required for tangible property such as artwork, but if one is obtained, it should be attached to the return. Rev. Rul. 96-15 delineates appraisal requirements, which include a summary of the appraiser’s qualifications, and the assumptions made in the appraisal. If no appraisal is made, the return should indicate how the value of the tangible property was determined. The provenance of artwork will greatly affect its transfer tax value. As is the case with large blocks of stock, if large blocks of artwork are gifted, a blockage discount may apply. Calder v. Com’r, 85 TC 713 (1985). The IRS does not recognize fractional interest discounts in the context of artwork, since the IRS believes that there is “essentially no market for selling partial ownership interests in art objects. . .” Rev. Rul. 57-293; see Stone v. U.S., 2007 WL 1544786, 99 AFTR2d 2007-2292 (N.D. Ca. 5/25/07), (District Court found persuasive testimony of IRS Art Advisory Panel, which found discounts applicable to real estate inapplicable to art; court allowed only 2 percent discount for partition.)

Planning for and preserving the marital deduction is always an important objective. However, it reaches its zenith when the estate tax is in a state of flux, as is currently the case. By making a “QTIP” election, the Executor will enable the decedent’s estate to claim a full marital deduction. To qualify, the trust must provide that the surviving spouse be entitled to all income, paid at least annually, and that no person may have the power, exercisable during the surviving spouse’s life, to appoint the property to anyone other than the surviving spouse. Since the Executor may request a 6 month extension for filing the estate tax return, the Executor in effect has 15 months in which to determine whether to make the QTIP election.

Electing QTIP treatment is not always advantageous. Inclusion of trust assets in the estate of the first spouse to die may “equalize” the estates. Equalization may have the effect of utilizing the full exemption amount of the first spouse and avoiding higher rate brackets that apply to large estates. Still, the savings in estate taxes occasioned by reason of avoiding the highest tax brackets may itself be diminished by the time value of the money used to pay the estate tax at the first spouse’s death. On the other hand, if no marital deduction is claimed, and the second spouse dies soon after the first, a credit under IRC §2013 may reduce the estate tax payable at the death of the surviving spouse.

The executor may elect QTIP treatment for only a portion of the trust, with the nonelected portion passing to a credit shelter trust. If such a partial QTIP election is anticipated, separating the trusts into one which is totally elected, and second which is totally nonelected, may be desirable. In this way, future spousal distributions could be made entirely from the elected trust, which would reduce the size of the surviving spouse’s estate.

QTIP property is included in the estate of the surviving spouse at its then FMV. The estate of the surviving spouse is entitled to be reimbursed for estate tax paid from recipients of trust property. IRC § 2207A. Reimbursement is calculated using the highest marginal estate tax bracket of the surviving spouse. The failure to seek reimbursement is treated as gift made to those persons who would have been required to furnish reimbursement. However, the failure by the estate of the surviving spouse to seek reimbursement will not be treated as a gift if the decedent’s will expressly waives the right of reimbursement with respect to QTIP property.

Care must be taken when making the QTIP election, since the IRS takes the position that if the election taken on the initial federal and state estate tax returns was defective — but the IRS did not notice the defect and allowed the marital deduction — the assets will nevertheless be includible in the estate of the surviving spouse under IRC §2044. In other words, the IRS takes the position that the assets are includible in the estate of the surviving spouse even if the estate of the first spouse would have incurred no estate tax had the QTIP election not been made. See PLR 9446001.

On the other hand, a properly made but unnecessary QTIP election will occasion of fewer harsh results. Under Rev. Proc. 2001-38, an unnecessary QTIP election for a credit shelter trust will be disregarded to the extent that it is not needed to eliminate estate tax at the death of the first spouse. Similarly, a mistaken overfunding of the QTIP trust will not cause inclusion of the overfunded amount in the estate of the surviving spouse. TAM 200223020.

Since the estate tax is a “tax inclusive,” as opposed to the gift tax, which is “tax exclusive,” there is a distinct tax benefit to making lifetime, as opposed to testamentary, transfers. Distributions from a QTIP trust can assist in accomplishing this objective.

A surviving spouse’s right to withdraw principal may be used by the surviving spouse to make gifts. Treas. Reg. §20.2056(b)-7(d)(6) provides: “The fact that property distributed to a surviving spouse may be transferred by the spouse to another person does not result in a failure to satisfy the requirement of IRC § 2956(b)(7)(B)(ii)(II).”

The trust instrument may limit the right of the surviving spouse no right to withdraw principal, and may grant the trustee discretion to make distributions of principal. If such discretionary distributions were disallowed, the gifts could be brought back into the estate of the surviving spouse. However, Estate of Halpern v. Com’r, T.C. Memo. 1995-352 held that discretionary distributions made to the surviving spouse which were later used to make gifts would not result in inclusion in her estate. However, the trust may not require the surviving spouse to apply the principal to make gifts, as this would as this would constitute an impermissible limitation on the spouse’s unqualified right to income during his or her lifetime.

The IRS has ruled that granting the surviving spouse a power to withdraw the greater of 5 percent of trust principal or $5,000 per year (a “five and five” power) will not result in disqualification of QTIP treatment. If the spouse were given an unlimited right to withdraw principal, the QTIP trust could morph into a general power of appointment trust. While the unlimited marital deduction would be secure, the decedent’s right to choose who would ultimately receive the property would effectively be defeated if the surviving spouse appointed all of the property during his or her lifetime.

If greater rights of withdrawal were given to the surviving spouse under an intended QTIP, but those rights did not rise to the level of an unrestricted right to demand principal, the trust would be neither fish nor fowl. The trust would constitute neither a general power of appointment trust nor a QTIP trust. This would result in a trust “meltdown” for tax purposes. The marital deduction would be lost and the entire trust would be brought back into the estate of the first spouse to die, and the decedent’s power to determine ultimate trust beneficiaries would be severely curtailed.

To illustrate, assume at a time when the applicable exclusion amount is $5 million, father has an estate of $8 million, and mother has an estate of $2 million. Father (who has made no lifetime gifts) wishes to give his four children $6 million outright. If $6 million were left to the children, $1 million would be subject to federal estate tax, and $5 million would be subject to New York estate tax. The total estate tax liability would be approximately $1.15 million [($1 million x .35) + ($5 million x. .16)].

This would leave $4.85 million of the $6 million bequest to the children. If instead of leaving $6 million to the children outright, father were to leave only $1 million to them outright, and place $5 million in a trust qualifying for a QTIP election, federal and New York estate tax would be eliminated at father’s death. If mother’s estate were not to increase during her lifetime, no federal estate tax would be owed at her death, since here estate would not exceed the (combined) applicable exclusion amount of $10 million.

If the surviving spouse made absolutely no taxable gifts during her lifetime, the New York State estate tax of $800,000 deferred by the marital deduction ($5 million x .16) would be payable upon her death by her estate. If, however, the surviving spouse were to make gifts to the children during her lifetime, the eventual New York State estate tax could be diminished or even eliminated.

Consider the effect of the surviving spouse, would now be worth $7 million, making gifts of $0.25 million to each child per year for a few years. Each year, the surviving spouse would report a gift of $1 million for federal gift tax purposes. Since the gift and estate taxes have been reunified, no transfer tax liability would result for federal purposes.

Since New York State has no gift tax, no New York transfer tax liability would arise by reason of the surviving spouse making yearly gifts of $1 million. Each year in which the surviving spouse made those gifts, the eventual New York State estate tax liability would be reduced by approximately $160,000.

Although this strategy appears sound — and perhaps nearly unimpeachable — for tax purposes, it must be remembered that for the strategy to work, the surviving spouse must actually make the gifts contemplated. The cost of insuring against the risk of the surviving spouse not making the contemplated gift is the transfer tax savings, since any attempt to impose a legal obligation on the surviving spouse to make the gifts would result in the QTIP failing.

Accordingly, this strategy would likely not work in second marriage situations, or in situations where the surviving spouse could not be depended upon to make the contemplated gratuitous transfers. Although these considerations do circumscribe the utility of this strategy, the risk of the surviving spouse not making the gifts could conceivably be reduced to an acceptable level by leaving a substantial sum of money to the children outright, and while leaving some to the trustee of a QTIP trust.

The strategy of making gifts consisting of distributions of principal depends upon the availability of funds for distribution. Principal may consist of land, or interests in a closely held company — in other words, property that cannot easily be distributed. Even if principal could otherwise be made, the trust may not provide for distributions of principal, or may limit the Trustee’s ability to make distributions of principal. A QTIP trust need only provide that all income be distributed to the surviving spouse.

If the surviving spouse has no right to withdraw principal and the trustee cannot make discretionary distributions of principal, gift planning is more difficult, but may still possible by falling back to a release or a disclaimer. The surviving spouse may contemplate making a transfer of his or her lifetime income interest. However, IRC §2519 may pose a problem with a release. As is the case with gifts of principal, although there must be no prearranged agreement that the spouse will make a transfer of his or her lifetime income interest, use of a QTIP trust can leverage the applicable exclusion amount by leaving assets to the surviving spouse who would then be expected — but not required — to make a gift of the qualifying income interest.

Reliance on a disclaimer is inherently risky for two reasons: First, a “qualified” disclaimer must be made within a relatively short time period; and second, the disclaimant must not have accepted any of the benefits of the property to be disclaimed. This requirement may pose problems. While a nonqualified disclaimer may still be possible, such a disclaimer will be less attractive from a tax perspective.

Let us first examine a release of the surviving spouse’s right to income. The surviving spouse can make a gift of — or release — her qualifying income interest in the trust property to which she would otherwise be entitled. This would constitute a garden variety gift under IRC §2511. However, the disposition would also trigger IRC §2519.

IRC §2519 provides that “any disposition of all or part of a qualifying income interest for life in any property to which this section applies is treated as a transfer of all interests in the property other than the qualifying income interest.” Therefore, were wife to gift one-half of her qualifying income interest, she would be deemed to have made a gift of the entire remainder interest in trust, in addition to the gift of the income interest. Under IRC §2207A(a), she would have a right to recover gift tax attributable to the deemed transfer of the remainder interest under IRC §2519.

IRC §2519(a) provides that the disposition of “all or part of a qualifying income interest for life in any property” for which a QTIP election was made is treated as a “transfer of all interests in such property other than the qualifying income interest.” IRC §2519 provides that if a surviving spouse disposes of a qualifying income interest in trust property, he is deemed also to have disposed of all interests in that property other than the qualifying income interest. If the surviving spouse releases part of his qualifying income interest, he will be treated, under IRC §2519, as having disposed of all trust property. Therefore, were spouse to gift one-half of a qualifying income interest, he or she would be deemed to have also made a gift of the entire remainder interest in the trust, in addition to the gift of the income interest.

This means that a gift tax would be imposed on all trust property, even though the income interest released by the surviving spouse pertained only to part of the trust property. The harshness of the rule is unjustified from a transfer tax standpoint. If the statute required reporting as a gift only that portion of the trust property which related to the qualifying income interest disposed of — which most commentators believe is correct — then the estate of the surviving spouse would include the trust assets not previously reported as a gift. Nevertheless, this is not the case, and a gift of a partial qualifying income interest will in fact trigger the harsh result mandated by IRC §2519, and if no curative measure is found to alter this result, the surviving spouse would be required to report as a gift the entire value of the QTIP trust. Fortunately, the IRS allows taxpayer to sever QTIP trusts prior to the surviving spouse disposing of a partial income interest in the QTIP. This avoids the harshness of the “transfer of all interests” rule. See PLRs 200438028, 200328015.

To illustrate, assume the surviving spouse is 85 years old and releases his qualifying income interest in a trust worth $1 million. Under the prevailing applicable federal rate (AFR) and using actuarial tables, the surviving spouse is deemed to have made a gift of $180,000. For purposes of IRC §2511, the surviving spouse has made a taxable gift of $180,000. For purposes of IRC §2519, the surviving spouse is deemed to have made a gift of $820,000, i.e., all interests in the property other than the qualifying income interest. Under IRC §2207A, the QTIP trust would have a right to recover gift tax attributable to the deemed transfer of the remainder interest under IRC §2519.

Under IRC §2207A, if the surviving spouse is deemed to have made a gift under IRC §2519, he has a right of reimbursement for gift taxes paid. Proposed regulations provide for “net gift” treatment of the deemed gift of a remainder interest under IRC §2519. (A net gift occurs if the donee is required, as a condition to receiving the gift, that he pay any gift taxes associated with the gift.) Since the value of what the donees receive is reduced by the gift tax reimbursed to the surviving spouse, the amount of the gift reportable is also reduced by the reimbursement. The gift taxes so paid by the donee may be deducted from the value of the transferred property to determine the donor’s gift tax.

Assume the value of the income and remainder interest in a QTIP trust is $500,000. Wife makes a gift of one-half of her income interest, or $250,000. Under IRC § 2519, she will be deemed to have made a gift of the entire $500,000. An interrelated calculation gives the result that at a 50 percent gift tax rate, a gift of $333,333 would result in a gift tax of $166,667. Backing into the hypothetical, a gift of $500,000 would result in a net gift of $333,333, since the value of the gift is reduced by the gift tax, which in this case is $166,667. In this case, $500,000 is reduced by $166,667, to leave $333,333.

Although releasing a qualifying income interest may be effective if the surviving spouse cannot withdraw principal and the trustee cannot make discretionary distributions of principal, spendthrift limitations which appear in most testamentary trusts may pose problems. An income beneficiary of a spendthrift trust generally cannot assign or alienate an income interest once accepted. See, e.g., Hartsfield v. Lescher, 721 F.Supp. 1052 (E.D. Ark. 1989). Is this the end of the road? Not necessarily.

If a spendthrift limitation bars the spouse from alienating the income interest, it may still be possible to disclaim the interest under New York’s disclaimer statute, EPTL 2-1.11. Note that if instead of releasing the qualifying income interest, the surviving spouse had made a qualified disclaimer with respect to that interest, no gift would have resulted. New York law requires that the disclaimer be made within nine months, but the time period may be extended for “reasonable cause”.

To constitute a qualified disclamer under federal law, the disclaimer must meet the requirements of state law, and it must be made within nine months. If a New York Surrogate extended the time for reasonable cause, the renunciation would not constitute a qualified disclaimer under IRC §2519. Rather, the disclaimer would be a “nonqualified disclaimer.” A nonqualified disclaimer could trigger IRC §2519, since such a disclaimer would be ineffective for federal transfer tax purposes.

IRC §2044 requires that remaining QTIP assets be included in the gross estate of the surviving spouse. However, those assets are not aggregated with other assets in the estate of the surviving spouse. Thus, in Estate of Bonner v. U.S., 84 F.3d 196 (5th Cir. 1996) the surviving spouse at her death owned certain interests outright, and others were included in her estate pursuant to IRC §2044. The estate claimed a fractional interest discount, which the IRS challenged. The Fifth Circuit held that assets included in the decedent spouse’s gross estate which were held outright were not aggregated with those included under IRC §2044 by virtue of the QTIP trust. The estate was entitled to take a fractional interest discount. Apparently, even if the surviving spouse were a co-trustee of the QTIP trust, no aggregation would be required. See FSA 200119013.

Under Bonner, could the trustee of the QTIP trust distribute a fractional share of real estate owned by the QTIP trust in order to generate a fractional interest discount at the death of the surviving spouse? Possibly, but in Bonner, the surviving spouse owned an interest in certain property, and then became the income beneficiary of a QTIP trust which was funded with interests in the same property. The surviving spouse in Bonner already owned a separate interest in the same property. This situation is distinguishable from one in which the QTIP trusts owns all of the interest in a certain piece of property, and then distributes some of that interest to the surviving spouse. In that case, it is less clear that the IRS would not succeed in attempting to aggregate the interests in the same property for the purpose of precluding the estate from claiming a valuation discount. The case would be weaker if the distribution of the fractional interest to the surviving spouse had, as one of its principal purposes, no intention other than to support a later assertion of a fractional interest discount.

A QTIP trust may be asset protected with respect to corpus. The income interest would be subject to creditor claims.

Disclaimers can be useful in accomplishing post-mortem estate planning. A person who disclaims property is treated as never having received the property for gift or estate or tax purposes under IRC § 2516. Although the disclaimer statute appears in Chapter 11, the gift tax provisions, a disclaimer under IRC § 2516 is also effective for income tax purposes.

The significance of a disclaimer is that had the disclaimed property been received and then transferred, gift tax liability would attach. If the diclaimer meets the requirements of IRC § 2518, the disclaimant is treated as never having received the property. A fortiori, the disclaimant will have made no transfer.

Although Wills frequently contain express language advising a beneficiary of a right to disclaim, such language is superfluous, or advisory in nature, since a beneficiary may always disclaim.

For a disclaimer to achieve the intended federal tax result, it must constitute a “qualified disclaimer”“ under IRC §2518. If the disclaimer is not a “qualified,” the disclaimant is treated as having received the property and then having made a taxable gift. Treas. Regs. §25.2518-1(b).

Under the NY EPTL, as well as under the law of most states, the person disclaiming is treated as if he had predeceased the donor, or died before the date on which the transfer creating the interest was made. Neither New York nor Florida is among the ten states which have adopted the Uniform Disclaimer of Property Interests Act (UDPIA).

For a disclaimer to be qualified under IRC § 2518, the disclaimer must meet the following requirements:

(i) The disclaimer must be irrevocable and unqualified. PLR 200234017 stated that a surviving spouse who had been granted a general power of appointment had not made a qualified disclaimer of that power by making a QTIP election on the estate tax return, since the estate tax return did not evidence an irrevocable and unqualified refusal to accept the general power of appointment.

(ii) The disclaimer must be in writing, identify the property disclaimed and be signed by the disclaimant or by his legal representative. Under EPTL § 2-1.11(f) the right to disclaim may be waived if in writing;

(iii) The disclaimer must be delivered to either the transferor or his attorney, the holder of legal title, or the person in possession. Copies of the disclaimer must be filed with the surrogates court having jurisdiction of the estate. If the disclaimer concerns nontestamentary property, the disclaimer must be sent via certified mail to the trustee or other person holding legal title to, or who is in possession of, the disclaimed property;

(iv) The disclaimer must be made within nine months of the date of transfer or, if later, within nine months of the date when the disclaimant attains the age of 21. It is possible that a disclaimer might be effective under the EPTL, but not under the Internal Revenue Code. For example, under EPTL §2-1.11(a)(2) and (b)(2), the time for making a valid disclaimer may be extended until “the date of the event by which the beneficiary is ascertained,” which may be more than 9 months after the date of the transfer. In such a case, the disclaimer would be effective under New York law but would result in a taxable gift for purposes of federal tax law;

(v) The disclaimer must be made at a time when the disclaimant has not accepted the interest disclaimed or enjoyed any of its benefits. Consideration received in exchange for making a disclaimer would constitute a prohibited acceptance of benefits under EPTL §2-1.11(f); and

(vi) The disclaimer must be valid under state law, so that it passes to either the spouse of the decedent or to a person other than the disclaimant without any direction on the part of the person making the disclaimer. EPTL §2-1.11(g) provides that a beneficiary may accept one disposition and renounce another, and may renounce a disposition in whole or in part. One must be careful to disclaim all interests, since the disclaimant may also have a right to receive the property by reason of being an heir at law, a residuary legatee or by other means. In this case, if the disclaimant does not effectively disclaim all of these rights, the disclaimer will not be a qualified disclaimer with respect to the portion of the disclaimed property which the disclaimant continues to have the right to receive. IRC §2518-2(e)(3).

(Note: An important exception to this rule exists where the disclaimant is the surviving spouse. In that case the disclaimed interest may pass to the surviving spouse even if she is the disclaimant. Treas. Reg. §25.2518-2(e); EPTL §2-1.11(e).)

IRC § 2518(c) provides for what is termed a “transfer disclaimer.” The statute provides that a written transfer that meets requirements similar to IRC § 2518(b)(2) (timing and delivery) and IRC § 2518(b)(3) (no acceptance) and which is to a person who would have received the property had the transferor made a qualified disclaimer, will be treated as a qualified disclaimer for purposes of IRC §2518. The usefulness of IRC § 2518(c) becomes apparent in cases where federal tax law would permit a disclaimer, yet state law would not.

To illustrate, in Estate of Lee, 589 N.Y.S.2d 753 (Surr. Ct. 1992), the residuary beneficiary signed a disclaimer within nine months, but the attorney neglected to file it with the Surrogates Court. The beneficiary sought permission to file the late renunciation with the court, but was concerned that the failure to file within nine months would result in a nonqualified disclaimer for federal tax purposes.

The Surrogates Court accepted the late filing and opined (perhaps gratuitously, since the IRS is not bound by the decision of the Surrogates Court) that the transfer met the requirements of IRC § 2518(c). [Note that in the converse situation, eleven states, but not New York or Florida, provide that if a disclaimer is valid under IRC § 2518, then it is valid under state law.]

Treas. Reg. § 20.2055-2(c) provides that a charitable deduction is available for property passing directly to a charity by virtue of a qualified disclaimer. If the disclaimed property passes to a private foundation of which the disclaimant is an officer, he should resign, or at a minimum not have any power to direct the disposition of the disclaimed property. The testator may wish to give family members discretion to disclaim property to a charity, but yet may not wish to name the charity as a residuary legatee. In this case, without specific language, the disclaimed property would not pass to the charity. To solve this problem, the will could provide that if the beneficiary disclaims certain property, the property would pass to the specified charity.

Many existing wills contain “formula” clauses which allocate to the credit shelter trust the maximum amount of money or property that can pass to beneficiaries (other than the surviving spouse) without the imposition of federal estate tax. If the applicable exclusion amount is exceeds the value of the estate, the surviving spouse could be disinherited unless the beneficiaries of the credit shelter trust disclaim part of their interest. To the extent such interest is disclaimed and passes to the surviving spouse (either by the terms of the Will or by operation of law) it will qualify for the marital deduction.

Another use of the disclaimer in a similar situation is where either the surviving spouse renounces a power of appointment so that the trust will qualify as a QTIP trust. A surviving spouse who is granted a general power of appointment over property intended to qualify for the marital deduction under IRC § 2056(b)(5) may disclaim the general power, thereby enabling the executor to make a partial QTIP election. This ability to alter the amount of the marital deduction allows the executor to finely tune the credit shelter amount. If both spouses die within nine months of one another, a qualifying disclaimer by the estate of the surviving spouse can effect an equalization of estates, thereby reducing or avoiding estate tax.

Consider the effect of a qualified disclaimer executed within nine months by a surviving spouse of his lifetime right to income from a credit shelter trust providing for an outright distribution to the children upon his death. If, within nine months of his spouse’s death, the surviving spouse decides that he does not need distributions during his life from the credit shelter trust, and disclaims, he will treated as if he predeceased his wife. If the will of the predeceasing wife provides for an outright distribution of the estate to the children if husband does not survive, then the disclaimer will have the effect of enabling the children to receive the property that would have funded the credit shelter trust at the death of the first spouse.

Disclaimers can also be utilized to increase basis in inherited assets by causing property that would otherwise pass by operation of law, to pass through a predeceasing spouse’s estate. Assume surviving spouse paid no consideration for certain property held jointly with that spouse’s predeceasing spouse. If second spouse disclaims within nine months, the property would pass through the predeceasing spouse’s probate estate. If the Will provided for a residuary bequest to the surviving spouse, that spouse would inherit the disclaimed property with a full basis step up under the terms of the Will.

A qualifying disclaimer executed by the surviving spouse may also enable the predeceasing spouse to fully utilize the applicable exclusion amount. For example, assume the will of the predeceasing spouse leaves the entire estate of $10 million to the surviving spouse (and nothing to the children). Although the marital deduction would eliminate any estate tax liability on the estate of the first spouse to die, the eventual estate of the surviving spouse would likely have an estate tax problem. By disclaiming $5 million, the surviving spouse would create a taxable estate in the predeceasing spouse, which could then utilize the full applicable exclusion amount of $5 million. The taxable estate of the surviving spouse would be reduced to $5 million.

To refine this example, the will of the first spouse to die could provide that if the surviving spouse disclaims, the disclaimed amount would pass to a family trust of which the surviving spouse has a lifetime income interest. The Will could further provide that if the spouse were also to disclaim her interest in the family trust, the disclaimed property would pass as if she had predeceased.

The grantor may wish to ensure that the named trustee will be liberal in making distributions to his children. By giving the child beneficiary the unrestricted right to remove the trustee, this objection can be achieved. However, if the child has the ability to remove the trustee, and the trust grants the trustee the power to make distributions to the child that are not subject to an ascertainable standard, the IRS may impute to the child a general power of appointment. If the IRS were successful, the entire trust could be included in the child’s taxable estate. To avoid this result, the child could disclaim the power to remove the trustee. This might, of course, not accord with the child’s nontax wishes.

If a surviving spouse is given a “five and five” power over a credit shelter or family trust, 5 percent of the value of the trust will be included in her estate under IRC §2041. However, if the surviving spouse disclaims within nine months, nothing will be included in his or her estate

At times, all beneficiaries may agree that it would be better if no trust existed. If all current income trust beneficiaries (which might include the surviving spouse and children) disclaim, the trust may be eliminated. In such a case, the property could pass to the surviving spouse and the children outright. Note that if minor children are income beneficiaries, their disclaimers would require the the appointment (and consent) of guardians ad litem.

Under New York law, if one disclaims, and by reason of such disclaimer that person would cause one to retain Medicaid eligibility, such disclaimer may be treated as an uncompensated transfer of assets equal to the value of any interest disclaimed. This, in turn, could impair Medicaid eligibility. In some states, if a disclaimer defeats the encumbrance or lien of a creditor, it may be alleged that the disclaimer constitutes a fraudulent transfer. Not so in New York and California, where a disclaimer may validly be utilized o defeat the legitimate claims of creditors. In Florida, the result in contra: A disclaimer cannot prevent a creditor from reaching the disclaimed property.

Until 1999, it had been unclear whether a qualified disclaimer could defeat the claim of the IRS. The 2nd Circuit in United States v. Camparato, 22 F3d. 455, cert. denied, 115 S.Ct. 481 (1994) held that it did not, finding that a federal tax lien attached to the “right to inherit” property. Therefore, a subsequent disclaimer did not affect the federal tax lien under IRC §6321. Resolving a split among the circuits, the Supreme Court, in Drye v. United States, 528 U.S. 49 (1999), adopted the view of the Second Circuit, finding that the federal tax lien attached to the property when created, and that any subsequent attempt to defeat the tax lien by disclaimer would not eliminate the lien.

Bankruptcy courts have generally reached the same result as in Drye. The disclaimer of a bequest within 180 days of the filing of a bankruptcy petition has in most bankruptcy courts been held to be a transfer which the trustee in bankruptcy can avoid. Many courts have held that even pre-petition disclaimers constitute fraudulent transfers which the bankruptcy trustee can avoid. If the Drye rationale were applied to bankruptcy cases, it would appear that pre-petition bankruptcy disclaimers would, in general, constitute transfers which the bankruptcy trustee could seek to avoid. However, at least one bankruptcy court, Grassmueck, Inc., v. Nistler (In re Nistler), 259 B.R. 723 (Bankr. D. Or. 2001) held that Drye relied on language in IRC §6321, and should be limited to tax liens.

The acceptance of benefits will preclude a disclaimer under state law. EPTL §2-11(b)(2) provides that “a person accepts an interest in property if he voluntarily transfers or encumbers, or contracts to transfer or encumber all or part of such interest, or accepts delivery or payment of, or exercises control as beneficial owner over all or part thereof . . . ”

Similarly, a qualified disclaimer for purposes of IRC § 2518(c) will not occur if the disclaimant has accepted the interest or any of its benefits prior to making the disclaimer. Treas. Regs. §25.2518-2(d)(1) elaborates, providing that actions “indicative” of acceptance include (i) using the property or interest in the property; (ii) accepting dividends, interest, or rents from the property; or (iii) directing others to act with respect to the property or interest in the property. However, merely taking title to property without accepting any benefits associated with ownership does not constitute an acceptance of benefits. Treas. Regs. §25.2518-2(d)(1). Nor will a disclaimant be considered to have accepted benefits merely because under local law title to property vests immediately in the disclaimant upon the death of the decedent. Treas. Regs. §25.2518-2(d)(1).

The acceptance of benefits of one interest in property will not, alone, constitute an acceptance of other separate interests created by the transferor and held by the disclaimant in the same property. Treas. Regs. §25.2518-2(d)(1). Thus, TAM 8619002 advised that a surviving spouse who accepted $1.75x in benefits from a joint brokerage account effectively disclaimed the remainder since she had not accepted the benefits of the disclaimed portion which did not include the $1.75x in benefits which she had accepted.

The disclaimant’s continued use of property already owned is also not, without more, a bar to a qualifying disclaimer. Thus, a joint tenant who continues to reside in jointly held property will not be considered to have accepted the benefit of the property merely because she continued to reside in the property prior to effecting the disclaimer. Treas. Regs. §25.2518-2(d)(1); PLR 9733008.

The existence of an unexercised general power of appointment in a will before the death of the testator is not an acceptance of benefits. Treas. Regs. §25.2518-2(d)(1). However, if the powerholder dies having exercised the power, acceptance of benefits has occurred. TAM 8142008.

The receipt of consideration in exchange for exercising a disclaimer constitutes an acceptance of benefits. However, the mere possibility that a benefit will accrue to the disclaimant in the future is insufficient to constitute an acceptance. Treas. Regs. §25.2518-2(d)(1); TAM 8701001. Moreover, actions taken in a fiduciary capacity by a disclaimant to preserve the disclaimed property will not constitute an acceptance of benefits. Treas. Regs. §25.2518-2(d)(2).

A disclaimant may make a qualified disclaimer with respect to all or an undivided portion of a separate interest in property, even if the disclaimant has another interest in the same property. Thus, one could disclaim an income interest while retaining an interest in principal. PLR 200029048. So too, the right to remove a trustee was an interest separate from the right to receive principal or a lifetime special power of appointment. PLR 9329025. PLR 200127007 ruled that the waiver of the benefit conferred by right of recover under IRC §2207A constituted a qualified disclaimer.

A disclaimant makes a qualified disclaimer with respect to disclaimed property if the disclaimer relates to severable property. Treas. Regs. §25.2518-3(a)(1)(ii). Thus, (i) the disclaimer of a fractional interest in a residuary bequest was a qualified disclaimer (PLR 8326033); (ii) a disclaimer may be made of severable oil, gas and mineral rights (PLR 8326110); and (iii) a disclaimer of the portion of real estate needed to fund the obligation of the residuary estate to pay legacies, debts, funeral and administrative expenses, is a severable interest. PLR 8130127.

For disclaimants (other than a surviving spouse) who are residuary legatees or heirs at law, the disclaimant must be careful not only to disclaim the interest in the property itself, but also to disclaim the residuary interest. If not, the disclaimer will not be effective with respect to that portion of the interest which the disclaimant has the right to receive. §25.2518-2(e)(3). To illustrate, in PLR 8824003, a joint tenant (who was not a surviving spouse) was entitled to one-half of the residuary estate. The joint tenant disclaimed his interest in the joint tenancy, but did not disclaim his residuary interest. The result was that only half of the disclaimed interest qualified under IRC §2518. The half that passed to the disclaimant as a residuary legatee did not qualify.

The disclaimant may not have the power, either alone or in conjunction with another, to determine who will receive the disclaimed property, unless the power is subject to an ascertainable standard. However, with respect to a surviving spouse, the rule is more lenient. Estate of Lassiter, 80 T.C.M. (CCH) 541 (2000) held that Treas. Reg. §25.2518-2(e)(2) does not prohibit a surviving spouse from retaining a power to direct the beneficial enjoyment of the disclaimed property, even if the power is not limited by an ascertainable standard, provided the surviving spouse will ultimately be subject to estate or gift tax with respect to the disclaimed property.

An impermissible power of direction exists if the disclaimant has a power of appointment over a trust receiving the disclaimed property, or if the disclaimant is a fiduciary with respect to the disclaimed property. §25.2518-2(e)(3). However, mere precatory language not binding under state law as to who shall receive the disclaimed property will not constitute a prohibited “direction”. PLR 9509003.

Limits on the power of a fiduciary to disclaim may have tax implications. PLR 8409024 stated that trustees could disclaim administrative powers the exercise of which did not “enlarge or shift any of the beneficial interests in the trust.” However, the trustees could not disclaim dispositive fiduciary powers which directly affected the beneficial interest involved. This rule limits the trustee’s power to qualify a trust for a QTIP election.

In some states, representatives of minors, infants, or incompetents may disclaim without court approval. EPTL §2-1.11(c) permits renunciation on behalf of an infant, incompetent or minor. However such renunciation must be “authorized” by the court having jurisdiction of the estate of the minor, infant or incompetent. In Estate of Azie, 694 N.Y.S.2d 912 (Sur. Ct. 1999), two minor children were beneficiaries of a $1 million life insurance policy of their deceased father. The mother, who was the guardian, proposed to disclaim $50,000 of each child. The proposed disclaimer would fund a marital trust and would save $40,000 in estate taxes. The Surrogate, disapproving the proposed disclaimer, stated that the disclaimer must be advantageous to the children, and not merely to the parent.

A disclaimer may be valid under the EPTL but not under the Code. EPTL §2-1.11-(b)(2) provides that a renunciation must be filed with the Surrogates court within 9 months after the effective date of the disposition, but that this time may be extended for “reasonable cause.” EPTL §2-1.11(a)(2)(C) provides that the effective date of the disposition of a future interest “shall be the date on which it becomes an estate in possession.” Since under IRC §2518, a renunciation must be made within nine months, the grant of an extension by the Surrogates court of the time in which to file a renunciation might result in a valid disclaimer under the EPTL, but under federal tax law. Similarly, while the time for making a renunciation of a future interest may be extended under EPTL §2-1.11(a)(2)(C), such an extension would likely be ineffective for purposes of IRC §2518.

The rules for disclaiming jointly owned property can generally be divided into two categories. The first category consists of joint bank, brokerage and other investment accounts where the transferor may unilaterally regain his contributions. With respect to these, the surviving co-tenant may disclaim within nine months of the transferor’s death but, under the current EPTL, only to the extent that the survivor did not furnish consideration.

The second category comprises all other jointly held interests. With respect to all other interests held jointly with right of survivorship or as tenants by the entirety, a qualified disclaimer of the interest to which the disclaimant succeeds upon creation must be made no later than nine months after the creation.

A qualified disclaimer of an interest to which the disclaimant succeeds upon the death of another (i.e., a survivorship interest) must be made no later than nine months after the death of the first tenant. This is true (i) regardless of the portion of the property contributed by the disclaimant; (ii) regardless of the portion of the property included in the decedent’s gross estate under IRC §2040; and (iii) regardless of whether the property is unilaterally severable under local law.

A bill has been introduced in the New York legislature which would conform New York law to federal law. EPTL 2-1.11(b)(1) now provides that a surviving joint tenant or tenant by the entirety may not disclaim the portion of property allocable to amounts contributed by him with respect to such property. Under the proposed legislation, the surviving joint tenant or tenant by the entirety may disclaim to the extent that such interest could be the subject of a qualified disclaimer under IRC § 2518.

Transfer made by gift or by sale are frequently expressed by formula to avoid adverse gift tax consequences that could result if the value of the transferred interest were successfully challenged by the IRS on audit. There are two principal types of formula clauses: “value adjustment” clauses and “value definition” clauses.

A value adjustment clause provides for either an increase in the price of an asset or a return of a portion of the transferred asset to the donor if the value of the transferred asset is determined to be greater than anticipated at the time of the transfer. However, this technique, which utilizes a condition subsequent to avoid a transfer in excess of that which is contemplated, is generally ineffective. A number of courts have ruled this would constitute a condition subsequent which would have the effect of undoing a portion of a gift. That would be against public policy and therefore void.

A value definition clause defines the value of the gift or sale at the time of the transfer. The agreement between the parties does not require a price adjustment or an adjustment in the amount of property transferred. The transaction is complete, but the extent of the property sold or given is not fully known at that time. An adjustment on a revaluation by the IRS will simply cause an adjustment of the interests allocated between the transferor and transferee(s). A value definition clause could allocate the transferred amount among non-taxable transferees, which could include charities, QTIP trusts, or outright transfers to spouses.

The Eighth Circuit, in Estate of Christiansen, approved the use of formula disclaimers. __F.3d__, No. 08-3844, (11/13/09); 2009 WL 3789908, aff’’g 130 T.C. 1 (2008). Helen Christiansen left her entire estate to her daughter, Christine, with a gift over to a charity to the extent Christine disclaimed her legacy. By reason of the difficulty in valuing limited partnership interests, Christine disclaimed that portion of the estate that exceeded $6.35 million, as finally determined for estate tax purposes. Following IRS examination, the estate agreed to a higher value for the partnership interests. However, by reason of the disclaimer, this adjustment simply resulted in more property passing to the charity, with no increase in estate tax liability. The IRS objected to the formula disclaimer on public policy grounds, stating that fractional disclaimers provide a disincentive to audit.

In upholding the validity of the disclaimer, the Court of Appeals remarked that “we note that the Commissioner’s role is not merely to maximize tax receipts and conduct litigation based on a calculus as to which cases will result in the greatest collection. Rather, the Commissioner’s role is to enforce the tax laws.” Although “savings clauses” had since Com’r. v. Procter, 142 F.2d 824 (4th Cir.), cert. denied, 323 U.S. 756 (1944), rev’g and rem’g 2 TCM [CCH] 429 (1943) been held in extreme judicial disfavor on public policy grounds, carefully drawn defined value formula clauses have seen a remarkable rehabilitation. So much so that the Tax Court in Christiansen concluded that it “did not find it necessary to consider Procter, since the formula in question involved only the parties’ current estimates of value, and not values finally determined for gift or estate tax purposes.”

New York estate tax can be paid out of either the marital trust or the credit shelter trust. Since estate tax imposed by New York will again qualify as a deduction for federal estate tax purposes beginning in 2011, it is inconsequential for federal estate tax purposes whether New York estate taxes are paid out of the marital share or the credit shelter share. However, New York estate tax liability will differ depending on the source of the payment.

If payment is made from the credit shelter share, the amount that can ultimately pass free from federal estate tax will be reduced. This could result in greater exposure to future federal estate tax. If New York estate taxes are paid out of the marital share, a loss of the marital deduction will cause an immediate increase in New York estate tax. However, credit shelter share will not be reduced.

New York imposes estate tax on a pro rata basis to nonresident decedents with property subject to New York estate tax. New York imposes no estate tax on nonresidents’ intangibles. TSB-M-92 provides that “New York has long maintained a tax policy that encourages nonresidents to keep their money, securities and other intangible property in New York State.” TSB-A-85(1) further provides that shares of stock of a New York corporation held by a nonresident are not subject to New York estate tax since shares of stock are considered intangible personal property. TSB-A-08(1)M, provides that an interest of a nonresident in an S Corporation which owns a condominium in New York is an intangible asset provided the S Corporation has a legitimate business purpose. Presumably, if the S Corporation had only a single shareholder, and its only purpose was to hold real estate, New York could attempt to “pierce the veil” of the S Corporation and subject the condominium to New York estate tax in the estate of the nonresident.

Real property is generally taxed in the state where it is situated. Since LLC or partnership interests are intangibles, they would not be subject to New York estate tax. Therefore, nonresidents who own New York real property might consider converting the real property to personal property by contributing the real might consider converting the real property to personal property by contributing the real proprty to an LLC and taking back membership interests.

The mechanics of electing QTIP treatment are fairly simple. An election is made by completing Schedule M on the estate tax return. The executor Separate New York State QTIP Election. One New York State estate tax problem in connection with generously funding a QTIP was recently resolved by the New York State Department of Finance in a manner beneficial to New York residents.

