Tax-Free Exchange Advisor More Flexibility for Reverse Exchanges - - PDF document

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miller nash llp | Fall 2014

Tax-Free Exchange Advisor

More Flexibility for Reverse Exchanges

When the real estate market is hot, it can be a great time to sell real property. And because people don’t want to pay tax unless they have to, it can be attractive to complete a 1031 exchange with the pro- ceeds from the sale. But a hot real estate market can be a difficult time to buy real estate, and if a taxpayer sells real estate, it doesn’t necessarily mean that accept- able replacement property can be found within the timelines required by Section

• 1031. Private Letter Ruling 201416006,

issued earlier this year, provides a little additional flexibility for taxpayers with multiple real estate holdings who com- plete a reverse 1031 exchange. Reverse exchanges are typically accomplished by complying with the “parking” rules in Revenue Procedure 2000-37. In a typical reverse exchange, a taxpayer will enter into a qualified exchange accommodation agreement (re- ferred to as a “QEAA”) with an exchange accommodation titleholder (referred to as an “EAT”; this role is typically played by a single-member limited liability company formed by the 1031 accommodator). This approach can be used to ensure that the taxpayer isn’t under any time pressure to find and purchase replacement property,

(continued on page 5)

inside this issue

2 Many Related-Party Exchanges Are Perfectly Legal 2 Jeneé Hilliard Named Editor 3 Exchanges and Single- Member LLCs 4 Exchanging Adjacent Parcels: One Exchange or Two? but replaces that risk with the fact that the exchange will fail if the taxpayer cannot find someone to buy his or her relinquished property within the 180-day

• period. This structure also requires that

the taxpayer have the cash and financ- ing available to acquire the replacement property before the relinquished prop- erty is sold; for many taxpayers, this is a difficult hurdle to overcome. A typical reverse exchange can be il- lustrated as follows. Our taxpayer, Leon- ard, finds an apartment complex that he’d like to buy as investment property, and he also wants to sell his current invest- ment duplex without paying tax. Leonard can sign a QEAA and have an EAT buy the apartment complex for him, and then Leonard can list his duplex for sale. If the duplex sells within 180 days after the apartment complex is purchased, he can complete the exchange and have the apartment complex serve as replacement property for his duplex. But if Leonard has multiple duplexes, owns them through various partnerships, and is willing to sell any of the duplexes as part

• f a 1031 exchange, it increases Leonard’s

chances of completing a 1031 exchange if he can use whichever duplex sells first as the relinquished property in an exchange with the apartment complex. Private Letter Ruling 201416006 has

• pened the door to allow more flexibility

in designating relinquished property in reverse exchanges. The facts of Private Letter Ruling 201416006 can be illustrated as follows. Leonard owns three duplexes and also

• wns 51 percent of the Howard Leonard

Partnership and 51 percent of the Shel- don Leonard Partnership. Each of the partnerships also owns three duplexes. Leonard finds the apartment complex and wants it to serve as replacement property for whichever of the nine duplexes sells first. Leonard has an EAT acquire the apartment complex as potential replacement property. He then enters into three QEAAs with the EAT. One QEAA is with Leonard personally,

• ne QEAA is with the Howard Leonard

by Jeneé Hilliard

jenee.hilliard@millernash.com 503.205.2505

2 | miller nash llp | Tax-Free Exchange Advisor

(continued on page 5)

Many Related-Party Exchanges Are Perfectly Legal!

by Ronald A. Shellan

ronald.shellan@millernash.com 503.205.2541

In the good old days, a taxpayer could exchange his high-basis relin- quished property for his wife’s low- basis replacement property. Thereafter, the taxpayer could sell the replacement property (which now has a substituted high basis) with little or no gain. This technique is known as a basis swap. Years ago, Congress changed the law to plug the basis-swap loophole by ban- ning many related-party exchanges. But one can still complete many types

• f exchanges with related parties!

