Related Party 1031 Exchanges
Chris Burti, President Statewide Title Exchange Corporation

Part of the 1031 XChange Index - Originally Published 7/31/2006 at STEC

Related party transactions bear the most restricted exchange limitations under Section 1031 of the Internal Revenue Code. Under Section 1031(f)(1), a taxpayer exchanging like-kind property with a related person is disqualified from the nonrecognition provisions if, within 2 years of the date of the last transfer, either party disposes of the exchange property.

A "related person" means any person bearing a relationship to the taxpayer described in Sections 267(b) or 707(b)(1). This list is lengthy, and it is important to be aware of its extent due to the potential for problems. It includes members of a family, defined as brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants. A "related person" is a partnership in which the taxpayer owns, directly or indirectly, more than 50 percent of the capital or profits interest in such partnership. Also included in the definition is an individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; two corporations which are members of the same controlled group; a grantor and a fiduciary of any trust; a fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts; a fiduciary of a trust and a beneficiary of such trust; a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts; a fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust; a person and an educational and charitable organization exempt from tax which is controlled directly or indirectly by such person or by members of the family if such person is an individual; a corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership; an S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation; an S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or, an executor of an estate and a beneficiary of such estate (except in the case of a sale or exchange in satisfaction of a pecuniary bequest).

The purpose of the Section 1031(f) limitations, adopted in 1989, is to prevent abuse of the Section to avoid tax by exchanging high basis property for low basis property and cashing out. Congress determined that transactions between related persons and controlled entities offered the most potential for basis shifting and loss acceleration. Therefore, the Code now treats related parties as if they were the same as the taxpayer. In the case of a related party, a sale of exchange property within two years is treated as a cash out by the taxpayer. In a recently released Revenue Ruling the Service asserts that a taxpayer who transfers relinquished property to a qualified intermediary in exchange for replacement property transferred from a related party that receives cash or other non like-kind property for the replacement property is not entitled to nonrecognition treatment under Sec. 1031(a). This determination is found in Rev. Rul. 2002–83, 2002–49 I.R.B., 927, released December 9, 2002.

The facts presented in the Ruling are as follows: "Individual A owns real property (Property 1) with a fair market value of $150x and an adjusted basis of $50x. Individual B owns real property (Property 2) with a fair market value of $150x and an adjusted basis of $150x. Both Property 1 and Property 2 are held for investment within the meaning of § 1031(a). A and B are related persons within the meaning of § 267(b). C, an individual unrelated to A and B, wishes to acquire Property 1 from A. A enters into an agreement for the transfers of Property 1 and Property 2 with B, C, and a qualified intermediary (QI). QI is unrelated to A and B.

Pursuant to their agreement, on January 6, 2003, A transfers Property 1 to QI and QI transfers Property 1 to C for $150x. On January 13, 2003, QI acquires Property 2 from B, pays B the $150x sale proceeds from QI's sale of Property 1, and transfers Property 2 to A."

The Service sets out all of the relevant provisions of the Code and regulations in the ruling. Of particular interest to this discussion it notes that "Under § 1031(d), the basis of property acquired in a § 1031 exchange is the same as the basis of the property exchanged, decreased by any money the taxpayer receives and increased by any gain the taxpayer recognizes."

"Section 1.1031(k)–1(g)(4) allows taxpayers to use a qualified intermediary to facilitate a like-kind exchange. In the case of a transfer of relinquished property involving a qualified intermediary, the taxpayer's transfer of relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary is treated as an exchange with the qualified intermediary."

"Section 1031(f) provides special rules for property exchanges between related parties. Under § 1031(f)(1), a taxpayer exchanging like-kind property with a related person cannot use the nonrecognition provisions of § 1031 if, within 2 years of the date of the last transfer, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The taxpayer takes any gain or loss into account in the taxable year in which the disposition occurs. For purposes of § 1031(f), the term "related person" means any person bearing a relationship to the taxpayer described in § 267(b) or 707(b)(1)."

The Ruling then analyzes the purpose and legislative history of Section 1031(f). The ruling states that the Section "is intended to deny nonrecognition treatment for transactions in which related parties make like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. The legislative history underlying § 1031(f) states that ‘if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, "cashed out" of the investment, and the original exchange should not be accorded nonrecognition treatment.' H.R. Rep. No. 247, 101st Cong. 1st Sess. 1340 (1989). To prevent related parties from circumventing the rules of § 1031(f)(1), § 1031(f)(4) provides that the nonrecognition provisions of § 1031 do not apply to any exchange that is part of a transaction (or a series of transactions) structured to avoid the purposes of § 1031(f)(1)."

The Service notes further that the legislative history underlying § 1031(f)(4) provides: "If a taxpayer, pursuant to a pre-arranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within 2 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. Id. at 1341."

The Ruling makes it clear that using a QI does not salvage a transaction that would not otherwise qualify. Tying the legislative history to the facts giving rise to the ruling, the Service determines that "if an unrelated third party is used to circumvent the purposes of the related party rule in § 1031(f), the nonrecognition provisions of § 1031 do not apply to the transaction. In the present case, A is using QI to circumvent the purposes of § 1031(f) in the same way that the unrelated party was used to circumvent the purposes of § 1031(f) in the legislative history example. Absent § 1031(f)(1), A could have engaged in a like-kind exchange of Property 1 for Property 2 with B, and B could have sold Property 1 to C. Under § 1031(f)(1), however, the non-recognition provisions of § 1031(a) do not apply to that exchange because A and B are related parties and B sells the replacement property within 2 years of the exchange. Accordingly, to avoid the application of § 1031(f)(1), A transfers low-basis Property 1 to QI who sells it to C for cash. QI acquires the high-basis replacement property from B and pays B the cash received from C. Thus, A engages in a like-kind exchange with QI, an unrelated third party, instead of B. However, the end result of the transaction is the same as if A had exchanged property with B followed by a sale from B to C. This series of transactions allows A to effectively cash out of the investment in Property 1 without the recognition of gain." The determination finds that "A's exchange of property with QI, therefore, is part of a transaction structured to avoid the purposes of § 1031(f) and, under § 1031(f)(4), the non-recognition provisions of § 1031 do not apply to the exchange between A and QI. A's exchange of Property 1 for Property 2 is treated as a taxable transaction." Section 1031(f)(4) might be described as a codification of the step transaction doctrine which allows the Service to ignore form over the substance of a series of transactions that would serve no substantial business purpose other than tax avoidance.

This conclusion is also predicated on the tax treatment of related persons as one taxpayer. Obviously, A does not actually receive any cash under these facts. Yet, A is treated as if the cash were paid directly. Applying Section 1001(a) to the facts of the ruling, the Service notes that "A has gain of $100x, the difference between A's amount realized on the exchange ($150x, the fair market value of Property 2) and A's adjusted basis in the property exchanged ($50x)". This might result in a very unfortunate financial crisis where the transaction was at arm's length and A, not receiving money, does not have sufficient resources to pay the tax liability.

This ruling presents several pitfalls that real property practitioners should be careful to avoid. Closely held business entities owned by a related person present a particularly insidious trap for the unwary. Whenever replacement property is being conveyed by an unfamiliar business entity, it is incumbent upon the attorney structuring a closing involving a Section 1031 exchange to inquire as to whether the owners may be related persons as defined by the Code. Surnames can be deceptive due to marital relationships therefore, owners may not be obviously related. The Ruling implicitly acknowledges that related parties may exchange properties in a qualified transaction as long as cash or non like-kind property is not received. This offers another pitfall where property may not qualify once transferred to the related party due to its being categorized as "inventory". If the related person is a developer, lot held for investment by the taxpayer may be considered inventory for the related person. This would be treated as a payment of a cash equivalent instead of an exchange of like-kind property. Under this Ruling, the exchange would not qualify even though transacted through a qualified intermediary.

This determination does not address, directly or implicitly, essentially the same fact situation but varied where the related person's basis in the property is also low or where the taxpayer has a relatively high basis. The rationale behind Section 1031(f)(4) would lead one to a logical conclusion that the exchange should qualify for deferral of gain for the taxpayer since the related party will be taxed on the gain realized from the transfer of the replacement property and the opportunity for abuse is not present. Prudence would dictate that the ruling be interpreted literally and one should assume that all transactions involving a related party that receives cash or non-like-kind property will not qualify for deferral of gain or loss until clarified by a future determination. In a similar issue, conventional wisdom in the exchange industry holds that a sale to a related party through a QI with replacement property acquired from an unrelated party is not disqualified by Section 1031(f) upon a subsequent sale of the relinquished property by the related person within two years. While there is no definitive answer the reasoning was that since the taxpayer is not receiving property from a related party, there is no application of Section 1031(f). The wording of the subsection analyzed in light of this new ruling casts some doubt on that conclusion.

How Can Leaseholds Qualify Under IRS Code Section 1031
STEC

Part of the 1031 XChange Index - Originally Published 11/1/2006 at STEC

Most IRS Section 1031 exchanges involve the sale of real estate and the acquisition of like-kind replacement property. As we have previously noted, property held for investment, income production or use in a business is qualified as like kind with any other property held for investment, income production or use in a business. Fee simple ownership of investment real estate is the most common form of ownership in property involved in exchanges, but other ownership interests may be used as well. Specifically, leasehold interests can be used in exchange transactions, but special rules apply to various situations. These exchanges are not as common as transfers of the fee interest in real property, but leasehold exchanges have been around for a long time and can provide great flexibility for clients when used appropriately with knowledgeable tax advice.

IRS regulations provide that a leasehold interest of 30 years or longer is treated as like kind with fee simple real estate. Subsequent rulings make it clear that optional renewal periods are included in determining the length of the leasehold interest. For example if the lease has a 10-year initial term and 5 five-year options, the length of the lease is 35 years for 1031 exchange purposes. As long as the lease in this example is in the first five years of the term, there will be more than thirty years left and it will be treated as like kind.

For example, a Taxpayer wishes to use an exchange to swap a $250,000 warehouse for an existing lease on a shopping center out-parcel with a value of $275,000. The 20-year lease has two 10-year extensions and is in its ninth year. Therefore, the leasehold length is 31 years (20 years plus two 10-year extensions equals 40 years minus nine years nets 31 years). Taxpayer can sell the warehouse and buy the 45-year leasehold interest as replacement property to complete a successful exchange as long as the exchange is in compliance with all other IRS guidelines.

Short-term leases are not like kind with fee simple real estate. However, they may be considered like kind with other short-term leasehold interests. Although the IRS has approved some short-term leasehold interest exchanges in private letter rulings, it has offered taxpayers no authoritative guidelines on whether the leasehold interests must be similar in term to be considered like kind. For instance, we do not know whether a 5-year leasehold will be considered like kind with a 10-year leasehold.

Taxpayers wishing to construct replacement property improvements on land owned by other parties can use a leasehold in conjunction with an improvement exchange. A successful tax-deferred exchange can be accomplished if the leasehold improvements equal or exceed the value of the relinquished property before the end of the 180-day exchange period. This will require the services of both a QI and an Exchange Accommodation Titleholder. After the relinquished property closing, the EAT enters into the leasehold agreement on the taxpayer's behalf and uses the sale proceeds to construct the improvements. Once the improvements are complete or the 180-day period has ended, the EAT transfers the leasehold interest, which includes the improvements, to the taxpayer via the QI. Of course, the lease term must exceed 30 years as noted above and the identification rules will require a fairly specific description of the state of the improvements if they will not be anticipated to be substantially complete at the end of the exchange period. Valuation issues add complexity to this identification process and should be undertaken only with expert guidance.

Another possibility is where the taxpayer builds leasehold improvements on ground it already owns or controls through a related party. A recent PLR suggests the IRS may allow such transactions if they are carefully structured. PLR 200251008 involved a construction exchange where the party on the other side of the long-term lease was a "related party". What seemed to be a key factor was the existence of a 30-year or longer leasehold interest on the land. This allowed for two different conveyable elements: the underlying fee interest and the leasehold interest. By creating a separate conveyable leasehold interest, the taxpayer increased the value of the leasehold by building improvements that the IRS allowed to be conveyed as the replacement property.

Rev. Proc. 2004-51, issued two years later, was promulgated by the IRS to avoid a situation where a taxpayer conveys property to an accommodator who completes a build-to-suit exchange then conveyed it back as replacement property in an exchange. This makes it clear that we should expect close scrutiny for these exchanges. Therefore, this type of exchange is extremely complicated and requires expert interpretation of a combination of tax and legal issues. Taxpayers must consult tax and legal professionals before attempting this type of transaction.

Annuity Funded "Structured Sales"
STEC

Part of the 1031 XChange Index - Originally Published 3/1/2007 at STEC

Structured Sales funded by annuities are promoted as alternatives to IRS Code Section 1031 tax deferred exchanges and as a replacement for Private Annuity Trusts which have been disallowed. IRS Code Section 1031 exchanges defer recognition of capital gain, but require the seller to continue holding qualified property in replacement of the disposed property. Continued investment in real estate may not always suit the needs, desires and requirements of an investor.

Structured Sales may work well for sellers who wish to completely dispose of their investment property and have a continuing income stream with less risk than a traditional installment sale. The structure of these transactions is similar to but a bit simpler than that of a Private Annuity Trust (PAT).

