Alexandra and I extend our heartfelt thanks to all who have made the ultimate sacrifice in service to this great country. America continues to be the best country because of all they have done for us.
In light of our recent partnership, the All States 1031 blog has merged with the Strategic Property Exchanges blog.
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Happy Memorial Day 2010
May 31st, 2010 by Moore McLaughlin
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Massachusetts Homeowner Oil Heating System Upgrade and Insurance Law
May 31st, 2010 by Moore McLaughlin
The following comes courtesy of Stephen Ryan, Esq., General Counsel of the Massachusetts Association of Realtors.
The law regarding compliance rules for all Massachusetts homes heated with oil is designed to eliminate the oil leaks that have plagued numerous older homes in the Commonwealth where a fuel line leaves the oil tank and is then buried in concrete and reappears at the burner.
In some of the homes, the buried portion of the fuel line leaks, and this causes expensive environmental damage. In addition, the new law requires homeowner insurance companies to make available coverage, at an additional cost, for oil spills to all homes that are in compliance with the new rules. The law goes into effect on July 1, 2010. The following is from a recently released fact sheet from the Massachusetts Department of Environmental Protection.
The Law
By July 1, 2010, homeowners must upgrade their home heating system equipment to prevent leaks from tanks and pipes that connect to the furnace. Making a relatively small expenditure now will prevent a much greater expense in the future.
The new law (see Chapter 453 of the Acts of 2008: http://www.mass.gov/legis/laws/seslaw08/sl080453.htm) has two
major provisions that require:
???? the installation of either an oil safety valve or an oil supply line with protective sleeve on systems that do not currently have these devices; and
???? insurance companies that write homeowner policies to offer coverage for leaks from heating systems that use oil.
Most homeowner policies do not currently include such coverage, leaving many to pay for costly cleanups out of their own pockets. Although it is mandatory that insurance companies offer this coverage, the insurance is an optional purchase for homeowners.
Who must take action?
Owners of one- to four unit residences that are heated with oil must already have or install an oil safety valve or an oil supply line with a protective sleeve, as shown in the diagram below. Installation of these devices must be performed by a licensed oil burner technician. Technicians are employed by companies that deliver home heating oil or are self-employed. It is important to note that heating oil systems installed on or after January 1, 1990 are most likely already in compliance because state fi re codes implemented these requirements on new installations at that time.
Who is exempt?
Homeowners are exempt from taking these leak prevention steps if:
???? the oil burner is located above the oil storage tank and the entire oil supply line is connected to and above the top of the tank; or
???? an oil safety valve or oil supply line with protective sleeve was installed on or after January 1, 1990; and
???? those changes are in compliance with the oil burning equipment regulations; a copy of the oil burner permit from the local fire department may be used to demonstrate compliance.
Why comply?
Not only is complying with the new law required, it makes good financial and environmental sense. Homeowners who take these preventive measures can avoid the disruption and expense that can be caused by heating oil leaks. A leak may result in exposure to petroleum vapors in your home. If the leak reaches the soil or groundwater beneath your house, then a cleanup must be performed to restore your property to state environmental standards. Leaks that affect another property or impact drinking water supply wells can complicate the cleanup and increase the expense. Each year, several hundred Massachusetts families experience some kind of leak.
What will an upgrade cost?
The typical cost of installing either an oil safety valve or oil supply line with a protective sleeve ranges from $150 to $350 (including labor, parts, and local permit fees).
What could it cost to clean up a leak?
The cleanup cost for a “simple” leak can be as much as $15,000. In cases where the leak impacts the groundwater or is more extensive, the cleanup costs can reach $250,000 or more.
What kind of insurance is available?
To be eligible for the new insurance coverage, homeowners must ensure that their oil heating systems are in compliance with the new law. Homeowners who have been certified to be in compliance with (or exempt from) the leak prevention measures qualify to purchase insurance that:
???? provides “first party coverage” of at least $50,000 for the cost of cleaning up a leak to soil, indoor air, or other environmental media from a home heating system at the residence itself and reimbursement for personal property damage; and
???? provides “third-party coverage” of at least $200,000 for the cost of dealing with conditions on and off the insured’s property because the leak from this system has impacted or is likely to impact groundwater or someone else’s property. The coverage also includes costs incurred for legal defense, subject to a deductible not to exceed $1,000 per claim.
What steps should be taken?
???? Determine whether you have had an oil safety valve or new oil supply line with protective sleeve installed since January 1,1990. If you have, your permit from the fire department for the installation can be used to document your compliance. You can request a copy from the fire department if the permit is on file, or a licensed oil burner technician can certify that status on a form.
