Structuring 1031 Like-Kind Exchanges After IRS Victory in North - - PowerPoint PPT Presentation

Structuring 1031 Like-Kind Exchanges After IRS Victory in North Central Leasing

Preserving Tax-Deferral Treatment for Transactions Involving Related Parties and Qualified Intermediaries

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, MAY 19, 2015

Presenting a live 90-minute webinar with interactive Q&A Joseph C. Mandarino, Attorney, Cohen Pollock Merlin & Small, Atlanta Renato Matos, Partner, Capell Barnett Matalon & Schoenfeld, Jericho, N.Y . Ricky Novak, CEO, Strategic 1031 Exchange Advisors, Atlanta

The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800- 926-7926 ext. 10.

NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no longer permitted.

Tips for Optimal Quality

Sound Quality If you are listening via your computer speakers, please note that the quality

• f your sound will vary depending on the speed and quality of your internet connection.

If the sound quality is not satisfactory, you may listen via the phone: dial 1-866-873-1442 and enter your PIN when prompted. Otherwise, please send us a chat or e-mail sound@straffordpub.com immediately so we can address the problem. If you dialed in and have any difficulties during the call, press *0 for assistance. NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no longer permitted. Viewing Quality To maximize your screen, press the F11 key on your keyboard. To exit full screen, press the F11 key again.

FOR LIVE EVENT ONLY

Continuing Education Credits

For CLE credits, please let us know how many people are listening online by completing each of the following steps:

• In the chat box, type (1) your company name and (2) the number of attendees at your location
• Click the SEND button beside the box

In order for us to process your CLE, you must confirm your participation by completing and submitting an Official Record

• f Attendance (CLE Form) to Strafford within 10 days following the program.

The CLE form is included in your dial in instructions email and in a thank you email that you will receive at the end

• f this program.

For CPE credits, attendees must listen throughout the program, including the Q & A session, and record verification codes in the corresponding spaces found on the CPE form, in order to qualify for full continuing education credits. Strafford is required to monitor attendance. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please complete the following steps:

• Click on the ^ symbol next to “Conference Materials” in the middle of the left-hand column on your

screen.

• Click on the tab labeled “Handouts” that appears, and there you will see a PDF of the slides for today's

program.

• Double click on the PDF and a separate page will open.
• Print the slides by clicking on the printer icon.

FOR LIVE EVENT ONLY

Qualified to be more than just your Intermediary…….

Tax-Deferred Exchange Strategies: Beyond the Basics

Ricky B. Novak, Esq.

Qualified to be more than just your Intermediary…….

1031 Exchange Fundamentals

6

Qualified to be more than just your Intermediary…….

1031 Exchange Basics

• Internal Revenue Code §1031 allows for the deferral of capital gains tax on the

sale of like-kind property either held for investment or productively used in a trade

• r business
• Also allows for the deferral of depreciation recapture and deferral of state taxes (where

applicable)

• Deferral can be indefinite, as the taxpayer will not recognize capital gain until the

replacement property is sold without the use of an exchange

• Estate planning opportunities include leaving the assets to one’s heirs, whereby at the

taxpayer’s death, heirs receive the assets at a stepped-up basis (e.g. current fair market value)

• Essentially, the taxpayer deferred payment of capital gains tax and the heirs are only taxed

if and when they sell the inherited asset at a value that exceeds the stepped-up basis

7

Qualified to be more than just your Intermediary…….

1031 Exchange Basics

• Taxpayer has 45 days from the date of the relinquished property sale to identify potential

replacement property, and 180 days to close on this property

• Identification Rules include the 3 Property Rule, 200% Rule and the 95% Rule
• Like-Kind is broadly defined for real property exchanges, allowing the taxpayer to trade

between: raw land, retail, office, warehouse/industrial, residential rental, and other property types.

• Like-Kind is very narrowly defined for personal property, and often requires the taxpayer to

exchange assets within the same general asset or product class. Personal property assets can include: aircraft, watercraft, collectibles, art, FF&E, certain intangible rights, etc.

8

Qualified to be more than just your Intermediary…….

1031 Exchange Basics

• Requirements for complete tax deferral:

– Taxpayer must acquire replacement property that equals or exceeds in value the property which was relinquished – Taxpayer must roll relinquished sale proceeds (referred to as “cash boot”) forward into the replacement property, and replace any debt that was extinguished at the relinquished sale (referred to as “mortgage boot”) with either new debt, new cash or any combination of the two

• Should the taxpayer fail to acquire replacement property that equals or exceeds the value
• f the relinquished property, taxpayer may still complete a partial exchange

– Replacement property value must exceed the adjusted basis of the relinquished property in order for taxpayer to defer taxation

• Exchanges require involvement by a third-party known as a Qualified Intermediary

(“QI”)

9

Qualified to be more than just your Intermediary…….

1031 Exchange Basics

• Exchange Tax Deferral Example:

– Taxpayer purchases income producing commercial property for $1 million in 2004 (using $250,000 in cash and a $750,000 interest only loan to acquire the property), and enters into a contract to sell the property in 2015 for $1.4 million. –From 2004-2014, Taxpayer takes depreciation on the property in the amount of $250,000 and performs capital improvements to the property in the amount of $100,000. Therefore the adjusted basis of the property is $850,000 (sum of $1 million purchase price, minus $250,000 in depreciation, plus $100,000 in capital improvements). –Taxpayer’s potential taxable gain is $550,000 (sum of $1.4 million sales price, minus $850,000 adjusted basis). –In order to defer all potential taxable gain, the Taxpayer will need to acquire replacement property that equals or exceed the relinquished property sales price ($1.4 million) AND must roll all $650,000 in cash boot ($1.4 million sale price, minus $750,000 mortgage boot) into the replacement property).

