ESTATE PLANNING USING LIKE KIND EXCHANGES
© 2005, Charles H. Egerton, Esq.
Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A.
Orlando, Florida
I.
NEW LIFE AFTER DEATH: PLANNING TO ACHIEVE PERMANENT DEFERRAL
UNDER SECTIONS 1014 AND 1031.
A.
Facts. Lou, who is 80, a widower and has a history of heart problems, owns
Blackacre, which he acquired in 1975 for $500,000 to operate as a cattle ranch.
Due to the rapid growth of nearby Urbana City, the value of Blackacre has risen
dramatically in recent years. Lou has just received a cash offer of $10,000,000
from Trammell Crowbar, a local developer, which Lou believes is “top dollar” for
his property. Lou would like to accept the offer but his only child, Mary Greedy,
has urged him to hold on to Blackacre. Mary’s CPA has advised her that, if Lou
retains Blackacre until the time of his death, she will get a stepped up tax basis in
Blackacre under §1014 (provided that Lou cooperates and dies prior to January 1,
2010 when we shift from a step up in basis to a carryover basis), and she can then
sell it for its fair market value with no taxable long term capital gain. The CPA
also pointed out that there is no necessity to sell Blackacre at the present time
because Lou has ample liquidity in the form of an irrevocable life insurance trust
which will not be included in Lou’s gross estate for federal estate tax purposes,
but will hold sufficient liquid assets to cover any estate tax liability that he might
conceivably have.
B.
Use of Section 1031 to Effect a Sale and Permanently Avoid Taxable Gains. Lou
firmly believes that Trammell Crowbar’s offer presents a unique opportunity that
may not present itself again any time in the near future. Accordingly, he
consulted his long time tax adviser who suggested that there is perhaps a way for
Lou and Mary to have their cake and eat it too. He suggested that Lou could
accept Trammell Crowbar’s offer but structure the sale as a deferred §1031
exchange. Lou, who is a savvy real estate investor, has had his eye on a number
of properties within a 20-mile radius of Urbana City with excellent upside
potential and which have an aggregate value exceeding $10,000,000. The tax
adviser outlined his plan as follows:
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1.
Lou would insist upon the inclusion of a §1031 cooperation clause in the
contract to sell Blackacre to Trammell Crowbar under which Crowbar
would agree to cooperate with Lou in structuring the sale as a §1031
exchange using a qualified intermediary.
2.
Upon closing of the sale of Blackacre, the proceeds would be paid into a
qualified escrow account administered by the qualified intermediary. Lou
would then identify parcels that he has researched with an aggregate fair
market value of approximately $15,000,000 within 45 days of the closing,
and would then get at least $10,000,000 of these properties under contract
and close upon them within the time period specified in §1031(a)(3).
3.
C.
If Lou succeeds in reinvesting the entire proceeds in qualified replacement
properties in a manner that complies with §1031(a)(3), he will have
accomplished the following:
a.
The $9,500,000 realized gain on the disposition of Blackacre will
be deferred under §1031(a). Lou’s tax basis in the replacement
properties will be determined under §1031(d) and will be reduced
by the $9,500,000 realized gain that was deferred under §1031(a).
b.
The acquisition of multiple replacement properties will diversify
Lou’s real estate holdings.
c.
If Lou retains the replacement properties until his death (and
assuming that he dies on or before December 31, 2009), Mary will
still get a stepped up basis in all of the replacement properties
under §1014, thereby converting the deferral of gain achieved
under §1031(a) into a permanent avoidance of gain.