The law actually allows tax-free exchanges with related parties if both the taxpayer and the related party hold

• n to the properties received in the

exchange for two years. But obviously, that exception has only limited utility. Who can wait two years? Another exception is that a taxpayer can transfer his relinquished property to his child or other related party and acquire the replacement property from an unrelated person. It works, and there is no risk, as long as both the taxpayer and the related party hold the replace- ment property and the relinquished property respectively for at least two

• years. Thus, while you generally cannot

complete an exchange by acquiring the replacement property from a related person, you can complete an exchange by selling the relinquished property to a related party. Another work-around is to acquire the replacement property from a related party who does not technically meet the requirements for being a related party under the tax rules. Let’s say that Joe wants to help out his daughter Sally by buying her house as replacement property in a tax-free exchange and financing the purchase by selling relin- quished property that he owns to a third

• party. While he can’t do that, he could

buy the house from Sally’s husband, Clyde, since Clyde is not related to Joe in such a way that it triggers the related- party rules. Of course, if Sally transfers the house to Clyde the day of closing so Clyde can sell it to Joe, the IRS can ar- gue that in essence it is a related-party

• transaction. But if Sally transfers the

house to Clyde, waits a month or two, and there is no agreed-on plan that the house will be purchased by Joe, it will probably pass IRS muster. Another exception relates to situa- tions that in effect have no basis swap. Thus, Joe can complete an exchange by purchasing the replacement property from his daughter Sally, a transaction that is generally not allowed, provided that Sally’s taxable gain on the trans- action is roughly equal to the gain that Joe will defer by completing the

• exchange. Thus, there is no basis swap,

since someone within the related fam- ily group is paying taxes; Uncle Sam is happy! Note, however, that if Sally has a net operating loss and won’t pay taxes Miller Nash

LLP

partner Jeneé Hilliard has been named editor

• f the Tax-Free Exchange
• Advisor. Ronald Shellan

is stepping down as editor in anticipation of his retirement this

• December. Jeneé, whose primary prac-

tice focus is on real estate and tax-free exchanges, has worked for almost a de- cade in the tax-free exchange arena. She is currently finalizing the “Like-Kind Exchanges” chapter in the Principles

• f Oregon Real Estate Law handbook

published by the Oregon State Bar.

Jeneé Hilliard Named Editor

Engaged Guidance, Exceptional Counsel. EXPERIENCE • PRACTICE TEAMS

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Attorneys in Miller Nash’s tax practice represent clients ranging from national companies to indi- viduals and closely held businesses. We add value by helping our clients plan their business and investment activities to attain their business objectives while minimizing their local, state, and fed- eral taxes. Our tax attorneys deal with the Internal Revenue Service, the Oregon Department of Revenue, and the Washington Department of Revenue, as well as many local governments, and are actively involved with local, state, federal, and international tax issues. Additionally, Miller Nash represents national, regional, and local companies in administrative hearings and in state and fed- eral courts in tax disputes with revenue authorities. Miller Nash tax attorneys are recognized leaders in their fi eld, from having served (or serving) on the executive committee of the Oregon State Bar’s Tax Section (three as its chair) and from being regular speakers at a variety of industry and professional seminars. Our tax attorneys work behind the scenes on legislative and regulatory matters and represent clients through all stages of appeals and in tax court. W W W . M I L L E R N A S H . C O M learn more about our tax team at

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Tax-Free Exchange Advisor | miller nash llp | 3

Exchanges and Single-Member LLCs

While a multimember limited li- ability company (“LLC”) is treated as a partnership for tax purposes, a single

• member limited liability company

(“SMLLC”) is not. Its existence is ig- nored for tax purposes, and its income, expenses, and other tax attributes are reflected on the tax return of its sole

• member. SMLLCs are a great tool to

solve various exchange issues. In particular, an SMLLC can avoid issues when structuring a reverse or improvement exchange and provide added flexibility for spouses in community property states. One

• ften-used

technique is to form an SMLLC to be used to hold title to the replacement property in an exchange. When a taxpayer sells the relinquished property, the replacement property can be purchased by an SMLLC owned by the taxpayer. If the relinquished prop- erty is owned by tenants in common

• r by a husband and wife, each of the
• wners can form his or her own sepa-

rate SMLLC and hold the replacement property as a tenant in common with the other owners. There are quite a few advantages to using this technique. For example, many lenders require loan collateral to be placed in a single-asset entity, and this is an easy way to accommodate the