10

Qualified to be more than just your Intermediary…….

Taxable Gain Deferred Gain Basis $400,000 Basis

$1,000,000 Relinquished Sale $900,000 Replacement Purchase

$500,000 Deferred Capital Gain $400,000 Basis $100,000 Taxable Gain

Understanding the Math

$600,000 Capital Gain

11

Qualified to be more than just your Intermediary…….

Current Issues for 1031 Transactions

12

Qualified to be more than just your Intermediary…….

Qualifying the Intermediary

• Over the past few years, there have been numerous instances of intermediaries filing

bankruptcy or misappropriating client funds.

• Top areas to focus on when considering a QI:
• Disinterested – QI must be a disinterested third party and not have acted in any agency capacity

for the prior two years

• Knowledge – Do they understand complex exchange issues, and truly appreciate how these issues

affect the taxpayer’s short & long term tax, real estate, and other objectives?

• Security – How are funds invested, is this a transparent process that allows input from the taxpayer,

and what security measures are in place to protect principal and ensure liquidity?

• Service – Do you have direct access to the person with 1031 expertise at all times, or do you get

handed off to a less qualified back office paper processor with “9-5” hours?

13

Qualified to be more than just your Intermediary…….

Cash-Out Options for 1031 Transactions

14

Qualified to be more than just your Intermediary…….

Cash-Out Options

• Taxpayers may perform a partial exchange whereby cash is taken at closing
• Cash is taxed as it is deemed to be paid from the gain portion of the transaction;

this also applies to any refund of initial equity investments

• Note that debt repayment for amounts legitimately loaned to an entity (LLC, S-Corp,

C-Corp, Partnership) are not characterized as cash out

• Solution to achieve 100% tax deferral: taxpayer does not take cash at closing, but

instead performs a post-closing cash-out refinance

15

Qualified to be more than just your Intermediary…….

Title & Partnership Issues for 1031 Transactions

16

Qualified to be more than just your Intermediary…….

Title / Entity Issues

• The 1031 rules require that title is taken to replacement property by the same taxpayer who

relinquished title

• Title should not be changed immediately before or immediately after an exchange

transaction

• Definition of “immediately” varies since there is no statutorily driven requirement
• Tax professionals find a varying degree of risk associated with this issue, especially when considering

Drop & Swap structuring

• Husband & Wife are an exception to the “immediate” rule, as the IRS does not perceive any

potential abuse

17

Qualified to be more than just your Intermediary…….

Partnership Issues

• Options for partners who wish to perform an exchange but also want to discontinue the

partnership relationship when selling real estate

• Drop & Swap: Property is deeded out, or “dropped” to each partner in advance of closing,

and individual partners then perform their own exchange

• Requires significant preplanning; most tax professionals recommend the “drop” occur before the

property is under contract, and long before closing (~one year); however in practical application many taxpayers perform the drop immediately prior to the swap

• There are potential Lender issues to consider if property is leveraged with third-party debt with a

due-on sale clause

• Dissolution of partnership is also recommended
• State of California does not recognize a drop and swap performed immediately prior to the

relinquished sale closing

18

Qualified to be more than just your Intermediary…….

More Partnership Issues

• Swap & Drop: In the event there is not sufficient time to properly execute the Drop &

Swap, the partnership can perform the exchange and then perform the drop in the future

• Partnership typically sets-up a new single-member LLC for each partner and each LLC acquires

replacement property according to each partner’s need

• Identification issues must be considered
• Each partner manages their respective LLC of interest, and after sufficient time has passed (~one

year?), the partnership is liquidated and each partner receives their respective LLC in the liquidating distribution

19

Qualified to be more than just your Intermediary…….

Exchanges of Vacation Homes/Second Homes

20

Qualified to be more than just your Intermediary…….

Vacation Homes & Second Homes

• A taxpayer wishing to exchange these types of property must be certain that they have

established a held for investment intent and must avoid significant personal use of the property

• Personal use property does not qualify for exchange treatment
• Regardless of the existence of an “investment intent” by the taxpayer, personal use will

typically trump this intent

• Moore v. Commissioner, T.C. memo. 2007-134
• IRS argued, and Court agreed that the existence of an investment intent, in and of itself, is not

sufficient

• Must look at totality of circumstance

21

Qualified to be more than just your Intermediary…….

Vacation Homes & Second Homes

• IRS issued safe-harbor guidelines for residential properties in Rev Proc 2008-16, 2008-10

IRB; note that this is only a safe-harbor

• IRS will not challenge whether a dwelling unit satisfies the intent test if:
• The taxpayer owns both the Relinquished Property and Replacement Property for at least 24

months, which is deemed long enough to establish a qualifying use ; AND

• In each of the two 12-month periods immediately preceding and following the exchange, (i) the

taxpayer rents the dwelling unit to another person(s) at a fair market rental for 14 days or more, and (ii) the period of the taxpayer’s personal use of the dwelling unit doe not exceed the greater of 14 days or 15 percent of the number of days during the 12-month period that the dwelling

22

Qualified to be more than just your Intermediary…….

