structuring 1031 like-kind exchanges: revisiting real...

Structuring 1031 Like-Kind Exchanges:

Revisiting "Real Property," Applying 199A

Business Deduction

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

The audio portion of the conference may be accessed via the telephone or by using your computer's

speakers. Please refer to the instructions emailed to registrants for additional information. If you

have any questions, please contact Customer Service at 1-800-926-7926 ext. 1.

THURSDAY, DECEMBER 12, 2019

Presenting a live 90-minute webinar with interactive Q&A

Professor Bradley T. Borden, Professor of Law, Brooklyn Law School, Brooklyn, N.Y.

Marie C. Flavin, Senior Vice President/Northeast Regional Manager, Investment Property

Exchange Services, Armonk, N.Y.

Tips for Optimal Quality

Sound Quality

If you are listening via your computer speakers, please note that the quality

of your sound will vary depending on the speed and quality of your internet

connection.

If the sound quality is not satisfactory, you may listen via the phone: dial

1-877-447-0294 and enter your Conference ID and PIN when prompted.

Otherwise, please send us a chat or e-mail [email protected] immediately

so we can address the problem.

If you dialed in and have any difficulties during the call, press *0 for assistance.

Viewing Quality

To maximize your screen, press the ‘Full Screen’ symbol located on the bottom

right of the slides. To exit full screen, press the Esc button.

FOR LIVE EVENT ONLY

Continuing Education Credits

In order for us to process your continuing education credit, you must confirm your

participation in this webinar by completing and submitting the Attendance

Affirmation/Evaluation after the webinar.

A link to the Attendance Affirmation/Evaluation will be in the thank you email

that you will receive immediately following the program.

For additional information about continuing education, call us at 1-800-926-7926

ext. 2.

FOR LIVE EVENT ONLY

Program Materials

If you have not printed the conference materials for this program, please

complete the following steps:

• Click on the link to the PDF of the slides for today’s program, which is located

to the right of the slides, just above the Q&A box.

• The PDF will open a separate tab/window. Print the slides by clicking on the

printer icon.

FOR LIVE EVENT ONLY

Tax-Free Exchanges under IRC Section 1031

BRADLEY T. BORDEN

MARIE C FLAVIN

5Section 1031 Exchanges

Presenters


➢ Bradley T. Borden

• Professor, Brooklyn Law School

• Special Counsel, Duval & Stachenfeld LLP

• [email protected]

➢ Marie C. Flavin

• Senior Vice President/Northeast Regional Manager, Investment Property Exchange Services

• [email protected]

Overview of Contents


➢ Introduction to Section 1031

➢ Tax Savings Under Section 1031

➢ Elements of Section 1031

➢ Identification and Receipt

➢ General Exchange Structures

➢ Related-Party Exchanges

➢ Advanced Exchange Structures

➢ Exchanges and Business Transactions

➢ Concurrent Ownership Structures (TICs and DSTs)

Introduction to Section 1031


Reasons to do a Section 1031 Exchange


➢ Obtain property with more potential appreciation

➢ Alleviate joint tenancy or partnership problems

➢ Reduce management problems by exchanging into NNN property

➢ Diversify property holdings

➢ Consolidate properties

➢ Estate planning

Fundamentals of Section 1031


➢ Dispositions of real property generally trigger gain and tax

➢ No gain on disposition that qualifies for Section 1031 treatment

• Satisfy all Section 1031 requirements

• Acquire Replacement Property of equal or greater value

➢ Section 1031 preserves net worth

➢ Section 1031 defers gain

Taxable Sale of Real Property


Example 1

• Allen owns Ranch

• Purchased for $50,000

• Fair value = $250,000

• Allen sells for $250,000

• Uses proceeds plus $100,000 to purchase Apartment Building

Cash Received (Amount Realized) $250,000

Adjusted Basis $50,000Gain Realized $200,000

Gain Recognized $200,000Tax Rate 20%Tax Owed $40,000

Cost Basis in Apartment Building $350,000Deferred Gain $0

Net Worth $310,000

Exchange of Real Property


Example 2

• Allen owns Ranch

• Purchased for $50,000

• Fair value = $250,000

• Exchanges Ranch plus $100,000 for Apartment Building

Fair Value of Apartment Building $350,000Cash Paid $100,000Adjusted Basis $50,000Gain Realized $200,000

Gain Recognized $0Tax Rate 20%Tax Owed $0

Cost Basis in Apartment Building $150,000Deferred Gain $200,000

Net Worth $350,000

Section 1031 Tax Accounting


Exchange or Sell?


