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Special Issues Related to Real Estate Exchanges - Topic 11

Many exchanges involve multiple Relinquished Properties and/or multiple Replacement Properties. For example, you exchange a rental property and two investment parcels for a larger apartment complex. Or you exchange one property for three others. Or you exchange two properties for two others. These transactions follow the same rules as a one-for-one §1031 deferred exchange with additional requirements for allocating “sales price” and “substituted basis” to the assorted properties.

The first step in planning a multiple property exchange is to determine if you are going to set up one exchange for all properties. Or should you use two or more different exchanges? This decision should be made based on realities of the current real estate market and single exchange rules for multiple property exchanges.

The single exchange rule applies if you transfer more than one Relinquished Property and they are transferred on different dates. If this happens, the 45-day Identification Time Period and the 180-day Exchange Time Period are measured from the earliest date on which any of the properties are transferred. Not following this rule can cause your exchange to end in disaster.

All the other rules and requirements spelled out in the Regulations apply in the usual manner. You simply combine the numbers from the sale of both Relinquished Properties and following tax accounting allocation rules, apply them to the exchange for the Replacement Property.

Parallel Point 11-1

You enter into an exchange agreement with your Qualified Intermediary. As part of the exchange transaction, you are selling two Relinquished Properties and acquiring one Replacement Property. You sell Property One on July 1, 2003 for $150,000 with terms of $30,000 cash and the buyer assumes your mortgage of $120,000. You sell Property Two on July 21, 2003 for $200,000 with terms of $130,000 and the buyer pays off your mortgage of $70.000.

This entire set of transactions is treated by IRS as one exchange transaction. Your 45-day Identification Period for both properties starts on July 1, 2003. To successfully qualify for exchange treatment on both properties, you must identify the Replacement Property within this 45-day period. To qualify for complete non-recognition of gain, you must “invest” at least the $160,000 cash proceeds in the Replacement Property plus off-set $190,000 of mortgage relief boot. It’s just a matter of adding the numbers of both sales together to determine the financial requirements for the purchase of the Replacement Property.

IRS Reg 1.1031(k)-1(c)(4) provides that multiple properties exchanged as part of the same exchange are subject to the same identification rules applying to the exchange of a single Relinquished Property:

 The 45-day identification time period and the 180-day exchange period start running on the day the first Relinquished Property is sold, and

the taxpayer may identify only three Replacement Properties under the three-property rule. The taxpayer cannot identify three properties for each Relinquished Property in the exchange. These restrictive rules can be fatal to the taxpayer because even the best-planned exchange is subject to delayed closings or termination before the closing. 

To overcome the problems of exchanging multiple Relinquished Properties, taxpayers are structuring their exchange by separating the Relinquished Properties into separate exchanges. Each exchange will then have its own 45-day identification period and 180-day exchange period.

In cases where two Relinquished Properties are being exchanged for one Replacement Property, the identification of the Replacement Property must meet special requirements. Even though the Replacement Property is only one physical property (100%), the taxpayer must furnish his Qualified Intermediary the allocation percentage that each Relinquished Property bears to the Replacement Property. This allocation is applied to the identification of the Replacement Property for each of the Relinquished Properties and is necessary to satisfy the identification requirements of the Section 1031 regulations. Allocation information is provided to the taxpayer by his tax professional.

Note: This allocation may not be necessary until the 45^th day of the identification period for the first Relinquished Property sold as explained in this Parallel Point:

Parallel Point 11-2

Even thought no allocation of percentage interest or dollar value was described in the Replacement Property identification, both exchanges are successful. Under the regulations, any Replacement Property you receive before the end of the identification period will in all events be treated as identified before the end of the identification period. The Replacement Property was acquired after the closings of both Relinquished Properties and within the first 45-day identification period.

Now let’s look at the same exchange as in Parallel Point 11-2  except 456 Avenue is not sold before the 123 Main Street 45-day identification time period runs out. In this case, the taxpayer must make second identification for the 123 Main Street property. He does this by providing his Qualified Intermediary the allocation percentage for the identification 123 Main Street. This identification must be made by the 45^th day of the identification period for 123 Main Street.

Parallel Point 11-3

Here are the steps in this scenario:

1.       Taxpayer opens two exchanges with his Qualified Intermediary, one for 123 Main Street and one for 456 Avenue.

2.       123 Main Street is sold.

3.       123 Main Street identifies 100% interest in Replacement Property.