Planning to Use Both Rolling Options and Section 1031 Exchanges for the
Disposition of Property which will be Developed in Multiple Phases. Assume the
same facts as set forth in Parts I.A. and B. above except that Trammell Crowbar
desires to acquire Blackacre in a series of four “rolling options.” Under this
approach, Blackacre will be divided into four separate parcels which will be
designated as Option Parcels 1 through 4. Crowbar will initially pay Lou
$250,000 as consideration for an option to purchase Option Parcel 1 for a total
purchase price of $3,000,000, which option will remain open for a period of 18
months. The 18-month period is designed to enable Crowbar to pursue and obtain
all necessary entitlements (i.e., zoning, permits and approvals from all
governmental and quasi-governmental authorities) necessary to develop
Blackacre into a full scale mixed use community with single-family lots, multifamily parcels and some commercial development. If the option is exercised, the
$250,000 option monies will be applied against the purchase price for Option
Parcel 1. If the option lapses, the monies will be forfeited and the options with
respect to Option Parcels 2 through 4 will terminate. The purchase prices for
Option Parcels 2 through 4 will also be agreed upon in advance as well as the time
and sequence in which such options will be exercisable. The prices will be
negotiated and will take into account the fact that Lou must hold these properties
off the market during the applicable option periods; that Lou will be bearing the
risk that Trammell Crowbar will not exercise all of his options; and that the
properties will likely appreciate in value both because of normal inflation and due
to development of the contiguous properties by Crowbar. The full purchase price
for each Option Parcel will be payable at closing. At Lou’s insistence, Trammell
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Crowbar has also agreed that he will cooperate to structure the sale of each Option
Parcel as a like kind exchange if requested by Lou to do so.
1.
Putting aside the like kind exchange aspects of the transaction for the
moment, what are the income tax consequences to Lou arising from
structuring the transaction as a rolling option?
a.
Despite the fact that Lou will have unrestricted use of the $500,000
of option monies from the point in time that he receives this
payment, he will not be taxed on this money until the option to
acquire Option Parcel 1 is either exercised or lapses. See, Virginia
Iron, Coal & Coke Co. v. Commissioner, 37 BTA 195 (1938),
aff’d., 99 F.2d 919 (4th Cir. 1938), cert. denied, 307 U.S. 630;
Kitchin v. Commissioner, 340 F.2d 895 (4th Cir. 1965); Koch v.
Commissioner, 67 T.C. 71 (1976); Hicks v. Commissioner, 37
T.C.M. 1540 (1978); and Old Harbor Native Corporation v.
Commissioner, 104 P.C. 191 (1995). The rationale for not taxing
these option monies is that the taxability of the payments cannot be
determined until the option either lapses or is exercised.
i.
If an option is exercised and the option monies are applied
against the purchase price, the monies will be treated as
having been received in a sale or exchange of the option
properties. §1234(a)(1); Reg. §1.1234-1(a). Even if the
option monies are not applied against the purchase price,
the Tax Court in Koch v. Commissioner, supra held that the
same rule applies.
ii.
If the option lapses, the option monies must be reported by
Lou in the taxable year in which the lapse occurs. Prior to
September 4, 1997, such amounts were treated as ordinary
income. Reg. §1.1234-1(b); Rev. Rul. 57-40, 1957-1 C.B.
266. However, §1234A, which was added to the Code by
the Taxpayer Relief Act of 1997 (“TRA ‘97”), now
provides that any gain arising from a lapse or other
termination of a “right” with respect to property which is a
capital asset in the hands of the taxpayer will be treated as
gain from the sale of a capital asset. An option may be
treated as a “right” with respect to property. However, the
Conference Committee Report under TRA ’97 indicates
that gains from the lapse of an option will be treated as
arising from the sale or exchange of the property subject to
the option “to the extent provided in Treasury regulations”
issued under §1234A. Conf Com Rpt 521. Thus, sale or
exchange treatment will be accorded to gains derived from
the lapse of an option only if and to the extent provided in
regulations to be promulgated by the Secretary, which to
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date have not been issued. Therefore, the treatment of
gains from the lapse of an option with respect to real
property will presumably continue to result in ordinary
income unless and until regulations providing to the
contrary are issued.
b.
2.
One of the primary issues that arises in the context of a rolling
option is whether the structure of the transaction should be
respected as an option (entitled to the treatment described in Part
I.C.1.a. above), or whether it is really a disguised installment sale
subject to the provisions of §453. Classification of the transaction
as an installment sale has a number of adverse consequences,
including the imputation of interest under the OID rules of §§1272
through 1275, the acceleration of depreciation recapture under
§453(i) and the possible imposition of an “interest toll charge”
under §453A. It would also make it very difficult to structure the
transaction as a like kind exchange.
i.