???? If you do not have an oil safety valve or oil supply line with protective sleeve in place, have one or the other installed and certified. Either contact your oil delivery company to ask if it employs a licensed oil burner technician, or find a service person in your area. (A list of licensed technicians can be viewed at http://db.state.ma.us/dps/licenseelist.asp. Click on the “individuals” tab, scroll down to and then select “Oil Burner - Technical Certificate” in the “select a license type” box, type in your city or zip code, and click “select”).
???? Consider buying insurance coverage for the cleanup of a leak.
???? Determine whether your existing policy provides oil leak coverage.
???? If it does not, consider calling your homeowner insurance agent to amend the policy to include this coverage.
Like-kind exchange relief for those snared by QIs in bankruptcy or receivership
March 10th, 2010 by Moore McLaughlinThe IRS has at long last granted relief for taxpayers who were unable to timely complete a like-kind exchange because their qualified intermediary (QI) entered into bankruptcy or receivership. IRS will not treat taxpayers as being in actual or constructive receipt of exchange proceeds if they cannot complete an exchange because of a default of a QI in bankruptcy or receivership. Affected taxpayers may use a special safe harbor method to report gain or loss.
The IRS received many comments on this issue and has been promising action on it for a long time. As far back as 2007, when the real estate market started heading south in many areas, the IRS wrote Rep. Barney Frank (D-MA) to say that IRS was considering whether it was appropriate for it to extend relief where QIs went bankrupt. In substantially similar letters written to a number of Washington legislators in mid-2009, the IRS again said it was considering relief measures.
Background. In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. (Code Sec. 1031) Under Code Sec. 1031(a)(3), for a deferred exchange to be treated as tax-free, a taxpayer must identify the replacement property within 45 days of the transfer of the relinquished property and must acquire the replacement property by the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or the due date (determined with regard to extensions) of the taxpayer’s federal income tax return for the year in which the transfer of the relinquished property occurs. Absent relief, if the statutory timing requirements are met, a taxpayer would have to treat the relinquished property as having been disposed of in a taxable sale or exchange.
The regulations allow a taxpayer to use a QI to facilitate a like-kind exchange. (Reg. §1.1031(k)-1(g)(4)) When a taxpayer uses a QI, generally he will transfer the relinquished property to the QI, who sells the property to a buyer. The QI then takes the proceeds of the sale of the relinquished property, buys the replacement property, and transfers the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period in Code Sec. 1031(a)(3) and meets the other Code Sec. 1031 requirements, he is treated as having engaged in a like-kind exchange of property with the QI and he will not recognize gain on the exchange.
Victims of the recession and the troubled real estate markets. In Rev Proc 2010-14, IRS says it is aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI but were unable to complete the exchanges within the statutory time period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the relinquished property’s sale proceeds.
The IRS says it’s generally of the view that in such situations, a taxpayer should not have to recognize gain from the failed exchange until the tax year in which he receives a payment attributable to the relinquished property.
Who is entitled to relief. A taxpayer is entitled to relief under Rev Proc 2010-14 if he:
(1) Transferred relinquished property to a QI in accordance with Reg. §1.1031(k)-1(g)(4).
(2) Properly identified replacement property within the identification period (unless the QI default occurs during that period).
(3) Did not complete the like-kind exchange solely because of a QI default involving a QI that becomes subject to a bankruptcy proceeding or a receivership proceeding under federal or state law.
(4) Did not, without regard to any actual or constructive receipt by the QI, have actual or constructive receipt of the proceeds from the disposition of the relinquished property or any property of the QI before the QI entered bankruptcy or receivership. For purposes of this condition, relief of a liability under the exchange agreement before the QI default, either through the assumption or satisfaction of the liability in connection with the transfer of the relinquished property or through the transfer of the relinquished property subject to the liability, is disregarded.
Relief provisions. Rev Proc 2010-14, Sec. 4, provides that a taxpayer meeting the above conditions recognizes gain on the disposition of the relinquished property only as required under the safe harbor gross profit ratio method, and only as he receives payments attributable to that property.
Under the safe harbor gross profit ratio method, the portion of any payment attributable to the relinquished property that is recognized as gain is found by multiplying the payment by a fraction, having the taxpayer’s gross profit as the numerator, and having the taxpayer’s contract price as the denominator. For this purpose:
- A payment attributable to the relinquished property means a payment of proceeds, damages, or other amounts attributable to the disposition of the relinquished property (other than selling expenses), whether paid by the QI, the bankruptcy or receivership estate of the QI, the QI’s insurer or bonding company, or any other person. Unless it exceeds adjusted basis, satisfied indebtedness is not a payment attributable to the relinquished property.