A PAT is not an insurance product issued by a commercial insurance company. Instead, structuring a PAT involved creating a trust and transferring the property to a Trustee in return for an annuitized income stream. The transfer to the trustee by the taxpayer did not generate recognition of taxable gain. There is no tax on the sale to the PAT because the PAT would have actually purchased the property from the taxpayer at the fair market value of the asset and hence no gain. The Trustee would subsequently sell it at the current value, so there would again be no taxable gain recognized to the trust. The PAT pays the purchase price to taxpayer in agreed upon installments with the income stream funded by an annuity purchased from a life insurance company. The taxpayer who was the original owner of the property pays taxes only as the PAT payments are received. Under the original structuring rules, the trustee must have been independent, the annuity may not be secured in any way, and the transferor may not have any control over the trust or its investments.

The IRS has ruled that a PAT is no longer a valid capital gains tax deferral method as of October 17, 2006. While those taxpayers who implemented a PAT prior to the IRS ruling may continue to recognize its tax deferral benefits, PAT's are not properly used for tax deferral for transfers occurring after that date. Structured Sales, which also provide a relatively secure income stream in a similar fashion, have generated much interest as result.

Structured Sale Annuities were developed by Allstate Insurance company in 2005 and are a special insurance product developed to facilitate a type of installment sale pursuant to IRS Code Section 453. They are similar to those funding structured settlements in personal injury cases and the name is derived from a hybridization of the terms 'Structured Settlements' and 'Installment Sales'. They allow sellers to defer gains on the sale of a business or real estate from the year of sale to the tax year in which any installments of proceeds are received by the taxpayer.

Credit risk has been a major weakness that has traditionally limited the advisability of the use of installment sales. Traditional installment sales are usually secured by a Deed Of Trust on the transferred property and in certain instances by a Letter of Credit drawn on the Buyer's bank. However this puts the Seller in the position of a lender and many taxpayers find that unacceptable. In addition, as the taxpayer owns the replacement property directly in a Section 1031 exchange, they have far more control over the asset, its management and as discussed below, more liquidity. In addition, taxpayers may lawfully change the use of the property after the exchange without immediate tax consequences if they change their minds. Where that is a concern, taxpayers will find that a Section 1031 exchange may look better as an investment alternative.

In a Structured Sale, the Buyer does not pay installments to the taxpayer. Instead, the Buyer pays a negotiated amount that funds the purchase price of the annuity to an Assignment Company. The Assignment Company purchases the annuity from a life insurance company with sound financial ratings. A properly handled Structured Sale will be designed to comply with the IRS requirements for an Installment Sale, to avoid issues of constructive receipt or economic benefit and to reduce risk. We will discuss these issue in more depth.

There are only a few Life Insurance Companies selling this product. As the Assignment Company that implements the transaction is paid directly by the life insurance company that writes the annuity and is usually owned by them, the insurance companies selling the annuity usually select them. Transactions are often brokered by Structured Settlement Companies and can currently be done with proceeds as small as $100,000. Proceeds netting only $20,000 of potentially taxable gain will make most Section 1031 exchanges an economically viable mechanism for tax planning. Therefore Section 1031 exchanges prove useful over a wider range of transactions.

With a Structured Sale, the Seller recognizes capital gain and will be taxed in each year any installment payments are received. Interest is imputed and taxed annually, even in years during the contract where no installment payments are received. Taxation is the same as if the Buyer were making installment payments directly to the Seller. The ideal clients for structured sales are often described as older investors trying to free themselves from the headaches and risks of real estate and who don't wish to pay the tax on the gains of highly appreciated property in the tax year of the sale.

In order to derive these benefits and defer income recognition, the seller must avoid constructive receipt of the funds or receipt of economic benefit. To do so, a third party is needed to insulate the seller from a possible IRS determination of taxable receipt of the sale proceeds. The Buyer executes a "third-party assignment" with the Assignment Company owned by the life insurance company or the Structured Settlement broker. At the Seller's request, the Buyer will direct the proceeds intended for deferred treatment to be sent from the closing escrow account directly to the Assignment Company. The Assignment Company will then purchase the specified annuity and agrees to make all future periodic payments to the Seller. A simple one-page Sales Agreement between the Buyer and Seller includes the necessary language creating the structure, with the terms governing the payment schedule.

The Structured Sale must be properly documented in the transaction instruments and the money must be handled in such a way that the taxpayer will not constructively receive any payments for tax purposes until they are actually paid. The taxpayer may receive a down payment at the closing, which will be taxed in the year of the sale, but all installments must be carefully structured. In many instances, there is no difference for the Buyer from a traditional cash-and-title-now deal, except for additional paperwork and negotiation. However, because of tax advantages to the selling taxpayer, structuring the sale might result in a lower offer by the Buyer being more attractive. Because the Buyer has paid the negotiated sum in full, the Buyer may get full title at time of closing. Due to the relative newness of these products, not all are structured identically. In some instances, due to perceived risk, a traditional Deed of Trust may be required to secure the obligations of the Buyer and the Assignment Company.

This is an unsettled area in the current use of annuities to defer taxable gains and practices will vary between direct marketing by Life Insurance Companies and Structured Sales Annuity brokers that in many cases have been in the Structured Settlement business. Some Insurance Companies issuing the annuity contract will agree to guarantee the performance of the third party Assignment Company, thereby reducing the credit risk of the transaction. In some brokered transactions the Agreement may not give the Seller any status greater than that of a general creditor of the life insurance company and may not impose any greater obligation on the life insurance company than the obligation of the Assignment Company. The selling taxpayer would bear the risk of any Assignment Company insolvency and the Assignment Company or the life insurance company would not set aside any funds or assets as security or collateral for the benefit of the seller. In such cases, the Seller may require additional securitization and this may prove to be unacceptable to the Buyer. One can anticipate that these arrangements may not prove to be as simple as those who promote them would like for them to appear.

Some promoters have stated that there are "no associated charges, ever, with the purchase or management of the funds by the life insurance company or the broker placing the annuity - a further benefit over the aforementioned PAT's, TIC's CRT's and 1031 Exchanges." While literally true, these claims overlook the fact that there is a substantial difference in the negotiated price and the premium for the annuity that funds the stream of payments. In addition, the economic rate of return on the annuity will always be lower than the going rate on real estate financing. Therefore there is always a very real and significant economic cost to the seller for this product. While this may be acceptable to the Seller as the price for reducing risk, it should always be factored into the equation.

There seems to be adequate support in the Tax Code, Tax Cases and IRS Revenue Rulings to justify the anticipated tax treatment of this form of security. In fact, there is ample and cogent discussion of the legal issues readily available and for the purpose of this article we have assumed that the law is settled. However, it should be noted that we are not aware of any recent Revenue Ruling specifically on point. As of December 2006, the IRS hadn't issued any rulings on structured sale annuities and has declined to comment on them. Thus, there is always a risk that there may be unanticipated requirements by the IRS. This was the case with investors when the IRS disallowed favorable tax treatment of PAT's. Section 1031 tax treatment is well settled when operating within the context of the safe harbors of the regulations and therefore tax treatment is highly predictable.

In summary, the significant concerns with structured sales can be fairly said to be:

1. As with all tax strategies, there is always the risk that favorable tax treatment may be disallowed in the future because of IRS concern over possible abuses, just as it did on Oct. 17, 2006 when it announced that the private annuity trust may no longer qualify for tax-deferral benefits.
2. There are liquidity issues with a stream of payments. Once a structure is established, there is no way for the seller to access the balance of funds prematurely. Otherwise, there can be no tax deferral created by the structure.
3. The tax deferral strategy may backfire if the seller's personal tax rate is substantially higher in the future than the rate in effect at the time of sale. Because it is anticipated that Congress may raise the capital-gains rate soon, some financial advisors speculate that it may be better to pay a 15 percent tax now rather than wait until after the tax rate goes up.
4. Given the conservative nature of the insurance product, return on investment may be less than sellers will find acceptable. Given the strong economy of the last ten years, especially the remarkable increase in real estate values experienced in many regions, more investors are holding highly appreciated property. Low interest rates make current reinvestment in real estate a prudent choice. Concerns for a slowdown in appreciation of real estate also militate for postponing the selection of an annuity as an investment vehicle. If there is a turndown in the real estate market, one can expect a corresponding increase in interest rates as credit markets retract. If that occurs, annuities purchased during periods of higher interest rates will reflect a correspondingly higher rate of return.
5. As yet the documentation and structuring of the respective responsibilities of all participants has not standardized. As a result there is a certain substantial overhead incurred by prudent investors in having the proposed transactions and documentation reviewed by competent attorneys, tax counselors and financial advisors in order to avoid unacceptable risk or inadequate protection.

One may conclude that these financial planning products may be very useful at present for the sophisticated investor relying on competent, knowledgeable professionals for advice. Until these products have received wider acceptance and some standardization the average investor should approach these with extreme care and professional advice should be considered a must. Novices and those unwilling to incur the expense of professional counsel would be well advised to stay with proven and established products such as section 1031 exchanges.

Can I Get My Money Before the Exchange Ends?
Chris Burti, President Statewide Title Exchange Corporation

Part of the 1031 XChange Index - Originally Published 6/15/2007 at STEC

Once a QI enters into an exchange agreement with a taxpayer, there are certain fiduciary rules that pertain to taxpayer funds and property.

As a general rule in exchanges, the QI will disburse proceeds based on one of the following conditions:

• Taxpayer failed to identify any replacement property within the 45-day safe harbor window and the exchange has reached the 46th day.
• Taxpayer has received all replacement property to which he or she is entitled under the property identification form.
• Material and substantial contingency has occurred after the identification period has expired, said contingency being out of the control of the taxpayer, the occurrence relates to the exchange, and was provided for in writing.

The exchange agreement entered into between the QI and the taxpayer should list these situations as exceptions to the rule that the taxpayer does not have the right to receive, pledge, borrow, or benefit from the proceeds before the end of the exchange.

Practically speaking, these restrictions on disbursements apply to taxpayers in the following ways:

• Taxpayers may not expect any access to their proceeds within the first 45 days of the exchange except insofar as the QI may need to disburse some earnest money for a replacement property contract or the taxpayer may be ready to actually close on a replacement property.
• Taxpayers who have identified more than one replacement property may not ask the QI for a disbursement prior to the end of the exchange period or acquisition of all identified properties.
• Taxpayers cannot ask for an early disbursement because they changed their minds about buying a piece of property identified in a timely manner.
• Taxpayers may have access to their account if the identified property is destroyed by an Act of God (i.e., flood literally washing away the contracted-for property).
• Taxpayers may have access to their account if the seller of replacement property irrevocably breaches the contract after the identification period and there is insufficient time to cure the breach or sue for specific performance.
• Taxpayers may not have access to proceeds in order to pay a debt or purchase non-like-kind property.

This limited control over funds and/or property during the exchange is a key distinction between a straight sale and purchase and reaping the tax benefits of a like kind exchange.

Build To Suit Exchanges
STEC

Part of the 1031 XChange Index - Originally Published 10/1/2007 at STEC

In a real property exchange, can proceeds from the relinquished property sale be used to acquire replacement property and improvements thereon? Yes. This type of exchange often falls under the moniker of construction exchange, improvement exchange or more commonly known as a build to suit (BTS) exchange.

While highly complex, the BTS exchange provides the taxpayer exchanger an opportunity to invest his or her exchange funds into replacement property and improvements thereon. This exchange structure can be attained through a forward or reverse exchange, allowing taxpayers the benefit of this tax deferral strategy while providing more flexibility to either renovate an existing improved property or construct new improvements on raw land. The delayed build-to-suit exchange begins when the taxpayer exchanger sells his/her relinquished property and acquires the identified replacement property, only after it has been improved, with the proceeds from the sale of the relinquished property.

Under the safe harbors noted in Revenue Procedure 2000-37, the entity created to hold title to the replacement property, during the exchange period, is referred to as the Exchange Accommodation Titleholder (EAT). The replacement property is parked with the EAT during the exchange period and while improvements are made. The EAT will typically be a special purpose entity like an LLC. The Qualified Exchange Accommodation Agreement (QEAA), the contractual agreement between exchange parties, will be created between the taxpayer exchanger, the EAT and the Qualified Intermediary.

The QEAA will allow the EAT to use exchange proceeds to acquire the replacement property and make any identified improvements made thereon. Typically, the contractor will arrange for the construction contract to spell out the construction details to take place during the exchange period. The EAT is party to the construction contract as the entity with qualified indicia of ownership of the property being improved. The QEAA also provides for the taxpayer exchanger to act as project manager to oversee all aspects of the construction during the exchange period. The taxpayer will approve and confirm improvements have been made to the real property and submit approved invoices for payment to the EAT. In the event the taxpayer exchanger secures a construction loan from a lender, the taxpayer or his/her counsel should clearly communicate the details of the exchange to the lender. The lender must be aware of the EAT holding title to the collateral property.

During the exchange, there may be many fees and disbursements that need to be monitored carefully by the EAT and QI. Most build-to-suit exchanges are burdened with architect's fees, permit fees, demolition expenses, debris removal, etc., all before any improvements are actually constructed. Without payment of those fees, the project would not get underway. It is crucial to remember, however, that even if it is permissible to disburse proceeds (either sale or loan proceeds) for these expenses, the expenditures themselves pre-construction do not improve the fair market value of the property. Taxpayers would be well cautioned to remember that even if they use all of their exchange proceeds during the 180-day construction period, the IRS may not view the exchange as one in which proceeds can be fully deferred if the fair market value of the replacement property does not exceed the fair market value of the relinquished property. An exchange that is fee-heavy on non-construction items may not yield the value expected, and needed, by the taxpayer.

