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Like-kind exchanges - common problems and solutions.

EXECUTIVE SUMMARY

* Exchanges of real estate often involve personal property issues; clients should be advised of planning strategies involving improvements to the replacement property.

* Like-kind exchanges involving partners and partnerships often create potential obstacles to gain deferral; tax advisers and clients should carefully consider solutions and planning.

* Clients engaging in like-kind exchanges should become familiar with the identification and replacement period requirements and know how to maximize them.

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A tax adviser's help is crucial to properly plan a like-kind exchange. This article focuses on some of the most common issues, solutions and strategies that should be considered in structuring a tax-deferred exchange under Sec. 1031.

Clients selling real estate and engaging in Sec. 1031 tax-free exchanges often rely on professional exchange companies--such as affiliates of escrow and title companies--to draft documents, advise on tax and legal issues and close the transaction. Professional exchange companies, in turn, attempt to limit their liability with document language stating that the exchanging property owner "does not rely on the professional exchange company for legal or tax advice." They advise clients to "use their own separate tax professionals." Despite these warnings, clients often fail to engage separate professional help and rely solely on the exchange company.

However, without proper tax advice, clients can make mistakes in structuring exchanges, resulting in taxable income. (1) Some of the more common mistakes and solutions are discussed below.

Exchange of Real Estate Including Personal Property

A basic Sec. 1031 exchange requirement is that the property transferred (relinquished property) and the property received (replacement property) must be "like-kind." Generally, real estate is classified as like-kind to other interests in real estate. Thus, land can be exchanged for improved real estate under Regs. Sec. 1.1031(a)-1(b), and a 30-year-or-more leasehold can be exchanged for a fee interest in real estate under Regs. Sec. 1.1031 (a)-1(c). (2)

If the relinquished or replacement property also consists of personal property, the other property must consist of similar like-kind personal property or, alternatively, "like-class" personal property (3) to other depreciable tangible personal property. Depreciable tangible personal properties are of a like-class if they are within the same "General Asset Class" or "Product Class." (4)

Real estate cannot be exchanged tax free for personal property. Unfortunately, some clients unwittingly violate this requirement when a building includes personal property (e.g., refrigerators, washers and moveable stoves in apartment buildings) or when cost-segregation studies have been performed.

Incidental Property

Under the "incidental property exception" in Regs. Sec. 1.1031(k)1(c)(5)(i), minor items of personal property do not have to be separately identified in a deferred tax-free exchange. (5) However, this exception only applies to determine whether a property is being properly identified for purposes of complying with the time requirements of the deferred-exchange rules; it does not apply to the Sec. 1031 like-kind exchange requirements. If even a small amount of personal property is transferred or received along with real property, then like-kind or--class personal property must also be transferred or received to meet Sec. 1031's requirements.

Reclassified Building Parts

Parts of a building can be reclassified from real to personal property. Reclassification allows sophisticated building owners to reduce their income taxes, by accelerating depreciation and amortization deductions (6) and avoiding the 39-year straight-line recovery period for commercial property or the 27 1/2-year straight-line period for residential property. Reclassified personal property can be amortized and depreciated over shorter time periods (usually five or seven years) using the double-declining-balance method. (7) Prior to 2005, an even greater tax incentive existed to reclassify building parts as personal property--first-year bonus depreciation deductions of 30% and 50% were available. (8)

To reclassify parts of a building as personal property, clients and their advisers commonly perform cost-segregation studies. Such studies are based on rules described in Hospital Corp. of America. (9) The reclassified personal property is then depreciated over a shorter recovery life than the real property. Thus, carpet and window coverings can be recovered over five years. (10) Similarly, specialized refrigeration, restaurant, medical, manufacturing or computer equipment, as well as the plumbing, electrical, ventilation and flooring systems connected with them, can be classified as personal property. (11) Other potential personal property includes office cabinetry, carpeting, special lighting fixtures, (12) gasoline pump canopies (13) and retail signs. (14)

Matching Personal Property

Even minor amounts of personal property involved in real property exchanges can trigger gain recognition. To meet the Sec. 1031 like-kind property requirement, when personal property comprises part of the relinquished or replacement property, like-kind or -class personal property should be included in the other property. Under Kegs. Sec. 1031(j)-1, the multiple-property like-kind rules determine the classification of the various properties when both real and personal property are being exchanged.

If only the relinquished property (or only the replacement property) contains personal property, the gain recognized by exchanging the non-like-kind personal property is limited to the personal property's FMV. Thus, if the personal property has little or no value, the recognized gain may not be significant. Clients can obtain an appraisal to substantiate a low value, as well as an agreement on that value from the relinquished property's buyer (however, such buyer may prefer a higher valuation to increase its own depreciation deductions).