Personal Property Exchanges

23

Qualified to be more than just your Intermediary…….

Personal Property Exchanges

• The like-kind element for personal property assets that are used in a trade or

business or held for investment is much more narrowly defined as compared to real property assets

• In certain situations the taxpayer must acquire Replacement Property that is

within the same General Asset or Product Class, with an added element of qualification involving the location in which asset is predominantly housed or used

• State and/or local sales and use tax concerns must be also addressed when

selling personal property assets, especially if there are multijurisdictional issues; this can become even more complex when structuring a Reverse Personal Property exchange

24

Qualified to be more than just your Intermediary…….

Types of Personal Property

• Typical personal property assets include:
• Depreciable Tangible Personal Property
• Requires the property to be of like product or general asset class
• FF&E, aircraft, watercraft, railroad cars, autos, trucks, etc.
• Non-Depreciable Tangible Personal Property
• Art, collectibles, livestock, etc.
• Intangible Personal Property
• Requires analysis of the nature or character of the rights involved and the nature and the character of the

underlying property to which the intangible relates

• Patents, software, designs and drawings, trade secrets and know-how, etc.

25

Slide Intentionally Left Blank

Qualified to be more than just your Intermediary…….

Multi-Asset Exchanges

27

Qualified to be more than just your Intermediary…….

Understanding Multi-Asset Exchanges

• When taxpayers sell a business, they have the alternative to perform a stock sale
• r an asset sale
• Prior to finalizing any sales agreement, the taxpayer should consider the various

financial and tax concerns associated with each of these alternatives

• It is recommended that the taxpayer consider sales proceeds allocations prior to

entering into any sales agreements, as this may ultimately influence the manner in which they structure their business sale

• Asset sales have the ability to be structured as a 1031 exchange, with values

being allocated to real property, personal property and goodwill/going concern

28

Qualified to be more than just your Intermediary…….

Understanding Multi-Asset Exchanges

• Within the realm of justifiable economic feasibility, the taxpayer should attempt to

allocate values of Relinquished Property based on the taxpayer’s intended Replacement Property; remember that the seller and buyer should agree to these allocations and file a Form 8594

• As an example, should that taxpayer plan to only purchase income producing real

estate as Replacement Property, then value should maximized in allocations to the real property which is being relinquished, as opposed to the personal property and goodwill/going concern

29

Qualified to be more than just your Intermediary…….

The International Perspective

30

Qualified to be more than just your Intermediary…….

International 1031 Exchanges

• US Taxpayer (resident alien, naturalized citizen, etc.) with non-US real property

holdings

• Exchange must be foreign to foreign or US to US (whereby US is defined as the 50 States

plus US protectorates)

• Currency issues
• Treatment of how real estate is held in foreign jurisdictions
• Foreign person who holds US property
• FIRPTA (Foreign Investment in Real Property Tax Act) Withholding
• On or after January 1, 1985
• Any person who acquires US real property from a foreign seller (person or corporation)
• 10% of sales price mandatory withholding by purchaser, regardless of cash involved or

basis of foreign seller

• These funds are treated outside the 1031 exchange and result in gain to the foreign

seller (unless apply & receive a withholding certificate)

31

Qualified to be more than just your Intermediary…….

Firm Contact Information

1.888.800.1031 www.sea1031.com

Ricky B. Novak

direct: 678.522.8801 email: rbnovak@sea1031.com

32

Structuring 1031 Lik ike-Kind Exchanges After IR IRS Vic ictory ry in in North Central Leasing

By: Renato Matos, Esq.

CAPELL BARNETT MATALON & SCHOENFELD LLP. ATTORNEYS AT LAW (516) 931-8100 rmatos@cbmslaw.com

Reverse 1031 Exchanges What is a Reverse 1031 Exchange?

• A reverse 1031 exchange occurs when an exchangor purchases the

replacement property before the sale of the relinquished property

• The Qualified Intermediary in a reverse 1031 exchange will create a

limited liability company that temporarily takes title to the property

• The entity that takes title to the property is called an Exchange

Accommodation Titleholder (EAT)

34

Reverse 1031 Exchanges Reasons for a Reverse 1031

• There are numerous reasons for engaging in a reverse 1031 exchange.

Some of the more common reasons are:

• Exchangor finds the replacement property and closes on it before they have a

buyer for the relinquished property;

• To eliminate the 45 day calendar identification period as in a forward 1031;
• Exchangor may lose a deposit or favorable financing rate if it fails to close on

the replacement property by a certain date; and

• Improvements need to be made on the new property

35

Reverse 1031 Exchanges Steps when Parking the Relinquished Property (Exchange First)

• When parking the relinquished property, exchangor will transfer title

to the relinquished property to the EAT

• This transfer of title must take place before the closing on the

replacement property.

• If there is financing on the replacement property, the EAT will take the

replacement property subject to existing loan.

36

Reverse 1031 Exchanges Steps when Parking the Relinquished Property (Exchange First)

• When the EAT takes the property subject to an existing loan, the exchangor will

provide the EAT with cash equal to the amount of the loan. Therefore, the danger in parking the relinquished property first is that the exchangor is paying off their loan on the relinquished property, and purchasing the replacement property, prior to the actual sale of the relinquished property.

