7th Annual Education ConferenceDallas CPA Society

“Like Kind Exchanges in a Recovering Economy: Update, Planning & Possibilities”

Carla Janousek

Republic Title

Dallas, Texas

cjanousek@republictitle.com

214-855-8888

Todd D. Keator

Thompson & Knight LLP

Dallas, Texas

todd.keator@tklaw.com

214-969-1797

May 26, 2011

2

Agenda

• Current Events

• QI Regulation

• Distressed Market Issues

3

Goolsby v. Commissioner, TC Memo 2010-64

Buyer

Seller 2

RentHouse

$188,000

Georgia 4-plex (investment)

Georgia House(T or B or

investment?)

Rent House (investment)

Georgia House and 4-plex

QI

$136,000 $47,000

TP

Seller 1

4

Goolsby v. Comm’r, Cont’d• Factors indicating that TP lacked the requisite investment intent:

– TP’s rental efforts were trivial (brief ads in local newspaper)

– TP moved into Georgia house 2 months after closing

– Purchase of Georgia house contingent on sale of TP’s primary residence in California

– TP’s conversations with QI contemplated use as personal residence

– TP began finishing out the basement immediately after acquisition

• Accuracy-related penalty imposed

5

Goolsby v. Comm’r, Cont’d

• Notes Re. Goolsby

– Unclear whether the IRS obtained information about TP’s conversations with the QI from the TP or the QI. TP was pro se and likely revealed this information unwittingly.

– Discussions with a QI are not privileged.

– Exchange of the 4-plex qualified, despite TP’s attempt to exchange the Georgia house.

6

Rev. Proc. 2010-14 • Background:

– Precipitated primarily by LandAmerica bankruptcy (among others)

– 97% of LandAmerica creditors approved bankruptcy plan in late 2009

– REIT with a QE received 98% recovery outside of bankruptcy

– After the REIT, $110 million available for 450 exchangers as follows:

• 50 in segregated accounts – 70% recovery

• 400 in commingled account – 25% recovery

– Additional recovery possible from auction-rate securities litigation

• Personal residence exchange pandemic?

7

Rev. Proc. 2010-14, Cont’d

• Applies to TP who:

– Properly transferred relinquished property (RLP) to QI;

– Properly identified replacement property (RPP) within the identification period (unless the QI default occurred during such period),

– Did not complete the 1031 exchange solely because of a QI default involving a QI that becomes subject to bankruptcy or receivership, and

– Did not, without regard to actual or constructive receipt by the QI, have actual or constructive receipt of the proceeds from the disposition of the RLP, or any other property of the QI, prior to the time of the QI bankruptcy or receivership. For this purpose, liability relief is disregarded.

8

Rev. Proc. 2010-14, Cont’d• TP must recognize gain from disposition of the RLP only as required under

the safe harbor “gross profit ratio method.”

• TP reports gain only as payments are received (like installment method).

• Formula: Gain Recognized = Payment x (Gross Profit ÷ Contract Price). Complex series of defined terms drive the calculations.

• Special rules for debt. Generally, debt in excess of basis is a deemed payment.

• Loss deduction allowed for actual losses and gain incorrectly recognized in a prior year.

• Imputed interest rules apply.

• 1/1/2009 effective date.

9

Example 1 – No debt • TP attempts to exchange Blackacre ($150 FMV; $50 AB) using a

QI. QI holds $150 of exchange proceeds for TP in year 1.

• QI files for bankruptcy while TP’s exchange is pending.

• In year 2, bankruptcy court approves $130 distribution to TP to satisfy all claims. So, TP’s overall gain should be $80 ($130 - $50).

• No gain recognized in year 1 (because no payment in year 1)

• Gross profit ratio = 80/130.

• Gain recognized in year 2 = $80. [$130 x (80/130)].

• No loss allowed because payments exceed basis.

