Outline: Hot Topics in Income Taxation of Real Estate ...



HOT TOPICS IN INCOME TAXATION

OF REAL ESTATE TRANSACTIONS

© 2005, Charles H. Egerton, Esq.

Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A.

Orlando, Florida

SELECTED TECHNIQUES TO MAXIMIZE LONG TERM CAPITAL GAINS ON SALES OF REAL ESTATE TO A RELATED DEVELOPER.

1 Factual Setting. Assume that a taxpayer has a parcel of vacant land with a tax basis of $500,000 which the taxpayer has held for ten years for investment purposes. Taxpayer believes the land is ripe for development and has assembled a team of consultants to assist him in developing the property. The taxpayer expects to incur expenditures of an additional $1,500,000 for planning, platting, engineering, permitting and approvals as well as construction of improvements and infrastructure. Thus, the total tax basis of the fully developed parcel will be $2,000,000. Assume that the property will be developed into a multi-phase single-family residential project with a total projected sell-out netting $10,000,000. If the taxpayer develops his own property and generates $10,000,000 from the sale of lots, he will have $8,000,000 of ordinary income.

1 Character of Income. Gains from sales or exchanges of capital assets held for more than one year by non-corporate taxpayers are now taxed at a maximum rate of 15% (or a maximum rate of 5% if the taxpayer is in the 15% tax bracket). §1(h). However, gains from the sale of depreciable real property will be taxed at a maximum rate of 25% to the extent of any unrecaptured §1250 gains. By contrast, the maximum rate imposed on the ordinary income of a non-corporate taxpayer, including income from the sale of “dealer properties,” is 35%. In the case of individuals, the effective rate applicable to ordinary income can be increased under §68 by limiting the use of itemized deductions and under §151(d)(3) by phasing out the personal and dependent exemptions. Thus, there is a potential differential in excess of 20% between the maximum long term capital gain rates and the ordinary rates of individual taxpayers.

2 Sale of Property to Related Entity. If the property has an appraised value before any development work is commenced of $2,500,000, a sale of the property for its current fair market value to a controlled entity will, if respected for tax purposes, convert $2,000,000 (i.e., the excess of the $2,500,000 fair market value over the $500,000 initial tax basis) of the potential $8,000,000 of gains from ordinary income into long term capital gains.

2 Sale to Related Corporation. Taxpayers frequently attempt to sell undeveloped property to a controlled corporation in order to lock in the pre-sale appreciation at long term capital gains rates. Generally the sale is made to the corporation on an installment basis. If the sale is respected, the corporation will take a new tax basis under §1012 equal to the cost of acquiring the property.

1 Debt vs. Equity. The Service may argue that the installment notes received by the taxpayer from the sale should be treated as equity and the equivalent of stock received in a §351 exchange with the following results:

1 The taxpayer’s lower cost basis carries over to the corporation.

2 The corporation will receive additional taxable income as a result of the lower tax basis and, after corporate taxes, will have additional E&P to support dividend distributions.

3 The taxpayer’s receipt of interest and principal payments will be taxed as dividends.

The above referenced analysis assumes that the corporate purchaser is a C corporation. If, on the other hand, the purchaser is an S corporation, the taxpayer’s lower cost basis will also carry over and, as a result thereof, gains from the sale of developed properties by the S corporation will be greater. These gains will pass through to the shareholders in proportion to their stock and purported payments of purchase price are likely to be treated as distributions. If a promissory note is given, and such note is held other than proportionately by the shareholders, there will also be an issue as to whether the note, which would be treated as equity for tax purposes, will be regarded as a second class of stock. See, §1361(b)(1)(D) and the regulations thereunder. If a purported purchase money installment obligation is deemed to be disguised equity which is treated as a second class of stock, the S election will terminate effective as of the date of issuance of such note. §1362(d)(2).

2 Cases Upholding the Service’s Treatment of “Debt” as “Equity” and Treating a Purported “Sale” as a Disguised Contribution to Capital. Cases which have addressed the “debt vs. equity” and “sale vs. contribution to capital” issues and held for the government are as follows: Gooding Amusement Co. v. Commissioner, 23 T.C. 408 (1954), aff&d., 236 F.2d 159 (6th Cir. 1956), cert. denied, 352 U.S. 1031 (1957) (sale of business); Aqualane Shores, Inc. v. Commissioner, 30 T.C. 519 (1958), aff&d., 269 F.2d 116 (5th Cir. 1959) (sale of land); Truck Terminals, Inc. v. Commissioner, 33 T.C. 876 (1960), acq., 1960-2 C.B. 7, aff&d., 314 F.2d 449 (9th Cir. 1963) (sale of equipment to subsidiary); Burr Oaks Corp. v. Commissioner, 43 T.C. 635 (1965), aff&d., 365 F. 2d 24 (7th Cir. 1966), cert. denied, 385 U.S. 1007 (1967) (sale of land); Slappey Drive Ind. Park v. United States, 561 F.2d 572 (5th Cir. 1977) (sale of land); Western Hills, Inc. v. United States, 71-1 U.S.T.C. ¶9410 (S.D. Ind. 1971) (successive sales of land); Marsan Realty Corp. v. Commissioner, 22 T.C.M. 1513 (1963) (sale of land). All of the above-cited cases resulted in adverse decisions to the taxpayer.

3 Adverse Factors. Factors which led to the adverse decisions noted in 2 above include:

1 Inadequate or “thin” capitalization.

2 Identity of interest between those who own stock and notes.

3 Intention not to enforce the notes, such as failing to insist upon payment of interest and principal payments when due.

4 Notes subordinated to general creditors.

5 Inflated price.

6 No overriding business purpose.

4 Installment Sales to Controlled Corporations That Have Been Respected by the Courts. An installment sale of real property to a controlled corporation may be respected if there is a demonstrated likelihood of early repayment. Sun Properties v. United States, 220 F.2d 171 (5th Cir. 1955) (income from transferred warehouse sufficient to pay expenses and notes); Piedmont Corp. v. Commissioner, 388 F.2d 886 (4th Cir. 1968) ($10,000 cash and $160,000 purchase money notes equal value of option right to purchase land, and there was a reasonable probability that notes would be repaid; “thin capitalization” not alone sufficient to negate sale); Gyro Engineering Corp. v. United States, 417 F.2d 437 (9th Cir. 1969) (income from transferred apartment house was sufficient to pay expenses and notes; “thin capitalization” doctrine held not applicable); Hollywood, Inc. v. Commissioner, 10 T.C. 175 (1948), acq., 1948-1 C.B. 2 (sale of land to corporation which did not develop but, instead, resold it in the same condition as when acquired); Evwalt Development Corp. v. Commissioner, 22 T.C.M. 220 (1963) (sale of land to corporation having “not negligible” capital, 14 months after it was formed; and notes given for prior sales were paid promptly); Charles E. Curry v. Commissioner, 43 T.C. 667 (1965), nonacq., 1968-2 C.B. 3 (sale of income producing office building); Arthur M. Rosenthal v. Commissioner, 24 T.C.M. 1373 (1965); Ainslie Perrault v. Commissioner, 25 T.C. 439 (1955), acq., 1956-1 C.B. 5, aff&d., 244 F.2d 408 (10th Cir. 1957); Sheldon Tauber v. Commissioner, 24 T.C. 179 (1955), acq., 1955-2 C.B. 9; Warren H. Brown, 27 T.C. 27 (1956), acq., 1957-2 C.B. 4 (each involving sale of business, and ascribing goodwill as an asset which augmented capital).

