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Issue 116 Article 200
Recent Updates in Section 1031 Tax-Deferred Exchange Practice and Procedure
Sarah Friede, Legal Counsel and Senior Underwriter
IRS Notice 2005-3, published in December 2004, grants extensions of Section 1031 deadlines to victims of Hurricanes Charley, Frances, Ivan, and Jeanne, as well as Hurricane Bonnie. Late last summer when the first storms made landfall, the IRS issued a News Release pursuant to Revenue Procedure 2004-13, in order to grant certain relief to victims of Bonnie and Charley. The news release was a formal identification of Presidentially-declared disaster areas for which relief was available, as required by Rev. Proc. 2004-13. The release identified the taxpayers entitled to relief as those falling into three categories: those physically located within the disaster area; those whose businesses or records were located within the disaster areas; and workers assigned to relief efforts in the disaster areas. Despite that broad classification of taxpayers entitled to relief, Rev. Proc. 2004-13 fell short in certain other aspects, which have now been rectified by Notice 2005-3.
Rev. Proc. 2004-13 extended the 45-day and 180-day deadlines only until December 30, 2004. Notice 2005-3 permits a 120-day extension of deadlines in certain circumstances rather than ending on a certain date. The 120-day extension may be used if the taxpayer encounters difficulty in complying with the 45-day identification period or the 180-day exchange period for forward exchanges, and all safe harbor periods for reverse exchanges if, after the identification period has expired, the identified property has been substantially damaged by one of the named storms. Notice 2005-3 applies to those acts that were required to be performed on or after January 26, 2004.
It is also important at this time of year to remind everyone that taxpayers serving in the military are automatically entitled to an extension of tax deadlines, pursuant to IRC § 7805.
We strongly advise attorneys to remind clients that they must consult with a tax professional before determining they are entitled to these extensions, so as to avoid potential problems in the future. Along with sound advice, the professionals can also make sure the correct forms are filed, so as to make clear to the IRS which extension is being requested.
Revenue Procedure 2005-14, regarding the application of Section 121 and 1031 to a single exchange of property
It is not a secret that many taxpayers buy investment property with the intent of using it as their primary residence some time in the future. In the course of acting as Qualified Intermediary for clients, we are frequently asked how long the property must be used for investment purposes before converting it to personal use, without running afoul of the IRS or risking the exchange in the event of an audit. In some instances, property can be used for both investment and personal uses simultaneously, making it even more difficult for taxpayers to know how to treat the sale or exchange of that property. Although the IRS has not provided a hard-and-fast rule, recently-released Revenue Procedure 2005-14 provides some guidance on how gain on the sale of property that has both personal and business uses can be treated. This procedure follows up Section 840 of the American Jobs Creation Act, which effectively closed a loophole that allowed taxpayers to take advantage of the absence of guidelines. In October 2004, Congress passed the American Jobs Creation Act, of which Section 840 provides as follows:
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.
More detail about Section 840 can be found in our November 2004 newsletter. The result is that it very succinctly eliminated the possibility of taxpayers being able to defer gain on business property as part of a 1031 exchange and also benefit from exclusion of gain if they quickly converted it to their personal residence after completing their exchange.
On the heels of Section 840’s strict limitations, however, Revenue Procedure 2005-14 can be viewed as providing some relief by explaining how the joint application of IRC §1031 and §121 to a single transaction can be accomplished without running afoul of the limitation. Although Section 840 limits the use of IRC §1031 and §121 in subsequent transactions, Rev. Proc. 2005-14 opens the door to possibilities of using both as part of a single transaction.
Internal Revenue Code Section 121 speaks solely to personal residences and Section 1031 speaks solely to investment or business property, and thus they would seem mutually exclusive. Given the frequency of people having a home office or retiring to beach homes they have rented out to vacationers over the years, many taxpayers have been forced to guess at how to properly file tax returns if they wished to defer or exclude gain to the fullest extent permitted.
Section 121 permits taxpayers to exclude up to $250,000 gain (or $500,000 for a marriage couple filing a joint return) realized on the sale or exchange of property that was used as the taxpayer’s principal residence for at least 2 years during the 5-year period ending on the date of the sale or exchange. Section 1031 permits taxpayers to defer gain on the sale of property held for productive trade or use in a business or for investment purposes, by reinvesting in other "like-kind" business property. Rev. Proc. 2005-14, which became effective January 27, 2005, applies to taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under Section 121 and the non-recognition of gain on the exchange of like-kind properties under Section 1031.