10

Example 2 – Debt Less Than Basis

• TP attempts to exchange Blackacre ($160 FMV; $90 AB; $60 debt) using a QI. After satisfying the debt, QI holds $100 of exchange proceeds for TP in year 1.

• QI files for bankruptcy while TP’s exchange is pending.

• In year 2, bankruptcy court approves $70 distribution to TP to satisfy all claims, payable $35 in year 2 and $35 in year 3. TP’s overall gain should be $40 ($130 - $90).

• No gain recognized in year 1 (because no payment in year 1).

• Gross profit ratio = 40/70.

• Gain recognized in year 2 and 3 = $20 per year. [$35 x (40/70)].

• No loss allowed because payments exceed basis.

11

Example 3 –Debt Exceeds Basis

• Facts are the same as last example, except TP’s AB is $40 (instead of $90). TP’s overall gain should be $90 ($130 - $40).

• Now TP deemed to have received a payment of $20 in year 1 (to the extent of debt ($60) in excess of basis ($40)).

• Gross profit ratio = 120/120.

• Gain recognized in year 1 = $20. [$20 x (120/120)].

• Gain recognized in year 2 and 3 = $35 per year. [$35 x (120/120)].

• No loss allowed because payments exceed basis.

12

Questions Re. Rev. Proc. 2010-14

• “QI default” is narrowly defined as bankruptcy or receivership. What else could have been included? Theft? Bad investment? Dissolution? IRS appears to be seeking comments on these other types of default.

• Failure to complete the like kind exchange must be due “solely” to QI default.

– Does this mean TP must have previously identified RPP having a value at least equal to the value of the RLP?

– What if a combination of events prevents the 1031 exchange? For example, assume QI enters bankruptcy on day 46 of TP’s exchange, emerges on day 120 with 100% of TP’s exchange proceeds, but TP has missed the deadline to close on RPP due to contractual language in the PSA, and TP has not identified any alternative properties. Is the failed 1031 “solely” due to QI default?

13

Questions Re. Rev. Proc. 2010-14

• What does it mean for the QI to become “subject to” a bankruptcy or receivership proceeding? Does this include involvement as a creditor? For example, if the QI secures the exchange funds via a qualified escrow or trust, and the escrow holder or trustee enters bankruptcy, and the QI cannot access the TP’s exchange funds as a result, is the TP within the scope of the Revenue Procedure?

• The Revenue Procedure is only a safe harbor. What other relief is available? Can a TP change QIs midstream?

• What if the TP never receives any payments. Can the safe harbor still apply?

• Safe harbor does not apply if TP has actual or constructive receipt of the exchange proceeds “or any property of the QI.” Does this preclude use of QI notes?

PLR 201024036

Parent

Subsidiary

Step (1) Sub distributes NOx Credits to Parent

Third Party

Step (2) Parent exchanges NOx Credits for VOCs Credits

NOx

VOCs

PLR 201024036• Rev. Proc. 92-91: Emission allowances are treated as

“like kind” under 1031.• NOx and VOCs treated as government licences or

permits and intangible property for federal tax purposes.• IRS ruled “nature and character” of the rights were the

same because issued by same authority as part of same program to control air pollution (ozone) in same region. Also could be used interchangeably. Any differences relate only to grade or quality, not nature or character.

• Accordingly, NOx and VOCs credits were of “like kind.” • Parent considered to have, prior to the exchange, held

the NOx credits for productive use in a trade or business.

PLR 201030020

• Bank requested ruling that it could serve both as QI and as trustee of a qualified trust in a single transaction.

• IRS ruled that it could. • Query: Can a QI now hold a Taxpayer’s

funds in a basic “trustee” capacity without imposing a formal “qualified trust” wrapper? See Treas. Reg. Sec. 1.1031(k)-1(k)(3).