- Gross profit means the selling price of the relinquished property, minus the taxpayer’s adjusted basis in it (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
- The selling price of the relinquished property is generally the amount realized on its sale, without reduction for selling expenses. But if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver specifies, by the end of the first tax year in which the taxpayer receives a payment attributable to the relinquished property, an amount to be received by the taxpayer in full satisfaction of his claim, the selling price of the relinquished property is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
- The contract price is the selling price of the relinquished property minus the amount of any satisfied indebtedness not in excess of the property’s adjusted basis. Satisfied indebtedness means any mortgage or encumbrance on the relinquished property that was assumed or taken subject to by the buyer or satisfied in connection with the transfer of the relinquished property.
Rev Proc 2010-14, Sec. 4, has detailed rules covering situations involving satisfied indebtedness exceeding adjusted basis, recapture income, and imputed interest.
A Code Sec. 165 loss deduction may be claimed for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of (1) the payments attributable to that property (including satisfied indebtedness in excess of basis), plus (2) the amount of any satisfied indebtedness not in excess of basis. Those claiming a loss deduction may also claim a Code Sec. 165 loss deduction for the amount of any gain recognized in accordance with Rev Proc 2010-14, Sec. 4, in a prior tax year.
Illustration: Mr. Able, a calendar year taxpayer owned investment property (Property 1) with a fair market value of $1.5 million and an adjusted basis of $500,000. He entered into an agreement with QI to facilitate a deferred like-kind exchange. On May 6, Year 1, Able transferred Property 1 to QI and QI transferred the property to a third party in exchange for $1.5 million. Able intended that the QI use the money held by it to acquire Able’s replacement property. On June 1, Year 1, Able identified Property 2 as replacement property. On June 15, Year 1, QI notified Able that it filed for bankruptcy protection and could not acquire replacement property. As a result, Able failed to acquire Property 2 or any other replacement property within the exchange period. As of December Year 1, QI’s bankruptcy proceedings are on-going and Able has received none of the $1.5 million proceeds from QI or any other source.
On July 1, Year 2, QI exits from bankruptcy and the bankruptcy court approves the trustee’s final report, which shows that Able will be paid $1.3 million in full satisfaction of QI’s obligation under the exchange agreement. Able receives the $1.3 million on August 4, Year 2 and does not receive any other payment attributable to the relinquished property.
Under Rev Proc 2010-14, Able is not required to recognize gain in Year 1 because he did not receive any payments attributable to the relinquished property in that year. He recognizes gain in Year 2, as follows:
… His selling price is $1.3 million, i.e., the payments attributable to the relinquished property (the amount specified by the trustee before the end of the first tax year in which he receives a payment attributable to the relinquished property).
… His contract price also is $1.3 million because there is no satisfied or assumed indebtedness.
… His gross profit is $800,000 (the selling price of $1.3 million less his $500,000 adjusted basis).
… His gross profit ratio is 80/130 (gross profit over the contract price).
… Able’s recognized gain in Year 2 is $800,000 (the $1.3 million payment attributable to the relinquished property multiplied by the gross profit ratio (80/130)).
Even though the payment attributable to the relinquished property ($1.3 million) is less than the $1.5 million that the QI received, Able is not entitled to a Code Sec. 165 loss deduction because the payment attributable to the relinquished property exceeds his adjusted basis in the relinquished property ($500,000). (Rev Proc 2010-14, Sec. 4.10, Ex. 1)
Rev Proc 2010-14 carries four other detailed examples illustrating nuances of the new safe-harbor relief.
Effective date of relief. Rev Proc 2020-14 is effective for taxpayers whose like-kind exchanges fail due to a QI default occurring on or after January 1, 2009. A taxpayer who is within the scope of Rev Proc 2020-14 may, subject to the Code Sec. 6511 limitations on credit or refund, file an original or amended return to report a deferred like-kind exchange that failed due to a QI default in a tax year ending before January 1, 2009, in accordance with Rev Proc 2010-14.
Supreme Court lets stand decision that using qualified intermediary cannot avoid §1031 related party rule
February 24th, 2010 by Moore McLaughlin
Supreme Court of the United States of America
The Supreme Court has declined to review a Ninth Circuit holding that a taxpayer could not avoid the Code §1031 like-kind-exchange related-party rule by using a qualified intermediary (QI). Teruya Brothers, Ltd. & Subsidiaries , (CA 9 2/11/2009) 104 AFTR 2d ¶ 2009-5345 , cert denied 2/22/2010.