An alternative tax strategy for exchanging into like-kind property following a cost-segregation study is to argue that reclassified personal property remains "real estate" for Sec. 1031 purposes, based on the definition of real property under state law. (15) Exchanging parties can argue that reclassified personal property is still real estate for Sec. 1031 purposes, because Secs. 168 and 167 allow parts of buildings to be classified as personal property only for tax depreciation purposes. For Sec. 1031 purposes, however, state law determines whether property is personal or real. (16)

Exchanges Involving Future Improvements

Clients sometimes wish to sell the relinquished property and then exchange into the replacement property when improvements are to be constructed on the latter later. However, contracts to construct improvements are not like-kind to real property for Sec. 1031 purposes.

Regs. Sec. 1.1031(k)-(1)(e) indicates that partially constructed improvements to the replacement property qualify as being like-kind to real estate to the extent classified as real estate under state law on the date of receipt. Thus, in a deferred exchange, a client may acquire replacement property to be improved during the 180-day deferral period (or due date of the client's return, if sooner). Under Kegs. Sec. 1.1031(k)-1(e)(3)(iii), improvements not completed before the end of the deferred-exchange period will still be deemed substantially the same as the replacement property identified by the client within the 45-day identification period, if: (1) the improved replacement property would have been considered substantially the same property as identified by the client, had it been completed when received by the client; and (2) when the replacement property is received, the partially completed improvements constitute real property under applicable state law.

If the replacement property improvements are constructed after the client receives the replacement property in a completed forward exchange, they Hill not qualify under Sec. 1031. (17) Thus, when a client finds that it has to use the relinquished property's exchange proceeds to construct improvements on the replacement property after the exchange-deferral period, it should restructure the exchange to become a reverse exchange (discussed below), rather than a conventional forward exchange.

Reverse Tax-Free Exchanges

To construct improvements on the replacement property that will qualify for a like-kind exchange, clients often have them constructed by an independent party, and then, at a later date, exchange into the replacement property. For example, a client may do a "reverse tax-free exchange" by first having an independent party (not classified as the client's agent for tax purposes) acquire replacement property land and later construct improvements thereon. When the improvements are constructed and become part of the replacement property, that property (including the newly constructed improvements) is then exchanged for the relinquished property.

"Parking" arrangements under Rev. Proc. 2000-37: One form of a reverse exchange--referred to as a "parking arrangement"--occurs when the replacement property is first acquired or "parked" with a third party, referred to as an exchange accommodation titleholder (EAT). Kev. Proc. 2000-37 (18) provides a safe harbor for parking arrangements when the replacement property is acquired by the EAT before the disposition of the relinquished property. In Rev. Proc. 2004-51, (19) the IRS stated that Kev. Proc. 2000-37 Hill not apply if the taxpayer owned the replacement property before the exchange. It is not clear what would happen if the taxpayer owned the replacement property and disposed of it in an unrelated transaction before the exchange.

Rev. Proc. 2000-37 permits an EAT to borrow money from the exchanging party and for the latter to guarantee the EAT's construction loans. Unfortunately, exchanging parties may have difficulty meeting the procedure's time requirements, which mandate that the exchanging party receive the replace ment property within 180 days of the EAT acquiring title to it. Because of potential construction delays, the EAT in many cases may take longer than 180 days to construct the improvements. (20)

Parking arrangements outside of Rev. Proc. 2000-37: If Rev. Proc. 2000-37's safe harbor cannot be met, an exchange may still be structured to qualify under Sec. 1031, based on case law. (21) In a typical non-safe-harbor transaction, an independent accommodator (22) first acquires the replacement property on which the improvements are to be constructed. The accommodator's acquisition financing and the construction financing come from either the client or the client's lender. In many cases, the client has an option to acquire the replacement property after the improvements are constructed, to complete the exchange. When the client is prepared to sell the relinquished property to a buyer, the client closes the exchange by using a qualified intermediary (QI) to transfer the relinquished property and acquire the replacement property from the accommodator. (23)

In J.H. Baird Publishing Co., (24) an accommodator acquired the replacement property and constructed improvements thereon on the taxpayer's behalf; the accommodator was held not to be the taxpayer's agent. Similarly, in Fredericks, (25) an accommodator who acquired the replacement property was not classified as the taxpayer's agent, even though it was owned and controlled by the taxpayer who acquired the replacement property. On the offer hand, in DeCleene, (26) the taxpayer was denied tax-free exchange treatment when he transferred land to a third party that constructed improvements and transferred the improved land back to the taxpayer. In Rev. Proc. 2004-51, the IRS emphasized its position that Sec. 1031 will not apply if the taxpayer owns the replacement property that it intends to exchange into.

These decisions teach that clients desiring to construct improvements on the replacement property should not take title to it first, but should instead use an accommodator to take title and construct improvements. Additionally, an accommodator's acquisition of the replacement property should be structured to shift the burdens and benefits of such property ownership to it (as much as possible), so that the accommodator (not the client) will be recognized for tax purposes as the replacement property's owner until the exchange is completed.