4.       456 Avenue fails to sell within 123 Main Street’s 45-day identification period.

5.       123 Main Street makes second identification by identifying its allocation percentage in the Replacement Property before its 45-day identification period expires.

6.       Later, 456 Avenue is sold and closed within the 123 Main Street 180-day exchange period.

7.       456 Avenue identifies its Replacement Property by identifying its allocation percentage of the Replacement Property within its own 45-day identification period. 

8.       After both 123 Main Street and 456 Avenue sales have been closed, the Replacement Property is acquired and closes within the 123 Main Street 180-day exchange period.

âNote: Even though 456 Avenue would have its own 45-day identification period and 180-day exchange period, the acquisition of the Replacement Property must adhere to the 180-day exchange period of the 123 Main Street property to qualify as a successful exchange for 123 Main Street.

If for any reason, 456 Avenue cannot be sold before closing of the Replacement Property, the 123 Main Street exchange will still be successful since it had correctly identified its Replacement Property – the 100% identification. However since the 456 Avenue exchange never took place, it might create some problems for the taxpayer. Unless he made a timely backup identification of one or two additional Replacement Properties for 123 Main Street, it is too late to identify another less costly Replacement Property. And there is always the risk the taxpayer cannot get enough cash out of the 123 Main Street sale to buy the identified Replacement Property. Or he might have to make a new loan on the Relinquished Property not sold.

Designing separate exchanges must be done with great care to avoid having the IRS treating it as one exchange and the taxpayer should consult with his attorney or tax professional and also assure himself that his Qualified Intermediary is experienced in administering separate exchanges and their special problems.

Particular consideration must be given to the IRS version of what constitutes “one property.” Some elements are clear such as different buyers, different purchase and sales agreements and sales of noncontiguous Relinquished Properties with different buyers. Some elements are not clear. For advanced study on this issue, see Revenue Procedure 2002-22.

No gain or loss is recognized on a transfer of property from an individual to a spouse. If the transfer is incident to a divorce, no gain or loss is recognized on a transfer of property to a former spouse. There is no gain or loss even if the transfer is in exchange for the release of marital right or for other considerations or the transferred property is subject to liabilities that are more than the property's adjusted basis and it was not transferred in trust.

Any transfer of property to a spouse or former spouse not subject to gain or loss is treated as a gift and is not considered a sale or exchange. There are no gift taxes if the transfer is made within a certain three-year period. This period starts two years before the divorce and ends one year after the divorce—a total of three years. If the transfer is made at any other time, it is subject to the gift tax. However a transfer under a property settlement agreed on before the divorce, and approved more than two years later by a divorce court, is subject to the gift tax.

Like-kind exchanges can take many forms. One of these forms, the sale-leaseback, is still open to some dispute even though a leasehold interest of 30 years or more in exchange for a fee interest constitutes like-kind within the meaning of Reg 1.1031(a)-1(c). The provisions of Section 1031 require nonrecognition of gain or loss if you exchange qualified property of like-kind for other qualified property of like-kind. Since the IRS treats a leasehold of 30 years or more and real estate used in a trade or business (or held for investment) as property of like-kind, the nonrecognition provision of §1031 applies. This treatment may disallow a loss on a sale-leaseback transaction if exchanged for a lease 30 years or longer. In other words, you cannot deduct your loss

If you suffer a loss on the sale-leaseback transaction, great care must be taken to avoid Section 1031 treatment. Will the IRS reclassify the sale as a Section 1031 like-kind exchange? This Reg bars recognition of loss to a taxpayer who is not a dealer in real estate on exchange of a leasehold of a fee with 30 years or more to run for real estate. The reasoning is that this a nontaxable exchange of property of like-kind subject to the rules of §1031. Even though this regulation has been in force for many years, the Eight Circuit said it has the force of law, other courts do not agree.

However, the parties to a real estate sale-leaseback transaction are treated differently. In most cases, the courts have upheld the recognition of loss by the seller/lessee, despite the fact the leasehold was for more than 30 years. In most cases, the courts have upheld the recognition of loss by the seller/lessee, despite the fact the leasehold was for more than 30 years. Losses have traditionally been upheld where sales were followed by leasebacks of 20 to 25 years. In the sale-leaseback situation where the leasehold interest runs for 30 years or more, the “seller” can qualify for tax-free exchange treatment. However, it is not an exchange of like-kind properties for the “buyer-landlord.” The real estate received by the “buyer-landlord” is treated as an advance rental in consideration of the execution of the lease. The “buyer-landlord” must report the fair market value of the real estate received as ordinary income in the taxable year he receives it.