Upon the earlier of the 180-day exchange period or construction project completion, the EAT conveys the deed to the replacement property, with improvements, to the taxpayer exchanger to complete the exchange. Any construction to be included in the exchange must be affixed to the real property prior to the replacement property being conveyed from the EAT to the taxpayer exchanger. It is important to note that any improvements made to the replacement property after the deed to the replacement property is transferred to the taxpayer will not be considered like kind to property sold in the exchange. Similarly, sale proceeds remaining after the replacement property is conveyed to the taxpayer will be treated as taxable boot.

The BTS exchange can also be facilitated when the taxpayer exchanger must acquire the replacement property to be improved prior to selling his/her relinquished property. This is a reverse BTS exchange. In a reverse BTS, the taxpayer's relinquished property does not close until later in the exchange period. In this structure, there are no exchange funds to draw from, so typically a lender will provide the funds to the EAT to acquire and improve the replacement property.

While the EAT takes title to the replacement property, the taxpayer exchanger must still appropriately identify the replacement property, including any improvements, he or she will take title to at the conclusion of the exchange. This identification must be submitted in writing, no later than midnight of the 45th day from the first closing, to a party not associated with the exchange, most commonly to the Qualified Intermediary. If the BTS exchange is conducted as a reverse build-to-suit, the relinquished property identification rules apply.

It is always wise to seek tax counsel before applying for any type of tax relief, particularly a BTS exchange. So many variables can affect this structure (weather, construction delays, permits, subcontractors, compliance issues, etc). The tax code provides only 180 days from closing on the relinquished property to acquire the replacement property. While there is great risk in whether that can be accomplished, not all improvements must be completed within the 180 day period. The challenge is to ensure the taxpayer takes title to property substantially similar to what is formally identified.

One of the best ways to accomplish the taxpayer's goal in this process is to ensure all parties involved have a clear understanding of the taxpayer's intent. The taxpayer, taxpayer's legal counsel, taxpayer's tax counsel, general contractor and QI should all have a clear understanding of the roles, responsibilities and timeframes involved in this process. Communication and education on the front end will help prove less complication and frustration on the back end.

Safe Harbors Help Taxpayers Play it Safe
STEC

Part of the 1031 XChange Index - Originally Published 10/1/2007 at STEC

1984 was a pivotal year for the 1031 Industry. It was that year that the 9th Circuit Court of Appeals issued the appellate decision (Starker, 602 F2d 1341 (9th Cir. 1979) providing the structure for non-simultaneous (delayed) exchanges. Up until that time, the IRS Code Section 1031 was predicated on simultaneous swaps of land. Several iterations were made since that time providing further clarify and guidance. These iterations included the introduction of guidelines known as the safe harbors for structuring a 1031 tax deferred exchange. These safe harbors include:

Safe Harbor time limits must be followed

There are two strict deadlines that must be met in order for the exchange to remain within the safe harbor guidelines:

• Identification Period. The taxpayer has 45 days after the first closing (whether it was a purchase or sale) to identify property for the second closing. The identification must be made in writing and sent to the intermediary or someone else who is not closely associated with the taxpayer. The taxpayer can identify up to three replacement properties without regard to value; or can identify more than three as long as the aggregate fair market value does not exceed 200% of the fair market value of the relinquished property.
  
  
• Exchange Period. The taxpayer has a total of 180 days for the entire exchange period. In other words, all properties must be closed within 180 days from the first closing

The property exchanged must be qualifying property

Qualifying property in a land exchange is defined as real property held for productive use in trade or business, property acquired for investment and/or income generating property. The following items do not qualify:

• Stock in trade or other property held primarily for sale,
• Stocks, bonds, or notes,
• Other securities or evidence of indebtedness or interest,
• Interests in a partnership,
• Certificates of trust or beneficial interests

Property use must be qualified as being held for use in trade, business and/or investment.

This eliminates properties used for:

• Personal residence
• Second residences, vacation homes
• Dealer Property (considered inventory)
• Property acquire primarily for sale

Replacement property must be like kind to relinquished property

Real property is like kind to real property, regardless of character or structure. That allows taxpayers to exchange farmland for a rental unit, commercial complex for vacant land, etc.

IRS Code Section 1031 also permits exchange benefits for personal property such as airplanes, office furniture, trucks, livestock, art, collectibles and more. The definition of what is considered like kind is much more narrowly defined for personal property exchanges. The Standard Industrial Classification (SIC) Codes published by the Office of Management and Budget dictate the bands of property considered like kind.

The taxpayer cannot be in receipt of money from the sale

This rule is a key element of the tax code requirements. The purpose of this rule is fairly simple and is the underlying reason why the IRS permits favorable tax treatment in an exchange. Taxpayers swap properties and show that profits from the sale of one property went directly to the purchase of another, which effectively places the taxpayer in the same financial situation. Therefore, if a taxpayer wants to successfully defend the position that he/she is not financially better off than if he/she had not sold the property, the taxpayer cannot benefit from receiving the proceeds of the sale.

Same taxpayer must be on the both legs of the exchange

1031 Tax Deferred Exchange protection is valid only if the identical taxpayers or legal entities both buy and sell property. For example, taxpayers may not sell relinquished property vested in their individual names and take title to the replacement property in the name of a trustee for their revocable living trust. However, if taxpayers are the sole member of a Limited Liability Company (LLC), they can sell relinquished property vested in their name and take title to the replacement property in the name of the LLC. This is because a single member LLC is considered a ‘flow-through’ entity for tax purposes and does not need its own taxpayer identification if it has elected to not be taxed as a corporation. Similarly, if the relinquished property was vested in the names of both husband and wife, then both parties must take title to the replacement property to avoid potential tax consequence.

US Tax Court Limits Exchanges of Vacation Homes
Chris Burti, President Statewide Title Exchange Corporation

Part of the 1031 XChange Index - Originally Published 1/2/2008 at STEC

Between its mountainous western counties, its piedmont lakes and its 130 miles of coastline, North Carolina has a tremendous number of vacation homes and resort rental properties. As one might expect, any Exchange Company headquartered in such a location must deal frequently with questions concerning the qualification of such properties for treatment under Section 1031 of the Internal Revenue Code (sec. 1031, I.R.C.). Historically, there has not been much specific guidance from the IRS concerning treatment of such properties under Section 1031, therefore one must infer what their position might be from several different sections of the Code together with revenue rulings and private letter rulings applicable to those sections. Not surprisingly, this has resulted in disparate opinions being voiced in the counseling of taxpayers by various exchange industry advisors.

In the U. S. Tax Court decision in Moore v. IRC, T.C. Memo., 2007-134, released on May 30, 2007 the IRS's position as accepted by the Tax court is now much clearer. The decision will come as no surprise to those who applied existing doctrine conservatively. The more adventuresome souls are surely anticipating the expiration of relevant statutes of limitations with some measure of anxiety. The case involved two separate tax issues and we will ignore the portions of the Tax Court's discussion that is not related to Exchanges.

The plaintiffs purchased a vacation home in their home state of Georgia in 1988 on two lots on Clark Hill Lake. The family used the home for recreational purposes during the spring and summer months. The plaintiffs relocated in the mid 90's which lengthened the commute to the vacation home and in 1999 they decided to purchase another vacation home closer to their new home. In 2000, the plaintiffs disposed of the first vacation home and acquired a replacement vacation home pursuant to a series of transactions that were intended to qualify as a tax deferred, like-kind exchange under sec. 1031, I.R.C. The plaintiffs and their children used both vacation homes exclusively for recreational purposes, and the plaintiffs never rented or offered to rent either vacation home to third parties. One of the stated motives of the plaintiffs' for acquiring and holding each vacation home was the prospect of an appreciation in value that might result in a profit on the eventual sale of the properties.

The plaintiffs' decision to purchase the Georgia vacation property was motivated, in part, by the fact that both their families owned property on or near it, and they had been advised that property on Clark Hill Lake had appreciated and would continue to appreciate. Their decision to invest in real estate rather than in intangibles, such as stocks or bonds, was influenced by a prior bad experience with a financial adviser who had stolen their money. When they purchased the Clark Hill property in 1988, their primary residence was in Norcross, Georgia, a 3-hour drive. In 1995 or 1996, petitioners changed their primary residence to Marietta, Georgia between a 5 and 6 hour drive.

The plaintiffs used the property with their family a few weekends each month during seasonal weather and for maintenance during the winter. They made improvements to the property and to the mobile home located there over the years that enhanced its value. They refused to sell the property even though they had been offered money for it up until the time that they decided to acquire the Lake Lanier property. They never rented, attempted to rent the home to others or had ever advertised the Clark Hill property for sale until then. They listed deductions for "home mortgage interest" on their Federal income tax returns, but they did not list any deduction for investment interest, maintenance or other expenses associated with the Clark Hill property on those returns.

After they moved from Norcross to Marietta, Georgia, the inconvenience of the longer drive to the Clark Hill property was compounded by their children's increased local weekend activities. As a result, they used the property less and less frequently. It then became a chore just to maintain the property, so that it became rundown and had to be either renovated or sold. This caused the plaintiffs to investigate properties on Lake Lanier, which is much closer to their Marietta, Georgia home. They felt that a house on Lake Lanier would be of more use to them and that property on Lake Lanier would appreciate more rapidly than the Clark Hill property because it was closer to the metropolitan Atlanta area.

The Lake Lanier property consisted of a 1.2-acre plus tract of land, with the "largest double slip dock allowable on the lake (complete with two lifts), and a house that had five screened-in porches overlooking the lake, a full party deck, a covered veranda, a great room with a stone fireplace, five bedrooms, and 4-1/2 bathrooms. At the time of purchase, the house was partially furnished, and, after purchase, petitioners completed the furnishing themselves. They installed a satellite TV system and a VHS recorder, and, before their second summer at the property, they purchased a motorboat with room for six to eight passengers."

The occupied the property in essentially the same fashion as they had at the Clark Hill property prior to their move. They claimed deductions for home mortgage and investment interest paid on their loan to purchase the property on their tax return. They did not list on their 2000-02 returns any deductions for maintenance or other expenses associated with the Lake Lanier property as they had not for the Clark Hill property. Nor did they ever rent or attempted to rent the Lake Lanier property. They never offered it for sale until forced to do so in connection with the division of their assets incident to their divorce.

There were other issues before the Court, but in this case, in order to prevail on the section 1031 issue, they needed to satisfy the Court that they held both properties for investment. This depends on their intent determined as of the time of the exchange.

The court's analysis of this issue follows, unedited as it is very illustrative.

"Petitioners point to their interest in the appreciation potential of the Clark Hill and Lake Lanier properties, both before and after acquisition, and argue: 'If investment intent is one motive for holding … property, it is held for investment for purposes of Section 1031.' Petitioners' argument, if carried to its logical extreme, is that the existence of any investment motive in holding a personal residence, no matter how minor a factor in the overall decision to acquire and hold (or simply to hold) the property before its inclusion in an exchange of properties, will render it 'property … held for investment' with any gain on the exchange eligible for nonrecognition treatment under section 1031. Petitioners are mistaken. It is a taxpayer's primary purpose in holding the properties that counts. Montgomery v. Commissioner, T.C. Memo. 1997-279 ("section 1031 requires that both the property transferred and the property received in a like-kind exchange be held primarily for productive use in a trade or business, or for investment."), affd. in part and revd. in part on another issue without published opinion 300 F.3d 866 (10th Cir. 1999). Indeed, in Starker v. United States, 602 F.2d 1341, 1350-1351 (9th Cir. 1979), the U.S. Court of Appeals for the Ninth Circuit recognized the longstanding rule that the exclusive use of property by the owner as his residence contradicts any claim by him that the property is held for investment. The court applied the rule specifically to section 1031 exchanges. The court said:

It has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment. Losses on the sale or exchange of such property cannot be deducted for this reason, despite the general rule that losses from transactions involving … investment properties are deductible."

"A similar rule must obtain in construing the term 'held for investment' in section 1031. … [Id.; citations omitted.] This and other courts have reached the same conclusion in the context of deciding whether expenses incurred with respect to a personal residence are deductible under section 212(2) as 'expenses paid or incurred … for the management, conservation, or maintenance of property held for the production of income'. Property held for investment is property held for the production of income within the meaning of section 212. See Newcombe v. Commissioner, 54 T.C. 1298, 1302 (1970) (an expense deduction is justified under section 212(2) only if the property to which it relates 'is "held for investment," i.e., for the production of income'); sec. 1.212-1(b), Income Tax Regs. Thus, both section 1031 and section 212(2) involve the same factual inquiry whether the property in question was held for investment."

"As a preliminary matter, we accept as a fact that petitioners hoped that both the Clark Hill and Lake Lanier properties would appreciate. However, the mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence. See Jasionowski v. Commissioner, 66 T.C. 312, 323 (1976) ('if the anticipation of eventually selling the house at a profit were in itself sufficient to establish that the property was held with a profit-making intent, rare indeed would be the homeowner who purchased a home several years ago who could not make the same claim'). Moreover, a taxpayer cannot escape the residential status of property merely by moving out. In Newcombe v. Commissioner, supra, the taxpayers listed their former residence for sale on or about the day they moved out, December 1, 1965. They sold the property at a loss on February 1, 1967. The issue in Newcombe relevant to this case was whether, during 1966, the property was held for the production of income (i.e., for investment) so as to entitle the taxpayers to deductions for maintenance expenses under section 212(2). In denying those deductions we stated: The taxpayer must … be seeking to realize a profit representing post-conversion appreciation in the market value of the property. Clearly, where the profit represents only the appreciation which took place during the period of occupancy as a personal residence, it cannot be said that the property was 'held for the production of income.' … [Id. At 1302.]