Deed of Trust (or Other Liability) as Boot

Gain on a Sec. 1031 exchange is recognized to the extent of the money and FMV of other property received (known as "boot"). (27) If the relinquished property is subject to a deed of trust or other liability, the amount owed on this deed of trust, which the client is relieved of in the exchange, is treated as money or boot received by the client under Sec. 1031(b). Regs. Sec. 1.1031 (b)-l(c) provides that any debt of which the client is relieved is netted against the liabilities the client assumes or takes the replacement property subject to.

Replacement property debt, for purposes of the netting rules, also includes a new deed of trust placed on the replacement property when acquired by the client. However, under Regs. Sec. 1.1031(d)-2, money or other property received by the client in an exchange cannot be netted against the client's assumed liabilities on the replacement property.

What if the exchanged properties consist of both real estate and personal property? When the relinquished property is encumbered by a deed of trust, the client can unexpectedly recognize gain, because Regs. Sec. 1.1031(j)-l(b)(2)(ii) requires all of the liabilities in an exchange to be allocated among each property exchange group (based on the relationship of each property group's FMV), even if the liabilities are not secured by a particular exchange group's properties. Thus, the liability netting rules can produce recognized gain when both real and personal property are involved in an exchange.

Partnership Liabilities

What are the tax consequences when a partnership owns the relinquished property? Sec. 752(a) states that any increase in a partner's share of liabilities is deemed a contribution of money by that partner to the partnership. Any decrease in a partner's share of liabilities is deemed a distribution of money to the partner by the partnership, under Sec. 752(b). On a distribution of property to a partner, the partner must recognize gain under Sec. 731(a)(1) to the extent that the deemed distribution exceeds the partner's adjusted basis in its partnership interest immediately before the distribution. Thus, when encumbered relinquished property is conveyed to a QI, the partner's share of liabilities is reduced. On the exchange's second leg, when acquisition of the replacement property is subject to a loan, the partner's share of liabilities increases.

In Rev. Rul. 2003-56, (28) the IRS ruled on the tax consequences of partnership liabilities in a deferred Sec. 1031 exchange occurring over two tax years. It held that if a partnership enters into a deferred like-kind exchange in which relinquished property subject to a liability is conveyed in year 1, and replacement property subject to a liability is acquired in year 2, the two liabilities are netted for purposes of the Sec. 752 rules. Similarly, if the relinquished property has relief of liabilities in excess of the replacement property's liabilities, the resulting gain is taxable in year 1, when the relinquished property is transferred. This contrasts with the result when cash boot received in a deferred exchange covering two tax years is recognized as taxable income in year 2.

Refinancing

Refinancing relinquished property before an exchange: Clients who sell real estate in a tax-free exchange may want to receive money, but not recognize taxable gain. Normally, cash received from an exchange escrow is taxed to the selling client as boot. However, instead of receiving taxable cash as part of the exchange, a client could refinance the relinquished property immediately before the exchange and receive the loan proceeds tax free. (29) However, to avoid gain recognition, after the exchange the replacement property needs to be subject to at least the same amount of debt as the client was relieved of on the relinquished property.

Twenty years ago, the IRS took the position in a letter ruling (30) that encumbering property immediately before an exchange may result in boot. However, the Service has not been successful in asserting this position in court. (31)

Refinancing replacement property after an exchange: In another tax planning strategy, the client can complete the tax-free exchange first and then refinance the replacement property, thereby receiving the refinancing proceeds tax free. To avoid an IRS challenge that the refinancing proceeds received from the replacement property are boot, the client should refinance the replacement property only after closing the escrow for the acquisition of the replacement property, and should use a separate escrow and closing statement.

Avoid step transactions: To avoid IRS assertions that the refinancing loan proceeds are taxable boot under the step-transaction doctrine, the refinancing of the replacement property after the exchange, or of the relinquished property before the exchange, should not be tied to the exchange by any written or oral understanding. (32)

Partnership "Drop and Swap" Exchanges

When partnerships and limited liability companies (LLCs) want to split up, they sometimes liquidate and distribute all of their relinquished property to partners or members as tenants--in-common; the former partners or members then immediately sell the relinquished property. The selling former partners then exchange into different properties and may even receive cash. However, this arrangement risks violating Sec. 1031, which requires exchanging partners to "hold" both the replacement property and the relinquished property for "productive use in a trade or business or for investment."

The IRS has ruled that a taxpayer did not hold the relinquished property for the required qualified use, when the taxpayer received the property as a liquidating distribution from a legal entity, then immediately exchanged it for the replacement property. (33) Contrary to this ruling, the Tax Court in Mason (34) held that exchanges by partners who received the relinquished property in a liquidation qualified for Sec. 1031 treatment. Similarly, in Bolker, (35) the Ninth Circuit held that shareholders qualified for tax-free treatment, even though they exchanged the relinquished property after they received it in a corporate liquidation. The Ninth Circuit held that Sec. 1031 only requires a taxpayer to own the property before entering into the exchange and to have no intent either to liquidate it or to use it for personal purposes.

