Tax-Free Exchange Advisor Related-Party Exchanges Can Sometimes Be - - PDF document

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miller nash llp | Winter 2012

Tax-Free Exchange Advisor

Related-Party Exchanges Can Sometimes Be Tax-Free

Congress passed the related-party ex- change rules to prevent a taxpayer from exchanging out of low-basis property and acquiring high-basis property from a related party. There are a number of sig- nificant exceptions to the general rule. One of the most important excep- tions is available if either the disposition

• f the relinquished property or the

acquisition of the replacement property did not have as one of its principal pur- poses the avoidance of federal income taxes (the “No Tax Avoidance Exception”). IRC § 1031(f) (2) (C). This exception has expanded over the years and provided quite a number of different ways to avoid the related-party rules. These exceptions are discussed more fully below. But a note of caution: This exception has an ad- ditional requirement that the application

• f the exception must be “established to

the satisfaction of the” IRS. What follows is a laundry list of the exceptions to related-party rules: Two-Year Wait. The taxpayer may convey the relinquished property to a related party and receive in exchange replacement property from the related

by Ronald A. Shellan

ronald.shellan@millernash.com (503) 205-2541

(continued on page 5)

inside this issue

2 Exchange Tossed—Replace- ment Property Was Really Taxpayer’s Residence 3 How Long Must I Hold It? 4 Taxpayer Caught Complet- ing Indirect Related-Party Exchange 5 Goodwill Can Be Exchanged if Treated as Real Estate party if both parties wait two years before disposing of either property. The disposi- tion of either the relinquished property

• r the replacement property following

the death of the taxpayer or the related party is an exception to the two-year rule. IRC § 1031(f)(2)(A). A disposition of either property as a result of a condemnation or threat of condemnation of the property is also an exception to the two-year rule. IRC § 1031(f)(2)(B). Sell Relinquished Property to Re- lated Party. The taxpayer may sell the relinquished property to a related party and buy the replacement property from an unrelated party, even if the related party plans to sell the relinquished prop- erty within two years. See Priv Ltr Rul 200709036 (Nov. 28, 2006); Priv Ltr Rul 200712013 (Nov. 20, 2006); Priv Ltr Rul 200728008 (Apr. 12, 2007). The IRS has taken the position that that there was no basis swap and neither party cashed out

• f its investment in real estate.

Undivided Interests Exchanged. If the taxpayer and its related parties

• wn undivided interests in multiple

properties, the parties may complete exchanges, even if the parties will not all hold their interests in the properties for an additional two years, provided that at the end of the exchange each party

• wns an entire property or owns a larger

undivided interest in a property than it

• wned before the exchange. See Priv Ltr

Rul 200730002 (Apr. 26, 2007); Priv Ltr Rul 200706001 (Oct. 31, 2006). See also Priv Ltr Rul 200541037 (June 29, 2005); Priv Ltr Rul 199926045 (Apr. 2, 1999). No Net Tax Savings From Exchange. If the net tax paid as a result of the ex- change is greater than the tax that the taxpayer would have paid, the exchange is permissible because there will have been no tax-avoidance purpose. For example, if the taxpayer were to complete an exchange by which he acquired the replacement property from his sister (deferring $300,000 of taxable income), the exchange would be tax-free as long as

2 | miller nash llp | Tax-Free Exchange Advisor

Exchange Tossed—Replacement Property Was Really Taxpayer’s Residence

by Ronald A. Shellan

ronald.shellan@millernash.com (503) 205-2541

The Tax Court had no trouble toss- ing out an attempted tax-free exchange because the replacement property was determined to be the taxpayer’s resi- dence. The taxpayer in Goolsby, TC Memo 2010-64, sold investment property and exchanged it into a replacement-prop- erty home located in Fayetteville, Geor- gia, which the Court referred to as the Pebble Beach property. For an exchange to be effective, both the relinquished and the replacement property must be held for investment or for productive use in a trade or business. In determining whether the re- placement property’s use qualifies for tax-free treatment, the courts have al- ways looked at the intent of the taxpayer

• n the day the replacement property is
• acquired. The Tax Court determined

that the Pebble Beach property was not qualified replacement property on the day it was acquired. Why did the Court make this determination? The evidence showed that the taxpayer actually moved into the house just two months after it was acquired. The taxpayer made the purchase of the Pebble Beach property contingent on the sale of the taxpayer’s existing personal residence. There were some attempts to rent the property, but the Court found them to be rather