We added: 'The placing of the property on the market for immediate sale, at or shortly after … its abandonment as a residence, will ordinarily be strong evidence that a taxpayer is not holding the property for post-conversion appreciation in value.' Id."

"This Court has frequently applied the reasoning of one or both of Jasionowski and Newcombe in rejecting taxpayer arguments that because a second or vacation home was held for appreciation (i.e., investment) the taxpayer was entitled to a deduction, under section 212(2), for expenses incurred to maintain or improve the property. See, e.g., Ray v. Commissioner, T.C. Memo. 1989-628; Houle v. Commissioner, T.C. Memo. 1985-389; Gettler v. Commissioner, T.C. Memo. 1975-87. In both Ray and Houle we denied the deductions on the ground that the taxpayers treated the houses as a "second home" (Ray) or 'second residence' (Houle). In Gettler, we denied the deductions, concluding that "the primary purpose in both acquiring the house and holding on to it was to use it as a vacation home." The cited cases stand for the proposition that the holding of a primary or secondary (e.g., vacation) residence motivated in part by an expectation that the property will appreciate in value is insufficient to justify the classification of that property as property 'held for investment' under section 212(2) and, by analogy, section 1031."

The court in conclusion stated that "the evidence overwhelmingly demonstrates that petitioners' primary purpose in acquiring and holding both the Clark Hill and Lake Lanier properties was to enjoy the use of those properties as vacation homes; i.e., as secondary, personal residences." The case law that the plaintiffs argued supported their position actually involved taxpayers that never occupied the properties, nor used them for personal purposes "and, although the taxpayers' children and friends stayed in both properties, they paid fair market rent to the taxpayers."

The Court's conclusion was that neither the Clark Hill nor Lake Lanier property was property held for investment for purposes of Section 1031 and that the plaintiffs' transfers did not qualify as a tax deferred "like-kind" exchange of properties under Section 1031. As we initially noted, this conclusion should be considered unsurprising. Advisors who have been relying on the absence of express guidance will need to re-think the issue. In many quarters it will even be considered welcome as it will make it significantly easier to deal with taxpayers who are resistant to compliance.

It is important to note that the plaintiffs' personal use of the property disqualified it for the purpose of deducting depreciation on it or expenses for its maintenance other than interest and taxes on their tax return. While the court noted that they didn't make these deductions, it is clear that they couldn't. For those looking for a simple rule in this regard, one might consider generalizing the issue for improved resort/vacation property as, if you can't depreciate it or deduct expenses due to personal use limitations, you probably can't qualify for 1031 treatment as relinquished or replacement property.

Exchange Regulation
Chris Burti, President Statewide Title Exchange Corporation

Part of the 1031 XChange Index - Originally Published 7/18/2008 at STEC

During the past year 1031 Exchange accommodation businesses or Qualified Intermediaries (QI's) engaged in 1031 tax free exchanges have been under scrutiny as a result of several recent companies closing their doors and leaving with taxpayer funds. Uneasiness within the industry has increased with news that many major banks are on shaky ground. The Federation of Exchange Accommodators (FEA) is the only trade organization for Qualified Intermediaries. In addition they play a huge role in lobbying for legislative issues to preserve the 1031 industry and to raise the comfort level of its clients. The FEA has been busy lobbying for industry regulation for QI's that would set industry standards for the manner in which client funds are held.

The U.S. Department of Treasury publishes regulations from time to time that provide rules and guidelines for the mechanics of a 1031 exchange. One such regulation, Sec 1.1031(k)-1(g), states that funds from relinquished property are required to be held by a Qualified Intermediary. However, the regulations do not specify how those funds are to be held, just that the taxpayer cannot take actual or constructive receipt of those funds. The Federation of Exchange Accommodators (FEA), the trade association for 1031 Exchange accommodation companies, has written the Treasury Department and requested a change in the regulations regarding the manner in which exchange funds are held. Basically, the requested change calls for new rules that would require relinquished funds to be deposited in a qualified trust account. Statewide Title Exchange Corp. (STEC) has obtained permission from the FEA to publish the requested rules change along with the proposed change in the Safe Harbor rules and it is our pleasure to be able to present this new information to our clients. The new rules will add an extra layer of protection to the client by requiring exchange funds be held in escrow accounts that do not expose them to risk. Statewide Title Exchange Corp. (STEC) has always as a matter of practice kept client funds in federally insured interest bearing bank accounts. We never invest your funds in risky accounts or speculative stock funds or securities. We welcome the new rules and the added security they bring to our industry.

STEC thanks you for the continued confidence you have placed in us over the years. As always, should you have any questions about you 1031 exchanges please do not hesitate to contact one of our Exchange Professionals at STEC.

-Reprinted Letter Follows-

CAPITOL TAX PARTNERS
June 2, 2008

Internal Revenue Service
Attn: CC:PA:LPD:PR (Notice 2008-47)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Notice 2008-47 (Guidance Priority List)

Dear Sir or Madam:

In response to Notice 2008-47 requesting items for inclusion on the 2008-09 Priority Guidance Plan, we respectfully suggest that you publish guidance that would modify the safe harbors provided in Treasury regulation section 1.1031(k)-1(g).

Under present law, Treasury regulation section 1.1031(k)-1(g) provides that a taxpayer undertaking a deferred like-kind exchange described in section 1031 will not be deemed to be in actual or constructive receipt of certain exchange funds if the taxpayer meets certain safe harbors. These safe harbors involve the deposit of the funds pursuant to an agreement in a qualified escrow account or a qualified trust (section 1.1031(k)-1(g)(3)) or with a qualified intermediary (section 1.1031(k)-1(g) (4)) (hereinafter, collectively, "safe harbor agreement"). The regulations do not require the safe harbor agreement to specify how the exchange funds may be held or invested by the escrow account holder, trustee or qualified intermediary (hereinafter, collectively, "intermediary").

On behalf of the Federation of Exchange Accommodators ("FEA"),¹ we request that Treasury regulation section 1.1031(k)-1 (g) be modified to require that any safe harbor agreement to deposit money or other property in a qualified escrow account or qualified trust or with a qualified intermediary specify that such funds or property be held or invested in a manner that satisfies the investment goals of liquidity and preservation of capital. Moreover, the safe harbor agreement must prohibit (1) the commingling of the exchange funds with the operating accounts of the intermediary, and (2) the lending or other transfer of the funds to a party related to the intermediary (other than to an affiliated bank or to an exchange accommodation titleholder pursuant to a qualified exchange accommodation arrangement for the taxpayer, as described in Revenue Procedure 2000-37). Attached to this letter is suggested language for the modifications to Treasury regulation section l.1031(k)-l(g).

The suggested modifications are supported by strong tax policy and administrative principles. Under present law, section 1031 provides that gain or loss is not recognized on the exchange of certain property if such property is exchanged solely for property of a like kind. Section 1031(a)(3) provides that the exchange of the like-kind properties need not be simultaneous, but that the property be identified and the exchange be completed within a relatively short period of time (45 and 180 days, respectively). Nonrecognition treatment under section 1031 is premised on the tax policy that a taxpayer should not be subject to tax when his or her economic position has not changed.

The safe harbors of the section 1031 regulations reflect this policy by providing that the taxpayer undertaking a deferred exchange not have access to the exchange funds (sections 1.1031(k)-1(g)(3)(ii)(B) and (iii)(B) and section 1.1031(k)-1(g)(4)(ii)), and may only benefit economically by interest or a "growth factor" in the nature of interest with respect to the investment or deposit of the funds (sections 1.1031(k)-1(g)(5) and 1.1031(k)-1(h)). Thus, section 1031 and the regulations contemplate that proceeds from the relinquished property will be used in a timely manner to acquire the replacement property and may accrue earnings, but those earnings must be in the nature of interest from the investment in cash or cash equivalents for a temporary period. Section 1031 and the safe harbors do not contemplate that a taxpayer may sell investment property (the relinquished property), invest the sales proceeds in risky or speculative investments such as stock or securities or in an enterprise, and then re-invest in another investment property (the replacement property).

The proposed modifications further the underlying policies of section 1031 and the safe harbors. The modifications would require the safe harbor agreement to provide that the exchange funds will be held or invested so that they are available, in whole, to complete the contemplated exchange quickly and seamlessly. The modifications contemplate that the exchange funds would not be subject to risks usually associated with investment activities, regardless of whether the investment is directed by the taxpayer or an intermediary.

Further, under the proposed modifications, certain uses of the exchange funds would be prohibited per se by the safe harbor agreement. These uses involve the use of exchange funds by the intermediary either directly in its operational accounts or indirectly by loans to affiliates. These prohibitions are motivated, in part, by the recent financial failures of certain intermediaries. In these cases, taxpayers lost their exchange funds and could not complete their deferred exchanges. The proposed modifications would help to avoid future losses by insuring that exchange funds are not exposed to the enterprise risk of an intermediary or its affiliates, and are not directed by the taxpayer or the intermediary into risky or speculative investments.

Adoption of the proposed modifications will aid tax administration, strengthen faith in the tax system, not create any new complexities for the IRS or taxpayers, and be easily implemented. The recent financial failures of certain intermediaries raised several difficult tax issues for taxpayers, their advisors, and the IRS. The proposed modifications to the section 1031 regulations should lessen the likelihood of future financial failures by qualified intermediaries and help avoid these difficult issues.

For many taxpayers, a deferred like-kind exchange is a one-time or infrequent event. These taxpayers may be relatively unsophisticated tax-wise and place their trust in an intermediary to guide them through the transaction. The recent intermediary financial failings may have shaken this trust not only in the individual firms involved, but also in the tax system as a whole. Adoption of the proposed modifications should help restore taxpayer confidence by reducing the possibility of future defaults.

Adoption of the proposed modifications will not create new burdens for the IRS or taxpayers. The modifications would require that the safe harbor agreement provide that the exchange funds will be held or invested in a manner that meets the investment goals of liquidity and capital preservation. The IRS will not need to inquire how the funds were actually held or invested or whether the goals were achieved. The only relevant inquiry is whether the safe harbor agreement called for the required investment standard. If the safe harbor agreement contains a provision that meets the standard, but the funds are not appropriately held or invested, the exchange will still qualify under section 1031 (assuming all other requirements are met). In these cases, the taxpayer may have a cause of action against the intermediary for breach of contract.

Adoption of the proposed modifications will not create significant new burdens for intermediaries, Almost all intermediaries currently hold or invest exchange funds with the investment goals of liquidity and capital preservation. Requiring this best practices standard in the regulations will not be burdensome.

Thank you for your consideration of this matter. We would be happy to meet with you to discuss this important issue in greater detail. In the meantime, if you have any questions or comments, please do not hesitate to contact the undersigned.

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¹The FEA is the only national trade organization formed to represent qualified intermediaries, their primary legal/tax advisors, and affiliates who are directly involved in IRC section 1031 exchanges. Formed in 1989, the FEA was organized to promote the discussion of ideas and innovations in the industry, to establish and promote ethical standards of conduct for the industry, to offer education to both the exchange industry and the general public, and to work toward the development of uniformity of practice and terminology within the exchange profession.

Sincerely,
Joseph M. Mikrut
Joseph M. Mikrut

Attachment

cc:
The Honorable Eric Solomon The Honorable Donald Korb
Assistant Secretary (Tax Policy) Chief Counsel
Department of the Treasury Internal Revenue Service
Ms. Karen Gilbreath-Sowell Ms. Clarissa Potter
Deputy Assistant Secretary (Tax Policy) Deputy Chief Counsel
Department of the Treasury Internal Revenue Service
Mr. Eric San Juan Mr. Edward S. Cohen
Tax Legislative Counsel Deputy Assoc. Chief Counsel
Department of the Treasury Internal Revenue Service
Mr. Dennis Tingey Ms. Donna Crisalli
Attorney-Advisor Senior Technical Reviewer
Department of the Treasury Internal Revenue Service

MODIFY REQUIREMENTS FOR WRITTEN SAFE HARBOR AGREEMENT BY ADDING NEW SECTION (g)(6)(iv); MODIFY SECTIONS (g)(3)(ii)(B), (g)(3)(iii)(B), (g)(4)(ii) and (g)(6)(i) TO REFERENCE NEW (g)(6)(iv) (Changes in italics)

(g) SAFE HARBORS
(1) IN GENERAL.
Paragraphs (g)(2) through (g)(5) of this section set forth four safe harbors the use of which will result in a determination that the taxpayer is not in actual or constructive receipt of money or other property for purposes of section 1031 and this section. More than one safe harbor can be used in the same deferred exchange, but the terms and conditions of each must be separately satisfied. For purposes of the safe harbor rules, the term "taxpayer" does not include a person or entity utilized in a safe harbor (e.g., a qualified intermediary). See paragraph (g)(8), Example 3 (v), of this section.

(2) SECURITY OR GUARANTEE ARRANGEMENTS. [not included]
...