Using a Tenancy-in-Common

In another tax planning strategy, the former partners of a liquidated partnership hold their relinquished property tenancy-in-common interests for an extended period before exchanging them for the replacement property. However, for tax purposes, the former partners' tenancy-in-common must not be structured as a partnership. (36) Under Regs. Sec. 301.7701-1 (a)(2), a co-tenancy can avoid being classified as a partnership if it simply maintains, repairs and rents the property. The co-tenancy's management activities should be limited as much as possible to avoid raising the relationship to partnership tax status. The parties should have a written agreement preserving the normal rights of a co-tenancy under state law. To formalize the appearance of a tenancy-in-common, the individuals' names should be listed on the property's deed; the partnership's liquidation should be legally formalized by filing the requisite state dissolution and termination documents. (37)

Rev. Proc. 2002-22: (38) This procedure lists the conditions under which the IRS will consider a ruling request that a tenancy-in-common interest will not be treated as a partnership interest for tax purposes. Rev. Proc. 2002-22 was issued in response to the real estate syndication industry that has sprung up in the past several years to market tenancy-in-common interests to persons needing replacement property to complete a Sec. 1031 exchange. Its conditions are "not intended to be substantive rules and are not to be used for audit purposes." However, because of the uncertainty of when a tenancy-in-common becomes a partnership for tax purposes, IRS field agents are likely to defer to this procedure's listed conditions on audit. Nonetheless, many tax advisers feel that violating certain of its conditions does not automatically trigger partnership classification.

As a practical matter, Rev. Proc. 2002-22 offers guidelines for structuring tenancy-in-common ownership of relinquished property for the period before completion of the exchange. Having a partnership liquidate its properties to partners as tenants-in-common is probably the most frequently used technique when some partners want to exchange for property and others want to cash out. Taxpayers have relied on Bolker (discussed above) and Rev. Proc. 2002-22 to liquidate and be treated as a tenancy-in-common. However, advisers should caution clients that under Rev. Proc. 2002-22, the IRS will not issue a favorable ruling when the exchanging tenants-in-common previously held their property interests through a partnership. This condition sends a "warning" of how the IRS might treat a partnership liquidation followed by an exchange.

Based on Rev. Proc. 2002-22, tenancy-in-common co-ownerships should not (1) file a partnership tax return, (2) conduct business under a common name, (3) hold themselves out or identify themselves as partners, by agreement or otherwise and (4) indicate to third parties that they are conducting their real estate activities as a partnership.

Rev. Proc. 2002-22 requires each co-tenant to retain the right to approve the major decisions of the tenancy-in-common. Further, each co-tenant must have the right to approve the hiring of any manager and the sale, disposition or lease of the property, or creation of a lien. Because it is cumbersome for large numbers of co-tenants to approve a sale or lease, or to make other major decisions, some tenancy-in-common agreements contain an "implied consent" provision, under which each co-tenant is notified of an event (i.e., a sale, lease, finance or reappointment of the manager), and has a specified period to object (e.g., 72 hours). If none of the co-tenants objects to the proposed action within the specified period, it is deemed to have been approved.

Some co-tenancies use a master lease to remove the need to have every co-tenant approve a lease for each tenant (such as in an office or apartment building). Under a master lease, the co-tenancy leases the entire replacement property to one master tenant that in turn subleases the property's individual premises to each actual user.

Using disregarded entities to own a tenancy-in-common: Persons owning tenancy-in-common interests in the replacement or relinquished property may want to limit their personal liability exposure by owning such interests in a disregarded entity's name, such as a single-member LLC, rather than in their individual names. This arrangement also avoids a problem if an individual cotenant died or went bankrupt, thus affecting the other tenants-in-common. Rev. Proc. 2002-22 permits disregarded tax entities to own a tenancy-in-common interest. (39)

Cashing Out Partners

Commonly, when real estate partnerships desire to split up, certain partners receive cash ("cash-out partners"); the remaining partners exchange tax free into other real estate. To achieve these dual goals, partnerships sometimes sell the real estate and use a portion of the sales proceeds to exchange tax free into other real estate, while simultaneously distributing cash to the cash-out partners in full redemption of their interests. The partnership's intent is for the cash-out partners to report taxable gain proportionate to the sales proceeds they receive, and for the remaining partners to receive tax-free exchange treatment. However, even though only the cash-out partners receive cash, all of the partners (including the remaining partners who desire to receive tax-free exchange treatment) would be taxed on the recognized gain if the partnership agreement allocates gain to all partners in proportion to their percentage interests.

Specially allocating gain to cash-out partners: Partners may consider amending their partnership agreement to attempt to specially allocate all gain from a property's sale to only the cash-out partners, and none to the remaining partners who complete an exchange. However, this special gain allocation is likely to fail Sec. 704(b)'s substantial economic effect test, became it would have to be reflected in the cashed-out partners' capital accounts, which in turn could alter the economic deal among the partners. (40)

Redeeming cash-out partners before exchange: An alternative to allocating all of the sale's taxable gain only to the cash-out partners is to redeem their interests using partnership cash reserves before the relinquished property's sale. The partnership could then exchange such property for the replacement property in a tax-free exchange.