Background. If statutory identification and replacement period requirements are met, gain or loss is not recognized currently on the exchange of property held for productive use in a trade or business or for investment for property of like kind that will be held for productive use in a trade or business or for investment. (Code §1031) QIs may be used to structure like-kind exchanges. However, under Code §1031(f), gain or loss on an exchange between related persons (under Code §267(b) or Code §707(b)(1)) must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. Nonrecognition treatment under the like-kind exchange rules does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule. (Code §1031(f)(4)) However, under Code §1031(f)(2)(C), a disposition will not trigger the related party bar if it is established to IRS’s satisfaction that neither the original transaction nor the later disposition had as one of its principal purposes the avoidance of federal tax.
Facts. Teruya Brothers Ltd. (Teruya) owned 62.5% of the common shares of Times Super Market Ltd (Times), so the two entities were related. In 1995, in one series of planned transactions, Teruya transferred Real Property 1 to TGE, a QI, which then sold it to an unrelated third party. TGE used the sale proceeds, as well as additional funds from Teruya, to buy like-kind Replacement Property 2 for Teruya from Times, and then transferred Replacement Property 2 to Teruya. In another series of planned transactions, Teruya transferred Real Property 3 to TGE, which sold it to an unrelated party. TGE used the sale proceeds from Real Property 3, plus some cash from Teruya, to buy like kind Replacement Properties 4 and 5 from Times.
Teruya realized a $1.3 million gain on Property 1 and a $10.7 million gain on Property 3. Times realized and recognized a $1.3 million gain on Property 2 and a $2.2 million gain on Property 5, but these gains were offset by a large net operating loss. Times realized a $6.4 million loss on Property 4, but did not recognize it because of the Code §267 related-party restriction on loss recognition.
Teruya treated its transactions as tax-deferred like-kind exchanges under Code §1031, but IRS said the transactions ran afoul of the Code §1031(f)(4) related-party rule and hit Teruya with a $4 million deficiency.
Tax Court. In 2005, the Tax Court held that the transactions were economically equivalent to direct exchanges of properties between Teruya and Times (with boot from Teruya to Times), followed by the sales of the properties by Times to unrelated third parties. The interposition of a QI couldn’t obscure the end result.
Observation: In 2009, the Tax Court applied its Teruya reasoning and decision to rule against another taxpayer on the QI- Code §1031(f) issue (see Ocmulgee Fields, Inc., (2009) 132 TC No. 6).
Ninth Circuit. In 2009, the Ninth Circuit concluded that the Tax Court did not err in determining that the transactions were structured to avoid the purposes of Code §1031(f)(4). It rejected Teruya’s contention that the economic consequences of the transactions to Times were irrelevant, and that Teruya’s continued investment in real property was dispositive. Code §1031(f)(1)(C)(i) disallows nonrecognition treatment if a related party disposes of exchanged property within two years, regardless of whether the taxpayer does as well. Thus, examining the taxpayer and related party’s economic position in the aggregate is often the only way to tell if Code §1031(f) applies.
The legislative history indicating Congress’s desire to bar like-kind exchange treatment where related parties have, in effect, cashed out of the investment, confirmed that a taxpayer and a related party should be treated as an economic unit to see if Code §1031(f) applies. The Ninth Circuit pointed out that the changing economic positions of Teruya and Times readily showed that the related parties used the exchanges to cash out of an investment in low-basis real property. Before the exchanges, Teruya owned Property 1 and Property 3, and Times owned Properties 2, 4, and 5. After the exchanges, Properties 1 and 3 had been sold, Teruya owned Properties 2, 4, and 5, and Times had the cash from the sale of Properties 1 and 3 (along with boot from Teruya). All in all, Teruya and Times decreased their investment in real property by approximately $13.4 million, and increased their cash position by the same amount. By allowing Teruya and Times to cash out of a significant investment in real property under the guise of a nontaxable like-kind exchange, the Ninth Circuit concluded that the transactions were undoubtedly structured to contravene Congress’s desire that nonrecognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.
The Ninth Circuit said Teruya could have exchanged its properties directly with Times, followed by Times’s selling Property 1 and Property 3 to the third-party purchasers, but this would not have had a tax-free result, since direct exchanges between related parties are ineligible for nonrecognition treatment when the exchanged property is sold within two years. Instead, Teruya employed TGE; the latter’s involvement as a QI served no purpose besides rendering simple, but tax disadvantageous, transactions more complex in order to avoid Code §1031(f)’s restrictions.