(3) QUALIFIED ESCROW ACCOUNTS AND QUALIFIED TRUSTS.
(i) In the case of a deferred exchange, the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like-kind replacement property will be made without regard to the fact that the obligation of the taxpayer's transferee to transfer the replacement property to the taxpayer is or may be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow account or in a qualified trust.
(ii) A qualified escrow account is an escrow account wherein --
(A) The escrow holder is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section), and
(B) The escrow agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account, and expressly limits the escrow holder’s rights to hold and invest the money or other property held by the escrow holder, all as provided in paragraph (g)(6) of this section.
(iii) A qualified trust is a trust wherein --
(A) The trustee is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section, except that for this purpose the relationship between the taxpayer and the trustee created by the qualified trust will not be considered a relationship under section 267(b)), and
(B) The trust agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held by the trustee, and expressly limits the trustee's rights to hold and invest the money or other property held by the trustee, all as provided in paragraph (g)(6) of this section.
(iv) Paragraph (g)(3)(i) of this section ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the qualified escrow account or qualified trust. Rights conferred upon the taxpayer under state law to terminate or dismiss the escrow holder of a qualified escrow account or the trustee of a qualified trust are disregarded for this purpose.
(v) A taxpayer may receive money or other property directly from a party to the exchange, but not from a qualified escrow account or a qualified trust, without affecting the application of paragraph (g)(3)(i) of this section.

(4) QUALIFIED INTERMEDIARIES.
(i) In the case of a taxpayer’s transfer of relinquished property involving a qualified intermediary, the qualified intermediary is not considered the agent of the taxpayer for purposes of section 1031(a). In such a case, the taxpayer's transfer of relinquished property and subsequent receipt of like-kind replacement property is treated as an exchange, and the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like-kind replacement property is made as if the qualified intermediary is not the agent of the taxpayer.
(ii) Paragraph (g)(4)(i) of this section applies only if the agreement between the taxpayer and the qualified intermediary expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary, and expressly limits the qualified intermediary's rights to hold and invest the money or other property held by the qualified intermediary, all as provided in paragraph (g)(6) of this section.
(iii) A qualified intermediary is a person who
(A) Is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section), and
(B) Enters into a written agreement with the taxpayer (the "exchange agreement") and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.
(iv) Regardless of whether an intermediary acquires and transfers property under general tax principals, solely for purposes of paragraph (g)(4)(iii)(B) of this section --
(A) An intermediary is treated as acquiring and transferring property if the intermediary acquires and transfers legal title to that property,
(B) An intermediary is treated as acquiring and transferring the relinquished property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person, and
(C) An intermediary is treated as acquiring and transferring replacement property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the replacement property for the transfer of that property and, pursuant to that agreement, the replacement property is transferred to the taxpayer.
(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.
(vi) Paragraph (g)(4)(i) of this section ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. Rights conferred upon the taxpayer under state law to terminate or dismiss the qualified intermediary are disregarded for this purpose. (vii) A taxpayer may receive money or other property directly from a party to the transaction other than the qualified intermediary without affecting the application of paragraph (g)(4)(i) of this section.

(5) INTEREST AND GROWTH FACTORS. [Not included]
...

(6) ADDITIONAL RESTRICTIONS ON SAFE HARBORS UNDER PARAGRAPHS (g)(3) THROUGH (g)(5).
(i) An agreement limits a taxpayer's rights as provided in this paragraph (g)(6) only if the agreement provides that the taxpayer has no rights, except as provided in paragraphs (g)(6)(ii) and (g)(6)(iii) of this section, to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period, and expressly limits the rights of the escrow holder, trustee or qualified intermediary to hold and invest the money or other property held as provided in paragraph (g)(6)(iv) of this section.
(ii) The agreement may provide that if the taxpayer has not identified replacement property by the end of the identification period, the taxpayer may have rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property at any time after the end of the identification period.
(iii) The agreement may provide that if the taxpayer has identified replacement property, the taxpayer may have rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property upon or after --
(A) The receipt by the taxpayer of all of the replacement property to which the taxpayer is entitled under the exchange agreement, or
(B) The occurrence after the end of the identification period of a material and substantial contingency that --
(1) Relates to the deferred exchange,
(2) Is provided for in writing, and
(3) Is beyond the control of the taxpayer and of any disqualified person (as defined in paragraph (k) of this section), other than the person obligated to transfer the replacement property to the taxpayer. (iv) The agreement must expressly provide that all cash or cash equivalents held by the escrow holder, trustee or qualified intermediary must be held in a manner that provides liquidity and preserves principal, and if invested, must be invested in a manner that satisfies investment goals of liquidity and preservation of principal. The agreement must expressly prohibit commingling of money held in the exchange account with the operating accounts of the escrow holder, trustee, or qualified intermediary, and lending or other transfer of money held in the exchange account to a party related to the escrow holder, trustee, or qua fl/led intermediary, other than an affiliated bank or an "exchange accommodation titleholder" for the purposes of an exchange by the taxpayer under Revenue Procedure 2000-37.

IRS Issues Final Regulation on Qualified Intermediary Funds
Chris Burti, President Statewide Title Exchange Corporation

For some time now, the IRS has been going through the process of promulgating a final regulation governing the tax treatment of the interest earned on funds held in a qualified escrow account or by a Qualified Intermediary under Sections 468B and 7872. The IRS has taken the position that the money that is held by an exchange facilitator as part of a deferred exchange should be treated as a loan by the taxpayer to the exchange facilitator. As such, the loan would be subject to imputed interest rules and the loan must be tested under section 7872 to determine whether it is a below-market loan for purposes of that section. The proposed regulations would have provided that a taxpayer must use a special 182-day applicable Federal rate (AFR) to test whether an exchange facilitator loan is a below-market loan. If an exchange facilitator loan was a below-market loan, the loan would be treated as a compensation-related loan that is not exempt as a loan without significant tax effect under Section 7872. Thus the taxpayers would be charged and taxed for income they had not received where the exchange facilitator retained any of the interest on the account which is a common practice in the industry.

Under the final regulations, if exchange funds are treated as being loaned by the taxpayer to the Qualified Intermediary, interest will be imputed to the taxpayer under section 7872 unless the exchange facilitator pays "sufficient interest". If the Qualified Intermediary does not provide for sufficient interest and the loan is not otherwise exempt from section 7872, interest income will be imputed to the taxpayer. Therefore, Qualified Intermediaries will be required to keep records of the amount of income paid to a taxpayer and may be required to report the income on Forms 1099 if not otherwise reported. The IRS estimated that most small businesses subject to the proposed regulations currently maintain records of the amount of income paid to the taxpayer and report the payments on Forms 1099. They concluded that the proposed regulations would not significantly increase the compliance burden of keeping records and reporting income paid to taxpayers. The exchange industry provided a study that showed that the added workload to comply with the proposed regulations is substantial and the software needed to comply with the recordkeeping requirements is not available at a cost affordable to many small businesses. Those commenting on the proposed regulations complained that the loan characterization rules would cause a large number of small businesses to suffer a substantial revenue loss and to fail or reduce their workforces. They claimed that small Qualified Intermediaries would be disproportionately affected because many often retain all or some, of the interest earned on the funds held in the exchange accounts. Obviously, if these businesses were required to impute interest on exchange funds, their customers would demand that this interest be paid to them. They assert that because bank-affiliated Qualified Intermediaries earn profits by means of credits that are not attributed to exchange funds, bank-affiliated Qualified Intermediaries will not be required to raise fees, creating an economic disparity between similarly situated bank-affiliated Qualified Intermediaries and independent Qualified Intermediaries. The smaller Qualified Intermediaries would be required to change their business practices, paying all income to the taxpayer and to charge higher fees to remain profitable, while large, bank-affiliated Qualified Intermediaries would generally be unaffected.

In response to the comments, the final regulations provide an exemption from section 7872 for exchange transactions in which the amount of exchange funds treated as loaned does not exceed $2 million and the funds are held for 6 months or less. The IRS advises that this exemption amount may be increased in future published guidance. Based upon comments received the $2 million amount is expected to exempt most deferred exchange transactions handled by small business exchange facilitators from the application of section 7872. This would eliminate a significant number of transactions which would generate only a nominal amount of tax revenue due to the small sums and short duration for which they are held. For sums over $2,000,000, the final regulations provide that, if exchange funds are held with a depository institution in an account (including a sub-account) that is separately identified with a taxpayer's name and Tax Identification Number, only the earnings on the account are treated as earnings attributable to the exchange funds. If the escrow agreement, trust agreement, or exchange agreement specifies that all the earnings attributable to exchange funds are payable to the taxpayer, the exchange funds are not treated as loaned from the taxpayer to the exchange facilitator. Thus taxpayer only takes into account all items of income, deduction, and credit attributable to the exchange funds. Even if the exchange facilitator commingles taxpayers' exchange funds (whether or not a taxpayer's funds are held in a separate account) all earnings attributable to a taxpayer's exchange funds are treated as paid to the taxpayer if all of the earnings allocable on a pro rata basis to a taxpayer, are paid to the taxpayer.

When an exchange facilitator benefits from the use of the taxpayer's exchange funds in a non-exempt account, characterizing the exchange funds as having been loaned from the taxpayer to the exchange facilitator is consistent with the substance of the transaction and with the definition of loan in the legislative history of Section 7872. It was felt that the standard AFR would produce too high an amount as the funds in an exchange are usually held short term. To mitigate the harshness of the standard AFR, the final regulations provide a special AFR that is the investment rate on a 13-week (generally, 91-day) Treasury bill. In addition, because the short-term AFR may be lower than the 91-day rate, the final regulations provide that taxpayers must apply the lower of the 91-day rate or the short-term AFR when testing for sufficient interest under Section 7872.

In order to allow for exchange companies to bring their forms and practices into compliance with the new regulations, the final regulations will only apply to transfers of relinquished property made on or after October 8, 2008. There is a transition rule with respect to transfers of relinquished property made by taxpayers after August 16, 1986, but before October 8, 2008. In those instances the Internal Revenue Service will not challenge "a reasonable, consistently applied method of taxation for income attributable to exchange funds."

Qualified Intermediaries such as Statewide Title Exchange Corporation will be largely unaffected by these amendments to the regulations because they have always segregated the taxpayers' accounts, identified them with the taxpayers' TIN, remitted all of the interest to, or on behalf of, the taxpayers and provided for the proper issuance of all required 1099's.

Section 1031, Holding Requirements for Drop/Swap and Swap/Drop Deals
Chris Burti, President, Statewide Title Exchange Corporation

Part of the 1031 XChange Index - Originally Published 10/31/2008 at STEC

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This article was revised in 2015 as the previous proposals are now in effect.

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Strategies used to structure Internal Revenue Code Section 1031 exchanges often become more complex when the exchanges involve property owned by partnerships, limited liability companies and closely held corporations. Investors cannot exchange interests held in such business entities and also defer recognition of gain or loss under Section 1031. Effective for transfers after March 31, 1984, the Tax Reform Act added partnership interests as non-qualified property for deferred treatment under IRC Section 1031. Yet, the entity itself can make an exchange of its qualified property and like any other taxpayer it will not have to pay capital gains taxes or recapture depreciation as a result. For example, if an entity owns an office building, the entity can exchange that office building under Section 1031 for another office building, or an apartment complex, or any other qualified "like-kind" property.

Dissolution of a closely held business and distribution of its assets after an exchange of any of its assets is an exit strategy referred to as a "swap and drop." If two parties own an entity that owns a single property worth $100,000, that entity may trade it for two properties worth $50,000 each (the swap). Those properties would then be matched with the ownership interest of the partners and this matching would subsequently allow for an easier dissolution of the entity (the drop).

There are occasions when it makes financial sense to split up or liquidate an entity and subsequently exchange the real property assets held by the entity to take advantage of the tax deferral benefits of Section 1031. In a "drop and swap" transaction, an entity first distributes assets to the partner(s) who want to cash out of the entity (the drop), and then these partners exchange the assets, as individual owners, under Section 1031 (the swap). For example, the partners may have developed different investment goals or perhaps they no longer desire to work together. In such cases, they may want to exchange out of the entity property, but each investor wants to invest their share of the proceeds independently. Under IRC Section 731(a) and (b), a distribution liquidating a partner's interest is generally tax-free to both the partner and the partnership (with exception for distributed cash, receivables and inventory exceeding the partner's adjusted basis). Subsequently, the entity will be liquidated and the entity's entire real property assets distributed individually to each partner. In some instances, one or more of the partners may opt out of the enterprise and in a liquidation of their interest, receive a distributive share of the assets individually or as an undivided interest in common with the entity rather than complete a dissolution of the  entity.

One problem with structuring such transactions so as to qualify for favorable treatment under Internal Revenue Code Section 1031 is that the Code requires that the properties exchanged must be held for productive use in a trade or business or for investment. In the case of the transactions we've described, the holding period is very brief which, arguably, gives rise to the question of whether they have been held long enough to show the requisite intention to hold the property for the qualified purposes. The penultimate question may be how long must the property be held after a swap and drop or a drop and swap to qualify. Unfortunately, the Internal Revenue Code, the IRS, nor the courts have provided much certainty in this area.

We can look to Dealer Property issues for a start in analyzing the holding period issue. Stock in trade, inventory, or property that is primarily held for sale is disqualified from exchange treatment under Section 1031 if held for sale to customers in the ordinary course of the taxpayer's business. Real property held for sale by developers and real estate dealers is likewise not qualified property under Section 1031 and is referred to as dealer property. In determining who is a dealer with respect to a specific real estate transfer, the IRS looks at the facts and circumstances of each case and makes its determination on a property-by-property basis. The reason for this is that someone whose primary business is being a dealer may do a Section 1031 exchange with respect to property that actually qualifies as having been held for the required purposes. There is no clear-cut definition of dealer property, but the IRS tends to focus on the following issues: what is the taxpayer's primary business; what is the percentage real estate sales of the taxpayer's total income; how many property sales has the taxpayer transacted in the tax year; why was the property acquired and/or transferred; how long was the property held; what kind of development activity has the taxpayer been involved with on the property; and did the property have income-producing potential?