• The exchangor and the EAT will enter into an Agreement with regard to the

relinquished property, the result of which the exchangor is still responsible for loan payments, insurance, taxes and operating expenses through a triple net lease agreement.

• At this point, the exchangor must sell the relinquished property within 180 days

after the EAT takes title to it, but the exchanger will get all the proceeds of that sale.

37

Reverse 1031 Exchanges Pros and Cons of Parking the Relinquished Property (Exchange First)

• Pros:
• This is lender friendly, because the EAT does not have to sign loan documents

if the exchangor is securing the replacement property by a loan

• However, exchangor’s must determine whether they need a lender’s consent to transfer

the existing loan to an EAT

• Cons:
• The exchangor must be able to invest enough equity into the replacement

property as of the initial closing of that property to at least equal equity that the exchangor will receive from the sale of the relinquished property

• The exchangor must know of which property he will dispose of in the

exchange

38

Reverse 1031 Exchanges Steps for Parking the Replacement Property (Exchange Last)

• When parking the replacement property, the EAT acquires the

replacement property, and subsequently parks it, and a simultaneous 1031 exchange is completed upon the sale of the relinquished property

• Just like when parking the relinquished property, the EAT and the

exchangor enter into an Agreement and a triple net lease, and the exchangor will have full control over the replacement property, such as paying the expenses, and receiving the income from the property

39

Reverse 1031 Exchanges Steps for Parking the Replacement Property (Exchange Last)

• Once the closing is ready to take place on the relinquished property,

the Qualified Intermediary (QI) sells the relinquished property to the buyer, and uses those funds to acquire the replacement property from the EAT

• The EAT then transfers the replacement property to the exchangor

and the EAT receives the exchange funds as the purchase price for the replacement property

• The EAT then pays off the loan to the exchanger using the exchange

funds

40

Reverse 1031 Exchanges Pros and Cons of Parking the Replacement Property (Exchange Last)

• Pros:
• It is easier to ensure the entire transaction is tax deferred if the EAT takes title

to the replacement property

• It allows the exchangor access to funds before the relinquished property

closes, but allows the exchangor to pay down the loan so that all of the exchange funds can be invested into the replacement property, and complete a tax deferred exchange

• Exchangor has 45 days to decide which property to dispose of in the exchange
• Cons:
• This is not lender friendly, since the EAT is securing the loan on the

replacement property, but the EAT will have no personal liability

41

Reverse 1031 Exchanges Requirements for Property to be Held in a EAT

• According to IRS Rev. Proc. 2000-37, property is held in a EAT if all of the

following requirements are met:

• Qualified indicia of ownership of the property is held by a person
• At the time of the transfer to the EAT, it is the exchangor’s bona fide intent that the

property held by the EAT represent either replacement property or relinquished property in an exchange that is intended to qualify for non-recognition of gain or loss under 1031

• No later than 5 business days after the transfer of ownership of the property to an

EAT, the exchangor and the EAT enter into a written agreement that provides the EAT “is holding the property for the benefit of the taxpayer in order to facilitate an exchange under 1031 and this revenue procedure and that taxpayer and the [EAT] agree to report the acquisition, holding, and disposition of the property as provided in this revenue procedure.”

• Additionally, the agreement must specify that the EAT will be treated as the beneficial owner
• f the property for all federal income tax purposes. Both parties must report the federal

income tax attributes of the property on their federal income tax returns.

42

Reverse 1031 Exchanges Requirements for Property to be Held in a EAT

• According to IRS Rev. Proc. 2000-37, property is held in a EAT if all of

the following requirements are met:

• The relinquished property must be identified within 45 days of the transfer of
• wnership in the replacement property
• No later than 180 days after the transfer of ownership in the replacement

property, the property must be transferred to the exchangor as replacement property or to a person who is not the exchangor or a disqualified person as relinquished property

• The combined period the relinquished property and the replacement

property are held in a EAT does not exceed 180 days

43

Tenancy-in-Common (TIC) Interests in 1031 Exchanges Background of the TIC

• Under 1031(a)(2)(D) partnership interests are excluded from consideration

in 1031 exchanges

• In 2002 the IRS issues Rev. Proc. 2002-22 which stated the conditions in

which the IRS will consider a request for a ruling that an undivided fractional interest in rental real property is not an interest in a business entity, and thus not excluded from consideration in a 1031 exchange

• Bergford v. Comm’r: Held that the co-ownership was a partnership for tax

purposes, mainly because there were limitations on the co-owners’ ability to sell, lease, or encumber either the co-ownership interest or the underlying property, and the manager of the properties’ interest in profits and losses

44

Tenancy-in-Common (TIC) Interests in 1031 Exchanges Why TIC’s?

• TIC’s allow an investor to invest in rental real estate as a co-owner

with other investors, creating ownership in a physical undivided part

• f the entire parcel of the property, while achieving the 1031 deferred

tax benefits

• Each co-owner is entitled to the profits from the property, therefore

investor’s can secure cash flow

• Investor’s can diversify their investment portfolio

45

Tenancy-in-Common (TIC) Interests in 1031 Exchanges Why TIC’s?