1 The decision in Warren H. Brown provides helpful guidelines on this issue:

“. . . the apparent intention of the parties, the form of contract here in question, the reservation of title in the transferors until the full purchase price is paid, the obvious business considerations motivating the partners to cast the transaction in the adopted form, the substantial investment by the transferors in stock of the corporation, the superior position of the transferors’ claims to the claims of the other corporate creditors, the fact that the contract price was equal to the stipulated fair market value of the assets transferred thereunder, the contract provision calling for fixed payments to the partners without regard to the corporate earnings, the provision requiring the payment of interest to the transferors at a reasonable rate, the absence of an agreement not to enforce collection, and the subsequent payment of all installments which became due under the contract during the years in issue. . .” 27 T.C. at 35, 36.

5 Corporation/Purchaser’s Dealer Activities May Adversely Affect Taxpayer’s Ability to Claim Capital Gains on Sales. If the corporate purchaser immediately subdivides and sells the land purchased from the taxpayer in a manner in which stamps it as a dealer, some cases have applied various theories to find that these dealer activities will cause a taxpayer to have ordinary income on his sale to the controlled corporation. See, e.g., Burgher v. Campbell, 244 F.2d 863 (5th Cir. 1957), Tibbals v. United States, 362 F.2d 266 (Ct. Cl. 1966), and Brown v. Commissioner, 448 F.2d 514 (10th Cir. 1971). However, in a decision by the Fifth Circuit Court of Appeals, the Service’s attempt to attribute dealer activities of the corporate purchaser to the selling taxpayer was squarely rejected. In Bramblett v. Commissioner, 960 F.2d 526 (5th Cir. 1992), the “taxpayer” was a partner in a partnership which acquired several parcels of land for the stated purpose of investment. The partnership was comprised of four individuals. Shortly after the partnership was formed, the same four individuals who were partners in the partnership formed a new corporation which was owned by them in the same proportions as they held their partnership interests. The partnership then sold almost all of its land to the corporation which subsequently developed and sold it to third parties in the ordinary course of its business. The partnership reported its income from the sale of land to the corporation as long term capital gains. The Service argued that the profits should be taxed as ordinary income because the partnership, in conjunction with the corporation which was owned by the same persons and in the same proportions as the partnership, were jointly engaged in the development and sale of real estate in the ordinary course of a business. The Fifth Circuit, reversing the Tax Court, held that the partnership was entitled to long term capital gains treatment. It began its analysis by reviewing the seven Winthrop factors and found that, based solely upon a review of the partnership’s activities, the property was certainly not “dealer property” in the hands of the partnership. The court went on to hold that the corporation was a separate taxable entity and that, under the Supreme Court’s decisions in National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949) and Commissioner v. Bollinger, 485 U.S. 340 (1988), the corporation cannot be said to have been functioning as an “agent” for the partnership. The court also refused to apply the “substance over form” doctrine to attribute the corporation’s dealer activities to the partnership.

6 Installment Sale Rules.

1 Gains from the sale of property by a taxpayer to a “related party,” as defined in §453(f)(1), are eligible for installment reporting, but any amounts received by the transferee upon a subsequent disposition of the property within two years of the date of the original sale will result in acceleration of income. Under §453(e), any amounts received by the transferee upon a subsequent disposition will be treated as a payment received by the taxpayer unless an exception applies.

1 “Related parties” are defined in §453(f)(1) using the attribution rules of both §267(b) and §318.

2 If depreciable property is sold to a “related party,” which, for purposes of this provision, will be limited to parties described in either §1239(b) or §707(b)(1)(B), the seller will not be eligible to report on the installment method. Exception to this disallowance is available, however, if the taxpayer can demonstrate to the Service that he did not have as one of his principal purposes the avoidance of federal income taxes. §453(g)(2).

3 Any recapture income resulting from the sale of real property to a controlled entity under §1245 and/or §1250 must be reported in the year of sale (i.e., deferral under the installment method is not available). §453(i).

4 As a general rule, “dealers” who are selling property for sale to customers in the ordinary course of a trade or business will no longer be eligible for installment reporting. §§453(b)(2)(A) and 453(l). However, certain dealers in timeshare properties and residential lots may elect to utilize the installment method if they agree to pay an interest toll charge for the privilege of doing so. See, §453(l).

3 Sale to Related Partnership.

1 Section 707(b)(2). Under §707(b)(2), a sale of property between a person and a partnership which, in the hands of the transferee is property that is not classified as a capital asset (as defined in §1221), the gain will be ordinary if the seller owns, directly or indirectly, more than 50% of the capital interests or profits interests in the partnership.

1 Under §707(b)(3), “ownership” of a capital or profits interest in a partnership is to be determined in accordance with the rules of constructive ownership of stock provided in §267(c) (other than paragraph 3 of such section). Under §267(c) the following rules apply:

1 Capital or profits interests owned directly or indirectly by or for a corporation, partnership, estate or trust are considered to be owned proportionately by or for its shareholders, partners or beneficiaries; and

2 An individual is considered to own partnership capital or profits interests owned, directly or indirectly, by or for members of his family. “Family” includes brothers and sisters, spouse, ancestors, and lineal descendants.

Note that §707(b)(2) would recharacterize the nature of income on the sale of any property that is not a capital asset. Thus, a sale of a §1231 asset (even if not depreciable) would be caught in this section.

A key to avoiding §707(b)(2) is to sell to a partnership or LLC (that is treated as a partnership) which the selling party does not directly or indirectly control.

2 Contrast Tax Treatment with Sale to Controlled S Corporation. There is no counterpart to §707(b)(2) in the S corporation area. The only section that has to be dealt with for recharacterization purposes in an S corporation setting is §1239.

3 Applicability of “Debt” vs. “Equity” and “Sale” vs. “Disguised Contribution” to Sales of Property to a Partnership. To date, there have been no recorded cases applying the debt vs. equity or sale vs. contribution concepts to sales of real estate to a partnership. Nevertheless, there is no reason to expect that the analysis applicable in the corporate setting would not apply in a partnership context. If a purported sale is treated as a disguised contribution to capital by one or more partners, the basis of the contributed property will carry over to the partnership (§723); the excess of the value of the property at the date of contribution (which is not necessarily going to be the same as the purported selling price) over the carry over basis of the property will be treated as §704(c) built-in gain that must be allocated to the contributing partner upon disposition under §704(c); and purported payments of principal and interest on the note will, instead, be treated as distributions from the partnership to the selling partner under §731.

2 Section 1239. Section 1239 would recharacterize capital gain into ordinary income upon sales of assets between a person and a partnership in which the selling person owns more than 50% of the capital or profits, directly or indirectly, and if the property, in the hands of the transferee partnership, is depreciable property. The §267(c) attribution rules also apply in the case of §1239.

1 Note that there is obvious overlap between §707(b)(2) and §1239 in connection with the sale of depreciable property to a controlled partnership. However, §707(b)(2) would also apply to non-depreciable property such as inventory or raw land that constitutes a §1231 asset.

COST SEGREGATION AND 1031 EXCHANGES.

1 Cost Segregation Studies. Many taxpayers have engaged in “cost segregation studies” of improved real properties to achieve at least partial acceleration of depreciation deductions.

