7th Annual Education Conference
Dallas CPA Society
“Like Kind Exchanges in a Recovering
Economy: Update, Planning & Possibilities”
May 26, 2011
Carla Janousek
Republic Title
Dallas, Texas
cjanousek@republictitle.com
214-855-8888
Todd D. Keator
Thompson & Knight LLP
Dallas, Texas
todd.keator@tklaw.com
214-969-1797
Agenda
• Current Events
• QI Regulation
• Distressed Market Issues
2
Goolsby v. Commissioner,
TC Memo 2010-64
Buyer
Rent
House
$188,000
Rent House (investment)
TP
QI
Georgia House and 4-plex
Georgia
4-plex
(investment)
Georgia House
(T or B or
investment?)
$136,000
Seller 1
$47,000
Seller 2
3
Goolsby v. Comm’r, Cont’d
• Factors indicating that TP lacked the requisite investment intent:
– TP’s rental efforts were trivial (brief ads in local newspaper)
– TP moved into Georgia house 2 months after closing
– Purchase of Georgia house contingent on sale of TP’s primary
residence in California
– TP’s conversations with QI contemplated use as personal residence
– TP began finishing out the basement immediately after acquisition
• Accuracy-related penalty imposed
4
Goolsby v. Comm’r, Cont’d
• Notes Re. Goolsby
– Unclear whether the IRS obtained information
about TP’s conversations with the QI from the
TP or the QI. TP was pro se and likely
revealed this information unwittingly.
– Discussions with a QI are not privileged.
– Exchange of the 4-plex qualified, despite TP’s
attempt to exchange the Georgia house.
5
Rev. Proc. 2010-14
• Background:
– Precipitated primarily by LandAmerica bankruptcy (among others)
– 97% of LandAmerica creditors approved bankruptcy plan in late 2009
– REIT with a QE received 98% recovery outside of bankruptcy
– After the REIT, $110 million available for 450 exchangers as follows:
• 50 in segregated accounts – 70% recovery
• 400 in commingled account – 25% recovery
– Additional recovery possible from auction-rate securities litigation
• Personal residence exchange pandemic?
6
Rev. Proc. 2010-14, Cont’d
• Applies to TP who:
– Properly transferred relinquished property (RLP) to QI;
– Properly identified replacement property (RPP) within the
identification period (unless the QI default occurred during such
period),
– Did not complete the 1031 exchange solely because of a QI
default involving a QI that becomes subject to bankruptcy or
receivership, and
– Did not, without regard to actual or constructive receipt by the QI,
have actual or constructive receipt of the proceeds from the
disposition of the RLP, or any other property of the QI, prior to
the time of the QI bankruptcy or receivership. For this purpose,
liability relief is disregarded.
7
Rev. Proc. 2010-14, Cont’d
•
TP must recognize gain from disposition of the RLP only as required under
the safe harbor “gross profit ratio method.”
•
TP reports gain only as payments are received (like installment method).
•
Formula: Gain Recognized = Payment x (Gross Profit ÷ Contract Price).
Complex series of defined terms drive the calculations.
•
Special rules for debt. Generally, debt in excess of basis is a deemed
payment.
•
Loss deduction allowed for actual losses and gain incorrectly recognized in
a prior year.
•
Imputed interest rules apply.
•
1/1/2009 effective date.
8
Example 1 – No debt
• TP attempts to exchange Blackacre ($150 FMV; $50 AB) using a QI.
QI holds $150 of exchange proceeds for TP in year 1.
• QI files for bankruptcy while TP’s exchange is pending.
• In year 2, bankruptcy court approves $130 distribution to TP to
satisfy all claims. So, TP’s overall gain should be $80 ($130 - $50).
• No gain recognized in year 1 (because no payment in year 1)
• Gross profit ratio = 80/130.
• Gain recognized in year 2 = $80. [$130 x (80/130)].
• No loss allowed because payments exceed basis.