It is clear that the mere grant of an option is not a sale or
other disposition of the underlying property pursuant to
§1001 (and, therefore, could not be an installment sale
under §453). San Joaquin Fruit and Investment Co., 197
U.S. 496 (1936); Rev. Rul. 78-182, 1978-1 C.B. 265; and
Rev. Rul. 84-121, 1984-2 C.B. 168).
ii.
The proper analysis seeks to determine if the benefits and
burdens of ownership of the property have effectively
shifted from the optionor (Lou) to the optionee (Trammell
Crowbar).
If the transaction is respected as a rolling option for tax purposes, Lou can
decide whether or not to structure the sale of each Option Parcel as a like
kind exchange when each option is exercised and is about to close. Lou’s
contractual rights as the optionor-seller with respect to each Option Parcel
can be assigned to a qualified intermediary pursuant to an exchange
agreement in the same manner as described in Part I.B. above.
a.
If Lou elects to treat the sale of an Option Parcel as a like kind
exchange under §1031, what are the tax consequences associated
with the prior receipt of the option payment by Lou? Clearly, if
Lou retains the option monies, this will treated as “boot” under
§1031(b) and a portion of Lou’s realized gain will have to be
recognized for tax purposes. On the other hand, in PLR 7952086,
an optionor taxpayer who structured the sale of an option parcel as
a like kind exchange was not required to report any gain
recognition when he paid the entire amount of the option payments
previously received by him into the qualified escrow account at the
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time of closing. If PLR 7952086 represents a proper analysis of
applicable law, Lou may transfer the full amount of the option
monies received from Trammell Crowbar to the qualified
intermediary at the time of closing and, assuming that he had not
received any other boot in the exchange, the entire amount of his
gain on Option Parcel 1 could be deferred.
3.
What are the estate planning advantages to Lou from the use of a
combination of a rolling option and like kind exchanges?
a.
D.
Just as noted in Part I.B. above, Lou will achieve a diversification
of his real estate investments and Lou’s daughter, Mary Greedy,
will obtain a full step up in basis at the time of Lou’s death (if he
dies prior to 2010). Compare the results of a rolling option/like
kind exchange format with an outright sale of Blackacre for (for
example) 25% down with a balance represented by a long-term
secured purchase money note and mortgage.
i.
From an income tax standpoint, the disadvantages of an
installment sale versus a rolling option are the ordinary
income component attributable either to stated interest or
(if stated interest is not sufficient) the imputation of interest
under the OID rules of §§1272-1275; the interest toll
charge imposed under §453A with respect to the deferred
tax liability inherent in purchase money notes in excess of
$5,000,000; and special acceleration and character
changing rules of §§453(e), (g) and (i).
ii.
In addition, the installment note, if still held by Lou at the
time of his death, will be treated as “income in respect of a
decedent” (“IRD”) under §691. As such, Mary Greedy
would not be entitled to a step up in basis under §1014(c).
iii.
By contrast, if the rolling option structure is respected for
federal income purposes, the ordinary income component
attributable to stated interest or OID will be completely
eliminated; any unexercised options will not be treated as
IRD; and Mary Greedy will still be entitled to a full step up
in basis under §1014.
Planning to Use Section 1031 to Convert Non-Income Producing Real Estate into
Income Producing Property to Meet the Needs of Aging Clients. Assume the
same facts as set forth in Parts I.A. and B. above but, in addition, assume that
Blackacre is non-income producing property. Lou, who is “land rich but cash
poor,” would like to accept Trammell Crowbar’s offer and invest some or all of
the proceeds in income producing assets in order to fund his newly acquired
lavish lifestyle. Lou’s tax advisor points out that if Lou structures the disposition
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of Blackacre to Trammell Crowbar as a deferred like kind exchange, he could
carefully select high quality commercial and residential rental properties that will
provide him with more than enough income to satisfy even his extravagant tastes.