Previously, New York had not recognized a “state-only” QTIP election. That is, if no QTIP election were made on the 706 (and no election would be made in 2010 since none is needed to eliminate the federal tax in 2010), no separate New York QTIP election was possible.

i. Separate NYS QTIP Election TSB-M-10(1)M, issued in February, 2010, now provides that a QTIP Election for New York State purposes when no Federal Return is Required. “In certain cases, an estate is required to file a return for New York State estate tax but is not required to file a federal return. This may occur if there is no federal estate tax in effect on the decedent’s date of death or if the decedent died while the federal estate tax was in effect but the value of his or her gross estate was too low to require the filing of a federal estate tax return. In either instance, and if applicable, the estate may still elect to take a marital deduction for Qualified Terminal Interest Property (QTIP) on a pro-forma federal estate tax return that is attached to the New York State estate tax return.” For dates of death on or after February 1, 2000, the New York State estate tax conforms to the federal Internal Revenue Code of 1986 (IRC) including all amendments enacted on or before July 22, 1998. Because the IRC in effect on July 22, 1998, permitted a QTIP election o be made for qualifying life estates for a surviving spouse (see IRC § 2056(b)(7)), that election may be made for purposes of a decedent’s New York State estate tax return even if a federal return is not required to be filed. If no federal return is required, the election must be made on the pro-forma federal estate tax return attached to the New York State return. As provided in IRC § 2056(b)(7), once made, this election is irrevocable. In addition, the value of the QTIP property for which the election is made must be included in the estate of the surviving spouse. See IRC § 2044 and New York Tax Law § 954.

Real estate and farm property is generally valued at fair market value based on its highest and best use for estate tax purposes. If elected, the special use valuation election under § 2032A can reduce the estate tax value of qualified real property or an existing business based on its actual or “special” use. The greatest decrease in value allowed in 2011 is $1 million. The qualified real property must be located in the U.S. and have been used by the decedent or a member of his or her family who materially participated in the trade or business for at least five of the eight years preceding the date of death, disability or retirement. To qualify for the election, the adjusted value of the real or personal property must equal 50 percent or more of the adjusted value of the gross estate. In addition, the adjusted value of the real property must equal 25 percent or more of the adjusted value of the gross estate. The property also must pass from the decedent to a “qualified heir”, as defined in IRC §§ 2032A(e)(1) and (e)(2). The election is made by the executor on the estate tax return and once made, is irrevocable. A properly executed “notice of election” and a written agreement signed by each person with an interest in the property must be attached to the estate tax return. Any estate can be recaptured if, within 10 years after the decedent’s death, the property is disposed of, or if the qualified heir ceases to use the property for the qualified use. The written agreement subjects all qualified heirs to personal liability for payment of the recaptured estate tax.

Where a QTIP election is made by the executor, the donor’s estate takes the marital deduction. Normally, the surviving spouse is considered to be the the transferor for GST tax purposes. However, the executor of the donor spouse may make a second election to treat the donor spouse as the transferor for GST tax purposes. IRC § 2652(a)(3).

Expenses of administration actually an necessarily incurred in administering the estate are deductible. IRC § 2053; Treas. Regs. § 1.2053-3.

Some estate administration expenses may be deducted either on the estate tax return or on the fiduciary income tax return. Under IRC § 642(g), no income tax deduction for expenses is allowed unless the executor files a statement with the IRS agreeing not to claim those expenses as deductions on the estate tax return. The election may be made on an item-by-item basis. Treas. Regs. § 1.642(g)-2. The election is irrevocable after the statement is filed. The waiver statement must be filed before the statute of limitations for assessment on the income tax return runs. Therefore, if it is unclear on which return it would be preferable to take the expenses, it may be prudent to wait until the statute of limitations is about to expire.

Expenses deductible either on the estate or fiduciary income tax return (or split between them) include (i) appraisal expenses; (ii) court costs; (iii) executor’s commissions; (iv) attorney’s fees; (v) accountant’s fees; (vi) selling expenses; and (vii) costs of preserving, maintaining and distributing estate property. Medical expenses paid within a year of death may be deducted on either the 706 or the 1041, but may not be split.

Some expenses may be deducted only on the estate tax return. These include (i) personal expenses that are not deductible for income tax purposes (e.g., funeral expenses); (ii) income and gift taxes; (iii) or expenses incurred in producing tax-exempt income.

Other expenses are deductible only on the decedent’s final income tax return. These include (i) net operating losses of the decedent; (ii) capital losses of the decedent; and (iii) unused passive activity losses of the decedent.

Deductions in respect of a decedent, which are the mirror-image of income in respect of a decedent, may be deducted on the fiduciary income tax return under IRC § 691(b), as well as the estate tax return under IRC § 2053. These deductions consist of income tax deductions which accrued prior to the decedent’s death, but which were never deducted on an income tax return. They are deductible under IRC § 2053 as expenses that reduce the size of the gross estate. These include interest expenses, taxes, and investment expenses that were incurred prior to death.

Any loss carryovers which exist when the estate terminates may be utilized by the beneficiaries under IRC § 642(h).

In most cases, if there is an estate tax liability, it will be preferable to claim the expense on the decedent’s estate tax return, since the estate tax rate exceeds the income tax rate. The estate tax is also due nine months after the date of the decedent’s death, whereas the income tax may be deferred until a later year. However, the disparity has been reduced of late since the maximum estate tax rate is now 35 percent. If there is no estate tax liability — either because the taxable estate does not exceed the applicable exclusion amount, or the taxable estate has been vanquished by the marital deduction — then taking the deduction on the income tax return will be the only viable option.

All federal circuits, except the Eighth, have long adhered to the view that post-mortem events must be ignored in valuing claims against an estate. Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929) held that “[t]empting as it is to correct uncertain probabilities by the now certain fact, we are of the opinion that it cannot be done, but that the value of the wife’s life interest must be established by the mortality tables.”

However, Proposed Regs. §20.2053-1(a)(1) state that post mortem events must be considered in determining amounts deductible as expenses, claims, or debts against the estate. Those proposed regulations limit the deduction for contingent claims against an estate by providing that an estate may deduct a claim or debt, or a funeral or administration expense, only if the amount is actually paid. An expenditure contested by the estate which cannot not be resolved during the period of limitations for claiming a refund will not be deductible. However, the executor may file a “protective claim” for refund, which would preserve the estate’s ultimate right to claim a deduction under IRC §2053(a). A timely filed protective claim would thus preserve the estate’s right to a refund if the amount of the liability is later determined and paid.

Although a protective claim would not be required to specify a dollar amount, it would be required to identify the outstanding claim that would be deductible if paid, and describe the contingencies delaying the determination of the liability or its actual payment. Attorney’s fees or executor’s commissions that have not been paid could be identified in a protective claim. Prop. Regs. §20.2053-1(a)(4).

A second limitation on deductible expenses also applies: Estate expenses are deductible by the executor only if approved by the state court whose decision follows state law, or established by a bona fide settlement agreement or a consent decree resulting from an arm’s length agreement. This requirement is apparently intended to prevent a deduction where a claim of doubtful merit was paid by the estate.

The proposed regulations suffer from some defects. To illustrate one, assume the will of the decedent dying in 2008 whose estate is worth $10 million, designates that $2 million should fund the credit shelter trust, with the remainder funding the marital trust. Assume also the existence of a $3 million contested claim against the estate. If the executor sets apart $3 million for the contested claim and files a protective claim for refund, the marital trust would be funded with only $5 million, instead of $8 million. If the claim is later defeated, the $3 million held in reserve could no longer be used to fund the marital trust, and would be subject to estate tax.

Alternatively, the executor could simply fund the marital trust with $8 million, not set aside the $3 million, and not file a protective claim. If the claim is later determined to be valid, payment could be made from assets held in the marital trust. However, by proceeding in this manner, the IRS could later assert that the marital deduction was invalid.

Some have speculated that the existence of a large protective claim might also tempt the IRS to look more closely at other valuation issues involving other expenses claimed by the estate as a hedge against the possibility of a large future deduction by the estate.

Posted in Federal Estate Tax, Post Mortem Estate Tax Planning | Tagged disclaimers, estate attorney, estate planning attorney, estate tax, estate tax return, Post mortem estate tax planning, tax attorney, tax lawyer | Leave a comment

2010 Like Kind Exchange Decisions and Rulings

Posted on April 2, 2013 by David L. Silverman, J.D., LL.M. (Taxation)

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

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
Failed Exchanges

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.

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Like Kind Exchanges of Real Estate Under IRC §1031 — Treatise (January 2011)

Posted on April 2, 2013 by David L. Silverman, J.D., LL.M. (Taxation)

PDF: Like Kind Exchange Treatise

Like Kind Exchanges of
Real Estate Under IRC §1031

January 1, 2011

TABLE OF CONTENTS

I. Introduction 1
A. Section 1031 is Power Tax-Deferral Technique 1
B. Congressional Action to Limit Scope of Section 1031 Exchanges 3
C. Property Excluded From Like Kind Exchange Treatment 5
D. Holding Period of Replacement Property “Tacked” 9
E. Tax Deferral Becomes Permanent if Taxpayer Dies 10
F. Potential Capital Gains Tax Savings 10
G. Loss of Cost Basis in Tax-Free Exchange 16

II. Requirements for Like Kind Exchange 16
A. Transaction May Be Structured For Exchange Treatment 16
B. Federal Reporting Requirements 17
C. Substantial Authority 18
D. IRC Section 6694 Preparer Penalties Change Reporting Landscape 18
E. New York State Reporting Requirements 20
F. California’s “Clawback” Rule 20
G. Oregon Imposes Statutory Rule 22
H. Contrast Sale-Leaseback Transactions 22
I. Requirement That Taxpayer Be the Same 23

III. Qualified Use Requirement 23
A. Temporal Aspect 23
B. Attributing Entity’s Qualified Use to Taxpayer 25
C. Attributing Taxpayer’s Qualified Use to Entity 27
D. Summary of Qualified Use Cases, Rulings, Statutes and Regulations 28
E. Disregarded Entities 30
F. PLR 200908005 – Substituted Qualified Intermediaries 31
G. Acquiring All Interests of Disregarded Entity 31
H. Vacation Homes, Residences and “Qualified Use” Issues 32

IV. Determining Whether Replacement Property is of “Like Kind” 35
A. Exchanges Involving Real Estate Enjoy Rarefied Status 35
B. Exchanges of Tangible Personal Property Limited 39
C. Real Property Containing Personal Property 41
D. Exchanges of Intangible Property 42

V. Basis of Property Received in Exchange 45
A. Calculation of Basis Adjustments in Like Kind Exchange 45
B. Basis Allocated First to Nonqualifying Property 46
C. Illustration of Basis Allocation Where Boot Received in Exchange 47
D. Allocation of Consideration Received Where Boot is Given in Exchange 48
E. Transfers Involving Multiple Assets 49

VI. Gain or Loss in Like Kind Exchange 51
A. Realized Gain Recognized to Extent of Boot Received 51
B. Generally No Gain if Taxpayer “Trades Up” 52
C. Installment Method of Reporting Boot Gain 53
D. Treatment of Boot Given in Like Kind Exchange 55
E. Closing Costs Permitted to be Expensed Reduce Amount Realized 55
F. Items Not Permitted to be Expensed But Permitted to Offset Boot 56
G. ABA Position on Boot Gain 57
H. Treatment of Expenses and Transactional Items Paid by QI 57

VII. Treatment of Liabilities 74
A. Relief From Liabilities Treated as Cash Received 74
B. Liability Netting Rules Summarized 76

VIII. Consequences of Refinancing Before and After Exchanges 76
A. Regulations Do Not Prohibit Pre-Exchange Financing 76
B. Hypothetical Illustration of Pre-Exchange Financing 76
C. Pre-Exchange Financing With Replacement Property Less Risky 77
D. Post-Exchange Financing Less Risky 78

IX. Interest Tracing Rules 80
A. Interest Expense on Refinanced Indebtedness 80

X. Depreciation and Recapture Issues 82
A. Section 1245 Property Defined 82
B. Section 1250 Property Defined 82
C. Hospital Corporation of America 82
D. Effect of Reclassification on Like Kind Requirement 84
E. Minimizing Section 1245 Property Relinquished 87
F. Section 1250 Recapture Issues Rare 87
G. Allocation of Basis Upon Reclassification 88

XI. Related Party Transactions 88
A. In General 88
B. Operation of Statute 90
C. “Disposition” Defined 91
D. Does Section 1031(f) Address Only Two-Party Swaps? 94
E. Cases and Rulings Interpreting Related Party Rules 94
F. Reporting Related Party Exchanges 99

XII. Multi-Party Exchanges 100
A. Rationale 100
B. Dynamics of Multi-Party Exchange 100
C. Problems with Multi-Party Exchanges 101
D. Use of QI Safe Harbors in Simultaneous Exchanges 104

XIII. Deferred Exchanges Under the Regulations 104
A. Deferred Exchanges Sanctioned in Starker v. U.S. 104
B. Statutory Basis for Deferred Exchanges: TRA 1984 104
C. Replacement Property Must Be Acquired Within 180 Days 110
D. Actual or Constructive Receipt Negates Like-Kind Exchange 111
E. Safe Harbors Avoid Problem of Constructive Receipt 112
F. Security or Guarantee Arrangements 112
G. Qualified Escrow or Trust Accounts 113
H. Qualified Intermediaries 114
I. Tax Treatment of Exchange Funds Held by QI 120
J. Interest and Growth Factors 122
K. Traps for the Unwary 122
L. Installment Sale Reporting of Deferred Exchanges 123
M. Inadvertent Opt-Out of From Installment Method 125
N. Rev. Proc 2010-14 – Installment Method for Failed Exchanges 125
O. Structuring Down Payment 126
P. Regulation of Qualified Intermediaries 127
Q. Required Legal Documentation 127

XIV. Reverse Exchanges 129
A. History of Reverse Exchanges 129
B. Theory of IRS Challenge to Reverse Exchanges 130
C. Rationale for Engaging in Reverse Exchange 130
D. Promulgation of Revenue Procedure 2000-37 Safe Harbor 131
E. Exchange First Format 142
F. Exchange Last Format 143
G. Typical Steps in Exchange Last Reverse Exchange 143
H. Non-Safe-Harbor Exchange Last in Build to Suit 145
I. Comparison of Exchange Last and Exchange First Reverse Exchanges 146
J. Cases and Rulings Involving Reverse Exchanges 147

XV. Build to Suit 151
A. Taxpayer Must Avoid Actual or Constructive Receipt 151
B. Role of Qualified Intermediary 152
C. Improvements Require More Than 180 Days 152
D. Cases and Rulings Involving Build-to-Suit Exchanges 152

XVI. Tenancy-in-Common Interests and Undivided Fractional Interests 155
A. Increased Popularity of TIC Interests 155
B. Role of Sponsor 155
C. Tax Issues Involving TICs 156
D. IRS Response to TIC Activity: Revenue Procedure 2002-22 158
E. Conditions for Obtaining Tenancy In Common Ruling 158
F. Requirements Limit Practicality 160
G. Revenue Ruling 2004-86 – Delaware Statutory Trusts 163

XVII. Partnership and LLC Exchange Transactions 166
A. Exchanges of LLC Interests Barred 166
B. Distinguish: Exchanges by LLC or Partnership 166
C. Problem of Liabilities and Section 752 167
D. At-Risk Issue Involving LLCs 167
E. Passive Loss Issues Involving LLCs 168
F. Partnership Must Avoid Termination 168
G. Partnership Exchange Followed by Direct-Deeding to Partners 169
H. Distributing Interests Followed by Exchange “Drop and Swap” 169
I. Exchange Followed by Distribution “Swap and Drop” 172
J. External Buy-Out of Partner’s Interest 177
K. Elect Out of Subchapter K 179
L. May Partners Make Special Allocations of Gain? 180
M. Summary of Hypothetical Partnership Transactions 183

INDEX 184

Like Kind Exchanges of
Real Estate Under IRC §1031

I. Introduction

A. Section 1031 is Power Tax-Deferral Technique

Over the past three decades, Congress has enacted various Code provisions and modified existing provisions in an attempt to impede taxpayers’ ability to reduce income tax liability when engaging in real property transactions. The Section 1031 “like-kind” exchange is a powerful tax-deferral technique that has, for the most part, escaped rigorous Congressional scrutiny. The statute permits a taxpayer to relinquish property (often real property) held for “productive use in a trade or business” or for “investment” and exchange it for “like kind” replacement property, without recognizing gain or loss. A cash sale of property followed by a cash purchase of like kind property will not constitute a like kind exchange. Halpern v. U.S., 286 F.Supp. 255 (ND Ga. 1968); PLR 7918018. To constitute an “exchange” within the meaning of the statute, the transaction must be a “reciprocal transfer of property, as distinguished from a transfer of property for a money consideration only.” Regs. § 1.1002-1(d). The rationale for nonrecognition in this circumstance stems from Congress’ view that tax should not be imposed on realized gains where the investment continues in nearly identical form.

1. Terminology

For purposes of this outline, the terms “exchange” and “like kind exchange” are synonymous, as are the terms “exchange treatment” and “like kind exchange treatment.” “Replacement” property refers to property the taxpayer acquires in the like kind exchange; “relinquished” property refers to property which the taxpayer transfers. The term “taxpayer” refers to the owner of property engaging in a like kind exchange. The term “cash buyer” refers to the person acquiring the relinquished property for cash. The term “cash seller” refers to the person supplying the replacement property. The cash buyer acquiring legal title or the cash seller relinquishing legal title may do so in a direct exchange with the taxpayer, or through an intermediary, who may, depending upon the context, be either an “accommodator” in a multi-party simultaneous exchange under Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979) and Revenue Ruling 77-297; a “qualified intermediary” (QI) in a deferred exchange under Regs. § 1.1031(k)-1; an “exchange accommodation titleholder” (EAT) in a safe harbor “reverse exchange” under Revenue Procedure 2000-37; or an “accommodator” in a “non safe harbor” reverse exchange. The term “boot” refers to nonqualifying property received in a like kind exchange. Nonqualifying property may consist of (i) cash; (ii) relief from liabilities; (iii) property that could be exchanged under Section 1031, but is not of like kind to the relinquished property; or (iv) or property expressly excluded from exchange treatment under Section 1031(a)(2).

2. Write-Off Periods Long by Historical Standards

During the 1980’s, various declining balance methods combined with short write-off periods (i.e., 15 years in 1981 for both nonresidential and residential real estate) created large current depreciation deductions for investments in real property. Depreciation benefits for real estate were significantly curtailed by the Tax Reform Act of 1986. Since 1994, depreciation for all real property has been limited to the straight line method. Nonresidential real estate is now depreciated over 39 years, longer than at any time since 1953. Residential real estate is depreciated over 27½ years, longer than at any time since 1971. (“Depreciation and the Taxation of Real Estate,” Congressional Research Service, Report for Congress, May 12, 1999; Janet G. Gravelle, Senior Specialist in Economic Policy, Government and Finance Division.)

B. Congressional Action to Limit Scope of Section 1031 Exchanges

Section 1031 exchanges have been characterized by Congress as “tax expenditures,” which are defined as spending programs channeled through the tax system. The Joint Committee on Taxation estimated that like kind exchange transactions would reduce federal revenues by $9.1 billion during fiscal years 2005-2009. Joint Committee on Taxation, Estimated Budget Effects of the Conference Agreement for H.R. 4520, The “American Jobs Creation Act of 2004,” JCX-69-04, Oct. 2004. Given the significant cost to the Treasury of like kind exchanges, it is not surprising that Congress has attempted to limit the number of situations in which the statute could apply, and has imposed more stringent statutory requirements for qualifying “like kind” property.

1. Section 121 Exclusion Compared

Section 121 provides an exclusion of $250,000 ($500,000 for married persons filing joint returns) of capital gain if during the 5-year period ending on the sale date, the taxpayer owned and used the property as a principal residence for periods aggregating 2 years or more.

a. Tax Court Holds Residences Cannot be Exchanged

Since personal residences are often held for investment, can they be exchanged tax-free? Although some have recently raised this possibility, it appears to be an unwarranted reading of the statute. See, Bolker v. Com’r 81 T.C. 782 (1983), aff’d, 760 F.2d 1039 (9th Cir. 1985). (Taxpayer cannot convert business property to personal use property and claim exchange treatment.) The Tax Court also denied like kind exchange treatment for a vacation home used by the taxpayer but never rented. Barry E. Moore, T.C. Memo, 2007-134. Moore held that property held for personal use, such as a principal residence or a “second home” used solely for personal enjoyment cannot qualify under Section 1031 because it is neither held for productive use in a trade or business nor for investment.

2. Congress Limits Use of Sections 1031 and 121

The Jobs Creation Act of 2004 curtailed the use of Sections 121 and 1031 to achieve tax windfalls. Consider taxpayer A who owns both a California home with an adjusted basis is $100,000, and fully depreciated Manhattan rental real estate with a zero basis. The California home is worth of $600,000 and the Manhattan property is valued at $500,000. Both are unencumbered. On January 1, 2006, A swaps the Manhattan rental property for a Florida condo also worth $500,000. A then sells the California residence and excludes $500,000 of gain. After the Florida condo (whose basis is zero) has been rented for six months, A converts it to his principal residence, on June 30, 2006. Two years later, on June 30, 2008, A sells the Florida condo, now A’s principal residence, still worth $500,000, and again excludes $500,000 of gain. In two and a half years, A has disposed of the zero-basis Manhattan rental property at no gain, and used the Section 121 exclusion twice, to exclude a total of $1 million in capital gain. Section 121(d)(10) now provides that no residence exclusion may be claimed in connection with the sale of a residence acquired within the preceding five years in a like kind exchange. A would now have to wait until January 1st, 2011 – five years from the January 1st, 2006 like kind exchange – before claiming the residence exclusion with respect to the Florida condo.

C. Property Excluded From Like Kind Exchange Treatment

Although most like kind exchanges involve real property, tangible personal and even intangible property may be exchanged. However, not all property, even if held for productive use in a trade or business or for investment, may be exchanged under Section 1031. Tax-free exchanges of the following property are expressly excluded by Section 1031(a)(2):

A. Section 1031(a)(2)(A) excludes
stock in trade or other property held primarily for sale;

B. Section 1031(a)(2)(B) excludes
stocks, bonds, or notes;

C. Section 1031(a)(2)(C) excludes
other securities or evidences of indebtedness or interest;

D. Section 1031(a)(2)(D) excludes
interests in a partnership;

E. Section 1031(a)(2)(E) excludes
certificates of trust or beneficial interests; and

F. Section 1031(a)(2)(F) excludes
choses in action.

1. Stock in Trade or Property Held Primarily For Sale

a. Primary Purpose Determinative

b. Dealers in Real Estate

Real estate dealers cannot exchange real property held as inventory, since such property would not have been held for the productive use in a trade or business or for investment. Whether one is a dealer in real estate involves a “facts and circumstances” inquiry, which considers (i) the reason and purpose for which the property was acquired; (ii) the length of time the property was held; (iii) the sales activity over a period of time; (iv) the amount of gain realized on the sale when compared to gains realized by other dealers or investors; and (v) the extent to which the taxpayer or his agents or employees engaged in sales activities by developing or improving the property by soliciting customers, or by advertising.

(1) Baker Enterprises v. Com’r.

Baker Enterprises v. Com’r. held that property was held “primarily for sale” by a real estate dealer even though it was not held as dealer property. Critical in the court’s decision was its finding that the taxpayer classified the property as a “work in progress” rather than an investment, on its books. T.C. Memo, 1998-302.

2. Stock, Bonds, or Notes

The exchange of stock does not qualify for exchange treatment. However, Section 1036(a) provides for nonrecognition of gains or losses derived from exchanges of common-for-common or preferred-for-preferred stock in the same corporation. In addition, exchanges of stock may be tax-free in the context of corporate reorganizations pursuant to Sections 354 et seq.

3. Other Securities or Evidences of Indebtedness or Interest

Section 1236(c) defines “securities” as corporate stock or a corporate note, bond, debenture, or right to purchase any of the foregoing.

4. Choses in Action

A “chose in action” is a claim or debt upon which a recovery may be made in a lawsuit. It does not constitute present possession, but merely a right upon which suit may be brought. Some contract rights, such as professional baseball player contracts, are deemed to constitute property used in a trade or business and may qualify as like kind exchange property. Revenue Ruling 67-380, 1967-2 C.B. 291. However, a right to receive royalties under an oil payment contract was held to be merely an assignment of income rather than “property,” and would therefore not constitute qualifying exchange property under Section 1031. Com’r v. P.G. Lake, Inc., 356 U.S. 260 (1958).

5. Certificates of Trust or Beneficial Interests

Section 1236(c) provides that certificates of trust represent a right to an interest in stock of a corporation. As such, they may not be exchanged under Section 1031.

6. Partnership Interests

The Tax Reform Act of 1984 amended Section 1031 to exclude partnership interests from qualifying for exchange treatment. Although some earlier revenue rulings provided otherwise, no exchanges of partnership interests, regardless of whether the exchanges are of general or limited partnership interests, or of interests in the same or different partnerships, can now qualify for exchange treatment. Regs. § 1.1031-1(a)(1).

a. Election Under Section 761(a)

The Revenue Reconciliation Act of 1990 amended Section 1031(a)(2) to provide that an interest in a partnership which has in effect a valid election under Section 761(a) shall be treated as an interest in each of the assets of the partnership rather than an interest in the partnership. Under Section 761(a), members of a partnership may elect to exclude the organization from the partnership rules of Subchapter K. Section 761(a)(1) provides that such election may be availed of “for investment purposes only and not for the active conduct of a business.” Regs. § 1.761-2(a)(2) requires that the members of such an organization own the property as co-owners and not actively conduct business. This requirement would appear to limit the utility of a Section 761(a) election to facilitate the exchange of partnership interests of partnerships owning real estate.

b. PLR 200909008 – EAT Acquires Partnership Interest

This ruling concluded that an EAT may acquire a 50 percent partnership interest as replacement property for the taxpayer’s exchange where the taxpayer owns the other 50 percent. The partnership’s only asset is comprised of real estate. Although IRC § 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.

D. Holding Period of Replacement Property “Tacked”

Since the investment following an exchange continues in nearly identical form, Congress provided in Section 1223(1) that the holding period of the property acquired in an exchange is “tacked” onto the holding period of the relinquished property, provided (i) the relinquished property is either a capital asset or Section 1231 property, and (ii) the basis of the property acquired is determined in whole or in part by the basis of the property relinquished.

1. Holding Period of “Boot” Not Tacked

Since under Section 1031(d) basis is allocated to nonqualifying property (other than debts or cash) to the extent of that property’s fair market value, condition (ii) is not satisfied. Accordingly, the holding period of nonqualifying property (boot) begins immediately after the exchange.

E. Tax Deferral Becomes Permanent if Taxpayer Dies

Section 1031, unlike Section 121, provides a deferral, but not an exclusion, of gain (and loss). Realized gain, and the potential for eventual recognized gain, remains in the form of a transferred basis in the replacement property. The deferral becomes permanent if the taxpayer owns the property at death, when (under current law) the property included in a decedent’s estate receives a stepped-up basis under Section 1014(d)(1). Basis problems associated with ownership of real estate through partnership interests can be mitigated by distributing the real property to the partner as a tenancy-in-common interest before death, thereby ensuring a stepped-up basis.

F. Potential Capital Gains Tax Savings

Even with reduced capital gains tax rates, substantial tax savings are possible by virtue of a like kind exchange. Net long-term capital gains (i.e., assets held more than 12 months) are now generally taxed at 15 percent. However, Section 1(h)(7)(A) taxes unrecaptured Section 1250 gain at 25 percent. Short term gains are taxed at the taxpayer’s highest ordinary income rate. Section 1(h)(1). New York imposes a maximum 8.97 percent tax on taxable income, without distinction for capital gains. Thus, the combined federal and state rate on long term capital gains (assuming no unrecaptured Section 1250 gain) is 23.97 percent, and 27.62 percent for NYC residents (or NYC property). If depreciable real estate is involved, the combined federal and state rates on long term capital gains climbs to 28.97 percent, and 32.62 percent for NYC residents. A Manhattan resident exchanging a zero basis vacant lot worth $1,000,000 (and by definition not subject to unrecaptured Section 1250 gain) could save a total of $271,500 in federal, NYS, and NYC taxes in a like kind exchange. A sale generating short term capital gain attracting a 35 percent federal tax would result in a total tax to New York residents of 43.97 percent and 47.62 percent for NYC residents.

1. TRA 1997 Taxes Unrecaptured Section 1250 Gains at 25 Percent

Section 1(h)(7) taxes unrecaptured Section 1250 gain at 25 percent. Unrecaptured Section 1250 gain generally refers to gain realized on the sale or exchange of real estate that has been depreciated on the straight line basis. For example, assume taxpayer purchased NYC property for $100,000, and has taken $25,000 in straight line depreciation deductions. If the property is later sold for $140,000, realized gain equals $65,000 [($140,000 – ($100,000 – $25,000)]. Total federal tax equals $12,250, which is (i) 15 percent of $40,000, plus (ii) 25 percent of $25,000. The effective federal tax rate would equal 18.85 percent ($12,250/$65,000).

a. Tax Rates Where Property Fully Depreciated

If the NYC property had been fully depreciated using the straight line method, the sale would attract a total tax of 37.63 percent, consisting of (i) a federal tax of 25 percent; (ii) a New York tax of 8.97 percent; and (iii) a NYC tax of 3.65 percent.

b. Effect of Section 1245 Recapture

If a portion of the gain from the sale of real estate is subject to ordinary income recapture under Section 1245, the combined federal and state tax rate would be higher.

2. Another Example

Taxpayer sells a building on June 30th, 2006, for $1 million. The building had originally cost $700,000. Of the $300,000 in depreciation deductions taken, $100,000 was in excess of that allowed under the straight line method. Therefore, $200,000 of the depreciation would be unrecaptured Section 1250 gain, and $100,000 would be recharacterized as ordinary income under Section 1245. Of the total recognized gain of $600,000 (i.e., $1 million – $400,000), $200,000 would be taxed at 25 percent (unrecaptured Section 1250 gain), $100,000 would be taxed at 35 percent (“excess” deprecation under Section 1245(a)), and $300,000 would be taxed at 15 percent (LTCG). If taxpayer resided in NYC, the total tax would be $203,200; i.e., [($100,000 x .35) + ($200,000 x .25) + ($300,000 x .15) + ($600,000 x .077) + ($600,000 x .045)] The combined federal, state and NYC tax liability would equal 33.87 percent of the realized gain (i.e., $203,200/$600,000).

3. New York State Transfer Tax

New York State imposes a transfer tax (“Real Estate Transfer Tax”) with respect to conveyances of real property within New York State. (Form TP-584). Transfer taxes are typically paid when the deed is filed with the county clerk. If the deed and accompanying documents are not in proper order, the record clerk will not accept them. In a situation involving an Exchange Accommodation Titleholder (EAT) in a reverse exchange, the taxpayer may claim that the EAT, who acquires “qualified indicia of ownership” (QIA) is merely the agent of the taxpayer, and that no transfer taxes are due. In practical terms, it will be the county clerk – and not the courts or the IRS – who will decide whether the EAT is actually only acquiring “bare” legal title. If the clerk believes that more than bare legal title is being acquired by the EAT, the clerk will refuse to record the deed.

4. Avoiding Transfer Tax in Swap and Drop Transactions

In some circumstances it will be necessary to “cash out” a partner receiving cash, rather than participating in a deferred exchange. Some transfers of partnership interests not involving a “controlling” interest will not be subject to real estate transfer taxes. However, the transfer of a “controlling” interest in a partnership or LLC will be subject to transfer tax in New York (as well as Connecticut, Pennsylvania, and South Carolina). Two transfer taxes will normally be generated in a like kind exchange: Transfer tax imposed on the sale of the relinquished property; and the transfer tax incurred in connection with the sale of the replacement property. However, if a partner is also being cashed out, a third transfer tax could also be incurred. In addition, if the replacement property is acquired by a disregarded single member LLC (as would likely be the case with an EAT) a fourth transfer tax could be incurred. Transfer tax planning is thus an important consideration when planning a like kind exchange.

a. Rate of New York State Transfer Tax

The rate of transfer tax imposed by New York equals 0.4 percent of the total consideration. The transfer tax is the responsibility of the seller.

b. New York State “Mansion Tax”

With respect to conveyances of residential property where the consideration equals $1 million or more, New York imposes an additional tax of 1 percent on the total consideration, the payment of which is the responsibility of the purchaser.

5. New York City Transfer Tax

New York City imposes a “Real Property Transfer Tax” (RPTT) on transfers of property in NYC. The tax is based on the total consideration for the conveyance. (Form NYC-RPT). Transfers include the sale or transfer of a 50 percent or greater ownership interest in a corporation, partnership, trust, or other entity that owns or leases real property. A transfer is defined as a change in beneficial ownership. The payment of the RPTT is the responsibility of the seller.

a. Rate of Tax

(1) Residential Transfers

The rate imposed on residential transfers equals 1 percent where the consideration is $500,000 or less. If the consideration is more than $500,000, the rate is 1.45 percent. There are no graduated rates. If the consideration exceeds $500,000, the higher rate applies to the entire consideration.

(2) All Other Transfers

The rate of tax imposed on all nonresidential transfers equals 1.45 percent if the consideration is $500,000 or less. If the consideration is more than $500,000, the rate is 2.625 percent. Again, if the consideration exceeds $500,000, the higher rate applies to the entire consideration.

b. Exempt Transfers

Certain transactions are exempt from the RPTT but must nevertheless be reported. One such exempt transfer that may be relevant in like kind exchanges includes transfers from a principal to his agent, or from an agent to his principal. In a “reverse” exchange, an Exchange Accommodation Titleholder (EAT) acquires bare legal title to the deed. The transfer of replacement property to the EAT could qualify for the “mere change in form or identity” exemption. In a typical deferred exchange the Qualified Intermediary (QI) is not required to acquire even bare legal title. Therefore, by definition, no transfer tax could be imposed. As will be seen, the deferred exchange regulations impose a legal fiction in which the QI is deemed to acquire title for purposes of the exchange, even though the relinquished and replacement properties are direct-deeded by the taxpayer, and the QI never acquires record title.

6. Combined NYS & NYC Transfer Tax

The combined NYS and NYC transfer tax on the sale of nonresidential property for $1 million would therefore equal 3.025 percent (i.e., 0.4 percent + 2.625 percent). This would push the tax, as a percentage of realized gain, in the preceding example to 39.28 percent (i.e., [($203,200 + $32,500)/$600,000]. Both New York State and New York City transfer tax liability would normally arise in connection with a Section 1031 exchange. However, by use of “direct deeding” in an exchange involving a third party, no more transfer tax should arise in connection with a like kind exchange than would otherwise be occasioned by a sale for cash.

7. Other Tax Considerations

New York State taxes are deductible for federal income tax purposes. The examples above do not reflect this tax deduction. However, the amount of money available for reinvestment following a like kind exchange is also not diminished by any income tax paid (except to the extent of boot). Assume first a taxable sale for $1 million, with $700,000 remaining after payment of taxes. Next assume a like kind exchange with respect to the same property. The taxpayer will have 42 percent more to invest in a like kind exchange as compared to a sale (i.e., $300,000/$700,000) assuming replacement property of equal value. If through financing replacement property of greater value is acquired, the increase in cash flow (and potential equity appreciation) possible in an exchange when compared to a sale is even more pronounced.

G. Loss of Cost Basis in Tax-Free Exchange

If fully depreciated real estate is exchanged for like kind real estate in a qualifying tax-free exchange, the replacement property will have a zero basis. Contrast this with a typical purchase, where the buyer takes a full cost basis in the purchased property. This problem can be mitigated somewhat by purchasing property whose value exceeds that of the replacement property. A new cost basis will be available for any cash outlay made to accomplish this, including any new debt incurred to acquire the replacement property. Section 1012; Crane v. Com’r, 331 U.S. 1 (1947).

II. Requirements for Like Kind Exchange

A. Transaction May Be Structured For Exchange Treatment

Though technically not elective, compliance with Section 1031 itself, the regulations promulgated thereunder, case law authority, and IRS revenue rulings and revenue procedures should enable the taxpayer to successfully plan for exchange treatment. Accordingly, as a practical matter, exchange treatment is indeed elective.
1. Losses Arising From Sham Sale Disallowed

Since Section 1031 applies to losses as well as gains, the IRS has at times argued that a transaction falls within Section 1031 to deny the taxpayer recognition of realized losses. Thus, in Horne v. Com’r, 5 T.C. 250 (1945), the Tax Court disallowed a loss arising from the sale of a membership in a commodity exchange where an identical interest had been purchased a few days earlier. The court found that the transaction had been designed solely to obtain a tax loss. The case is interesting since the exchanges which the IRS claimed had occurred were clearly not simultaneous. Yet, more recently the IRS has argued that multiparty exchanges in which gain deferral was sought were not within Section 1031 because those exchanges were not simultaneous. [Note that under the deferred exchange rules, a taxpayer today could likely succeed in recognizing a loss by deliberately failing to identify replacement property within the 45-day identification period described in Section 1031(a)(3)(A).]

2. IRS Attempts to Limit Scope of Section 1031

Congress used a broad brush when drafting Section 1031. Over the years, like kind exchanges have acquired a distinct judicial gloss, sometimes reflecting the view of the Circuit Court of Appeals in which the taxpayer resides or litigates. Taxpayers have often emerged victorious in disputes involving the applicability and scope of the statute. For this reason, taxpayers who might otherwise be inclined to obtain an advance ruling may plan an exchange without obtaining such a ruling. Various safe harbors articulated in regulations, revenue rulings and revenue procedures, discussed later, can also facilitate planning for exchanges. With notable exception of its refusal to acquiesce to view expressed by the Ninth Circuit in Starker v. U.S., 602 F.2d 1341 (1979) that exchanges need not be simultaneous (which refusal led to the enactment of the deferred exchange statute in 1984, and later the deferred exchange regulations), the IRS has generally been reasonable in its interpretation of the statute.

B. Federal Reporting Requirements

Proper reporting of like-kind exchanges can reduce the chances of audit. Form 8824 (“Like-Kind Exchanges”) requires the following information: (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. The IRS now requests 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”).

1. Form 8824 Requires Related Party Information

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.

C. Substantial Authority

Whether 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. Substantial authority exists if the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. By contrast, if a position is not supported by “substantial authority,” penalties may be imposed unless the position has been adequately disclosed and there is a “reasonable basis” for the position.

1. Tax Opinion Letters

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. On the other hand, some transactions, although generating clear and favorable conclusions from a tax standpoint, will not have substantial authority, perhaps because IRS never issued guidance. Those transactions would presumably not require disclosure.

D. IRC Section 6694 Preparer
Penalties Change Reporting Landscape

Under revised IRC §6694, a return preparer (or a person who furnishes advice in connection with the preparation of the return) is subject to substantial penalties if the preparer (or advisor) does not have a reasonable basis for concluding that the position taken was more likely than not. If the position taken is not more likely than not, penalties can be avoided by adequate disclosure, provided there is a reasonable basis for the position taken. Under prior law, a reasonable basis for a position taken means that the position has a one-in-three chance of success. P.L. 110-28, §8246(a)(2), 110th Cong., 1st Sess. (5/25/07). This penalty rule applies to all tax returns, including gift and estate tax returns. The penalty imposed is $1,000 or, if greater, one-half of the fee derived (or to be derived) by the tax return preparer with respect to the return. An attorney who gives a legal opinion is deemed to be a non-signing preparer. The fees upon which the penalty is based for a non-signing preparer could reference the larger transaction of which the tax return is only a small part.

1. Notice 2008-13 Provided Interim Relief to Return Preparers

Notice 2008-13 contains guidance concerning the imposition of return preparer penalties. It provides that until the revised regs are issued, a preparer can generally continue to rely on taxpayer and third party representations in preparing a return, unless he has reason to know they are wrong. In addition, preparers of many information returns will not be subject to the penalty provisions unless they willfully understate tax or act in reckless or intentional disregard of the law. Revised IRC §6694 joins Circular 230 (which Roy M. Adams observed effectively “deputizes” attorneys, accountants, financial planners, trust professionals and insurance professionals) “extends the government’s reach and helps fulfill a perceived need to patch up the crumbling voluntary reporting tax system.” The Changing Face of Compliance, Trusts & Estates, Vol. 147 No. 1, January 2008. The perilous regulatory environment in which attorneys and accountants now find themselves counsels caution when advising clients concerning tax positions. Although a taxpayer’s right to manage his affairs so as to minimize tax liabilities is well settled, Congress has signified its intention to hold tax advisors to a higher standard when rendering tax advice.