9
Example 2 –
Debt Less Than Basis
• TP attempts to exchange Blackacre ($160 FMV; $90 AB; $60 debt)
using a QI. After satisfying the debt, QI holds $100 of exchange
proceeds for TP in year 1.
• QI files for bankruptcy while TP’s exchange is pending.
• In year 2, bankruptcy court approves $70 distribution to TP to satisfy
all claims, payable $35 in year 2 and $35 in year 3. TP’s overall
gain should be $40 ($130 - $90).
• No gain recognized in year 1 (because no payment in year 1).
• Gross profit ratio = 40/70.
• Gain recognized in year 2 and 3 = $20 per year. [$35 x (40/70)].
• No loss allowed because payments exceed basis.
10
Example 3 –
Debt Exceeds Basis
• Facts are the same as last example, except TP’s AB is $40 (instead
of $90). TP’s overall gain should be $90 ($130 - $40).
• Now TP deemed to have received a payment of $20 in year 1 (to the
extent of debt ($60) in excess of basis ($40)).
• Gross profit ratio = 120/120.
• Gain recognized in year 1 = $20. [$20 x (120/120)].
• Gain recognized in year 2 and 3 = $35 per year. [$35 x (120/120)].
• No loss allowed because payments exceed basis.
11
Questions Re. Rev. Proc. 2010-14
•
“QI default” is narrowly defined as bankruptcy or receivership.
What else could have been included? Theft? Bad investment?
Dissolution? IRS appears to be seeking comments on these
other types of default.
•
Failure to complete the like kind exchange must be due “solely” to
QI default.
–
Does this mean TP must have previously identified RPP having a
value at least equal to the value of the RLP?
–
What if a combination of events prevents the 1031 exchange? For
example, assume QI enters bankruptcy on day 46 of TP’s exchange,
emerges on day 120 with 100% of TP’s exchange proceeds, but TP
has missed the deadline to close on RPP due to contractual language
in the PSA, and TP has not identified any alternative properties. Is
the failed 1031 “solely” due to QI default?
12
Questions Re. Rev. Proc. 2010-14
•
What does it mean for the QI to become “subject to” a bankruptcy
or receivership proceeding? Does this include involvement as a
creditor? For example, if the QI secures the exchange funds via a
qualified escrow or trust, and the escrow holder or trustee enters
bankruptcy, and the QI cannot access the TP’s exchange funds
as a result, is the TP within the scope of the Revenue Procedure?
•
The Revenue Procedure is only a safe harbor. What other relief
is available? Can a TP change QIs midstream?
•
What if the TP never receives any payments. Can the safe harbor
still apply?
•
Safe harbor does not apply if TP has actual or constructive receipt
of the exchange proceeds “or any property of the QI.” Does this
preclude use of QI notes?
13
PLR 201024036
Step (2) Parent
exchanges NOx Credits
for VOCs Credits
Parent
Step (1) Sub
distributes NOx
Credits to Parent
Third Party
VOCs
Subsidiary
NOx
PLR 201024036
• Rev. Proc. 92-91: Emission allowances are treated as
“like kind” under 1031.
• NOx and VOCs treated as government licences or
permits and intangible property for federal tax purposes.
• IRS ruled “nature and character” of the rights were the
same because issued by same authority as part of same
program to control air pollution (ozone) in same region.
Also could be used interchangeably. Any differences
relate only to grade or quality, not nature or character.
• Accordingly, NOx and VOCs credits were of “like kind.”
• Parent considered to have, prior to the exchange, held
the NOx credits for productive use in a trade or business.
PLR 201030020
• Bank requested ruling that it could serve
both as QI and as trustee of a qualified
trust in a single transaction.
• IRS ruled that it could.
• Query: Can a QI now hold a Taxpayer’s
funds in a basic “trustee” capacity without
imposing a formal “qualified trust”
wrapper? See Treas. Reg. Sec.
1.1031(k)-1(k)(3).
PMTA 2010-05
• Facts: Tenants-in-Common (TICs) co-owned
distressed real estate; sponsor entered
bankruptcy; lender threatening to foreclose.