1 Authority. Hospital Corporation of America, 109 T.C. 21 (1997) held that many items attached to a building may properly be treated as tangible personal properties under §168 if such properties were treated as personal property under prior law governing the investment tax credit. The IRS argued in Hospital Corporation of America that the general prohibition against component depreciation (See, Prop. Regs. §1.168-2(e)(1)) applied to these items as well. However, the Tax Court disagreed and held that any properties within a building that would have been treated as tangible personal properties under the now repealed investment tax credit rules will be eligible to be depreciated separately from the building under §168.

1 The IRS has now acquiesced in Hospital Corporation of America. AOD 1999-008 (8-30-99), amended, Announcement 99-116, 1999-52 I.R.B. 763; but see, Chief Counsel Advice 199921045 which states that the determination of what portion of the cost of the building, if any, that can be allocated to tangible personal property is a facts and circumstances test, and any cost segregation studies should not be based on non-contemporaneous records, reconstructed data or the taxpayer’s estimates or assumptions that have no supporting records, and further advises examining agents to closely scrutinize any such studies.

2 Many CPA firms are aggressively promoting cost segregation studies which, if properly done, involve a joint analysis conducted by a qualified engineering firm together with a CPA firm.

3 Examples of properties found to be eligible for MACRS depreciation separate from buildings are branch electrical wiring and connections for energy powered generation systems (Hospital Corporation of America, supra; Scott Paper Co., 74 T.C. 137 (1980)); carpeting (S. Rep. No. 1263, 95th Cong., 2d Sess. 117 (1978)); decorative lighting fixtures (FSA 200203009); and movable and removable partitions (King Radio Corp. vs., 486 F.2d 1091 (10th Cir. 1973). For a more extensive list of properties recognized as eligible for separate tangible personal property treatment, see, Maule, No. 531-2d, T.M., Depreciation: MACRS and ACRS at pp. A-133 and A-134.

2 Advantage of Cost Segregation Studies. Buildings and their components must generally be depreciated on a straight line basis over either 27.5 years for residential rental properties or 39 years for commercial properties. §§168(b)(3)(A) and (B) and 168(c). Most tangible personal properties contained in buildings that may be separately depreciated under §168 will have shorter depreciable lives (typically 5, 7 or 10 years) and can be depreciated using a double declining method. See, §§168(b) and (c). Other assets will be treated as land improvements (e.g., sidewalks, driveways and landscaping) which can be depreciated over 15 years using a 150% declining balance method. Id. In addition, for newly acquired properties, §179 may allow a current deduction of up to $100,000 of the cost of tangible personal properties; §168(k), which was added by the Job Creation and Worker Assistance Act of 2002, permits taxpayers to deduct an additional 30% first year depreciation for certain personal properties; and §168(k)(4), which was added by the Jobs and Growth Tax Reconciliation Act of 2003, raised the deduction for additional first year depreciation to 50% from 30% for certain depreciable personal property placed in service after May 5, 2003, thereby adding additional incentive to use cost segregation.

3 Consequences of Reclassifying Properties.

1 Section 1245 Properties. If properties contained in a building are “identified” in a cost segregation study as 5, 7, or 10 year properties, they will be treated as §1245 properties.

1 Section 1245(a)(3) defines §1245 property as depreciable property that is either personal property or certain other properties (not including a building or its structural components) used in manufacturing or for certain other specified purposes.

2 Reg. §1.1245-3(b) provides that personal property includes tangible personal properties as defined in Reg. §1.48-1(c), which pertains to the now repealed investment tax credit. “Tangible personal property” that was eligible for the investment tax credit was broadly construed under the §48 regulations. Because §168 adopts the definitional scheme of §48, the bias toward classification of property as “tangible personal property” carries over to §168 as well. Consider the following language from Reg. §1.48-1(c):

“The fact that under local law property is held to be personal property or tangible property shall not be controlling. Conversely, property may be personal property for purposes of [§1245] even though under local law the property is considered to be a fixture and therefore real property. For purposes of this section, the term “tangible personal property” means any tangible personal property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structure). . . .Tangible personal property includes all property (other than structural components) that is contained in or attached to a building.”

4 Section 1245 property does not include a building or its structural components. The pertinent focus in connection with cost segregation studies is whether such properties are “structural components.” Reg. §1.48-1(e)(2) defines “structural components” of a building to include the following:

“. . .such parts of a building as walls, partitions, floors, ceilings, as well as any permanent coverings therefore such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building.”

Although the list set forth above is very broad, the bias toward classification of properties as tangible personal property under §168 and Reg. §1.48-1(c), nevertheless, provides a means of breaking out a significant portion of properties from most buildings and treating them as tangible personal properties, subject to a faster write off.

2 As noted in II.A.2 above, some types of real property, such as sidewalks, driveways and landscaping, will be treated as §1250 properties, but depreciable over a 15-year life and eligible for the 150% declining balance method of depreciation.

2 Exchanges of Cost Segregated Properties.

1 Like Kind. The threshold question in a Section 1031 exchange of cost segregated properties is whether the segregated assets comprising a portion of the relinquished property are “like kind” to the replacement properties received in the exchange. If the segregated items constitute real property, they will benefit from the broad general rule of Reg. §1.1031(a)-1(b):

“The words ‘like kind’ have reference to the nature or character of the property and not to its grade or quality . . . The fact that any real estate involved is improved or unimproved is not material, that fact relates only to the grade or quality of the property and not to its kind or class.”

The determination of whether an asset is real property or tangible personal property is normally governed by state law. Rev. Rul. 72-151, 1972-1 C.B. 225; Oregon Lumber Co., 20 T.C. 192 (1953). For example, fixtures will most likely be treated as real property under the law of most states, but may nevertheless be §1245 property.

1 If, on the other hand, an asset is tangible personal property under state law, the determination of whether a replacement property asset is like kind to such asset requires that it either be of “like class” or similar or related in service or use. Reg. §1.1031(a)-(2).

2 If tangible personal property which is relinquished is not “like kind” to any of the replacement property received, all realized gain attributable to such relinquished tangible personal property will be recognized in the exchange.

4 Section 1245 Depreciation Recapture. Section 1245(a)(1) provides that if §1245 property is disposed of, the excess of: (i) the lower of the “recomputed basis” of the property or the amount realized in the sale or exchange, over (ii) the adjusted basis of the property must be recognized and reported as ordinary income, notwithstanding any other provision of Subtitle A (i.e., all income tax provisions) of the Code.

1 Section 1245(b)(4) sets forth rules applicable to the inclusion of §1245 property in a Section 1031 exchange. The first step in the §1245 computation is to determine the amount that would have been recaptured under the general rules of §1245(a)(1) if the §1245 property had been disposed of in a fully taxable transaction. This, of course, is the maximum amount that will be subject to mandatory recognition as ordinary income under §1245. Next, the transaction must be examined under §1245(b)(4) which imposes a limitation on the amount of depreciation recapture income to be recognized under §1245. Under §1245(b)(4), the amount of gain required to be recognized under §1245(a) will not exceed the sum of: (i) the amount of gain otherwise required to be reported on the exchange (because of boot), plus (ii) the fair market value of property acquired as replacement property in the exchange of §1245 properties which is not §1245 property and which was not otherwise included within the boot gain recognized under (i) above.

2 Section 1245 can be a “sleeper” that creates an unpleasant surprise because it can trigger gain recognition at ordinary rates in what might otherwise appear to be a completely tax free Section 1031 exchange.

