By Roland Freasier | November 30th, 2016 | Tags: Deferral Opportunities, Internal Revenue Code, United States Internal Revenue Code | 0 Comments.
United States Internal Revenue Code (26 U.S.C.§1031) Deferral Opportunities
Internal Revenue Code §1031 provides a way to defer tax on realized gains on the disposition of both real and personal property which is held for either investment or for use in a trade of business.
The basic IRC §1031 exchange is one in which the taxpayer exchanges one property held for investment or for use in his trade or business for another property held for one of these two purposes. Property held for personal use, such as a personal residence or a personal automobile does not qualify for tax-free exchange under IRS §1031.
There are some basic requirements that must be complied with in order to qualify for this tax-free exchange as follows:
- The properties must be “held for” the permitted purpose set forth above.
- The property transferor must be the transferee of the property received in the exchange.
- The property given up and the property received must be “like kind”.
Additionally, there are several kinds of property that are excluded from IRC §1031 exchange treatment, notwithstanding meeting each of the above threshold requirements. Some examples are; stocks, bonds and notes, investments in LLCs and partnerships, other securities or evidences of indebtedness.
Often a taxpayer has an acceptable offer for a property he wishes to exchange but has not identified a replacement property. The exchange can still qualify for IRC §1031 treatment by using a “Qualified Intermediary” to facilitate the exchange. IRC §1031(a)(3) sets forth the requirements for such a deferred exchange as follows:
- i) The property to be acquired in the deferred exchange must be identified within 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, and
- ii) Such property must be received by the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange or the due date (including extensions) of the transferor’s tax return for the taxable year in which the transfer of the relinquished property occurs.
If the taxpayer receives in addition to “like kind” property, cash or other property, his gain to the extent of such “other property”, must be recognized, but only to the extent of such “other property” fair market value.
For example, a taxpayer exchanges a vacant lot (held for investment) for (1) an apartment building worth $900,000.00 and (2) an additional $100,000.00 cash. Assume further, that the tax basis of the vacant lot was $100,000.00. The taxpayer has a gain of $900,000.00, but only the $100,000.00 cash is recognized. The remaining $900,000.00 of gain is tax fee.
Notice that a vacant lot was exchanged for apartments. These properties are considered “like kind” as IRC §1031 treats all domestic real estate as “like kind” and all personal property as “like kind” if both are used predominately in the United States. [Reg. §1.1031(a)(c)]
Often one or both properties involved in an exchange will be debt encumbered. While this doesn’t prohibit using IRC §1031 to exchange the properties, some taxable gain may be incurred. The rule is that any net debt relief in such an exchange is considered “taxable boot”.
For example, assume a taxpayer exchanges real property with a $1,000,000.00 mortgage for real property with a $600,000.00 mortgage. Assume a basis of $3,000,000.00 and a fair market value of $5,000,000.00. In total, the gain in the exchange is $2,000,000.00. Since the taxpayer has been relieved of the debt of $400,000.00 (net of $1,000,000.00 mortgage minus $600,000.00 mortgage), all $400,000.00 of this gain is taxable. However, the remaining $1,600,000.00 is tax free.
We have frequently encountered a situation in which real property is held in an LLC which has two members. One member wishes to do an IRC §1031 exchange while the other member wishes to “cash out”. It should be noted that if the LLC engages in the exchange, the gain will be taxed to the full extent of the cash received, which is necessary to “cash out” the departing member.
We have resolved this situation in a manner that allows each member to accomplish his goal, by having the LLC distribute the property to the two members as tenants in common. The property can be exchanged with each member exchanging his fifty percent undivided interest; one for a “like kind” property and the other for cash. The distribution of the property to each member is tax-free pursuant to IRC §731 and IRC §732. The IRS initially attempted to tax these “drop and swap” transactions on the theory that once the property was “dropped” it was not “held” for investment, but was held solely for disposition. The IRS position as stated in Reg. §1.1002-1(d) is that the new property is substantially a continuation of the old investment still unliquidated. This position is inconsistent with the IRS “drop and swap” argument.
The United States Tax Court in Magneson v. Commissioner 81 T.C. 767 (1983) and published opinion 153 F. 2d 1490 (9th Cir.) disagreed with the IRS position that a “drop and swap” did not qualify under IRC §1031 because the property acquired in the exchange was immediately transferred to a partnership under a prearranged plan. The United States Court of Appeals for The Ninth Circuit, in affirming the U.S. Tax Court, said, “a change in the mechanism of ownership which does not significantly affect the amount of control or the nature of the underlying investment does not preclude nonrecognition under section 1031(a)”. Also, in Maloney v. Commissioner 93 T.C. 89 (1989), the Tax Court held that investment property held by a wholly owned corporation, which was exchanged for the investment property and then distributed to shareholder in complete liquidation of the corporation, qualified for nonrecognition under IRC §1031. Furthermore, notwithstanding that this was done according to a prearranged plan. This is a prime example where contesting the IRS position can result in taxpayers’ victories.
Often, a client will present a transaction to us for our evaluation, which they wish to execute on a tax favored basis. Many times, we conclude that the transaction as contemplated, will not qualify for the desired treatment. However, in most cases, rather than just saying “this will not work”, we find an alternative way in which the desired result can be accomplished.
Teeple Hall, LLP takes pride in creating solutions to difficult problems in IRC §1031 cases and in many other aspects of taxation. Our firm will never recommend a solution to a tax problem unless, in our opinion, the chance of success in the event of an IRS challenge, is more likely than not.