The Second Circuit said Congress did not intend the exchange of like-kind property provision to apply to the return of a lesser interest in property conveyed and refused to hold that a sale and leaseback for a term of more than 30 years was an exchange of property of like-kind. But IRS doesn't follow this decision. [Rev Rul 60-43.]

In Leslie Co vs. Com. 1976, CA3, Leslie Co arranged to build a new plant with financing by Prudential Insurance Company. Prudential agreed to buy the property for the lesser of $2,400,000 or the actual cost of the land, building, etc., and to lease it back to Leslie for 30 years with two l0-year renewal periods plus an option to buy. The annual rent was set at 8% of the $2,400,000 for the original 30-year period and dropped to 3% thereafter.

Leslie's actual cost of building plus land ran to about $3,200,000. Leslie therefore reported an $800,000 ordinary loss on the sale for $2,400,000. IRS argued that the transaction was an exchange of like-kind property for a long-term leasehold, and therefore resulted in no loss. It would have allowed Leslie to amortize the “loss” as a cost of the leasehold over 30 years. The Third Circuit held that there was no exchange of like-kind property, simply a transfer solely for cash. The leasehold acquired had no capital value. “Among other considerations, the rental charged at fair market rates, the lack of compensation for the leasehold interest in the event of condemnation, and the absence of any substantial right of control over the property all support this conclusion.”

Losses have been recognized on sales and leasebacks for less than 30 years where the leaseback was for 24 years without renewal or repurchase options and where the leaseback was for 20 years without renewal option. Since the property involved in sale and leaseback arrangements is generally real or depreciable property used in the taxpayer's trade or business, a recognized loss is deductible as an ordinary loss under the capital gain-ordinary loss rule.

If a sale and leaseback is held to be an exchange of like property any gain realized would be recognized only to the extent of the “boot.” Since the usual sale in a leaseback transaction is for cash, the boot would consist of the cash received. But a loss realized on the exchange would not be deductible. However, the basis of the leasehold to the seller-lessee would be equal to his adjusted basis for the fee less the cash received. The seller-lessee would be entitled to depreciation on its basis for the leasehold over the term of the lease.

The fact that cash is received does not dismiss the transaction from §1031 treatment if the taxpayer also receives like-kind property. However, if the taxpayer receives full value for the property in cash, it's absurd for the IRS to argue that the leasehold is received in exchange for the property. Three defenses against this illogical argument are:

If at all possible, make the lease term less than 30 years. Remember, the lease term includes options to renew.

Get a good appraisal to prove the property was sold for full value.

The leasehold is received in consideration of the agreement to pay rent.

If there is a reported gain on the sale by the taxpayer, the exchange question is moot since the cash selling price received (boot) is more than the gain. Losses on the sale of real estate may be disallowed if the sale is made to a related party.

âCaution: Related parties' sale and leaseback or leaseover. Where a sale and leaseback is made to a related “buyer-lessor”, IRS may contend that the transaction is a sham disguised as a rent deduction what is really a nondeductible assignment of income or a distribution of dividends from the “seller-lessee” to the “buyer-lessor.” The same result has been reached where instead of a leaseback there is a leaseover to a related party. The Tax Court, however, has held that a transfer and leaseback between the taxpayer (a sole proprietor) and a corporation of which he was the sole stockholder served a valid business purpose where the transfer improved the taxpayer's bonding capacity and where the corporation was created to provide an alternative source of income to the taxpayer.

Partnership interests are specifically excluded as qualified property under §1031. However, it is possible in many situations to design a transaction to accomplish the goal of an investor to get out of the partnership and still qualify for §1031 treatment.

The first thing to examine is the legal status of the investor. For example, tenants in common can split up without dealing with outsiders and get §1031 treatment in the split-up. Under Rev Rul 73-476, the IRS approved this transaction. Three investors owned an undivided interest as a tenant in common. There were no mortgages on the property and the property was held for investment. Each of the three investors exchanged his undivided interest in the three separate parcels for 100% ownership of one parcel.

Sometimes, however, the investors are partners rather than tenants in common. If this is the case, the investors should seek expert legal and tax counsel regarding a tax-free liquidation in kind of the partnership properties to the investors. Then, as tenants in common, they could seek to execute a §1031 exchange.