3 Example: Taxpayer owns Property X, an unencumbered commercial office building comprised of the following items:

Fair Market Depreciation

Asset Value Adj. Basis Claimed

Land $ 500,000 $100,000 $0

Building $1,000,000 $550,000 $100,000 (S/L)

§1245 Property $ 100,000 $ 50,000 $ 50,000

Taxpayer exchanges Property X for unencumbered Property Y, which consists of the following:

Fair Market

Asset Value

Land $ 550,000

Building $1,000,000

§1245 Property $ 50,000

Assume for purposes of this example, that the §1245 property consists of fixtures which are treated as real property under applicable state law. Although the taxpayer might expect full nonrecognition treatment under §1031 since it is engaging in an exchange of real properties for real properties with no boot, §§1245(a)(1) and (b)(4) require the taxpayer to recognize $50,000 of ordinary income in this example.

16 If a taxpayer disposes of real property that is “§1245 recovery property,” as defined in former §1245(a)(5) (now repealed) and which generally consists of nonresidential real property as well as certain other residential real properties that were depreciable over 19 years on an accelerated basis under prior law, it is impossible today to acquire replacement property that will be treated as §1245 recovery property in the hands of the taxpayer. Does this mean that there will be 100% recapture upon disposition of the §1245 recovery property in an otherwise nonrecognition exchange under Section 1031? Is it possible to offset the §1245 recovery property with §1245 properties with a fair market value equal to or in excess of the value of the §1245 recovery properties disposed of? At the present time, the IRS has not issued any guidance on this subject.

5 Section 1250 Depreciation Recapture. Depreciation recapture under §1250(a), which also requires recognition notwithstanding any other provision of Subtitle A of the Code (see, §1245(a)(1)(A), last sentence), is more limited than §1245 because it only recaptures “additional depreciation” which generally means the excess of depreciation deductions taken by the taxpayer using the accelerated method over the depreciation that would have been taken on a straight line method. §§1250(a)(1) and (b)(1). Since buildings must generally be depreciated on the straight line basis, §1250 usually does not generate depreciation recapture upon disposition. [Note: §1(h)(1)(D) imposes a 25% capital gains rate, rather than the general 15% rate, to unrecaptured §1250 gain. However, this only applies to gains which are recognized under other Code sections; it is not a depreciation recapture provision that will override the nonrecognition rules of (§1031).] However, certain land improvements such as sidewalks, driveways, and landscaping which may be written off over 15 years are also eligible for the 150% declining balance method of depreciation. Thus, any gains from the disposition of these land improvements can also result in depreciation recapture income under §1250 in an otherwise valid §1031 exchange.

3 Does Cost Segregation Still Make Sense for Properties Likely to be Disposed of in a Section 1031 Exchange? Unless the benefits of cost segregation are minimal, most taxpayers will most likely gladly trade depreciation recapture at the time of a future disposition for substantially greater write offs each year prior to disposition. In other words, the present value of the money saved from the greatly accelerated depreciation deductions will normally be more than offset by the depreciation recapture at ordinary rates that will result upon a future disposition.

1 Depreciation Recapture under either §1245 or §1250 can sometimes be minimized by carefully selecting and valuing replacement properties with appropriate amounts (in terms of fair market value) of §1245 and §1250 properties.

2 Be sure to advise the client in writing when the cost segregation study is being done of the impact of future depreciation recapture when the property is disposed of.

4 New Temporary Regulations Provide Guidance on How to Depreciate Replacement MACRS Properties Received in a 1031 Exchange. Temporary regulations were issued on March 1, 2004 relating to the depreciation of MACRS properties acquired as replacement property in a §1031 exchange or as a result of an involuntary conversion under §1033. Reg. §1.168(i)-6T.

1 General Rule. MACRS property received as replacement property in a §1031 exchange for relinquished property that was MACRS property in the taxpayer’s hands will be depreciated under Reg. §1.168(i)-6T(c) using the “general rule” (explained below) unless an exception applies or unless the taxpayer has elected out of the general rule.

1 The “general rule” under Reg. §1.168(i)-6T(c) provides that replacement MACRS property will be depreciated over the remaining recovery period, using the same depreciation method and convention that were applicable to the MACRS relinquished property in the hands of the taxpayer (the so-called “step-into-the-shoes method”). Note that the previous owner’s method of depreciating the replacement property prior to its receipt by the taxpayer is not relevant to the determination of how to depreciate such property in the hands of the taxpayer. Reg. §1.168(i)-6T(c)(2).

2 The general rule only applies to the “exchanged basis” portion of the replacement property. The “exchanged basis” portion is the lesser of: (i) the basis of the replacement property as determined under §1031(d) and the regulations thereunder, or (ii) the adjusted depreciable basis (as defined in Reg. §1.168(b)-1T(a)(4)) of the relinquished MACRS property. Reg. §1.168(i)-6T(b)(7).

3 The “excess basis,” which is defined in Reg. §1.168(i)-6T(b)(8) as the basis of the replacement MACRS property determined under §1031(d) over the “exchanged basis,” will be treated as newly acquired property and the taxpayer must use the applicable recovery period, depreciation method and convention prescribed in §168 for such property. Reg. §1.168(i)-6T(d)(1).

2 Exceptions to General Rule. The general rule will not apply to replacement MACRS property that either has a longer useful life or a less accelerated depreciation method than the taxpayer’s relinquished MACRS property. Reg. §1.168(i)-6T(c)(4).

1 If the recovery period applicable to the replacement MACRS property is longer than the recovery period applicable to the relinquished MACRS property, the taxpayer must depreciate the “exchanged basis” of the replacement MACRS property as if it had been placed in service on the same date as the relinquished MACRS property, but using the longer recovery period. Reg. §1.168(i)-6T(c)(4)(i). (Note: If the recovery period applicable to the replacement MACRS property is shorter than the recovery period applicable to the relinquished property, the general rule will apply. Reg. §1.168(i)-6T(c)(4)(ii).)

2 If the depreciation method applicable to the replacement MACRS property is less accelerated than that of the relinquished MACRS property, once again the replacement MACRS property will be treated as if it had been placed in service by the taxpayer on the date the relinquished property was placed in service, but the depreciation allowance for the exchanged basis beginning in the year of replacement will be determined using the less accelerated depreciation method.

3 Election Out. Taxpayers may determine that the bifurcation of basis of a single asset into an “exchanged basis” and an “excess basis” and the application of different depreciation periods and/or methods to such components will be unduly burdensome to maintain. In such a case, the taxpayer may elect out of the “general rule” under Reg. §1.168(i)-6T(i) and simply treat the replacement property as having been placed in service in the year of replacement. Thus, the recovery period as well as the depreciation method and convention applicable to the entire basis of the replacement MACRS property will be determined as if the replacement MACRS property were newly acquired in such year. The election must be made with respect to each separate exchange transaction. Reg. §1.168(i)-6T(j)(1).

4 Effective Date. The new temporary regulations apply to exchanges in which both the disposition of the relinquished MACRS property and the acquisition of the replacement MACRS property occur after February 27, 2004.

NEW DEVELOPMENTS AND OLD ISSUES RESURFACED IN 1031 EXCHANGES.

1 Build-to-Suit Exchanges with Related Parties.

1 Section 1031(f). The Revenue Reconciliation Act of 1989 added §§1031(f) and (g) limiting the application of Section 1031 nonrecognition treatment with respect to exchanges between related parties.