2. Notice 2009-5 Continues Provisions in Notice 2008-13

Notice 2009-5 provides that tax return preparers may apply the substantial authority standard in the 2008 Tax Act, or may continue to rely on Notice 2008-13, which provides interim guidance.

E. New York State Reporting Requirements

New York State imposes few special reporting requirements for like kind exchanges involving New York residents. New York imposes no withholding tax on exchange proceeds, except for nonresidents, who are subject to a 7.7 percent withholding tax. 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 State income tax purposes. However, since an LLC is a “person” as defined in Section 1101(b)(4) of the Tax Law, 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” (discussed infra) that provide exchange services in New York. Finally, the acquisition of replacement property outside of New York State should not affect the tax-free nature of the exchange for New York tax purposes.

F. California’s “Clawback” Rule

Non-California residents should be be aware of California’s “clawback” rule, which encourages only “one way” investments in California realty. Although California allows exchange treatment, deferred gain must continue to be reported indefinitely if out-of-state replacement property is acquired. If that property is ever sold in a taxable sale, California will “claw” its way back, and impose tax on the initial deferred gain. This would result in double state tax with respect to the later sale. Apparently the “clawback” rule cannot be avoided by investing in partnership interests. However, whether the clawback rule applies to corporations is less clear. The maximum income tax rate in California is 9.3 percent. Although some have suggested that California’s tax is an unconstitutional burden on interstate commence, nothing in Section 1031 requires states to follow the federal like kind exchange regime, or to even provide like kind exchange treatment. New York and other states are said to be considering such a rule. The rule is probably not unconstitutional, since no state is required to provide like kind exchange treatment as an initial matter.

1. California Senate Bill No. 1316

On April 22, 2010, the California Legislature introduced Bill 1316 which would treat Section 1031 exchanges as taxable transactions. A later amendment to the bill would have required as a condition to tax deferral the requirement that replacement property be located in California. The bill is now “inactive”.

2. Illustration

New York resident exchanges low basis Manhattan property for a tenancy in common (TIC) interest in a Walgreens in Los Angeles in 2006. The taxpayer intends to “park” the exchange proceeds in the TIC investment until suitable permanent replacement property can be located. Two years later, the taxpayer engages in a second like kind exchange and acquires replacement property in Houston. California continues to track the initial deferred gain from the exchange of the California property. If the Houston property is ever sold, California will impose tax of 9.3 percent on the initial deferred gain, with the result that the sale would attract both California and New York income tax, with no possibility of credit from either state. Despite the rigor of California’s rule, there is no enforcement mechanism: California may never know when the later out-of-state property is sold. California is considering imposing continuing reporting requirements after the initial sale of the relinquished property.

G. Oregon Imposes Statutory Rule

Oregon has imposed by statute a “clawback” rule similar to that imposed by California. Oregon requires a continuing information return to be filed by nonresidents. Oregon recognizes exchanges of property located in Oregon for property located in another state provided the exchanger is Oregon resident. Non-Oregon residents who exchange Oregon property for out-of-state property must pay Oregon tax. Massachusetts imposes a clawback rule by regulation, as does Montana. To date, New York has not sought to impose a clawback rule, although New York is said to be unhappy where New York property is exchanged for property in a state with no income tax, where the property is

H. Contrast Sale-Leaseback Transactions

Suppose the taxpayer sells real property at a loss, and simultaneously enters into a long term lease of more than 30 years with respect to the same property. The IRS could assert the “sale” is a disguised like kind exchange, since real property is of like kind with leases in excess of 30 years. Regs. § 1.1031(a)-1(c). If the IRS were successful, the loss on the original sale would be disallowed, and payments received by the taxpayer would be recharacterized as boot. The IRS position would be weak if the rent called for under the lease were fair market value, since that would mean that the value of the lease was zero. If the lease has no value, it is difficult to see how it could be exchanged for real property, and recent cases have so held. See Leslie Co. v. Com’r, 64 T.C. 247 (1975), nonacq., 1978-2 C.B. 3, aff’d. 539 F.2d 943 (3d Cir. 1976); Crowley, Miller & Co. v. Com’r, 76 T.C. 1030 (1981). However, if the lease does have value, the case law has held that a like kind exchange may indeed have occurred. See Century Electric Co. v. Com’r, 192 F.2d 155 (8th Cir. 1951).

I. Requirement That Taxpayer Be the Same

Issues concerning the identity of the taxpayer or taxpayers engaging in a like kind exchange occasionally arise. To satisfy Section 1031, the taxpayer that disposed of relinquished property must be the same that acquires replacement property. For example, if husband and wife appear on the deed of the relinquished property, they must both take title to the replacement property. If only one name appears on the deed for the relinquished property, husband and wife may not take title to the replacement property in tenancy by the entirety (joint tenancy between husband and wife). This issue may also arise in circumstances involving (i) the death of the taxpayer; Rev. Rul. 64-161; Goodman v. Com’r., 199 F2d 895 (CA3 1952); or (ii) where property is held in trust; Rev. Rul. 92-105. The problem does not arise when a partnership exchanges property since, for this purpose, the partnership is viewed as an entity, and the entity, rather than the individual partners, engages in the exchange. TAM 9227002; TAM 9818003.

III. Qualified Use Requirement

A. Temporal Aspect

Section 1031(a)(1) provides that

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. (Emphasis added).

Therefore, an exchange of property acquired not for productive use, but rather for the purpose of engaging in a like kind exchange, would likely violate Section 1031(a)(1). Revenue Ruling 84-121. Even so, the Tax Court in Mason Est. v. Com’r, T.C. Memo 1988-273 held that exchanges by former partners of property received from their recently terminated partnerships did qualify for exchange treatment.

1. How Long Must Taxpayer Hold Property?

The phrase “held for” means the property must be in the possession of the taxpayer for a definite period of time. Exactly how long has been the subject of considerable debate. PLR 8429039 stated that property held for two years satisfies the statute. Some have suggested that, at a minimum, the property should be held for a period comprising at least part of two separate taxable years (e.g., November, 2010 through October, 2011). However, it should be taxpayer’s intent that is actually determinative. Therefore, an exchange of property held for productive use in a trade or business should qualify even if it were held for less than two years provided the taxpayer’s intent when acquiring the property was to hold the property for productive use in a trade or business or for investment, (rather than to hold it just long enough to qualify for exchange treatment). Of course, evidencing the taxpayer’s intent for a short period of time might be difficult, and for this reason guidelines, such as that articulated in PLR 8429039 are useful.

2. No Requirement that Both Parties Seek Exchange Treatment

No statute or regulation requires both parties involved in the transaction to seek like kind exchange treatment. Therefore, it would seem that an unrelated party may obtain real estate and immediately transfer it to another party who is seeking like kind exchange treatment. However, if related parties are involved, any gain deferred on the initial exchange will be recognized as of the date either party disposes of property acquired in the initial exchange if that disposition occurs within 2 years of the date of the initial exchange. Section 1031(f)(1).

3. Exchange of Investment Property for Business Property

Property held for productive use in a trade or business and property held for investment are synonymous for purposes satisfying the qualified use requirement. Thus, property held for productive use in a trade or business may be exchanged for property to be held for productive use in a trade or business property or for property to be held for investment, and vice versa. Regs. § 1.031(a)-1(a)(1).

4. Using Replacement Property as Personal Residence Negates Exchange

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.

B. Attributing Entity’s Qualified Use to Taxpayer

The IRS may be unwilling to attribute an entity’s “qualified use” to the taxpayer after a transfer of the property from the entity to the taxpayer. In Revenue Ruling 77-337, the IRS found the “qualified use” requirement violated where the taxpayer received the property in a liquidating distribution from his wholly owned corporation and then immediately engaged in an exchange.

1. Bolker v. Com’r. Upholds Exchange Treatment

The Ninth Circuit in Bolker v. Com’r, 81 T.C. 782 (1983), aff’d, 760 F2d 1039 (9th Cir. 1985), in circumstances similar to those in Rev. Rul. 77-337, upheld exchange treatment where the relinquished property had been received in a tax-free liquidating distribution from the taxpayer’s wholly owned corporation on the same day the taxpayer entered into a Section 1031 exchange agreement. The court found significant the fact that the relinquished property was not held by the taxpayer for sale or for personal use, but was intended to be, and actually was, exchanged three months later for similar property. This implied an investment purpose.

2. Maloney v. Com’r. Finds Qualified Use Not Violated

In Maloney v. Com’r, 93 T.C. 89 (1989), the Tax Court held that a liquidating distribution of the replacement property to the controlling shareholder a month after an exchange did not violate the “qualified use” requirement, since the remaining shareholders continued to have an economic interest in essentially the same investment. Moreover, the taxpayer had not “cashed in” his investment.

3. PLR 200521002 Distinguishes Distribution From Exchange

In PLR 200521002, the IRS issued a favorable ruling where a trust entered into an exchange with the intention of terminating and distributing the replacement property to trust beneficiaries. The “held for” requirement was satisfied since the IRS viewed the distribution and exchange as being wholly independent.

4. PLR 200812012 – Further Relaxation of Qualified Use

In PLR 200812012, Trust A was established under the terms of the decedent’s will to administer estate assets. The trust owned real property assets in various states which were held for investment. Under the terms of the will, Trust A terminated. Pursuant to a Termination Plan formulated by Trustees, Trust A assets were contributed to an LLC. The issue raised was whether the LLC could 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 held or managed the replacement property. The ruling distinguished Rev. Rul. 77-337, which involved “voluntary transfers of properties pursuant to prearranged plans.”

C. Attributing Taxpayer’s Qualified Use to Entity

Magnesson v. Com’r, 753 F.2d 1490 (9th Cir. 1985), aff’g, 81 T.C. 767 (1983) held that a contribution of replacement property to a partnership following an exchange did not violate the qualified use requirement, even if the replacement property had been acquired with the intention of contributing it to a partnership. The court reasoned that the change in ownership did not significantly affect control of the property. However, Revenue Ruling 75-292 found the qualified use requirement violated where the taxpayer transferred replacement property to its wholly owned corporation immediately following the exchange. Can Revenue Ruling 75-292 be distinguished from Magnesson? Perhaps. While the IRS was not willing to impute the taxpayer’s qualified use to the corporation, the Ninth Circuit, viewing the partnership under the aggregate theory, was apparently willing to impute the taxpayer’s qualified use to the partnership. D. Summary of Qualified Use Cases, Rulings, Statutes and Regulations

Case, Ruling Transaction Qualified Rationale
Regulation or Statute Use Violated?

Rev. Rul. 75-292 Taxpayer transferred replacement YES
property to wholly-owned corporation
Immediately following exchange

Rev. Rul. 77-297 Multiparty exchange NO
involving accommodator

Rev. Rul. 77-337 Distribution from wholly-owned YES
owned corporation followed by exchange

Starker v. U.S. Deferred exchange where replacement NO Exchanges need not be simultaneous
602 F.2d 1341 property acquired five years after
(9th Cir. 1979) transfer of relinquished property

Rev. Rul. 84-121 Property acquired for purpose of YES
engaging in like kind exchange

PLR 8429039 Replacement property held for NO Rule of administrative convenience
Two years before sale

IRC §§ 1031(a)(3)(A), Taxpayer identifies replacement NO Legislative adoption of Starker v. U.S.
(B); (1984) property within 45 days; acquires 602 F.2d 1341 (9th Cir.) dispensing with
replacement property within 180 days requirement of simultaneity in exchange

IRC § 1031(a)(2)(D) Exchanges of partnership interests YES Legislation intended to prevent avoidance
of boot recognition rules

Bolker v. Com’r Same as Rev. Rul. 77-337, except NO Taxpayer not required to hold property
81 T.C. 782 (1985) distribution and exchange part of “indefinitely” to satisfy requirement
single plan

Magnesson v. Com’r Taxpayer transferred replacement NO
753 F.2d 1490 (1985) property to partnership following
exchange

Mason Est. v. Com’r. Exchanges by former partners of NO Held to be exchange of assets individually
T.C. Memo 1988-273 property received from recently rather than partnership assets; therefore
terminated partnerships no violation of Section 1031(a)(2)(D)

Case, Ruling Transaction Qualified Rationale
Regulation or Statute Use Violated?

Maloney v. Com’r Liquidating distribution of replacement NO
93 T.C. 89 (1989) property to shareholder month after
exchange

IRC § 1031(d) Related party exchanges where YES Statute intended to prevent “basis
(1989) Either party to exchange disposes of shifting” between related taxpayers
property within 2 years of exchange

Treas. Regs. Deferred exchanges with NO Addresses problems of agency and
§1.1031(k)-1(f)(1),(2) qualified intermediary constructive receipt; permits exchanges to
(1991) be planned with element of certainty

PLR 9807013 SMLLC owned by taxpayer NO SMLLC is disregarded for purposes of
acquires replacement property Section 1031 as well for income tax purposes

Rev. Proc. 2000-37 Acquisition of replacement property NO Administrative adoption of Bezdijian v.
Prior to transferring relinquished Com’r., 845 F.2d 217 (9th Cir. 1988)
property permitting “parking” transactions

Rev. Proc. 2002-22 Requirements for distribution of TIC NO
interests not to result in tax partnership

Rev. Rul. 2004-86 Receipt of interests in Delaware NO DST interest not subject to reclassification
Statutory Trust constitute receipt as trust; grantor treated as owner of real
of qualifying property property owned by trust under § 677(a)

PLR 200521002 Trust entered exchange with intent NO
of terminating and distributing
replacement property to beneficiaries

Moore v. Com’r Exchange of vacation home YES Property never rented
T.C. Memo 2007-134

PLR 200812012 Trust assets contributed to LLC NO
which then engaged in exchange

Goolsby v. Com’r Taxpayer moved into replacement YES Insufficient effort to rent; use of
T.C. Memo 2010-64 property two months after exchange replacement property for personal
“antithetical” to investment purpose

E. Disregarded Entities

The taxpayer may insist that replacement property be held by an entity possessing personal liability protection. Similarly, lenders financing replacement property may insist that the borrower form a single purpose “bankruptcy remote entity” to acquire the replacement property. Grantor trusts, business trusts, Illinois land trusts, and single member LLCs (SMLLCs) have been used to accomplish this purpose. Under Regs. § 301.7701-3, a single-owner entity, other than a corporation, will be disregarded for federal income tax purposes unless it elects to be taxed as a corporation.

1. Limited Liability Companies

a. Single Member LLC

The “qualified use” requirement seemed to preclude transferring newly-acquired replacement property to an LLC immediately following an exchange. However, property owners may now under Regs. § 301.7701-3 form single member LLCs (SMLLCs) owned by them to insulate themselves from potential liability. Since a SMLLC is ignored for income tax purposes, transferring newly-acquired replacement property into a SMLLC should not violate the qualifying use requirement of Section 1031. PLR 9807013 confirmed this premise, stating that a SMLLC may purchase replacement property or be the transferee of replacement property. The ruling diminished concerns that the disregarded entity might “poison” the exchange by reason of (i) the SMLLC being an entity different from that which transferred the relinquished property and (ii) the SMLLC violating the qualified use requirement by immediately acquiring the replacement property.

b. Two-Member LLC

PLR 199911033 stated that even a two-member Delaware LLC would be disregarded for federal income tax purposes where (i) under Delaware law, a member need not possess any interest in capital and (ii) the sole purpose of the second member is to serve as a control check against bankruptcy filings or other actions that would cause the LLC to violate covenants with its lenders. In the ruling, the taxpayer possessed all profits, losses and capital interests in the LLC. Since the second member of the LLC did not enter into the LLC agreement with the intent to operate a business and share profits, the LLC would not be treated as a partnership for federal income tax purposes.

F. PLR 200908005 – Substituted Qualified Intermediaries

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 subject to the same federal tax law treatment as would the three entities, there would be no change in the manner in which the corporations conducted business. The ruling leaves open the question of how the IRS would view the acquisitions of a bankrupt or insolvent qualified intermediary by another entity.

G. Acquiring All Interests of Disregarded Entity

1. PLR 200118023

PLR 200118023 stated that the acquisition of all interests of an entity disregarded under Regs. § 301.7701-(2), which entity itself owns like kind property, constitutes the receipt of qualifying replacement property (provided the SMLLC has not elected to be taxed as a corporation for federal tax purposes).

2. PLR 200807005

In PLR 200807005, taxpayer, a limited partnership, intended to form a wholly-owned LLC which would be a disregarded entity for federal tax purposes. The taxpayer and its wholly-owned LLC would acquire 100 percent of the interests of the 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 first addressed the issue of whether the exchange qualified for nonrecognition treatment. Answering in the affirmative, the ruling noted that 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 taxpayer is treated as having acquired those interests from the partners rather than from the partnership. Accordingly, the transaction qualified as a like kind exchange, rather than a prohibited exchange of partnership interests. The second issue raised was whether the taxpayer may hold the replacement property in a newly-created state law entity that is disregarded for federal income tax purposes. Again answering in the affirmative, the ruling concluded that 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 taxpayer may hold the replacement property in a newly-created state law entity that is disregarded for federal income tax purposes without violating Section 1031.

H. Vacation Homes, Residences and “Qualified Use” Issues

1. Vacation Property Generally Ineligible for § 121 Exclusion

Gains from the sale of a vacation home will not qualify for the Section 121 exclusion, since the vacation home is not the taxpayer’s principal residence. Can a vacation home be exchanged under Section 1031? Although property held solely for personal use and enjoyment is not eligible for like kind exchange treatment, vacation property may be held for investment purposes and may therefore qualify for exchange treatment. See PLR 8508095. The Tax Court denied like kind exchange treatment for a vacation home used by the taxpayer but never rented. Barry E. Moore, T.C. Memo, 2007-134.

2. Revenue Procedure 2008-16 Safe Harbor

The issue of whether exchange treatment is available for vacation homes which are rented has been unclear. The report of the Treasury Inspector General for Tax Administrator (TIGTA) on September 17, 2007 determined that the IRS had been remiss in its oversight of capital gains deferred through like kind exchanges. More than 338,500 Forms 8824, claiming deferred gains (or losses) of more than $73.6 billion, were filed for tax year 2004. The audit also found that regulations for exchanges involving vacation homes “are complex and may be unclear to taxpayers.” In response to the TIGTA mandate, the IRS issued Revenue Procedure 2008-16, which attempts to clarify situations in which vacation homes will qualify for like kind exchange treatment. Rev. Proc. 2008-16 establishes a “safe harbor” for determining whether a vacation home will meet the “for productive use in trade or business” requirement of Section 1031. The ruling applies to situations where the vacation home is both rented by the taxpayer to third parties, and also used by the taxpayer. The safe harbor will have been met if (i) the vacation home is owned continuously by the taxpayer throughout the qualifying use period; and (ii) within each of the two 12-month periods comprising the qualifying use period, the taxpayer rents the vacation home to another person or persons at fair rental value for 14 days or more, and the period of the taxpayer’s personal use of the dwelling unit does not exceed the greater of 14 days or 10 percent of the number of days during the 12-month period that the dwelling unit is rented at fair rental value.

3. IRC § 280A May Govern by Analogy

Section 280A governs the deductibility of expenses other than real estate taxes and mortgage interest associated with vacation properties in which there is some personal use. It may by analogy provide insight as to whether vacation property is held for investment under Section 1031. Section 280A(d) states that a dwelling is a residence if personal use exceeds the greater of 14 days or 10 percent of the number of days the unit is rented at fair market value. The taxpayer could argue that the investment purpose requirement of Section 1031 is satisfied if personal use by the taxpayer falls below these thresholds.

4. Requirement That Property Be Held For “Investment”

Regs. § 1.1031(a)-1(b) provides that the term “investment” includes holding real property for future appreciation. Taxpayers contemplating an exchange of vacation property should document their intention to hold the property as an investment by maintaining accurate books and records. In addition, to meet the “qualified use” test, a vacation home should be held for a reasonable period of time (e.g., 12 months) prior to being disposed of in an exchange. While the property is being held, an attempt should be made to rent the property at fair market value to unrelated third parties. Finally, personal use should be kept to a minimum, and should not exceed the periods prescribed by Section 280A.

5. Coordination Between Sections 121 and 1031

a. Section 121

Revenue Procedure 2005-14 coordinates Sections 121 and 1031 with respect to property used both as a personal residence and for business purposes. The Section 121 exclusion may be claimed even for the business portion of gain on mixed-use property, provided the office was a portion of a single structure. Furthermore, the Section 121 exclusion continues to apply even after property is converted entirely to business use. Although this result is not surprising, no guidance had previously been issued which confirmed this.

b. Ordering Rules

Revenue Procedure 2005-14 provides ordering rules for applying Sections 121 and 1031. The Section 121 exclusion is applied before applying Section 1031. This ordering rule is helpful, since the exclusion provided by Section 121 is generally preferable to the deferral provided by Section 1031. The boot recognition rule is also relaxed in that boot received is taxed only if and to the extent gain on the business portion of the single-dwelling unit is not excluded under Section 121.

IV. Determining Whether Replacement Property is of “Like Kind”

A. Exchanges Involving Real Estate Enjoy Rarefied Status

Determining whether particular property is of “like kind” necessitates a review of IRS pronouncements, decisional case law, and the Regulations. The Regulations provide that the words “like kind”

[h]ave reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. [However,] whether any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. (Emphasis added). Regs. § 1.1031(a)-1(b).

As the Regulations state, exchanges involving real estate enjoy special status. Regs. §1.1031(a)-1(c) further provides that the exchange of a fee interest for a 30 year lease, or the swap of city real estate for a ranch or farm, are exchanges of “like kind” property. The exchange of a fee interest for coop shares would also appear to qualify under Section 1031. See also PLR 943125, stating that a lot held for investment is of like kind with a townhouse to be used as rental property.

1. Revenue Ruling 67-255

Revenue Ruling 67-255 stated that a building is not of like kind to a building and land. It may therefore be difficult to strip a building from the underlying land and engage in an exchange. However, if the building includes an easement or lease, the building and lease might together qualify as real property for purposes of a like kind exchange.

2. Foreign Real Estate Not of “Like Kind” to Domestic Real Estate

Section 1031(h)(1) provides that “[r]eal property located in the United States and real property located outside the United States are not property of a like kind.” Although nonresidents may engage in like kind exchanges, Section 1031 applies only to exchanges of United States property interests for interests in property the sale of which would be subject to United States income tax. Section 897 provides for the treatment of gain or loss realized by a nonresident individual or foreign corporation who disposes of a United States real property interest. Section 1445 (subject to some exemptions) requires withholding of 10 percent of the amount realized in a transaction subject to Section 897.

3. Ruling Expands Scope of Real Property

Revenue Ruling 2004-86 expanded the scope of “like kind” real property by finding that real property and interests in a Delaware Statutory Trust which itself owns real property are of like kind. This result occurs because the owner of an interest in a Delaware Statutory Trust (DST), which is a grantor trust, is treated as owning assets which are owned by the trust. Therefore, such an exchange actually consists of the exchange of real property interests, rather than the exchange of a real property interest for a certificate of trust that would be barred under Section 1031(a)(2)(E).

4. New York Coops Are Real Property

The IRS blessed the exchange of cooperative shares in PLR 200631012. While acknowledging that “New York case law might suggest that there are conflicts concerning whether a cooperative interest in real property is real property [citations omitted],” the Ruling remarked that “various New York statutes treat an interest in a cooperative as equivalent to an interest in real property.” Accordingly, the Ruling held that interests in cooperative apartments in New York are of like kind improved and unimproved realty.

5. Development Rights Real Property Interests

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.

6. PLR 200842019 – Exchange of Leaseholds

a. Facts.

In PLR 200842019, the taxpayer exchanged an existing leasehold interest for a new lease. An understanding was reached between the taxpayer and the existing landlord for the taxpayer to engage in a like kind exchange with a qualified intermediary following construction of the taxpayer’s new leasehold. Upon completion of the leasehold improvements, the following events would occur: (i) the taxpayer would transfer the current lease (together with leasehold improvements and office equipment) to QI; (ii) QI would transfer the current lease to taxpayer’s current landlord; (iii) QI would enter into a new lease with the new landlord; and (iv) QI would transfer the new lease (with leasehold improvements and office equipment) to the taxpayer, and the taxpayer would become a party to the new lease and assume all obligations under the new lease. The taxpayer’s current landlord would be required to provide funds for construction of leasehold improvements for premises under New Lease. New landlord would enter into a construction contract with independent construction company to construct leasehold improvements at taxpayer’s direction. Taxpayer would be required to provide assurances to New landlord.

b. Ruling & Analysis

(1) Like Kind Determination. 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.

(2) Build-to suit Considerations. 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.
(3) Basis Considerations. 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 § 1.1031(j)-1(c).

(4) Receipt of Boot. 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.

B. Exchanges of Tangible Personal Property Limited

In contrast to exchanges involving real property, exchanges of tangible personal property will qualify under Section 1031 only if the properties bear a strong resemblance to one another. In making this determination, the “similar or related in service or use” test of Section 1033(a)(1), rather than the rules developed for determining whether real estate is of like kind, appears to be the standard called for in the Regulations. Revenue Ruling 82-166 states that gold bullion and silver bullion are not of like kind since “silver and gold are intrinsically different metals . . . used in different ways.” Regs. § 1.1031(a)-2 provides that depreciable tangible personal property qualifies for exchange treatment if the properties are of “like kind” or “like class.” Properties are of “like class” if on the exchange date they are of the same (i) “General Asset Class” or (ii) “Product Class.” Regs. § 1.1031(a)-2(b)(2) provide a list of thirteen General Asset Classes. The SIC codes for Product Classes were replaced by the North American Industrial Classification System (NAICS) with respect to exchanges after August 13, 2004. Exchanges involving nondepreciable personal property (e.g., a Van Gogh for a Monet) would involve a facts and circumstances inquiry.

1. General Asset Classes

Under Regs § 1.1031(a)(2)(b)(2), a light general purpose truck is not of the same General Asset Class as a heavy general purpose truck. Nor is a computer of the same General Asset Class as office furniture (or equipment). However, an automobile and a taxi are of the same General Asset Class, as are noncommercial airplanes (airframes and engines) and “all helicopters.” The origin of the regulations appears to be Revenue Procedure 87-56, which lists asset classes for purposes of depreciation.

2. Product Classes

a. Former Classification Method

Product Class was formerly determined by reference to the 4-digit Standard Industrial Classification (SIC) codes published in the Office of Management and Budget’s SIC Manual, modified every five years. Any 4-digit product class ending in a “9” (i.e., a miscellaneous category) was not considered a Product Class. If property was listed in more than one Product Class, the property was treated as though listed in any of those Product Classes. Regs § 1.1031(a)-2(b)(3).

b. Present Classification Method

The SIC codes for Product Classes were replaced by the North American Industrial Classification System (NAICS) and Manual with respect to exchanges after August 13, 2004. Regs. § 1.1031(a)-2(b)(3) (superseded). Under the new regime, the NAICS Manual provides that depreciable tangible property is listed within a 6-digit product class listed in the NAICS Manual. Categories contained in the NAICS Manual are narrower than in the SIC Manual formerly used.

3. Properties May be of Like Kind Without Being of Like Class

4. Foreign Tangible Personal Property Not of Like Kind

Section 1031(h)(2) provides that personal property used predominantly in the United States is not of like kind to personal property used predominantly outside the United States. Predominant use is based on the 2-year period preceding the exchange with respect to relinquished property, and the 2-year period following the exchange, with respect to replacement property. Section 1031(h)(2)(C).

C. Real Property Containing Personal Property

Some exchange property may itself be comprised of both real and personal property. For example, an exchange may involve an apartment building or restaurant that contains furniture, fixtures, equipment or other assets. Since real property cannot be exchanged for personal property, the IRS views such transactions as exchanges of multiple assets rather than exchanges of one economic unit. The properties transferred and properties received must be separated into “exchange groups” by matching properties of like kind or like class to the extent possible. After the matching process is completed, if non-like kind assets remain, gain recognition may be required with respect to those assets. Regs. § 1.1031(j)-1.

1. Determination of Whether Real or Personal Property

At times, it may be difficult to determine whether exchange property is real property or personal property. The determination of whether exchange property is real or personal property is based on the law of the state in which the property is located. Aquilino v. U.S., 363 U.S. 509 (1960); Coupe v. Com’r., 52 T.C. 394 (1969). Whether particular property exchanged constitutes real property or personal property is important, as the receipt of personal property where real property was relinquished would produce boot. Such a dispute arose in Peabody v. Com’r, 126 T.C. No. 14 (2006). In that case, the IRS argued a coal supply contract itself, not the mine supplying the coal, possessed most of the value of property being exchanged. Accordingly, IRS argued that upon the receipt of replacement property consisting of a gold mine, a good exchange occurred, but that since the supply contract was not of like kind to the gold mine, the taxpayer received boot. However, the Tax Court ruled the right to mine coal and sell coal is inherent in the fee ownership, and the two cannot be separated. Thus, the exchange was held not to produce boot.

D. Exchanges of Intangible Property

Although like kind exchanges are most often associated with real property or tangible personal property (e.g., an airplane), exchanges involving intangible personal property, consisting of customer lists, going concern value, assembled work force, and good will may also occur. An exchange of business assets requires that the transaction be separated into exchanges of its component parts. Revenue Ruling 57-365, 1957-2 C.B. 521. Unlike the case involving exchanges of real property or tangible personal property, little regulatory guidance is provided for exchanges of intangible property. Whether such an exchange qualifies under Section 1031 is therefore reduced to an inquiry as to whether the exchanged properties are of “like kind” under the words of the statute itself. In published rulings, the IRS has imported concepts from the regulations dealing with real property exchanges. As might be surmised, exchanges of intangible personal property are at times problematic.

1. Nature and Character of Rights and
Underlying Properties Determinative

Regs. § 1.1031(a)-2(c) provides that whether intangible personal properties are of like kind depends on the nature and character of (i) the rights involved and (ii) the underlying property to which the intangible personal property relates. The Regulations take the position that the goodwill or going concern value of one business can never be of like kind to the goodwill or going concern value of another business. Therefore, such exchanges would always produce boot. The Regulations state that a copyright on a novel is of like kind to a copyright on another novel. However, a copyright on a song is not of like kind to a copyright on a novel since, although the rights are identical, the nature of the underlying property is substantially different. The objective in an exchange of businesses will therefore be first to demonstrate that the intangible assets being swapped do not consist of goodwill. The taxpayer must then demonstrate that both the rights and the underlying properties involved are also of like kind.

a. Differences in “Grade or Quality” Inconsequential

TAM 2000035055 stated that the exchange of a radio license for a television license qualified for exchange treatment. The rights involved, and the property to which the rights related, involved differences only in “grade or quality,” rather than in their “nature or character.” Both licenses enabled the licensee to broadcast programming over the electromagnetic spectrum, making the rights “essentially the same.” The underlying property related to the use of the radio transmitting apparatus rather than the apparatus itself. The ruling concluded that although the bandwidth of radio and television broadcasts are different, those differences constituted differences only in grade or quality, rather than differences with respect to nature or character.

b. TAM 200602034 More Restrictive

TAM 200602034 took a more restrictive view of exchanges involving intangible personal property, stating that the rule for intangibles is “still more rigorous” than for tangible personal property. The rationale for this conclusion appears questionable.

2. CCA 200911006 – 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. CCA 20091106 states 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 Exchange Accommodation Titleholder (EAT), and use the parked property as part of a like-kind exchange within 180 days.

3. PLR 201024036 – Volatile Organic Compound (VOC)
Credits and Nitrogen Oxide (NOx) Credits Are of Like Kind

V. Basis of Property Received in Exchange

A. Calculation of Basis Adjustments in Like Kind Exchange

Section 1031(d) and the Regulations provide that the basis of property received in an exchange equals the aggregate basis of property transferred

decreased by

(i) cash received;

(ii) liabilities associated with the relinquished property; and

(iii) loss recognized on the transfer of nonqualifying property

and increased by

(i) cash notes or notes transferred in the exchange;

(ii) gain recognized (i.e., on the receipt of boot, or on the transfer of nonqualifing property); and

(iii) liabilities associated with the replacement property.

B. Basis Allocated First to Nonqualifying Property

Basis is first allocated to nonqualifying property received in the exchange to the extent of its (or their) fair market value(s). Remaining basis is then allocated to nonrecognition properties in proportion to their respective fair market values. Section 1031(d).

C. Illustration of Basis Allocation Where Boot Received in Exchange

Taxpayer exchanges a building with an adjusted basis of $500,000, a fair market value of $800,000, and subject to a mortgage of $150,000, for consideration consisting of (i) a vacant lot worth $600,000; (ii) $30,000 in cash; and (iii) a Picasso sketch worth $20,000. Realized gain (AR – AB) equals $300,000 [($600,000 + $150,000 + $30,000 + 20,000) – $500,000]. Since the debt relief of $150,000 is treated as cash received, $200,000 of nonqualifying property has been received. Realized gain of $300,000 must be recognized to the extent of the $200,000 of nonqualifying property (boot) received. IRC § 1031(b). This results in $100,000 of realized gain being deferred. Basis calculations are as follows:

1. Basis of Relinquished Building …………… $ 500,000

2. Basis Increase: Gain Recognized ………… $ 200,000

3. Basis Decreases:
a. Money Received …………………….. $ 30,000
b. Debt Relief …………………………….. $ 150,000
Total Basis Decreases ………………………… $ 180,000

4. Basis of Relinquished Building …………… $ 500,000
Plus: Basis Increase …………………………… $ 200,000
Minus: Basis Decreases ……………………… $ 180,000
Total Basis to be Allocated …………………. $ 520,000

5. Allocation of Basis Allocated Remaining
Total Basis to Be Allocated ………………… $520,000
First: To Picasso Sketch to extent of FMV $20,000 $500,000
Next: Remainder of Basis to Land ……….. $500,000 -0-

Note: If one year following the exchange the vacant lot which is still worth $600,000 and the Picasso sketch which is still worth $20,000 are both sold, the Picasso sale will produce no gain, but the land sale will generate $100,000 in recognized gain, which corresponds to the deferred gain from the initial exchange.

D. Allocation of Consideration Received
Where Boot is Given in Exchange

Transferring nonqualifying property along with qualifying property will not take a transaction out of Section 1031. Where the taxpayer transfers qualifying and nonqualifying property in an exchange, the consideration received must be allocated between qualifying and nonqualifying property in proportion to their respective fair market values. Treas. Regs. §1.1060-1(c)(2). Consideration allocated to nonqualifying property transferred will result in gain or loss recognition under Section 1001(c). Regs. § 1.1031(d)-1(e). No gain or loss is recognized with respect to the transfer of cash, since no “sale or exchange” occurs.

1. Illustration

Taxpayer exchanges a building, with an adjusted basis of $1 million and a FMV of $1.1 million, plus GM stock with an adjusted basis of $400,000 and a FMV of $200,000, for a vacant lot with a FMV of $1.3 million. The consideration of $1.3 million is allocated between the building and the GM stock in proportion to their fair market values. The taxpayer realizes gain of $100,000 on the building ($1.1 million – $1 million) and recognizes a loss of $200,000 under IRC § 1001(c) on the GM stock ($400,000 – $200,000). Gain realized from the exchange of the building for the vacant lot is not recognized because those properties are of like kind. IRC § 1031(c). The basis of the vacant lot is calculated as follows:

1. Loss on transfer of GM stock
a. Adjusted Basis ………………………………….. $ 400,000
b. Less: amount realized ………………………… $ 200,000
c. Loss realized and recognized ……………… $ 200,000

2. Adjusted basis of relinquished building ……….. $ 1,000,000
Plus: Adjusted basis of GM stock …………….. $ 400,000
Aggregate basis of property transferred ……….. $ 1,400,000

3. Aggregate basis of property transferred ……….. $ 1,400,000
Less: Loss recognized on GM stock ………….. $ 200,000
Basis of vacant lot …………………………………….. $ 1,200,000
E. Transfers Involving Multiple Assets

1. Prior to Multiple Asset Exchange Regulations

Prior to the multiple asset exchange regulations of § 1.1031-1(j), where multiple assets were transferred and both had potential realized gain or loss, to calculate the nature and character of gain, boot was allocated between the assets transferred in accordance with fair market value. In an exchange involving relinquished property consisting of (i) a jet held for 5 months with an adjusted basis of $3.7 million and fair market value of $4 million and (ii) a train held for 2 years with an adjusted basis of $1 million and fair market value of $2 million, if replacement property consisting of another jet and $1 million cash, realized and recognized gain would have been calculated as follows.

Jet

Amount Realized $4.0 million
Basis of Jet transferred $3.7 million
Gain Realized $0.3 million
Boot Allocable $0.667 million
Gain Recognized $0.3 million
Character of Gain: Ordinary

Train

Amount Realized $2.0 million
Basis of Train transferred $1.0 million
Gain Realized $1.0 million
Boot Allocable $0.333 million
Gain Recognized $0.333 million
Character of Gain: §1231

Note: Even though boot of $1 million was received, and overall realized gain equals $1.3 million, gain recognized would only have totaled $0.633 million. This favorable result occurred because prior to the multiple asset exchange regulations, the application of Section 1031 occurred on a property-by-property basis. Here, the jet produced only $0.3 million in realized gain.

2. Multi-Asset Exchange Regulations

a. Definition of Multiple Asset Exchanges

For multiple asset exchanges after April 11, 1991, the multiple asset exchange rules of Regs § 1.1031(j)-1 apply. A multiple asset exchange is an exchange in which (i) more than one exchange group is created or (ii) only one exchange group is created but more than one property is being transferred or received within that exchange group. Regs. § 1.1031(j)-1(a)(1).

b. Calculation of Gain and Basis

In general, the amount of gain recognized in an exchange of multiple properties is computed by first separating the properties transferred and the properties received into “exchange groups.” Next, all liabilities assumed in an exchange are offset by all liabilities of which the taxpayer is relieved in the exchange. Then, the rules of Section 1031 are applied separately to each exchange group to determine the amount of gain recognized in the exchange. Finally, the rules of Section 1031 and the regulations are applied separately to each exchange group to determine the basis of properties received in the exchange. Regs. § 1.1031(j)-1(a)(2) Resulting “exchange group deficiencies” would lead to less favorable boot gain results than would be the case prior to the multiple asset regulations.

VI. Gain or Loss in Like Kind Exchange

A. Realized Gain Recognized to Extent of Boot Received

Realized gain equals the sum of money and the fair market value of property received in the exchange less the adjusted basis of property transferred. Regs. § 1.1001-1(a). Realized gain is recognized to the extent of the sum of money and the fair market value of nonqualifying property received. Section 1031(b). Thus, if property with a fair market value of 10x dollars and basis of zero is exchanged for property with a fair market value of 5x dollars and 5x dollars in cash, realized gain of 10x dollars is recognized to the extent of the 5x dollars in cash received. Although basis would be increased by 5x dollars to reflect gain recognized, basis would also be decreased by 5x dollars to reflect cash received. Therefore, basis in the replacement property would be zero.

1. Debt Relief Treated as Cash Received

If liabilities associated with the relinquished property are assumed by the other party to the exchange, the taxpayer is deemed to receive cash. Section 1031(d); Regs. § 1.1031(b)-1(c); Coleman v. Com’r, 180 F2d 758 (8th Cir. 1050). Whether another party to the exchange has assumed a liability of the taxpayer is determined under Section 357(d).

2. Compare: Realized Loss Not Recognized

Although realized gain is recognized to the extent nonqualifying property is received in an exchange, Section 1031(c) provides that realized loss with respect to relinquished exchange property is never recognized, even if nonqualifying property is received in an exchange. However, this does not mean that loss will never be recognized in a like kind exchange. Under Section 1001(c), both gains and losses are recognized with respect to nonqualifying property transferred in a like kind exchange. Section 1031 takes a restrictive view of nonqualifying property received in an exchange, since it undermines the purpose of the statute. However, Section 1031 imposes no special rules with respect to the transfer of nonqualifying property in a like kind exchange.

a. Illustration

Taxpayer exchanges property in Florida which has declined in value, for an oil and gas lease in Montana, and cash. Realized loss with respect to the Florida property is not recognized because loss is not recognized with respect to the transfer of qualifying property, even if boot is received. However, if as part of the consideration for the Montana property the taxpayer also transferred Ford stock which had declined in value, realized loss on the Ford stock would be recognized (whether or not the taxpayer received cash boot) because both gains and losses are recognized with respect to the transfer of nonqualifying property in a like kind exchange.