• lender. Additionally, holding title to the

replacement property in an SMLLC can help shield other assets of the taxpayer from liability created by the replace- ment property (e.g., environmental contamination or slip-and-fall injuries). In an improvement exchange or a reverse exchange, the use of an SMLLC has additional advantages. A typical structure for an improvement exchange is that the accommodator builds improvements on real estate and then transfers the completed or partially completed structure to the taxpayer as replacement property. If an SMLLC is used to acquire title to the replacement property by the accommodator, when the improvements are completed, the transfer of the replacement property to the taxpayer can be completed by the accommodator transferring the mem- bership interests in the SMLLC to the taxpayer instead of transferring fee title to the replacement property. Since no deed is recorded when the real estate is transferred from the accommodator to the taxpayer, in some jurisdictions real estate transfer taxes can be avoided. And because the SMLLC continues to

• wn the real estate, the original title

insurance obtained when the property was first acquired remains in effect. Title insurance could be lost if the property were simply deeded over by the accommodator to the taxpayer. Another advantage to using an SMLLC in an improvement exchange can occur if the construction to com- plete the improvements will continue after the exchange is completed. By transferring only the membership in- terest in the SMLLC, there is no need to amend or assign construction contracts

• r loan agreements to the taxpayer (al-

though it may be necessary to negotiate into construction or loan agreements that a transfer of the SMLLC to the taxpayer will not violate antiassignment provisions or trigger a due-on-transfer clause). One exception to the normal rules that an SMLLC must be owned by a single member relates to com- munity property. If an LLC is owned by a husband and wife as community property, it is treated as an SMLLC for tax purposes, because, for tax purposes, the husband and wife together are treated as a single member. Very difficult issues can occur, how- ever, if it is not clear whether the LLC is community property. For example, if the LLC documents indicate that the LLC is owned by

• nly the wife, but the parties are

in a long- term marriage and all their assets have been acquired during the marriage, the husband might still have a community- property interest in the LLC, even though he isn’t listed as an owner in the LLC documents. Or, alternatively, if both husband and wife are shown as the LLC’s owner, but the husband acquired some of the LLC assets before marriage or from an inheritance, the LLC membership interests might not be community property. The 1031 issue for a community- property LLC is that the same entity, for tax purposes, must sell the relinquished property and purchase the replacement

• property. Thus, if the operating agree-

ment lists husband as the sole member, the LLC could be a community-property SMLLC that would allow husband and wife to jointly acquire the replace- ment property, or the LLC could be an SMLLC that qualifies as husband’s

by Jeneé Hilliard

jenee.hilliard@millernash.com 503.205.2505

“SMLLCs are a great tool to solve various exchange issues. In particular, an SMLLC can avoid issues when structuring a reverse or improvement exchange and provide added flexibility for spouses in community property states..”

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Tax-Free Exchange Advisor | miller nash llp | 4

Exchanging Adjacent Parcels: One Exchange or Two?

by Ronald A. Shellan

ronald.shellan@millernash.com 503.205.2541

When an exchange involves two parcels of real estate that are adjacent to each other, it can be tricky to figure out whether they should be treated as two exchanges or a single exchange. This is a distinction with a difference! It matters because the 45-day identifica- tion rules and the 180-day replacement- property rules cover only a single “property,” which might or might not include two adjacent properties. It can also matter for purposes

• f the carryover holding

period, the rules regarding when and how boot is taxed, and other related rules. Example: Rebecca owns Blackacre and Whiteacre, which are adjacent to each

• ther. Rebecca purchased

Blackacre for $500,000, and it is currently worth $500,000. She purchased Whiteacre for $400,000, and it is currently worth $1 million. Can she sell Blackacre in a taxable transac- tion for $500,000 (since no gain would be recognized), and also sell Whiteacre as part of a tax-free exchange? What factors determine whether the two parcels should be treated as a single property for exchange purposes or as multiple properties? As it turns out, a lot of factors should be considered. The factors include the following: 1. Are the two properties part of a single economic or business unit? For example, if a hotel was located on two parcels that were owned by the same owner, they would be treated as the sale of a single property. On the other hand, if the hotel had vacant land next to it that was not used as part of the hotel, it is more likely that the hotel property and the vacant-land could be treated as two separate properties. 2. How adjacent were the proper- ties? Did they have a common property line? Or were they separated by a road or a river? 3. Should a farm that is operated as a single operating unit, but that has properties scattered

• ver one or more tax lots, be

treated as a single property or multiple properties? It is very hard to tell.

• 4. Was the transaction document-

ed as a single sale or two sales? If they were documented as two single sales instead of one, it is more likely that they will be treated as two sales. This pre- sumption could be overcome if the two sales were contractually linked to each other so that one sale could not close unless the

• ther sale closed.