1 The impetus for the change was the concern of Congress that Section 1031 was being employed to avoid the impact of the repeal of General Utilities in TRA ’86. For example, assume Corporation X owns 100% of the stock of Corporations Y and Z. Corporation Y owns Property 1 with the fair market value of $1,000,000 and a tax basis of $100,000. Corporation Z owns Property 2 with a fair market value of $1,000,000 and a basis of $1,000,000. Corporation Y desires to sell Property 1 but does not want to incur the tax on $900,000 of gain. In order to avoid taxation on the gain, Corporation Y and Corporation Z exchange Property 1 for Property 2. After a suitable waiting period, Corporation Z, which now owns Property 1 with a new $1,000,000 substituted basis (See, §1031(d)), sells Property 1 and recognizes no gain on the transaction.

2 In order to preclude the result described in a. above, §1031(f) now provides that if a taxpayer obtains nonrecognition treatment under §1031 upon an exchange of property with a “related person” nonrecognition treatment will be lost if either the taxpayer or the related party disposes of the property received by it in the exchange within two years. The two-year holding period will be suspended and held open under §1031(g) for any period of time in which any of the exchanged properties for which nonrecognition treatment was afforded under §1031 are subject to a “put,” a “call,” a short sale or any transaction with similar effect (providing that such put, call, etc. arose prior to the expiration of the two-year period).

3 In defining “related parties,” §1031(f)(3) adopts the definitional rules contained in §267(b) and §707(b)(1), with minor exceptions.

4 Section 1031(f)(4) establishes an anti-abuse rule to prevent taxpayers from structuring transactions in a manner designed to circumvent the §1031(f) related party rules. Section 1031(f)(4) provides as follows:

“This section [i.e., all of §1031] shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”

1 Guidance for interpreting this provision is found in the Senate Finance Committee Report which contains the following statement:

“Nonrecognition will not be accorded to any exchange which is part of a transaction or series of transactions structured to avoid the purposes of the related party rules. For example, if a taxpayer pursuant to a prearranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within two years of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment under section 1031.” S. Rpt. No. 56, 101st Cong., 1st Sess. 151 (1989).

3 Any transaction which is outside of §1031(f)(1) but which achieves a basis shift between related parties is presumably the type of transaction that §1031(f)(4) is designed to ferret out and penalize.

4 Rev. Rul. 2002-83, 2002-49 I.R.B. 927, the taxpayer owned relinquished property with a fair market value of $150x and a tax basis of $50x. The taxpayer first disposed of the relinquished property through a qualified intermediary to an unrelated party for $150x in a purported §1031 exchange. The taxpayer identified replacement property owned by a related party (to the taxpayer) which had a fair market value of $150x and a tax basis in the hands of the related party of $150x. The qualified intermediary paid the proceeds held in the qualified escrow of $150x to the related party and the replacement property was then direct deeded to the taxpayer. The Service held the transaction was structured in order to avoid the related party rules of §1031(f)(1) and that the transaction did not qualify for nonrecognition treatment under Section 1031. See, also, TAM 9748006; TAM 200126007; and FSA 1999-31002 which have similar holdings.

2 Possible Use of Leasehold Interest for Build-To-Suit Exchange with a Related Party. Taxpayer owns relinquished property with a fair market value of $150x and a tax basis of $50x. The taxpayer enters into an Exchange Agreement with a qualified intermediary who disposes of the taxpayer’s relinquished property for $150x cash. A related party to the taxpayer then leases an undeveloped tract of land owned by the related party to the qualified intermediary (or to a limited liability company wholly owned by the QI) for a lease term of 30+ years at a fair rental value. The qualified intermediary, pursuant to the taxpayer’s instructions, constructs improvements on the leased property. The qualified intermediary then transfers ownership of the improvements and assigns the lease to the taxpayer within the applicable exchange period. Will this qualify for nonrecognition treatment under Section 1031?

1 In PLR 200251008 (9/11/02), the Service ruled that a “reverse exchange” in which an exchange accommodation party acquired a sub-sub leasehold interest from a related party (to the taxpayer), borrowed money from the taxpayer and constructed improvements on the property that was subject to the sub-sub leasehold interest, and then conveyed the improvements and leasehold interest to the taxpayer through a qualified intermediary, to be a valid Section 1031 exchange, and that §1031(f)(4) did not apply. The Service determined that there was no basis shifting and no cash-out event and, therefore, there was no tax avoidance motive. Comments recently submitted by the ABA Tax Section to the Service would also support the holding of this PLR. However, Rev. Proc. 2004-51, 2004-33 I.R.B. 1, discussed below, apparently reflects a Service attitude against utilizing parking transactions involving build-to-suit exchanges on property owned by a related party. Such ruling notes that:

“The Service and Treasury Department are continuing to study parking transactions, including transactions in which a person related to the taxpayer transfers a leasehold in land to an accommodation party and the accommodation party makes improvements to the land and transfers the leasehold with the improvements to the taxpayer in exchange for other real estate.”

3 Query: Consider the results if the taxpayer (rather than a related party) leased property that it owned to an exchange accommodation titleholder under Rev. Proc. 2000-37, 2000-2 C.B. 308, loaned the exchange accommodation titleholder money to construct improvements on the property leased to it, and then ultimately received an assignment of the leasehold interest together with a transfer of the improvements back to itself to close out a reverse exchange in which it disposed of relinquished property to an unrelated party. The risk is that this might be viewed as one integrated transaction and that what the taxpayer received in exchange for its relinquished property was construction of improvements on its previously owned property which was held not to qualify for Section 1031 nonrecognition treatment in Bloomington Coca Cola Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951). Alternatively, this might be viewed a sham transaction because the facts are similar to those set forth in DeCleene v. Commissioner, 115 T.C. 457 (2000). (Such arguments may also be aided by the fact that the assignment of the lease back to the taxpayer, who is also the lessor, will result in a merger of the lessor and lessee interests which effectively terminates the lease.) Comments submitted by the ABA Tax Section argue that this transaction should be accorded nonrecognition treatment because the taxpayer has not “cashed out” its investment, there is no “basis shifting” that would violate the spirit of the §1031(f)(4) related party anti-abuse rules, and the taxpayer is in the same economic position as if it had entered into a similar transaction with an unrelated party.

However, in Rev. Proc. 2004-51, published on August 16, 2004, the Service held that Revenue Procedure 2000-37, 2000-2 C.B. 308 (which provided the Service’s safe harbor for parking transactions) does not apply if the taxpayer owns the property intended to qualify as replacement property within the 180 day period ending on the date of transfer of indicia of ownership to the exchange accommodation title holder. Rev. Proc. 2004-51 provides that it is effective for transfers on or after July 20, 2004, of qualified indicia of ownership, to exchange accommodation title holders. The Revenue Procedure clearly will have a dampening effect on the expansion of parking transactions involving improvements on property owned by the taxpayer or related parties. Many issues are raised by Rev. Proc. 2004-51:

1 If a taxpayer owns land and transfers it to an exchange accommodation title holder who builds improvements thereon, does Rev. Proc. 2004-51 disqualify the land only, or the land and improvements (only the land was owned by the taxpayer within 180 days of the transfer to the exchange accommodation title holder)?

2 May the taxpayer improve its chances by structuring the transfer to the exchange accommodation title holder as a long term lease, with the exchange accommodation title holder making the improvements on the leased property? While this issue is not specifically addressed in Rev. Proc. 2004-51, the following comment in the Revenue Procedure seems to reflect a negative Service position on such a lease:

“An exchange of real property owned by the taxpayer for improvements on land owned by the same taxpayer does not meet the requirements of

§1031.”

6 May the taxpayer avoid the 180 day rule by conveying the property to a friendly party who holds it for six (6) months prior to the conveyance to the exchange accommodation title holder?