Rev. Proc. 2005-14 requires that in computing gain from these types of transactions, taxpayers must first apply Section 121 to the gain realized before applying Section 1031. It further specifies that boot (cash or other non-like-kind property received by the taxpayer in the sale of relinquished property) is taken into account only to the extent that the boot exceeds the gain excluded under Section 121. Basis in the replacement property is computed by adding any gain attributable to the relinquished business property that is excluded under §121.
Rev. Proc. 2005-14 includes some examples of how these rules can be applied. Taxpayer (T) buys a house in for $210,000, and uses it as a primary residence for four years. For the next two years, T rents out the house and claims depreciation of $20,000 on her tax returns. T then exchanges the house for $10,000 cash and a townhouse with a fair market value of $460,000, which T plans to rent to tenants. (This hypothetical assumes there is no mortgage on the properties.)
T realizes $280,000 gain on the exchange. That figure is calculated as follows:
Amount realized: $470,000 ($460,000 FMV + $10,000 cash)
- Adjusted Basis $190,000 ($210,000 basis - $20,000 depreciation)
Realized Gain $280,000
After computing the gain realized, T may then exclude the full amount allowed by §121, which is $250,000 for an unmarried individual. Subtracting the gain excluded under §121, T can then utilize §1031 to defer the remaining $30,000 gain.
To compute T’s basis in the townhouse, the following formula is used:
Basis in relinquished property at time of exchange $190,000
+ Gain excluded under §121 $250,000
- Cash received $ 10,000
For properties that involve simultaneous personal and business uses, the amount realized, basis, adjusted basis, and realized gain must be calculated by allocating percentages to personal and business use.
We at Statewide Title always recommend that clients rely on the advice of a tax professional before beginning a 1031 exchange. We have seen many taxpayers with mistaken notions of what gain they expect to defer, without taking into account depreciation, debt forgiveness, and the like. With the release of Rev. Proc. 2005-14, more and more taxpayers will want to rely on it without necessarily understanding fully the details involved. We hope that attorneys and staff take advantage of this newsletter to explain to clients that there is more to an exchange than just the contract sales price, and that it is critical for them to have a competent tax professional on whom they can rely for guidance.
Teruya Brothers, Ltd. & Subsidiaries v. Commissioner of Internal Revenue, United States Tax Court, 124 T.C. No. 4 (filed February 9, 2005)
In a case of first impression before the Tax Court, Petitioner Teruya Brothers argued that the use of a qualified intermediary as a grantee of replacement property from a business entity related to Teruya Brothers before passing title through to Teruya Brothers was a legitimate bypass of related party exchange rules of §1031(f). The case also clarifies that complying with the 2-year holding period requirement after completion of the exchange does not make the exchange valid if the exchange was conducted solely for tax avoidance purposes and the related party "cashed out" the proceeds. When studied in tandem with Private Letter Ruling (PLR) 20440002, discussed in the November 2004 newsletter, it is clear that related party exchanges are subject to strict scrutiny by the IRS and withstand an audit only in limited circumstances.
PLR 200440002 authorizes the acquisition of replacement property from a related party without running afoul of the two-year holding period so long as the related party is also doing a 1031 exchange. Section 1031(f) requires that all exchanged properties must be held by the related parties for more than two years after the exchange, in order for the exchange to be valid. The holding period imposed represents an attempt by the IRS to prohibit a related party from cashing out on proceeds from the same transaction in which the taxpayer is seeking to defer gain. Before subsection (f) was enacted, taxpayers wanting to sell property with market value far exceeding basis would exchange that property for a high-basis property owned by a related party. The related party would then have a much higher basis in the relinquished property and could sell it to a pre-arranged buyer without recognizing as much gain as the taxpayer. This practice, known as basis shifting, works like this: A purchased Blackacre for $100,000 but it now has a fair market value of $1,000,000. Rather than directly sell Blackacre to X, A exchanges it for Whiteacre, owned by B (a related party) with a basis of $800,000 and fair market value of $1,000,000. B then sells Blackacre to X for $1,000,000. Had A sold Blackacre to X, she would have recognized a gain of $900,000; instead, B now recognizes gain of only $200,000 on the sale because it carried over its basis from Whiteacre to Blackacre. B effectively "cashed out" on the proceeds, while A recognized no taxable gain on the exchange. Congress closed this loophole by enacting subsection (f) and imposing the two-year holding period before either Blackacre or Whiteacre can be sold.