Using a promissory note: Another strategy is for the partnership to sell the relinquished property for cash and a promissory note. After the sale, the cash-out partners receive a distribution of the note in exchange for their partnership interests. The promissory note is structured to pay the cash-out partners principal and interest in the year of the exchange and in the following calendar year. If an installment obligation is received in a Sec. 1031 exchange, recognizable gain is deferred under the installment method until payment is received. The note's distribution to the partners will not accelerate gain under Sec. 453; Regs. Sec. 1.453-9(c)(2) states that a partner's receipt of an installment note in a Sec. 731 distribution does not trigger gain under Sec. 453B. Thus, distribution of the note to the cash-out partners will not trigger recognized gain to the partnership, nor to those partners until they receive payments. (41) Partners seeking tax-free exchange treatment then continue as partners and have the partnership use their share of the property's sales proceeds to engage in a Sec. 1031 exchange. In a typical transaction, substantially all of the note payments are made right after the close of the relinquished property's sale; the remaining payments are made shortly after the beginning of the next tax year, to qualify for installment sale treatment under Sec. 453(b)(1).

Sometimes clients are concerned with using an installment note when the relinquished property's buyer has a weak credit rating. One way to overcome this is to have the buyer post a stand-by letter of credit as further collateral. Receipt of such a letter is not treated as a payment, under Regs. Sec. 15A.453-1(b)(3)(i).

Distributing tenancy-in-common interests: Another alternative is to have the partnership distribute a fractional tenancy-in-common portion of the relinquished property to the cash-out partners in redemption of their partnership interests. The cash-out partners and the partnership then hold their respective relinquished property interests as tenants-in-common for a while, after which the relinquished property is sold. In the sale, the cash-out partners retain their sales proceeds (and report the sale gain), while the partnership uses its portion of the relinquished property's sales proceeds to enter into a tax-free exchange. The tenancy-in-common relationship must not be structured as a continuation of the former partnership. (42) Also, the Sec. 1031 requirement--that tenants-in-common hold the relinquished property for use in a trade or business, or for investment--must be met.

"Swap and Drop" to New Partnership

Clients receiving replacement property in a tax-free exchange may attempt to pool the property's equity with others by completing a tax-free exchange and contributing that property (or a tenancy-in-common interest in it) to a partnership with others. However, contributing replacement property to a partnership immediately following an exchange risks violating Sec. 1031's holding requirement. The IRS might argue that the replacement property was not held for productive use in a trade or business or for investment, but instead was immediately disposed of by its contribution to a partnership. For example, in Rev. Rul. 75-292, (43) a prearranged transfer of the replacement property to a newly owned corporation did not qualify for Sec. 1031 treatment, became the replacement property had not been held by the exchanging party for a permissible use.

Satisfaction of Holding Requirement

Attributing partnership's holding to original exchanging party: Clients who immediately contribute interests in the replacement property to a partnership after an exchange might rely on Magneson (44) to attribute the partnership's holding to themselves. Magneson stated that the taxpayer's contribution of the replacement property to a partnership did not violate the Sec. 1031 "held for" requirement, because (1) the taxpayer intended to and did continue to "hold" the replacement property through its ownership of a general partnership interest; and (2) there was a "mere change" in the form of the taxpayer's ownership. However, Magneson was decided for tax years before the enactment of Sec. 1031(a)(2)(D), which denies tax-free treatment to exchanges of partnership interests. Today, the IRS might argue that the step-transaction doctrine should apply to such a "swap and drop" transaction, making it an impermissible acquisition of a partnership interest as the replacement property. In other words, the tax-payer was receiving back a partnership interest in exchange for real estate, which violates Sec. 1031's like-kind requirement. (45)

Holding replacement property as a tenant-in-common: An alternative and safer tax plan is for the client to hold the replacement property as a tenant-in-common with the partnership for a substantial period after completing an exchange, rather than immediately contributing it to the partnership. To avoid having the exchange and later contribution tied together as a step transaction, there should be no oral or written agreement to do so. (46) Also, a client's tenancy-in-common ownership of the replacement property should not be structured as a partnership for income tax purposes. (47)

Maximizing Identification and Replacement Periods

Clients engaging in deferred tax-free exchanges must identify the replacement property within 45 days after closing the relinquished property sale. Also, in a deferred exchange, the client must receive the replacement property on the earlier of the 180th day after the relinquished property is transferred or the due date of the client's return for the tax year of such transfer (including extensions). (48)

Replacement Property Period

If the 180-day period to receive the replacement property ends after the due date of the client's return for the tax year of the relinquished property's transfer, the client should file for an extension to maximize the replacement period.

Identifying replacement property: Selling clients can identify (1) three alternative replacement properties within 45 days of the relinquished property's sale without regard to its FMV; or (2) any number of replacement properties, as long as the aggregate FMV at the end of the 45-day identification period does not exceed 200% of the relinquished property's aggregate FMV. (49) Alternatively, clients can identify multiple replacement properties if they close the purchase of at least 95% of the value of all identified replacement properties before the end of the exchange period. (50)

No backdating of identification documents: As some exchanging clients find themselves approaching the 45-day deadline without having yet identified the replacement property, they may be tempted to "backdate" identification documents. Clients who falsify documents or change dates should keep in mind Dobrich, (51) in which the taxpayer was liable for civil fraud penalties for backdating such documents.