Example 3

• Property value = $45,000,000

• Adjusted basis = $10,000,000

• Tax rate = 20%

• Sale = receive cash

• Exchange = receive like-kind property

Taxable SaleSection 1031

Exchange

Sale Proceeds $45,000,000 $45,000,000

Gain $35,000,000 $0

Tax ($7,000,000) NONE

Available for Re-investment

$38,000,000 $45,000,000

Effect of Receiving Boot


➢ Gain• Realize = receive economic value• Recognize = report on tax return

➢ Boot

• Money • Non-like-kind property• Net liability relief

➢ Gain recognition• Realized gain > boot = recognize amount of boot• Realized gain < boot = recognize realized gain

Gain Realized Greater Than Boot


Example 4

• Company C owns Old Building

• Value = $25,000,000


• Wants to acquire New Building

• Value = $20,000,000

• Additional cash = $5,000,000

Value of New Building $20,000,000

Cash Boot $5,000,000

Amount Realized $25,000,000

Adjusted Basis of old building $12,000,000

Gain Realized $13,000,000

Boot Received $5,000,000

Gain Recognized $5,000,000

Gain Deferred $8,000,000

Gain Realized Less Than Boot


Example 5


• Value = $25,000,000



• Value = $20,000,000


Value of New Building $20,000,000

Cash Boot $5.000,000

Amount Realized $25,000,000

Adjusted Basis of old building $22,000,000




Gain Deferred $0

Basis and Adjustments (Mechanics of Gain Deferral)


Example 4A


• Value = $25,000,000



• Value = $20,000,000


Adjusted Basis in Old building $12,000,000

Plus Gain Recognized $5,000,000

Less Money Received ($5,000,000)

Basis in New Building $12,000,000



Gain Deferred $8,000,000

Gain Deferred =$20,000,000 value of replacement property

- $12,000,000 basis in replacement property

Exchanges Involving Liabilities


➢ Exchanger’s liability relief is boot (liability-relief boot)

• Liability relief

• Transfer property subject to a nonrecourse liability

• Transferee assumes recourse liability as part of transfer

• Sale proceeds pay down existing liability at time of closing

➢ Exchanger’s liability assumed offsets liability relief

• Liability assumed reduces liability-relief boot

➢ Exchanger’s cash paid for replacement property offsets liability relief

• Cash paid reduces liability-relief boot

➢ Exchanger’s liability assumed does not offset cash received

Liability Relief Treated as Cash Received


Example 6

• Company E owns Property A

• Value = $20,000,000


• Liability = $10,000,000

• Wants to acquire Property B

• Value = $10,000,000

Value of Property B $10,000,000

Liability Relief $10,000,000

Total amount realized $20,000,000

Adjusted Basis of Property A $12,000,000


Boot (liability relief) $10,000,000


Computing Boot with Liability-Netting


Example 7:

• Company F owns Property A• Value = $20,000,000• Adjusted basis = $12,000,000• Mortgage = $10,000,000

• Wants to acquire Property B• Value = $18,000,000• Mortgage = $8,000,000

Value of Property B $18,000,000

Liability ReliefLiability assumed

$10,000,000$8,000,000




Boot (net liability relief) $2,000,000


Cash Paid Offsets Liability Relief


Example 8:

• Company G owns Property A• Value = $20,000,000• Adjusted basis = $12,000,000• Mortgage = $10,000,000• Cash = $4,000,000

• Wants to acquire New Building• Value = $14,000,000

Amount Realized Property B $14,000,000

Liability Relief $10,000,000



Cash $4,000,000

Total Adjusted Basis $16,000,000

Gain realized $8,000,000

Boot (liability relief – cash paid) $6,000,000


Liability Assumed Does Not Offset Cash Received


Example 9:

• Company H owns Property A • Value = $20,000,000• Adjusted basis = $12,000,000

• Wants to acquire New Building• Value = $24,000,000• Mortgage = $10,000,000

Amount Realized Property B $24,000,000

Cash $6,000,000

Liability assumed $10,000,000



Gain realized $8,000,000

Boot (cash received) $6,000,000


Loss Disallowed


➢ Inadvertent exchange of loss-property = nonrecognition of loss

➢ IRS may recast structures that are designed to defeat the exchange requirement

Elements of Section 1031


General Requirements


1. Exchange Requirement

2. Real-Property Requirement

3. Like-Kind Property Requirement

4. Holding and Use Requirement

5. Qualified-Asset Requirement

Exchange Requirement

➢ Exchange• Reciprocal transfer of property

for property

• Not a transfer of property for money consideration

➢ Structure typically exists in exchange structures• In multi-party exchanges, the QI

generally becomes the exchange partner


Exchanger

Rel. Prop

Rep. Prop.

Exchange Partner

Real-Property Requirement


➢ TCJA of 2017 added Real-Property Requirement

➢ No Section 1031 definition of real property• Generally accepted Real Property

• Land

• Permanent structures

Real-Property Definition


➢ Section 512 (UBTI)• All real property• Any property that is not personal property• Three types of real property

• Intangibles—leaseholds• Building and structural components• Other tangible real property

➢ Section 263A (capitalization rules)• Land• Unsevered natural products of land• Buildings• Inherently permanent structures

➢ Section 856 (REIT)• Land

• Water, air space, natural products, deposits unsevered from the land

• Improvements to land• Inherently permanent structures and their

structural components

Real-Property Definition


➢ Section 897 (FIRPTA, ECI)• Land• Unsevered natural products of the land• Improvements• Personal property associated with the

use of real property• Property used in mining, farming,

forestry• Property used in improvement of

real property• Property used in operation of

lodging facility• Property used in the rental of

furnished office and other work space

Like-Kind Property Requirement


➢ Nature and character

➢ Not grade or quality

➢ General interests in real property (land and permanent structures) are like-kind

All Real Property Like Kind?