• pathetic. An ad was placed in a newspa-

per for a few months, but the taxpayer failed to research rental transactions in the Pebble Beach area and did not even know whether a rental violated the homeowner covenants governing the property. The taxpayer even started remodeling the property’s basement within a few weeks after purchasing the property. A really scary fact was that the ac- commodator’s staff was called to the witness stand. Testimony revealed that the taxpayer had asked the accommoda- tor if the taxpayer could move into the Pebble Beach property if no one could be found to rent it. The Court found that this showed intent to move into the property. What lessons does the Goolsby case teach us? First, a court will see through window-dressing attempts to pretend that the property was not intended for personal use. Second, be careful what you say to anyone about your intent (with the exception of your lawyer) be- cause it could end up in court. Finally, and perhaps most importantly, this case once again proves that one can be too aggressive. The taxpayer should have either given up trying to com- plete an exchange or made an earnest and meaningful attempt to lease the property.

For those in the Portland area, Miller Nash invites you to a complimentary one-hour program on estate planning. The program will answer the following questions:

• What is a probate?
• Who gets my assets if I don’t have a Will?
• How are trusts set up and what are their uses?
• Will my estate be subject to estate taxes?
• What are some approaches we can use if we have children from prior marriages?
• Can a Will avoid probate?
• How do I plan for jointly owned property, 401(k) accounts, and life insurance benefits?
• What must I consider when passing property to children and grandchildren?
• What are the basic strategies used to minimize estate taxes?
• What should business owners consider when planning their estates?

In addition to these topics, we invite other estate planning questions that you may have. The program is appropriate for business owners, retirees, and executives. Spouses and adult children are welcome to join. You can register by sending an e-mail to marika.giers@millernash.com or by calling 503.205.2367. When: January 31 (9:00-10:00 a.m.) Where: Miller Nash LLP (111 S.W. Fifth Avenue, Suite 3400, Portland, Oregon 97204)

Continental breakfast provided. Parking will be validated. If the date above does not work for you, we will be hosting similar programs on March 6 and March 20. Find more information online at www.millernash.com.

Estate Planning Seminar

Engaged Guidance, Exceptional Counsel.

3

How Long Must I Hold It?

How a Taxpayer’s Intentions for Its Property Affect the Taxpayer’s Ability to Complete a 1031 Exchange

by Jeneé Hilliard

jenee.hilliard@millernash.com 503.205.2505

Talking about “holding it” always makes me think of family road trips when I was a kid. In the case of 1031 exchanges, messing up the “holding it” part can be equally disastrous. In- ternal Revenue Code Section 1031(a)(1) provides that a taxpayer may complete a 1031 exchange only if both the relin- quished property and the replacement property are “held for productive use in a trade or business or for investment.” Additionally, Code Section 1031(a)(2)(A) provides that “property held primarily for sale” is not eligible to serve as relin- quished property or replacement property, and of course, property held for personal use is not eligible ei-

• ther. It can be difficult to determine

when the holding requirement has been met because the Code, regulations, and case law do not provide clear standards about what it means to “hold it.” There are no bright line rules with respect to the holding requirement; in- stead, whether property was “held” for the required purpose (investment or in a trade or business, and not for resale) is a fact-specific inquiry that focuses on the taxpayer’s intended use of the prop-

• erty. Because only the taxpayer knows

what he or she intended, although tax- payer testimony about intent is relevant, courts typically find the taxpayer’s

• utward actions more compelling than

self-serving testimony about his or her actual intent. The taxpayer’s outward actions that are commonly persuasive are the length of time that the taxpayer

• wned the property and the taxpayer’s

actual use of both the relinquished property and the replacement property. Length of ownership is relevant because immediately reselling property after it is acquired often shows intent to hold the property primarily for sale and not intent to hold the property for investment, especially if the property is not income-producing property. Own- ing property for at least two years should be long enough to show that the property was not held primarily for resale. Owning property for even

• ne year is probably long enough, but

the longer the relinquished property is owned before the exchange and the longer the replacement property is

• wned after the exchange, the better.