3. Boot Gain Taxed In Year Received

When cash boot is received in a deferred exchange covering two taxable years, taxable income is presumably not recognized until the second year, when boot is received. See Revenue Ruling 2003-56.

B. Generally No Gain if Taxpayer “Trades Up”

Where a taxpayer “trades up” by acquiring property more valuable than the property relinquished and no boot is received, Section 1031 operates to defer recognition of all realized gain, (except in unusual circumstances involving depreciation recapture under Section 1245). However, if the taxpayer “trades down” and acquires property less valuable than that relinquished (thereby receiving cash or other nonqualifying property in the exchange) like kind exchange status will not (for this reason) be imperiled, but the taxpayer will be forced to recognize some of the realized gain. Boot may consist of property excluded from like kind exchange treatment (e.g., partnership interests) or simply property which fails to constitute property that is of like kind to the property relinquished in the exchanged (e.g., a truck for a horse). Even if no nonqualifying property is received in the exchange, the IRS has taken the position that an exchange of real estate whose values are not approximately equal may yield boot. See PLR 9535028. This could occur, for example, in a situation involving the exchange of property among beneficiaries in the administration of an estate.

C. Installment Method of Reporting Boot Gain

1. Installment Method Reporting Generally

Section 453 provides that an “installment sale” is a disposition of property where at least one payment is to be received in the taxable year following the year of disposition. Income from an installment sale is taken into account under the “installment method.” The installment method is defined as a method in which income recognized in any taxable year following a disposition equals that percentage of the payments received, which the gross profit bears to the total contract price. Gain recognized in a like kind exchange Such recognized gain may be eligible for installment treatment if the taxpayer otherwise qualifies to use the installment method to report gain. Therefore, if a taxpayer sells real estate with a basis of $250,000 for $1 million, 75 percent of payments (i.e., gross profit/total contract price) received would be taxable as gross income.

2. Timing of Reporting Installment Gain in Exchange

Section 453(f)(6)(C) provides that for purposes of the installment method, the receipt of qualifying like kind property will not be considered “payment.” However, the Temporary Regulations provide that the term “payment” includes amounts actually or constructively received under an installment obligation. Therefore, the receipt of an installment obligation in a like kind exchange would constitute boot. Prop. Reg. § 1.453-1(f)(1)(iii) provides for the timing of gain upon receipt of an installment obligation received in a like kind exchange. Installment notes (which qualify for installment reporting) received in a like kind exchange would not be taxed as the time of the exchange. Rather, as payments are received on the installment obligation, a portion of each payment would taxed as gain, and a portion would constitute a recovery of basis.

a. Method of Allocating Basis to Installment Note

The Regulations generally allocate basis in the transferred property entirely to like kind property received in the exchange where an installment obligation is received. The result is that less basis is allocated to the installment obligation. This is disadvantageous from a tax standpoint, since a greater portion of each payment received under the installment obligation will be subject to current tax.
b. Illustration

Taxpayer exchanges property with a basis of $500,000 and a fair market value of $1 million for like kind property worth $750,000 and an installment obligation of $250,000. The installment note would constitute boot, but would be eligible for reporting under the installment method. Under the Proposed Regulations, the entire $500,000 basis would be allocated to the like kind replacement property received in the exchange. No basis would be allocated to the installment obligation. Consequently, all of the principal payments made the note would be taxed as gain to the taxpayer. Had the $500,000 basis instead been permitted to be allocated to the installment obligation and the replacement property in proportion to their fair market values, the note would have attracted a basis of $125,000 (i.e., 1/4 x $500,000). In that case, 50 percent ($125,000/$250,000) of each payment would have been a return of basis, and only 50 percent would have been subject to tax. The remainder of the realized gain would have been deferred until the replacement property were later sold.

D. Treatment of Boot Given in Like Kind Exchange

Transferring nonqualifying property along with qualifying property will not take a transaction out of Section 1031. However, consideration received must be allocated between the qualifying property and the nonqualifying property transferred in proportion to their respective fair market values. Consideration allocated to nonqualifying property transferred will result in gain or loss recognition under Section 1001(c). Regs. § 1.1031(d)-1(e). No gain or loss is recognized with respect to the transfer of cash, since no “sale or exchange” occurs.

E. Closing Costs Permitted to be Expensed Reduce Amount Realized

The receipt of cash or other nonqualifying property would normally produce taxable boot to the extent of realized gain. However, Rev. Rul. 72-456 provided that brokerage commissions and many other transaction costs may be expensed, reducing gain realized and, in effect, also reducing recognized gain. Blatt v. Com’r, 67 T.C.M. 2125; T.C. Memo (1994-48) concurred, and held that expenses incurred in connection with the exchange and not deducted elsewhere on the taxpayer’s return may offset boot. In such cases, the taxpayer may in effect “trade down.” Blatt suggested that the following expenses, incurred in connection with closing, should be allowed as exchange expenses:

1. Allowable Exchange Expenses

a. Escrow fees;
b. Fees in obtaining lender statement;
c. Document preparation fees;
d. Title insurance policy fees;
e. Sub-title fees;
f. Exchange tie-in fees;
g. Recording deed fees;
h. Recording reconveyance fees;
i. Documenting fees for transfer tax;
j. Statement fees;
k. Reconveyance fees;
l. Loan organization fees;
m. Document preparation fees;
n. Tax service fees;
o. Processing fees;
p. Messenger fees;
q. Lenders title policy premium fees;
r. Sub-escrow fees;
s. Recording trust deed fees; and
t. Loan tie-in fees.

2. Illustration

Assume taxpayer sells real estate for $1 million. Taxpayer pays $10,000 of attorneys’ fees in connection with the sale. At closing the taxpayer receives qualifying like kind exchange property worth $900,000 and $100,000 of cash. The “net selling price” would be $990,000. If the taxpayer’s adjusted basis in the property were $900,000, $90,000 of realized gain would result, all of which would be recognized. Note that had the attorneys’ fee not been expensed, all of the $100,000 of realized gain would have been recognized. Therefore, even though the attorneys’ fees were paid by cash from exchange proceeds, $10,000 of that cash did not produce boot. Other typical selling expenses incurred in connection with a closing include (i) broker or selling agent sales commissions; (ii) finder’s fees; (iii) inspection and testing fees; (iv) title insurance premiums; (v) escrow fees; (vi) transfer taxes; (vii) recording fees; and (viii) qualified intermediary exchange fees.

F. Items Not Permitted to be Expensed But Permitted to Offset Boot

Some items paid at closing cannot be expensed, but nevertheless can offset boot received in the exchange in a manner other than reducing the amount realized (as would exchange expenses). To illustrate, assume that in the previous example, closing occurs on June 1st, 2008, and that the seller had paid $100,000 for a service contract on January 1st, 2008 effective for the entire year. Assume further that no cash was paid to the seller at closing to account for the seller’s prepaid expense. The closing statement would reflect a credit to the seller for $50,000. The credit – even though an expense incurred by the seller in economic terms – would not reduce the “net selling price” as would attorneys’ fees, since the service contract was not incurred in connection with the exchange. The realized gain in the transaction would be $100,000. However, the taxpayer could net the service contract credit (boot paid) with other boot the taxpayer may have received in the exchange. For example, assume the seller collected rent of $100,000 on June 1st, 2008, which the seller kept. This item would be reflected on the closing statement as a credit to the buyer and would constitute boot to the seller. However, since the seller also paid boot of $50,000, the two could be netted. After netting, a boot gain of $50,000 would result. The basis of the replacement property would be increased by the $50,000 of gain recognized. The effect of the netting would be to permit the taxpayer to capitalize the transactional item into the basis of the replacement property.

G. ABA Position on Boot Gain

The ABA Section of Taxation takes the position that virtually all kinds of expenses incurred in connection with the exchange, except expenses attributable to refinancing, should offset boot, regardless of whether they are attributable to the relinquished property or the replacement property. The expenses allowed in Blatt seem to include even refinancing expenses.

H. Treatment of Expenses and Transactional
Items Paid by QI and Related to Closing

Regs. §1.1031(k)-1(g)(7) permits typical closing expenses to be paid from exchange proceeds held by the qualified intermediary. However, if there is any doubt about the timing of the payment, the expense should not be paid until the closing of the replacement property, when the taxpayer would otherwise have the right to receive the funds. Otherwise, the payment by the QI during the exchange period could conceivably result in boot. In the worst case scenario, the payment could take the transaction out of the safe harbor deferred exchange regulations entirely, resulting in constructive receipt by the taxpayer of the entire exchange proceeds, thereby nullifying the like kind exchange.======================================================================

TREATMENT OF EXPENSES AND TRANSACTIONAL ITEMS
RELATED TO CLOSING ON THE RELINQUISHED PROPERTY

A. Selling Expenses Excluded From Amount Realized

The following items are deducted from the contract price in determining the amount realized. They affect realized gain only.

1. Broker’s commissions
2. Transfer taxes
3. Recording Fees
4. Attorney’s Fees
5. Qualified Intermediary Exchange Fee

B. Closing Costs or Transactional Expenses That May be Paid With
Exchange Proceeds But Which Are Not Excluded From Amount
Realized or Added to the Basis of Replacement Property

Rather, they are operating costs due to the ownership of real property. However, even though they may not affect calculations with respect to the like kind exchange (and may therefore not appear on Form 8824), they may be deductible elsewhere on the return. Examples of these items include the following:

1. Real estate taxes
2. Rent
3. Costs incurred to remove mechanic’s liens

C. Transactional Prorations Which Result in Boot Received
When Relinquished Property is Sold

1. Credit to buyer-purchaser for rents collected by taxpayer-seller but allocable to period following the closing

[The portion of the rent collected by the taxpayer for periods after the closing are credited to the buyer, but never pass to the qualified intermediary. Since the taxpayer-seller retains the cash, it is a clearly boot. However, if boot may be an issue in the exchange, the problem might be avoided if the taxpayer-seller prior to closing places the unearned rent into an escrow account which passes to the qualified intermediary.]

2. Credit due to buyer for prorated security deposits paid by taxpayer-seller.

[The security deposits for which the buyer receives a credit at closing, constitute part of the purchase price of the real estate. If instead of crediting the buyer, the seller cut a check to the buyer at closing, more funds would be delivered to the QI. Since the cash remains in the account of the seller-taxpayer it is treated as boot received. If boot is not a problem in the transaction, the seller-taxpayer would likely prefer to keep the cash.]

3. Credit to buyer for repair costs

[The seller-taxpayer might prefer to reduce the selling price. However, this might affect the buyer’s financing.]

4. Credit to buyer for accrued (unpaid) utility charges

[The seller-taxpayer, although giving the buyer a credit, has received boot in the form of the relief of the liability. This is analogous to the boot gain resulting from the buyer’s assumption of a mortgage.]

5. Payoff for loan, including (i) principal balance; (ii) accrued interest through closing date; and (iii) prepayment penalty

6. Credit due to Buyer for Prorated Accrued Property Taxes

[Prorated accrued property taxes are treated as liabilities and reflect liability boot which may be offset with corresponding liabilities on the replacement property.]

D. Transactional Prorations Which Result in Boot Paid
When Relinquished Property is Sold

1. Credit due to seller for escrow deposits with lender

[The purchase price is increased, which means that more cash is going to the QI]

2. Credit due to seller for prepaid service contracts

[Seller-taxpayer has paid post-closing liability in cash for which he was not responsible]

=================================================================

TREATMENT OF EXPENSES AND TRANSACTIONAL ITEMS
RELATED TO CLOSING ON THE REPLACEMENT PROPERTY

A. Selling Expenses Excluded From Amount Realized

The following items are deducted from the contract price in determining the amount realized. They affect realized gain only.

1. Finder’s fees
3. Survey, unless solely for purposes of loan
3. Property inspection & environmental testing fees,
unless solely for purposes of loan
4. Title insurance premiums (owner’s policy)
5. Recording fees
6. Attorney’s fees

B. Closing Costs or Transactional Expenses That May be Paid With
Exchange Proceeds But Which Are Not Excluded From Amount
Realized or Added to the Basis of Replacement Property

1. Real estate taxes
2. Rent
3. Costs incurred to remove mechanic’s liens

[Note: This is the same discussion as obtained with respect to the disposition of the relinquished property.

C. Transactional Prorations Which Result in Boot Paid
When Replacement Property is Purchased

1. Credit to taxpayer-buyer for rents received by seller but which are allocable to periods following the closing

[The portion of the rent collected by the seller for periods following the closing are credited to the taxpayer-buyer. The boot paid by the taxpayer-buyer consists of the funds which remain the account of the seller. The seller could also refund these amounts, instead of issuing a credit on the closing statement. In either case, the taxpayer would have taxable income. However, if boot gain may be a problem, it would be preferable for the taxpayer-buyer to be credited, rather than receive a refund, since the boot paid will offset boot received in the exchange.]

2. Credit due to taxpayer-buyer for prorated accrued property taxes

[Prorated accrued property taxes are treated as liabilities assumed by the taxpayer-buyer, and may offset liabilities with respect to which the taxpayer was relieved on the relinquished property.]

3. Credit due to taxpayer-buyer for prorated security deposits

[The security deposits for which the taxpayer-buyer receives a credit at closing would otherwise have been paid in cash. Since this item, if credited rather than received in cash, would constitute boot paid, it may be preferable for the taxpayer to take the credit rather than receive the cash, since the boot paid will offset boot received in the exchange.]

D . Transactional Prorations Which Result in Boot
Received When Replacement Property is Purchased

1. Credit due to seller for prepaid service contracts

[Seller has paid a post-closing liability in cash for the benefit of the taxpayer-buyer which results in boot]

2. Prepaid property casualty & liability insurance premium

[Seller has paid a post-closing liability in cash for the benefit of the taxpayer which results in boot]

3. Prepaid per diem interest on loan

4. Title insurance (lender’s policy)

5. Appraisal fee

6. Loan origination fee

7. UCC search fees

I. Issues Involving Earnest Money Deposits

1. Relinquished Property

A deposit should never be paid to taxpayer directly. Any downpayment deposited by the taxpayer should be transferred to the QI when the relinquished property contract is assigned to the QI. Alternatively, the taxpayer could return the downpayment to the buyer and request that the buyer cut another check to the QI. If the taxpayer has entered into an option agreement whereby the buyer paid for the right to purchase the relinquished property, the option payment will likely be considered boot. If the downpayment is held by the taxpayer’s attorney, the taxpayer should assign its rights to the downpayment (as well as all of its rights in the relinquished property contract) to the QI.

2. Replacement Property

The QI may make a downpayment for replacement property after the purchase agreement for the replacement property has been assigned to the QI. The escrow instructions should provide that if the taxpayer does not close on the property, the deposit will be returned to the QI, and not the taxpayer. If the taxpayer is already in contract for the purchase of the replacement property before the QI is involved, the taxpayer will have made the deposit with his own funds. At some point, the QI will come into possession of the exchange funds, and the taxpayer will also have assigned the rights in the replacement property contract to the QI. It would clearly violate the deferred exchange regulations if the QI reimbursed the taxpayer for the earnest money deposit prior to closing. However, at closing, the QI could properly reimburse the taxpayer from the exchange funds.

J. Disbursement of Exchange Funds

1. G-6 Limitations

Regs. §1.1031-1(k)-1(g)(6) govern the disbursement of funds to the taxpayer. The regulations provide that the exchange agreement must limit the taxpayer’s right to receive, pledge, borrow, or otherwise obtain the benefits of the proceeds prior to the expiration of the exchange period.

2. When Proceeds May be Disbursed

The taxpayer may receive excess proceeds at the end of the exchange period, whether or not the taxpayer has closed on all properties identified in the identification period.

a. After Relinquished Property
Closing but Prior to 46th Day

If the taxpayer has closed on all identified replacement property prior to the 46th day, then excess exchange proceeds may be distributed after that time. Likewise, if the taxpayer has identified no replacement property before the expiration of the 45-day identification period, then the exchange proceeds may be distributed on the 46th day.

b. After the 45th day Identification Period

If the taxpayer has identified property during the identification period, the proceeds are frozen with the QI until the 180-day exchange period has expired, even if the taxpayer decides not to acquire the replacement property on the 46th day. If the taxpayer has identified more than one property, and closes on only one property (either before or after the 45-day identification period), the remaining exchange proceeds will be frozen with the QI until after the exchange period has ended.

3. Installment Treatment of Excess Exchange Funds?

If taxpayer has funds remaining in the exchange account following the identification period (if no identification is made) or at the end of the exchange period (if no or insufficient replacement property is acquired), the remaining exchange funds paid to the taxpayer over time may qualify for installment sale treatment. Special installment sale rules apply during the pendency of a like-kind exchange pursuant to Treas. Regs. § 1.1031(k)-1(j)(2). That “protection” terminates at the end of the exchange.

4. Insurance Against Failed Exchange?

As insurance against a failed like-kind exchange, at the time of the (g)(6) event, the QI gives an installment note to the taxpayer and assigns the obligation under the note to an unrelated assignment company. The assignment company may use funds to purchase an annuity from an insurance company to provide a funding source for the installment note. It is unclear whether this transaction would qualify for installment sale treatment. Structures like this are being marketed as a fall back to a failed exchange.

HYPOTHETICAL

Wimbledon Investors, LLC, (“Wimbledon”) owns an office building in Great Neck with an adjusted basis of $5.42 million that it has contracted to sell for $10 million. The downpayment of $1 million is being held by the attorney for Wimbledon in an attorney escrow account. Wimbledon has engaged JPMorgan Chase (“Chase”) as QI , and has assigned its rights under the relinquished property contract and the earnest money deposit to Chase. Wimbledon has an outstanding principal balance of $4,748,345 on a Citibank loan encumbering the relinquished property, which loan cannot be assumed and is subject to a prepayment penalty.

Wimbledon has contracted to purchase replacement property in Long Island City for $11 million. If Wimbledon acquires the replacement property within the 45-day identification period, the “actual purchase” rule will be satisfied. Wimbledon entered into the purchase and sale contract for the Long Island City property prior to engaging Chase as QI. Accordingly, Wimbledon paid the $1,100,000 downpayment from its own funds, but will be reimbursed from exchange funds at closing. Wimbledon assigned its rights in the replacement property contract to Chase as QI. Wimbledon will obtain financing for the acquisition of the replacement property from HSBC.

RELINQUISHED PROPERTY CLOSING STATEMENT: TAXPAYER-SELLER’S TRANSACTION
SELLER: J.P. Morgan Exchange, Inc., as QI for Wimbledon Investors, LLC
BUYER: Adirondack Properties, LLC
PROPERTY: Office Building at 11111 Northern Boulevard, Great Neck, NY 10021
DATE: December 15, 2008, 10:00 AM
Purchase Price $ 10,000,000
Plus:
Credit due to taxpayer for escrow deposits that pass to buyer [BOOT PAID] $ 50,243
Credit due to taxpayer for prorated prepaid service contracts [BOOT PAID] $ 13,387
Credit due to taxpayer for prorated prepaid property taxes [BOOT PAID] 11,123
Subtotal $ 74,753
Less:
Earnest Money Deposit $ 1,000,000
Credit to Buyer for prorated post-closing rent retained [BOOT RECEIVED] 20,000
Unpaid accrued utility charges assumed by buyer [BOOT RECEIVED] 14,439
Credit due to Buyer for security deposits retained [BOOT RECEIVED] 17,500
Payoff for Citibank Loan (receipt of cash)
Principal balance [BOOT RECEIVED] 4,748,345
Accrued interest through closing date [BOOT RECEIVED] 32,432
Prepayment penalty [BOOT RECEIVED] 20,000
Broker’s Commission [EXPENSE] 400,000
Attorneys’ fees [EXPENSE] 10,000
Recording Fees [EXPENSE] 140,000
Qualified Intermediary exchange fee [EXPENSE] P.O.C.
Subtotal $ 6,402,716
Balance due Seller $ 3,672,037
Funds delivered to Qualified Intermediary $ 4,672,037 REPLACEMENT PROP. CLOSING STATEMENT: TAXPAYER-BUYER’S TRANSACTION
SELLER: Atlantis Properties, LLC, a New York Limited Liability Company
BUYER: J.P. Morgan Exchange, Inc., as QI for Wimbledon Investors, LLC
PROPERTY: Commercial building at 1201 Skillman Avenue, Long Island City, NY
DATE: December 28, 2008, 10:00 AM
Purchase Price $ 11,000,000

Less: Credit due to Taxpayer for prorated rent collected by seller [BOOT PAID] $ 2,750
Credit due to Taxpayer for Seller’s for accrued property taxes [BOOT PAID] 13,387
Credit due to Taxpayer for security deposits retained by seller [BOOT PAID] 11,123
Earnest money deposit paid by Taxpayer (refunded to taxpayer at closing) 1,100,000
Subtotal $ 1,127,260
Plus: Credit due to Seller for prorated prepd service contracts [BOOT REC’D] $ 9,600
Credit to Seller for Prepaid per diem interest on loan [BOOT REC’D] 19,540
Credit to Seller for Prepd proprty casulty & liab. ins. prem [BOOT REC’D] 9,500
Title insurance – lender’s policy [BOOT REC’D] 9,000
Appraisal fee [BOOT REC’D] 7,500
Loan Origination Fee [BOOT REC’D] 80,000
UCC search fees [BOOT REC’D] 275
Survey [EXPENSE] 2,000
Attorneys’ fees [EXPENSE] 10,000
Recording fees [EXPENSE] 150
Environmental study [EXPENSE] 6,500
Title insurance – owner’s policy [EXPENSE] 22,000
Qualified Intermediary exchange fee [EXPENSE] P.O.C.
Subtotal $ 176,065
Total due from Buyer $ 10,048,805
Deposit from Qualified Intermediary $ 3,571,037
Balance due to Seller – Loan proceeds from HSBC [BOOT PAID] $ 6,477,768

Check: Net Credits to Seller: $ 11,380
Purchase Price: $ 11,000,000
Amt Due Seller w/credits $ 11,011,380

Less: Deposit $ 1,100,000
Net due Seller $ 9,911,380

Total Due from Buyer: $ 10,048,805
Less buyer expenses paid from escrow $ 137,425
Total remaining for seller $ 9,911,380

CLASSIFICATION OF TRANSACTIONAL ITEMS
1. Relinquished Property Exchange Expenses:
Broker’s commission $ 400,000
Recording fees 140,000
Attorneys’ fees 10,000
Qualified Intermediary exchange fee 1,000
TOTAL $551,000
2. Relinquished Property Prorations and Other
Transactional Items Treated as Boot Received by Seller:
Credit due to Buyer for prorated rent (after closing rent kept by seller) $ 20,000
Credit due to Buyer for security deposits (deposits kept by seller) 17,500
Accrued utility charges (Liability assumed by buyer) 14,439
TOTAL $ 51,939
3. Relinquished Property Prorations and Other
Transactional Items Treated as Boot Paid by Seller:
Credit due to Seller for escrow deposits with lender (cash foregone) $ 50,243
Credit due to Seller for prorated prepaid service contracts (prepaid liab.) 13,387
Credit due to Seller for property taxes paid through 12/31/08 (prepd liab.) 11,123
TOTAL $ 74,753
4. Replacement Property Exchange Expenses:
Title Insurance – owner’s policy $ 22,000
Attorneys’ fees 10,000
Environmental study 6,500
Survey 2,000
Recording fees 150
TOTAL $40,650
5. Replacement Property Loan Costs Treated as Boot Received by Buyer:
Title Insurance – lender’s policy (cash otherwise wld have gone to QI) $ 9,000
Appraisal fee (Cash otherwise would have gone to QI) 7,500
Loan origination fee (cash otherwise would have gone to QI) 80,000
UCC search fees (cash otherwise would have gone to QI) 275
TOTAL $ 96,775
6. Replacement Property Prorations and Other
Transactional Items Treated as Boot Received by Buyer:
Credit due to Seller for prorated prepaid service contracts (prepd liab.) $ 9,600
Prepaid property and casualty liability insurance premium (prepd liab.) 9,500
Prepaid per diem interest on new loan 19,540
TOTAL $ 38,640
7. Replacement Property Prorations and Other
Transactional Items Treated as Boot Paid by Buyer:
Credit due to Buyer for prorated rent received by seller (cash foregone) $ 2,750
\ Credit due to Buyer for Seller’s portion of accrued taxes (liab. assumed) 13,387
Credit due to Buyer for prorated security deposits (cash foregone) 11,123
TOTAL $ 27,260 DETERMINATION OF NET BOOT RECEIVED OR PAID

Netting of Prorations and Other Transactional Items:

Relinquished property prorations and other items treated as boot paid $ 74,753
Replacement property prorations and other items treated as boot paid 27,260
Less relinquished property prorations and other items treated as boot (51,939)
received
Less replacement property loan costs treated as boot received (96,775)
Less replacement property prorations and other items treated as boot
received (38,640)

Net boot paid (received) on prorations and transactional items $ (85,341)

Less relinquished property liabilities assumed that are
treated as boot received:
Principal balance of mortgage loan $4,748,345
Accrued interest on mortgage loan 32,432
Prepayment penalty on mortgage loan 20,000 (4,800,777)

Plus replacement property liabilities assumed
New mortgage loan 6,477,768

Net boot paid (received) $1,591,650

GAIN REALIZED AND RECOGNIZED
ON SALE OF RELINQUISHED PROPERTY

Selling Price of Relinquished Property $10,000,000

Less selling/purchasing expenses
Selling expenses of relinquished property $551,000
Purchase expenses of replacement property $ 40,650 591,650

Net selling price of relinquishes property $9,408,350
(i.e., Amount Realized)

Less adjusted basis of relinquished property 5,420,000

Gain Realized A $3,988,350

Net boot received B $ -0-

Gain Recognized – lesser of A or B $ -0-

Deferred Gain $3,988,350

BASIS OF REPLACEMENT PROPERTY

Basis of relinquished property $5,420,000

Gain recognized -0-

Add net boot paid 1,591,650

Basis of replacement property $7,011,650

Check:

Purchase price of replacement property $11,000,000

Deferred gain 3,988,350

Basis of replacement property $7,011,650

VII. Treatment of Liabilities

A. Relief From Liabilities Treated as Cash Received

If another party to an exchange assumes liabilities associated with the relinquished property, the debt relief is treated as money received by the taxpayer, and is taxed as boot. Section 1031(d); Regs. § 1031(b)-1(c); Allen v. Com’r, 10 T.C. 413 (1948). However, if the taxpayer also assumes liabilities associated with the replacement property, the two liabilities – those assumed by the taxpayer and those of which the taxpayer is relieved – are permitted to be netted. Regs. §1031(d)-2, Examples 1 and 2. Additional boot arises only when the taxpayer is relieved of more liabilities than he assumes in the exchange. In addition, cash and other nonqualifying property paid by the taxpayer is treated as a liability assumed by the taxpayer, and accordingly may be netted against liabilities associated with the relinquished property which are assumed by the other party. For example, if the taxpayer is relieved of a mortgage of 10x dollars, but also pays 10x dollars to the other party, the taxpayer will have no taxable boot. PLR 9853028 stated that a purchase money mortgage given by the taxpayer to acquire the replacement property may be netted against liabilities associated with relinquished property of which the taxpayer is relieved in the exchange.

1. Rationale for Permitting Cash Paid to be Netted

Assume the taxpayer is relieved of 10x dollars of liabilities but assumes only 5x dollars of liabilities in the exchange and is thus required to pay 5x dollars in cash. Although the taxpayer has net debt relief of 5x dollars, the Regulations permit the cash paid to offset the net debt relief. The rationale for allowing this tax treatment is that had the taxpayer reduced the liabilities associated with the relinquished property by 5x dollars prior to the exchange, the properties exchanged would be subject to identical mortgages, and no boot gain would result. Since the economics of the two situations are virtually identical – in both cases the taxpayer pays 5x dollars and ends up with property having a mortgage of 5x dollars – the taxpayer should not be required to report boot gain in one situation but not the other.

2. Determination of Whether Taxpayer’s Liabilities Assumed

Whether another party has assumed a liability of the taxpayer is determined under Section 357(d), which provides that, in general, a recourse liability is treated as having been assumed if the transferee has agreed to, and is expected to, satisfy such liability. The amount of a nonrecourse liability treated as having been assumed is reduced by the amount of the liability which an owner of assets not transferred to the transferee and also subject to such liability has agreed with the transferee to, and is expected to, satisfy.

3. Cash Received Not Netted Against Liabilities Assumed

Cash or other nonqualifying property received by the taxpayer in the exchange may not be netted against net liabilities assumed by the taxpayer in the exchange. Although the analysis justifying a “no boot” conclusion where the taxpayer pays cash could in theory be applied in this situation, the IRS is unwilling to endorse this analysis. To illustrate: Taxpayer assumes liabilities of 10x dollars associated with the replacement property, is relieved of liabilities of 5x dollars in the exchange, and receives 5x dollars in cash. Even though the taxpayer has assumed 5x dollars of new net liabilities, he may not net the 5x dollars in cash received with the 5x dollars in new liabilities assumed – the taxpayer has taxable boot of 5x dollars. Regs. § 1.1031(d)-2; Coleman v. Comr., 180 F.2d 758 (8th Cir. 1950).

a. Possible Solutions?

Since netting is not allowed in this situation, may the other party pay down the mortgage on the replacement property prior to the exchange, obviating the need for the taxpayer to receive an additional 5x dollars in cash? Or may the taxpayer increase the mortgage on the relinquished property by 5x dollars in advance of the exchange, thereby receiving mortgage proceeds rather than the cash from the other party? Presumably, the IRS could object unless a business purpose were present and the debt were “old and cold.” See Garcia v. Com’r, 80 T.C. 491 (1983), acq, 1984-1 C.B. 1, infra.

B. Liability Netting Rules Summarized

The netting rules may be summarized as follows:

May Money or Other Property
Net Liabilities Relieved Money or Given Offset
vs. Liabilities Assumed Other Property Liability Relief? Boot Gain Comment

None No Money Liabilities Relieved – Liabilities Assumed Nothing to Net
Net Liabilities Relieved Given Yes Liabilities Relieved – Liab. Assumed – Boot Given Netting Permitted
Received No Liabilities Relieved – Liab. Assumed + Boot Rec’d Netting Not Permitted
Liabilities Relieved None No Money None Nothing to Net
Equal Given Yes None Netting Not Required
Liabilities Assumed Received No Cash Received Netting Not Permitted
None No Money None Nothing to Net
Net Liabilities Assumed Given Yes None Netting Not Required
Received No Cash Received Netting Not Permitted

VIII. Consequences of Refinancing Before and After Exchanges

A. Regulations Do Not Prohibit Pre-Exchange Financing

Pre-exchange financing may be arranged for the following reasons: (i) to avoid boot gain associated with debt relief; (ii) to extract cash tax-free from property to be exchanged; or (iii) to avoid the necessity of transferring cash in connection with an exchange. The Regulations contain no prohibition on pre-exchange financing. Furthermore, a straightforward reading of Regs. § 1.1031(b)-1(c) appears to treat a new loan obtained shortly before an exchange of relinquished property as bona fide debt if the relinquished property secures the debt. Nevertheless, the IRS may challenge pre-exchange financing unless the debt is “old and cold.”

B. Hypothetical Illustration of Pre-Exchange Financing

If the relinquished and replacement properties are of equal value, but the replacement property is subject to a larger mortgage, the cash buyer will be required to include cash for the consideration to be equal. Yet, that cash will cause boot gain to the taxpayer. Suppose instead the taxpayer mortgages the relinquished property in advance of the exchange to “even out” mortgages? Since loan proceeds are not taxable, boot would appear to be avoided. The IRS might argue that the transaction lacks substance, since the taxpayer’s economic position is no different than it would have been had the cash buyer had simply paid cash boot.

1. Fredericks v. Com’r

Fredericks v. Com’r, T.C. Memo 1994-27 posed the scenario described above. The replacement property was more heavily mortgaged than the relinquished property. Rather than receive cash boot, the taxpayer mortgaged the relinquished property. Fredericks approved of the refinancing since it was (i) independent of the exchange; (ii) not conditioned on closing; (iii) dependent on creditworthiness of the taxpayer, rather than the cash buyer; and (iv) made sufficiently in advance (i.e., “old and cold”) of any contemplated exchange. If these requirements are not met, the IRS may argue that the mortgage was, in substance, obtained by the cash buyer and constitutes taxable boot. See also, Behrens v. Com’r, T.C. Memo 1985-195. Ideally, the taxpayer’s reasons for refinancing should be unrelated to the exchange, and should be motivated, at least in part, by an independent business purpose. Would partner discord or estate planning be such a purpose?

C. Pre-Exchange Financing With Replacement Property Less Risky

In the situation described above, the taxpayer mortgages the relinquished property and receives cash to even out the mortgages. Refinancing relinquished property obviates the need for the taxpayer to receive cash boot. Pre-exchange refinancing by the seller of the replacement property may also be desirable where relinquished property is more heavily mortgaged than the replacement property. In this situation, if the mortgages are not evened out, the taxpayer will have to pay cash. In Garcia v. Com’r, 80 T.C. 491 (1983), acq, 1984-1 C.B. 1, to avoid having to pay cash, the taxpayer prevailed on the seller to increase the mortgage on the replacement property. Garcia prevailed and the IRS acquiesced. The Garcia type of pre-exchange financing appears to pose less tax risk than the type of financing accomplished in Fredericks, the critical difference being that while the taxpayer in Garcia received no cash, the taxpayer in Fredericks received cash from a new mortgage on property that was soon to be relinquished.

1. “Evening-Up” May Require Independent Business Purpose

In PLR 8248039, the “evening-up” of mortgages prior to an exchange was permitted. In PLR 8434015, two loans were proposed to “even up” the mortgages. One loan was from a bank. The second was from owners of the replacement property, and was secured by the relinquished property. Citing the “tax-motivated refinancing of the property immediately prior to the exchange,” the IRS ruled that both loans constituted taxable boot. The refinancing in Garcia was distinguished on the basis of its having had “independent economic significance.” Thus, it appears that if the debt becomes taxpayer’s liability for more than the time needed to close on subsequent parts of the exchange, there is a greater likelihood that the loan will be respected for tax purposes, and there will be no IRS objection to the routine application of the boot-netting rules.

2. Wittig v. Com’r.

In Wittig v. Comr., T.C. Memo, 1995-461, the replacement property was encumbered with a new mortgage prior to the exchange. The taxpayer retained the loan proceeds. Although the Tax Court initially held that the taxpayer did not “assume or take subject to” a mortgage, as the Regulations require, it subsequently withdrew its decision as a part of a settlement that permitted the netting.

3. PLR 9853028

PLR 9853028 stated that a new mortgage placed on the replacement property could be netted against an existing mortgage on the relinquished property. The taxpayer’s immediate satisfaction of the new mortgage encumbering the replacement properties was inconsequential.

D. Post-Exchange Financing Less Risky

In contrast to pre-exchange financing – where the taxpayer is generally relieved of any new mortgage placed on the relinquished property following the exchange – in post-exchange financing, the taxpayer will remain liable on any new mortgage taken out on the replacement property. Accordingly, such financing would likely attract less IRS scrutiny. Furthermore, there appears to be no judicial or legislative authority that would preclude a taxpayer from encumbering replacement property immediately after an exchange. However, the replacement property should be held for a period of time – no matter how brief – before encumbering the replacement property with a new mortgage; i.e., the “millisecond rule.” To avoid the step transaction doctrine, post-exchange financing should also be separated from replacement property financing, if at all possible. A different lender should be used for post-exchange financing.

1. Step Transaction Doctrine

The step transaction doctrine, which emphasizes substance over form, may be invoked by the IRS to collapse a multi-step transaction into a single transaction for tax purposes. The doctrine limits the taxpayer’s ability to arrange a series of business transactions to obtain a tax result that would be unavailable if only a single transaction were used. The Supreme Court, in Court Holding Company v. Com’r, observed:

To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress. 45-1 USTC ¶9215, 324 U.S. 331, 65 S.Ct. 707 (1945).

2. Precautions to Observe When Closing Title

When closing title where post-exchange financing is involved, the following additional precautions should be observed:

a. No new financing proceeds should be taken at the closing of the replacement property. Any refinancing with respect to the replacement property should be done separately and later, and should not appear on the replacement property closing statement; and

b. If additional construction draws will be made following the acquisition of the replacement property, only the advance made by the construction lender, and not the amount of the later draws, should be reflected on the closing statement.IX. Interest Tracing Rules

Proper planning will help preserve the deduction for interest paid on refinanced indebtedness in connection with a Section 1031 exchange.

A. Interest Expense on Refinanced Indebtedness

The deductibility of interest on refinanced indebtedness depends on the use to which the borrowed funds are placed. In general, interest expense on a debt is allocated in the same manner as the debt to which the interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. Temp. Regs. § 1.163-8T(a)(3). Property used to secure the debt is immaterial. Temp. Regs. § 1.163-8T(c)(1); § 1.163-8T(a)(3).

1. Allocation of Expenditures

Expenditures are allocated into one of six categories: (i) passive activities; (ii) former passive activities; (iii) investment; (iv) personal; (v) portfolio; and (vi) trade or business. Temp. Regs. § 1.163-8T(a)(4)(i)(A)-(E). Thus, the investment of refinancing proceeds in tax exempt bonds would result in a denial of the interest deduction. Likewise, personal use of refinancing proceeds would result in a complete denial of the interest deduction. The deduction for investment interest is limited to “net investment income.” Section 163(d)(1). Investment interest does not include interest taken into account under the passive activity loss rules. Section 163(d)(3)(A),(B). Proceeds of refinanced indebtedness used in an active business are subject to no limitations on deductibility. Section 163(a).

2. Allocation Period

Debt is allocated to an expenditure for the period beginning on the date the proceeds of the debt are used and ending on the earlier of (i) the date the debt is repaid; or (ii) the date the debt is reallocated. Temp. Regs. § 1.163-8T(c)(2).

3. Allocation of Debt Where Proceeds Not Disbursed to Taxpayer

If a lender disburses debt proceeds to a person other than the taxpayer, the debt is treated as if the taxpayer had used an amount of the debt proceeds equal to such disbursement to make an expenditure for such property. Temp. Regs. § 1.163-8T(c)(3)(ii).

4. Debt Assumptions Not Involving Cash Disbursements

If a taxpayer assumes a debt or takes property subject to a debt, and no debt proceeds are disbursed to the taxpayer, the debt is treated as if the taxpayer used an amount of the debt proceeds equal to the balance of the debt outstanding at such time to make an expenditure for such property. Temp. Regs. § 1.163-8T(c)(3)(ii).

5. Deposits Into Taxpayer’s Account

A deposit into the taxpayer’s account of debt proceeds, whether made by the taxpayer or by the lender, is treated as an investment expenditure, and amounts held in the account are treated as property held for investment. Temp. Regs. § 1.163-8T(c)(4)(i). When funds in the account are disbursed for another type of expenditure, they are reallocated to that type of expenditure on the date the change in use occurs. Temp. Regs. § 1.163-8T(j)(1)(i).

a. Illustration

Taxpayer borrows $10,000 and places it into an account. The deposit is treated as an investment expenditure, and the interest accruing is treated as investment interest. If the funds are later used to make a personal expenditure, that interest would be personal interest.

6. Fifteen-Day Rule For Expenditures

Debt proceeds are generally considered expended from an account on a first-in, first-out basis, ignoring any unborrowed funds. Temp. Regs. § 1.163-8T(c)(4)(ii). However, a special rule allows the taxpayer to treat any expenditure made from an account within fifteen days after debt proceeds are deposited into such account as made from such proceeds to the extent thereof, notwithstanding the general rule. Temp. Regs. § 1.163-8T(c)(4)(iii)(B).