PMTA 2010-05

• Facts: Tenants-in-Common (TICs) co-owned distressed real estate; sponsor entered bankruptcy; lender threatening to foreclose. TICs jointly took the following actions:

• 1.) Pooled funds on a non-pro rata basis to pay attorneys fees and costs relating to bankruptcy and to pay debt service;

• 2.) Appointed one of the TICs as “payment agent” and “communications agent” to interact between the TICs and third parties.

PMTA 2010-05

• Issue: Whether the TIC actions caused them to lose their status as TICs and become partners in a de facto partnership.

• Ruling: No. IRS reasoned that the TIC actions were prompted by the sponsor’s bankruptcy, were necessary to protect the property, and did not cause the TICs to become partners.

Related Party Cases and Rulings - Background

• Section 1031(f)(1) applies to indirect transfers by related persons through intermediaries. Example from Rev. Rul. 2002-83:

– IRS ruled that A used QI to circumvent Section 1031(f)(1). Under Section 1031(f)(4), the transaction was recharacterized as a direct exchange of property between A and B, followed by a sale by B to C. Thus related persons cannot use a QI to escape Section 1031(f).

C 2

1

QI

4

3

B

Office

$150 Cash

Office

Apartm

ents Apartmen

ts

$150 Cash

(Apartments: $150 FMV; $150 AB)

A (Office: $150 FMV; $50 AB)

Ocmulgee Fields, Inc. v. Comm’r, 613 F.3d 1360 (11th Cir. 2010)

– Related Party was a partnership, so BIG was subject to tax at 15% ($600,000); Taxpayer was a corporation, and BIG was subject to tax at 34% ($2m).

– Had TP sold W.S. directly, gain = $6.1m; but if TP and RP exchange, and RP sells W.S. to 3P, gain = $4.2m ($1.9m less gain, and $1.4m less tax).

3P 2

1

QI

4

3

Related Party (Partnership)

W.S.

$6.8m (net after expenses)

W.S.

B&

N

B&N

$6.7m

(Barnes & Noble Corner: $6.7m; $2.5m AB; $4.2m BIG )

Taxpayer (Corporation) (Wesleyan Station: $6.8m; $700k AB; $6.1m BIG)

Ocmulgee Fields, Inc. v. Comm’r, 613 F.3d 1360 (11th Cir. 2010)

• Under 1031(f)(4), Court recast as direct exchange between Taxpayer and Related Party, followed by sale of Wesleyan Station by Related Party to the third party. The Court then tested 1031(a)(2)(C) exception and found that, due to basis shifting, transaction had principal purpose of tax avoidance.

• Factors: (1) Parties cashed in on the low-basis property, but paid tax only on the gains from the sale of the high-basis property; (2) Related Party’s partners paid tax at only 15%; (3) one partner in related party fully-offset his share of the gain with a charitable deduction; and TP selected Barnes & Noble Corner just 6 days after engaging the QI.

• Notably, Court hinted that lack of basis-shifting could save a transaction under a similar fact pattern.

PLR 201027036

Taxpayer

Related Party Buyers

QI

Unrelated Seller

Equipment

Relinquished Equipment

$100x

$100xReplacement Equipment

PLR 201027036

• IRS ruled 1031(f)(1) not applicable because Taxpayer exchanged with QI.

• 1031(f)(4) also not applicable because Taxpayer and Related Parties did not exchange properties. Reason: Related Party did not own any property Taxpayer acquired in the exchange.

• [Contrast acquisitions of replacement property from a related party.]

PLR 201048025 –“Serial Exchanges”

TPRelated Party Affiliate

Third Party

QI QI QI

Buyer

RLP1

RLP1$100x

$100x $100x

$100x

RLP2/RPP1

RLP3/RPP2

RPP3

PLR 201048025

• IRS upheld Taxpayer’s exchange provided all parties remained invested in replacement properties for at least 2 years.

• IRS ruled transactions were valid 1031 exchanges because related parties did not cash out and remained invested in like kind property.