It is also important to recognize that you do not have to be primarily in the business of buying and selling real estate for your property to be treated as dealer property by the IRS. As an example, when a buyer of a taxpayer's Relinquished Property requires the taxpayer to preliminarily undertake subdivision approval activities or preliminary development work for the buyer's ultimate development of the property, the taxpayer could be considered as being in business with the buyer, and then the IRS could disqualify the exchange by characterizing it as a sale of dealer property.

Similarly, Section 1031treatment is not available for real estate investors who "flip" properties regularly.  "Flipping" is the practice of buying real estate and then quickly reselling it (with or without new improvements) at a profit. This property is not eligible because it is held for resale and not for productive use in a trade or business or for investment. The taxpayer must remain aware of the requirement that both the relinquished and the replacement properties be held for use in a trade or business or for investment rather than resale. If the IRS characterizes the property as being held by the taxpayer for the purpose of resale rather than use in a trade or business or for investment, then the property will be disqualified from the Section 1031 exchange process unless the taxpayer can prove otherwise.

For tax purposes, a taxpayer can recharacterize property that does not ordinarily qualify for favorable Section 1031 treatment by actually using it in a trade or business or for the production of income. The IRS will look at how a taxpayer characterized that property on tax returns and whether the taxpayer has taken deductions for expenses, maintenance, and depreciation or has reported rental income on the property as part of its analysis of whether a particular property has been held for productive use in a trade or business or for investment. Although there is no written guidance on how long the property must be held for a qualifying use before it is recharacterized and can be exchanged, some tax professionals suggest six months, but that is arguably a bit arbitrary. Some advisors suggest holding it across at least one tax reporting period as a minimum. In Black v. Commissioner, 35 T.C. 90 (1960), the taxpayer received property and flipped it nine months later, with the Tax Court holding that this was not property held for investment. Others argue for a holding period of two years, reasoning the strict holding rules for related parties suggest a safe haven. Note that the IRS insists that it will examine each exchange on an individual basis, but has indicated that two years of business use is required to be sufficient in PLR 8429039. Where the disposition of the Replacement Property was required by events that were unrelated to the exchange, the IRS approved a holding period of less than six months in PLR 8126070.

These recharacterization issues might be applied to the drop and swap and swap and drop issues regarding holding requirements as well. The IRS has historically taken the position that property that is the subject of a tax-free exchange under Section 1031 may not be transferred immediately before or after that exchange. (see: Rev. Rul. 84-21, Rev. Rul. 77-337, Rev. Rul. 75-292, P.L.R. 822105).  Older cases tend to be adverse to the taxpayer, and required clear evidence of holding period and qualified intent at the time the property was acquired. In Regals Realty Co. v. Commissioner, 43 B.T.A. 194 (1940), aff'd 127 F.2d 931 (2nd Cir. 1942), the property received in the 1031 exchange was immediately transferred to a new corporation and held to not meet the holding period requirement. In Revenue Ruling 75-292, the IRS ruled that a taxpayer transferring Replacement Property in a prearranged transaction to a corporation in exchange for stock under Internal Revenue Code Section 351, did not hold the Replacement Property for investment and the exchange did not qualify under Internal Revenue Code Section 1031.

In Magneson v. Commissioner, 81 T.C. 767 (1983), aff'd 753 F.2d 1490 (9th Cir. 1985), the court held that a swap and drop to a partnership worked. The Tax Court ruled that the prearranged transfer of an interest in real property to a partnership following a tax-free exchange satisfied the holding requirement of IRC Section 1031(a). The majority in the Circuit Court of Appeals reasoned that the contribution represented a continuation of the old investment and not a liquidation of that investment since the transfer to the partnership was not taxable under IRC Section 721.

Similarly,  Bolker v. Commissioner, 81 T.C. 782 (1983), aff'd 760 F.2d 1039 (9th Cir. 1985) a Tax Court case appealed to the United States Court of Appeals for the Ninth circuit, dealt with a drop and swap and the Court held that they were permissible.  Here corporate property received in liquidation was exchanged in a pre-arranged transaction for other like-kind property, the exchange qualified under Section 1031. The Commissioner argued unsuccessfully that because Bolker acquired the property with the intent, and almost immediate contractual obligation, to exchange it, Bolker never held the property for productive use in trade or business or for investment as required by section 1031(a). The Court relied on its decision in Magneson and determined that the fact that the tax-free transaction preceded rather than followed the like-kind exchange was not significant enough to warrant a different result. The Court examined all of the facts and circumstances of the negotiations and determined that the transaction was negotiated and consummated by the individual shareholder rather than the corporation, even though the agreement preceded distribution and liquidation of the corporation.

In Bolker the Court said that when "a taxpayer owns property which he does not intend to liquidate or to use for personal pursuits, he is "holding" that property "for productive use in trade or business or for investment" within the meaning of section 1031(a). Under this formulation, the intent to exchange property for like-kind property satisfies the holding requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits."  It may be significant that several recent letter rulings by the IRS have said that an exchange is not a sale which may give support to the position that a drop and swap should be less problematic than in the past.

There are potential problems with both of these cases.  They dealt with facts preceding the effective date of, the Tax Reform Act of 1984 that added Internal Revenue Code Section 1031(a)(2)(D) which excludes exchanges of partnership interests. Though are important taxpayer favorable decisions, relying on them may be risky. Courts in other circuits are not bound by Ninth Circuit decisions even if Magneson has been cited favorably in two other Circuits. Even in the Ninth Circuit, a case involving different fact patterns could yield different results.

In Bonnie B. Maloney 93 T.C. 89, (1989) the Tax Court approved a swap and drop exchange structured by a corporation exchanging Relinquished Property for Replacement Property and then distributing the Replacement Property to its shareholders.  The IRS contended that the exchange failed because the corporation never intended to retain the Replacement Property for business or investment purposes but acquired it only to distribute to the shareholders. The Tax Court determined that the corporation held the Replacement Property for investment purposes regardless of its subsequent transfer of the Replacement Property to the shareholders. It is significant the corporation was liquidating completely subsequent to the exchange and this may suggest that partial liquidations might not be considered advisable for risk adverse taxpayers.

It is argued that these more recent cases should apply equally to transactions involving partnerships and LLC's, since for many purposes the Internal Revenue Code recognizes them as taxable entities. If they are recognized as a separate entity for purposes of tax-free exchanges under IRC Section 1031, in order to avoid the partnership being treated as the transferor, all negotiations and transactions must be carefully orchestrated to make clear that they are being conducted by a partner in an individual capacity. Under the language of Bolker, it would appear that a partner could negotiate an eventual transaction of property received in distribution prior to its actual receipt without violating the entity concept of Court Holding. Although Bolker and Magneson, in effect, overruled a couple of 1970's Revenue Rulings, the IRS has never revoked those Rulings.  There is some speculation that the IRS may wish to keep these rulings alive in the event it chooses to actively challenge the drop transactions based upon a strict interpretation of  Internal Revenue Code Section 1031(a)(2)(D ) combined with the application of the step transaction doctrine. 

There are some cautionary determinations after Bolker and Magneson that must be evaluated when considering how to structure an entity drop transaction. In TAM 9818003, an exchange was disallowed when a partnership deeded the Relinquished Property directly to the transferee, but had the Replacement Property deeded directly to the partners. In 1997 the IRS issued PLR 9741017 which disallowed exchange treatment for two brothers who attempted to exchange their 1/2 undivided interest in a division of several tracts of land held title as tenants in common. They were deemed partners because they had filed partnership returns and the IRS determined that they had exchanged a partnership interest for the fee simple interest. Technical Advice Memorandum 9645005 (July 23, 1996) addressed a § 1033 involuntary conversion in which a partnership distributed the Relinquished Property to the partners one day before its sale, and the partners received various replacement properties. The IRS held that the co-tenants had sold the Relinquished Property as conduits for the partnership and had never had the benefits or burdens of ownership.

The IRS has seemed to show more leniency when the taxpayer has not cashed out of the investment in the Relinquished Property in any significant way. In PLR 9751012 the IRS determined that acquiring Replacement Property by a taxpayer corporation, through the use of two wholly-owned LLCs, qualified for favorable Section 1031 treatment notwithstanding that the relinquished properties had been held by related predecessor corporations which were liquidated and merged into the taxpayer corporation. In PLR 200521002 the IRS ruled that Replacement Property acquired by a trust in a Section 1031 exchange may be distributed to the trust beneficiaries without affecting the tax deferral.

In July 2008 the IRS made changes to Form 1065, which is the form used by partnerships (as well as limited liability companies treated as partnerships for federal income tax purposes) to report income and losses. The revisions, which apply to 1031 exchanges, are found in questions 13 and 14 of Schedule B of the Form.  These changes suggest heightened IRS interest in distributions by a partnership of property to its partners immediately before or after a 1031 tax deferred exchange. These distributions are referred to as "drop and swap" when they occur before the exchange and "swap and drops" for those occurring after.  The IRS has consistently maintained that "drop and swap" and "swap and drop" transactions fail to qualify as valid 1031 exchanges as we discussed above.   

The changes are as follows:

Question 13:  Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (including a disregarded entity).

Question 14:  At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?

Question 13 looks to whether a partnership has completed an exchange and then distributed the property to its partners or distributed the property to another entity in a "swap and drop.  This applies to the tax year of the filing and the prior year. Question 14 looks to whether a partnership has distributed an undivided interest in the property to one or more partners in a partial or complete liquidation of that partner's interest which might be a precursor to a "drop and swap" for a subsequent 1031 exchange.

The likely purpose of these changes is to track the distribution/contribution activities of partnerships or their partners engaging in 1031 exchanges.  How the Service intends to use this information is not yet clear, but there are holding period implications for a 1031 exchange.  One pitfall may be increased audit risk by the IRS for partners of a partnership that indicates on the forms that they have engaged in such transactions.

Bankruptcy Court: 1031 Funds are Assets of QI's Estate
Chris Burti, President Statewide Title Exchange Corporation

Part of the 1031 XChange Index - Originally Published 7/1/2009 at STEC

The U.S. Bankruptcy Court for the Eastern District of Virginia ruled in late April that funds held pursuant to tax-deferred exchange agreement under IRC Section 1031by a Qualified Intermediary in a Chapter 11 filing are property of the bankrupt estate. Millard Refrigerated Services, Inc. v. Landamerica 1031 Exchange Services, Inc., APN 08-03147-KRH, U.S. Bankruptcy Court, Eastern District, Virginia, Richmond Division. The bankruptcy court ruled that the relationship between the Qualified Intermediary and the Taxpayer claimant was that of debtor and creditor and not of trustee and beneficiary contended by the plaintiff.

A 1031 Exchange allows a taxpayer to defer the payment of tax that otherwise would be due upon the realization of a gain on the disposition of business or investment property through the use of a Qualified Intermediary. In the typical transaction, a taxpayer desiring to structure a transaction as a qualifying exchange assigns its rights as seller under a contract for the disposition of business or investment property to a qualified intermediary pursuant to the terms of a written exchange agreement. The purchaser of the relinquished property transfers the net sales proceeds directly to the qualified intermediary who holds the funds for the completion of the exchange. Under Internal Revenue Code Section 1031, the exchanger must identify like-kind replacement property within 45 days. The taxpayer has a maximum of 180 days to close on the replacement property after the conveyance of the relinquished property. The qualified intermediary, in theory, purchases the replacement property and then transfers the replacement property to the taxpayer, but in most instances, the actual conveyances are accomplished by direct deeding among the respective parties. If the replacement property is not identified or the replacement property purchase is not completed within these time periods, the qualified intermediary then pays the net sales proceeds realized from the sale of the relinquished property to the taxpayer.

In this case, the Qualified Intermediary invested certain of the exchange funds it received from its customers in the ordinary course of its business. Some of the exchange funds received by the Qualified Intermediary were invested in the form of auction rate securities that are now illiquid as a result of the rapid economic decline experienced in late 2008 that left these credit markets frozen. As a result, the Qualified Intermediary does not have the liquidity to fund all of its exchange obligations within the Section 1031 time limits.

This case was one of over 85 adversary proceedings that have been brought by former customers of the Qualified Intermediary in connection with its Chapter 11 bankruptcy case. They assert that the exchange proceeds deposited into the Qualified Intermediary's bank accounts are held in trust for their benefit and should be returned to them. On the Petition Date, the Debtor had approximately 450 uncompleted exchange transactions pursuant to separate exchange agreements. The Debtor employed two primary types of exchange agreements: "(a) agreements that included language contemplating that the applicable exchange funds would be placed into an account or sub-account associated with the relevant customer's name (the "Segregated Account Agreements"); and (b) agreements that did not include this "segregation" language (the "Commingled Account Agreements")." Only 50 of the uncompleted exchange transactions involved Segregated Account Agreements. The Court entered a protocol order in January of 2009 staying litigation in all but five of these proceedings. Each of the selected cases were allowed to proceed on an expedited basis, presented legal and factual issues common to the other adversary proceedings. The plaintiff's proceeding was selected to be the representative case for customers with segregated exchange agreements.