7. Treatment of Debt Proceeds Used to Pay Interest

If debt proceeds are used to pay interest, such debt is allocated in the same manner as the debt with respect to which the interest accrued. Temp. Regs. § 1.163-8T(c)(6)(ii). For debt allocated to more than one type of expenditure, the repayment of a portion of a debt will result in the repayment being applied first to personal expenditures.

X. Depreciation and Recapture Issues

Section 1245 or Section 1250 depreciation recapture can affect depreciable property held for more than one year and disposed of at a gain by reclassifying that gain as ordinary income.

A. Section 1245 Property Defined

Section 1245 property is any depreciable property consisting of either tangible personal property or intangible amortizable personal property described within Section 1245(a)(3)(B) through (F). Section 1245 property employs “accelerated” or “front-end loaded” methods of depreciation, such as 200 percent or 150 percent declining balance. Whether property constitutes Section 1245 property for depreciation purposes is a federal tax determination. Local law classification of property as real property or personal property – though important for purposes of Section 1031 – has little relevance for purposes of determining whether property is Section 1245 property or Section 1250 property.

B. Section 1250 Property Defined

Section 1250 property, defined by exclusion, consists of depreciable real property, other than Section 1245 property. Commercial and residential real property both constitute Section 1250 property. Commercial property is depreciable over 39 years using the straight-line method, while residential real estate is depreciable on the straight-line method as well, but over 27.5 years.

C. Hospital Corporation of America

Hospital Corporation of America, 109 T.C. 21 (1997) held that tangible personal property includes many items permanently affixed to a building. The decision, to which the IRS subsequently acquiesced, made viable the use of cost analysis studies to allocate building costs to structural components and other tangible property. The result of reclassification of Section 1250 property is the birth, for depreciation purposes, of Section 1245 property. By reclassifying Section 1250 real property as Section 1245 personal property, shorter cost recovery periods can be used. A successful cost segregation study would convert Section 1250 property to Section 1245 property with depreciation periods of five or seven years, using the double-declining balance method in Section 168(c) and (e)(1). The tax benefits accruing from a cost segregation study must be weighed against the cost of the study.

1. Cost Segregation Study

The IRS Cost Segregation Audit Techniques Guide states that a cost segregation study should be prepared by a person with knowledge of both the construction process and the tax law involving property classifications for depreciation purposes. In general, a study by a construction engineer is more reliable than one conducted by a person with no engineering or construction background. Cost segregation professionals must verify the accuracy of blueprints and specifications, and take measurements to calculate the cost of assets and then to segregate them. The average cost segregation study may identify 25 percent to 30 percent of a property’s basis that is eligible for faster depreciation.

2. Illustration

Taxpayer plans to exchange land and a building in Brooklyn that he has owned for seven years. The property has a fair market value of $3 million and an adjusted basis of $1 million. As Section 1250 property, it has been depreciated using the straight-line method over 39 years. Replacement property, consisting of land and an office building in Manhattan is acquired for $3 million, 80 percent of the value of which is allocated to the building. The basis of the replacement building is therefore $800,000. The basis of the land is $200,000. A cost segregation study determines that 25 percent of the value of the office building is personal property qualifying for a 7-year recovery period using the 200 percent declining balance method of depreciation. The cost segregation study has increased the total first year depreciation deductions from $20,513 (i.e., $800,000/39) to $71,385 [($600,000/39) + (2/7) x $200,000)].

3. May IRS Challenge Decision Not to Reclassify?

The IRS could argue that not all of all property acquired in an exchange qualifies as like kind replacement real property, since some of the relinquished property might have earlier been reclassified as Section 1245 property, but was not. However, as a policy matter, this appears unlikely. Still, there appears to be no theoretical reason why the IRS could not argue that reclassification is not strictly elective. Therefore, a taxpayer who selectively reclassifies property, “cherry picking” those which yield the most depreciation deductions, while ignoring properties whose reclassification would produce fewer depreciation deductions, could conceivably the arouse IRS interest.

4. Cost Segregation Best When Trading Up

The basis of replacement property reflects the basis of relinquished property. If relinquished property has been heavily depreciated and little basis remains (or had a low basis to begin with) an otherwise successful cost segregation study of the replacement property would yield little tax benefit. However, if new funds have been invested or borrowed to exchange into more valuable property, the basis of the replacement property will reflect that investment, and a cost segregation study might yield tangible tax benefits.

D. Effect of Reclassification on Like Kind Requirement

1. Reclassified Property May Not Be of Like Kind

Some Section 1245 property, such as a barn, which constitutes a “single purpose agricultural structure” under Section 1245(a)(3)(D), would clearly be of like kind to real property. Section 1031 largely defers to local law in determining whether property is real or personal. However, local law may be unclear or ambiguous as to what constitutes real property. For example, state law may characterize permanently affixed machinery as real property for transfer tax purposes, but as personal property for UCC purposes. Therefore, some property may be classified as Section 1245 property for purposes of depreciation, since that is a federal tax determination, while at the same time be classified as real property for purposes of Section 1031, since that determination is predominantly one of local law.

2. Dual Characterization Benefits Real Estate Owners

If Section 1250 property has been reclassified as Section 1245 property for purposes of depreciation but still is real property under local law, the taxpayer will enjoy the best of both worlds: faster depreciation and qualification as real property for future exchange purposes. However, suppose reclassification results in Section 1245 property that is personal property under local law. If that property is later exchanged for either (i) real property or (ii) personal property that is not of like class, boot gain will result. Generally, if replacement property does not have the same “mix” of real and personal property for purposes of Section 1031 – or even the same “mix” of “like class” personal property, the resulting inability to completely satisfy the “like kind” exchange requirement will result in boot, and perhaps also depreciation recapture.

a. Like Kind Exchange With No Boot

As noted above, if Section 1245 property is classified as real property under local law, and is exchanged for property that is real property under local law, no boot will result. However, since Section 1245 trumps Section 1031, the taxpayer is not out of the woods, because the operative provisions of Section 1245, relating to depreciation recapture, might still apply. Depreciation recapture can occur in a boot-free like kind exchange if more Section 1245 property is relinquished in the exchange than is received.

b. Like Kind Exchange With Boot

If some or all of the relinquished property does not constitute real property under local law, it will not be of like kind to replacement property consisting entirely of real property under local law. Boot gain may also result if the Section 1245 property relinquished is not of “like class” to the Section 1245 property received in the exchange. In these situations, although the exchange may proceed, boot gain will result. As in the case where no boot is present, depreciation recapture may also result if more Section 1245 property is relinquished than is received in the exchange.

3. Section 1245 Depreciation Recapture

As noted, whether or not boot gain is present, Section 1245 ordinary income depreciation recapture may occur in an exchange if more Section 1245 property is relinquished than is received.

a. Extent of Depreciation Recapture

In a Section 1031 exchange, Section 1245(b)(4) provides that total depreciation recapture cannot exceed the amount of gain recognized without regard to Section 1245 plus the fair market value of non-Section 1245 property acquired in the exchange. Therefore, Section 1245 recapture cannot exceed the sum of (i) boot gain attributable to the like kind exchange and (ii) the extent to which Section 1245 property relinquished in the exchange exceeds Section 1245 property received in the exchange. Section 1245(b)(4)(B).

b. Recapture Cannot Exceed Realized Gain

Ordinary income recapture cannot exceed gain realized in the exchange. Section 1245(a)(1)(B).

c. Class Life of Acquired Property

The Regulations under Section 1245 require only that the replacement property be Section 1245 property to avoid recapture. Thus, no depreciation recapture will result if Section 1245 property with a class life of 7 years is replaced with Section 1245 property with a class life of 10 years. However, the boot analysis under Section 1031 is different: Boot will result if the Section 1245 property exchanged and received are not of like kind or like class, a local law determination. In this respect, the recapture rules of Section 1245 are more lenient than the boot rules of Section 1031.

E. Minimizing Section 1245 Property Relinquished

As noted, the extent of depreciation recapture may depend on the value of Section 1245 property relinquished versus the value of Section 1245 property received in the exchange. If more Section 1245 property is relinquished than is received, ordinary income depreciation recapture may result. Anticipating efforts to undervalue Section 1245 property relinquished, Regs. § 1.1245-1(a)(5) requires the total amount realized on the disposition to be allocated between Section 1245 property and non-Section 1245 property in proportion to their respective fair market values. If the buyer and seller have adverse interests, an arm’s length agreement will establish the allocation. In the absence of an agreement, the allocation is based on a facts and circumstances approach.

F. Section 1250 Recapture Issues Rare

Although Section 1250 recapture can also occur in an exchange, the Tax Reform Act of 1986 generally required that both residential and commercial real property be depreciated on a straight line basis. Therefore, Section 1250 recapture should no longer be an issue in most exchanges, even if the exchange involves property that had been previously reclassified for depreciation purposes. If property subject to Section 1250 depreciation recapture is disposed of in an exchange for replacement property that is also Section 1250 property, the potential ordinary income recapture rolls over into the replacement property and is deferred until a taxable sale of the replacement property. Section 1031(d)(4)(D); Regs. § 1.1250-3(d)(5).

1. Unrecaptured Section 1250 Gain

Property subject to unrecaptured Section 1250 gain is taxed at 25 percent when sold. Section 1(h)(7). Unrecaptured Section 1250 gain applies to all depreciation taken on real property, whether straight line or otherwise, except for Section 1250 “excess” depreciation that is subject to ordinary income recapture.

a. Fate of Unrecaptured Gain Following Exchange

What happens to unrecaptured Section 1250 gain following a like kind exchange? The Code does not address the issue. Presumably, unrecaptured Section 1250 gain would be treated in the same manner as Section 1250 excess depreciation, so that the deferred unrecaptured Section 1250 gain would roll over into the replacement property.

G. Allocation of Basis Upon Reclassification

Basis must be allocated to reclassified replacement property following a Section 1031 exchange, since reclassified replacement property will consist of both Section 1245 and Section 1250 property. The aggregate basis of the reclassified replacement property equals the basis of the relinquished property, with adjustments as provided for in Section 1031(d). Regs. § 1.1245-5(a)(2) requires that basis first be allocated to non-Section 1245 property to the extent of its fair market value, with the residue being allocated to Section 1245 property. The effect of this forced allocation will be to produce longer depreciation periods.

XI. Related Party Transactions

A. In General

Section 1031(f) was enacted as part of the Revenue Reconciliation Act of 1989 to eliminate revenue losses associated with “basis shifting” in some related party exchanges. Basis shifting occurs when related persons exchange high basis property for low basis property, with the high basis property being sold thereafter by one of the related persons. Basis shifting allows the parties to retain desired property but shift tax attributes. S. Rep. No. 56, 101st Cong., 1st Sess. 151 (1989). Section 1031(f)(1) precludes nonrecognition when a taxpayer exchanges like-kind property with a related person if either party disposes of property acquired in the exchange within two years. The rules suffer from the defect that many related party transactions involve no tax avoidance. The rules can even work to deny exchange treatment where a tax-deferred exchange could easily have been accomplished, but a related party was involved merely to facilitate the exchange.

1. Related Person Described

A “related person” is any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1).

a. Section 267(b)

Section 267(b) provides that related parties include (i) family members (spouses, siblings, ancestors, and lineal descendants); (ii) an individual and a corporation more than 50 percent of the value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; (iii) two corporations which are members of the same controlled group; (iv) certain grantors, fiduciaries and beneficiaries of trusts; and (v) a corporation and a partnership if the same person owns more than 50 percent of the value of the outstanding stock of the corporation and more than 50 percent of the capital or the profits interest in the partnership.

(1) Attribution Rules of Section 267(c)

Section 267(c) provides for constructive ownership of stock. For example, Section 267(c)(1) provides that stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries. Similarly, an individual is considered as owning stock owned, directly or indirectly, by or for his family. IRC § 267(c)(2).

b. Section 707(b)(1)

Section 707(b)(1) provides that related parties include (i) a partnership and a person owning, directly or indirectly, more than 50 percent of the capital or profits interest in such partnership; and (ii) two partnerships in which the same person owns, directly or indirectly, more than 50 percent of the capital interest or profits interest.

B. Operation of Statute

Section 1031(f)(1) establishes a 2-year holding period for property given or received in an exchange involving related persons. The holding period begins on the date of the last transfer constituting part of the related party exchange. (In a deferred exchange, the date of the last transfer may be up to 180 days after the transfer of the relinquished property.) If either related party “disposes” of property acquired in the exchange within two years of the initial exchange date, gain or loss deferred on the initial exchange will be recognized as of the date of the subsequent disposition. Section 1031(g) suspends the running of the 2-year period during any time when an exchanging party’s risk of loss is substantially diminished through certain contractual arrangements, such as a put option. See Coastal Terminals, Inc. v. U.S., 320 F.2d 333 (4th Cir. 1963); Revenue Ruling 61-119, 1961-1 C.B. 395.

1. Illustration

Son owns unimproved Florida swampland with a basis of $2 million, and a fair market value of $1 million. Father owns a fully depreciated Manhattan building with a basis of 0, and a fair market value of $1 million. Father and Son exchange the properties in an exchange qualifying for Father. Prior to Section 1031(f), Son could have sold the Manhattan property immediately after acquiring it and recognized a loss. Father’s gain would be deferred. The effect of the presale exchange would have had the effect of deferring recognition of Father’s $1 million gain, and accelerating recognition of Son’s $1 million loss. Section 1031(f) now requires Father to recognize deferred gain realized in the initial exchange if, within 2 years of the initial exchange, either of the following occurs: (i) Son disposes of the Manhattan property or (ii) Father disposes of the Florida property. Therefore, if either Father or Son disposes of property acquired in the exchange after one year, Father will at that time be required to report all of the initial deferred gain. However, in that case Father would still benefit from one year of tax deferral.

a. Variation of Illustration

Prior to the enactment of the related party rules, in the above illustration, Father could have repurchased the Manhattan property from Son at fair market value and obtained a new depreciable basis. However, that strategy might have been challenged under the step transaction doctrine.

C. “Disposition” Defined

The term “disposition” is broad in scope and encompasses many transfers of property whether they be by sale, gift, contributions to an entity, or the granting of easements. The legislative history indicates that nonrecognition transfers involving carryover basis, such as those described in Sections 351, 721 or 1031 itself, do not constitute dispositions for the purpose of Section 1031(f)(1)(c)(ii). The granting of a lease should not be a disposition, provided the lease is a “true” lease. However, the term disposition does include an indirect disposition of property, such as that which occurs in connection with the transfer of corporate stock or a partnership interest. S. Rep. No. 56, 101st Cong., 1st Sess. 151-152 (1989).

1. Grantor Trusts

Transfers to a grantor trust do not constitute a “disposition” within the meaning of Section 1031(f)(1)(c)(ii). PLR 9116009. However the transfer by a grantor trust to a third party or the termination of grantor trust status might be a disposition.

2. “Excepted” Dispositions

Under Section 1031(f)(2)(A)-(C), certain transactions, which would otherwise constitute “dispositions” for purposes of Section 1031(f)(1)(c)(ii), are excepted from the application of the related party rules. These exceptions are limited to dispositions which occur by reason of (i) the death of either related party; (ii) a compulsory or involuntary conversion under Section 1033 (if the exchange occurred before the threat or imminence of such conversion); or (iii) under Section 1031(f)(2)(C), a transaction with respect to which neither the exchange nor the disposition “had as one of its principal purposes the avoidance of federal income tax.” (The Conference Committee Report states that the exception is intended to apply to situations (i) that do not involve the shifting of basis between related taxpayers and to those (ii) that involve the partitioning of property between siblings which results in each taxpayer owning the entire interest in a single property.)

a. Illustration of Section 1031(f)(2)(C) Exception

Taxpayer enters into a safe harbor deferred exchange agreement with a qualified intermediary and transfers property to a cash buyer through the QI. A related party, who has no interest in pursuing a like kind exchange, acquires replacement property for cash. The taxpayer identifies that property as replacement property, and the second leg of the exchange proceeds through the QI. The related party merely facilitated the exchange. No tax avoidance purpose is present. Arguably, the related party rules should be inapplicable here. However, after Teruya Brothers Ltd. v. Com’r, discussed below, this hypothesis may be suspect, at least in the Ninth Circuit.

3. Section 1031(f)(4) “Catch All”

Section 1031(f)(4) provides that like kind exchange treatment will not be accorded to any exchange that is a part of a transaction, or series of transactions, structured to avoid the purposes of Section 1031(f). One test used in determining whether the Section 1031(f)(4) “catch all” applies is to determine whether the related persons, as a group, have more cash after the related party transaction than before. If cash “leaves” the group, there is less chance that a tax avoidance motive is present. Conversely, if cash “enters” the group, a tax avoidance purpose is more likely.

4. Time For Testing Relationship

The relationship is tested at the time of the exchange. If parties become “related” after the exchange, the related party rules presumably will not apply. Conversely, if the parties are related at the start of the exchange, the transaction will presumably be subject to the related party rules even if the parties are no longer related at the time of a disposition to which the subsection applies. For example, assume the taxpayer were to exchange property with an S corporation owned by his brother. A year later brother sells all of his stock in the S corporation. Shortly thereafter, the S corporation sells the property originally acquired from the taxpayer. The sale by the S corporation would result in gain to the taxpayer, even though the taxpayer and the S corporation were no longer related at the time of the sale. With the same facts, the S corporation would also recognize gain if the taxpayer sold the property he originally acquired within the two-year period.

5. Two Year Rule Safe Harbor?

Field Service Advisory (FSA) 200137003 stated that the related party rules have no application after the 2-year period has elapsed, regardless of taxpayer motive. However, taxpayers would be well advised not to structure any tax transaction solely on the basis of a Field Service Advisory, which has little precedential value. Furthermore, the “catch all” provided in § 1031(f)(4) clearly states that “[t]his section shall not apply to any exchange which is part of transaction (or series of transactions structured to avoid the purposes of this subsection.” The word “section” refers to Section 1031 itself, and not to subsection § 1031(f)(4). Therefore, a straightforward reasonable interpretation of the statute would seem to lead to the inexorable conclusion exchange treatment will not obtain if § 1031(f)(4) is violated, regardless of whether two years elapses before a related party disposes of property acquired in the exchange.

6. Depreciation Recapture

Related party dispositions within 2 years may also trigger depreciation recapture. Section 1239 recharacterizes as ordinary income gain recognized on sales or exchanges between persons related under Sections 1239(a) or 707(b)(1) and (2). Since no gain is ordinarily recognized initially in a related party exchange, no ordinary income recapture would occur at the initial exchange if no boot is present. If boot is present, ordinary income recapture could occur, but not by reason of the related party rules, but rather by the application of Section 1239 itself. If recharacterization under Section 1239 would otherwise have occurred at the time of the initial like kind exchange but for the fact that no boot is present, the IRS takes the position that a related party disposition within the proscribed period will trigger ordinary income recapture at the time of the later related party disposition. See PLR 8350084, 8646036, and Revenue Ruling 72-151.

7. “Insurance” Against Lapsing of Replacement Period

May the taxpayer identify (within the 45-day identification period) and acquire replacement property from a related party as insurance against the possibility that other identified properties owned by unrelated parties cannot be acquired within the 180-day exchange period? Provided the taxpayer intended to close on the other properties, it seems as if the “no tax avoidance” exception of Section 1231(f)(2)(C) would be met in this circumstance.

D. Does Section 1031(f) Address Only Two-Party Swaps?

Sections 1031(f) and (g) seem to address only direct two-party swaps between related persons. The Regs do not state whether three-party exchanges (involving the taxpayer, an unrelated party, and a related party) or four-party exchanges (involving the taxpayer, an unrelated party, a qualified intermediary or accommodator, and a related party) are within the scope of the statute. Could a taxpayer transfer property to a related party but acquire replacement property from an unrelated party or from a QI without triggering Section 1031(f)? In its rulings, the IRS seems to take the position that if a related person is involved in the exchange in any capacity (e.g., a buyer, seller or prior owner of any of the properties involved in the exchange) the Section 1031(f)(4) tax-avoidance “catch all” may apply.

E. Cases and Rulings Interpreting Related Party Rules

1. Technical Advice Memorandum 9748006

In TAM 9748006, the taxpayer transferred property to an unrelated party, and acquired his mother’s property through an unrelated party as replacement property. The exchange violated Section 1031(f)(4), since the economic result of the series of transactions was identical to a direct exchange between the taxpayer and his mother, followed by her sale of the relinquished property. The TAM stated that “a qualified intermediary is not entitled to better treatment than the related party referred to in the House Budget Committee Report.”

2. Field Service Advisory (FSA) 199931002

FSA 199931022 extended the reach of Section 1031(f) to transactions involving qualified intermediaries. The taxpayer engaged a QI to facilitate an exchange in which the taxpayer transferred property to an unrelated party and directed the QI to use the proceeds to acquire replacement property from a related party. The IRS advised that the taxpayer’s sale of the replacement property within two years of the exchange violated Section 1031(f)(4), since the replacement property had been transferred from a related party. TAM 9748006 and FSA 199931002 address exchanges involving replacement property originating from a related party. However, the statute may also apply where a related party acquires the taxpayer’s relinquished property through a third party.

3. Revenue Ruling 2002-83

In Rev. Rul. 2002-83, the taxpayer’s property was sold to an unrelated party through a QI. The QI acquired the related party’s property for cash and transferred it to the taxpayer to complete the exchange. By using a QI, the taxpayer and the related party avoided a direct exchange within Section 1031(f)(4). The ruling stated that the engagement of a QI was part of a transaction structured to avoid Section 1031(f). The taxpayer was not entitled to nonrecognition treatment since, as part of the transaction, a related party received cash or other non-like kind property.

4. Teruya Brothers Ltd. v Com’r

a. Ninth Circuit Uphold Tax Court

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).

5. Ocmulgee Fields v. Com’r (T.C. No. 6 (2009)).

a. Eleventh Circuit Affirms Ocmulgee

The Eleventh Circuit 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 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).

6. PLR 200616005

In PLR 200616005, Trust and S Corp. were related parties. Trust desired as replacement property a building owned by S Corp. S Corp. intended to complete its own Section 1031 exchange. A qualified intermediary was used to accomplish the exchanges. The related party rules would not apply, provided the Trust and the S Corp. each held their respective replacement properties for at least two years. Section 1031(f) did not apply since neither party had “cashed out” of its investment.

7. PLR 200706001

In PLR 200706001, three siblings and a trust owned three tracts of timberland. One sibling wished to continue the timber investment, but the others wished to cash out. To achieve this result, one of the siblings exchanged her undivided 25 percent fractional interest in parcel 1 for a fee simple interest in parcel 3. Like kind exchange treatment was accorded pursuant to Rev. Rul. 73-476, which provides that an exchange of an undivided interest in real estate for 100 percent ownership of one or more parcels qualifies for exchange treatment. Although Section 1031(f) appeared to apply – the taxpayer exchanged her interest with a related party, and the related party then sold various parcels – the IRS concluded that since the transaction did not involve basis-shifting, the related party rules would not apply.

8. PLR 200712013

In PLR 200712013, a related party wished to acquire the taxpayer’s property (“Blackacre”). However, the related party owned no property which the taxpayer wished to acquire. A plan was devised whereby the taxpayer in step one would acquire replacement property (“Whiteacre”) in an exchange last “reverse exchange”. Accordingly, the taxpayer provided funds to the Exchange Accommodator Titleholder (EAT), which acquired Whiteacre. At this point, the EAT held title to Whiteacre, which would eventually be transferred to the taxpayer. In step two, the taxpayer and the related party entered into a contract for the sale of Blackacre for cash. In step three, the taxpayer assigned all rights in this contract to a qualified intermediary (QI). In step four, the QI transferred title in Blackacre to the related party for cash. In step five, the QI transferred the cash to the EAT, which then transferred title in Whiteacre to the taxpayer and extinguished the taxpayer’s debt, thus completing the reverse exchange. In the ruling request, the related party stated that it intended to dispose of Blackacre within two years. Ruling favorably, the IRS stated that Section 1031(f)(4) would not apply to this transaction, since the transfer of Blackacre to a related party was not part of a “transaction or series of transactions structured to avoid the purposes of Section 1031(f)(1).” The related party did not own any property prior to the exchange; therefor no shifting of basis occurred, and the sale by the related party of Blackacre within two years would not trigger gain. An important aspect of this ruling was that the QI was not viewed as an agent of the taxpayer for purposes of applying Section 1031(f)(1).

9. PLR 200919027

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 agreed to exchange each of 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. Further, 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 stated that with respect to the taxpayer and the trust, there was no exchange between related persons for purposes of IRC §1031(f).

10. Chief Counsel Memorandum 20103038

[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.

11. PLR 201027036

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.

F. Reporting Related Party Exchanges

Form 8824 (“Like Kind Exchanges”) 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 qualified intermediary or an exchange accommodation titleholder) or (ii) an exchange made by a disregarded entity (i.e., a single member LLC) if the taxpayer or a related party owns that entity. Form 8824 must be filed for two years following the taxable year of a related party exchange.

XII. Multi-Party Exchanges

A. Rationale

If like kind exchanges were limited to simultaneous exchanges involving two parties, few exchanges would transpire, since both parties – whether or not they both sought exchange treatment – would have to desire the other’s property. This is not likely to often be the case. Responding favorably to taxpayer creativity in finessing the problem of simultaneity, courts in the 1970’s developed the doctrine that replacement property could originate from a third person involved in the exchange. Often, three or four parties were involved. Multiparty deferred exchanges received the imprimatur of the Ninth Circuit in Starker v. U.S., 602 F.2d 1341 (9th Cir., 1979), which recognized a deferred exchange occurring over five years. While the IRS recognized simultaneous multi-party exchanges in Revenue Ruling 77-297, it never acquiesced to Starker’s view that exchanges were not required to be simultaneous. The IRS objection to Starker was mooted by the enactment of Section 1031(a)(3) in the Tax Reform Act of 1984, which expressly recognized deferred exchanges.

B. Dynamics of Multi-Party Exchange

A three-party exchange would typically involve the taxpayer, and two other persons, Y and Z. Y would acquire the taxpayer’s property, and Z would own the replacement property. To accommodate the taxpayer, Y would purchase Z’s property and then exchange it for the taxpayer’s property. If Y were unwilling to acquire Z’s property to complete the exchange, an intermediary might be used. In that case, M, for a fee, would acquire Z’s property. At closing, M would simultaneously (i) acquire Z’s property for cash; (ii) transfer that property to the taxpayer in exchange for the taxpayer’s property; and (iii) transfer the taxpayer’s property to Y for cash. Since the transactions would be simultaneous, cash from Y’s purchase of the relinquished property could be used by M to purchase the replacement property from Z.

1. Taxpayer Must Avoid “Substantial Implementation” Test

In Estate of Bowers, 94 T.C. 582 (1990), the taxpayer owned an oil and gas lease that he agreed to sell for $2 million. Three months later, taxpayer agreed to purchase a farm for $1.1 million. The taxpayer then attempted to structure the transaction as an exchange, by inducing the purchaser of the oil and gas lease to first acquire the farm, which would then be exchanged for the oil and gas lease. Invoking the “substantial implementation” test, the Tax Court determined that Bowers had sold the oil and gas lease and had purchased the farm prior to the contemplated exchange. The taxpayer’s reporting of income attributable to the farm on a tax return filed before the exchange belied his tax position. Bowers demonstrates the importance of planning for exchange treatment before implementing the sale of relinquished property or the acquisition of replacement property.

C. Problems with Multi-Party Exchanges

1. Problem of Intent

The IRS position had long been that a “sale” followed by a reinvestment of the proceeds could not qualify for exchange treatment, despite the taxpayer’s intention to effectuate an exchange. The Fifth Circuit, in Swaim v. U.S., 651 F.2d 1066 (5th Cir. 1981) held that mere intention to effectuate a tax-free exchange is insufficient. However, Garcia, 80 T.C. 491 (1983), acq., 1984-1 C.B.1 held that the taxpayer’s intent is important, especially if the form of the transaction is consistent with an exchange. However, the court added that neither intent nor result alone is determinative in deciding whether an exchange has occurred. A year after Garcia was decided, the IRS acquiesced. 1984-1 C.B.1., PLR 8434015.

2. Problem of Simultaneity

Garcia approved the use of escrows, which had become a practical necessity in effectuating multi-party exchanges. Since multiparty exchanges can now be structured to come within a safe harbor enumerated in the deferred exchange regulations, why should simultaneity any longer even be an issue? The answer is that while simultaneous or deferred exchanges are both permitted under the safe harbor regulations, exchanges cannot always be structured to come within a safe harbor. Moreover, even if safe harbor qualification is possible, the taxpayer may not wish to incur the additional expense of engaging the services of a qualified intermediary. Therefore, a deferred multiparty non-safe-harbor exchange may still be contemplated in certain situations.

3. Problem of Agency

As noted above, an “accommodator” may purchase desired replacement property, transfer it to the taxpayer in exchange for relinquished property, and then transfer the relinquished property to a cash buyer, completing the exchange. However, the courts have been quite lenient in not finding an agency where taxpayer engaged an accommodator to facilitate an exchange. See Mercantile Exchange Company of Baltimore, Board of Tax Appeals (1935); Coupe v. Comr., 52 T.C. 394 (1969), acq., 1970-2 C.B. xix. Nevertheless, the risk of employing an accommodator is that the IRS could view the accommodator as the taxpayer’s agent. If so, the taxpayer would be in constructive receipt of the exchange funds, taking the transaction out of Section 1031. However, Garcia demonstrates that courts are inclined to minimize the agency issue if the taxpayer intends to effectuate an exchange.

a. Escrow Agents

Regs. 1.1031(k)-1(f)(2) provides that actual or constructive receipt of money by an agent of the taxpayer constitutes actual or constructive receipt of the funds by the taxpayer. However, Reed v. Com’r, 723 F.2d 138, (1st Cir. 1983) held that an escrow agent is not the taxpayer’s agent for tax purposes provided the escrow agent represents the interests of both the taxpayer-seller and the other party to the escrow agreement. See Hillyer v. Comr., T.C. Memo 1996-214. At closing, the party from whom the replacement property is acquired must receive payment directly from the escrow agent. The taxpayer may receive money or other nonqualifying property when closing on the replacement property. However, this property will constitute taxable boot to the extent of realized gain.

(1) Taxpayer’s Attorney as Escrow Agent

If the escrow agent is the taxpayer’s attorney, the attorney could be deemed the taxpayer’s agent for income tax purposes. However, by reason of the attorney’s fiduciary obligations as escrowee, this is unlikely. Furthermore, it appears that some of the strict rules relating to escrowed funds have also been tempered somewhat to reflect administrative necessities involving real estate transactions. Apparently, the taxpayer’s attorney may deposit the down payment for the relinquished property in an escrow account, and may pay certain closing costs (e.g., title fees) without jeopardizing qualification under Section 1031.

4. Problem of Taxpayer’s Involvement in Transaction

Will the taxpayer’s involvement in the acquisition of replacement property by taking part in the negotiations along with the intermediary impair the tax-deferred exchange? Revenue Ruling 77-297 states that the taxpayer can properly assist in locating and identifying replacement property. Will the taxpayer’s guarantee of an accommodator’s obligation to acquire replacement property result in a determination that the accommodator is the taxpayer’s agent for federal tax purposes? Will direct-deeding of replacement property to the taxpayer (rather than through the accommodator) imperil exchange treatment? Brauer v. Com’r 74 T.C. 1134 (1980) held that the failure of the accommodator to acquire legal title would not result in a denial of exchange treatment. The trend of the cases is that none of these actions will necessarily imperil an exchange, provided the taxpayer’s intent was to complete an exchange. However, the accommodator in a multi-party exchange must actually incur risks and obligations – no matter how insignificant and how brief – in connection with acquiring the replacement property unless, as will be discussed infra, the transaction is structured under the deferred exchange regulations safe harbor, or the safe harbor for reverse exchanges found in Rev. Proc. 2000-37.

D. Use of QI Safe Harbors in Simultaneous Exchanges

Issues of agency and constructive receipt can be avoided by utilizing the “qualified intermediary” safe harbor, discussed below. However, the QI safe harbor cannot be used in a three-party exchange, where the cash buyer acquires the replacement property and transfers that property to the taxpayer, since the deferred exchange regulations provide that the QI must acquire and transfer the relinquished property. In a three-party exchange, the cash buyer acquires and retains the relinquished property. This requirement of transfer appears to necessitate the use of a professional QI in a QI safe harbor deferred exchange.

XIII. Deferred Exchanges Under the Regulations

A. Deferred Exchanges Sanctioned in Starker v. U.S.

A deferred exchange may be a practical necessity if the cash buyer insists on closing before the taxpayer has identified replacement property. Recognizing the problem, Starker v. U.S., 602 F2d 1341 (9th Cir. 1979) articulated the proposition that simultaneity is not a requirement in a like kind exchange: “[W]e hold that it is still of like kind with ownership for tax purposes when the taxpayer prefers property to cash before and throughout the executory period, and only like kind property is ultimately received.” Responding to the IRS refusal to acquiesce to Starker, evolving case law which permitted nonsimultaneous exchanges was codified by the Tax Reform Act of 1984.

B. Statutory Basis for Deferred Exchanges: TRA 1984

As amended, Section 1031(a)(3)(A) provides that the taxpayer must

identif[y] . . . property to be received in the exchange [within] 45 days after . . . the taxpayer transfers the property relinquished in the exchange.

The Regulations refer to this as the “identification period.” Regs. § 1.1031(k)-1(b)(1)(i). The identification of the replacement property must be evidenced by a written document signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to (i) the person obligated to transfer the replacement property to the taxpayer (i.e., the cash seller); or (ii) to all persons involved in the exchange (e.g., any parties to the exchange, including an intermediary, an escrow agent, and a title company). Regs § 1.1031(k)-1(c)(2). The 45-day period is jurisdictional: failure to identify replacement property within 45 days will preclude exchange treatment. Moreover, contrary to many other time limitation periods provided for in the Internal Revenue Code, the 45-day period is computed without regard to weekends and holidays.

1. When Does Identification Period Begin to Run?

The statute states the 45-day identification period begins upon the “transfer” of the relinquished property. Does the identification period therefore begin to run on the closing date? Or when the exchange funds are transferred if that date is not coincident? Can an argument be made that the identification period does not commence until the deed is actually recorded?

2. Multiple Transfers of Relinquished Property

Where multiple transfers of relinquished property occur, the 45-day identification period (as well as the 180-day exchange period) begin to run on the date of transfer of the first property. Treas. Reg. § 1.1031(k)-1(b)(2).

3. Backdating Identification Documents Constitutes Tax Fraud

Some taxpayers, unable to identify replacement property within 45 days, have attempted to backdate identification documents. This is a serious mistake. The taxpayer in Dobrich v. Com’r, 188 F.3d 512 (9th Cir. 1999) was found liable for civil fraud penalties for backdating identification documents. Dobrich also pled guilty in a companion criminal case to providing false documents to the IRS. If the 45-day identification period poses a problem, the taxpayer should consider delaying the sale of the relinquished property to the cash buyer. If the sale cannot be delayed, the possibility should be explored of leasing the property to the cash buyer until suitable replacement property can be identified.

a. Recognizing Losses

It would appear that a taxpayer could deliberately structure an exchange to recognize a loss by deliberately failing to identify replacement property within the 45-day period.

4. Description Must be Unambiguous

Replacement property must be unambiguously described in the written document or agreement. Real property is generally unambiguously described by a street address or distinguishable name (e.g., the Empire State Building). Personal property must contain a particular description of the property. For example, a truck generally is unambiguously described by a specific make, model and year. Regs. § 1.1031(k)-1(b)(1).

a. Acquisition Without Identification Permitted

Acquisition of replacement property before the end of the identification period will be deemed to satisfy all applicable identification requirements (the “actual purchase rule”). Regs. § 1.1031(k)-1(c)(4)(ii)(A). However, even if closing is almost certain to occur within the 45-day identification period, formally identifying replacement property insures against not closing within the 45-day identification period. Identifying back-up replacement property insures against not closing on the intended replacement property within the 180-day exchange period.

5. Three Rules for Identifying Replacement Properties

a. “3 Property Rule”

Up to three replacement properties may be identified without regard to fair market value. Regs. § 1.1031(k)-1(c)(4)(i)(A).

b. “200 Percent Rule”

Any number of properties may be identified provided their aggregate fair market value does not exceed 200 percent of the aggregate fair market value of all relinquished properties as of the date the relinquished properties were transferred. Regs. § 1.1031(k)-1(c)(4)(i)(B).

c. “95 Percent Rule”

If more than the permitted number of replacement properties have been identified before the end of the identification period, the taxpayer will be treated as having identified no replacement property. However, a proper identification will be deemed to have been made with respect to (i) any replacement property received before the end of the identification period (whether or not identified); and (ii) any replacement property identified before the end of the identification period and received before the end of the exchange period; provided, the taxpayer receives before the end of the exchange period identified property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified properties. Regs. § 1.1031(k)-1(b)(3)(ii)(A)-(B).

(1) Risks and Benefits of 95 Percent Rule

In situations where the taxpayer is “trading up” and wishes to acquire replacement property whose fair market value is far in excess of the relinquished property, this rule is useful. While under the 200 percent rule, the taxpayer may acquire property whose fair market value is twice that of the relinquished property, under the 95 percent rule, there is no upper limit to the new investment. While there is also no upper limit to the value of the replacement property using the 3 property rule, substantial diversification may not be possible using that rule. Although the 95 percent rule therefore possesses distinct advantages, there is a substantial risk: If the taxpayer does not satisfy the 95 percent rule, then the safe harbor is unavailable. This could result in the disastrous tax result of exchange treatment being lost with respect to all replacement properties. If the 95 percent rule is to be used, the taxpayer must be confident that he will ultimately be successful in closing on 95 percent of all identified properties. There is little room for error.

d. Failing All Three Identification Rules
Does Not Necessarily Mean No Exchange

In TAM 200602034, the taxpayer identified numerous properties whose fair market value well exceeded 200 percent of the fair market value of the relinquished property, so neither the 3-property rule nor the 200 percent rule could be satisfied. In addition, since the value of the replacement properties ultimately acquired was less than 95 percent of the value of all identified replacement properties, the taxpayer also failed the 95 percent rule. This meant that only those properties that satisfied the “actual purchase rule,” i.e., those properties actually acquired within 45-days of the date of sale of the relinquished property, were deemed to have satisfied the identification requirement.

6. Revocation of Identification

An identification may be revoked before the end of the identification period provided such revocation is contained in a written document signed by the taxpayer and delivered to the person to whom the identification was sent. An identification made in a written exchange agreement may be revoked only by an amendment to the agreement. Regs. § 1.1031(k)-1(c)(6). Oral revocations are invalid. Regs. § 1.1031(k)-1(c)(7), Example 7, (ii).

7. “Incidental Property Exception”

Regs. § 1.1031(k)-1(c)(5)(i) provides that minor items of personal property need not be separately identified in a deferred exchange. However, this exception in no way affects the important statutory mandate of Section 1031(a)(1) that only like kind property be exchanged. Therefore, if even a small amount of personal property is transferred or received, the like kind and like class rules apply to determine whether boot is present and if so, to what extent. It may therefore be advantageous for the parties to agree in the contract of sale that any personal property transferred in connection with the real property has negligible value.

8. Identification Period Where Multiple Parcels

If multiple parcels are relinquished in the exchange, the 45-day period begins to run upon the closing of the first relinquished property. The last replacement property must close within 180 days of that date. If compliance with this rule is problematic, it may be possible to fragment the exchange into multiple deferred exchanges.

9. Multiple vs. Alternative Identifications

If exchange proceeds remain, the determination of whether the taxpayer has made “multiple” or “alternative” identifications may be important. If the identification was alternative, compliance with one of the three identification rules may be less difficult. Whether an identification is alternative may depend upon the taxpayer’s intent.

C. Replacement Property Must Be Acquired Within 180 Days

Section 1031(a)(3)(B) provides that replacement property must be acquired on the earlier of

180 days after the . . taxpayer transfers the property relinquished in the exchange, or the due date [including extensions] for the transferor’s return for the taxable year in which the transfer of the relinquished property occurs.