• IRS relied on exception in IRC Sec. 1031(f)(2)(C) allowing subsequent dispositions that do not have a tax avoidance purpose. Legislative history makes clear that the non-tax avoidance exception includes subsequent dispositions in nonrecognition transactions.

• De minimis boot allowed.

PLR 201048025

• Observations:– Parties allowed 3x 180 exchange periods

(540 days total). Equates to 405 day ID period (180 + 180 + 45).

– Ruling states that Taxpayer and Affiliate could be the same party. Thus, Related Party’s subsequent exchange could be back to the Taxpayer!

– Potential to extend time limits indefinitely.

Morton v. U.S., 107 AFTR 2d 2011-XXXX

• TP exchanges aircraft 1 for aircraft 2 using a QI. • At closing, escrow agent accidentally transferred the

sales proceeds to TP’s account instead of QI’s account. TP returned the funds the next day.

• IRS argued constructive receipt and busted 1031. • Court held for TP: “We disagree that an accidental

transfer followed by an immediate return of funds would constitute actual or constructive receipt.”

• The Court also found that the Exchange Agreement contractually obligated TP not to “receive, pledge, borrow or otherwise obtain the benefits of the Exchange Value,” and, therefore, TP was contractually bound to return the exchange funds, which he did. Court was unwilling to hold TP responsible for the “mistaken actions of a third party.”

QI Regulation

• The Situation:– Significant QI defaults (LandAmerica, 1031

Tax Group, Southwest, Summit, Vesta, etc.)– Taxpayers losing money in Bankruptcy Court

(See LandAmerica). – QI integrity suffers. – Congress starts to look at 1033 rollover

mechanism as an alternative to 1031.

QI Regulation

• Current Regulatory Environment:– State level only; no federal regulation. – Regulating states: California, Colorado,

Idaho, Maine, Nevada, Virginia, Washington.– Federation of Exchange Accommodators

worked to obtain model state-level QI regulation resulting in laws in 6 of these 7 states.

• Advisors must recommend certified QIs!

Distressed Markets – Oil & Gas is Hot

• Reduced volume of real estate exchanges, but increased activity with oil & gas!

• 1031 Issues Re. Oil & Gas Interests– Qualifying Interests– Recapture– Sale vs. Lease– Tax Partnerships

Qualifying Interests

• Fee Interest in Minerals

• Working Interest

• Royalty (including overriding royalties)

• Net Profits Interest

• Not Production Payments

Recapture

• Recapture generally rolls over in 1031• Exceptions:

– Section 1254 property for non-section 1254 property (and vice versa)

– Developed property for undeveloped property? See Treas. Reg. Sec. 1.1254-1(b)(2)(iv)(1) (defining “natural resource recapture property” in part as property if “the property is an operating mineral interest with respect to which the expenditure [i.e., IDC] has been deducted.” (emphasis added).

Sale vs. Lease• Big, big issue. • 1031 requires a sale, not a lease. Pembroke v. Helvering, 70 F.2d

850 (D.C. Cir. 1934); Crooks v. Comm’r, 92 T.C. 816 (1989). • Trap: Retained royalty converts a “sale” into a lease for federal tax

purposes.• Example: X, the owner of a working interest, “sells” the working

interest to B in return for $100 cash and retains a 3% overriding royalty. The transaction is a sublease for federal income tax purposes, rather than a sale. 1031 cannot apply.

• Alternatively, suppose X, the owner of the working interest, “sells” 90% of the working interest to Y and retains 10% of the working interest. X has sold (rather than leased) the 90% interest because X retains no continuing non-operating interest in the property sold.

Sale vs. Lease

• Potential Solutions:– Retain part of working interest, not a royalty (a

different business deal).– Carve-off royalty to separate taxpayer prior to

negotiations with buyer (requires non-tax business purpose to avoid step transaction challenge).

• Typical business purposes: minimize state tax (e.g., TX margin tax); ability to issue profits interests tied solely to royalties; ability to raise money from tax-exempt investors; isolate liabilities.