The plaintiff entered into three separate exchange agreements with LandAmerica Exchange Services in October of 2008, and the Qualified Intermediary opened segregated client sub-accounts in the plaintiff's name and taxpayer Identification number under a master control account that the Qualified Intermediary maintained and controlled. The opinion set out a fairly detailed summary of the cash management procedures of the Debtor and apparently found them significant as refuting the plaintiff's arguments. Suffice it to say that the procedures were solely for the purpose of allowing the Debtor to rake off a significant return from the funds entrusted to its care for its own benefit. There is nothing in the record the Court presents to suggest that the plaintiff knew about, approved of or consented to the debtor's use of the skimmed earnings.

The plaintiff contended that the facts showed that under the terms of the Exchange Agreements the Qualified Intermediary was required to place the funds in segregated sub-accounts in the plaintiffs' name and tax identification number, the plaintiff was entitled to the accrued interest, and there was no imposition of risk of loss on the Qualified Intermediary commonly associated with ownership. It argued that all of the exchange funds should be turned over to it outside of the bankruptcy pro rata distribution system. The plaintiff contended that facts proved that it never relinquished its equitable right in the funds and that the Qualified Intermediary was holding the funds in trust for its benefit. The Creditors' Committees and the Debtor argued that the exchange funds were held by the Qualified Intermediary pursuant to the terms of exchange agreements between the parties and were assets of the Debtor. The Creditors' Committees asserted that under the provisions of the exchange agreements, the plaintiff disclaimed all "right, title and interest" in the exchange funds and provided the Qualified Intermediary with exclusive rights of "dominion, control and use" over them. They argued that this evidenced the clear intention of the parties not to create a trust arrangement. The court held that the facts in the case mandate a presumption that the exchange funds are the property of the Qualified Intermediary's bankruptcy estate and that for the plaintiff to successfully rebut this presumption, it must show that it retained some right in and to the funds.

The court analyzed state ( Virginia ) law to determine the existence of an express or constructive trust that would mandate that the funds should be excluded from the bankruptcy estate. Under Virginia law, an express trust is created only where there is an affirmative intent to create a trust and the requisite intent can be established by express language between the parties or by circumstances that clearly demonstrate the intent to create a trust. Clearly, the court would not find any such express language or use of the terms "trust", "trustee", or "beneficiary" in any typical exchange agreement and did not here. The court held that the language of the Exchange Agreements actually showed the parties' intention to not create a trust.  

 
The court also found it significant that the plaintiff chose to use the Qualified Intermediary safe harbor to the exclusion of the other safe harbors available to them under Treasury Reg. 1.1031(k)-1(g). The Treasury Regulations permit the use of a separate qualified escrow or qualified trust to secure the transferee's obligation to deliver replacement property. While the terms and conditions of the safe harbors must be satisfied separately, they are not mutually exclusive. In this instance a separate qualified trust arrangement was not employed. Thus, the Court found that there was no express trust created in these exchanges.
 
Additionally, the court held that the parties' intentions were clearly discernible by the terms of the Exchange Agreements and that the parties evidenced their intention not to create a trust and the funds were considered part of the Qualified Intermediary bankruptcy estate.

The treasury regulations governing exchanges sanctioned by Internal Revenue Code Section 1031 require that the taxpayer must abrogate all control over the exchange funds until the exchange is completed. The court notes: "'If the taxpayer actually or constructively receives money or property in the full amount of the consideration for the relinquished property before the taxpayer actually receives like-kind replacement property, the transaction will constitute a sale and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.' Treas. Reg. § 1.1031 (k)-1(f). However, the abrogation of control required by the treasury regulations does not require the taxpayer to relinquish all right, title and interest to the exchange funds as the parties to these Exchange Agreements (as hereinafter defined) contracted for Millard to do. See DeGroot v. Exchanged Titles, Inc. (In re Exchanged Titles, Inc.), 59 B.R. 303, 306 (Bankr. C.D. Cal. March 27, 1993) ("for the purpose of the exchange . . . there was no need for [the accommodator] to acquire ‘real' interest in the . . . property . . . to make the exchange qualify under the statute. . . .'") (citation omitted); Cook v. Garcia, No. 96-55285 1997 WL 143827, at *1 (9th Cir. 1997) ("A taxpayer need not abandon all equitable interests in the proceeds . . . for a transaction to qualify as a non-taxable event under section 1031."). This negates Millard's argument that the disclaimers contained in Section 2 of the Exchange Agreements were included only because the treasury regulations required them to be included."

The Court goes on to observe: "Treasury Regulation Section 1.468B-6, 26 C.F.R. § 1.468B-6,8 establishes rules concerning the taxation of exchange funds held by exchange facilitators. The default rule established by the treasury regulation is that where the exchange funds exceed $2 million, they will be treated for tax purposes as a loan from the taxpayer to the qualified intermediary. Treas. Reg. § 1.468B-6(c)(1); Treas. Reg. § 1.7872-5(b)(16). There are, however, four safe harbor exceptions to this default rule. One of those safe harbors provides that if a qualified intermediary holds the exchange funds in a segregated account established under the taxpayer's name and identification number, then the qualified intermediary need not take into account items of income, deduction, and credit attributable to the exchange funds. Treas. Reg. § 1.468B- 6(c)(2)(i)-(ii).9 Under this exception exchange funds held in sub-accounts are treated as separate accounts even though they may be linked to a master account. Treas. Reg. § 1.468B-6(c)(2)(ii)."

While the court uses this analysis to support its conclusion that the funds belong to the Debtor's estate, there is a fundamental fallacy in its logic. If the funds were not so segregated, they would be treated for tax purposes as a loan. Had that been the case here, the Court's conclusion would be correct. But, the Treasury regulations provide that where the account is segregated and all interest attributable pursuant to the account is payable to the taxpayer, the exchange funds will not be treated as being loaned to the Qualified Intermediary.  If the money were loaned to the Qualified Intermediary, the interest would be attributed to it and taxed as income of the Qualified Intermediary. Clearly the IRS considers the funds to be the taxpayer's and the income taxed as such where the account meets this standard. As the taxpayer took the steps to prevent that treatment, it militates more to demonstrate the intent of the parties to treat the plaintiff as retaining an equitable interest in the funds. The court also observes that the Treasury Regulations say that the "‘determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like kind replacement property is made as if the qualified intermediary is not the agent of the taxpayer.' This further suggests that the intent of the Internal Revenue Service is to treat the funds as NOT those of the taxpayer."

Nonetheless, in this case, the Court determined that "the facts mandate a presumption that the Exchange Funds are the property of the Qualified Intermediary bankruptcy estate. The Exchange Funds were derived from the proceeds of the sale of the Relinquished Properties that Millard had assigned to the Qualified Intermediary. The Exchange Funds were transferred from the third party purchasers of these Relinquished Properties directly into the bank account of the Qualified Intermediary by the closing agents. The transferred funds remained in the bank accounts of the Qualified Intermediary through the Petition Date. Millard never had any ability to withdraw the funds. The accounts were under the complete control of the Qualified Intermediary. Only the Qualified Intermediary had the ability to disburse or withdraw the funds. As the Qualified Intermediary maintained the exchange funds in bank accounts in its name and under its control, the money is presumably property of the Qualified Intermediary bankruptcy estate. (citations omitted)"

In order to rebut this presumption, the plaintiff contended that the Qualified Intermediary was temporarily holding the Exchange Funds on its behalf solely for the purpose of facilitating the exchange, that it never parted with its equitable interest, that the Qualified Intermediary was required to place the Exchange Funds in segregated sub-accounts associated with its name and taxpayer identification number and that the Qualified Intermediary was holding the Exchange Funds in trust for its benefit.

This may be considered a tactical error. Clearly under state law in Virginia (and likely elsewhere), the plaintiff and debtor did everything possible to avoid a trust relationship so that the agent control issue would not make the debtor unqualified under the Treasury regulations. The Court notes that "not only is there an absence of any language that the parties intended to create a trust, but there is language in the Exchange Agreements that actually evidences an intent not to do so. Millard, in the Exchange Agreements, conveyed exclusive possession, dominion, control and use of the Exchange Funds to the Qualified Intermediary. It also disclaimed any right, title or interest in and to the Exchange Funds. That conveyance combined with that disclaimer is inconsistent with the establishment of a trust. Under a trustee beneficiary relationship, the trustee holds legal title in the trust property and the beneficiary holds an equitable interest in the trust property." and "Further evidence that the parties did not intend the Exchange Agreements to create a trust can be found in the parties' agreement to limit the duties of the Qualified Intermediary to those expressly contained in the Exchange Agreements. A trust necessarily requires the establishment of fiduciary duties." …" Fiduciary duties create a special relationship of trust and good faith that goes beyond the duties set forth in an ordinary contract between commercial parties." (citations omitted)

The court properly concludes:  "The Exchange Funds are not excluded from property of the estate pursuant to 11 U.S.C. § 541(d) because of the existence of an express trust or as a result of the imposition of a resulting trust. The plain, unambiguous language of the Exchange Agreements clearly establishes that it was not the intent of the Qualified Intermediary or Millard to create an express trust. As the Exchange Agreements were integrated contracts, Millard cannot use parol evidence to prove the existence of an express trust"

It seems that in arguing the issue of "trust", the attorneys may have overlooked the most obvious argument...Why was the Qualified Intermediary holding funds and for whom? Trust law is totally irrelevant and the Court and the parties seem confused on this issue. In the typical transaction a taxpayer desiring to structure a transaction as a qualifying exchange, must limit control of the funds in every respect under the Treasury regulations. In no way do the regulations require the taxpayer to cede a claim of beneficial ownership in those funds. This discussion and conclusion exhibit the failure of the Court to grasp the fundamental nature of tax deferred exchanges in modern commerce. Simply put, Internal Revenue Code Section 1031 exchanges are an IRS approved procedure for deferring tax on the disposition of business property when it is being replaced by like kind property. They can simply not be considered true exchanges as the transactions are generally structured.  They are simply dressed up as exchanges with the IRS blessing to comport with archaic language and the IRS requirements to conform transactions accordingly. Every taxpayer considers the money in all exchange accounts as belonging to them, as do all revenue agents, as do all Qualified Intermediaries. What the IRS is concerned about is control of the funds not ownership of them. The language in the exchange agreements that the court focused on as relinquishing ownership, is included to reinforce the taxpayers' total lack of control of these funds in order to avoid constructive receipt and recognition of gain. If you were to ask any participant prior to this decision; "Whose money is it?" the answer would invariably be "The Taxpayer's."

Yet, not all equitable interests are trusts. A bank account can be said to be analogous to an exchange account. The bank holds the funds in the taxpayer's name pursuant to the terms of a contract. The bank controls these funds irrespective of the accounting or characterization of them as agreed to between the parties. When the time, circumstance and conditions of the contract provisions call for payment, and only then, can and will payment be made. It can be fairly said that the funds themselves are legally owned by the bank and that the depositor only has an equitable interest that, by contract, entitles the depositor to delivery. That equitable interest is solely contractual in nature. The fact that the account is in the Debtor's name and the Debtor only has control of the account does not in itself determine who the equitable owner is. An equitable interest is an interest held under an equitable title that indicates a beneficial interest in property and that gives the holder the right to acquire formal legal title. Not all equitable title is held under trust theory. A classical example of such an interest arising out of contract is that of an equitable lien. A document, may by its form, purport to make an absolute transfer of the ownership of property and yet be found, in substance, to be a security instrument. In the real property context, this may be referred to as an equitable mortgage or equitable lien.

The court acknowledges this principle as being applicable to the bankruptcy estate where it cites as follows: "Section 541(d) of the Bankruptcy Code creates a limitation on the otherwise broad definition of property of the estate. That section provides in pertinent part that: ‘property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate under sub-section (a)(1) or (2) of this section only to the extent of the debtor's legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.'" Where the court goes astray is in assuming that a trust relationship is the only form of equitable ownership and forgets that Equity incorporates the legal principles supplementing the strict rules of law where their application would operate harshly, in order to achieve fairness. Some would simply call it common sense.

Related Party Pitfalls
Chris Burti, Vice President and Senior Legal Counsel

Part of the 1031 XChange Index - Originally Published 1/1/2010 at STEC

The U.S. Tax Court issued an opinion in 2009 denying 1031 exchange treatment for a forward exchange where the relinquished property was sold to a third party and the replacement property was acquired from a related party. In Ocmulgee Fields, Inc., 132 T.C. No. 6 (2009) the taxpayer sold appreciated property to an unrelated party, through the use of a Qualified Intermediary. Although the taxpayer intended to acquire a replacement property from an unrelated party, it was unable to identify acceptable third party replacement property. As a result, the taxpayer chose to acquire a property from a related entity upon the advice of its tax advisors. The Tax Court upheld the determination of a deficiency by the IRS finding that such an exchange violates the restrictions on exchanges between related parties.

The taxpayer argued that tax avoidance was not a principal purpose of the exchange because there was a business reason for the exchange. The taxpayer further argued that the exchange recombined the replacement property with adjacent property owned by the taxpayer which would increase operating efficiency and would increase the overall value of the combined properties. The Court did not find these allegations credible and held that even if true, the IRS was none the less permitted to find that a principal purpose of the exchange was tax avoidance. .

Section 1031(f) provides special rules for property exchanged between related parties. Under the rules of the Section, there is no nonrecognition of gain or loss to the taxpayer with respect to the exchange of property, if a taxpayer exchanges the property with a related person and the related person disposes of the property within two years of the date of the last transfer in the exchange or if the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer. There is a generic exception to the application of this rule where it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax. However, the Section expressly does not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. See Internal Revenue Code Section 1031(f)(4).