7 Is the taxpayer in a better position if the property to be improved is owned, not by the taxpayer, but by a related party? Although this is not the factual situation addressed by Rev. Proc. 2004-51, as noted above the Revenue Procedure cautions:

“The Service and Treasury Department are continuing to study parking transactions, including transactions in which a person related to the taxpayer transfers a leasehold in land to an accommodation party and the accommodation party makes improvements to the land and transfers the leasehold with the improvements to the taxpayer in exchange for other real estate.”

2 Rev. Rul. 2003-56 and its Treatment of Partnership Liabilities in 1031 Exchanges: New Clarification and Confusion.

1 Treatment of Boot in 1031 Exchanges. If a taxpayer transfers qualified relinquished Property X with a fair market value of $1,000 and an adjusted basis of $100 to a third party in exchange for qualifying replacement Property Y with a fair market value of $900 plus $100 in cash, the taxpayer’s realized gain of $900 must be recognized to the extent of the $100 cash boot received. §1031(b). “Boot” also includes relief from liabilities encumbering the taxpayer’s relinquished property that are either assumed, or taken subject to, by the transferee. Reg. §1.1031(b)-1(c).

2 Boot Netting. In many exchanges, a taxpayer will both give and receive boot. In such instances, the applicable regulations permit a “netting” of the boot transferred by the taxpayer against boot received by the taxpayer in the exchange, subject to limitations explained below.

1 Under Reg. §1.1031(b)-1(c), liabilities of the taxpayer encumbering its property which are either assumed or taken subject to by the other party to the exchange may be offset, or “netted,” against liabilities encumbering the replacement property which are either assumed or taken subject to by the taxpayer in the exchange.

2 Liabilities of the taxpayer encumbering its property which are assumed or taken subject to by the other party to the exchange may also be offset by cash given by the taxpayer to such other party. Reg. §1.1031(d)-2, Exs. 1 and 2; Barker v. Commissioner, 74 T.C. 555 (1980).

3 A taxpayer who receives cash in an exchange to compensate for a difference in net values in the properties may not offset the cash boot received by boot given in the form of assumption of liabilities encumbering the replacement property received by the taxpayer. Reg. §1.1031(d)-2, Ex. 2; Barker supra; Coleman v. Commissioner, 180 F.2d 758 (8th Cir. 1950). This rule is apparently predicated upon the assumption that the taxpayer receiving cash is free to use it for whatever purposes it desires and is not necessarily required to apply it in reduction of the “excess” mortgage indebtedness assumed.

4 If both the relinquished property and the replacement property are encumbered by mortgages at the time of an exchange, the taxpayer may “net” the mortgages for purposes of computing the amount of boot received in the exchange, and only the excess of the mortgage balance on the relinquished property over the mortgage balance on the replacement property will be treated as boot. In the case of a deferred exchange, however, it will presumably not be known at the time the relinquished property is conveyed whether the replacement property will be encumbered or, if so, what the outstanding balance of the mortgage encumbering the replacement property will be. The deferred exchange regulations address the application of the boot netting rules to a deferred exchange in an example which confirms that the deferred netting of mortgages will be allowed. Reg. §1.1031(k)-1(j) Ex. 5. The regulations effectively treat both the prior disposition of the encumbered relinquished property and the subsequent receipt of the encumbered replacement property as one integrated transaction and provide that boot will only be deemed received if the mortgage balance on the relinquished property exceeds the mortgage balance on the replacement property which, of course, can only be determined when the replacement property is received. Although both the disposition of encumbered relinquished property and the subsequent receipt of encumbered replacement property occur within the same taxable year in Example 5, presumably the same analysis would apply if the deferred exchange spanned two taxable years.

3 Installment Reporting. Section 453(a) permits income derived from an installment sale to be reported under the installment method. An installment sale is defined in §453(b) as a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.

1 Under the installment reporting method, a portion of each payment received by the taxpayer must be reported as income. The portion to be recognized as income is determined by multiplying the amount of the payment by a fraction (referred to as the “gross profit ratio”), the numerator of which is the “gross profit,” and the denominator is the “total contract price.” Temp. Reg. §15A. 453-1(b)(2)(i).

1 “Gross profit” is the selling price less adjusted basis in the property. Temp. Reg. §15A. 453-1(b)(2)(v).

2 “Total contract price” is the selling price less “qualifying indebtedness” assumed or taken subject to by the buyer to the extent that such qualifying indebtedness does not exceed the taxpayer’s adjusted basis. Temp. Reg. §15A. 453-1(b)(2)(iii). Note that debt assumed or taken subject to by the buyer is only taken into account to the extent of adjusted basis in computing the “total contract price.” Any debt assumed or taken subject to which exceeds the taxpayer/seller’s adjusted basis will be treated as an additional payment in the year of sale and will be fully taxable. Temp. Reg. §15A. 453-1(b)(3)(i).

2 Example: Taxpayer owns Property X which has a fair market value of $300x and in which the taxpayer has an adjusted basis of $80x. Property X is encumbered by a mortgage of $100x. Taxpayer sells Property X to an unrelated party for $300x with the buyer assuming the existing mortgage of $100x and giving taxpayer a purchase money note for $200 payable interest only for the first year and with the remaining balance of principal together with interest to be paid over the following four years. The taxpayer’s realized gain of $220x will be reported on the installment basis. The gross profit ratio is 100%. [“Gross profit” is $220x; the “total contract price” is also $220x, computed by reducing the selling price by the mortgage indebtedness assumed by the buyer to the extent that it does not exceed the taxpayer’s basis ($80x).] Thus, 100% of each and every payment of principal received by the taxpayer with respect to the sale will be treated as income as and when it is received. For this purpose, the excess of the mortgage indebtedness assumed ($100x) over the taxpayer’s adjusted basis ($80x) will be treated as a payment in the year of sale. Thus, the taxpayer must report $20x of income on the installment basis in the year of sale. The remaining $200 of gain will be reported as and when payments of principal are made to the taxpayer on the purchase money installment note.

4 Installment Reporting of Boot in Deferred Exchange.

1 Section 453(f)(6), which was added to the Code by the Installment Sales Revision Act of 1980, P.L. 96-471, and was subsequently amended by the Technical Corrections Act of 1982, P.L. 97-448, establishes rules to coordinate the installment sale reporting provisions of §453 with the gain deferral provisions of §1031. Under §453(f)(6), if boot is received in connection with a §1031 exchange and if one or more payments of such boot is payable in a year subsequent to the year of disposition of the relinquished property, gain attributable to such boot payments will be reported on the installment method in accordance with the special rules set forth therein.

2 On April 20, 1994, final regulations were issued which provide guidance for coordinating the deferred exchange safe harbor rules with the installment sale provisions. See, Reg. §1.1031(k)-1(j)(2). The principal provisions of these regulations are as follows:

1 The qualified escrow, qualified trust, and qualified intermediary safe harbors of Reg. §§1.1031(k)-1(g)(3) and (4) will also apply for purposes of determining whether a taxpayer has either actually or constructively received a payment under §453 and Temp. Reg. §15A. 453-1(b)(3)(i). Reg. §1.1031(k)-1(j)(2)(i) and (ii). Thus, subject to the general provisions of §§453 and 453A, taxpayers who comply with a deferred exchange safe harbor requirement may report any gain to be recognized in a deferred exchange on the installment basis.