– For producing properties, re-write royalty not to be a royalty (e.g., use a term shorter than the expected life of the burdened properties).

Tax Partnerships

• Jointly operated oil & gas properties generally constitute a tax partnership.

• 1031 N/A to partnership interests, including tax partnerships. Parties must elect out under § 761(a) for 1031 to apply.

• All members must consent (a practical problem). Carrying party may not consent for IDC reasons.

• Election may be formal (blank Form 1065) or deemed (evidenced by the intent of the parties, e.g., a written agreement).

Distressed Markets – Busting a 1031 Exchange

• 1031 is mandatory if it applies. See Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5th Cir. 1968).

• TP in a loss situation or with NOLs may not want 1031 to apply.

• Potential methods to “bust” a 1031 exchange:– Different taxpayer acquires replacement property. – Structure as separate sale and purchase transactions,

instead of an exchange. Taxpayer should “touch the cash.”

– Consolidated groups may trigger 311(b) gain.

Distressed Markets – Drop & Swap

• Potential solution to exclusion of exchanges of partnership interests.

• Prior to exchange, partnership “drops” undivided interests in property to exchange partners. Afterwards, exchange partners “swap” pursuant to § 1031.

• Issue: Did exchange partners satisfy the “held for” requirement with respect to the relinquished property?

• The Tax Court and 9th Circuit have ruled in favor of TPs on this issue, but the IRS continues to challenge these transactions (e.g., recent amendment to Form 1065, Schedule B).

• Tax preparer penalty?

Distressed Markets – Swap & Drop

• TP exchanges property, and then immediately contributes it to a partnership or corporation controlled by the TP.

• Issue: Did the TP satisfy the “held” for requirement with respect to the replacement property?

• Again, the Tax Court and the 9th Circuit have ruled in favor of TPs on this issue, but the IRS continues to challenge these transactions (e.g., recent amendment to Form 1065, Schedule B).

• Tax preparer penalty?

Distressed Markets - Workout-Driven Exchanges (Example)

• TP’s property:– Original price = $150– Held for investment/trade or

business– FMV = $50– AB = $20– Nonrecourse debt = $100– Lender threatening to

foreclose.

• If no 1031 exchange:– TP has gain of $80 (Tufts)– Minimum tax (assuming no

recapture) = $12; possibly as high as $20 if all § 1250 gain taxed at 25%.

Can 1031 apply?– Probably yes. – No requirement that QI hold

cash or property– Deed-in-lieu agreement may

be assigned to QI– TP must assume $100 of debt

on replacement property, or pay cash of $100, or some combination, in order to avoid boot gain; RPP will require substantial down payment, but this can be funded with foregone tax (e.g., $20 down and $80 new debt)

Workout-Driven Exchanges - Issues

• If lender will not accept a deed-in-lieu, can TP still do a 1031 exchange? The problem is that there is no “agreement” to be assigned to the QI. Potential Solutions: – Deed property to QI prior to judicial or nonjudicial foreclosure.

• Problems: – Can TP find a QI willing to take title to foreclosure property?– Does QI satisfy § 1031 regulations requirement that QI must “transfer

the relinquished property” to the buyer if the sheriff or trustee signs the deed and makes the conveyance?

– Create “Agreement to Foreclose”? Any substance?– Assign rights under Deed of Trust to QI?

• If recourse debt, part may be COI income– In prior example, $30 would be gain from sale, and $50 would be

COI income (ineligible for § 1031).

Workout-Driven Exchanges – Issues

• Better to have lender consent. – Deed in lieu– Agreement to Foreclose

• Issues without lender consent: – Is deemed transfer to QI a breach of the loan documents? – Could 1031 exchange trip the recourse carveouts? – Does the Exchange Agreement become part of the lender’s

collateral? – Could replacement property become part of lender’s collateral? – Could lender write-down the debt prior to foreclosure, creating

COI income for debtor?

• Can TP locate highly-leveraged replacement property?