It is, unfortunately, all too common for a closing attorney to learn for the first time at the settlement table that a transaction has been structured as a tax deferred, like-kind exchange under Internal Revenue Code Section 1031. Recent developments in tax law will likely have a substantive impact on certain real property transactions involving commercial property that have been structured under this Section.
It would be a stretch of the existing law to claim that an attorney who is only responsible for the closing and title matters should be held accountable for a failure of the transaction to secure anticipated tax benefits if it does not meet IRS requirements. That reality is unlikely to satisfy the unhappy client looking for someone else to blame for the failure.
Familiarity with these new developments may raise the awareness of closing attorneys to a level where they may recognize the signs of a transaction headed for a tax disaster and head off the problems even though they are not otherwise providing tax counsel.
American Jobs Creation Act of 2004 (H.R.4520)
The President signed this legislation into law on October 22, 2004. A significant portion of the Act addresses the closing of what many consider being tax loopholes. One provision that should be of significance to real property attorneys, concerns Internal Revenue Code Section 1031 tax deferred exchanges.
Section 1031 makes provision for a taxpayer to be able to sell business or investment property and replace it with like kind property without recognizing or paying taxes on the gain realized on the sale. Currently the gain, if recognized, would typically be taxed at a rate of 15%. If the taxpayer were required to pay the tax, it would limit the ability of the taxpayer to reinvest in property of equal or greater value. The effect of the inability to reinvest without tax liability would have a serious impact upon commercial property investment because depreciation recapture rules substantially increase the gain recognized and the corresponding tax liability.
Section 1031 applies to exchanges of qualified personal property as well as qualified real property. With regard to real property exchanges, the applicable regulations create certain safe harbors that permit the exchanges to be transacted by direct deeding on a deferred time schedule if properly observed. These safe harbors permit a taxpayer benefit from the tax deferment permitted by the section while using standard transactional methods and avoiding the necessity of artificially structuring an actual ‘exchange’ of deeds.
It is common for taxpayers to have a need to close on a replacement property before they can accomplish the closing on the relinquished property. Since taking title to the replacement property prior to the conveyance of the relinquished property would disqualify it under existing rulings, regulations and case law, taxpayers have long resorted to parking the replacement property with a third party until the transaction could be completed in the more traditional manner. This form of exchange is commonly referred to as a Reverse Exchange.
For many years exchange professionals under interpretations of existing IRS rulings, regulations and Tax Court cases structured these Reverse Exchanges so as to provide a high probability of surviving audit. Because there were no clear, IRS approved, guidelines these transactions were fraught with a degree of uncertainty.
Revenue Procedure 2000-37, effective October 1, 2000, provided that the IRS would not challenge a Reverse Exchange structured under its requirements. This Revenue Procedure cleared up many concerns created by pre-existing revenue Rulings and Tax Court decisions with regard to Reverse Exchanges. Under the Procedure taxpayers could park real estate in much the same manner as they parked the funds in delayed forward exchanges. The Procedure is more liberal and went much further in authorizing business practices than was permitted under prior rulings.
Real property exchanges enjoy far greater liberality in the definition of ‘like-kind’ than do personal property exchanges. Any land that is held for the production of income, held for use in a business or held for investment is qualified regardless of what type of structure may or may not be present. As a result hotels may be exchanged for residential rental units or undeveloped land, shopping centers, factories, stores, farmland or virtually any such properties.
Specifically excepted from the definition of qualified property is the taxpayer’s principal residence. Section 121 of the Internal Revenue Code provides that taxpayers may generally exclude up to $250,000 ($500,000 for married couples filing a joint return) in gain realized on the sale of a personal residence. The Section mandates that they must have owned the residence and resided in it for periods totaling two-years out of the five-year period ending on the date of sale.
Tax deferral often provides sufficient economic reward, in and of itself, to justify structuring a transaction in order to reap its benefit. More desirable to taxpayers is tax avoidance (as opposed to tax evasion, which is illegal). A way of accomplishing tax avoidance under Section 1031 involves structuring a transaction under the following method or a variation of the same.
Taxpayers decide to exchange a property used in their business for residential rental property (often in a resort area). After a suitable period of time they may decide to sell their principal residence, take the permitted exclusion and then move into the rental property. After living in the rental property, now treated as their principal residence, for two years, they sell it and again take the permitted exclusion. They would then have avoided all recognition of gain if the transaction were within the exclusion limits.
As long as the transaction had not been initially structured with this purpose in mind, it would have been perfectly legitimate as a method of obtaining tax avoidance. Of course, if the original intent in acquiring the rental property was to convert it to a personal residence, qualify it for the purpose of selling it and taking the exclusion, the series of transactions would likely be susceptible to a successful challenge by the IRS.