The Ninth Circuit also affirmed the Tax Court’s conclusion that Code Sec. 1031(f)(4) applied because improper avoidance of federal income tax was one of the principal purposes of the transactions.
Late in 2009, Teruya appealed the Ninth Circuit’s decision to the Supreme Court. However, on February 22, 2010, the Supreme Court declined to review the decision.
For more information on 1031 exchanges, or to ask specific questions regarding the related party rule of §1031, please contact Alexandra L. Hart, CES® at All States 1031 Exchange Facilitator, LLC by e-mail at AHart@AllStates1031.com or Moore McLaughlin, Esq., CPA, CES® by e-mail at FMM@AllStates1031.com or either of them by phone toll-free at 877-395-1031 extension 217.
What do I do if my TIC is in trouble?
February 20th, 2010 by Moore McLaughlinAlexandra L. Hart, CES® and I have been asked this question almost every other day for the past several months. With the national commercial real estate and financial markets in turmoil, many investments that seemed solid only a year or two or three ago are now floundering. Lenders are beginning foreclosure proceedings or are negotiating with the owners to take back a deed in lieu of foreclosure. Buildings are being sold in so-called short sales. And, lenders are selling off the promissory notes at deep discounts. In other instances, the banks are not taking any immediate action, but the sponsors are offering to buy out investors for the amount of their investment. Sometimes, individual investors are concerned and want to sell their interests, thus giving the other co-tenants an opportunity to buy a larger percentage for a small amount.
The question that we are continually asked is “What is my tax exposure?” As a tax lawyer, I have been trained to answer “Well, it depends.”
In every TIC I know of, the property is encumbered by non-recourse debt. Non-recourse debt is a loan made by a lender (could be a bank, an insurance company, a pension plan or some other type of lender) which debt is secured only by the property. The key feature of non-recourse debt is that no one is personally liable for the debt and the lender can look only to the property for repayment. As long as the rents are able to cover the expenses of the property and make the mortgage payments, then the lender typically feels comfortable. However, if the cash flow only covers the expenses and the investors do not receive any distributions, then the investors are not comfortable. Once the cash flow fails to cover the expenses, then the trouble really begins.
Sometimes the sponsor or property manager will make a cash call. If one or more of the owners is not willing or able to contribute enough cash, then the tenant-in-common agreement generally provides that the non-contributing owner either has to sell his or her interest, or the property has to be sold. In any event, if there is insufficient cash to cover the expenses, the lender will eventually take action.
In most of these cases, the TIC investors do not contribute additional cash. Thus, the lender starts the process of taking back or selling the property. Because the debt is non-recourse, the lender cannot go after the TIC owners, and cannot force the TIC owners to pay any money. So, the TIC owners generally lose the property, and their investment, but that is the extent of their losses.
These investors are convinced that they have sustained a loss for tax purposes. In almost every instance, that is not the case. For tax purposes, if a property that is encumbered by non-recourse debt is foreclosed upon or transferred back to the lender by a deed in lieu of foreclosure, the investor is treated for tax purposes as if he or she sold their interest in the property for their share of the non-recourse debt. For tax purposes, this is known as the amount realized. Taxable gain is calculated as the amount realized minus the adjusted tax basis of the property.
So, the next issue is to determine the investors’ adjusted tax basis in the property. Most of the TIC owners acquired the TIC interest as a replacement property in a 1031 exchange. If so, then their adjusted tax basis in the TIC interest is determined, in whole or in part, based on their adjusted tax basis in the property or properties that they sold in the 1031 exchange(s). If the investor traded up in value on the 1031 exchange, then the investor may have added to his or her adjusted tax basis. Any investor facing this dilemma should consult a qualified CPA or tax attorney who can make these complicated calculations.
Non-recourse debt that is forgiven does not result in cancellation of indebtedness income (”COD income”). COD income can be generated only from recourse debt. COD income is subject to a completely different set of tax rules. So, investors should not become confused with how the COD income rules operate.
The character of the gain on the foreclosure or deed in lieu of foreclosure of a TIC interest is likely to be capital. The holding period of the TIC interest is determined, to some extent, based upon the holding period the investor had in his or her relinquished property or properties from the 1031 exchange. However, if the investor traded up in value, he or she could have a split holding period. In order to enjoy the lower long-term capital gains tax rates, the property has to have been held for more than twelve months. In calculating the 12-month holding period, the investor may be able to tack on the holding period from his or her relinquished property. Again, any investor in this situation needs to consult a qualified CPA or tax attorney.