Furthermore, if Lou retains the properties until the time of his death (and
assuming that he dies on or before December 31, 2009), he can also have the
satisfaction of knowing that Mary will still obtain a stepped up basis in the
replacement properties owned by him at death. Thus, the use of a tax free
exchange cannot only achieve a permanent deferral of taxable gain but can also
solve Lou’s immediate needs for additional income by converting an investment
in non-income producing real estate into high grade investment properties which
generate significant cash flows.
II.
ANALYZING THE IMPACT OF PRE-EXCHANGE AND POST-EXCHANGE
TRANSFERS OF PROPERTIES FOR ESTATE PLANNING PURPOSES.
A.
Gifts of Replacement Property Received in Like Kind Exchange. Assume that the
exchange of Blackacre by Lou which is described in Part I.B. above has been
completed. Two months after the closing on the acquisition of the replacement
properties, and acting on the advice of his estate planning advisors, Lou transfers
an undivided 25% interest in two of the replacement properties received by him in
the exchange to Mary. Lou hopes to shelter a portion of the value of the interest
from federal gift taxes by claiming a discount for an undivided interest in the
property. He also expects the property to appreciate significantly in the future
and, by making a gift of a partial interest in the property to Mary now, the future
appreciation attributable to her 25% interest will effectively be removed from his
estate. Although the gift of an undivided 25% interest to Mary may have
significant advantages from the estate planning standpoint, what impact (if any)
will these transfers have upon the prior exchange?
1.
The issue which arises when replacement properties received in a §1031
exchange are gifted shortly after they are received in the exchange is
whether such replacement properties were “held” by the taxpayer for
investment purposes or for productive use in a trade or business.
a.
The Tax Court in Wagenson v. Commissioner, 75 T.C. 653 (1980)
held that an exchange followed by a gift of the replacement
property within nine months of the exchange did not violate the
“holding” requirement of §1031(a)(1). The Tax Court found that
the taxpayer had held the property for productive use in a trade or
business during the nine months following the exchange and also
noted that the property continued to be used in the same trade or
business after the gift because it was used by the father and his son
in partnership while continuing to conduct the same business that
the father was engaged in prior to the exchange.
b.
However, in Click v. Commissioner, 78 T.C. 223 (1982), the Tax
Court struck down a purported §1031 exchange because it found
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that the taxpayer had intended as of the time of the exchange to
give away the replacement property and, in fact, did so within 7
months thereafter. The Court took special notice of the fact that,
during the 7-month period in which the taxpayer continued to hold
the replacement property after the exchange, the taxpayer’s
children lived in the properties and even made improvements to
them. Thus, the Tax Court in Click ruled that the taxpayer had
acquired the property for transfer (and not for productive use in a
trade or business or for investment).
2.
B.
Assume that Lou had no intention of gifting the replacement property to
Mary at the time he received the replacement property. Two years later
Lou made a gift of the property to Mary. Can Mary immediately
thereafter transfer the property to a third party in connection with a taxfree exchange? The Service has ruled that a donee cannot take advantage
of her donor’s attributes. Rev. Rul. 77-337, 1977-2 C.B. 305; Rev. Rul.
75-292, 1975-2 C.B. 333. Thus, Mary must hold the property for a
sufficient period of time to demonstrate that she has used the property for
either investment or for productive use in a trade or business before she
can dispose of it in a qualifying §1031 exchange.
Transfers of Replacement Properties to Family Limited Partnership. Assume that
instead of gifting properties to Mary, Lou transfers part or all of the replacement
properties to a family limited partnership within two months of the time that they
are received as replacement properties in an exchange. Shortly after the
partnership is formed, Lou then transfers limited partner interests to Mary.
1.
The Service has taken the position that if property received in an exchange
which would otherwise be treated as qualified replacement property in an
exchange is promptly disposed of in a non-recognition transaction, such
property will not be eligible for §1031 treatment because it was not “held”
for the required purposes. See, e.g., Rev. Rul. 75-292, 1975-2 C.B. 333
(property received in a purported §1031 exchange immediately transferred
to a controlled corporation under §351 declared ineligible for §1031 nonrecognition treatment). However, the Service has, on at least two
occasions, issued rulings approving prearranged transfers of replacement
properties. See, PLR 8126070 (receipt of replacement property in a §1031
exchange by a trust that is required to promptly distribute such properties),
and TAM 9252001 (disposition of replacement property in the context of a
tax-free reorganization of related corporations).