2 The right to utilize the installment sale provisions to defer recognition of gain in a deferred exchange is conditioned in the regulations upon a “bona fide intent” on the part of the taxpayer to enter into and complete a deferred exchange. Reg. §1.1031(k)-1(j)(2)(iv). If the requisite bona fide intent is present, which is a facts-in-circumstances determination, generally any gain to be recognized attributable either to the receipt of boot or the failure to complete the exchange will generally be deferred until the subsequent year. See, Reg. §1.1031(k)-1(j)(2)(vi), Examples 2, 3, 5, and 6.

5 Special Issues which Arise when the Exchangor is a Partnership. If a partnership participates in a deferred exchange in which it transfers encumbered relinquished property in one taxable year and receives encumbered replacement property in the ensuing taxable year, all of the rules applicable to the computation of boot gain and the time for reporting such gain should arguably apply. However, several additional issues will also arise.

1 Section 752(a) provides that any increase in a partner’s share of partnership liabilities, or any increase in a partner’s individual liabilities by reason of the assumption by the partner of partnership liabilities, will be treated as a contribution of money by the partner to the partnership. Conversely, §752(b) provides that any decrease in a partner’s share of the underlying liabilities of the partnership, or any decrease in a partner’s liabilities by reason of the assumption by the partnership of individual liabilities of the partner, will result in a deemed distribution of money by the partnership to the partner. If the deemed distribution of money exceeds the partner’s adjusted basis in its partnership interest, gain will be recognized by the partner to the extent of such excess. §731(a).

2 In the case of a deferred exchange in which the partnership transfers encumbered real property pursuant to a deferred exchange in year 1 and receives encumbered replacement property in year 2, how do the constructive distribution rules of §752(b) and §731 work? Upon transfer of the encumbered relinquished property, the liabilities of the partnership are reduced by the amount of mortgage indebtedness encumbering the relinquished property that was either assumed or taken subject to by the buyer. Section 731(a)(1) provides that gain will be recognized “. . . to the extent that any money distributed exceeds the adjusted basis of such partner’s interest in the partnership immediately before the distribution . . .” (emphasis added). If §731(a) is applied literally, the full amount of the mortgage indebtedness encumbering the relinquished property will be treated as a deemed cash distribution by the partnership to its partners under §752(b) and not just the excess (if any) of the mortgage debt encumbering the relinquished property over the mortgage debt encumbering the replacement property. However, Reg. §1.752-1(f) provides as follows:

“If as a result of a single transaction a partner incurs both an increase in the partner’s share of the partnership liabilities . . . and a decrease in the partner’s share of the 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.”

A compelling argument can be made that the above quoted language supports the conclusion that the transfer of the encumbered relinquished property together with the receipt of encumbered replacement property constitutes “a single transaction” and that the liability should be netted to determine whether or not there is a reduction in a partner’s share of liabilities of the partnership resulting from the exchange.

5 Another issue which arises in a deferred exchange of encumbered properties that spans two taxable years by a partnership is the impact on computation of minimum gain. If there is a net decrease in partnership minimum gain as of the end of a taxable year, the partnership must allocate to each partner items of gross income or gain for the partnership taxable year in which the decrease occurs equal to such partner’s share of the net decrease. Reg. §1.704-2(f)(1). Reg. §1.704-2(d)(1) directs that partnership minimum gain be determined by examining each separate nonrecourse liability of the partnership and determining the gain (if any) the partnership would realize if it disposed of the property securing such nonrecourse liability for no consideration other than satisfaction of such liability. The amounts computed in this manner with respect to each nonrecourse liability are then aggregated to compute partnership minimum gain for such taxable year. The net increase or decrease in partnership minimum gain is then computed by comparing the partnership minimum gain as of the last day of the taxable year with the partnership minimum gain on the last day of the preceding taxable year.

If a partnership participates in a deferred exchange of relinquished property encumbered by a nonrecourse mortgage and receives replacement property secured by a nonrecourse mortgage and such exchange transaction spans two taxable years, how will partnership minimum gain be computed as of the end of the first taxable year? Once again, if Reg. §1.704-2(d) is applied literally, and if the amount of nonrecourse liability encumbering the relinquished property exceeds the adjusted tax basis of such property as of the end of the first taxable year, a reduction in partnership minimum gain will result unless the deferred exchange is treated as an integrated transaction and the minimum gain computation is made only after considering the impact of the receipt of the replacement property and any nonrecourse debt to which such replacement property may be subject.

6 Rev. Rul. 2003-56. On May 9, 2003, the IRS released Rev. Rul. 2003-56, 2003-23 I.R.B. 985 (this ruling was reissued in its entirety on May 22, 2003 with the only difference being the correction of a portion of the ruling dealing with partnership minimum gain computations). The ruling contains helpful guidance by assuring taxpayers that both the §752(b)/§731 computations and partnership minimum gain computations will be made by taking into account the ultimate receipt of the replacement property and any mortgage indebtedness associated with such replacement property that the taxpayer either assumes or takes subject to. On the other hand, the ruling contains some questionable analysis regarding the time for reporting income that may adversely affect many taxpayers.

1 Rev. Rul. 2003-56 addresses the tax consequences flowing from two separate factual situations. In Situation 1, the taxpayer is a general partnership with two equal partners that reports on the calendar year. The partnership owns Property 1 which is described as follows:

Property 1

FMV $300x

Basis $ 80x

Mortgage $100x

On October 16 of Year 1, the partnership transfers Property 1 pursuant to a deferred exchange transaction under §1031. On January 17 of Year 2, the partnership receives Property 2 which is described as follows:

Property 2

FMV $260x

Mortgage $ 60x

Situation 2 is the same as Situation 1 except that the information with respect to Property 2 is changed as follows:

Property 2 (Alternate)

FMV $340x

Mortgage $140x

14 The Service held that, in the case of Situation 1 involving a deferred exchange that straddles two taxable years and in which the mortgage debt encumbering the relinquished property exceeds the mortgage debt encumbering the replacement property (i.e., there will be net boot gain in the transaction), the net boot will be treated as money received by the partnership in Year 1 “ . . . since the excess is attributable to the transfer of the relinquished property subject to the relinquished liability in that year.” The Service goes on to hold that any gain resulting from the receipt of the net boot must be recognized and reported entirely in Year 1.

1 The realized gain in Situation 1 is $220x representing the difference between the amount realized of $300x [FMV of replacement property ($260x), increased by the relinquished liability ($100x), and decreased by the replacement liability ($60x)] and the adjusted tax basis in the relinquished property of $80x. Since there was a net reduction in mortgage liabilities of $40x ($100x relinquished liability less $60x replacement liability), $40x of gain must be recognized and reported in Year 1 under Rev. Rul. 2003-56.

2 The Service also permitted liability netting for purposes of determining the amount of net decrease in the partners’ shares of partnership liabilities under §752(b). In this regard, the Service held as follows:

“ . . .if a partnership enters into a §1031 exchange that straddles two taxable years of the partnership, each partner’s share of the relinquished liability is offset with each partner’s share of the replacement liability for purposes of determining any decrease in a partner’s share of partnership liability under §752(b). Any net decrease is taken into account in the first taxable year of the partnership since it is attributable to the transfer of the relinquished property subject to the relinquished liability in that year.”

The Service went on to hold that the deemed distribution of money to the partners under §752(b) resulting from the net mortgage reduction will be treated as an advance or drawing of money to the extent of each partner’s distributive share of partnership income for Year 1 pursuant to Rev. Rul. 94-4, 1994-1 C.B. 196. Under Rev. Rul. 94-4, this advance will be treated as an actual distribution to the partners at the end of Year 1.