Thus, if A relinquishes property on July 1st, 2006, he must identify replacement property by August 14th, 2006, and acquire all replacement property on or before January 1st, 2007, which date is the earlier of (i) January 1st, 2007 (180 days after transferring the relinquished property) and July 15th, 2007, (the due date of the taxpayer’s return, including extensions). This period is termed the “exchange period.” Regs. § 1.1031(k)-1(b)(1)(ii). The exchange period is also jurisdictional: failure to acquire all replacement property within the prescribed time limit will result in a taxable sale, rather than a like kind exchange. The exchange period, like the identification period, is calculated without regard to weekends and holidays.

1. Due Date of Tax Return Determined
Without Regard to Automatic Extensions

The Ninth Circuit, in Christensen v. Com’r, T.C. Memo 1996-254, aff’d in unpub. opin., 142 F.3d 442 (9th Cir. 1998) held that the phrase “due date (determined with regard to extension)” in Section 1031(a)(3)(B)(i) contemplates an extension that is actually requested. If the taxpayer fails to request an extension (even if one were automatically available) the due date of the taxpayer’s return without regard to extension would be the operative date for purposes of Section 1031(a)(3)(B). (However, if the due date for the taxpayer’s return without regard to extensions occurs after the 180-day period following the exchange (as in the example above), the point would be moot, since the taxpayer would in that case be required to complete the exchange within the 180-day period.)

2. Replacement Property Must be Substantially Same

Replacement property actually received must be substantially the same as the replacement property earlier identified. While the construction of a fence on previously identified property does not alter the “basic nature or character of real property,” and is considered as the receipt of property that is substantially the same as that identified, the acquisition of a barn and the land on which the barn rests, without the acquisition also of the previously identified two acres of land adjoining the barn, will result in the taxpayer being considered not to have received substantially the same property that was previously identified. Regs. § 1.1031(k)-1(d), Examples 2 and 3.

a. Replacement Property to be Produced

Replacement property that is not in existence or that is being produced at the time the property is identified will be considered as properly identified provided the description contains as much detail concerning the construction of the improvements as is possible at the time the identification is made. Moreover, the replacement property to be produced will be considered substantially the same as identified property if variations due to usual or typical production occur. However, if substantial changes are made in the property to be produced, it will not be considered substantially the same as the identified property. Regs. § 1.1031(k)-1(e).

D. Actual or Constructive Receipt Negates Like-Kind Exchange

If the taxpayer actually or constructively receives money or other property in the full amount of the consideration for the relinquished property before the taxpayer actually receives the like kind replacement property, the transaction will constitute a sale and not a deferred exchange. If the taxpayer actually or constructively receives money or other property as part of the consideration for the relinquished property prior to receiving the like kind replacement property, the taxpayer will recognize gain with respect to the nonqualifying property received (to the extent of realized gain). Regs. § 1.1031(k)-1(f)(2).

1. Definitions of Actual or Constructive Receipt

For purposes of Section 1031, the determination of whether the taxpayer is in actual or constructive receipt of money or other property is made under general rules concerning actual and constructive receipt without regard to the taxpayer’s method of accounting. The taxpayer is in actual receipt when he actually receives money or other property or receives the economic benefit thereof. Constructive receipt occurs when money or other property is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it. Section 446; Regs. § 1.446-1(c). However, the taxpayer is not in constructive receipt of money or other property if the taxpayer’s control over its receipt is subject to substantial limitations. Regs. § 1.1031(k)-1(f)(1),(2). Nixon v. Com’r, T.C. Memo, 1987-318, held that the taxpayer was in constructive receipt of a check payable to taxpayer which the taxpayer did not cash, but later endorsed to a third party in exchange for (intended) replacement property.

E. Safe Harbors Avoid Problem of Constructive Receipt

On April 25, 1991, final Regulations for deferred exchanges were promulgated. Regs. § 1.1031(k)-1(g). Presumably, the vast majority of deferred exchanges (and all involving qualified intermediaries) must now comply with one of the four safe harbors provided for in the regulations. Sensibly, the regulations also permit simultaneous exchanges to be structured under the deferred exchange regulations. While simultaneous exchanges can also be structured outside of the deferred exchange regulations, compliance with the safe harbor avoids difficult issues of constructive receipt and agency. It may therefore be beneficial to structure even simultaneous exchanges whenever possible under the deferred exchange regulations “qualified intermediary” safe harbor. That safe harbor is the only deferred exchange safe harbor made applicable to simultaneous exchanges. Regs. § 1.1031(b)-2.

F. Security or Guarantee Arrangements

The first safe harbor insulates the taxpayer from being in actual or constructive receipt of exchange proceeds where the obligation of the cash buyer to provide funds for replacement property is secured by a mortgage or letter of credit. Specifically, the safe harbor provides that whether the taxpayer is in actual or constructive receipt of money or other property before receipt of replacement property will be made without regard to the fact that the obligation of the taxpayer’s transferee (i.e., the cash buyer) is or may be secured by (i) a mortgage; (ii) a standby letter of credit (provided the taxpayer may not draw on the letter of credit except upon default by the transferee); or (iii) a guarantee of a third party. This safe harbor would typically be used where no qualified intermediary is present to secure the obligation of the cash buyer to finance the replacement property. Regs. § 1.1031(k)-1(g)(2). Compliance with this safe harbor eliminates concerns that the taxpayer is in constructive receipt of the secured obligations. However, compliance with this safe harbor does not dispel concerns about agency.

G. Qualified Escrow or Trust Accounts

The second safe harbor is similar to the first, except that instead of applying to situations involving a guarantee or letter of credit, this safe harbor addresses those situations in which the exchange funds themselves are segregated in an escrow account. The second safe harbor thus provides that the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the receipt of replacement property will be made without regard to the fact that the obligation of the taxpayer’s transferee to transfer the replacement property is or may be secured by cash or a cash equivalent, provided the funds are held in a “qualified escrow account” or a “qualified trust account.” Regs. § 1.1031(k)-1(g)(3). Note that compliance with this safe harbor also dispels concerns about constructive receipt, but also does not dispel concerns about agency. Only the qualified intermediary safe harbor, discussed below, addresses both of these issues.

1. Qualified Escrow or Trust Account Defined

A qualified escrow (or trust) account is an escrow (or trust) account in which (i) the escrow holder (or trustee) is not the taxpayer or a “disqualified person,” and (ii) the escrow agreement limits the taxpayer’s right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account. Regs. § 1.1031(k)-1(g)(3)(iii).

2. Disqualified Person

a. Agent of Taxpayer

The agent of the taxpayer is a disqualified person. For this purpose, a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer. However, services rendered in furtherance of the like kind exchange itself, or routine financial, title insurance, escrow or trust services are not taken into account.

b. Persons Related to Taxpayer

A person who bears a relationship to the taxpayer described in Section 267(b) or Section 707(b), (determined by substituting in each section “10 percent” for “50 percent” each place it appears) is a disqualified person.

c. Persons Related to Taxpayer’s Agent

A person who bears a relationship to the taxpayer’s agent described in either Section 267(b) or Section 707(b), (determined by substituting in each section “10 percent” for “50 percent” each place it appears) is a disqualified person.

d. Exceptions

The regulations provide that a person will not be disqualified by reason of its performance of services in connection with the exchange or by reason of its providing “routine financial, title insurance, escrow or trust services for the taxpayer”. Treas. Reg. § 1.1031(k)-1(k). The regulation permits banks and affiliated subsidiaries to act as qualified intermediaries even if the bank or bank affiliate is related to an investment banking or brokerage firm that provided investment services to the taxpayer within two years of the date of the exchange.

H. Qualified Intermediaries

The qualified intermediary safe harbor is the most useful of the four safe harbors, as it addresses both agency and constructive receipt concerns. This safe harbor provides that (i) a “qualified intermediary” is not considered an agent of the taxpayer for tax purposes, and (ii) the taxpayer is not considered to be in constructive receipt of exchange funds held by the qualified intermediary. For the QI safe harbor to apply, the exchange agreement must expressly limit the taxpayer’s right to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by the QI, until after the exchange period, or until the occurrence, after the identification period, of certain contingencies beyond the control of the taxpayer. Regs. § 1.1031(k)-1(g)(4).

1. Qualified Trust Account & Qualified Intermediary
Safe Harbors May Both Be Used in a Single Exchange

2. Distinguish Tax Agency from Legal Agency

The QI safe harbor bestows upon the transaction the important presumption that the taxpayer is not in constructive receipt of funds held by the QI – regardless of whether the taxpayer would otherwise be in constructive receipt under general principles of tax law. In addition, the QI is not considered the taxpayer’s agent for tax purposes. However, the QI may act as the taxpayer’s agent for other legal purposes, and the exchange agreement may so provide. For example, if the taxpayer is concerned about the possible bankruptcy of the QI, expressly stating that the QI is the taxpayer’s agent for legal purposes would reduce the taxpayer’s exposure. So too, the QI may be concerned with taking legal title to property burdened with possible claims or environmental liabilities. By stating that the QI is acting merely as the taxpayer’s agent, those concerns of the QI might be adequately addressed.

3. Three-Party Exchange and QI Safe Harbor

In a three-party exchange, the cash buyer accommodates the taxpayer by acquiring the replacement property and then exchanging it for the property held by the taxpayer. Since the QI safe harbor imposes the requirement that the QI both acquire and transfer the relinquished property and the replacement property, it appears that this safe harbor cannot be used in a three-party exchange since, in such an exchange, the cash buyer acquires the taxpayer’s property, but does not thereafter transfer it. Therefore, most safe harbor QI transactions would require four parties: i.e., the taxpayer, the QI, a cash buyer and a cash seller.

4. QI Safe Harbor Permitted in Simultaneous Exchange

The final Regulations permit the safe harbor for qualified intermediaries (but only that safe harbor) in simultaneous, as well as deferred, exchanges. Regs. § 1.1031-(k)-1(g)(4)(v).

5. Definition of Qualified Intermediary

A qualified intermediary is a person who (i) is not the taxpayer or a “disqualified person” and who (ii) enters into a written agreement (“exchange agreement”) with the taxpayer to (a) acquire the relinquished property from the taxpayer; (b) transfer the relinquished property to a cash buyer; (c) acquire replacement property from a cash seller; and (d) transfer replacement property to the taxpayer. Regs. § 1.1031(k)-1(g)(iii). A number of companies, often affiliated with banks, act as qualified intermediaries. If an affiliate of a bank is used as a QI, it may be prudent to require the parent to guarantee the QI’s obligations under the exchange agreement. Qualified intermediaries generally charge a fee (e.g., $1,000), but earn most of their profit on exchange funds invested during the identification and exchange periods. Although the QI might pay the taxpayer three percent interest on exchange funds held during the identification and exchange periods, the QI might earn four percent during those periods, providing the QI with a profit of one percent on the exchange funds held during the identification and exchange periods.

a. Acquisition and Transfer by QI

A QI is treated as acquiring and transferring property (i) if the QI itself acquires and transfers legal title; or (ii) if the QI (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person; or (iii) if the QI (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the replacement property for the transfer of that property and, pursuant to that agreement, the replacement property is transferred to the taxpayer. These rules permit the owner of the replacement property to directly deed replacement property to the taxpayer at the closing. Regs. § 1.1031(k)-1(g)(4)(iv)(A),(B)&(C). This may avoid additional complexity as well as additional transfer tax liability and recording fees.

b. Assignment to QI

A QI is treated as entering into an agreement if the rights of a party to the agreement are assigned to the QI and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant property transfer. Therefore, if a taxpayer enters into an agreement for the transfer of the relinquished property and thereafter assigns its rights thereunder to a QI and all parties to the agreement are notified in writing of the assignment on or before the date the relinquished property is transferred, the QI is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the QI is treated as having acquired and transferred the relinquished property. Regs. § 1.1031(k)-1(g)(v).

6. Protecting Relinquished Property Proceeds

a. Hold Funds in Separate Escrow Account

Regs. § 1.1031(k)-1(g)(3) permit the QI to deposit cash proceeds from the sale of the relinquished property into a separate trust or escrow account, which could protect funds against claims of the QI’s creditors. The exchange documents must still limit the exchanging party’s right to receive, pledge, borrow or otherwise receive the benefits of the relinquished property sale proceeds prior to the expiration of the exchange period. Regs. § 1.1031(k)-1(g)(6). These are referred to as the “G-6 Limitations.” One disadvantage to this approach is that if sales proceeds are significant, a better rate of return might be possible if the QI were not required to segregate the funds in a separate escrow account until the closing on the replacement property. Even though the QI will typically pay only a nominal interest rate on exchange funds being held, funds deposited into an escrow account may earn even less interest.

b. Use Letter of Credit or Guarantee

The obligation of the QI may be secured by a standby letter of credit or a third party guarantee. The standby letter of credit must be nonnegotiable and must provide for the payment of proceeds to the escrow to purchase the replacement property, rather than to the taxpayer.

7. Permissible Disbursements by QI

Regs. § 1.1031(k)-1(g)(7) enumerates items which may be paid by the QI without impairing the QI safe harbor, and which will be disregarded in determining whether the taxpayer’s right to receive money or other property has been expressly limited, as required. If an expense qualifies under the Regulations, not only will the QI safe harbor remain intact, but no boot will result. Regs. § 1.1031(k)-1(g)(7)(ii) provides that a QI may make disbursements for “[t]ransactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and appear under local standards in the typical closing statement as the responsibility of a buyer or seller (e.g., commissions, prorated taxes, recording or transfer taxes, and title company fees).” The Regulations do not include legal fees as a transactional item. Regs. § 1.1031(k)-1(g)(7)(i) provides that the QI may also pay to the seller items which a seller may receive “as a consequence of the disposition of the property and that are not included in the amount realized from the disposition of the property (e.g., prorated rents).”

8. Reimbursement of Taxpayer

If the taxpayer makes a deposit for replacement property, the QI may reimburse the taxpayer from exchange funds, but only after the replacement property has been acquired.

9. ABA Position on QI Disbursements

The ABA Tax Section Report on Open Issues first notes that Revenue Ruling 72-456, and GCM 34895 recognize that transactional expenses typically incurred in connection with an exchange, and not deducted elsewhere on the taxpayer’s return, offset boot. The Report notes that these expenses correspond closely to the list of transactional items found in Regs. § 1.1031(k)-1(g)(7). The Report concludes that transactional selling expenses paid by a QI should be treated as transactional items under Regs. § 1.1031(k)-1(g)(7) which can be paid by the QI at any time during the exchange period without affecting any of the safe harbors under Regs. §1.1031(k).

10. Other Payments Made by QI

Payments made by a QI not enumerated in Regs. § 1.1031(k)-1(g)(7) would presumably constitute boot. However, the question arises whether those payments would also destroy the safe harbor. Regs. §1.1031(k)-1(j)(3), Example 4, concludes the taxpayer who has a right to demand up to $30,000 in cash is in constructive receipt of $30,000, and recognizes gain to the extent of $30,000. However, Example 4 neither states nor implies that the exchange no longer qualifies under the safe harbor. Therefore, payment of an expense not enumerated in Regs. § 1.1031(k)-1(g)(7) to a person other than the taxpayer would result in boot, but would likely not destroy the safe harbor. However, any payment from the QI to the taxpayer during the exchange period would destroy the safe harbor.

I. Tax Treatment of Exchange Funds Held by QI

On July 7, 2008, the IRS issued final regulations under Section 468B(g) and 7872 regarding funds held by exchange facilitators in various safe harbors provided by Treas. Reg. § 1.1031(k)-1(g). The Regulations provide rules regarding the taxation of income earned on such escrow accounts, trusts, and other funds used in deferred like-kind exchanges. Under the final regulations, exchange funds are treated, as a general rule, as loaned by the taxpayer to an exchange facilitator, and the exchange facilitator then takes into account all items of income, deduction and credit. If, however, the escrow agreement, trust agreement, or exchange agreement provides that all earnings attributable to the exchange funds are payable to the taxpayer, the exchange funds are not treated as loaned from the taxpayer to the exchange facilitator, and the taxpayer then takes into account all items of income, deduction and credit. The final regulations apply to transfers of relinquished property made on or after October 8th, 2008.

1. Imputed Interest on Deemed Loan

Under Regs. § 1.468B, if the exchange agreement does not require the QI to pay to the taxpayer sufficient interest on the deemed loan, interest will be imputed under Section 7872. Sufficient interest is determined at a rate at least equal to the lower of the short-term AFR or the 13-week Treasury bill rate. The QI is first treated as paying interest to the taxpayer on earnings which the QI retains. The taxpayer is then treated as compensating the QI with an amount equal to the deemed interest payment received by the taxpayer.

2. De Minimis Exception

If exchange funds do not exceed $2 million and the funds are held for six months or less, no interest will be imputed under Section 7872.

3. Exception: “All of the Income” to Taxpayer

Another exception provides that if all of the earnings attributable to exchange funds are paid to the taxpayer, exchange funds are not treated as loaned from the taxpayer to the QI. The all the earnings rule applies if (i) the QI holds all of the taxpayer’s exchange funds in a separately identified account; (ii) the earnings credited to the taxpayer’s exchange funds include all earnings on the separately identified account; and (iii) the credited earnings must be paid to the taxpayer (or be used to acquire replacement property).

4. Effect of Imputed Interest Rule

The rule forces the taxpayer to capitalize as part of the cost of acquiring property (rather than deduct as a current expense) amounts paid to the QI. The applicable rate of interest on these transactions is the investment rate on a 182-day Treasury bill, determined at the time the imputed loan is made. This rate is published at http://www.publicdebt.treas.gov.

5. Divergence of Tax Treatment

The safe harbor deferred exchange regulations provide that the taxpayer will not be in constructive receipt of exchange funds for purposes of Section 1031. However, under the Proposed Regulations, an interesting tax dichotomy emerges. Even though the taxpayer is not considered as receiving the exchange funds for purposes of Section 1031, the taxpayer is treated as receiving those funds for other income tax purposes.

6. Disbursements Deemed Made by Taxpayer

For purposes of determining whether earnings attributable to exchange funds are payable to the taxpayer, transactional expenses such as appraisals, title examinations, recording fees and transfer taxes are treated as first paid to the taxpayer and then paid by the taxpayer to the recipient. A fee paid to the QI qualifies as a transactional expense if (i) the amount of the fee is fixed on or before the date the relinquished property is transferred and (ii) the fee is payable regardless of whether earnings attributable to exchange funds are sufficient to cover the fee. This rule is intended to address the perceived problem of a qualified intermediary “fee” actually being an interest “surrogate.”

J. Interest and Growth Factors

The fourth safe harbor provides that the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the receipt of replacement property is made without regard to the fact that the taxpayer is or may be entitled to receive any interest or growth factor with respect to the deferred exchange funds. Regs. § 1.1031(k)-1(g)(5).

K. Traps for the Unwary

1. Escrow Agreement Must Contain Limitations

The escrow agreement itself must expressly limit the taxpayer’s right to pledge, borrow or otherwise obtain the benefits of the cash held in the escrow account before the end of the exchange period. Regs. § 1.1031(k)-1(g)(2)(ii). It is not enough that the limitations exist in an ancillary document, or that they derive from local law. Florida Industries Investment Corp. v. Com’r., 252 F.3d 440 (11th Cir. 2001) held that where qualified intermediary was under the control of the taxpayer, the taxpayer had “effective control” of all escrow funds.

2. Retained Rights of Taxpayer

Regs. § 1.1031(k)-1(g)(5) provides several rules which address situations in which replacement property is not received by the end of the exchange period, or an unexpected contingency causes the exchange go to awry. First, despite the general rule that the taxpayer may not retain rights with respect to money being held by the QI, the exchange agreement may provide that the taxpayer may receive money at the end of the identification period if no replacement property has been identified by that time. Second, the taxpayer may retain the right to receive money held by the QI following the occurrence, after the identification period, of a material and substantial contingency that (i) relates to the deferred exchange; (ii) is provided for in writing; and (iii) is beyond the control of the taxpayer and any disqualified person.

3. Modification of Exchange Agreements

PLR 200027028 held that exchange agreements could be modified to allow for early distribution of cash where taxpayer was unable to reach a contract with the seller of replacement property.

4. Boot Paid By QI to Taxpayer Destroys Safe Harbor

Money or other property paid to the taxpayer by another party to the exchange will constitute boot, but it will not destroy the safe harbor. However, the payment to the taxpayer of money or other property from the QI or from another safe harbor arrangement prior to the receipt of all replacement properties to which the taxpayer is entitled under the exchange agreement will destroy the safe harbor. Regs. § 1.1031(k)-1(g)(6).

L. Installment Sale Reporting of Deferred Exchanges

1. Exchange Funds Could be Considered “Payment”

To benefit from installment reporting, the taxpayer must avoid the receipt of “payment” in the taxable year of the disposition. Under the installment sale rules, a seller is deemed to receive payment when cash or cash equivalents are placed in escrow to secure payment of the sales price. Temp. Regs. § 15A.453-1(b)(3)(i). The regulations further provide that receipt of an evidence of indebtedness that is secured directly or indirectly by cash or a cash equivalent is treated as the receipt of payment. Accordingly, the IRS has suggested that the exchange funds described in the deferred exchange safe harbor Regulations could be considered as “payment” under Temp. Regs. § 15A.453-1(b)(3)(i).

2. Deferred Exchange Regs Trump Installment Sale Regs

Fortunately, the safe harbor deferred regulations, rather than Temp. Regs. § 15A.453-1(b)(3)(i), apply in determining whether the taxpayer is in receipt of “payment” at the beginning of the exchange period. Thus, Treas. Reg. § 1.1031(k)-1(j)(2) provides that a transferor is not deemed to have received an installment payment under a qualified escrow account or qualified trust arrangement, nor is the receipt of cash held in an escrow account by a qualified intermediary treated as a payment to the transferor under the rules, provided the following two conditions are met: (i) the taxpayer has a “bona fide intent” to enter into a deferred exchange at the beginning of the exchange period and (ii) the relinquished property does not constitute “disqualified” property. See Temp. Reg. § 15A.453-1(b)(3)(i). Treas. Reg. § 1.1031(k)-1(k)(2)(iv) states that a taxpayer possesses a bona fide intent to engage in an exchange only if it reasonable to believe at the beginning of the exchange period that like kind replacement property will be acquired before the end of the exchange period.

3. Effect of Satisfying “Intent” Requirement

If the intent requirement is met, gain recognized from a deferred exchange structured under one or more of the safe harbors will qualify for installment method reporting (provided the other requirements of Sections 453 and 453A are met). However, the relief from the otherwise operative installment sales rules ceases upon the earlier of the end of the exchange period or when the taxpayer has an immediate right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or the cash equivalent. Treas. Reg. § 1.453-1(f)(1)(iii).

4. Illustration

On November 1st, 2006, QI, pursuant to an exchange agreement with New York taxpayer (who has a bona fide intent to enter into a like kind exchange) transfers the Golden Gate Bridge to cash buyer for $100 billion. The QI holds the $100 billion in escrow, pending identification and ultimate closing on the replacement property by the taxpayer. The taxpayer’s adjusted basis in the bridge is $75 billion. The exchange agreement provides that taxpayer has no right to receive, pledge, borrow or otherwise obtain the benefits of the cash being held by QI until the earlier of the date the replacement property is delivered to the taxpayer or the end of the exchange period. On January 1st, 2007, QI transfers replacement property, the Throgs Neck Bridge, worth $50 billion, and $50 billion in cash to the taxpayer. The taxpayer recognizes gain to the extent of $25 billion. However, the taxpayer is treated as having received payment on January 1st, 2007, rather than on November 1st, 2006. If the other requirements of Sections 453 and 453A are satisfied, the taxpayer may report the gain in 2007 under the installment method. Note: If the QI had failed to acquire replacement property by the end of the exchange period, and had distributed $50 billion in cash to taxpayer on January 1st, 2007, Regs. § 1.1031(k)-1(j)(2)(iv) would still permit gain to be reported on the installment method, since the taxpayer had a bona fide intent at the beginning of the exchange period to effectuate a like kind exchange. Note also: Under its “clawback” rule, California will continue to track the deferred gain on the exchange involving the Golden Gate Bridge. If the taxpayer later disposes of Throgs Neck Bridge in a taxable sale, California will impose tax on the initial deferred exchange. This will result in the taxpayer paying both New York (8.97 percent) and California (9.3 percent) income tax, in addition to New York City (4.45 percent) and federal income tax (15 – 25 percent) on the later sale.

M. Inadvertent Opt-Out of From Installment Method

In PLR 200813019, the IRS permitted the taxpayer to correct an inadvertent opt-out of the installment method. The taxpayer had intended to engage in a like kind exchange, but failed to acquire replacement property within 180 days. The taxpayer’s accountant reported all of the income in year 1, even though the failed exchange qualified as an installment sale because the taxpayer had not been in actual or constructive receipt of some of the exchange proceeds until the year following that in which the relinquished property was sold. Treas. Reg. § 15.453-1(d)(4) provides that an election to opt-out of installment sale treatment is generally irrevocable, and that an election may be revoked only with the consent of the IRS. The IRS allowed the taxpayer to revoke the inadvertent opt-out, noting that the opt-out was the result of the accountant’s oversight, rather than hindsight by the taxpayer.

N. Rev. Proc 2010-14 – Installment Method for Failed Exchanges

O. Structuring Down Payment

1. Relinquished Property Deposit

If the exchange agent has already been assigned to the QI, any earnest money deposit should be made to the QI. However, if the taxpayer has already received the earnest money deposit prior to the assignment of the contract to the QI, the taxpayer’s attorney may refund the deposit to the purchaser at closing. The purchaser would then increase the amount of the total purchase price to reflect the refunded deposit.

2. Replacement Property Deposit

a. Deposit Made by Taxpayer

The taxpayer may deposit with the seller of the replacement property an earnest money deposit. At closing, the seller may refund the earnest money deposit to the taxpayer provided the QI provides the seller with a replacement down payment check. Alternatively, the QI can reimburse the taxpayer, but only after the taxpayer has actually received the replacement property.

b. Deposit Made by QI

The taxpayer may request that the QI make an earnest money deposit on the replacement property only after the replacement property purchase contract has been assigned to the QI. The purchase contract should expressly provide that if the contract is terminated for any reason, the earnest money will be returned to the QI and not to the taxpayer.

P. Regulation of Qualified Intermediaries

1. Danger of QI Commingling Exchange Funds

In Nation-Wide Exchange Services, 291 B.R. 131, 91 A.F.T.R. 2d (March 31, 2003), the qualified intermediary commingled exchange funds in a brokerage account and sustained significant losses. The Bankruptcy Court found that the failure of Nation-Wide to use segregated accounts, effectively converted customer deposits to property of Nation-Wide for purposes of bankruptcy law. All disbursements made by Nation-Wide in the 90 days preceding its bankruptcy were returned to the

Q. Required Legal Documentation

1. Language for Relinquished Property Contracts

The following or similar language should appear in the contract of sale of the relinquished property:

The Purchaser understands that this transaction may, at the option of the Seller, constitute one part of a tax-deferred exchange as recognized under Section 1031 of the Internal Revenue Code. In that event, Purchaser agrees to execute any and all documents (subject to the reasonable approval of Purchaser’s counsel) as are necessary in connection therewith, at no cost, expense or liability to Purchaser, provided that the close of this transaction for the conveyance of Seller’s property shall not be contingent upon such exchange.

2. Language for Replacement Property Contract

The following or similar language should appear in the purchase contract for the replacement property:

The Seller understands that this transaction is one part of a tax-deferred exchange as recognized under Section 1031 of the Internal Revenue Code. Seller agrees to execute such documents as may reasonably be required to qualify the transaction for treatment under that section. Seller further agrees: (i) that purchaser’s interests in this contract may be assigned to a qualified intermediary (the Intermediary) (ii) that Seller will deed the property as directed by the Intermediary; and (iii) that the Intermediary can terminate this contract by the payment of liquidated damages in an amount not to exceed the funds held by the Intermediary.

3. Exchange Agreement

a. Exchange Agreement Recitals

The exchange agreement entered into by the taxpayer and the QI will recite that the taxpayer (i) owns certain real property; (ii) has entered into an agreement with a purchaser to sell relinquished property; (iii) desires to effectuate a Section 1031 exchange; and (iv) that the intermediary is willing and able to act as a “Qualified Intermediary” as defined in Regs. § 1.1031(k)-1(g)(4).

b. Exchange Agreement Substantive Terms

The exchange agreement will substantively provide that the taxpayer (i) has assigned rights in the contract to sell the relinquished property to the QI; (ii) will transfer the relinquished property to the QI in exchange for replacement property to be identified by the taxpayer; (iii) will have no right to receive cash paid by the purchaser to acquire the relinquished property; (iv) will receive credit from the QI for amounts received from the sale of the relinquished property (less fees and closing costs incurred by QI) for the purpose of acquiring the replacement property; (v) will receive interest on the exchange credit until acquisition of the replacement property; (vi) will identify and acquire replacement property within the time limits imposed by Section 1031; and that in order to avoid additional transfer tax, the taxpayer (vii) will deed his property directly to the purchaser; and the seller of the replacement property (viii) will deed that property directly to the taxpayer.

4. Assignment of Rights in Relinquished Property

The taxpayer must (i) execute an assignment of rights in the contract for the sale of the relinquished property to the QI; and (ii) furnish the buyer of the relinquished property and all parties to the exchange agreement with notice of assignment of the taxpayer’s rights in the relinquished property contract to the QI pursuant to Regs. § 1.1031(k)-1(g)(4)(v). Notice of the assignment can be given at or before the closing.

5. Notice of Identification of Replacement Property

On or before the end of the 45-day identification period, the taxpayer must, in accordance with Regs. § 1.1031(k)-1(b) and (c), identify one or more replacement properties to be acquired by the QI in exchange for the relinquished property. The replacement property must be identified in a written document signed by the taxpayer and mailed or faxed to the QI and all other persons involved in the exchange. (If the replacement property is acquired simultaneously with the transfer of the relinquished property, or is otherwise acquired prior to the end of the identification period, the replacement property will be deemed identified.)

6. Assignment of Rights in Replacement Property

The taxpayer must (i) execute an assignment of rights in the contract for the purchase of the replacement property to the QI; and (ii) furnish the seller of the replacement property and all parties to the exchange agreement with notice of assignment of the taxpayer’s rights in that contract pursuant to Regs. § 1.1031(k)-1(g)(4(v). Notice of the assignment can be given at or before the closing.

XIV. Reverse Exchanges

A. History of Reverse Exchanges

Although the deferred exchange regulations apply to simultaneous as well as deferred exchanges, they do not apply to reverse exchanges. See Preamble to final Regulations, 56 Red. Reg. 19933 (5/1/91). Reverse exchanges occur where the taxpayer acquires replacement property before transferring relinquished property. Perhaps because they are intuitively difficult to reconcile with the literal words of the statute, reverse exchanges were slow to gain juridical acceptance. An early case, Rutherford v. Com’r, TC Memo (1978) held that purchases followed by sales could not qualify under Section 1031. However, Bezdijian v. Com’r, 845 F.2d 217 (9th Cir. 1988) held that a good exchange occurred where the taxpayer received heifers in exchange for his promise to deliver calves in the future. Following Bezdijian, and perhaps emboldened by the deferred exchange Regulations, taxpayers began engaging in a variety of “parking” transactions in which an accommodator (i) acquired and “parked” replacement property while improvements were made and then exchanged it with the taxpayer (exchange last); or (ii) acquired replacement property, immediately exchanged with the taxpayer, and “parked” the relinquished property until a buyer could be found (“exchange first”). Just as deferred exchanges were recognized by courts, so too, reverse exchanges soon received a judicial imprimatur. The acquisition of replacement property prior to the transfer of relinquished property – a situation apparently not contemplated when Section 1031 was enacted – was termed a “reverse exchange.” Interestingly, many of the principles and rules governing safe harbor deferred exchanges in the regulations have found a new home in Revenue Procedure 2000-37, which governs safe harbor reverse exchanges.

B. Theory of IRS Challenge to Reverse Exchanges

In a typical reverse exchange parking arrangement, an accommodator holds replacement property. The IRS could argue that the accommodator is acting as the taxpayer’s agent. If this were the case, the taxpayer could be considered to be in constructive receipt of the replacement property, and therefore could not acquire it from himself in an exchange. However, Rev. Proc. 2000-37 provides that as long as the reverse exchange is structured to fall within the safe harbor, the IRS will not challenge qualification of property as either replacement property or relinquished property, and will not treat the accommodator as the agent of the taxpayer.

C. Rationale for Engaging in Reverse Exchange

Why would a taxpayer contemplate a reverse exchange? A situation calling for a reverse exchange might arise where the cash buyer of the property to be relinquished has defaulted, and the taxpayer must take title to the replacement property immediately or risk forfeiting the down payment. There are two types of reverse exchanges: “Non-safe harbor” (or “pure”) reverse exchanges; and reverse exchanges under Revenue Procedure 2000-37. The familiar 45-day identification and 180-day exchange periods found in Section 1031(a)(2) and which govern all deferred exchanges have been engrafted onto Revenue Procedure 2000-37. Non safe harbor reverse exchanges have no identification or exchange period requirements per se. Although the Revenue Procedure 2000-37 safe harbor provides a degree of certainty not possible using a non safe harbor reverse exchange, the time constraints imposed by Revenue Procedure 2000-37 may pose an insurmountable problem. If so, a non safe harbor reverse exchange may be the only option. However, difficult issues of agency and constructive receipt absent in safe harbor reverse exchanges under Revenue Procedure 2000-37 may arise in a non safe harbor reverse exchange.

D. Promulgation of Revenue Procedure 2000-37 Safe Harbor

Rev. Proc. 2000-37 allows taxpayers intending to complete a like-kind exchange after acquiring replacement property to accomplish that result in a predictable fashion. Although the deferred exchange regulations do not govern reverse exchanges, many of its rules and time periods have been “borrowed” by Rev. Proc. 2000-37. The 45-day period limits the time in which the taxpayer may identify up to three properties to be relinquished in an “Exchange Last” reverse exchange. The 180-day period limits the time in which the taxpayer must relinquish one of those three identified properties. The 180-day period applies to the Exchange Accommodation Titleholder (EAT), and limits the time in which an EAT may hold and improve replacement property in an Exchange Last reverse exchange. The 180-day period also limits the time in which the EAT may hold relinquished property for sale in an “Exchange First” reverse Exchange. Reverse exchanges under Rev. Proc. 2000-37 are effective with respect to an EAT that acquires beneficial title in either the relinquished or the replacement property. Under Rev. Proc. 2000-37, the EAT is treated as the owner of property for federal income tax purposes. To be the tax owner, the EAT must possess “qualified indicia of ownership” (QIO) from the acquisition date until the date the property is transferred. The taxpayer may continue to lease or manage the property while it is parked with the EAT. The EAT cannot be either the taxpayer or a “disqualified person.” Disqualification is determined under rules similar to those found in deferred exchange Regs. § 1.1031(k)-1(g). Revenue Procedure 2000-37 is effective with respect to an EAT that acquires legal or beneficial title on or after September 15, 2000.

1. Distinguish Qualified Intermediary (QI) and EAT

The role of the QI is distinguishable from that of the EAT in that the QI never acquires beneficial title in either the relinquished or the transferred property (and not even legal title if property is direct-deeded to the taxpayer) while the EAT must be the beneficial owner for tax purposes. Neither the QI nor the EAT is the taxpayer’s agent for federal income tax purposes. However, the QI may be the taxpayer’s escrow agent for legal purposes and for local (i.e., transfer tax) purposes. Since an escrow agent is bound by a fiduciary obligation, Regs. § 1.1031(k)-1(g)(3) provides that the taxpayer is not in constructive receipt of exchange funds held by the QI.

2. Qualified Exchange Accommodation Arrangement

The IRS will not challenge the qualification of either replacement property or relinquished property, or the status of the exchange accommodation titleholder (EAT) as the beneficial owner of such property, if the property is held pursuant to a “qualified exchange accommodation agreement” (QEAA). The QEAA will provide that the EAT is not the taxpayer’s agent for federal tax purposes.

3. Qualified Exchange Accommodation Arrangement

Property is deemed to be held pursuant to a QEAA only if the following conditions are satisfied:

a. Qualified Indicia of Ownership Held
by Exchange Accommodation Titleholder

The EAT must possess “qualified indicia of ownership” (QIO) from the date of acquisition until the property is transferred. QIO comprehends a situation in which the EAT possesses (i) legal title; (ii) beneficial title under principles of commercial law (i.e., a contract for deed); or (iii) interests in a disregarded entity such as a single-member LLC that itself holds legal title to property. Although the EAT must possess beneficial title, the EAT need not either acquire any equity interest or assume any risk. This is in sharp contrast to the situation involving non-safe-harbor reverse exchanges. The EAT cannot be either the taxpayer or a “disqualified person.” The EAT must be subject to and report federal income tax.

b. Disqualified Person

A disqualified person under Regs. § 1.1031(k)-1(k) is a person who is (i) an agent of the taxpayer (e.g., the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker; (ii) a person with whom the taxpayer bears a relationship described in either Section 267(b) or Section 707(b), determined by substituting in each section “10 percent” for “50 percent”; or (iii) a person who bears a relationship described in (ii) to the agent of the taxpayer. Essentially, the rules parallel the rules for persons who are disqualified from acting as qualified intermediaries in deferred exchanges under the Regulations.

c. Services of EAT Not Taken Into Account

Services for the taxpayer in connection with the person’s role as the EAT in a QEAA are not taken into account in determining whether that person or a related person is a disqualified person. However, even though property will not fail to be treated as being held in a QEAA by reason of services provided by the EAT, the IRS may recast an amount paid pursuant to such an arrangement as a fee paid to the EAT to the extent necessary to reflect the true economic substance of the arrangement.

d. Intention to Effectuate Section 1031 Exchange

At the time QIO is transferred to the EAT, the taxpayer must intend that such property represent either the replacement property or the relinquished property in an exchange intended to qualify under Section 1031.

e. Qualified Agreement with EAT

No later than five business days after the transfer of QIO to the EAT, the taxpayer and the EAT must enter into a written agreement, the “qualified exchange accommodation agreement” (QEAA) which provides that (i) the EAT is holding the property for the benefit of the taxpayer to facilitate an exchange under Section 1031 and Revenue Procedure 2000-37; (ii) the parties agree to report the acquisition, holding, and disposition of the property as provided for in Revenue Procedure 2000-37; (iii) the EAT will be treated as the beneficial owner of the property for all federal income tax purposes; and (iv) both parties will report the transaction in a manner consistent with the agreement.

f. 45-Day Period to Identify Relinquished Property

No later than 45 days after the transfer of QIO to the EAT, the relinquished property must be identified in a manner consistent with the principles described in the deferred exchange Regulations. Regs. § 1.1031(k)-1(c). (The taxpayer may also properly identify alternative and multiple properties, as provided in Regs. § 1.1031(k)-1(c)(4).). Thus, the taxpayer must furnish written notice to the EAT concerning the identity of the relinquished property by no later than midnight on the 45th day following acquisition of replacement property. [Note: The identification requirement would, by definition, have no application in the exchange first format, where the taxpayer at the outset transfers relinquished property to the accommodator, who immediately exchanges it for replacement property which the accommodator has purchased.]

g. Sale of Property Within 180-Day Period

No later than 180 days after the transfer of legal title to the EAT, the property must be transferred (i) directly or through a QI to the taxpayer as replacement property (“exchange last” format), or to a person (other than the taxpayer or a disqualified person) as relinquished property (“exchange first” format).

h. Combined Time Period

The combined time period during which the relinquished and the replacement property may be held in a QEAA cannot exceed 180 days.

4. Summary of Requirements for
Property Deemed to be Held in QEAA

a. EAT must have Qualified Indicia of Ownership (QIO);
b. EAT cannot be taxpayer or disqualified person;
c. EAT must be subject to and report federal tax;
d. Taxpayer must intend exchange when QIO transferred to EAT;
e. Taxpayer must enter into “Qualified Exchange Accommodation Agreement” with EAT within five days of transfer of QIO to EAT;
f. No later than 45 days after transfer of QIO to EAT, taxpayer must identify relinquished property in an exchange last reverse exchange;
g. No later than 180 days after transfer of legal title to EAT, (i) replacement property must be transferred by EAT through QI to taxpayer (exchange last); or (ii) relinquished property must be transferred by EAT to cash buyer (exchange first);
h. Combined time period during which relinquished and replacement property may be held in QEAA cannot exceed 180 days.