The PLR issued last fall considered specifically whether related parties who are both conducting1031 exchanges would be considered cashing out the proceeds by doing so. The IRS determined that an exchange of property acquired from a related party should not be considered a sale such that it would invoke the subsection (f) prohibitions. Unfortunately for taxpayers and tax professionals, Private Letter Rulings cannot be cited as binding authority by taxpayers other than those who received the PLR. Nonetheless, Private Letter Rulings provide sufficient guidance for tax professionals as well as for closing attorneys who may be able to recognize potential pitfalls for their clients’ transactions.
In Teruya Brothers, the Tax Court revisits the issue of cashing out in the context of a related-party exchange and gives a stern warning to those taxpayers who may hope to use a qualified intermediary as a strawman in order to sidestep the IRS. Teruya Brothers is a Hawaiian-based company whose primary business is the purchase and development of commercial and residential properties. The company was approached by a party interested in purchasing a fee simple interest in a Honolulu tract on which there was a condominium complex. When Teruya Brothers rejected the offer to sell, the interested buyer (which was the homeowners’ association for the condominium) then inquired as to whether Teruya Brothers would consider entering into a like-kind exchange for the property, for which the homeowners’ association would be the purchaser of the relinquished property. Teruya Brothers then entered into a letter of intent that stated, "It is understood and agreed that Teruya’s obligation to sell Teruya’s interests to [the association] is conditioned upon consummating a [section] 1031 tax-deferred exchange of Teruya’s interests." Some months later, Teruya Brothers entered into negotiations to buy some building pads owned by Times Super Market, Ltd., of which Teruya owned a majority share. Those contract terms included similar language limiting Teruya’s obligations to the execution of an exchange. Teruya entered into an exchange agreement with T.G. Exchange, Inc. TGE was the recipient of a direct deed of the condominium property from Teruya Brothers before TGE deeded it to the homeowners’ association. Likewise, Times deeded the building pads to TGE, which then deeded the building pads to Teruya Brothers. Teruya Brothers also consummated another 1031 exchange at approximately the same time, selling property to an unrelated buyer and acquiring replacement property from Times again. The contracts involved included the same language protecting Teruya, and Teruya again used TGE as the intermediary. Both exchanges were concluded by the end of the 1996 tax year, and Teruya Brothers still owned the replacement properties as of the time the petition was filed with the Tax Court.
The Tax Court ruled that even though it was undisputed that the transactions met the general requirements for an exchange under §1031(a)(1), Teruya Brothers nonetheless recognized and should have reported gains of more than $12,000,000, because of the following prohibition in §1031(f)(4):
[Section 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 (f).
Teruya Brothers argued, unsuccessfully, that Congress intended subsection (f) to apply only to exchangers who did not hold the replacement property for a two-year period, and that whatever happens to the relinquished property outside the exchange itself is irrelevant. The Tax Court rejected that argument, stating it was "flatly contrary to section 1031(f), which applies with equal force to post-exchange dispositions by either the taxpayer or the related person." The Court considered inconsequential the placement of TGE in the chain of title for both replacement and relinquished properties, and considered the exchange should be viewed as if they were direct exchanges between Teruya and Times as related parties. The Court wrote, "The interposition of a qualified intermediary in these transactions cannot obscure the result." No explanation was offered the Court by Teruya Brothers for structuring the transactions as it did, other than the mere avoidance of tax liability (which the Court found obvious from the facts and the purchase and sale agreements). Teruya Brothers argued that it was not disguising a sale of property in order to avoid tax liability, because it never intended to sell -- but only to exchange -- the relinquished properties. Rather than give weight to that semantic argument, the Court looked at the end result: Times, a related party to Teruya Brothers, cashed out on Teruya’s investments by immediately selling the relinquished property and recognizing gain on only a small percentage of what Teruya Brothers would have recognized had it sold the properties itself. In one of the exchanges, Times actually realized a gain larger than Teruya would have, but because the gain was offset by significant losses for the same year, Times incurred no liability on that gain.