Obtaining more time: One technique for a selling client to gain more time is to delay the closing of the relinquished property's sale. For example, a client can obtain more time to identify the replacement property by including a provision in the relinquished property's sale agreement that gives the client an option to extend the latter's escrow closing date. Another alternative is for the client to first lease the relinquished property to the buyer, with the buyer purchasing the relinquished property at a later date.

Verifying QI Creditworthiness

Some clients leave millions of dollars in the name of the QI who is to complete their exchanges. Surprisingly, clients who are careful to obtain tide insurance policies, perform due diligence on the replacement property and verify the creditworthiness of their tenants, often fail to verify their financial viability. Exchanging clients should investigate the financial condition of the QI that will hold and invest their exchange funds.

Protecting Sales Proceeds

There are several ways to protect a client's relinquished property sales proceeds being held by a QI.

Use of separate escrow or trust account: Most QIs do not put the exchange funds into a separate trust or escrow account, which could protect the funds from creditors. However, Regs. Sec. 1.1031(k)-1(g) (3) permits the cash proceeds to be held in an escrow or trust account by the QI. The exchange documents must, however, limit the exchanging party's right to receive, pledge, borrow or otherwise receive the benefits of the cash or cash equivalents held in such account.

Use deed of trust, letter of credit or guarantee: Clients can also have the QI's obligations secured by a deed of trust, conforming standby letter of credit or third-party guarantee. (52) Clients should review the guarantee carefully to determine if it is a normal commercial guarantee with adequate legal protections. The standby letter of credit must be nonnegotiable and should provide for the payment of the proceeds to escrow for the purchase of the replacement property, rather than to the exchanging owner. (53)

Related-Party Exchange Rules

Even though properties may be exchanged tax free between related parties, (54) Sec. 1031(f) imposes a two-year holding period requirement. (55) Basically, Sec. 1031(f) requires that, when a client exchanges property with a related party, both parties must hold their respective properties received in the exchange for at least two years to qualify under Sec. 1031. If not, any gain or loss on the exchange by either party will be recognized on the date of the disqualifying disposition. (56)

Purpose

Sec. 1031(f)'s related-party rules prevent taxpayers from exchanging low-basis property for high-basis property to (1) avoid the gain recognition on subsequent property sales or (2) accelerate a loss on retained property. The reason for the statutory change was that an exchange of properties between related parties, followed shortly by a disposition of the property, allowed related parties to "cash out" of the investment. (57) Without related-party rules, taxpayers could exchange low-basis relinquished property with a related party owning high-basis replacement property; the latter could then sell the relinquished property (which acquired a new, high basis in the exchange) and receive the sales proceeds tax free. (58)

Indirect Transfers

The related-party rules also cover "indirect" transfers that involve a QI. (59)

Example: T, a property owner, transfers his relinquished property to a QI that transfers it to an unrelated third party for cash. The QI uses the proceeds to acquire the replacement property from a related party, then transfers it to the taxpayer.

On these facts, the IRS ruled in Rev. Rul. 2002-83 (60) that the taxpayer would not receive tax-free exchange treatment, because the related party was deemed to have disposed of the relinquished property for cash within the prohibited two-year holding period. This ruling can be interpreted to mean that, if a QI is used for exchanges between related parties and either related party receives cash, Sec. 1031(f) will apply to prevent tax-free exchange treatment. (61)

Clients with related-party entities that own real property, often have the entities exchange the properties among themselves to change ownership for business reasons. Under these circumstances, Rev. Rul. 2002-83 could unexpectedly produce recognized gain, especially when a QI is used. To avoid Rev. Rul. 2002-83's application, clients should structure exchanges so that neither related party receives cash in the exchange, or from the sale of either the relinquished property or the replacement property, during the required two-year holding period. (62)

Conclusion

The cost-effectiveness of professional exchange companies encourages clients to use their services to perform Sec. 1031 exchanges. However, practitioners should also advise their clients on the multitude of tax issues inherent in such exchanges. Professional exchange companies warn clients, in their standardized documents, to use outside professionals; prudent clients will heed these warnings.

(1) Although the Federal long-term capital gain rate is currently only 15%, straight-line depreciation recapture on real estate is 25%. Additionally, the alternative minimum tax may apply and state income taxes may be imposed.

(2) Under Rev. Rul. 78-72, 1978-1 CB 258, options to renew are counted in determining whether a lease has a term of 30 years or more to run.

(3) See Kegs. Sec. 1.1031(a)-2(b)(1).

(4) Product classes are based on the North American Industry Classification System; see Temp. Regs. Sec. 1.1031 (a)-2T(b)(3).