5. Permissible Agreements

Property will not fail to be treated as being held in a QEAA by reason of any of the following contractual arrangements, even if such arrangements would not typically result from arm’s length bargaining.

a. EAT May Be QI

An EAT that satisfies the requirements of the QI safe harbor set forth in Regs. § 1.1031(k)-1(g)(4), and is not a disqualified person, may enter into an exchange agreement with the taxpayer to serve as the QI in a simultaneous or deferred exchange. Thus, qualified intermediaries and title companies may provide all of the services typically needed to effectuate a like-kind exchange. The same person may be the EAT for the acquisition of the replacement property as well as the QI in the sale of the relinquished property.

b. Guarantee of Obligations of EAT

The taxpayer or a disqualified person may (i) guarantee all or some of the obligations of the EAT, including secured or unsecured debt incurred to acquire the property, or (ii) indemnify the EAT against costs and expenses.

c. Funds May be Loaned to EAT

The taxpayer or a disqualified person may extend loans or advance funds to the EAT, or guarantee a loan or advance to the EAT. The loan need not bear interest, and there need not be any charge imposed for the loan guarantee.

d. Property Leased by EAT to
Taxpayer or Other Disqualified Person

The EAT may lease property to the taxpayer or a disqualified person. Rev. Proc. 2000-37 does not impose the requirement that any rent be paid to the EAT. Nevertheless, in practice the taxpayer will be required to remit to the EAT an amount equal to the debt service on a loan (if any) used to acquire the property.

e. Taxpayer or Other Disqualified
Person May Manage Property

The taxpayer or other disqualified person may manage the property, supervise improvement of the property, act as a contractor, or otherwise provide services to the EAT with respect to the property. Thus, although the EAT actually owns the property, the taxpayer will be responsible for improvements being made.

f. Puts and Calls

The taxpayer and the EAT may enter into arrangements and agreements regarding the purchase and sale of the property, including puts and calls relating to the purchase or sale of property, provided they are effective for not more than 185 days from the date the property is acquired by the EAT.

g. “Make Whole” Provision

In an “exchange first” transaction, the EAT acquires ownership of the relinquished property and may hold that property for a period of 180 days. During that time, the EAT is subject to the risk that value of the relinquished property might change. To avoid this result, the QEAA may permit the taxpayer and the EAT to enter into agreements and arrangements providing that any variation in the value of a relinquished property be taken into account upon the EAT’s disposition of the relinquished property.

h. Other Tax Treatment

Property will not fail to be treated as being held in a QEAA merely because the federal income tax treatment differs from the accounting, regulatory, or state, local or foreign tax treatment of the arrangement between the EAT and the taxpayer. Therefore, although the EAT must be the owner for federal income tax purposes, it need not be the owner for other purposes.

6. Summary of Permissible
Agreements Between EAT and Taxpayer

a. EAT may be QI;
b. Taxpayer or disqualified person may guarantee obligations of EAT;
c. Taxpayer or disqualified person may loan funds to EAT;
d. EAT may lease property to taxpayer or other disqualified person;
e. Taxpayer or other disqualified person may manage property;
f. Taxpayer and EAT may enter into contracts (including puts and calls) regarding the purchase and sale of property, provided contract is not effective for more than 185 days after EAT acquires property;
g. EAT and taxpayer may enter into contracts that take into account variation in value of relinquished property upon disposition by EAT;
h. Although EAT is owner for federal income tax purposes, tax treatment of EAT may differ for regulatory, state or local tax treatment.

7. State and Local Tax Treatment

In order to avoid a second imposition of transfer taxes, most QEAA arrangements attempt to treat the EAT as the taxpayer’s agent for state and local purposes.

8. Transactions Not Qualifying Under Rev. Proc. 2000-37

Many transactions, particularly “build-to-suit” arrangements, will not qualify under the Revenue Procedure 2000-37 safe harbor since the improved replacement property cannot be acquired within 180 days. If the EAT is a disqualified person, or it is necessary to go beyond 180 days, the taxpayer can still pursue a “pure” reverse exchange. Section 3.02 of the Revenue Procedure provides that “the Service recognizes that parking transactions can be accomplished outside of the safe harbor” and states that “[n]o inference is intended with respect to . . . arrangements similar to those described in this revenue procedure.” PLR 200111025 recognized that non-safe-harbor reverse exchanges survive Revenue Procedure 2000-37. Nonetheless, the safe harbor does appear to reflect the view of the IRS with respect to reverse exchanges in general. Stringent disqualification rules found in Revenue Procedure 2000-37, which substitute “10 percent” for “50 percent” under Sections 267(b) and 707(b) would, by definition, have no application in non safe harbor reverse exchanges. However, non-safe-harbor reverse exchanges would still be subject to the related party rules themselves, which also reference Sections 267(b) and 707(b), albeit without varying the “50 percent” language found in those sections.

a. Obstacle to Non-Safe-Harbor Reverse Exchange

If qualification under the safe harbor becomes problematic, the taxpayer could fall back on non-safe harbor qualification as a final resort. However, many of the permissible arrangements under Revenue Procedure 2000-37 would cause a non-safe harbor reverse exchange to violate agency or constructive receipt rules governing Section 1031 exchanges in general. In other words, stripped of the safe harbor protection of Rev. Proc. 2000-37, the Service could argue that the EAT was the taxpayer’s agent. Therefore, as a practical matter, non-safe harbor qualification may prove difficult if the transaction was originally intended to qualify under Revenue Procedure 2000-37.

9. When Reverse Exchanges Should be Contemplated

The requirement that the EAT obtain legal title to the parked property makes reverse exchanges relatively costly. Accordingly, their use should be reserved to situations where a deferred exchange is impossible, such as where the relinquished property buyer has defaulted, or where improvements must be commenced prior to disposition of the relinquished property. If improvements can be completed within the 180-day period in which the property may be parked with the EAT, Rev. Proc. 2000-37 provides a degree of certainty. However, if more time is required for construction, a non-safe-harbor reverse exchange may be the only option. The validity of a pure reverse exchange will depend upon whether the accommodator is respected as tax owner, or is merely deemed the taxpayer’s agent. Just as pre-regulation case law remains relevant in resolving deferred exchange disputes, decisions predating Rev. Proc. 2000-37 are presumably still relevant in resolving disputes arising in reverse exchanges.

10. Distinguish: Role of Qualified Intermediary

The deferred exchange regulations provide that the interposition of a qualified intermediary to receive exchange funds liberates the taxpayer from problems of constructive receipt and agency, which normally plague like kind exchanges. A QI may acquire legal title, though through direct deeding, this is not often the case. Whether or not the QI acquires legal title, the QI never acquires beneficial title in either the relinquished or replacement property. Most importantly, the QI is not considered the taxpayer’s agent for federal tax purposes. The EAT in a reverse exchange, by contrast, will acquire legal title to either the relinquished or the replacement property. Whereas neither the QI nor the EAT is considered the taxpayer’s agent for federal tax purposes, the EAT must be the tax owner of the property in a reverse exchange, since it is the EAT – and not the taxpayer – who is engaging in the like kind exchange. For taxpayers wishing to “opt out” of the safe harbor reverse exchange, a non safe harbor reverse exchange nominally at least imposes no jurisdictional time periods. Issues of agency and constructive receipt could doom many reverse exchanges which proceed outside of the safe harbor. 11. Comparison of Function of Exchange Accommodation
Titleholder (EAT) to Qualified Intermediary (QI)

Legal Beneficial Desired Agent for Escrow Constructive Receipt Applicability Applicability
Title? Title? Legal or Tax? Agent? of Exchange Funds? of 45-day Limit of 180-day Limit

EAT Yes, always Tax Owner Transfer tax Yes Safe harbor avoids In Exchange See footnote
(QIO) and perhaps legal Last, identify
but not federal tax relinquished
property. None
in Exchange
First.

QI Not required Never Transfer tax, Yes Safe harbor avoids Must identify Must acquire
to, but may and perhaps legal replacement replacement
but not federal tax property property

E. Exchange First Format

In an Exchange First Reverse Exchange, the EAT purchases the relinquished property from the taxpayer through the QI. The purchase price may be paid through financing arranged by the taxpayer. Using exchange funds, the QI purchases replacement property, which is transferred to the taxpayer, completing the exchange. Although the exchange is complete, the EAT may continue to retain the relinquished property for up to 180 days after acquiring QIO. During this period, the taxpayer arranges for a buyer. The funds received by the EAT upon the sale of the relinquished property are used to retire the debt incurred by the EAT in purchasing the relinquished property from the taxpayer.

1. EAT Never Acquires Ownership in Replacement Property

Since the replacement property is transferred directly by the QI to the taxpayer, the EAT never acquires ownership in the replacement property. Therefore, the EAT need not be involved in the loan process. The EAT need also not take title to the replacement property, which may be advantageous from a transfer tax standpoint. Furthermore, since the taxpayer is taking title to the replacement property immediately, it may be pledged as collateral for a loan. If management problems exist, it may also be preferable for the taxpayer to take immediate ownership in the replacement property.

2. When Exchange First Reverse Exchange Desirable

An Exchange First reverse exchange might be desirable if the purchaser of the property to be relinquished has defaulted, leaving the taxpayer obligated to close on the replacement property or risk losing his down payment. The taxpayer could acquire the replacement property before finding a new buyer for the relinquished property. By structuring an Exchange First reverse exchange under the safe harbor, the taxpayer sacrifices the luxury of time, since he may no longer wait 45 days to identify potential properties to be relinquished, nor wait 180 days to choose among those properties that property to be relinquished. Instead, the taxpayer must choose the property to be relinquished when the replacement property is acquired, and must actually relinquish it, since the QI must have the sales proceeds in hand to purchase the replacement property. The only applicable time constraint in a safe harbor Exchange First reverse exchange is the 180-period during which the EAT must dispose of parked relinquished property.

F. Exchange Last Format

In an Exchange Last reverse exchange, the EAT takes title to (i.e., acquires “QIO”) and “parks” replacement property. Financing for the acquisition may be arranged by the taxpayer. The EAT may hold title to the replacement property for a period not exceeding 180 days from the date it acquires QIO to the replacement property. While parked with the EAT, the replacement property may be improved, net-leased, or managed by the taxpayer. The taxpayer then arranges to dispose of the relinquished property through a QI. The taxpayer must identify property to be relinquished within 45 days of the EAT acquiring title (QIO) to the replacement property, and must dispose of the relinquished property through a qualified intermediary within 180 days of the date when the EAT acquires title (QIO). The QI transfers proceeds from the relinquished property sale to the EAT in exchange for the parked replacement property, which the EAT direct-deeds to the taxpayer as replacement property, completing the exchange. The EAT uses the cash received from the QI to retire the debt incurred in purchasing the replacement property from the cash seller.

G. Typical Steps in Exchange Last Reverse Exchange

1. The EAT creates an LLC to hold title to the replacement property which it will acquire pursuant to the Qualified Exchange Accommodation Agreement (QEAA).

2. The QEAA provides that the taxpayer will assign to the EAT all contractual rights to purchase the replacement property. The EAT will convey title in the replacement property to the taxpayer through the qualified intermediary at such time as the taxpayer conveys title to the property being relinquished.

3. Financing for the purchase of replacement property by the EAT will be provided by the taxpayer or by the seller of the replacement property, or by the EAT itself.

4. The EAT may, enter into a six-month triple net lease (taxes, insurance, debt service) agreement with the taxpayer whereby the replacement property is leased to the taxpayer for a nominal amount of rent (e.g., $100/month).

5. The taxpayer must identify within 45 days, property to be relinquished, pursuant to the normal identification rules (e.g., 3-property rule, 200% rule). The taxpayer must acquire title to the replacement property within 180 days.

6. Pursuant to the QEAA, the EAT will be obligated to sell the replacement property to the QI once the QI obtains the proceeds from the sale of the taxpayer’s relinquished property. The QEAA must provide that the EAT may hold the replacement property for a period not exceeding 180 days after acquiring title (QIO). (The EAT is not a party to the exchange agreement between the taxpayer and the QI.)

7. The QI will cause the relinquished property to be sold, with the taxpayer direct-deeding title to the relinquished property to the purchaser. The QI will use the proceeds to purchase the replacement property from the EAT. The EAT will convey title in the replacement property directly to the taxpayer, completing the exchange.

8. The net proceeds from the sale of the relinquished property will be used first to pay costs of the sale (transfer and recording fees and taxes, title insurance, etc.,), and then to satisfy the indebtedness incurred by the EAT to purchase the replacement property. If the net proceeds are insufficient, the taxpayer will provide additional funds to the EAT. The remaining cash may be used by the taxpayer to acquire other like kind exchange property in a deferred exchange, subject to the 45-day identification and 180-day deferred exchange requirements. See CCA 200836024.

9. Advantages of Exchange Last

Since the parked property will have been initially acquired by the EAT and will not have been previously owned by the taxpayer, there is little risk the EAT will be disregarded for tax purposes. Another advantage of Exchange Last is that following acquisition by the EAT of the replacement property, the taxpayer can consider several potential properties to be relinquished, and ultimately choose that which generates the least gain. However, if the taxpayer elects to proceed under the safe harbor provided by Rev. Proc. 2000-37, flexibility will be limited, since the taxpayer must identify three potential properties to be relinquished within the 45-day identification period.

10. EAT Title Owner of Property

While the replacement property is parked with the EAT, the EAT is title owner of that property. Therefore, the EAT will be the borrower on a loan associated with the acquisition of the replacement property until the loan is satisfied by proceeds from the sale of the relinquished property. To avoid loan application problems, the taxpayer should apprise the lender at an early stage of the planned reverse exchange and the presence of the EAT.

11. Build-to-Suit Reverse Exchanges Employ Exchange Last

A build-to-suit reverse exchange would always employ the exchange last format, since the replacement property may be improved while parked with the EAT. Many “build-to-suit” arrangements will not be suitable for the Rev. Proc. 2000-37 safe harbor, since completion of improvements may not be possible within the 180-day period in which the property is held by the EAT.

H. Non-Safe-Harbor Exchange Last in Build to Suit

If it is necessary to go beyond 180 days (or if the EAT is a “disqualified person”) the taxpayer can still a pursue “non-safe-harbor” or “pure” reverse exchange. Rev. Proc. 2000-37 states that “the Service recognizes that parking transactions can be accomplished outside of the safe harbor.” PLR 200111025 explicitly recognized that non-safe-harbor reverse exchanges survive Rev. Proc. 2000-37. Pure reverse exchanges free the taxpayer of constraints imposed by the 45-day identification period and the 180-day period during which the EAT may improve the replacement property. However, pure reverse exchanges pose more tax risk, as they are burdened with issues of agency, constructive receipt and beneficial ownership. Therefore, if more than 180 days are required, and a planned safe harbor Exchange Last reverse exchange is converted into a non-safe-harbor reverse exchange, liberties taken when planning under the safe harbor may doom a non-safe-harbor reverse exchange unless these issues are considered from the start.

I. Comparison of Exchange Last and Exchange First Reverse Exchanges

Time taxpayer EAT Acquisition Role of EAT Build Advantages Disadvantages Typical Use
acquires to-suit
replacement possible?
property

Exchange At outset Relinquished Park relinquished NO (i) EAT not (i) Loss of Buyer
First property only property until involved in flexibility defaults and
at outset from disposition loan for w/r/t taxpayer must
taxpayer within 180 days replacement choosing take title to
of acquiring QIO property; (ii) relinquished replacement
Replacement property; property or
Property may (ii) transfer risk losing
be used as tax cost downpayment
collateral for
loan; (iii)
immediate
ownership; (iv)
Taxpayer has
time to locate
replacement
property w/o
pressure of
45-day
identification
period

Exchange Following 45-day Replacement Park replacement YES (i) taxpayer has (i) Typically, Build-to
Last identification, and property only property until time to choose not much suit where
within 180-day at outset from taxpayer relinquished advantage no time to
exchange period cash seller acquisition through properties; (ii) over garden arrange for
QI within 180 days EAT title owner variety disposition
of EAT acquiring (iii) can fall deferred of relinquished
QIO. back to non- exchange w/ property, so
safe harbor QI engaged typical deferred
reverse exchange; to construct exchange with
(iv) can combine improvements; QI not feasible
w/deferred (ii) transfer
Exchange. tax cost

J. Cases and Rulings Involving Reverse Exchanges

1. The “Unplanned Reverse Exchange” – TAM 200039005

In TAM 200039005, a deferred exchange with a qualified intermediary was contemplated until the cash buyer failed to obtain financing. To avoid losing his deposit on the replacement property and to preserve exchange treatment, the taxpayer structured a hasty “exchange last” parking arrangement with an accommodator, in which the accommodator took legal title to the replacement property. Pursuant to an oral agreement, the taxpayer (i) provided financing and remained personally liable on the loan for the replacement property and (ii) continued to occupy the parked replacement property without a formal lease. The taxpayer then assigned the contract for the relinquished property to the accommodator. At closing, the accommodator transferred title (i) in the replacement property to the taxpayer and (ii) in the relinquished property to the cash buyer.

a. Taxpayer’s Argument

The taxpayer argued that (i) the transaction qualified as a deferred exchange with a QI under the safe harbor Regulations since the accommodator was acting as QI; (ii) the accommodator could act as agent under the deferred exchange Regs. § 1.1031(k)-1(g)(4)(i); and (iii) a qualifying like kind exchange can occur without regard to the order in which the QI performs its functions.

b. IRS Argument

The IRS argued that (i) the accommodator was acting as the taxpayer’s agent or nominee in acquiring replacement property; (ii) the safe harbor does not apply to reverse exchanges; and (iii) even if the safe harbor could apply to reverse exchanges, there was no written exchange agreement in place with the accommodator at the time replacement property was acquired from the cash seller. The transaction also reflected a lack of intent to effectuate an exchange, since the cash buyer was not part of the transaction when the accommodator acquired title to the replacement property.

c. Weakness in IRS Argument

Beyond the agreement of the QI and the taxpayer, there is no requirement of mutuality of intent among other parties to an exchange. Neither the cash buyer nor the cash seller is typically a party to the exchange or intends to complete an exchange. Nevertheless, taxpayer’s position would have been strengthened had an exchange agreement been entered into with the cash seller prior to the initial closing.

d. Upshot of TAM 200039005

Since that the taxpayer supplied funds for the parked property, was personally liable on mortgage, and had exclusive use of the parked property, it is not surprising that the IRS asserted the existence of an agency. Careful planning should avoid problems raised in the TAM.

2. DeCleene v. Comr. – “Planned” Build-to-Suit Reverse Exchange

a. Facts

DeCleene v. Com’r, 115 T.C. No. 34 (2000) was decided after Revenue Procedure 2000-37. DeCleene purchased unimproved land on Lawrence Drive, where it intended to build and relocate. Shortly thereafter, WLC expressed interest in other property owned by DeCleene. To accommodate Decleene’s desire to effectuate a like kind exchange, WLC agreed to purchase the Lawrence Street property and improve it, and then transfer it back to Decleene in exchange for the other property WLC desired. The consideration paid by WLC for the Lawrence Street property consisted of a non-recourse, interest-free promissory note for $142,000. The construction by WLC and the exchange were to both occur within a few months. To finance construction, DeCleene guaranteed a $380,000 non-recourse bank loan to WLC. DeCleene also paid WLC’s construction costs and real estate taxes. At closing, (i) WLC tendered $142,000 and title to the improved Lawrence Street property and (ii) DeCleene tendered title to the other property and assumed WLC’s $380,000 loan.

b. Tax Court Denies Exchange Treatment

Finding that DeCleene had never relinquished ownership of Lawrence Drive to WLC, the Tax Court denied what it characterized as an attempted reverse exchange. The court found significant DeCleene’s failure to engage an accommodator, and questioned whether the $142,000 paid to the DeCleene at closing constituted payment under the note, given initially by WLC to purchase the Lawrence Street property, which the parties professed to intend, or simply represented cash payment for the other property which WLC desired. If the $142,000 were simply payment for the other property, no exchange occurred.

c. Problems with Transaction as Structured

Had the $142,000 actually been paid to DeCleene initially, WLC would have possessed the benefits and burdens of ownership. However, WLC made no economic outlay during the brief period of construction, bore no exposure for real estate taxes (or any liabilities during the three-month period), and had no potential for economic gain or loss during the period. Accordingly, WLC was never the tax owner of Lawrence Drive. The court intimated that an exchange might have occurred had the parties utilized an accommodator rather than a cooperative buyer. Bloomington Coca-Cola Bottling was cited for the for the proposition that a taxpayer cannot exchange property for other improved property owned by him. Decisions favorable to the taxpayer, such as Coastal Terminals and Boise Cascade, were distinguished in that in those cases the taxpayers (i) had never owned the property on which the improvements were made and (ii) had used their own funds to finance construction.

d. Avoiding Problems in DeCleene

DeCleene represented an unusual IRS victory where the form of the transaction constituted an exchange. Most build-to-suit reverse exchanges can be structured to avoid the problems encountered in DeCleene. Ideally, the taxpayer should not own the replacement property prior to exchange. If it does, an accommodator (rather than a cooperative buyer) should truly obligate itself with respect to the replacement property. In addition, (i) the taxpayer should not pay or be obligated to pay real estate taxes; (ii) the accommodator should have some equity risk (e.g., use its own funds or obtain recourse financing) unless the transaction is structured as a reverse exchange under Rev. Proc. 2000-37; and (iii) the time frame should be enlarged to avoid the risk of the application of the step-transaction doctrine. (The cooperative buyer was obligated to improve and reconvey the property within four months).

3. CCA 200836024 – Reverse and Deferred Exchanges Combined

a. Exchange Last Reverse Exchange

In CCA 200836024 the taxpayer, pursuant to Rev. Proc. 2000-37, structured an “exchange last” reverse exchange and a deferred exchange. In an exchange last 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 alternative relinquished properties. Redacre was one of those properties. On the 180th day following the EAT’s acquisition of Greenacre, Redacre was relinquished, and the reverse exchange was unwound.

b. Problem of Boot

Since the value of Redacre far exceeded the value of Greenacre, the taxpayer would have significant boot in the exchange. To remedy this, the taxpayer proposed to engage in a second exchange to defer the remaining gain, by treating the sale of Redacre as the relinquished property in a deferred exchange. Accordingly, 42 days after the sale of Redacre, the taxpayer identified three additional properties, as potential replacement properties in connection with the relinquishment of Redacre.

c. Could Same Relinquished Property Be Used in
Exchange Last Reverse Exchange and Deferred Exchange?

The issue was whether the taxpayer could utilize the same property as relinquished property in both an exchange last reverse exchange and as relinquished property in a deferred exchange. Reasoning that the taxpayer had complied with identification requirements for both reverse and deferred exchange, the advisory concluded that the taxpayer could properly engage in both a reverse and a deferred exchange with respect to the same property. The advice further noted that Rev. Proc. 2000-37 anticipated the use of a qualified intermediary in a reverse exchange. Finally, the advice 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.

XV. Build to Suit

A. Taxpayer Must Avoid Actual or Constructive Receipt

Property may be improved or constructed while being “parked” with an accommodator prior to being exchanged. In such build-to-suit arrangements, as in other realms of Section 1031, the taxpayer must avoid actual or constructive receipt of exchange proceeds, as well as problems involving agency. In a QI or QEAA safe harbor, issues of agency and constructive receipt do not arise. The efficacy of build-to-suit arrangements outside of the QI or QEAA safe harbors depends on whether the accommodator has acquired sufficient “burdens and benefits” of ownership with respect to the parked property so that he is treated as the tax owner rather than as merely the taxpayer’s agent. A build-to-suit arrangement may even be structured with a related party, provided that party is not an agent of the taxpayer. The related party rules of Section 1031(f) would apply to such a transaction. A reverse exchange build-to-suit by definition employs the “exchange last” format, since the replacement property must be “parked” with an accommodator during the time when improvements are made or construction occurs, prior to the exchange with the taxpayer. Under Revenue Procedure 2000-37, the taxpayer may exert considerable control over the improvements to the replacement property; more so than in a non safe harbor reverse exchange. That is, even though the EAT holds beneficial or legal title, the taxpayer may direct the EAT to construct improvements according to the taxpayer’s specifications.

B. Role of Qualified Intermediary

If sufficient improvements to the replacement property can be made within the 180-day exchange period, construction is typically done by the QI. Note that the QI must (i) acquire title; (ii) pay for the improvements; and (iii) transfer the replacement property to the taxpayer prior to the end of exchange period. Regs. §1.1031(k)-1(g)(4) permits the QI to be the designated agent of the taxpayer. This may eliminate a second transfer tax and also facilitate construction financing. A QI could presumably pay construction costs incurred during the 180-day exchange period.

C. Improvements Require More Than 180 Days

If more than 180 days are required to construct improvements, the taxpayer may have no choice but to structure the transaction as a non-safe harbor reverse exchange, since only then can the taxpayer avoid the 180-day jurisdictional limitation imposed by Section 1031(a)(3)(B) for deferred exchanges and by Revenue Procedure 2000-37 for safe harbor reverse exchanges. Again, the accommodator in a non-safe harbor build-to-suit exchange should bear some risk of loss and incur some legal obligations.

D. Cases and Rulings Involving Build-to-Suit Exchanges

1. Bloomington Coca-Cola v. Com’r

Bloomington Coca-Cola v. Com’r, 189 F.2d 14 (7th Cir. 1951), held that an exchange of real property for services will not qualify under Section 1031. The taxpayer conveyed land and cash to a contractor in exchange for the construction of a bottling plant on other land owned by Coca-Cola. However, since the taxpayer already owned the land on which the plant was constructed, it was held to have received services and materials rather than qualifying real property in the exchange. (Deferred exchange Regulations § 1.1031(k)-1(e) similarly provide that “any additional production occurring with respect to the replacement property after the property is received by [the taxpayer] will not be treated as the receipt of property of a like kind.”)

2. J.H. Baird v. Com’r

In J.H. Baird v. Com’r, 39 T.C. 608 (1962), a real estate broker, for a fee, acquired title and constructed a facility according to the taxpayer’s specifications. Thereafter, the broker transferred the improved property to the taxpayer in exchange for other property owned by the taxpayer. Exchange treatment obtained since the broker, who earned a profit, had not acted as the taxpayer’s agent in selling the property and constructing the building.

3. Coastal Terminals v. U.S.

In Coastal Terminals, 320 F.2d 333 (4th Cir. 1963), the taxpayer assigned an option to acquire land on which the taxpayer desired a new facility to a prospective purchaser of other property owned by the taxpayer. The optionee constructed improvements in accordance with the taxpayer’s directions, and then transferred the improved property back to the taxpayer in exchange for the other property the optionee desired. A good exchange occurred, since the optionee used its own funds, and incurred its own obligations, in buying and building the facility for exchange with the taxpayer. The optionee was deemed the tax owner of the other property being improved.

4. Revenue Ruling 75-291

IRS Rulings and case law support the proposition that the taxpayer may remain actively involved in the construction process without jeopardizing exchange treatment, provided the work is completed before the taxpayer acquires the replacement property. In Revenue Ruling 75-291, Y acquired land and constructed a factory for the sole purpose of exchanging it for taxpayer’s property. Exchange treatment was accorded, since Y constructed the factory on its own behalf and not as an agent of taxpayer. Deferred exchange Regs. § 1.1031(k)-1(e) explicitly provides that replacement property may be constructed, and authorizes build-to-suit arrangements that have been adequately described during the identification period.

5. PLR 9428077

In PLR 9428077, the QI acquired property from the taxpayer, transferred the property to a cash buyer, and used the funds to acquire replacement property and build a golf course. Prior to the end of the exchange period, the QI transferred the golf course to the taxpayer. Exchange treatment was accorded, since the QI had sole authority to control the funds, and the taxpayer had no right to receive, pledge, borrow or otherwise obtain the benefits of the cash, other than to select improvements.

6. Fredericks v. Com’r

Fredericks v. Com’r, T.C. Memo 1994-27, decided prior to the enactment of the related party rules, held that a nontaxable exchange occurred where the taxpayer transferred an apartment complex to a wholly-owned corporation in exchange for the corporation’s promise to purchase undeveloped land, construct improvements, and convey the improved property to the taxpayer. Fredericks was successful in obtaining exchange treatment since (i) the taxpayer did not control sale proceeds prior to receiving the replacement property; (ii) the relinquished property was transferred and replacement property was received as part of an integrated plan; and (iii) the related party did not act as the agent of the taxpayer.

a. Application of Related Party Rules

Section 1031(f)(1) provides that if a taxpayer exchanges property with a related party and within two years, either the taxpayer or the related party disposes of property received in the initial exchange, any gain deferred in the initial transaction will be recognized as of the date of the later disposition. Fredericks was decided prior to the enactment of the related party rules. To avoid application of the related party rules, Section 1031(f)(2)(C) would today require the taxpayer to demonstrate that the transaction was not motivated by a tax avoidance purpose.

7. PLR 200901004

In PLR 200901004, the IRS ruled favorable regarding 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 LLC’s rights under the assigned easements. The ruling noted 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.

XVI. Tenancy-in-Common Interests and Undivided Fractional Interests

A. Increased Popularity of TIC Interests

Tenancy in common (TIC) interests have become popular as replacement properties. A TIC interest represents a slice of a larger fee interest. Ownership is evidenced by an individual deed stating an undivided ownership interest in the TIC property. A TIC owner possesses the same rights as would a sole owner. Given the popularity of TICs as replacement property, the most desirable TIC investments command a substantial premium. On the other hand, costs associated with the TIC ownership also reflect economies of scale. Since multiple owners may pool their resources, a TIC interest in high quality commercial property may be acquired for as little as $200,000. Since a smaller investment is required, there is a greater opportunity to diversify. TIC properties generally consist of high quality triple net leased buildings, or large retail or office buildings costing $1 million to more than $10 million. TICs provide a relatively secure monthly cash flow, since most tenants are creditworthy and commit to multi-year leases. The TIC sponsor will typically provide quarterly updates and annual reports. As the taxpayer builds equity in the TIC, it may be possible to trade up with sequential Section 1031 exchanges.

B. Role of Sponsor

A TIC sponsor will generally have placed the property under contract, constructed it, or purchased it for exchange. The sponsor analyzes leases, assesses maintenance requirements, conducts demographic studies, and determines desirable investment property. The sponsor may enter into a master lease with the TIC interest holders, and then lease the property to subtenants. Individual TIC interest holders will have little if any day-to-day management responsibility, making the investment particularly attractive for property owners who wish to minimize their level of involvement in replacement property. A TIC property marketed through a Private Placement Memorandum (PPM) can often be identified and closed within the 45-day identification period. A second TIC property owned by the sponsor can also be identified as backup replacement property. Before a TIC property is acquired, a business plan of three to seven years, as well as an exit strategy, may already be in place. A TIC lender will typically look for high debt coverage ratios and insist that sufficient reserves be placed in escrow to provide for future vacancies. The duration of a pre-arranged nonrecourse loan may be structured to coincide with the business plan, maximizing the benefit of current market rate interest options.

C. Tax Issues Involving TICs

The term “securities” has a different meaning for securities law and tax law purposes. Under securities law, the term is defined broadly, while under the tax law, the term is defined narrowly. For purposes of Section 1031, the definition of “security” appears to be limited to a stock, bond or note. Thus, there is little likelihood that an interest in a TIC (or a DST) interest would violate Section 1031(a)(2)(C), which prohibits the exchange of “securities” in a like-kind exchange. Even though TICs and DSTs constitute real property for tax purposes, they may constitute “securities” for purposes of the securities laws. A security is an investment in which a person other than the taxpayer manages the investment with a view to receiving income and achieving capital gain. The manager of a TIC would appear to be such other person. If TICs do constitute securities for purposes of the securities laws, they should be sold only by brokers to “accredited” investors through a Private Placement Memorandum (PPM), which discloses risks. Congress has become concerned over the marketing of TICs as real estate, often on the internet. Farmers have complained that TICs are putting unwarranted upward price pressure on farm land. Congress also appears to be concerned about “leveraging” for estate tax purposes. Taxpayers have acquired TICs and then dropped them into LLCs or partnerships that generate valuation discounts. If a taxpayer claims a gift or estate tax discount for both the TIC interest and the partnership interest, total discounts of 40 percent or more can be claimed.

1. Illustration

Taxpayer owns a shopping center on Long Island worth $7,500,000, with a mortgage of $5,000,000. Using the 200 percent rule, the taxpayer identifies the following TIC properties within the 45-day identification period: (i) a Class A 300,000 square foot distribution center in Chicago; (ii) a new 265 unit apartment community in Las Vegas; (iii) a shopping center in New Orleans; and (iv) an oil and gas interest in Alaska. The taxpayer closes on three of the properties within the exchange period. The fourth property was identified as a backup. Not only has the taxpayer diversified his investment, but he has chosen a mix of properties with differing cash flows and investment potential. For example, the distribution center in Chicago may have a high cash flow (i.e., capitalization); the New Orleans shopping center may offer unique federal and state tax advantages; the Las Vegas apartments may possess enhanced growth potential; and the Alaska oil and gas lease may offer attractive current write-offs.

a. Attractiveness of Oil and Gas as Replacement Property

Real estate owners who wish to leave the real estate market but still wish to defer gain may consider swapping the real estate for a royalty stream from mineral rights or a working interest in an oil or gas property. Provided the rights are held for productive use in a trade or business, or for investment, acquisition of these interests would qualify under Section 1031. Rev. Rul. 68-331. A working interest in an oil or gas well is not subject to the passive activity loss limitations of IRC § 469 provided the taxpayer holds the interest directly or through an entity in which liability is not limited. Therefore, current losses would be deductible. Although income from these activities would be ordinary rather than investment, the 15 percent yearly depletion deduction allowance could offset ordinary income.

2. Mechanics of Investing in Tenancy in Common Interests

The taxpayer’s counsel will first review the sponsor’s PPM. Since the taxpayer may borrow to “trade up” in value, the lender will typically require (i) a current financial statement; (ii) tax returns for the previous three years; and (iii) a schedule of real estate owned. Information regarding the form of ownership of the relinquished property will also be required, e.g., trust, LLC, corporation or partnership with associated documentation such as trust indenture, operating or partnership agreements or by-laws. The sponsor will typically form a special purpose entity limited liability company (SPE LLC) to hold the TIC interests. A purchase agreement and escrow instructions will accomplish the acquisition of the TIC interest; a TIC agreement will govern the rights of the tenants in common; and a property management agreement will be entered into by the tenants to manage the property. Tenants in common will typically be required either to sign a loan assumption agreement or agree to assume liability on all of the loan documents.

D. IRS Response to TIC Activity: Revenue Procedure 2002-22

Section 1031(a)(2)(D) bars the exchange of partnership interests in a like kind exchange. Since a formal partnership agreement is not required to tax co-owners of property as partners in a partnership, the lack of a formal partnership agreement does not mean that the TIC interests do not constitute a tax partnership. In response to the explosion of TICs as replacement property, the IRS issued Revenue Procedure 2002-22, which permits the acquisition of TIC interests by a group of owners, but prevents those TIC owners from operating as a de facto partnership. The ruling provides circumstances in which a group of small investors acquiring undivided interests in a larger single-tenant replacement property will be viewed as acquiring TIC interests or undivided fractional interests (UFIs), rather than partnership interests. At one time, PPMs contained a designation that the offering was “Revenue Procedure 2002-22 compliant.” However, as it became clear that certain conditions of Revenue Procedure 2002-22 were more important than others, and other guidance was issued, this designation was not as frequently made.

1. Neither Rule of Law Nor Safe Harbor

Revenue Procedure 2002-22 only provides a basis for obtaining a private letter ruling. It is not a substantive rule of law, nor does it provide a “safe harbor” for transactions involving TIC interests.

E. Conditions for Obtaining Tenancy In Common Ruling

Revenue Procedure 2002-22 sets forth information and documentation required to obtain a ruling request. The IRS will not consider a ruling request unless each of the conditions described below is satisfied. However, even if all of the conditions are satisfied, the IRS may decline to issue a ruling where that decision is warranted by the facts and circumstances and is in the interest of sound tax administration. The conditions are as follows:

1. Tenancy-in-Common Title Ownership: Each owner must hold title to the real property as a tenant in common owner.

2. Number of Co-Owners: No more than 35 persons may be co-owners. Related parties (under sections 267(b) and 707(b) – a husband and wife for example) will be considered a single person for purposes of this requirement.

3. No Treatment of Co-Owners as an Entity: The co-owners may not file partnership tax returns or in any way act as or hold themselves out to be a partnership.

4. Co-Ownership Agreement: The co-owners may enter into a limited co-ownership agreement that may run with the property. The agreement may authorize a co-owner to offer his portion of the property for sale to the other co-owners before marketing the property outside. The agreement may also provide for majority voting on some actions taken by the co-owners.

5. Unanimous Approval Required: The co-owners’ unanimous approval must be required for (i) any sale, lease or re-lease of all or a portion of the property; (ii) any negotiations or renegotiations of indebtedness secured by the entire property (“blanket lien”); (iii) the hiring of any manager; or (iv) the negotiation of any management contract, or any extension or renewal thereof.

6. Restrictions on Alienation: Each co-owner must have the right to transfer, partition and encumber his interest in the property without the approval of any person. However, lender restrictions that are consistent with common lending practices are permissible.

7. Creation of Blanket Liens: The co-owners must retain the right to approve the creation or modification of any blanket lien over the entire property, and any negotiations or renegotiations of indebtedness secured by the entire property. In addition, the lender may not be (i) a person related (under sections 267(b) or 707(b)) to any co-owner; (ii) the sponsor; (iii) the manager; or (iv) any lessee of the property.

8. Proportionate Sharing of Debt: The co-owners must share in any indebtedness secured by a blanket lien over the entire property in proportion to their undivided interests in the property.

9. Proportionate Sharing of Profits and Losses: Each co-owner must share in all the revenue generated by the property as well as all of the costs associated with the property in proportion to his interest. Neither the other co-owners, the sponsor, nor the manager, may advance funds to a co-owner to meet expenses associated with the property unless the advance is recourse and is for a period not exceeding 31 days.

10. Sharing Proceeds and Liabilities Upon the Sale of the Property: If the property is sold, any debt secured by the entire property (“blanket lien”) must be satisfied and the remaining proceeds must be distributed to the co-owners.

11. Options: Options may be issued by the co-owner, provided the exercise price reflects the fair market value of the property determined at the time the option is exercised.

12. No Business Activity: The activities of the co-owners must be limited to those customarily performed in connection with the maintenance and repair of rental real estate.

13. Management and Brokerage Agreements: The co-owners may enter into management or brokerage agreements that are renewable no less frequently than annually. The manager or broker may be a sponsor or co-owner but may not be a lessee. The management agreement may authorize the manager to (i) maintain common bank accounts for the collection and deposit of rents and (ii) offset expenses associated with the property against any revenues before distributing each co-owner’s share of net revenues. The management agreement may also authorize the manager to take certain actions on behalf of the co-owners subject to the voting rules. Management fees may not exceed comparable fees paid to unrelated parties for similar services.

14. Leasing Agreements: All lease agreements must be bona fide leases for federal tax purposes.

15. Payments to Sponsor: Payments to the sponsor for the acquisition of the co-ownership interest and services must reflect the fair market value of the interest acquired and the services rendered. Therefore, such payments and fees may not depend, in whole or in part, on the income or profits derived from the property. For purposes of the ruling, a “sponsor” is defined as a person who packages co-ownership interests for sale by acquiring property, negotiating a master lease on the property, and arranging financing.

F. Requirements Limit Practicality

The requirement of Revenue Procedure 2002-22 that co-tenants not conduct business under a common name has been interpreted as barring advertising and banking transactions. This sharply limits the revenue procedure’s practicality. While an apartment complex could operate under the name “Hampstead Estates,” it could not operate under the name “Hampstead Estates Associates.” Similarly, the guidance appears to bar co-owners from taking fractionalization discounts, perhaps to discourage its use in estate planning. Nevertheless, Revenue Procedure 2002-22 is by its own terms inapplicable to audits, where the compliance threshold is likely to be lower. The determination of whether the arrangement is a co-ownership or a tax partnership is a question of federal tax law. State law has little relevance in determining federal tax entity classification. For example, California’s statutory presumption that title taken in co-ownership does not constitute partnership property would likely have no bearing on the federal tax determination.