• TIC’s provide more options during the 45 day period to find a

replacement property

• TIC’s allow investors who do not want to be involved in the

management of property to be able to yield income without managing the property

• TIC’s allow investor’s to avoid taxation on boot amounts

46

Tenancy-in-Common (TIC) Interests in 1031 Exchanges Example

• An investor owns commercial real estate worth $1,000,000. However,

the investor does not want to manage the day-to-day operations of the property anymore, and wants to sell. However, for $1,000,000 there may not be great options for an investment in a similar property, producing similar income. However, the investor could exchange this property for a 20% interest in another property worth $5,000,000, as long as the co-ownership of this property follows IRS

• guidelines. This $5,000,000 property can produce income benefits

greater than the investment in a $1,000,000 property, while still achieving 1031 tax deferred benefits.

47

Tenancy-in-Common (TIC) Interests in 1031 Exchanges Key Requirements for TIC Consideration under 1031

• The tenancy in common created must be recognized as a tenancy in

common under local law

• According to Rev, Proc. 2022-22 there are 15 requirements that the

IRS reviews for TIC consideration:

• Tenancy in Common Ownership
• Number of Co-Owners
• No Treatment of Co-Ownership as an Entity
• Co-Ownership Agreement
• Voting
• Restrictions on Alienation
• Sharing Proceeds and Liabilities upon Sale of Property

48

Tenancy-in-Common (TIC) Interests in 1031 Exchanges Key Requirements for TIC Consideration under 1031

• According to Rev, Proc. 2022-22 there are 15 requirements that the

IRS reviews for TIC consideration:

• Proportionate Sharing of Profits and Losses
• Proportionate Sharing of Debt
• Options
• Management and Brokerage Agreements
• Leasing Agreements
• Loan Agreements
• Payments to Sponsors

49

Slide Intentionally Left Blank

Delaware Statutory Trusts (DST) and 1031 Exchanges Delaware Statutory Trust Act

• What is a Beneficial Owner?
• A beneficial owner is “any owner of a beneficial interest in a statutory trust, the fact of ownership to be determined and

evidenced (whether by means of registration, the issuance of certificates or otherwise) in conformity to the applicable provisions of the governing instrument of the statutory trust.

• Contributions by Beneficial Owners
• A beneficial owner can contribute cash to the statutory trust.
• Liability of Beneficial Owners
• A beneficial owner shall be entitled to the same limitation of personal liability extended to stockholders of private for profit

corporations organized under the general corporation law of the state

• Legal Proceedings
• A statutory trust may sue and be sued. The property of a statutory trust may be subject to attachment.
• Rights of Beneficial Owner and Trustees in Trust Property
• A beneficial owner shall have an undivided beneficial interest in the property of the statutory trust and shall share in the

profits and losses of the statutory trust in proportion of the entire undivided interest in the statutory trust owned by such beneficial owner.

• Management
• The trustee manages the trust.

51

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• General DST Facts with Real Property
• A property owner can transfer the real property into the DST
• The DST will assume all of the owner’s rights and obligations under a note

that property owner may have on the property

• The DST and the beneficial owners will not be personally liable to the lender under the

note

• The DST will assume a net lease on the property
• DST interests are freely transferable and there is no limitation on the amount
• f beneficial owners
• The DST will terminate on the earlier of 10 years from the date of its creation
• r the disposition of the property, but will not terminate on the bankruptcy,

death, or incapacity of any owner or on the transfer of any right, title, or interest of the owners

52

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• General DST Facts with Real Property
• The trustee of the DST distributes out all cash, less reserves, each quarter to

each beneficial owner for their proportionate share

• The trustee may only invest cash in short-term obligations
• Beneficial owner’s have the right to an in-kind distribution of its

proportionate share of trust property

• Beneficial owner’s names are not on the deed

53

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• Issue 1: To determine whether a DST is an entity for federal income tax

purposes that is recognized separate from its owners.

• Determinative Facts:
• Creditors of the beneficial owners of the DST cannot assert claims directly against

the property held by a DST

• A DST may sue or be sued, and the property of a DST is subject to attachment and

execution as if it were a corporation

• Beneficial owners of a DST are limited from personal liability from actions of a DST,

the same protection afforded to shareholders of a Delaware corporation

• A DST may merge or consolidate with or into one or more statutory entities, such as

partnership, and a DST can be formed for investment purposes

• Holding 1: The DST is an entity for federal income tax purposes that is

recognized separate from its owners.

54

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• Determinative Facts continued:
• Neither the DST or the trustee of the trust are agents of the beneficial
• wners, and there are not agency agreements between the trust or trustees

and the beneficial owners

• Holding 1: The DST is an entity that could not be disregarded for

federal income tax purposes, and thus, it is necessary for a DST to be classified as either a business entity or a trust.

55

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• Issue 2: To determine whether DST is a trust or a business entity for

federal tax purposes.

• Determinative Facts:
• There is no possibility of the reinvestment of money under a DST trust

agreement because:

• Any cash earned on short-term obligations held by the trust between distribution dates

has to be distributed quarterly

• No cash can be contributed to the trust by the beneficial owners
• The trust can not borrow money
• The disposition of the property would result in the termination of the trust

56

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• Determinative Facts continued:
• Limited power of the Trustee:
• The trustee’s activities are limited to the collection and distribution of income
• The trustee cannot exchange the property for other property, purchase assets other than

short-term investments or accept any additional contributions of assets (including money) for the trust

• The trustee cannot renegotiate the terms of the debt used to acquire the property and

cannot renegotiate the lease on the property with the existing tenant or enter into new leases with tenants other than the current tenant unless the trust is insolvent or bankrupt

• The trustee can only make minor non-structural modifications to its property except to the

extent required by law

• Holding 2: The DST is an investment trust, and will be classified as a trust

for federal tax purposes, since all of the interests in the trust were of a single class representing undivided beneficial interests in the assets of the trust, and because the trustee had no power to vary the investment of the beneficiaries of the trust so as to benefit from fluctuations in the market.