(5) For purposes of the deferred-exchange rules, "incidental property" is property transferred with a larger item of property in a standard commercial transaction, which has an aggregate fair market value (FMV) not exceeding 15% of the larger property's value. The incidental property must relate to the larger item of property.

(6) In Rev. Rul. 2003-54, 2003-1 CB 982, the IRS explained how property is classified as personal property--personal property includes tangible personal property as defined in the former investment tax credit rules in Regs. Sec. 1.481(c). Rev. Proc. 87-56, 1987-2 CB 674, sets forth the class lives of various types of property.

(7) See Sec. 168(c) and (e)(1). Most personal property associated with real estate will have a seven-year recovery period. However, in Ann. 99-82, 1999-2 CB 244, the IRS stated that certain personal property used in rental real estate (such as appliances, carpeting and furniture) would have a five-year recovery period.

(8) See Sec. 168(k)(1).

(9) Hospital Corp. of America, 109 TC 21 (1997), nonacq., AOD 1999-8. For an example of IRS approvals of cost-segregation studies, see "IRS LMSB Memorandum for Industry Directors on Planning and Examination of Cost Segregation Issues in Restaurant Business," BNA Daily Tax Report (12/18/03).

(10) See Ann. 99-82, note 7 supra.

(11) See Hospital Corp. of America, note 9 supra; and Piggly Wiggly Southern, Inc., 803 F2d 1572 (11th Cir. 1986).

(12) See Shoney's South, Inc., TC Memo 1984-413.

(13) In Rev. Rul. 2003-54, 2003-1 CB 982, the IRS ruled that gasoline station pump canopies are not inherently permanent structures and are tangible personal property to be recovered over five or nine years, depending on the depreciation system used.

(14) See Southland Corp., 611 F2d 348 (Ct. C1. 1979).

(15) Many states, including California, classify items (including property that might otherwise be personal property) permanently affixed to a building as "real property"; see Cal. Civil Code Section 658.

(16) IRS Letter Ruling 8443054 (7/20/84) indicates that state law principles apply to determine if property is real estate for Sec. 1031 purposes.

(17) See Bloomington Coca-Cola Bottling Co., 189 F2d 14 (7th Cir. 1951).

(18) Rev. Proc. 2000-37, 2000-2 CB 308, allows alternative safe-harbor parking arrangements using a third party EAT.

(19) Rev. Proc. 2004-51, IRB 2004-33, 294, indicates that the IRS continues to study parking transactions in the Sec. 1031 area.

(20) Rev. Proc. 2000-37, note 18 supra, specifically states that it does not override existing law as to parking arrangements. For a thorough discussion of Rev. Proc. 2000-37, see Borden, Lederman and Spear, "Build-to-Suit Ruling Breaks New Ground For Taxpayers Seeking Swap Treatment," 98 J of Tax'n 22 (January 2003).

(21) For example, in Fred L. Fredericks, TC Memo 1994-27, the Tax Court upheld tax-free exchange treatment for property improvements to be constructed in the future.

(22) See J.H. Baird Publishing Co., 39 TC 608 (1962), acq., 1963-2 CB 4. An accommodator is a person independent of the taxpayer that takes title to the replacement property in the construction exchange, so that the taxpayer does not own both the replacement property and relinquished property at the same time. If the taxpayer were to own both properties at the same time, there could not be an "exchange" for Sec. 1031 purposes.

(23) Generally, a QI will not want to serve directly as the accommodator for the construction, because of liability concerns. A QI is a person that enters into a written exchange agreement with the taxpayer and, as required by the agreement, acquires property from the taxpayer, transfers it and acquires like-kind replacement property and transfers it to the taxpayer. The QI cannot be the taxpayer or the taxpayer's agent or related to the taxpayer or the taxpayer's agent; see Regs. Sec. 1.1031(k)-1(g)(4)(iii).

(24) J.H. Baird Publishing Co., note 22 supra.

(25) Fredericks, note 21 supra.

(26) Donald DeCleene, 115 TC 457 (2000). However, IRS Letter Ruling 200111025 (3/19/01) recognized a successful Sec. 1031 exchange when the documentation provided that the accommodator would have a risk of loss or an economic benefit from owning the parked replacement property.

(27) There is no distinction between the assumption of a liability and the acquisition of property subject to a liability; see Regs. Sec. 1.1031(b)-1 (c).

(28) Rev. Rul. 2003-56, 2003-1 CB 985, is an analysis under the Sec. 1031 rules, not the Sec. 752 regulations.

(29) See Phillip M. Garcia, 80 TC 491 (1983), acq., 1984-1 CB 1, and Fredericks, note 21 supra.

(30) See IRS Letter Ruling 8434015 (5/16/84).

(31) See, e.g., Fredericks, note 21 supra.

(32) In IRS Letter Ruling 200019014 (5/12/00), the IRS ruled that liabilities placed on a replacement property, without a bona fide business reason apart from the exchange, may not be applied under the netting rules.

(33) See Rev. Rul. 77-337, 1977-2 CB 305.

