Download ii. cost segregation and 1031 exchanges.

HOT TOPICS IN INCOME TAXATION
OF REAL ESTATE TRANSACTIONS
© 2005, Charles H. Egerton, Esq.
Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A.
Orlando, Florida
I.
SELECTED TECHNIQUES TO MAXIMIZE LONG TERM CAPITAL GAINS ON
SALES OF REAL ESTATE TO A RELATED DEVELOPER.
A.
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.
B.
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:
a.
The taxpayer’s lower cost basis carries over to the corporation.
b.
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.
c.
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,
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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.
4.
Adverse Factors. Factors which led to the adverse decisions noted in 2
above include:
a.
Inadequate or “thin” capitalization.
b.
Identity of interest between those who own stock and notes.
c.
Intention not to enforce the notes, such as failing to insist upon
payment of interest and principal payments when due.
d.
Notes subordinated to general creditors.
e.
Inflated price.
f.
No overriding business purpose.
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).
a.
The decision in Warren H. Brown provides helpful guidelines on
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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
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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.
a.
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.
b.
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).
c.
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).
d.
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).
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C.
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.
a.
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.
b.
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.
c.
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
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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.
a.
II.
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 nondepreciable property such as inventory or raw land that constitutes
a §1231 asset.
COST SEGREGATION AND 1031 EXCHANGES.
A.
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.
a.
The IRS has now acquiesced in Hospital Corporation of America.
AOD 1999-008 (8-30-99), amended, Announcement 99-116, 199952 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.
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b.
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.
c.
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.
a.
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
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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.”
(3)
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
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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.
b.
B.
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.
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.
2.
a.
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).
b.
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.
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
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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.
a.
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.
b.
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.
c.
Example: Taxpayer owns Property X, an unencumbered
commercial office building comprised of the following items:
Asset
Fair Market
Value
Adj. Basis
Land
$ 500,000
$100,000
Building
$1,000,000
$550,000
$100,000 (S/L)
§1245 Property $ 100,000
$ 50,000
$ 50,000
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Depreciation
Claimed
$0
Taxpayer exchanges Property X for unencumbered Property Y,
which consists of the following:
Asset
Fair Market
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.
d.
3.
If a taxpayer disposes of real property that is Ҥ1245 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.
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
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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.
C.
D.
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.
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.
a.
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-theshoes 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).
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2.
3.
b.
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).
c.
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).
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).
a.
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).)
b.
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.
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
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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.
III.
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.
A.
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.
a.
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.
b.
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).
c.
In defining “related parties,” §1031(f)(3) adopts the definitional
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rules contained in §267(b) and §707(b)(1), with minor exceptions.
d.
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).
(2)
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.
(3)
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
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§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?
a.
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. 200451, 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.”
b.
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.
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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
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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.”
(3)
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?
(4)
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.”
B.
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
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in the exchange, subject to limitations explained below.
a.
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.
b.
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).
c.
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.
d.
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
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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.
a.
b.
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. 4531(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).
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
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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.
a.
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.
b.
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
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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.
a.
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).
b.
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:
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“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.
c.
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. §1.7042(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
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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.
a.
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)
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FMV
$340x
Mortgage
$140x
b.
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.
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(3)
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).
c.
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.)
d.
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
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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.
C.
D.
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).
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-incommon. This revenue procedure has led to an increased use of tenancyin-common exchange arrangements and to pre-packaged tenancy-incommon like-kind exchange vehicles as replacement property. The goal
of these arrangements is to structure an ownership as a tenancy-incommon 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
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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.
E.
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 comingled 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.
a.
2.
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.
Some or all of the following measures should be considered in order to
protect the taxpayer from this very significant exposure:
a.
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.
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b.
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).
c.
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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