1. Guidance From PLR 200513010

The IRS had issued little guidance with respect to how the taxpayer could meet the prolific requirements of Revenue Procedure 2002-22. Since replacement property must be identified within 45 days, the taxpayer has had to rely on tax opinions of counsel as to whether the requirements of Revenue Procedure 2002-22 were satisfied. PLR 200513010 ruled favorably on a multi-tenant net leased property with a blanket mortgage, stating that an undivided fractional interest (UFI) in rental real property owned by no more than 35 co-owners is not an interest in a business entity under Section 301.7701-2(a) of the Regulations for purposes of qualification of the UFI as eligible replacement property.

a. Conclusions From Ruling

PLR 200513010 suggests that (i) the IRS will not view the multi-tenant aspect of the building as creating a partnership; (ii) a blanket mortgage will not violate the guidelines of Revenue Procedure 2002-22; and (iii) the power of the manager to exercise discretion when leasing, without obtaining the express consent of the owners, will not cause the UFI to fail to constitute eligible replacement property. The Ruling also implies that a sponsor may retain an ownership interest for up to six months without causing the sponsor’s activities in selling the UFIs to the other co-owners to be attributed to those co-owners. Ownership by the sponsor may be important to investors as an indication of the prudent nature of the investment.

2. Overcoming Problem Requiring Unanimity of Tenants

An important condition for obtaining a favorable ruling under Revenue Procedure 2002-22 is that tenants in common each has a right to participate in decisions regarding tenants and management. Implied consent may be used to minimize this problem. A notice can be sent to tenants providing that their consent will be assumed unless they respond within 15 or 30 days. Certain business decisions, such as those involving leases to new tenants, require the approval of all co-owners. However, a prospective tenant might not agree to wait a month for approval by all co-owners. PLR 200513010 suggests that certain business decisions requiring expeditious action may be put to co-owners for their approval within a much shorter period of time without violating Revenue Procedure 2002-22.

3. PLRs 200826005, 200829012 and 200829013

In three recent PLRs, the IRS ruled that two 50 percent 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 percent tenancy-in-common ownership structures with regard to qualification as eligible replacement property. In approving a two-party 50 percent undivided interest structure for purposes of qualifying 1031 exchanges, the ruling modified four conditions specified in Rev. Proc. 2002-22:

a. Buy-Sell Procedure Approved

The Agreements 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 property, the PLRs construed this requirement with great latitude.

b. Co-Owner’s Right to Approve Encumbrances

Although Rev. Proc. 2002-22 provides that each co-owner may encumber his 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 percent owners, the restriction on the right of a co-owner to engage in activities that could diminish significantly the value of the other 50 percent 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.

c. Approve Right to Indemnification for Payment of Debt

The PLRs modified a requirement within Rev. Proc. 2002-22 regarding proportionate payment of debt. While the Rev. Proc. 2002-22 provided that each co-owner must share in any indebtedness secured by a blanket lien in proportion to his own indebtedness, the PLR approved an arrangement whereby an owner who paid more than 50 percent would have a right to be indemnified by the other co-owner. Therefore, the Agreement provides a mechanism whereby the co-owners could pay an amount which deviates from their proportionate share of debt.

d. Lease to Affiliated Entity Allowed

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 which allows 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.

G. Revenue Ruling 2004-86 – Delaware Statutory Trusts

Revenue Ruling 2004-86 expanded the scope of replacement property to include certain interests in grantor trusts which themselves own real property. The ruling equates interests in a Delaware Statutory Trust (DST) that owns real property with actual ownership of real property. Therefore, the exchange of real property for an interest in a Delaware Statutory Trust which itself owns real estate qualifies for exchange treatment. Delaware Statutory Trusts may be owned by any number of persons, although ownership by more than 499 would cause the DST to constitute a security subject to federal securities laws.

1. Delaware Statutory Trust Defined

A Delaware Statutory Trust is an unincorporated association recognized as an entity separate from its owners. The trust may sue or be sued, and property within the trust is subject to attachment or execution as if the trust were a corporation. Beneficial owners of a DST are entitled to the same limitation on personal liability extended to stockholders of a Delaware corporation. DST interests are freely transferable, but are not publicly traded on an established securities market. See Delaware Statutory Trust Act, 12 Del. C. 3801 et. seq. (1988).

2. DST Interests Not Subject to Reclassification as Partnership or Trust

The DST is not a business or commercial trust created by the beneficiaries simply as a device to carry on a profit. Therefore, the DST is not subject to reclassification as a partnership under Regs. § 301.7701-3. Furthermore, the trustee’s activities are limited to the collection and distribution of income. The trustee must distribute all available cash (less reserves) quarterly to each beneficial owner in proportion to that owner’s respective interest in the DST, and may not exchange real estate or purchase assets other than short-term Treasury obligations. The trustee has no power to vary the investment of the certificate holders and may not take advantage of variations in the market to improve the investment. Therefore, the DST is an investment trust for federal income tax purposes, and is not subject to reclassification as a business entity under Regs. § 301.7701-4(c)(1). See Com’r v. North American Bond Trust, 122 F.2d at 546.

3. Contribution to DST and Exchange

In the facts of the ruling, sponsor executes a promissory note to purchase Blackacre. The note is secured by Blackacre. Sponsor then enters into a 10-year triple net lease with tenant. Sponsor contributes Blackacre to a newly-formed DST, which assumes sponsor’s rights and obligations under the note and the lease. B and C, owners of Whiteacre and Greenacre, exchange their properties for Sponsor’s entire interest in the DST through a QI. Whiteacre and Greenacre were held for investment by B and C, and are of like kind to Blackacre. The issue posed in the ruling is whether B and C should be accorded exchange treatment.

4. Grantor Reports Income of Grantor Trust

Section 677(a) treats the grantor as owner of any portion of a trust whose income, without the approval or consent of any adverse party, is or may be distributed to the grantor or the grantor’s spouse. Section 677(a) also requires the grantor to report items of income and deduction attributable to the trust. Regs. §1.671-2(e)(1) provides that a person who owns an undivided fractional interest in a trust is considered to own the trust assets attributable to that interest. Accordingly, each DST certificate holder is treated as the owner of an undivided fractional interest (UFI) in the DST, and each is considered to own the trust assets attributable to that interest. B and C, who receive DST interests in exchange for real property, are considered grantors of the DST when they acquire these interests in exchange for their real property, and they are considered as owning an undivided fractional interest in the real property owned by the DST. See Revenue Ruling 85-13.

5. Exchange Qualifies Under Section 1031

In approving exchange treatment, Revenue Ruling 2004-86 concluded:

Accordingly, the exchange of real property . . . for an interest in a DST through a qualified intermediary is the exchange of real property for an interest in Blackacre, and not the exchange of real property for a certificate of trust or beneficial interest under Section 1031(a)(2)(E). Because [the replacement property] is of like kind to Blackacre, and provided the other requirements of Section 1031 are satisfied, the exchange of real property for an interest in the DST . . . will qualify for nonrecognition of gain or loss under Section 1031.

6. Distinguished from TICs

No more than 35 persons may own TIC interests. Since DST ownership is not so limited, a DST might require a much smaller initial investment than a TIC. A TIC is not a single legal entity, but rather is comprised of many tenants in common. A DST is a single legal entity. While neither a TIC nor a DST may operate as a business, a TIC may borrow money. The activities of a DST are sharply limited. Even a repair to an existing apartment could pose a problem for a DST. While rent receipts could be used to effectuate repairs, trust principal of the DST could not be used for that purpose. While insurance could be purchased by a DST, the refusal of an insurer to timely pay a claim could cause a severe cash flow problem to the DST. While a DST sponsor could put money into the DST to effectuate repairs, the sponsor could not withdraw the money after the repairs were made. These limitations suggest that a DST might work well for a long term triple net lease with a creditworthy tenant (e.g., Best Buy), but would not be an effective vehicle within which to own and operate multi-tenant commercial property.

XVII. Partnership and LLC Exchange Transactions

A. Exchanges of LLC Interests Barred

The prohibition placed on the exchange of partnership interests by Section 1031(a)(2)(D) in 1984 reflected the concern that the boot gain recognition rules could be avoided by exchanging interests in a partnership which held cash and other nonqualifying property. Since an LLC is treated as a partnership for federal income tax purposes, the exchange of LLC interests would also be excluded from exchange treatment under Section 1031(a)(2)(D). Revenue Rulings 88-76, 93-5, 93-6, 93-30 and 93-49.

B. Distinguish: Exchanges by LLC or Partnership

Although interests in a partnership or LLC may not be exchanged under Section 1031, an LLC or a partnership may itself engage in an exchange in the same manner as would an individual taxpayer. The qualified use requirement is determined at the LLC level, without regard to its members. Gain, if any, would be calculated at the entity level and would be allocated to members according to the operating agreement. Character of gain is generally determinated at the partnership level. IRC § 702.

1. Deferred Exchanges by Partnerships

The rules governing deferred exchanges by LLCs should be the same as rules governing such exchanges by individual taxpayers. Since the Regulations do not state who must sign the Notice of Identification of Replacement Property, prudence would dictate that the notice be signed by all of the members, or at least all of the managing members.

C. Problem of Liabilities and Section 752

Section 752(a) provides that any increase in a partner’s share of partnership liabilities shall be treated as a contribution of money by the partner. Conversely, Section 752(b) provides that any decrease in a partner’s share of partnership liabilities shall be considered as a distribution of money to the partner. Section 733 provides that the adjusted basis of the partnership interest is reduced, but not below zero, by the amount of money distributed to the partner by the partnership. Regs. § 1.752-1(f) provides that if, as a result of a single transaction, if a partner incurs both an increase in the partner’s share of partnership liabilities and a decrease in a partner’s share of partnership liabilities, only the net decrease is treated as a distribution from the partnership and only the net increase is treated as a contribution of money to the partnership. When a partnership relinquishes property subject to a liability and is relieved of those liabilities, a decrease in the partner’s share of partnership liabilities occurs. Under Section 1031(d) and Regs. § 1.1031(b)-1(c), the assumption of a taxpayer’s liabilities is taxed to him as boot. If a partnership relinquishes property subject to a liability in the first leg of a deferred exchange, is the later acquisition of replacement property also subject to a liability considered part of a single transaction for purposes of the Regulations under Section 752?

1. Revenue Ruling 2003-56

Revenue Ruling 2003-56 appears to resolve this issue. The ruling states that if the partnership enters into a deferred exchange in which the relinquished property subject to a liability is conveyed in year one, and replacement property subject to a liability is acquired in year two, the liabilities are netted for purposes of the Section 752 rules. The ruling states that if the relinquished property has liabilities in excess of the replacement property’s liabilities, the gain is taxed in year one.

D. At-Risk Issue Involving LLCs

Section 465, enacted in 1976, allows taxpayers to deduct losses from an activity only to the extent the taxpayer is “at risk” with respect to that activity at the end of the taxable year. The at-risk limitations were enacted to prevent taxpayers from deducting losses generated by activities where those losses exceeded the taxpayer’s actual investment risk. The at-risk rules are applied at the member level. Although the activity of holding real property was originally exempt from the at-risk rules, the exception was repealed by the Tax Reform Act of 1986. Section 465(e) provides that if, as a result of a like kind exchange, the member’s at-risk amount falls below zero, this negative amount at risk is recaptured as ordinary income.

1. Aggregation of Activities

Section 465(a) provides that the at-risk rules are computed separately with respect to each “activity” carried on by the taxpayer. This is disadvantageous, since it lowers the amount considered at-risk and causes more ordinary income recapture. However, replacement property might qualify for “aggregation” under Section 465(c)(3)(B) into a single activity. To qualify for aggregation, the activity must (i) constitute a trade or business of the member; and the member must (ii) either “actively participate” in that trade or business, or 65 percent or more of the losses for the taxable year must be allocable to persons who “actively participate” in the management of the trade or business. Section 465(c)(3)(C) provides that aggregation of activities is also permissible as provided in the Regulations. To date, no such Regulations have been promulgated.

E. Passive Loss Issues Involving LLCs

Section 469, enacted in 1987, prevents taxpayers from reducing or eliminating income tax liability by offsetting against taxable income current losses and deductions generated from “passive activities,” i.e., activities in which the taxpayer does not materially participate and all rental activity. Losses suspended under the passive loss rules will not be triggered if the taxpayer engages in a Section 1031 exchange, since less than all of the realized gain is recognized.

F. Partnership Must Avoid Termination

Another problem when structuring partnership exchange transactions is that the partnership must avoid a termination under Section 708(b). Section 708(a) provides that a partnership is terminated if no part of any business continues to be carried on by any of its partners or if, within a 12 month period, there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits. The ABA takes the position that the transfer of property to or from a partnership before or after a like kind exchange should not violate the qualified use requirement, since the proper standard for that requirement should be the absence of taxpayer intent to liquidate an investment in the subject property (i.e., intent to sell the property or give it as a gift) or acquire the property for personal use.

G. Partnership Exchange Followed by Direct-Deeding to Partners

Risk Assessment: HIGH

Would the requirements of the deferred exchange rules be satisfied if the partnership or LLC directed the QI to transfer title in the replacement property directly to partners following an exchange by the LLC? Under the “aggregate” theory, the partnership is ignored for purposes of computing federal income tax. However, the partnership is not ignored for purposes of satisfying the like kind exchange requirement. Regs. §1.1002-1(d) comprehend an “exchange” for purposes of Section 1031 as being a reciprocal transfer of property, as distinguished from a transfer of property for a money consideration only. Since the LLC itself must meet the qualified use test, a transaction in which the LLC never held title to the replacement property would probably not qualify under Section 1031.

H. Distributing Interests Followed by Exchange “Drop and Swap”

1. Distribution of All Partnership Interests
Followed by Separate Exchanges by Partners

Risk Assessment: LOW to MODERATE

Suppose first that the partnership distributes tenancy in common interests to all partners. If all partners then engage in separate exchanges, receiving separate replacement property, will those exchanges qualify under Section 1031? The partnership would recognize no gain on the distribution of tenancy in common interests under IRC § 731(b). The distributee partners would also recognize no gain on the distribution and would take a basis in the distributed interest equal to his basis in the partnership interest under IRC Sections 731(a)(1) and 732(b). Since TIC interests will be created when the property is dropped out of the partnership, separate sale contracts should be entered into by the partnership and by the partners exchanging their tenancy in common interests.

2. Distribution of All TIC Interests
Followed by One Partner Cashing Out

Risk Assessment: HIGH

Suppose that the partnership distributes tenancy in common interests to all partners, and one partner sells his TIC interest for cash and pay capital gains tax, while the other partners swap their tenancy-in-commons interests and acquire either a single replacement property or separate replacement properties? The receipt of cash by one partner seems to make the transaction more vulnerable under the step transaction doctrine enunciated by the Supreme Court in Court Holding Company v. Com’r, 45-1 USTC ¶9215, 324 U.S. 331, 65 S.Ct. 707 (1945) unless the transaction was planned well in advance of the exchange. Separate sale contracts should be entered into by the partners.

a. Advance Planning Imperative

Although time is not a luxury that partners wishing to dispose of partnership property can often afford, advance planning may greatly increase the probability of success in cashing out one partner. To illustrate, following the distribution to Partner A of an undivided partnership interest, that partner could lease the interest back to the partnership under a long-term triple net lease. Under the terms of that lease, Partner A would retain the right to partition the property and to dispose separately of his interest. Following the passage of at least one tax year, the partnership could begin active negotiations to sell the property. Partner A would sell, and the partnership would exchange, their respective interests to buyer. The long term lease would expire under the “merger” doctrine.

3. Distribution of Single Tenancy in Common Partnership
Interest Followed by Partnership Exchange

Risk Assessment: LOW to MODERATE

Would the distribution of a tenancy in common interest to one partner, followed by the partnership’s exchange qualify for like-kind treatment? The IRS could assert either that the qualified use requirement was violated or that the “exchange” consisted of an exchange by a tax partnership of partnership interests – rather than an exchange by co-owners of TIC interests. Separate sale contracts should be entered into by the partnership and by the partners.

4. Possible IRS Objections

a. Qualified Use Objection

In Mason v. Com’r, T.C. Memo 1988-273, a transaction between former partners following a partnership dissolution was held to be an exchange of assets held individually rather than an exchange of partnership assets. However, Mason is of questionable precedential value since the Tax Court failed to consider whether the qualified use requirement had been satisfied. Revenue Ruling 77-337 denied exchange treatment where a liquidating corporation distributed property to a shareholder who then sought to engage in a like kind exchange. The corporation’s qualified use could not be imputed to the shareholders. However, in the case of distributions by partnerships or LLCs followed by an exchange at the partner level, the qualified use test may be less difficult to satisfy, since for federal income tax purposes the partnership may viewed as an “aggregate” of its partners. To avoid a qualified use objection, the replacement property should be held for a reasonable amount of time prior to transferring it to another entity.

b. Objection Based on Rev. Proc. 2002-22

The distribution of TIC interests under state law may be treated by the IRS as the distribution of a partnership interest if, after the exchange, the entity is not engaged in completely passive activities. Revenue Procedure 2002-22, which sets forth the conditions for a ruling that a co-ownership is not a tax partnership, sheds some light on this issue. Structuring a drop and swap so that it meets as many of the criteria set forth in Rev. Proc. 2002-22 would appear to be prudent. Revenue Procedure 2002-22 states that no ruling will be issued if the co-owners held the interests in the property through a partnership or corporation immediately prior to the formation of the co-ownership. However, the fact that no ruling will be issued is not dispositive, since the ruling by its own terms is inapplicable to audits. To avoid a step transaction argument, the relinquished property should be out of the partnership at an early juncture – prior to entering into a contract if at all possible.

5. Transfer Tax Considerations

Additional transfer taxes will be generated by the distribution of tenancy in common interests. Following the distribution, ownership will change and new title policies will be required for closing. If the contract of sale for the relinquished property has been assigned to a QI before distribution of TIC interest, the IRS could invoke the step transaction doctrine. Therefore, the transaction should be planned before contract negotiations for the sale of the relinquished property commence.

6. New IRS Reporting Requirements for Partnerships

The IRS has shown renewed interest in partnerships which engage in like kind exchanges. Beginning in 1998, partnership income tax returns required information concerning like kind exchanges engaged in by the partnership. Question 13 of Schedule B of Form 1065 now inquires as to whether

during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (other than entities wholly-owned by the partnership throughout the tax year.

Question 14 now asks an even more probing question:

At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?

I. Exchange Followed by Distribution “Swap and Drop”

1. Distribution of Replacement Properties to Partners

Risk Assessment: LOW

Suppose an LLC designates three separate replacement properties which, after being acquired by the LLC, are then distributed to three LLC members. Is this a good Section 1031 exchange? Since the LLC has transferred the relinquished property and acquired the replacement property, the only objection could seemingly be one based on qualified use. The IRS could argue that the LLC did not acquire replacement properties for the purpose of holding them for productive use in a trade or business or for investment, as required under Section 1031(a)(1), but rather for the purpose of distributing it to its members. However, Maloney v. Com’r, 93 T.C. 89 (1989) held that an exchange by a corporation followed by a distribution of the replacement property did satisfy Section 1031(a)(1).

2. Cashing Out Using Installment Method

Risk Assessment: MODERATE

a. Relinquished Property Exchanged for Cash and Note

The use of a purchaser’s installment note can effectuate the cashing out of one partner while allowing the partnership to engage in an exchange. At closing, the cash buyer pays for the relinquished proper with a mix of cash and an installment note. The cash is transferred to a QI and a garden variety deferred exchange ensues with respect to that money. The installment note is transferred directly to the partnership in a taxable sale. Under the installment sale rules of Section 453, the receipt by the partnership of the purchaser’s installment note is not considered “payment”. Therefore, no gain will be recognized by the partnership upon receipt of the note.
b. Partnership Distributes Installment Note

The partnership would then distribute the installment note to the partner wishing to cash out. The distribution of the note (i) is tax-free under Section 731 because it is not “money” and (ii) will not constitute a “disposition” under Section 453B. See Regs. § 1.453-9(c)(2); PLR 8824044. Typically, 97 percent of the installment note would be payable a week after the redemption. The remaining 3 percent would be payable in the beginning of the following taxable year. Since payments would be made over two years, installment method reporting under Section 453 should be available. If the partner cashing out will not accept the purchaser’s own installment note, the obligation could be secured by a nonnegotiable commercial standby letter of credit without resulting in the receipt of the note by the partnership being considered “payment.”

c. Example Using Installment Note Method

ABC partnership is owned equally by three partners, A, B, and C. ABC partnership owns property in Manhattan worth $9 million and that has a basis to the partnership of $6 million. Each partner’s basis (and capital account) in ABC is $2 million. A and B wish to engage in a tax free exchange, and C wants to cash out. The cash buyer of the Manhattan property pays $6 million in cash to a qualified intermediary, who uses that money to purchase replacement property. In exchange for $6 million in cash, the QI directs the partnership to direct-deed its undivided two-thirds interest in the property described in the exchange agreement directly to the buyer.

The remaining $3 million is paid to ABC Partnership in the form of a promissory note, 97 percent of which is payable a week following the closing, and three percent on January 1st of the following year. If the note qualifies as an installment obligation, boot gain will be shifted from the partnership to C. In exchange for this note, the partnership itself conveys the remaining one-third undivided interest in the property to the buyer. The partnership books up its assets so that C’s capital account is increased to $3 million, representing the increased value of his interest in the partnership’s assets. At closing, the partnership distributes the $3 million note to C in redemption of his entire partnership interest.

Upon receipt of the promissory note, C will have a tax basis in the note equal to the tax basis he previously had in his partnership interest, or $2 million. C will recognize gain on each payment made under the installment note using the installment method as provided in IRC § 453(c). C’s basis in his capital account balance after the distribution will be $0, i.e., his original basis in his capital account balance in ABC of $2 million, increased by $1 million for the book up, and decreased by $3 million for the distribution of the promissory note. Since there is no special allocation of recognized gain, and since C’s capital account is zeroed out, the transaction appears to meet all Section 704(b) requirements. The distribution of the note must take place before any payments are made on the note; otherwise, the partnership will violate the special allocation rules.

d. Obtaining Letters of Credit

A commercial bank will issue a letter of credit provided the cash buyer deposits an equal sum with the bank. The cash buyer, who will have previously arranged for financing to purchase the replacement property, may not object to obtaining a letter of credit, although administrative considerations are more difficult now than before 2001. Consequently, the letter of credit should be arranged well in advance of closing. The partner receiving the promissory note must also be willing to forego the receipt of interest for a short period of time.

3. Variation Involving Redemption

A variation of the above method involves the partnership redeeming the partner’s interest in exchange for the partnership’s own installment note. Following the redemption, the partnership pursues a typical like kind exchange. Shortly after the acquisition of replacement property, the partnership engages in post-exchange financing and pays off the installment note held by the partner who was redeemed out over two taxable years, in the same manner as described above, where the purchaser provided the installment note.

4. Advantages of Installment Note Method

The installment note method has the following advantages: (i) no gain is recognized by the partnership upon receipt of the installment note of the purchaser; (ii) the distribution of the installment note to the partner cashing out should not result in gain recognition under Sections 453 and 731; and (iii) the exchange appears to meet the qualified use requirement since the partnership has (presumably) held the relinquished property for business or investment and will hold the replacement property in the active conduct of a trade or business or for investment. However, despite the allure of the installment note method, there are numerous exceptions to nonrecognition under Section 453 whose potential application should be carefully analyzed.

J. External Buy-Out of Partner’s Interest

Risk Assessment: LOW

May some partners, either before or after the exchange, buy out other partners who wish to receive cash? In the case of a pre-exchange buy out, the non-exchanging partners will receive cash before the closing, an advantage that may encourage those partners to cooperate with those partners who would like the partnership to engage in an exchange. A post-exchange buy out may also be structured. However, the partners wishing to be cashed out may not agree to wait until after the exchange to receive cash. Whether the buyout is pre- or post-exchange, additional cash will be required to acquire the partnership interests of the non-exchanging partners.

1. Advantages of External Buyout

The most attractive feature of the external buyout is its very low tax risk when properly structured. No qualified use issue appears to exist, since the partnership exchanges property which it has held for the required purpose and acquires property which it continues to hold for the requisite purpose. Since the buy out is external, one would argue that the partnership has not been affected for purposes of Section 1031. An external buyout works best where the partner sought to be bought out has a small interest and the partnership property itself has little debt. If a large mortgage exists on the property to be relinquished, the partnership may have to borrow large amounts of funds to exchange into property of equal value.

2. Disadvantages of External Buyout

As noted, the partners must provide cash to accomplish the buy out. Assume four partners have equal interests in a partnership, and one partner wants cash. Although the exchanging partners must find cash to buy out the interest of the partner cashing out, the partnership will still be required to exchange into property of equal value. In contrast, if the non-exchanging partner were redeemed out in exchange for a tenancy in common interest, the partnership would only be required to exchange into the value of partnership property remaining after the distribution of the TIC interest. If partnership property has a large amount of debt, the partnership would be required to exchange into highly leveraged property. Finally, if a partner or partners whose interests equal 50 percent or more are to be bought out, a partnership termination would have to be avoided.

3. Post-Exchange Financing

As noted, the partnership will be required to exchange into property whose value is unreduced by any amounts paid for the partner being cashed out. This disadvantage can be lessened if the partnership mortgages the newly acquired replacement property to pay off any bridge loans incurred for the buyout. Those post-exchange loans, secured by the replacement property, may be at a lower interest rate than the pre-exchange loans incurred by the partners to buyout the other partners’ interests.

4. Financing Should be Independent

Partners may want to repay higher interest pre-exchange bridge loans quickly following the exchange by obtaining a new loan on the replacement property. The two loans should not be tied together or made interdependent. In addition, the pre-exchange bridge loan should not be collateralized by the relinquished property. In any event, since the partners whose interests are being bought out would probably not accept their sale being contingent on the partnership closing on the replacement property, as a practical matter this concern may be moot. Moreover, the economic risk incurred by the exchanging partners in obtaining a bridge loan to accomplish the buyout, and the attendant possibility that the partnership might not close on the relinquished property, is precisely what minimizes the tax risks in structuring the transaction in this manner.

5. Partnership Election Under Section 754

Since the external buyout does not involve the purchase of partnership assets directly, the inside basis of partnership assets will remain unchanged following the buyout. Under Section 754, a partnership may elect to adjust the basis of partnership property in the case of (i) a distribution of partnership property, as provided for in Section 734 and in the case of (ii) a transfer of a partnership interest, as provided for in Section 743. By so electing, the inside basis of the partnership interests purchased in the buyout can be increased to fair market value. This will be beneficial to the remaining partners since it will increase depreciation deductions, and reduce gain when the partnership ultimately disposes of the replacement property.

a. Transfer of Partnership
Interest Under IRC § 743

Section 743 provides that where a partnership interest is sold or exchanged, and a Section 754 election is in effect, the partnership shall (i) increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis of the partnership property and (ii) decrease the adjusted basis of the partnership property by the excess of the transferee partner’s proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership.

b. Distribution of Partnership
Interest Under IRC § 734

Section 734 provides that where partnership property is distributed and a Section 754 election is in effect, the adjusted basis of partnership property is increased by the amount of gain recognized to the distributee partner and decreased by the amount of loss recognized to the distributee partner.

K. Elect Out of Subchapter K

Risk Assessment: VERY HIGH

An election under Section 761(a) to be excluded from Subchapter K has some facial appeal. However, Regs. § 1.761-2(a)(2) requires that the members of such an organization own the property as co-owners and not actively conduct business. The regulations provide that an investment partnership will exist where partners (i) own property as co-owners; (ii) reserve the right separately to take or dispose of their shares of any property acquired or retained; or (iii) do not actively conduct business. This requirement would appear to limit the utility of a Section 761(a) election to facilitate the exchange of partnership interests of partnerships owning real estate.

L. May Partners Make Special Allocations of Gain?

Risk Assessment: HIGH

When property ownership is through a tenancy-in-common rather than through a partnership, it appears that some co-tenants may exchange their interests in a like kind exchange, and others may sell their interests and receive cash. In that case, only the co-tenants receiving cash would presumably recognize taxable gain. Query whether the same tax result could be possible if the property is owned by a partnership? That is, may partners specially allocate gain recognized in the exchange to a partner who is not participating in the exchange, and whose interest in the partnership is about to be liquidated?

1. View of Regulations

According to Section 704(b) and the Regulations thereunder, an allocation of taxable income or loss agreed upon by the partners is permitted if the allocation meets one of the following tests: (i) the allocation has a “substantial economic effect;” (ii) the allocation is in accordance with the partners’ interests in the partnership; or (iii) the allocation is in accordance with IRC § 704(c).

2. Economic Effect

Generally, an allocation has “economic effect” if the partnership maintains its capital accounts in accordance with the Regulations, and upon dissolution, each partner receives the amounts remaining in his capital account. In such cases, the allocation will be consistent with the underlying economic arrangement between the partners. In general, if a partner has a capital account deficit following dissolution, he must be required to restore that deficit. This means that the allocation must result in the appropriate increase or decrease in the partner’s capital account, and partners must be required to make up negative balances in their capital accounts upon the liquidation of the partnership. Reg. § 1.704-1(b)(2)(ii)(a). Stated another way, when a tax benefit or tax burden is allocated to a partner, that partner must also receive a corresponding economic benefit or burden.

a. Substantial Economic Effect

It is not enough that an allocation have economic effect. The economic effect of the allocation must also be substantial. The economic effect of an allocation is “substantial” if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Regs. § 1.704-1(b)(2)(h)(iii)(a).

3. Partners’ Interests in the Partnership

Partnership allocations are often made in accordance with the partners’ interest in the partnership. A special allocation might have substantial economic effect if the partner had a zero capital account balance following the special allocation. However, if a partner’s pre-transaction capital account is 10x dollars and that partner is allocated 5x dollars of gain, the partner’s capital account will be 15x dollars following the closing. Even if all of the 5x dollars is distributed to the retiring partner, his capital account would be reduced, but only to 10x dollars. If the partner is left with a positive capital account balance following an exchange, it might be difficult to take the position that the tax allocation substantially affects the dollars amounts to be received by the non-retiring partners.

4. Allocation In Accordance with Principles of Section 704(c)

Section 704(c) applies rules to partnership properties that have book values that are different from the properties’ adjusted tax bases. However, seldom would a “book/tax” disparity exist which could cause the application of Section 704(c) in this circumstance.

5. View of ABA

The ABA Section of Taxation views a special allocation of gain in this circumstance as possessing substantial economic effect since there appears to be a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. This conclusion is based on the assumption that the retiring partner will not participate in the future economic profits or losses attributable to the replacement property, and that the remaining partners will benefit from potential profits and will also bear all of the risks associated with the replacement property. Therefore, the special allocation of gain will affect the dollar amounts received by the retiring partner. M. Summary of Hypothetical Partnership Transactions

Hypothetical Transaction Qualified Rationale
Transaction Use Violated?

Partnership Distribution of TIC interests; followed NO? Assuming partners hold TIC interests
Transaction #1 by separate exchanges by partners prior to exchange and partners have
separate sales contracts

Partnership Partnership exchange followed UNCLEAR Partnership apparently cannot meet
Transaction #2 by direct-deeding to partners “qualified use test if partnership never acquires replacement property

Partnership Distribution of all TIC interests, UNCLEAR Presence of cash increases likelihood
Transaction #3 followed by one partner cashing out of IRS asserting that a prohibited
exchange of partnership interests
has occurred

Partnership Distribution of all TIC interests, UNCLEAR Since separate TIC interests will be
Transaction #4 followed by separate exchanges created upon distribution, separate
by partners sales contracts should be entered into;
attempt to satisfy requirements of
Rev. Proc. 2002-22

Partnership Distribution of single TIC interest, UNCLEAR IRS could assert “exchange”
Transaction #5 followed by partnership exchange consisted of exchange by tax
partnership; see Rev. Proc. 2002-22

Partnership Distribution of replacement NO? Maloney v. Com’r, 93 T.C. 89 (1989)
Transaction #6 properties to partners
following exchange

Partnership Relinquished property exchanged UNCLEAR IRS could argue “exchange” consisted
Transaction #7 for cash and note of exchange by tax partnership, yet
partnership appears to have good exchange

Partnership External buyout of partner’s NO Partnership holds relinquished and
Transaction #8 interests followed by exchange replacement property for required
purpose; however, non-tax issues may
make unattractive

Partnership Election out of Subchapter K YES? Requirement that partners not
Transaction #9 “actively conduct” business appears
appears to doom

Partnership Special allocation of gain UNCLEAR Theoretically possible, but meeting
Transaction #10 requirements of regulations under
Section 704(b) may be very difficult

INDEX

Internal Revenue Code Sections
Section 357(d) 51
Sections 354 7
. Section 1031(c) 51
Section 1(h)(7)(A) 10
Section 1001(c) 48
Section 1014(d)(1) 10
Section 1031(a)(1) 23
Section 1031(a)(2)(E) 36
Section 1031(a)(3)(A) 104
Section 1031(a)(3)(B) 110
Section 1031(b) 51
Section 1031(d) 46
Section 1031(f) 90, 95
Section 1031(f) 95
Section 1031(f)(1) 24, 90
Section 1031(f)(1)(c)(ii) 91
Section 1031(f)(2) 95
Section 1031(f)(2)(A)-(C) 91
Section 1031(f)(4) 92, 93
Section 1031(g) 90
Section 1033(a)(1) 39
Section 1036(a) 7
Section 121 3, 5, 10
Section 121(d)(10) 5
Section 1221(a)(1) 6
Section 1223(1) 9
Section 1231 9
Section 1231(f)(2)(C) 94
Section 1236(c) 8
Section 1245 11, 52
Section 1245 84-86, 88
Section 1245(a)(3) 82
Section 1245(a)(3)(B) 82
Section 1250 10, 12, 82, 83, 87
Section 267(b) or Section 707(b) 114
Section 357(d) 75
Section 468(g) 120
Section 7872 120
Sections 1031(f) 88
Sections 1031(f) and 1031(g 88
Sections 1239(a) or 707(b)(1) and (2) 93
Sections 267(b) 88
Sections 267(b) or 707(b)(1) 88
Sections 351 91
Sections 351, 721 91
Under Section 761(a) 9
Revenue Procedures
Revenue Procedure 2002-22 158, 160, 161, 171
Revenue Procedure 2000-37. 2, 152
Revenue Rulings 23
Revenue Ruling 67-380 8
Revenue Ruling 72-151. 93
Revenue Ruling 2002-83 95
Revenue Ruling 2003-56 167
Revenue Ruling 2004-33 36, 163
Revenue Ruling 2004-33 165
Revenue Ruling 57-365, 1957-2 42
Revenue Ruling 61-119 90
Revenue Ruling 75-291 153
Revenue Ruling 75-292 27
Revenue Ruling 77-297 2, 100, 103
Revenue Ruling 77-337 25, 171
Revenue Ruling 82-166 39
Revenue Ruling 84-121. 23
Revenue Ruling 85-13. 165
Revenue Ruling 99-6 31
Revenue Rulings 88-76 166
Treasury Regulations
Regs. § 1031(b)-1(c) 74
Regs. §1.671-2(e)(1) 165
Regs. § 1.1002-1(d) 2
Regs. § 1.1031(k)-1(g)(3). 113
Regs. § 1.1031(k)-1(g)(7 119
Regs. §1.1031(k)-1(g)(4) 152
. Regs. § 1.1031(k)-1(e). 111
. Regs. § 1.1031(k)-1(g)(4). 115
Reg. § 1.704-1(b)(2)(ii)(a) 180
Regs § 1.1031(b)-1(c) 76
Regs § 1.1031(k)-1(c)(2). 105
Regs § 1.1031(k)-1(e) 153
Regs. 1.1031(a)-1(c) 35
Regs. 1.1031(k)-1(f)(2) 102
Regs. 1.1031(k)-1(g)(4)(i) 147
Regs. § 1.031(a)-1(a)(1) 25
Regs. § 1.1031(a)-1(2)(b) 35
Regs. § 1.1031(a)-1(b) 34, 35
Regs. § 1.1031(a)-2, 39
Regs. § 1.1031(a)-2(c) 43
Regs. § 1.1031(b) 51
Regs. § 1.1031(b)-1 51
Regs. § 1.1031(b)-1(c) 167
Regs. § 1.1031(d)(2) Ex. 2 74
Regs. § 1.1031(d)-2 75
Regs. § 1.1031(k)-1 112
Regs. § 1.1031(k)-1(b) 129
Regs. § 1.1031(k)-1(b)(1) 106
Regs. § 1.1031(k)-1(b)(1)(i) 104
Regs. § 1.1031(k)-1(b)(1)(ii) 110
Regs. § 1.1031(k)-1(c)(4)(i). 107
Regs. § 1.1031(k)-1(c)(4)(ii)(A) 106
Regs. § 1.1031(k)-1(c)(6). 109
Regs. § 1.1031(k)-1(c)(7), Example 7, (ii). 109
Regs. § 1.1031(k)-1(d), Examples 2 and 3. 111
Regs. § 1.1031(k)-1(e 111
Regs. § 1.1031(k)-1(e) 154
Regs. § 1.1031(k)-1(f)(1),(2). 112
Regs. § 1.1031(k)-1(f)(2). 111
Regs. § 1.1031(k)-1(g) 122
Regs. § 1.1031(k)-1(g)(1) 2
Regs. § 1.1031(k)-1(g)(2). 113
Regs. § 1.1031(k)-1(g)(2)(ii). 122
Regs. § 1.1031(k)-1(g)(3)(ii) 113
Regs. § 1.1031(k)-1(g)(4) 128
Regs. § 1.1031(k)-1(g)(4) 136
Regs. § 1.1031(k)-1(g)(4)(iv)(A), (B), (C). 117
Regs. § 1.1031(k)-1(g)(4)(v). 129
Regs. § 1.1031(k)-1(g)(5). 122
Regs. § 1.1031(k)-1(g)(6). 123
Regs. § 1.1031(k)-1(g)(7) 118, 119
Regs. § 1.1031(k)-1(g)(7). 119
Regs. § 1.1031(k)-1(g)(7)(i) 119
Regs. § 1.1031(k)-1(g)(7)(ii) 118
Regs. § 1.1031(k)-1(g)(iii). 116
Regs. § 1.1031(k)-1(g)(v) 117
Regs. § 1.1031(k)-1(j)(3) 119
Regs. § 1.1031-(k)-1(g)(4)(v). 116
Regs. § 1.1245-1(a)(5) 87
Regs. § 1.453-9(c)(2) 174
Regs. § 1.704-1(b)(2)(h)(iii)(a) 181
Regs. § 1.752-1(f) 167
Regs. § 1.761-2(a)(2) 9, 179
Regs. § 301.7701-3 30
Regs. § 301.7701-3. 164
Regs. § 301.7701-4(c)(1) 164
Regs. §1.1002-1(d) 169
Regs. §1031(d)-2, Exs. 1 and 2. 74

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Posted in Federal Income Tax, Like Kind Exchanges, Treatises | Tagged 1031 exchange, basis of property, boot gain, build-to-suit, deferred exchange, deferred exchanges, Delaware Statutory Trusts, depreciation in 1031 exchange, exchange first reverse exchange, exchange last reverse exchange, gain or loss in exchange, installment sale reporting of deferred exchanges, interest tracing, liabilities, like kind exchange, partnership exchanges, pre-exchange financing, qualified escrow accounts, qualified intermediary, qualified trust accounts, qualified use, related party exchanges, relinquished property, replacement property, reverse exchanges, tenancies in common | Leave a comment

Section 1031 Outline January 30 2011 Like Kind Exchanges of Real Estate Under IRC §1031 © 2011 David L. Silverman, J.D., LL.M. (Taxation)

Posted on April 2, 2013 by David L. Silverman, J.D., LL.M. (Taxation)

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