(34) Miles H. Mason, TC Memo 1988-273. However, Mason did not specifically address the Sec. 1031 "holding" requirement issue.

(35) Joseph R. Bolker, 760 F2d 1039 (9th Cir. 1985).

(36) See Regs. Sec. 301.7701-1(a)(2).

(37) For an example of how not to create a valid co-tenancy relationship, see Delwin G. Chase, 92 TC 874 (1989), in which the tenants-in-common did not execute an escrow agreement, and the partnership continued to manage the property and allocate economic benefits as though the tenancy-in-common distribution had not occurred.

(38) Rev. Proc. 2002-22, 2002-1 CB 733. For a detailed discussion of Rev. Proc. 2002-22, see McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, Supp. [paragraph] 3.03[5] (RIA, 3d ed., 2005).

(39) When a Delaware statutory trust, which is a grantor trust, engages in a Sec. 1031 exchange, the grantor's trust interest is treated as an ownership interest of the underlying trust assets; see Rev. Rul. 2004-86, IRB 2004-33, 191. This ruling, however, allows the use of a Delaware statutory trust as a disregarded entity only in limited situations.

(40) For further discussion, see Real Property Exchanges (California Continuing Education of the Bar, 3d ed., 2002) pp. 455-458.

(41) See Secs. 453 and 731. For Sec. 751 purposes, "unrealized receivables" are defined under Regs. Sec. 1.751-1(c)(1) as rights to payment for property other than a capital asset. Accordingly, an installment note sale of a capital or Sec. 1231 asset, and its distribution by the partnership, would not be subject to Sec. 751(a), except perhaps to the extent gain on a Sec. 1231 asset is treated as ordinary income.

(42) See the discussion of Rev. Proc. 2002-22 at note 38, supra.

(43) See Rev. Rul. 75-292, 1975-2 CB 333.

(44) Norman J. Magneson, 753 F2d 1490 (9th Cir. 1985).

(45) The Magneson holding was based on the replacement property being contributed to the partnership for a general partnership interest. Some commentators have suggested that Magneson is no longer applicable to Sec. 1031 exchanges, because it was based on certain California general partnership statutes that have since been amended; thus, this case may have very limited application.

(46) See Emory K. Crenshaw, 450 F2d 472 (5th Cir. 1971), for the application of the step-transaction doctrine to a partnership liquidation followed by a Sec. 1031 exchange.

(47) See the discussion of Rev. Proc. 2002-22 in the text at note 38, supra.

(48) See Regs. Sec. 1.1031(k)-1(b)(2)(ii).

(49) See Regs. Sec. 1.1031(k)-1(c)(4)(i).

(50) See Regs. Sec. 1.1031(k)-1(c)(4)(ii)(B).

(51) David Dobrich, 188 F3d 512 (9th Cir. 1999).

(52) See Regs. Sec. 1.1031(k)-1(g)(2)(i)(B).

(53) Payment of the letter of credit proceeds to the exchanging party will result in that party receiving cash, which could trigger recognized gain in an otherwise tax-free exchange; see Regs. Secs. 1.1031(k)-1(f)(2) and 15A.453-1(b)(3).

(54) See, e.g., Coastal Terminals, Inc., 320 F2d 333 (4th Cir. 1963) and Fredericks, note 21 supra.

(55) The determination of a related party is based on Secs. 267(b) and 707(b)(1).

(56) See Sec. 1031(f)(1). There are exceptions under Sec. 1031(f)(2) for a disposition within the two-year period by reason of the death of either related party, compulsory or involuntary conversion of the exchanged property or any disposition, if neither the disposition, nor the exchange, "has as one of its principal purposes the avoidance of Federal income tax."

(57) See S Fin. Rep't No. 101-56, 101st Cong., 1st Sess. (1989), p. 151.

(58) The related party's basis in the relinquished property received in the exchange increases to the high basis of the replacement property that the related party transferred in the exchange; see Sec. 1031(d).

(59) Sec. 1031(f)(4) states that transactions structured to avoid the "purposes" of the Sec. 1031(f) related-party rules will not qualify for Sec. 1031 treatment. In Teruya Brothers, Ltd., 124 TC No. 4 (2005), the Tax Court found that using a QI to purchase replacement property from the exchanger's related entity was structured to avoid the purposes of Sec. 1031(f).

(60) See Rev. Rul. 2002-83, 2002-2 CB 927.

(61) However, in IRS Letter Rulings 200251008 (12/19/02) and 200329021 (7/18/03), the IRS ruled that the related-party rules do not apply when the related party constructs improvements on the replacement property. In those rulings, an EAT constructed improvements on land leased from a related taxpayer.

(62) See IRS Letter Ruling 200440002 (10/1/04) (related parties successfully engaged in a Sec. 1031 exchange using a QI and neither party "cashed out" of its respective exchanged real property).

Robert A. Brinkin, J.D., LL.M.

Law Offices of Robert A. Briskin

Los, Angeles, CA

For more information about this article, contact: Mr. Briskin at rbriskin@rablegal.com.
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