Caution: This procedure can be risky but if the savings are substantial, it’s worth checking out with counsel.

A very common situation is the single property held by two “partners.” Many joint owners of a rental income property consider themselves as partners when in fact they are tenants in common. In general, a partnership is formed when two or more persons (includes corporations) join together to conduct a business activity with the intent of sharing profits and losses. However, mere co-ownership of real estate maintained and leased or rented is not a partnership unless the co-owners provide services to the tenants other than the normal landlord activities.

One case involved a commercial building where the co-owners provided janitor and security services to the tenants. The IRS said they were in fact a partnership.

The §1031 exchange is an excellent vehicle for “splitting-up” two (or more) co-owners. Here are two scenarios:

You and I are co-owners of rental property we call the Skyline Apartments. You want out but I am not willing to give up my interest. If I buy you out, you have a big taxable gain. This is unacceptable to you.

You find another rental you would like to acquire. I buy the property and swap it for your 50% tenant in common interest in Skyline. The result is you get your entire equity out of Skyline with no recognized gain and I end up with 100% ownership interest in Skyline.

This can also work to take out a 25% owner, 10% owner and so on.

Here is another:

Same situation except we both want out. I am willing to sell my interest and recognize gain but you are not. We sell the property, but you assign your rights in the sale to a Qualified Intermediary and follow the deferred exchange rules under §1031. The result is I get a taxable gain sale and you may qualify for §1031 treatment if you find another property meeting the requirements for a deferred exchange.

An interesting variation is we sell Skyline and both go the deferred exchange route separately.

Always keep in mind a partnership—as a legal entity—can enter into a §1031 exchange transaction as a partnership. And in almost all cases, the tenants in common are not partners. If any doubt, check with your attorney.

In LTR 9807013, the IRS said a limited partnership would be treated as having received replacement properties through single-owner entities and qualifies for 1031 treatment.

The limited partnership owned land and an office building leased under a long-term lease. The limited partnership wanted to dispose of the land and building and acquire several parcels of real estate. It located someone interested in buying the land and building. The limited partnership proposed to transfer title directly to a Qualified Intermediary (QI) and then form separate entities to take title from the QI for each of the replacement properties. The limited partnership would be the sole owner of each "replacement entity.” These entities would then either elect to be disregarded as an entity or would rely on the default classification for single-owner entities.

The nonrecognition rules of §1031 do not apply to an exchange of one kind or class of personal property for personal property of a different kind or class. However, there’s an important exception to the personal property rules related to deferred exchanges of real estate. It’s explained in Chapter Five. The exception defines incidental personal property transferred with real property in a §1031 exchange.

Depreciable tangible personal property may be either “like-kind” or “like class” to qualify for nonrecognition treatment. Personal property of a like class is considered to be of a “like-kind.” Like-class properties are depreciable tangible personal properties within the same General Asset Class or Product Class.

General Asset Classes describe the types of property frequently used in many businesses. They include:

Office furniture, fixtures, and equipment,

Information systems (computers and peripheral equipment),

Data handling equipment (except computers),

Airplanes (airframes and engines), planes used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines),

Automobiles, and taxis,

Buses,

Light general purpose trucks,

Heavy general purpose trucks,

Railroad cars and locomotives (except those owned by railroad transportation companies),

Tractor units for use over the road,

Trailers and trailer-mounted containers,

Vessels, barges, tugs, and similar water-transportation equipment (except those used in marine construction), and

Industrial steam and electric generation or distribution systems.

Product classes include property listed in a 4-digit product class (except any ending in “9”, a miscellaneous category) in Division D of the Standard Industrial Classification codes of the Executive Office of the President, Office of Management and Budget, Standard Industrial Classification Manual (1987) (SIC Manual).

Copies of the SIC Manual may be obtained from the National Technical Information Service, an agency of the U.S. Department of Commerce.

Here are two examples taken from Reg 1.1031(a)-2 Additional Rules for Exchange of Personal Property[xx]:

You transfer a personal computer used in your business for a printer to be used in your business. The properties exchanged are within the same General Asset Class and are therefore of like class.

Henry transfers a grader to Ron in exchange for a scraper. Both are used in a business. Neither property is within any of the General Asset Classes. Both properties, however, are within the same Product Class and are therefore of like-kind.