57

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• Issue 3: Whether the purchase of an interest in a DST would be treated as

the acquisition of interests in the real property in the DST, and whether taxpayers may exchange real property for an interest in a DST trust under 1031.

• Determinative Facts:
• A person that is treated as the owner of an undivided fractional interest of a trust is

considered, for federal income tax purposes, to own the trust assets attributable to that undivided fractional interest

• When beneficial owners of a DST acquire their interests in the trust, they are treated

as grantors of the trust

• Beneficial owners of a DST have right to distributions of all the income of the trust

attributable to their undivided fractional interests, and thus are considered owners

• f an aliquot portion of the trust

58

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• Determinative Facts continued:
• All income, deductions, and credits attributable to that portion are includable

as taxable income

• An exchange of real property for an interest in a DST is an exchange of real

property for an interest in the property held under the DST and not the exchange of real property for a certificate of trust or beneficial interest under 1031(a)(2)(E)

• Holding 3: An exchange of real property for an interest in the trust is

an exchange of real property for an interest in the property without recognition of gain or loss under 1031, if the other requirements of 1031 are satisfied.

59

Delaware Statutory Trusts (DST) and 1031 Exchanges Why DST’s for 1031 Exchange?

• There is no limit on the amount of owners in a DST
• It allows an investor to identify a property for a 1031 exchange within the 45 day time

frame

• There is investment income that comes from being a beneficial owner in a DST
• The DST is managed by a trustee, and therefore, it produces income without much of a

time commitment

• Beneficial owner’s do not have to be involved in the process of obtaining a loan
• No personal liability for the beneficial owner’s

60

Delaware Statutory Trusts (DST) and 1031 Exchanges Revenue Ruling 2004-86

• Restrictions on DST’s Trustee with regards to 1031
• A trustee of a DST CANNOT do one or more of the following if the DST is to be

considered a trust, and not a business entity for federal tax purposes:

• 1) Dispose of the real property and acquire new property;
• 2) Renegotiate the lease with the tenant;
• 3) Enter into leases with tenants other than the current tenant of the property;
• 4) Renegotiate the obligation used to purchase the property;
• 5) Refinance the obligation used to purchase the property;
• 6) Invest cash received to profit from market fluctuations; or
• 7) Make more than minor non-structural modifications to the property not required by

law

61

Relationship between TIC’s and DST’s

• There is NO relationship between the requirements that apply to a DST and the

requirements that apply to a TIC.

• A DST is an entity that seeks to be disregarded for tax purposes (because it is classified as

a trust), whereas a TIC involves a non-entity owned by multiple persons (tenants in common) who are seeking to avoid partnership classification.

• Nevertheless, it is still necessary to avoid classification of a DST arrangement as a
• partnership. The owners of beneficial interests in a DST could be treated as partners if

there were unequal sharing, for example, or if the sponsor were somehow subject to their obligations.

• The beneficiaries of a DST are not permitted to contribute any funds to the DST to

address the routine financial needs that arise in connection with the ownership and

• peration of rental properties. As a result, the DST is most useful for holding real estate

investments where additional capital is not needed, or an investment in land that is then leased to a user.

62

Comparing TIC and DST for 1031 Exchanges

Delaware Statutory Trusts Tenancy in Common Up to 499 investors Maximum of 35 owners One loan on the property (obtaining financing is easier) Each investor needs to qualify for their own loan (obtaining financing is harder) Owners have NO voting rights (trustee control) Each investor has equal voting rights(need unanimous

• wner approval on all issues)

No owner’s names on deed Owner’s name on deed No single member LLC Investors each form a single member LLC Owners are shielded from liability Owners are not shielded from liability

63

Thank You

Renato Matos, Esq.

CAPELL BARNETT MATALON & SCHOENFELD LLP. ATTORNEYS AT LAW (516) 931-8100 rmatos@cbmslaw.com

Related Party Exchanges

Joseph C. Mandarino Cohen Pollock Merlin & Small, P.C. 3350 Riverwood Parkway Suite 1600 Atlanta, Georgia 30339 www.cpmas.com

May 19, 2015

Related Party Rules

• General Rule
• Basis Shifting
• Guidance

66

Related Party Rules – General

• Under 1031(f), if a taxpayer and a related party enter into an exchange and

either property is disposed of within two (2) years, then the exchange does not qualify under Section 1031 for either party.

• If 1031(f) applies, any gain/loss is taxed at the time of the subsequent

disposition.

67

Who Are Related Parties

• A related person is any person bearing a relationship to the taxpayer

described in section 267(b) or 707(b)(1).

• Section 707(b)(1) relationships:
• a partnership and a person owning, directly or indirectly, more than

50% of the capital interest, or the profits interest, in such partnership,

• r
• two partnerships in which the same persons own, directly or indirectly,

more than 50% of the capital interests or profits interests.