TICs jointly took the following actions:
• 1.) Pooled funds on a non-pro rata basis to pay
attorneys fees and costs relating to bankruptcy
and to pay debt service;
• 2.) Appointed one of the TICs as “payment
agent” and “communications agent” to interact
between the TICs and third parties.
PMTA 2010-05
• Issue: Whether the TIC actions caused
them to lose their status as TICs and
become partners in a de facto partnership.
• Ruling: No. IRS reasoned that the TIC
actions were prompted by the sponsor’s
bankruptcy, were necessary to protect the
property, and did not cause the TICs to
become partners.
Related Party Cases and Rulings Background
•
Section 1031(f)(1) applies to indirect transfers by related persons through
intermediaries. Example from Rev. Rul. 2002-83:
A
(Office: $150 FMV; $50 AB)
B
4
(Apartments: $150 FMV; $150 AB)
3
1
Office
C
2
QI
$150 Cash
– IRS ruled that A used QI to circumvent Section 1031(f)(1). Under
Section 1031(f)(4), the transaction was recharacterized as a direct
exchange of property between A and B, followed by a sale by B to C.
Thus related persons cannot use a QI to escape Section 1031(f).
Ocmulgee Fields, Inc. v. Comm’r, 613 F.3d 1360 (11th Cir. 2010)
Taxpayer (Corporation)
(Wesleyan Station: $6.8m; $700k AB; $6.1m BIG)
Related Party (Partnership)
4
(Barnes & Noble Corner:
$6.7m; $2.5m AB; $4.2m BIG )
3
1
W.S.
3P
2
QI
$6.8m (net after expenses)
– Related Party was a partnership, so BIG was subject to tax at
15% ($600,000); Taxpayer was a corporation, and BIG was
subject to tax at 34% ($2m).
– Had TP sold W.S. directly, gain = $6.1m; but if TP and RP
exchange, and RP sells W.S. to 3P, gain = $4.2m ($1.9m less
gain, and $1.4m less tax).
Ocmulgee Fields, Inc. v. Comm’r, 613 F.3d 1360 (11th Cir. 2010)
• Under 1031(f)(4), Court recast as direct exchange
between Taxpayer and Related Party, followed by sale
of Wesleyan Station by Related Party to the third party.
The Court then tested 1031(a)(2)(C) exception and
found that, due to basis shifting, transaction had principal
purpose of tax avoidance.
• Factors: (1) Parties cashed in on the low-basis property,
but paid tax only on the gains from the sale of the highbasis property; (2) Related Party’s partners paid tax at
only 15%; (3) one partner in related party fully-offset his
share of the gain with a charitable deduction; and TP
selected Barnes & Noble Corner just 6 days after
engaging the QI.
• Notably, Court hinted that lack of basis-shifting could
save a transaction under a similar fact pattern.
PLR 201027036
Relinquished
Equipment
Related Party
Buyers
$100x
Taxpayer
QI
$100x
Equipment
Replacement
Equipment
Unrelated
Seller
PLR 201027036
• IRS ruled 1031(f)(1) not applicable
because Taxpayer exchanged with QI.
• 1031(f)(4) also not applicable because
Taxpayer and Related Parties did not
exchange properties. Reason: Related
Party did not own any property Taxpayer
acquired in the exchange.
• [Contrast acquisitions of replacement
property from a related party.]
PLR 201048025 –
“Serial Exchanges”
Related
Party
TP
RLP3/
RPP2
RLP2/
RPP1
Third
Party
Affiliate
RPP3
$100x
RLP1
QI
RLP1
$100x
Buyer
$100x
QI
$100x
QI
PLR 201048025
• IRS upheld Taxpayer’s exchange provided all parties
remained invested in replacement properties for at least
2 years.
• IRS ruled transactions were valid 1031 exchanges
because related parties did not cash out and remained
invested in like kind property.
• IRS relied on exception in IRC Sec. 1031(f)(2)(C)
allowing subsequent dispositions that do not have a tax
avoidance purpose. Legislative history makes clear that
the non-tax avoidance exception includes subsequent
dispositions in nonrecognition transactions.