A taxpayer who owns property for less than one year and wants to use the property as relinquished property in a 1031 exchange may still be able to do so, but should evaluate the situation more carefully than someone who has owned a rental property for 25 years before us- ing it as the relinquished property in a 1031 exchange. In an IRS evaluation of whether a taxpayer’s actual use of the property meets the holding requirement, the taxpayer’s actions to achieve his or her stated purpose can support a finding

• f the required intent, even if those ac-

tions were unsuccessful. For example, a taxpayer who owns a vacant office building for six months and the entire time aggressively markets space for rent and interviews and hires brokers to find tenants for the building can be found to have an investment intent for the property even if the efforts to procure tenants are unsuccessful. On the flip side, a taxpayer who buys a 50 percent occupied office building, completes substantial renovations, fills the vacancies, and sells the office building nine months later might have a more difficult time proving that the property was acquired for investment purposes and not primarily for sale. Even legitimate transfers of prop- erty or changes in use of property im- mediately before or after an exchange can increase the risk that an ex- change will be treated as invalid. For example, a taxpayer’s receipt

• f rental property as a gift or in

connection with the liquidation

• f a partnership could cause the

IRS to challenge the exchange. Similarly, by gifting replacement property or contributing replacement property to a partnership immediately after an exchange, a taxpayer might fail to meet the holding requirement. When it comes to the holding requirement,

• ur advice is to keep things as simple as

possible and recommend that the own- ership of the relinquished property not change for at least two years before the exchange, that the ownership of the re- placement property remain unchanged for at least two years after the exchange, and that during these periods the prop- erty be used in a trade or business or be income-producing property. Of course, many exchanges that don’t fall neatly within these param- eters can still be valid. But in those cases, we recommend that the facts be carefully evaluated before commencing an exchange so that the likelihood of a successful exchange can be enhanced. c c F

• c
• I

S

“Owning property for at least two years should be long enough to show that the property was not held primarily for resale.”

Tax-Free Exchange Advisor | miller nash llp | 4

Taxpayer Caught Completing Indirect Related- Party Exchange

by Ronald A. Shellan

ronald.shellan@millernash.com (503) 205-2541

Taxpayers (and sometimes their advisors) often believe that for any rule there is some way to get around it. This is sometimes true, but Congress and its staff read all the tax journals and often quickly close up any known loopholes. So it is with related-party exchang-

• es. In order to prevent a taxpayer from

exchanging low-basis property via a sale to an unrelated party in exchange for a purchase of high-basis property from a related party, Congress in IRC § 1031(f) prohibited such exchanges. Congress also prohibited in Section 1031(f)(4) ex- changes structured to manipulate the basic related-party rules. The law says that Section 1031 is not available “to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.” In Ocmulgee Fields, Inc. v. Comm’r, 106 AFTR2d 2010-5820 (11th Cir 2010), the taxpayer tried to get around the related-party rules by interposing an ac- commodator in the transaction. Thus, instead of completing an exchange with a related party, technically the exchange was completed using an exchange accommodator or qualified

• intermediary. In effect, the taxpayers

were attempting to complete a tax-free exchange they could not do directly, by completing the exchange indirectly by using an accommodator. The Court did not have much trouble in upholding the IRS’s assessment against the taxpayer. $ High-Basis Property

Accommodator Accommodator Accommodator Taxpayer Taxpayer Taxpayer y Buyer Buyer y Related Party—Seller Related Party—Seller Related Party—Seller

Low-Basis Property $ Low-Basis Property High-Basis Property

Related-Party Exchanges

5 | miller nash llp | Tax-Free Exchange Advisor Related-Party Exchanges Can Sometimes Be Tax-Free | Continued from page 1 the sister had to pay tax on her sale of at least $300,000. No one knows what would happen if the sister had to pay tax on $280,000 of taxable income, but it would probably work. At some point, if the sister’s tax liability were substan- tially less than her brother’s savings in taxable income, the IRS could treat the transaction as taxable. This exception would not apply if the sister’s $300,000 in taxable income did not generate a tax liability or generated a lesser tax liability than expected (e.g., she had a net oper- ating loss carryover that sheltered the gain or her tax bracket was substantially lower than her brother’s). See Teruya