Remember also that there is no bright-line test for how long a property has to be held to qualify as “held for investment” for purposes of section 1031. There is no 2-year rule, 1-year rule or any other hard and fast rule.
In summary, the investor is treated as having sold the TIC interest in an amount equal to his or her share of the non-recourse debt. The investor will recognize gain or loss on this deemed sale based on his or her adjusted tax basis. In addition, the investor must determine his or her holding period.
The good news is that for investors facing a large tax bill, they may be able to defer the tax by effectuating another 1031 exchange. Click here for more information about “coffin or “no equity” exchanges.
For more information about these issues, or to ask questions about a specific scenario, please contact Alexandra L. Hart, CES® by e-mail at AHart@AllStates1031.com or by phone toll-free at 877-395-1031 ext. 217.
How To Purchase 1031 Replacement Property at an Auction
February 15th, 2010 by Moore McLaughlinAlexandra L. Hart, CES® at All States 1031 Exchange Facilitator, LLC has been asked several times recently about how to buy replacement property at an auction. While there is certainly nothing in section 1031 that specifically prohibits or disqualifies such replacement property, the real problem lies in the process and logistics of the auction process. Most of the auctions are being held in connection with a mortgage foreclosure.
At most auctions, the bidders must show a certified check in a certain minimum amount, such check being evidence of the ability to make a deposit payment. Other than proof of ability to pay, and proof of identification, very little is required. Standard purchase and sale agreement are not typically used. The issues affecting the 1031 exchange include meeting the identification rules, assignment to the qualified intermediary of the right to buy the replacement property, and potential constructive receipt and boot issues.
In many auctions outside the 1031 arena, the bidders will bring a certified check payable to themselves. If they are the successful bidder, they will endorse the check to the seller or the auctioneer. In the 1031 world, if the QI issues a certified check payable to the exchanger, and then the exchanger endorses the check to the auctioneer, the IRS will likely assert that such amount was received by the exchanger and taxable as boot. Furthermore, the payment could possibly disqualify the entire exchange as a distribution in violation of the specific restrictions (known as the g(6) limitations (see Treasury Regulation Section 1.1031(k)-1(g)(6)) on payments from the exchange account. In other words, issuing a check payable to the exchanger is not a good idea.
One alternative is, prior to the auction, ask the auctioneer for the name of a title company they trust and have the QI place the exchange funds with them subject to the acceptance of the bid. The exchanger can take blank assignment of contract documents with them to the auction to be executed in the event that they are the successful bidder.
Another alternative is to have a certified check issued by the QI to the auctioneer to be used in the event of a successful bid. Otherwise, the check is returned to the QI.
Or, if the exchanger is trading up in value, the exchanger can use his or her own funds.
Other solutions could be found in particular situations. If you are contemplating purchasing a replacement property through the auction process, be sure to contact Alexandra L. Hart, CES® or F. Moore McLaughlin, Esq., CPA, CES® to determine the best alternative. You can reach Alexandra at AHart@AllStates1031.com or toll-free at 1-877-395-1031 extension 217.
1031 Exchanges Become More Valuable in Rhode Island
December 13th, 2009 by Moore McLaughlin1031 exchanges gained significant value recently in Rhode Island thanks to the state legislature and the Governor. The leaders of Rhode Island determined that raising the Rhode Island tax rate on capital gains from 1.67% to 9.9% was good for the economic viability of the state. These leaders did not really explain the basis for such a determination, they just passed the bill. This enormous rate increase will take effect for sales after December 31, 2009.
So, in order to avoid this additional tax, a 1031 exchange should be considered. See our website for the basics of 1031 exchanges and the types of properties that are eligible. But, for the right types of properties and for the right investor, the 1031 exchange will allow the Rhode Island tax to be deferred.
For more information on the Rhode Island tax, contact All States 1031 Exchange Facilitator, LLC owner F. Moore McLaughlin, IV, Esq., CPA, CES at 877-395-1031 or by e-mail at fmm@AllStates1031.com.
Non-Resident Tax Withholding and 1031 Exchanges
November 23rd, 2009 by Moore McLaughlinBecause we handle 1031 exchanges in every state, we are frequently asked about the tax laws of individual states. Alexandra L. Hart, CES® and I always encourage exchangers to seek tax and legal advice from their own professionals, who are generally more knowledgeable about local laws and the exchangers’ particular circumstances. One of the most frequently asked questions involves non-resident tax withholding.