Buyer hereby acknowledges it is the intention of Sellers to complete a deferred exchange and qualify for treatment under Internal Revenue Code Section 1031. This exchange will not delay the closing (of escrow) or cause additional expense to Buyer. Seller's rights and obligations under this agreement may be assigned to a Qualified Intermediary (as defined in IRS Regulation 1.1031(k)-1) of Seller's choice for the purpose of completing the exchange. Buyer agrees to cooperate with Seller and the Qualified Intermediary in a manner necessary to complete this exchange. 

Seller hereby acknowledges it is the intention of Buyer to complete a deferred exchange and qualify for treatment under Internal Revenue Code Section 1031. This exchange will not delay the closing (of escrow) or cause additional expense to Seller. Buyer's rights and obligations under this agreement may be assigned to a Qualified Intermediary (as defined in IRS Regulation 1.1031(k)-1) of Buyer's choice for the purpose of completing the exchange. Seller agrees to cooperate with Buyer and the Qualified Intermediary in a manner necessary to complete this exchange.

One of the vital tax concerns presented in structuring a §1031 real estate exchange is the issue of title. Almost all exchanges require the exchanger to take title to the Replacement Property in the mode the exchanger held title on the Relinquished Property. In other words, the same entity commencing the exchange must be the same entity receiving the Replacement Property and concluding the exchange. For example, if an individual owns the Relinquished Property, then the same individual owns the Replacement Property (however, see exception below for marrieds); ABC Corporation relinquishes and ABC Corporation acquires; XYZ Partnership relinquishes and XYZ Partnership acquires.

Anytime the vesting title is different in the Relinquished Property and the Replacement Property, the parties should consult their attorney before entering into the exchange agreement. For example, if an individual taxpayer owns the stock in a C Corporation, and the Corporation owns the Relinquished Property in an exchange and the Replacement Property is taken in the name of the individual taxpayer, §1031 exchange treatment is denied. In fact, the taxpayer has a severe problem of being charged with a distribution from the Corporation, which could be classified as dividend income with no deduction allowed to the Corporation.

Like most tax rules, there are some special exceptions. One of the most important applies to individuals who are married to each other. In a §1031 exchange, spouses can be added or not added to transfers of title interests without jeopardy. For example, The Relinquished Property is held in the name of John Smith who is married to Sue Smith. Sue’s name is not on title. They take title to the Replacement Property in both names. Or, the other way around.

Other Exceptions:

1. If the exchanger dies after the exchange is commenced but before it’s completed, the exchanger’s estate may complete the exchange.

2. There is a special rule that permits an individual who holds title to the Relinquished Property to relinquish that property in exchange for Replacement Property vested in the name of a single-member, single-asset LLC.

Exchanging with a related party is OK - but to qualify for §1031 treatment, you must know exactly what an exchange with a related party really means and the rules for making it work.

There are two kinds of exchanges involving related parties. One is a direct swap between related parties. The other is an exchange involving a sale of the Relinquished Property and the acquisition of a related parties property.

First, let’s look at the direct swap. It may qualify for 1031 treatment but a special 2-year rule applies that could result in triggering the gain when you least expect it. This rule affects all like-kind exchanges between related parties including reverse exchanges. Under this rule if you or the related party disposes of the property within 2 years after the exchange, the exchange is disqualified and gain or loss will be recognized for both you and the related party as of the original date of the exchange.

Some exchanges involving related parties are not subject to this unforgiving rule. These exchanges do not involve the direct swap of properties between related parties but related parties are involved. Here is an example of this frequent kind of exchange:

You are the owner of a property you want to sell. Your daughter owns the property you wish to acquire. She is not interested in your property but is willing to sell her property. You find a buyer for your property (Relinquished Property) but before closing the transaction enter into an exchange agreement with your Qualified Intermediary. As part of the exchange, you purchase your daughter’s property as your Replacement Property. Since you are the only party qualifying for §1031 exchange treatment, the exchange is not subject to the 2-year rule. Daughter has a taxable sale. 

Before the 2-year rule, taxpayers used the exchange with a related party to sell highly appreciated real estate without recognition of gain. Here is a Parallel Point illustrating how taxpayers used the exchange with related parties to sell highly appreciated property without recognition of gain.

Parallel Point 11-4

Here is an example of how taxpayers used the exchange with related parties to sell highly appreciated property without recognition of gain.