5. Were the properties sold to two buyers or one? If sold to two buyers, especially if they are not related to each other, treatment as two transactions is more likely.

• 6. Will the two transactions close
• n the same day or different

days? 7. Were the sales closed in one escrow or two?

• 8. Were two separate exchanges

set up with two accommodators

• r just one?
• 9. Were the properties

listed with a broker as a single property or two?

• 10. Were the properties

advertised for sale as a single property or two? In general, if the properties are part of the same economic unit, are adjacent to each other, and are sold to the same buyer under the same purchase agreement and close on the same day, they should be treated as a single property for exchange pur-

• poses. If the properties are not part
• f the same economic unit, are sold

to different buyers, and are in differ- ent closings on different days, they should be treated as two properties for exchange purposes. Often the facts are not clear, and a decision must be made. A tax professional should be retained who can help structure the transaction to help achieve the desired result.

5 | miller nash llp | Tax-Free Exchange Advisor More Flexibility for Reverse Exchanges | Continued from page 1 Partnership, and the final QEAA is with the Sheldon Leonard Partnership. When the EAT acquires the apartment complex, it is not clear whether Leonard, the Howard Leonard Partnership, or the Sheldon Leonard Partnership will complete the exchange and acquire the apartment complex as replacement property. So each QEAA acknowledges that there are QEAAs outstanding with two

• ther parties, and each QEAA

provides that any of the three parties can give notice to the EAT of the intent to acquire the apartment complex, and upon doing so, the other two parties will have no right to acquire the apartment complex. Leonard signs 45-day designations for all three taxpayers, and each designation lists the three duplexes owned by that taxpayer as the relinquished property. This results in nine duplexes being designated as potential relinquished properties to pair with the apartment complex. The IRS ruled that each of the three QEAAs was a separate QEAA meeting the require- ments of Revenue Procedure 2000-37 and that each taxpayer was allowed to complete a separate 45-day designa-

• tion. This structure provides flexibility

for a taxpayer with multiple potential relinquished properties held in various forms of ownership by increasing the number of potential relinquished prop- erties that can be designated for a single replacement property. There are, of course, a few limitations with this ruling. First, private letter rul- ings provide tax advisors with guidance about how the Internal Revenue Service might view an issue, but they can be relied on only by the taxpayer who requested the ruling and cannot be used or cited as precedent. Second, the taxpayer who requested the ruling asserted that each taxpayer had a bona fide intent to acquire the replacement property under the terms of the QEAA. In its ruling, the IRS specifically stated that it was relying on this representation in making its ruling. Ultimately

• nly one taxpayer can acquire the

replacement property, so it seems difficult for all three taxpayers to prove that they had a bona fide intent to acquire the property; this could be an area in which the IRS could challenge this type of arrangement. Nonetheless, this structure is interesting and worth considering in connection with reverse exchanges. even though she will have a taxable gain

• n the transaction, this technique will

not work. A variation on the no-basis swap transaction occurs when both the taxpayer and the related party are completing a tax-free exchange. Thus, Joe can acquire replacement property from his daughter Sally as part of Joe’s tax-free exchange, provided that Sally is selling her relinquished property to her father, Joe, as part of her own tax- free exchange. Thus, there is no basis swap because Sally will continue to own low-basis property that will generate substantial gain when she ultimately sells the replacement property that she acquired in the exchange. While the general rule continues to be that a taxpayer cannot complete a tax- free exchange with a related party, there are many potential ways to legitimately avoid the related-party rules. But don’t try this at home! It is always best to seek competent tax advice when structuring any of these types of transaction. Many Related-Party Exchanges are Perfectly Legal! | Continued from page 2 separate property, which means that the replacement property could not be acquired by husband and wife jointly

• r

through an LLC in which wife has an

• wnership
• interest. In any event, to prevent

possible problems, it is generally best for the LLC that owned the relinquished property to acquire the replacement property directly or through an SMLLC that is owned only by the LLC, rather than adding the taxpayer’s spouse as a new member of the LLC or creating a new LLC owned by husband and wife to acquire the replacement property, even in community-property states. Exchanges and Single-Member LLCs | Continued from page 3

“This structure provides flexibility for a taxpayer with multiple potential relinquished properties held in various forms of ownership by increasing the number of potential relinquished properties that can be designated for a single replacement property.”

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