The American Jobs Creation Act of 2004 puts an end to this method of tax avoidance to a certain extent. Section 840 of the Act imposes a new five-year ownership requirement for tax-free sale of a personal residence originally received as replacement property in a tax-deferred, like-kind exchange under Section 1031 of the Code. The new requirement is effective as of the President’s signing of the Bill on October 22, 2004.
The text of the Section Follows:
SEC. 840. RECOGNITION OF GAIN FROM THE SALE OF A PRINCIPAL RESIDENCE ACQUIRED IN A LIKE-KIND EXCHANGE WITHIN 5 YEARS OF SALE.
(a) IN GENERAL- Section 121(d) (relating to special rules for exclusion of gain from sale of principal residence) is amended by adding at the end the following new paragraph:
`(10) PROPERTY ACQUIRED IN LIKE-KIND EXCHANGE- If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.'.
(b) EFFECTIVE DATE- The amendment made by this section shall apply to sales or exchanges after the date of the enactment of this Act.
Reverse Exchange Safe Harbor Modified by IRS Revenue Procedure 2004-51
Some taxpayers have taken the position that Rev. Proc. 2000-37 allows a taxpayer to treat certain transactions where the taxpayer transfers property to an Exchange Accommodation Titleholder (EAT) and receives that same property back as replacement property in an exchange of other property of the taxpayer as a like-kind exchange. Some exchange professionals advocate using this process as part of a Reverse Exchange in order to convert the exchange proceeds from a relinquished property into qualified property, which in actuality consists of improvements to property already owned by the taxpayer.
In response to this practice, the IRS has issued a Treasury Release dated July 20, 2004, that explains that these taxpayers are wrong in taking the position that the safe harbor permits the use of a parking transaction to reinvest the proceeds of the sale of one piece of realty in improvements to other realty that the taxpayer or a related person already owns.
Effective for transfers on, or after, July 20, 2004, the safe harbor provisions of Rev. Proc. 2000-37 will no longer apply to Reverse Exchanges where the intended replacement property has been owned by the taxpayer within the 180-day period ending on the date of transfer to the EAT.
Existing transactions completed before the effective date should cause no loss of sleep. However pending transactions should be screened carefully.
Replacement Property Received from a Related Party Prohibited Except as a Part of Related Party’s Exchange
Recently issued Private Letter Ruling 200440002 has modified Revenue Ruling 2002-83 that was released by the IRS in 2003.
In Revenue Ruling 2002-83 the IRS provides that receiving Replacement Property from a related party who is ‘cashing-out’ in a three-party exchange doesn’t qualify for non-recognition under Internal Revenue Code Section 1031. The ruling makes it clear that a taxpayer may not structure a transaction through the use of a Qualified Intermediary that would otherwise be ineligible in a direct two party exchange. Taxpayers may not receive replacement property from a related party in a three-party exchange if the related party is selling the property and receiving the proceeds.
An exchange between related persons may qualify for non-recognition treatment under the Section if all of the exchanged properties are held by the related parties for more than two-years after the exchange. Any kind of a disposition within two years by either of the related parties causes the deferred income to become recognized and taxable in the tax year of the disposition. This is commonly referred to as the "two-year rule" and serves as the basis for many recommended holding periods advised by exchange professionals where there is, otherwise, no specific guidance.
The definition of Related Parties includes members of a taxpayer’s immediate family, spouse and a corporation, partnership or LLC if the taxpayer or related party family members own more than 50% of the entity.
In Practice, few exchanges occur directly between partieswhere each party exchanges deeds to the other. It is somewhat less rare where an exchange is entirely between related parties (a deed-swap) with no participation by an unrelated third party. This situation most commonly occurs when tenants in common desire to accomplish a land division. The IRS has analyzed these divisions in the context of Section 1031 treatment in this in PLR 199926045.
Related-party issues will most commonly arise in a three-party exchange when a related party either receives the relinquished party or when the taxpayer receives the replacement property from a related-party. Even though an unrelated third party or Qualified Intermediary participates in the exchange, Rev. Rul. 2002-83 makes it clear that when the related party is clearly selling the replacement property, it violates the two-year rule. The IRS takes the position in this ruling that that if the taxpayer or a related party "cashes out" of property in, Internal Revenue Code 1031(f)(4) is controlling and the exchange is disallowed.
Some exchangeprofessionals advocate that it is permissible for a related party to acquire relinquished property from the taxpayer without incurring any limitations with respect to the two-year rule. This is because neither the taxpayer nor the related party is shifting their tax basis from depreciated to depreciable. The tax law with respect to this issue is not clear and it would be advisable to observe the two-year-rule in order to be certain to avoid tax liability.
Recently issued Private Letter Ruling 200440002 modifies Rev. Rul. 2002-83 by authorizing an acquisition of replacement property from a related party if the related party is also doing an exchange (not cashing out). This is a logical result since the latter’s exchange should not be considered a sale within the required two-year holding period.