Taxpayer owns an investment lot with a basis of $25,000.

Builder offers Taxpayer $200,000 for the lot.

Taxpayer exchanges lot with Sister for her rental duplex with a basis of $200,000.

Sister's $200,000 basis in her rental duplex substitutes into the investment lot she receives in the exchange.

·         Sister sells the investment lot to the developer for $200,000. Since her substituted basis in the lot is $200,000, her recognized gain on the sale is zero.

·         The transaction has transferred the high basis ($200,000) of the duplex into the low basis ($25,000) lot and sold the lot for $200,000. The money is now in the family without recognition of gain to Taxpayer.

Under Current Rules: If Sister sold the lot within two years following the exchange, the $175,000 gain would trigger to Taxpayer. Ditto for the sale of the rental duplex. Gain or loss would be recognized.

Important Point: The strategy is still feasible in situations permitting a 2-year or longer holding period of properties involved in the exchange.

The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange.

You can qualify for nonrecognition of gain treatment under §1031 even when you make the exchange with a related party. However, a special 2-year rule applies that could result in triggering the gain when you least expect it. This rule affects all like-kind exchanges including reverse exchanges.

As with other like-kind exchanges, when related parties exchange like-kind property or like-class property, no gain or loss is recognized. Under these rules, however, if either party disposes of the property within 2 years after the exchange, then the exchange is disqualified from nonrecognition treatment. The gain or loss must then be recognized as of the date of disposition of the property.

Prior to this rule, taxpayers used the exchange with a related party to sell highly appreciated real estate without recognition of gain. This made IRS very unhappy and that's why we got the new rule.

The 2-year holding period begins on the date of the last transfer of property that was part of the like-kind exchange. If the holder's risk of loss on the property is substantially diminished during any period, however, that period is not counted toward the 2-year holding period. The holder's risk of loss on the property is substantially diminished by a “put” on the property or another's right to acquire the property.

A put is an option that entitles the purchaser to sell the property at any time before a specified future date.

Here is the rule: If property received in a §1031 exchange between related persons is disposed of before two years after the date of the last transfer in the exchange, the related taxpayer 2-year time rule applies. Any gain or loss not recognized on the original exchange will trigger and be recognized as of the date the property is disposed of.

A related person is:

Your family but only brothers and sisters (including half-blood), spouse, ancestors, and lineal descendants.

You and a corporation if you own—directly or indirectly—more than 50% in value of the stock. Or if the stock is owned for you.

Two corporations that are members of the same controlled group.

A grantor and a fiduciary of any trust.

A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts.

A fiduciary of a trust and a beneficiary of the same trust, if the same person is a grantor of both trusts.

A fiduciary of a trust and a corporation if more than 50% of the value of the outstanding stock is owned—directly or indirectly—by or for the trust or by or for a person who is a grantor of the trust.

A corporation and a partnership if you own (1) more than 50% of the value of the outstanding stock of the corporation and (2) more than 50% of the capital interest or the profits interest in the partnership.

An S corporation and another S corporation if you own more than 50% in value of the outstanding stock of each corporation.

An S corporation and a C corporation if you own more than 50% in value of the outstanding stock of each corporation.

For more coverage on the 2-year rule, see Rev Rul 2002 – 83.

Exceptions  to the 2-Year Rule

A related taxpayer exchange not disqualified if the disposition of property within the 2-year period following the original exchange takes place after the date of death of the taxpayer or the date of death of the related person.

A related taxpayer exchange is not disqualified if the disposition of property within the 2-year period following the original exchange if the disposition is made as the result of a compulsory or involuntary conversion of the property received in the original exchange. For this exception to apply, the original exchange had to occur before the threat or imminence of such conversion.

A related taxpayer exchange will not be disqualified if the disposition of property is made within the two year period following the original exchange if the IRS is satisfied that neither the original exchange or the later disposition has federal income tax avoidance as one of its principal purposes.

There are several exceptions to the related persons rule.

An exchange will not be disqualified if the disposition of property within the two-year period following the original exchange takes place after the date of death of the taxpayer or the date of death of the related person.

An exchange will not be disqualified if the disposition of property within the two-year period following the original exchange if the disposition is made as the result of a compulsory or involuntary conversion of the property received in the original exchange. For this exception to apply, the original exchange had to occur before the threat or imminence of such conversion.