In the several recent revenue rulings involving the IRS approving exchanges between related parties anticipating disposal by the related party within two years, the IRS has found the absence of basis shifting to be highly persuasive that no impermissible tax avoidance motive existed. In Ocmulgee the taxpayer acknowledged that some basis shifting had occurred but argued: "that the tax impact of a basis differential may be overridden and reversed by more important tax considerations such as rate differentials, lost elections, and the like–not to mention non-tax considerations." The taxpayer listed five "monumental" tax factors that, it argued, overrode the basis differential that it conceded existed here:

(i) the immediate tax on Treaty Fields's sale of the Barnes & Noble Corner,
(ii)  the immediate tax to * * * [petitioner] on the outstanding installment note from Treaty Fields from the earlier sale of the Barnes & Noble Corner to Treaty Fields,
(iii) the decrease in depreciation on the Barnes & Noble Corner,
(iv)  the 34% tax on * * * [petitioner] rather than the 15% tax rate Treaty Fields' partners would have had on the future sale of the Barnes & Noble Corner, and
(v)  The sacrifice of the Section 754 election for Charles Jones [upon his death] which would entirely eliminate 70 percent of the gain from the future sale of the Barnes & Noble Corner to a third party if Treaty Fields had retained ownership.

The Tax Court acknowledged that "there may be situations in which a taxpayer can overcome the negative inference to be drawn from basis shifting and a ‘cash out'…" but concluded that "this is not one of them." The court opined that they were "not prepared to say that, as a matter of law, a finding of basis shifting precludes the absence of a principal purpose of tax avoidance, but, in this case, the immediate tax consequences resulting from petitioner's deemed exchange with Treaty Fields included an approximately $1.8 million reduction in taxable gain and the substitution of a 15-percent tax rate for a 34-percent tax rate. The tax savings are plain, and petitioner's counterfactors are unconvincing or speculative." Thus, in this case the Taxpayer failed to show that the transaction lacked as a principal purpose the avoidance of Federal income tax. Therefore, the actual exchange was deemed to be part of a transaction structured to avoid the purposes of section 1031(f) and, under section 1031(f)(4), the nonrecognition provisions of section 1031 do not apply to that exchange.

The Court also made extensive comparisons to the facts in Teruya Bros., Ltd. & Subs. v. Commissioner, 124 T.C. 45 (2005). In Teruya Bros., the Court said that "Congress concluded that if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, ‘cashed out' of the investment, and the original exchange should not be accorded nonrecognition treatment." The Tax court explained section 1031(f)(4) as reflecting Congress's concern that related persons not be able to circumvent the purposes of section 1031(f)(1) by interposing an exchange with an unrelated third party, concluding that the described transaction was the economic equivalent of a direct exchange of properties between a taxpayer and a related person, followed by the related person's sale of that property to an unrelated third party. The use of a qualified intermediary in the transactions was not permitted to insulate the end result. Since the attempted exchange and sale in Teruya exchange was regulated by section 1031(f)(1), the Tax court then ascertained whether the principal purposes of the deemed exchange was avoidance of Federal tax and concluding it was. "The economic substance of the transactions remains that the investments in … [the relinquished properties] were cashed out immediately and ... [the related person] ended up with the cash proceeds."

The Internal Revenue Service had imposed an accuracy-related penalty equal to 20 percent of the portion of any underpayment of tax pursuant to Section 6662(a) and the Tax Court set that penalty aside after determining that the taxpayer here had reasonably relied on professional advice in good faith. The lesson to be learned as a result of this decision of the Tax Court, is that if a taxpayer wishes to operate outside of the safe harbor created by the regulations and revenue procedures, a careful analysis of the relevant rulings, cases, regulations and the statute itself are mandatory. If any serious question remains, a private letter ruling may well be in order.

Code Section 1031 and its regulations make reference to Internal Revenue Code Section 267 and Internal Revenue Code Section 707(b)(1) to define who is a related party. We summarize these sections for convenience and follow the summary with the text of the relevant parts of these Sections.

Related Parties Summary

1.      Members of a family,

a. brothers and sisters (whether by the whole or half blood),
b. spouse,
c. ancestors, and
d. lineal descendants;

2.      An individual and a corporation that they directly, or indirectly, own more than 50 percent of the outstanding stock.

3.      Two corporations which are members of the same controlled group.

4.      A grantor and a Trustee of any trust.

5.      Trustees of different trusts, if the same person is a grantor of both trusts.

6.      A Trustee of a trust and its beneficiary.

7.      A Trustee of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts

8.      A Trustee of a trust and a corporation controlled by the Grantor.

9.      A person and a charitable organization which is controlled directly or indirectly by such person or by members of their family.

10.  A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership;

11.  An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.

Controlled Corporations

The Ownership of Stock –

(1)   Stock shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries;

(2)   An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;

(3)   An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner;

(4)   Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated as owned by him for the purpose of again applying either of such paragraphs in order to make another the constructive owner of such stock.

Internal Revenue Code Section 267.

Losses, expenses, and interest with respect to transactions between related taxpayers

    (a) In general

      (1) Deduction for losses disallowed

        No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection

(b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

      (2) Matching of deduction and payee income item in the case of expenses and interest

        If -

          (A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

          (B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b), then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph).  For purposes of this paragraph, in the case of a personal service corporation  (within the meaning of section 441(i)(2)), such corporation and any employee-owner (within the meaning of section 269A(b)(2), as modified by section 441(i)(2)) shall be treated as persons specified in subsection (b).

      (3) Payments to foreign persons

The Secretary shall by regulations apply the matching principle of paragraph (2) in cases in which the person to whom the payment is to be made is not a United States person.

    (b) Relationships

      The persons referred to in subsection (a) are:

(1) Members of a family, as defined in subsection (c)(4);

(2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;

(3) Two corporations which are members of the same controlled group (as defined in subsection (f));

(4) A grantor and a fiduciary of any trust;

(5) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;

(6) A fiduciary of a trust and a beneficiary of such trust;

(7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

(8) A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

(9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

(10) A corporation and a partnership if the same persons own -

(A) more than 50 percent in value of the outstanding stock of the corporation, and

(B) more than 50 percent of the capital interest, or the profits interest, in the partnership;

(11) An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation;

(12) An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or

(13) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.

(c) Constructive ownership of stock

For purposes of determining, in applying subsection (b), the ownership of stock –

(1)   Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries;

(2)   An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;

(3)   An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner;

(4)   The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants; and

(5)   Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated as owned by him for the purpose of again applying either of such paragraphs in order to make another the constructive owner of such stock.

(d) Amount of gain where loss previously disallowed

If –

(1)   in the case of a sale or exchange of property to the taxpayer a loss sustained by the transferor is not allowable to the transferor as a deduction by reason of subsection (a)(1) (or by reason of section 24(b) of the Internal Revenue Code of 1939); and

(2)   after December 31, 1953, the taxpayer sells or otherwise disposes of such property (or of other property the basis of which in his hands is determined directly or indirectly by reference to such property) at a gain, then such gain shall be recognized only to the extent that it exceeds so much of such loss as is properly allocable to the property sold or otherwise disposed of by the taxpayer. This subsection applies with respect to taxable years ending after December 31, 1953. This subsection shall not apply if the loss sustained by the transferor is not allowable to the transferor as a deduction by reason of section 1091 (relating to wash sales) or by reason of section 118 of the Internal Revenue Code of 1939.

(e) Special rules for pass-thru entities

(1) In general

In the case of any amount paid or incurred by, to, or on behalf of, a pass-thru entity, for purposes of applying subsection (a)(2) –

(A)  such entity,

(B)   in the case of - (i) a partnership, any person who owns (directly or indirectly) any capital interest or profits interest of such partnership, or (ii) an S corporation, any person who owns (directly or indirectly) any of the stock of such corporation,

(C)  any person who owns (directly or indirectly) any capital interest or profits interest of a partnership in which such entity owns (directly or indirectly) any capital interest or profits interest, and

(D)  any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to a person described in subparagraph (B) or (C), shall be treated as persons specified in a paragraph of subsection (b). Subparagraph (C) shall apply to a transaction only if such transaction is related either to the operations of the partnership described in such subparagraph or to an interest in such partnership.

(2) Pass-thru entity For purposes of this section, the term ''pass-thru entity'' means -            

(A) a partnership, and

(B) an S corporation.

(3)   Constructive ownership in the case of partnerships For purposes of determining ownership of a capital interest or profits interest of a partnership, the principles of subsection (c) shall apply, except that –

(A)  paragraph (3) of subsection (c) shall not apply, and

(B)   interests owned (directly or indirectly) by or for a C corporation shall be considered as owned by or for any shareholder only if such shareholder owns (directly or indirectly) 5 percent or more in value of the stock of such corporation.

(4)   Subsection (a)(2) not to apply to certain guaranteed payments of partnerships In the case of any amount paid or incurred by a partnership, subsection (a)(2) shall not apply to the extent that section 707(c) applies to such amount.

(5)   Exception for certain expenses and interest of partnerships owning low-income housing

(A)   In general This subsection shall not apply with respect to qualified expenses and interest paid or incurred by a partnership owning low-income housing to - (i) any qualified 5-percent or less partner of such partnership, or (ii) any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to any qualified 5-percent or less partner of such partnership.

(B)   Qualified 5-percent or less partner For purposes of this paragraph, the term ''qualified 5-percent or less partner'' means any partner who has (directly or indirectly) an interest of 5 percent or less in the aggregate capital and profits interests of the partnership but only if - (i) such partner owned the low-income housing at all times during the 2-year period ending on the date such housing was transferred to the partnership, or (ii) such partnership acquired the low-income housing pursuant to a purchase, assignment, or other transfer from the Department of Housing and Urban Development or any State or local housing authority. For purposes of the preceding sentence, a partner shall be treated as holding any interest in the partnership which is held (directly or indirectly) by any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to such partner.

(C)   Qualified expenses and interest

For purpose of this paragraph, the term ''qualified expenses and interest'' means any expense or interest incurred by the partnership with respect to low-income housing held by the partnership but –

(i)  only if the amount of such expense or interest (as the case may be) is unconditionally required to be paid by the partnership not later than 10 years after the date such amount was incurred, and

(ii)  in the case of such interest, only if such interest is incurred at an annual rate not in excess of 12 percent.

(D)   Low-income housing

For purposes of this paragraph, the term ''low-income housing'' means –

(i) any interest in property described in clause (i), (ii), (iii), or (iv) of section 1250(a)(1)(B), and

(ii) any interest in a partnership owning such property.

(6)   Cross reference For additional rules relating to partnerships, see section 707(b).

(f) Controlled group defined; special rules applicable to controlled groups

(1)   Controlled group defined

For purposes of this section, the term ''controlled group'' has the meaning given to such term by section 1563(a), except that –

(A)  ''more than 50 percent'' shall be substituted for ''at least 80 percent'' each place it appears in section 1563(a), and

(B)   the determination shall be made without regard to subsections (a)(4) and (e)(3)(C) of section 1563.

(2)   Deferral (rather than denial) of loss from sale or exchange between members

In the case of any loss from the sale or exchange of property which is between members of the same controlled group and to which subsection (a)(1) applies (determined without regard to this paragraph but with regard to paragraph (3)) - (A) subsections (a)(1) and (d) shall not apply to such loss, but (B) such loss shall be deferred until the property is transferred outside such controlled group and there would be recognition of loss under consolidated return principles or until such other time as may be prescribed in regulations.

(3)   Loss deferral rules not to apply in certain cases

(A)   Transfer to DISC

For purposes of applying subsection (a)(1), the term ''controlled group'' shall not include a DISC.

(B)   Certain sales of inventory

Except to the extent provided in regulations prescribed by the Secretary, subsection (a)(1) shall not apply to the sale or exchange of property between members of the same controlled group (or persons described in subsection (b)(10)) if –

(i) such property in the hands of the transferor is property described in section 1221(a)(1),

(ii) such sale or exchange is in the ordinary course of the transferor's trade or business,

(iii) such property in the hands of the transferee is property described in section 1221(a)(1), and

(iv) the transferee or the transferor is a foreign corporation.

(C)   Certain foreign currency losses

To the extent provided in regulations, subsection (a)(1) shall not apply to any loss sustained by a member of a controlled group on the repayment of a loan made to another member of such group if such loan is payable in a foreign currency or is denominated in such a currency and such loss is attributable to a reduction in value of such foreign currency.

(4)   Determination of relationship resulting in disallowance of loss, for purposes of other provisions

For purposes of any other section of this title which refers to a relationship which would result in a disallowance of losses under this section, deferral under paragraph (2) shall be treated as disallowance.

(g) Coordination with section 1041 Subsection (a)(1) shall not apply to any transfer described in section 1041(a) (relating to transfers of property between spouses or incident to divorce).

Internal Revenue Code Section 707(b)(1).

(b) Certain sales or exchanges of property with respect to controlled partnerships

(1)   Losses disallowed

No deduction shall be allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between –

(A)  a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or

(B)   two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests. In the case of a subsequent sale or exchange by a transferee described in this paragraph, section 267(d) shall be applicable as if the loss were disallowed under section 267(a)(1). For purposes of section 267(a)(2), partnerships described in subparagraph (B) of this paragraph shall be treated as persons specified in section 267(b).