• De minimis boot allowed.
PLR 201048025
• Observations:
– Parties allowed 3x 180 exchange periods
(540 days total). Equates to 405 day ID
period (180 + 180 + 45).
– Ruling states that Taxpayer and Affiliate could
be the same party. Thus, Related Party’s
subsequent exchange could be back to the
Taxpayer!
– Potential to extend time limits indefinitely.
Morton v. U.S., 107 AFTR 2d 2011-XXXX
• TP exchanges aircraft 1 for aircraft 2 using a QI.
• At closing, escrow agent accidentally transferred the
sales proceeds to TP’s account instead of QI’s account.
TP returned the funds the next day.
• IRS argued constructive receipt and busted 1031.
• Court held for TP: “We disagree that an accidental
transfer followed by an immediate return of funds would
constitute actual or constructive receipt.”
• The Court also found that the Exchange Agreement
contractually obligated TP not to “receive, pledge,
borrow or otherwise obtain the benefits of the Exchange
Value,” and, therefore, TP was contractually bound to
return the exchange funds, which he did. Court was
unwilling to hold TP responsible for the “mistaken actions
of a third party.”
QI Regulation
• The Situation:
– Significant QI defaults (LandAmerica, 1031
Tax Group, Southwest, Summit, Vesta, etc.)
– Taxpayers losing money in Bankruptcy Court
(See LandAmerica).
– QI integrity suffers.
– Congress starts to look at 1033 rollover
mechanism as an alternative to 1031.
QI Regulation
• Current Regulatory Environment:
– State level only; no federal regulation.
– Regulating states: California, Colorado,
Idaho, Maine, Nevada, Virginia, Washington.
– Federation of Exchange Accommodators
worked to obtain model state-level QI
regulation resulting in laws in 6 of these 7
states.
• Advisors must recommend certified QIs!
Distressed Markets – Oil & Gas is
Hot
• Reduced volume of real estate exchanges,
but increased activity with oil & gas!
• 1031 Issues Re. Oil & Gas Interests
– Qualifying Interests
– Recapture
– Sale vs. Lease
– Tax Partnerships
Qualifying Interests
•
•
•
•
•
Fee Interest in Minerals
Working Interest
Royalty (including overriding royalties)
Net Profits Interest
Not Production Payments
Recapture
• Recapture generally rolls over in 1031
• Exceptions:
– Section 1254 property for non-section 1254 property
(and vice versa)
– Developed property for undeveloped property? See
Treas. Reg. Sec. 1.1254-1(b)(2)(iv)(1) (defining
“natural resource recapture property” in part as
property if “the property is an operating mineral
interest with respect to which the expenditure [i.e.,
IDC] has been deducted.” (emphasis added).
Sale vs. Lease
• Big, big issue.
• 1031 requires a sale, not a lease. Pembroke v. Helvering, 70 F.2d
850 (D.C. Cir. 1934); Crooks v. Comm’r, 92 T.C. 816 (1989).
• Trap: Retained royalty converts a “sale” into a lease for federal tax
purposes.
• Example: X, the owner of a working interest, “sells” the working
interest to B in return for $100 cash and retains a 3% overriding
royalty. The transaction is a sublease for federal income tax
purposes, rather than a sale. 1031 cannot apply.
• Alternatively, suppose X, the owner of the working interest, “sells”
90% of the working interest to Y and retains 10% of the working
interest. X has sold (rather than leased) the 90% interest because X
retains no continuing non-operating interest in the property sold.
Sale vs. Lease
• Potential Solutions:
– Retain part of working interest, not a royalty (a
different business deal).
– Carve-off royalty to separate taxpayer prior to
negotiations with buyer (requires non-tax business
purpose to avoid step transaction challenge).
• Typical business purposes: minimize state tax (e.g., TX
margin tax); ability to issue profits interests tied solely to
royalties; ability to raise money from tax-exempt investors;
isolate liabilities.
– For producing properties, re-write royalty not to be a
royalty (e.g., use a term shorter than the expected life
of the burdened properties).