In many states, when an individual or entity that is not a resident of the state is selling real property, the state may impose a capital gains tax or other income tax. Because the seller is not a resident of the state, the state assumes that the seller will not file a tax return for that state. Once the property has been sold, the seller may have no further contacts within the state. If the seller does not voluntarily file a tax return and pay the tax, the state may never collect the tax.
As a measure to make sure all taxes are collected, most states have implemented a mechanism whereby the closing attorney or escrow company is required to withhold a portion of the sales proceeds and remit them to the state. In most cases, the amount required to be withheld is based on the gross selling price, not the actual amount of the gain. The reason for this technique is to make sure the taxes are collected, but without requiring an inquiry into the tax basis and other tax attributes of the seller. If too much is withheld, the seller can file a non-resident income tax return and claim a refund, if one is due.
Many states recognize 1031 exchanges and adopt the federal tax rules. As a result, exchangers who complete a valid 1031 exchange, with no boot, will owe no taxes to the state. If taxes are withheld and then later returned to the exchanger, then such amounts could be treated as boot, and subject the exchanger to tax; which is quite a bad outcome.
To ameliorate this Catch-22 scenario, states typically allow an exchanger to provide a statement or certificate at the closing which relieves the closing agent from the requirement to withhold any amounts for taxes. In Rhode Island, the form is known as Form 71.3. Other states have similar forms or processes. Some states require the seller to request the certificate days or weeks in advance of the closing.
So, if you are selling real estate located in a state in which you or the selling entity is not a resident, call us or check with your tax professional to determine whether non-resident withholding is required and, if it is, whether an exception exists for 1031 exchanges. Please click here to find some of the state non-resident withholding forms. Or click here for links to the various state websites.
Please contact us with any questions you may have. You can reach Alexandra L. Hart CES® at 877-395-1031 or by e-mail at AHart@AllStates1031.com.
Thanks to all our Veterans
November 11th, 2009 by Moore McLaughlin
In my opinion, Veterans Day is one of the most meaningful memorials of the year. Without our veterans, we would not enjoy the freedoms we have today. Their selflessness and willingness to sacrifice everything sets them apart from the rest of us. We are all lucky to have them.
Thank you to all veterans.
Exchanging Real Estate Intangibles
October 27th, 2009 by Moore McLaughlinWhen exchanging real estate, the exchanger must acquire property that is like-kind to the property that was sold. Like-kind in connection with real estate is defined as “all other real estate.” The types of property that qualify are very broad. For example, raw land will be like-kind with improved real estate. An office building is like-kind with an apartment building. Real estate in Massachusetts or Rhode Island is like-kind with real estate in Florida, Texas or Arizona.
Further, a partial or fractional interest in real estate is like-kind to a full or fee simple interest in real estate. So, an exchanger could sell a fee simple interest in real estate and purchase a tenant-in-common interest in real estate.
Recently, a series of rulings have been issued by the IRS which confirms that certain intangible interests in real estate are like-kind to fee simple interests in real estate.
Conservation Easements
In Private Letter Ruling (PLR) 9621012, the IRS ruled that the exchange of a “perpetual scenic conservation easement” (PSCE) for a fee simple interest in land that was either timberland, a ranch, or a farm qualifies for tax-free treatment under section 1031. A PSCE means any limitation in a deed in the form of an easement, restriction, covenant, or condition, the purpose of which is to retain land predominantly in its natural, scenic, historical, agricultural, forested, or open-space condition. Under a PSCE, the subject property remains as scenic open space in perpetuity, and its owner is not able to develop the property. The ruling is based on a state’s civil code, which provides that a conservation easement is an interest in real property voluntarily created and freely transferable in whole or in part. Assuming the PSCE is, by virtue of state law, an interest in real property, the exchange of the PSCE for the proposed replacement property qualifies as an exchange of like-kind property for purposes of Section 1031.
In PLR 9232030, the IRS ruled that an agricultural conservation easement on a farm is of like kind to a fee simple interest in real estate.
In PLR 200201007, the IRS ruled that a taxpayer’s exchange of a perpetual conservation easement (PCE) on a ranch for other ranch property that would be subject to a PCE upon receipt by the taxpayer qualifies for like-kind exchange treatment under Section 1031.
In PLR 200651018, the IRS ruled that a perpetual stewardship easement as described in the ruling is of like-kind to fee interest in other real property, and use of proceeds from relinquished perpetual stewardship to purchase one or more fee interests in real property to be held by taxpayer for productive use in trade or business or for investment will not disqualify transaction from tax deferred exchange treatment.