• Bros. v. Comm’r, 104 AFTR2d 2009-

6274 (9th Cir 2009); Ocmulgee Fields,

• Inc. v. Comm’r, 106 AFTR2d 2010-5820

(11th Cir 2010). No Cash-Out. The IRS has held that if neither the taxpayer nor the related party cashed out (i.e., neither party re- ceived any cash in the exchange transac- tions), the No Tax Avoidance Exception

• applies. In Priv Ltr Rul 200251008

(Sept. 11, 2002), the taxpayer com- pleted an improvement exchange. The replacement property was a building constructed on a ground lease from a related party. Even so, since the related party did not receive any cash in the transaction, it was held that the related- party rules were not violated and that the exchange was tax-free. Taxpayer and Related Party Both

• Exchange. The taxpayer may acquire

the replacement property from a related party and sell the relinquished property to an unrelated third party as long as the related party also does its own 1031

• exchange. See Priv Ltr Rul 200616005

(Dec. 22, 2005); Priv Ltr Rul 200440002 (June 14, 2004). This exception applies even if the related party receives some taxable boot in its exchange. Priv Ltr Rul 200820025 (Feb. 7, 2008); Priv Ltr Rul 200810017 (Dec. 6, 2007). Family Feud. The No Tax Avoid- ance Exception has been applied to an exchange to resolve a family dispute. In Priv Ltr Rul 200012064 (Dec. 21, 1999), the IRS permitted a series of circular tax- free exchanges between related parties followed by a spin-off of a corporation when the purpose of the spin-off was not to avoid taxes, but rather to resolve disagreements between shareholders as to the management of the corporation. Additional Tax-Free Transaction. The No Tax Avoidance Exception has also been applied to dispositions of the replacement property in a second tax-free transaction (e.g., using the property as a capital contribution to a limited liability company). Priv Ltr Rul 200616005 (Dec. 22, 2005). If an exchange involves a related party, it may be taxable under the ap- plicable rules. But don’t stop there. A number of significant exceptions to the related-party rules allow those exchanges to be structured as tax-free exchanges. When attempting to exchange a business, exchanging the goodwill com- ponent is often a dead end. Goodwill of two different businesses may never be

• f like kind. Treas Reg § 1.1031(a)-2(c)(2).

Goodwill associated with real estate, however, can generally be treated as real estate and exchanged tax-free for other real estate. Certain types of real estate es- sentially constitute businesses in and

• f themselves. Examples of these are

shopping centers, motels, hotels, quar- ries, and golf courses. In these types of transactions, it is easy to separate the real property from the tangible personal property, such as the furniture and bed- ding used in a motel. It is very difficult, however, to separate the real estate from its goodwill, including the value of the above-market leases, name, telephone number, and workforce in place. It is probably not necessary to al- locate goodwill from real estate of this

• nature. Under IRC § 197, goodwill can

be amortized over 15 years. When Con- gress passed IRC § 197, it was concerned that taxpayers would attempt to divide goodwill from its associated real estate and amortize the goodwill over a very short 15 year period versus the much longer depreciation periods available for real estate. The regulations provide that for tax purposes, goodwill is not a separate asset from real estate: “Section 197 intangibles do not include any interest in land. For this purpose, an interest in land includes a fee interest, life estate, remainder, easement, mineral right, timber right, grazing right, riparian right, air right, zoning variance, and any

• ther similar right, such as a

farm allotment, quota for farm commodities, or crop acreage base.” Prop Treas Reg § 1.197-2(c) (3). Section 197 assets also do not in- clude the value of leases. For example,

by Ronald A. Shellan

ronald.shellan@millernash.com (503) 205-2541

Goodwill Can Be Exchanged if Treated as Real Estate

(continued on page 6)

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Goodwill Can Be Exchanged if Treated as Real Estate | Continued from page 5

Engaged Guidance, Exceptional Counsel.

• purchasing a shopping center does not

include a separate allocation for the value of the leases, even if the value of the real estate is increased because of the existence of a favorable lease. Prop Treas Reg § 1.197 2(c)(8). A much different problem is raised when real estate is a mere component

• f a business. In this situation, the

real estate must be separately valued, including any goodwill component. If possible, the allocation should be included in the purchase and sale

• agreement. The allocation of the value
• f each component of a business will

be controlled by the provisions of IRC § 1060.