2.
Despite the Service’s position that a post-exchange disposition of
replacement properties shortly after an exchange in a non-recognition
transaction (such as a transfer to a controlled corporation or a transfer to a
partnership) violates the “holding” requirement of §1031(a)(1), the courts
have been decidedly more lenient to taxpayers in these situations.
Compare, Magneson v. Commissioner, 81 T.C. 767 (1983), aff’d, 753 F.2d
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1490 (9th Cir. 1985); Bolker v. Commissioner, 81 T.C. 782 (1983), aff’d,
760 F.2d 1039 (9th Cir. 1985); Mason v. Commissioner, 55 T.C.M. 1134
(1988) and Maloney v. Commissioner, 93 T.C. 89 (1989) (all of which
cases held for the taxpayer), with Chase v. Commissioner, 92 T.C. 874
(1989) (which involved a case in which the taxpayer did everything wrong
resulting in a win for the Service).
3.
C.
D.
What impact (if any) will Lou’s transfer of limited partner interests to
Mary shortly after the formation of the partnership have upon the
qualification of the earlier exchange for nonrecognition treatment under
§1031?
How Long is Long Enough? Lou is a very conservative taxpayer and does not
wish to assume the risk the Service might disqualify an exchange as a result of
any post-exchange transfers, whether by a direct gift to Mary or by transfer to a
family partnership. Consequently, Lou raises the age old question to his tax
advisors of “how long must I hold the replacement property before I can dispose
of it?”
1.
The focus of any determination of whether Lou has met the requisite
holding purpose with respect to replacement property is whether, at the
time of the exchange, he intended to hold the replacement property either
for investment or for investment purposes. Thus, if Lou had a qualifying
intent with respect to the replacement property at the time of the exchange,
and that intent changed thereafter for unanticipated reasons, Lou should
prevail. However, this necessarily involves a facts and circumstances
analysis and the closer in time to the original closing on the replacement
property that a subsequent disposition occurs, the greater the burden on
Lou to prove his required intent at the time of the exchange.
2.
There is no magic number or bright line holding period that will assure
compliance with the holding requirements.
Death of Exchangor. Assume the same facts as set forth in Part I.A. and B. but
that Lou dies two days after he received the last qualifying replacement property.
Will Lou’s death so close in time to his receipt of the replacement properties
preclude him from having the requisite intent to hold the property either for
investment or for productive use in a trade or business? In PLR 8126070, the
Service ruled that replacement property received by a trust that shortly thereafter
distributed such property to its beneficiaries in accordance with the terms of the
trust agreement did not, in and of itself, violate the holding requirements. See,
also, §2032A(e)(14) which causes a decedent’s holding purposes with respect to
qualified real properties to be attributed to his heirs for purposes of §1031.
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III.
USE OF SECTION 1031 EXCHANGES TO FACILITATE POST-MORTEM TAX
PLANNING.
A.
Post-Mortem Elections. Although the focus of most estate planning is to reduce
wealth transfer taxes on a client’s assets, it is rarely possible to completely
eliminate these taxes on large sized estates. There are several provisions of the
Code which either limit the values of certain assets or permit deferrals for the
payment of federal estate taxes attributable to such assets if the estate can meet
very specific requirements. The most significant of these provisions relating to
real estate are §§2032A and 6166.
1.
2.
Section 2032A provides an exception from the general rule that property
must be valued at its highest and best use for federal estate tax purposes.
In the case of certain farm land and other real property used in a closely
held trade or business, an estate can elect to determine the fair market
value of such property as if the highest and best use of the property is for
farming or for business purposes (whichever is applicable), subject to
certain limitations. There are a number of requirements that must be met
in order for an estate to be eligible for an election under §2032A, the most
significant of which are:
a.