An exchange will not be disqualified if the disposition of property is made within the two year period following the original exchange if the IRS is satisfied that neither the original exchange or the later disposition has federal income tax avoidance as one of its principal purposes.

Another doctrine that must be considered when structuring a like-kind real estate exchange is the doctrine of substance over form. This doctrine is related to the step transaction and may be used by IRS to recharacterize an exchange based on the end result of the transaction, without regard to the formal steps taken to get the result. Always remember—intent or form always comes in second to substance.

In determining substance, the IRS and Courts will look beyond the formalities of the exchange transaction to determine the proper tax treatment. If the exchange is a fiction that fails to reflect the economic realities of the transaction, the substance over form doctrine will apply. The substance rather than the mere form in which it is cast governs. This is what happened in a 1980 exchange of an apartment house in San Francisco.[ii]

In 1978, Delwin and Gail Chase (Chase) owned an interest in a limited partnership. The partnership was formed for the purpose of buying, operating and holding an apartment house. Delwin Chase and another corporation were the general partners. The partnership agreement required all distributions to the limited partners to be made solely in cash.

In 1980, the partnership accepted an offer to sell the apartment house. Chase then attempted to structure the sale so they (the Chases) would not recognize any taxable gain on the sale. They had the partnership give them a deed to an undivided interest in the apartment house property and treated it as a liquidation of their limited partnership interest. However, the offer to sell the apartment house expired because the buyer did not deposit the necessary funds in escrow. Meanwhile, Chase did not record the deed given to them by the partnership.

Later that year, a second offer was made and accepted. It was structured the same as the first one. Nothing in the offer agreement indicated that the buyer knew that Chase had an individual ownership interest in the property. Just prior to the closing, Chase recorded their deed and entered into a real property trust agreement with the buyer.

The agreement required the buyer to transfer the Chases' share of the proceeds to the trust. The trustee would then buy like-kind property and transfer it to Chase.

The property closed in July 1980. The net proceeds were allocated between the partnership and the trust. But the allocation was incorrectly figured. Contrary to Chases' escrow instructions, the proceeds were distributed to the trustee as an allocation of Chases' share as a limited partner (complete liquidation as a limited partner) and not in accordance with their interest in the property.

The proceeds received by the trust were deposited in the trust account. In 1982, the trust purchased various parcels of like-kind property and transferred them to Chase.

Until the day the sale to the buyer was closed, all expenses of operating the apartment house property were paid by the partnership. Chase did not pay any of these expenses out of their own funds. Neither did they get any of the rental income. Everything was reported through the partnership. Chase claimed §1031 treatment for the disposition of their interest in the rental property, saying the form of the transaction was structured to satisfy the requirements of §1031. The IRS and the Tax Court said no.

The Tax Court held the substance over form doctrine applied and that in substance the partnership sold the property. Therefore, no exchange by Chase took place. There was no indication Chase had a direct ownership interest in the property. Even though the partnership conveyed an undivided interest in the property to Chase, at no time did Chase act as owner except in the role as partners. They were deeded their undivided interest when the first offer was made because it appeared a sale was imminent. When the sale failed to close, the deed went unrecorded until just before the second offer sale was closed.

(The partnership agreement prohibited any type of distribution to limited partners other than cash. Therefore, the distribution of the undivided interest in the property to Chase as a liquidation of partnership interest was in violation of the partnership agreement.)

The Court went on to say there was no indication that any party to the sale believed that anyone other than the partnership held title. Chase did not receive any rental income from the property or pay any of the costs of selling the property. The amount of the distribution of proceeds received by Chase was based on their distributive share of the net proceeds received by the limited partnership and not as direct owners.

The Court held the property was sold by the partnership and no exchange by Chase took place. The substance of the transaction reflected the true economic realities. The form was disregarded.

This case had an interesting aside. Chase argued if they were denied exchange treatment, they were entitled to report the sale using the installment method of tax reporting. The Court replied the election was available to the partnership and not Chase, because the partnership sold the building.

The step transaction doctrine embodies a general requirement that all steps, which are an integral part of the exchange, will be considered in determining the proper tax treatment for the exchange. The step doctrine may be applied by the IRS if

·        there was a pre-existing binding commitment to take each of the steps at the time the transaction was commenced, and,

·        the steps were functionally interdependent in the sense the earlier step would have been unproductive without the later steps.

The step transaction doctrine may also apply if all the steps, although functionally independent, were contemplated at the outset of the exchange.