5 Finally, the Service also permitted a netting of liabilities for purposes of computing partnership minimum gain as of the last day of Year 1 which was computed by using the replacement property and the replacement nonrecourse liability (the portion of Rev. Rul. 2003-56 relating to the computation of net changes in partnership minimum gain was changed in the “corrected version” of the ruling that was reissued on May 22, 2003).

15 In Situation 2, which involved a net increase in partnership liabilities of $40x upon consummation of the deferred exchange, the Service held in Rev. Rul 2003-56 that each of the partners will be deemed to have made a contribution to the partnership under §752(a) equal to their respective shares of the net increase in the partnership liabilities. However, in Situation 2 the deemed contribution will be treated as having been made in Year 2. (Since the partnership will not be treated as having received any net boot in Situation 2, no gain would be recognized under §1031 in the transaction.)

16 Observation: The Service’s analysis in Rev. Rul. 2003-56 with regard to the netting of relinquished liabilities against replacement liabilities is correct, and is consistent both with Reg. §1.1031(k)-1(j) Ex. 5 and Reg. §1.752-1(f). However, its analysis with respect to the time for recognition of boot gain as well as the time that §752(b) deemed distributions are made appears flawed because it is inconsistent with the installment sale rules discussed in III.B.3 and 4 supra. Consider, for example, what the results would be in Situation 1 if the partnership had sold (rather than exchanged) Property 1 for $300x consisting of the assumption of relinquished liability of $100x and the issuance of a purchase money installment note for $200, all of which was payable in Year 2. The partnership’s realized gain of $220x would be fully recognized and reported $20x in Year 1 (because the relinquished mortgage of $100x exceeds the partnership’s adjusted basis of $80x, thereby resulting in a deemed payment in the year of sale), with the balance of the gain ($200x) reported entirely in Year 2. Contrast this with the Service’s analysis of Situation 1 in Rev. Rul. 2003-56 involving a deferred §1031 exchange in which only $40x of the taxpayer’s $220x realized gain must be recognized, but the Service held that the entire $40x gain must be reported in Year 1. Why should the taxpayer have a greater gain to recognize in Year 1 in a §1031 exchange than it would have had if it sold Property 1 and reported its gain on the installment basis?

Consider what would happen if the owner of Property 2 increased the mortgage debt on Property 2 from $60x to $100x prior to consummation of the exchange and transferred Property 2 to the partnership subject to $100x mortgage indebtedness and paid the partnership an additional $40 in cash in order to compensate for the differences in net fair market values of the two properties. Under the analysis of Rev. Rul. of 2003-56, there is no net mortgage boot. However, there is cash boot of $40 which is received in Year 2. Under the installment sale rules discussed above, this would properly be reported in Year 2. If this analysis is correct, it produces an anomalous result that cash boot receives more favorable treatment (in terms of time for reporting) than mortgage boot.

3 Planning to Accommodate a Dissident Partner Who Does Not Want to Participate in an Exchange. If the relinquished property is held by a partnership and one of its partners does not wish to participate in the exchange, what (if anything) can be done to accommodate the dissident partner?

1 Distribution of Undivided Interest. Can an undivided interest in the property representing the dissident partner’s proportionate ownership in the property be distributed to it by the partnership and then sold by the dissident partner to the ultimate purchaser? (Probably not.)

2 Special Allocation of Gain. Can the partnership accept boot in the exchange equal to the dissident partner’s allocable share of the gain and then allocate 100% of that gain to the dissident partner under §704(b)? (No -- this will almost always violate the substantial economic effect rules.)

3 Distribution of Installment Note. Consider the use of a purchase money note rather than cash boot which will then be distributed to the dissident partner in liquidation of its partnership interest. For a discussion of this technique, see Egerton and Wiser, “Planning to Deal with the Recalcitrant Partner in a Code Sec. 1031 Exchange,” Vol. II, No. 2 Journal of Passthrough Entities at pp. 19-27 (April 1999).

4 Exchanges Involving Tenancies-in-Common.

1 In Revenue Procedure 2002-22, 2002-14 I.R.B. 733, the Service provided guidelines for issuing private letter rulings regarding tenancies-in-common. This revenue procedure has led to an increased use of tenancy-in-common exchange arrangements and to pre-packaged tenancy-in-common like-kind exchange vehicles as replacement property. The goal of these arrangements is to structure an ownership as a tenancy-in-common while still satisfying lender requirements for special purpose entities.

2 In a recent ruling, Revenue Ruling 2004-86, 2004-33 I.R.B. 1, the Service held that a Delaware statutory trust arrangement for property ownership may be treated as a disregarded entity and the owners of beneficial interests in the Delaware statutory trust will be treated as owners of undivided fractional interests in the real property owned by the trust. The ruling involves a very restrictive factual arrangement regarding the Delaware statutory trust involved which may limit the utility of this technique.

5 Lessons to Learn in Selecting a Qualified Intermediary. In this day and age, when it is not uncommon to find that a bank, savings and loan association, or insurance company has gone into bankruptcy or has been taken over by federal regulators, taxpayers and their advisors must be concerned that the obligation of the other party to the exchange (or, more commonly, the qualified intermediary) be secured by cash or cash equivalent held by in a qualified escrow or a qualified trust. Under the laws of most states, the mere existence of a qualified escrow or a qualified trust does not per se create a security interest in the monies held in escrow or in trust.

1 San Diego Realty Exchange, Inc. v. Vaca. In San Diego Realty Exchange, Inc. v. Vaca, 132 B.R. 424 (S.D. Cal. 1991), the debtor, which performed services as a qualified intermediary and a qualified escrow agent, entered into an exchange agreement with Vaca. The debtor received Vaca’s property, sold it to a third party, deposited the proceeds of sale in its general escrow account, and later purchased and deeded replacement property to Vaca pursuant to an Exchange Agreement. Unfortunately for Vaca, the acquisition and deeding of the replacement property occurred within 90 days of the filing of the debtor’s bankruptcy petition. The Bankruptcy Court refused to accept Vaca’s argument that the debtor held funds in a “constructive trust” for Vaca because the funds were co-mingled with the debtor’s other funds (and those of other exchange clients). Thus, the deeding of the replacement property to Vaca was held to be a preferential transfer. See, also, Nation-Wide Exchange Services, Inc., 291 B.R. 131; 91 A.F.T.R. 2d (March 31, 2003) to the same effect.

1 It is difficult, if not impossible, to create a perfected security interest in cash or its equivalent held by the escrow agent or trustee under the laws of most states short of taking actual possession of funds which, of course, would violate the deferred exchange safe harbor rules.

2 Some or all of the following measures should be considered in order to protect the taxpayer from this very significant exposure:

1 Investigate the financial status and reputation of the qualified intermediary or escrow agent (or trustee) thoroughly. Do not just select the lowest cost party -- this may cost you and your client in the end.

2 Always require that the funds from the sale of the relinquished property be segregated in a separate account (i.e., never allow these funds to be co-mingled with the funds of other parties with whom the qualified intermediary or escrow agent is performing services).

3 Consider using both a qualified intermediary and a separate qualified escrow or qualified trust. The funds from the disposition of the relinquished property may then be held by a substantial bank or trust company in a qualified escrow or qualified trust account. A separate unrelated party could then be selected to serve as a qualified intermediary. The qualified intermediary can be required to grant a security interest in its “beneficial interest” in the qualified escrow or qualified trust account to secure performance by it of its obligations under the qualified intermediary agreement.

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