50% or more of the “adjusted value” of the decedent’s gross estate
must consist of the “adjusted value” of real or personal property
that, at the time of death, is being used for a qualified use (i.e.,
farming or business);
b.
25% or more of the adjusted value of the gross estate must consist
of the adjusted value of qualified use real property; and
c.
such qualified use real property must have been owned and used
by the decedent or members of his family for a qualified use, and
the decedent or a member of his family must have materially
participated in the operation of the farm or business, for an
aggregate of 5 years or more during the 8-year period prior to
death.
Section 6166 enables an estate to pay the federal estate taxes attributable
to certain closely held business interests (regardless of whether owned by
the decedent as a sole proprietor, in a partnership or in a corporation) in up
to 10 annual installments, with a rate of interest essentially equal to 45%
of the applicable underpayment rate under §6621. In addition, the
commencement date for such payments can be deferred for up to 5 years.
The most significant requirements are that the value of the closely held
business interest must exceed 35% of the adjusted gross estate, and the
IRS has also issued interpretative guidance that requires the decedent to
have materially and actively participated in such business.
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B.
Planning to Use Section 1031 Exchanges to Help Qualify for Post-Mortem
Elections and to Provide Flexibility after Such Elections are Made.
1.
Assume that Louie owns 400 acres of real property (“Ranchland”) which
he acquired in 1975 for $100,000 and which has a present fair market
value of $1,000,000. Ranchland has been used by Louie to conduct his
ranching business since it was acquired. Louie also owns tractors,
equipment, livestock, feed and supplies with an aggregate value of
$500,000. Louie has also leased an additional 800 acres of contiguous
property for the past 10 years which he operates as part of his ranch
(“Lease Parcel”), and he has an option to purchase Lease Parcel for
$2,000,000. Louie operates the ranch as a sole proprietorship, but his 2
sons, Hewey and Dewey, work for him as employees and will inherit
Ranchland and the related assets at his death (Louie is a widower). Louie
has an estate of approximately $6,000,000, including Whiteacre which
Louie has held for investment purposes for 10 years and which has a
present fair market value of $2,000,000 and tax basis of $500,000.
Louie’s estate planning advisor has recommended that he dispose of
Whiteacre in a §1031 exchange with a qualified intermediary and use the
proceeds to acquire the Lease Parcel. This will enable Louie to acquire
the Lease Parcel with before-tax dollars and still enable Hewey and
Dewey to obtain the benefit of a step up in basis in both Ranchland and
Lease Parcel after Louie’s death. In addition, the estate planning advisor
points out that the exchange may also facilitate post-mortem planning for
Louie’s estate as described below.
2.
a.
Prior to the exchange, if Louie died unexpectedly his estate would
not qualify for any of the post-mortem elections described in Part
III.A. above because the value of the ranch assets represent only
25% of Louie’s estate.
b.
The acquisition of Lease Parcel will increase the value of Louie’s
ranch assets to approximately $3,500,000, or slightly in excess of
58% of Louie’s gross estate. If Louie died shortly after the
exchange, his estate would be in position to make an election under
§6166 to defer a portion of the estate taxes attributable to the ranch
assets because the value of the ranch assets would exceed 35% of
Louie’s adjusted gross estate. See §6166(a). In addition, if Louie
survives for at least 5 years after the exchange, and if he continues
to own, operate and materially participate in the ranch business
(which includes both Ranchland and Lease Parcel), his estate will
also be in a position to avail itself of the §2032A election as well.
If Louie’s estate is eligible to, and elects to claim the benefit of, §2032A,
additional possibilities are opened for the use of §1031 exchanges.
Section 2032A(e)(14) will enable Louie to make further §1031 exchanges
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during his lifetime with respect to Ranchland and Lease Parcel (or any
portion thereof) for other qualified properties to be used in the ranching
business prior to death without jeopardizing his estate’s opportunity to
claim the benefits of §2032A. In addition, §2032A(i) will also enable the
estate to make post-mortem §1031 exchanges without triggering additional
estate tax penalties under §2032A(c).
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