68

Section 267(b) Relationships – Part I

• Members of a family (brothers and sisters (whether by the whole or half

blood), spouse, ancestors, and lineal descendants);

• An individual and a corporation more than 50% 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;

[continued]

69

Section 267(b) Relationships – Part II

• 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% in value of the
• utstanding 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; [continued]

70

Section 267(b) Relationships – Part III

• A person and a tax exempt organization which is controlled directly or

indirectly by such person or (if such person is an individual) by members

• f the family of such individual;
• A corporation and a partnership if the same persons own (A) more than

50% in value of the outstanding stock of the corporation, and (B) more than 50% of the capital interest, or the profits interest, in the partnership; [continued]

71

Section 267(b) Relationships – Part IV

• An S corporation and another S corporation if the same persons own more

than 50% in value of the outstanding stock of each corporation;

• An S corporation and a C corporation, if the same persons own more than

50% in value of the outstanding stock of each corporation; or

• 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. [continued]

72

Section 267(b) Relationships – Part V

CRITICAL – all the above are subject to complex constructive ownership rules!!

73

Basis Shifting

• Adam and Eve are spouses.
• Adam owns Blackacre with FMV of $100 and basis of $100.
• Eve owns Whiteacre with FMV of $100 and basis of $25.
• Eve would like to sell Whiteacre. If Eve sells Whiteacre, she will have $75 gain.
• If Adam and Eve enter into a like-kind exchange and swap properties, Eve will

take Blackacre with a tax basis of $25 and Adam will take Whiteacre with a tax basis of $100.

• If Adam sells Whiteacre, but for Section 1031(f), he would have no gain on the

sale.

74

Holding Period

• If a related party exchange occurs, both parties must hold the received

properties for two (2) years.

• BUT – the holding period is extended for any time during which either

party’s “risk of loss” with respect to its property is substantially diminished by:

• the holding of a put with respect to such property,
• the holding by another person of a right to acquire such property, or
• a short sale or any other transaction

75

Permitted Dispositions – I

Certain dispositions are permitted during the holding period:

• a disposition after the earlier of the death of the taxpayer or the death of

the related person,

• a disposition that occurs in a compulsory or involuntary conversion if the

exchange occurred before the threat or imminence of such conversion, or

• a disposition with respect to which it is established to the satisfaction of the

IRS that neither the exchange nor such disposition had as one of its principal purposes the avoidance of federal income tax.

76

Permitted Dispositions – II

• The third “out” has given rise to considerable commentary.
• Because basis shifting is the stated rationale for Section 1031(f), a

transaction that does not implicate basis shifting should be approved by the IRS.

77

Anti-Abuse Rule

• There is very little guidance on this rule.
• If a taxpayer overtly enters into a related party exchange, the burden or

“cost” is compliance with the holding period rules.

• If a taxpayer attempts to avoid the related party rules in form, but not in

substance, then this anti-avoidance rule prohibits any part of Section 1031 from applying.

• For example, the IRS takes the position that using a QI to mask a direct

exchange with a related party triggers the anti-avoidance rule.

78

Authorities/Guidance

• Rev. Rul. 2002-83 -- Use of QI to avoid related party rules triggers anti-avoidance rule.
• PLR 2002-51-008 -- Appears to sanction a related party parking arrangement.
• PLR 2010-27-036 -- Related party exchange outside of Section 1031(f) and does not

trigger anti-avoidance rule.

• PLR 2012-16-007 – Related party exchange ok where related parties also enter into like-

kind exchanges and hold replacement property for two years.

• Teruya Brothers
• Ocmulgee Fields
• North Central Leasing

79

Slide Intentionally Left Blank

Teruya Brothers

Facts:

• TP corporation and related party subsidiary (“Sub”).
• First Swap:
• TP owned Prop1 with built-in-gain of $1.345 mm.
• Sub owned Prop2 with built-in-gain of $1.352 mm
• Sub sold Prop2 to QI – reported sale as a taxable transaction.
• TP sold Prop1 to QI and took back Prop2 – reported transaction as

§1031 exchange.

81

Teruya Brothers

• Court held that use of QI did not take the transaction out of the ambit of

§1031(f) – the First Swap was economically equivalent to an exchange directly between TP and its related party subsidiary.

• TP argued that related party Sub recognized more gain that TP would

have on a taxable sale – therefore the exchange met the exception under §1031(f)(2)(C) because it did not have “as one of its principal purposes the avoidance of Federal income tax.”

• Court noted that Sub had an NOL for year of sale so Sub recognized less

income that TP would have.

82

Teruya Brothers

• Court effectively held that taxpayers that use either basis shifting or loss

shifting are bound by the rules of §1031(f).

83

Teruya Brothers

Facts:

• Second Swap:
• TP owned Prop3 with built-in-gain of $11.2 mm.
• Sub owned Prop4 and Prop5 with combined built-in-loss of $4.6 mm.
• Sub sold Prop4 and Prop5 to QI – reported sale as a taxable

transaction.

• TP sold Prop3 to QI and took back Prop4 and Prop5 – reported

transaction as §1031 exchange.

84

Teruya Brothers

• Court again found that use of QI did not take the transaction out of the

ambit of §1031(f) – the First Swap was economically equivalent to an exchange directly between TP and its related party subsidiary.