Tax Partnerships
• Jointly operated oil & gas properties generally
constitute a tax partnership.
• 1031 N/A to partnership interests, including tax
partnerships. Parties must elect out under §
761(a) for 1031 to apply.
• All members must consent (a practical problem).
Carrying party may not consent for IDC reasons.
• Election may be formal (blank Form 1065) or
deemed (evidenced by the intent of the parties,
e.g., a written agreement).
Distressed Markets – Busting a
1031 Exchange
• 1031 is mandatory if it applies. See Redwing
Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5th
Cir. 1968).
• TP in a loss situation or with NOLs may not want
1031 to apply.
• Potential methods to “bust” a 1031 exchange:
– Different taxpayer acquires replacement property.
– Structure as separate sale and purchase
transactions, instead of an exchange. Taxpayer
should “touch the cash.”
– Consolidated groups may trigger 311(b) gain.
Distressed Markets – Drop & Swap
• Potential solution to exclusion of exchanges of
partnership interests.
• Prior to exchange, partnership “drops” undivided
interests in property to exchange partners. Afterwards,
exchange partners “swap” pursuant to § 1031.
• Issue: Did exchange partners satisfy the “held for”
requirement with respect to the relinquished property?
• The Tax Court and 9th Circuit have ruled in favor of TPs
on this issue, but the IRS continues to challenge these
transactions (e.g., recent amendment to Form 1065,
Schedule B).
• Tax preparer penalty?
Distressed Markets – Swap & Drop
• TP exchanges property, and then immediately
contributes it to a partnership or corporation
controlled by the TP.
• Issue: Did the TP satisfy the “held” for
requirement with respect to the replacement
property?
• Again, the Tax Court and the 9th Circuit have
ruled in favor of TPs on this issue, but the IRS
continues to challenge these transactions (e.g.,
recent amendment to Form 1065, Schedule B).
• Tax preparer penalty?
Distressed Markets - WorkoutDriven Exchanges (Example)
• TP’s property:
– Original price = $150
– Held for investment/trade or
business
– FMV = $50
– AB = $20
– Nonrecourse debt = $100
– Lender threatening to
foreclose.
• If no 1031 exchange:
– TP has gain of $80 (Tufts)
– Minimum tax (assuming no
recapture) = $12; possibly as
high as $20 if all § 1250 gain
taxed at 25%.
Can 1031 apply?
– Probably yes.
– No requirement that QI hold
cash or property
– Deed-in-lieu agreement may
be assigned to QI
– TP must assume $100 of debt
on replacement property, or
pay cash of $100, or some
combination, in order to avoid
boot gain; RPP will require
substantial down payment, but
this can be funded with
foregone tax (e.g., $20 down
and $80 new debt)
Workout-Driven Exchanges Issues
• If lender will not accept a deed-in-lieu, can TP still do a
1031 exchange? The problem is that there is no
“agreement” to be assigned to the QI. Potential
Solutions:
– Deed property to QI prior to judicial or nonjudicial foreclosure.
• Problems:
– Can TP find a QI willing to take title to foreclosure property?
– Does QI satisfy § 1031 regulations requirement that QI must “transfer
the relinquished property” to the buyer if the sheriff or trustee signs the
deed and makes the conveyance?
– Create “Agreement to Foreclose”? Any substance?
– Assign rights under Deed of Trust to QI?
• If recourse debt, part may be COI income
– In prior example, $30 would be gain from sale, and $50 would be
COI income (ineligible for § 1031).
Workout-Driven Exchanges –
Issues
• Better to have lender consent.
– Deed in lieu
– Agreement to Foreclose
• Issues without lender consent:
– Is deemed transfer to QI a breach of the loan documents?
– Could 1031 exchange trip the recourse carveouts?
– Does the Exchange Agreement become part of the lender’s
collateral?
– Could replacement property become part of lender’s collateral?
– Could lender write-down the debt prior to foreclosure, creating
COI income for debtor?
• Can TP locate highly-leveraged replacement property?