Development Rights
The IRS ruled in PLR 200901020 that residential density development rights to be transferred by taxpayer as relinquished property were for Section 1031 purposes of a like-kind to a fee interest in real estate, leasehold interest in real estate with 30 years or more remaining at time of the exchange, and land use rights for hotel units. The land use rights that were a part of the put option addressed in this PLR and the restrictive covenant (collectively referred to as Development Rights) constituted interests in real estate under state law. Taxpayer intended to exercise the put option and use the sales proceeds from the Development Rights (the relinquished property) to acquire like kind replacement property. Taxpayer’s replacement property included a fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining, and land use rights for hotel units. The IRS ruled that the Development Rights to be transferred by Taxpayer as relinquished property were of like kind, for purposes of Code Sec. 1031, to a fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining at the time of the exchange and land use rights for hotel units (which Taxpayer would receive if the Development Rights it transferred were for more than a certain number of residential units). The new rights for hotel units were to be applied to property Taxpayer already owned. The Development Rights were in perpetuity and were directly related and requisite to Taxpayer’s interest, use and enjoyment of the underlying land. The Development Rights were also interests in real property under state law. In effect, Taxpayer exchanged one set of Development Rights (pertaining to residential density) for other development rights (pertaining to hotel development). Some of the Development Rights were also to be exchanged for another fee interest in land, and another long-term leasehold interest in additional real property.
IRS has also ruled recently that development rights were like kind to the fee interest in property that a taxpayer relinquished in the exchange. The swap involved a complex exchange set up through a qualified intermediary (QI). In the PLR, Taxpayer was a C corporation that owned Property 1 and Property 2 located in City, State Z. It intended to transfer its fee interest in Property 1 (”Relinquished Property”) to a QI under an exchange agreement. QI wwould sell the Relinquished Property to a third-party purchaser in an arm’s-length transaction. QI would use part of the cash proceeds from this sale to buy Development Rights (”Replacement Property”) from a third-party seller. QI would transfer Development Rights to Taxpayer, who would cause Development Rights to be recorded with respect to Property 2. They would permit Taxpayer (or its lessee) to develop Property 2 with greater floor space than would otherwise have been allowed if Property 2 did not have Development Rights. Sections of State Z Tax Statute (and the corresponding sections of State Z regulations), defined “real property” to include “every estate or right, legal or equitable, present or future, vested or contingent, in lands, tenements or hereditaments, including buildings, structures and other improvements thereon, which are located in whole or in part within [State Z].” Sections of State Z Tax Statute further defined an “interest in real property” to include “title in fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupancy of real property or the right to receive rents, profits, or other income derived from real property.” Whether property constitutes real or personal property generally is determined under state or local law. In this case, Taxpayer proposed to acquire Development Rights as its replacement property and to transfer such rights to Property 2, which Taxpayer already owns. The IRS has previously noted that for purposes of Code Sec. 1031(a), it is not material that the property acquired by the taxpayer as the replacement property is on property already owned by that taxpayer so long as it is acquired in an arm’s-length transaction. For purposes of determining if Taxpayer’s proposed transaction qualifies as a like-kind exchange, IRS said it is thus immaterial that Development Rights to be acquired by Taxpayer will be used merely to enhance the real property already owned by it. More important is whether Development Rights constitute interests in real property under the state and local laws of State Z. Although it is unclear whether Development Rights were treated as interests in real property for all purposes of State Z law, it is clear that Sections of State Z Tax Statute and the regulations thereunder did treat Development Rights as an interest in real property. Moreover, the various sections of the local Ordinances provided that Development Rights are as-of-right and not discretionary, meaning that they exist permanently rather than at the discretion of a city agency or other decision-making authority. As such, these rights appear to be analogous to perpetual rights. In addition, a deed transfer is similar to the perfecting of Development Rights, which involves an actual transfer of rights from one property to another. Thus, while the Tax Statutes of State Z do not explicitly state that Development Rights are granted in perpetuity, IRS concluded that such rights do arise out of an interest in the underlying real estate. Moreover, City Ordinances did not set an expiration date for Development Rights, and thus they were effectively perpetual in nature. Thus, IRS concluded that Development Rights that Taxpayer intended to acquire as replacement property were like kind to the fee interest in Relinquished Property.
The point of this discussion is to alert all potential exchangers to the borad definition of real estate and what will qualify under Section 1031. For more information or questions about specific scenarios, please contact Moore McLaughlin, Esq., CPA, CES, owner of All States 1031 Exchange Facilitator, LLC at fmm@AllStates1031.com or Alexandra L. Hart, CES at AHart@AllStates1031.com.