• Here, appeared to fit within the basis shifting concern that underlies

§1031(f).

85

Teruya Brothers

• Note that in both swaps, the court appears to concede that the use of QI

meant that there was no direct exchange and therefore the transaction would otherwise not violate §1031(f)(1).

• However, the use of QI was an arrangement that caused the transaction

to fail under §1031(f)(4).

86

Ocmulgee

Facts:

• TP owned Prop1 with built-in-gain of $6.1 mm.
• LLC, a related party of TP, owned Prop2 with built-in-gain of $4.2 mm.
• LLC sold Prop2 to QI – reported sale as a taxable transaction.
• TP sold Prop1 to QI and took back Prop2 – reported transaction as 1031

exchange.

87

Ocmulgee

• As in Teruya, court implicitly conceded that the use of a QI took the

transaction out of §1031(f)(1).

• The court then turned to §1031(f)(4) – was the transaction structured to

avoid §1031(f)(1)?

• Citing Teruya, the court concluded that the transaction was economically

identical to a direct exchange between TP and LLC.

• Court then considered whether avoidance of tax was a principal purpose
• f the transaction.

88

Ocmulgee

• The court noted that TP would have paid tax on an additional $1.8 mm in

gain, and that by triggering gain in LLC, a pass-through entity, what tax was triggered was also subject to a lower tax rate.

• The court cautioned that it was possible that what otherwise appeared to

be a basis-shifting transaction could, because of countervailing facts, lack a tax avoid purpose.

• Finally, the court noted that it did not matter in the analysis whether the

use of a related party was pre-arranged or not.

89

North Central

Facts:

• TP was the 99% subsidiary of Owner, a related party.
• TP operated an equipment leasing business. Because it often disposed
• f used equipment and acquired new equipment in replacement, it set up

a like-kind exchange program.

• During the period before the court, TP entered into about 400 transactions

that is reported as §1031 exchanges

90

North Central

Representative Transaction (1 of 2):

• TP owns Prop1 with FMV of $750 and built-in-gain of $630.
• TP wants to Prop 2 from the equipment manufacturer (unrelated party).
• TP sells Prop1 through QI to true third party.
• Third party pays $750 and acquires Prop1 through QI.
• Owner, the 99% owner of TP, buys Prop2 from the equipment

manufacturer (unrelated party) for $750.

• Under equipment manufacturer incentives, Owner does not need to pay

the $750 for six months.

91

North Central

Representative Transaction (2 of 2):

• Owner sells Prop2 to TP through QI and QI transfers $750 to Owner.
• Owner pays equipment manufacturer $750 six months later.
• TP reports the sale of Prop1 and acquisition of Prop2 as a §1031

exchange.

• Owner reports the acquisition and re-sale of Prop2 as a taxable

exchange.

92

North Central

• Court found the various steps in the exchanges unnecessarily complex.

In particular, the court could not find reasonable ground for the involvement of Owner.

• Court suggests that involvement of Owner was an instance of
• verreaching.
• Specifically, the court suggests that the only purpose for involving Owner

was to take advantage of the six-month payment delay: “In sum, [Owner] was not necessary to the transactions at issue yet possessed significant, unearmarked cash proceeds as a result of the transactions.”

93

North Central

• Court found the unnecessary interposition of a party (Owner) and the

retention of cash proceeds by a related party was sufficient to demonstrate that the exchange program was structured to avoid §1031(f)(1).

• Court also found that the use of a QI was unnecessary. Although TP

argued that the use of QI permitted TP to come with the identification and receipt safe harbors, the court upheld the factual finding of the lower court that the intent of TP was to use a QI to avoid §1031(f)(1).

94

North Central

• Note that if TP purchased the replacement property directly from the

equipment manufacturer the transactions arguably would have qualified under §1031.

• Moreover, as re-structured, such an exchange program that utilized a QI

would likely also have passed muster.

• Given that, the court may have been correct that the involvement of

Owner suggests that the parties simply wanted the free use of sale proceeds, even if only for a short period.

95

Observations

• Related party exchanges are common.
• Diligence – are related parties present?
• Consider/weigh cost of holding period requirement.
• Use of QI will not defeat related party rules.
• But often the benefits of a QI are significant.
• Consider obtaining a PLR.

96

Observations

Lessons from case law:

• Basis shifting triggers §1031(f)(4) anti-avoidance analysis – this was

mentioned in legislative history.

• So does NOL shifting and tax rate shifting – this does not appear to be

mentioned in legislative history.

• Unfettered use of proceeds (even if only for short-term) also appears to

trigger anti-avoidance analysis.

• Courts will scrutinize structures that are overly complex – interposition of

unnecessary parties can trigger anti-avoidance analysis.

97

Observations

Lessons from North Central:

• If you could have structured the transaction to fit within §1031, courts will

scrutinize the rationale for the structure you ended up using.

• If that structure facilitates (1) basis shifting, (2) NOL shifting, (3) tax rate

shifting, or (4) access to sales proceeds, then court will likely apply §1031(f)(4) anti-avoidance analysis and often that will be fatal.

98

Thank You

Joseph C. Mandarino Cohen Pollock Merlin & Small, P.C. 3350 Riverwood Parkway Suite 1600 Atlanta, Georgia 30339 www.cpmas.com jmandarino@cpmas.com