➢ Each partial interest must be examined • Natural resources

• Water rights

• Leasehold interest of less than 30 years

• Easements

• Life estates & remainder interests

• Carve-outs

➢ Foreign Property not like-kind to U.S. real property

Holding & Use Requirements


➢ Replacement Property and Relinquished Property must be• Investment property or • Business-use property

➢ Excluded• Personal-use property • Property held for sale

➢ Holding Period• No minimum period• Determine intent at the time of exchange

➢ Business-Use Property• Held for productive use in trade or business.

➢ Investment Property• Held for future appreciation • Not personal-use property (i.e., not principal

residence and vacation home)

➢ Mixed-use property

Qualified-Asset Requirement


➢ Qualified Asset—any real property not held primarily for sale

➢ Dealer Property v. held for sale• Dealer: Hold property primarily for sale to customers in ordinary course of trade or

business

• Dealer property factors:

1. Nature & purpose of the acquisition of the property & duration of ownership

2. Extent & nature of taxpayer’s efforts to sell property

3. Number, extent, continuity, and substantiality of the sales

4. Extent of subdividing, developing, and improving the property

5. Use of a business office and advertising for the sale of the property

6. Supervision or control over representative selling the property

7. Time and effort the taxpayer actually devotes to the sale of the property

Identification and Receipt


Timing Requirements

180 Days

45 Days

Identification Period

Transfer of Relinquished

Property

Exchange Period


Identification Period


➢ Three-Property Rule• Any three properties regardless of value

➢ 200% Rule• Any number of properties, but total value

not greater than 200% of relinquished property value

➢ 95% Rule• Acquire at least 95% of value of identified

property

➢ Property Received Rule• Property received prior to the end of the

identification period will be deemed properly identified

Identification Requirements


➢ Received before the end of identification period = properly identified

➢ Written identification

• Signed by the exchanger

• Designating a property as replacement property

• Delivered to an allowed recipient before the end of the identification period

• An allowed recipient

• Person obligated to transfer replacement property

• Any other person involved in the exchange, other than exchanger or a disqualified person

• Document signed by all the parties should satisfy the delivery requirement

Exchange Period


➢ Begins upon transfer of relinquished property

➢ Ends on the earlier of

• 180 days after relinquished property was transfer date

• tax return due date for the tax year of relinquished property transfer

Receipt Requirement


➢ Property is received before the end of the Exchange Period if • Exchanger receives the replacement property before the

end of the exchange period and

• Property received is substantially the same property as identified

• Property being constructed

• Property may be identified before in existence

• Exchanger must provide as much detail of the nonexistent property as practicable at the time of identification

• Fair market value of property to be produced is its estimated fair market value as of the date it is expected to be received by exchanger

General Exchange Structures


General Exchange Structures


Two-Party Exchange

Multi-Party Exchanges

Deferred Exchanges

Reverse Exchanges

Two-Party Exchange


Exchanger

Rel. Prop

Rep. Prop.

Exchange Partner

Multi-Party Exchange (Starker)

Exchanger

Buyer Seller

1 3

2

1. Exchanger transfers Rel. Prop. to Buyer in exchange for Buyer’s Promise to acquire Repl. Prop. and transfer it to Exchanger. Exchanger identifies Rep. Prop. within 45-day period.

2. Within 180 days after transferring the Rel. Prop., Buyer acquires Repl. Prop. from Seller.3. Buyer transfers Rep. Prop. to Exchanger.

Rel. Prop

Rep.

Prop.

$$

Transfer of Rel. Prop.

Rep. Prop.


45-Day I.D. Period

180-Day Exchange Period

Deferred Multi-Party Exchange

Exchanger

Buyer Seller

1 4

3

1. Exchanger assigns rights in sales contract to QI. QI is treated as acquiring Rel. Prop. from Exchanger.2. QI is treated as transferring Rel. Prop. to Buyer; receives sale proceeds. Exchanger identifies Rep. Prop. within 45-day

period.3. Exchanger assigns rights to acquire Rep. Prop. to QI. QI uses exchange proceeds to acquire Rep. Prop. from Seller.4. Exchanger is treated as acquiring Rep. Prop. from QI. Transaction is complete within 180-day exchange period.

Rel. Prop

Rep. Prop

.

$$

Transfer of Rel. Prop.

180-Day Exchange

Period

45-Day I.D. Period

Rep. Prop.

QI2

Rel. Prop

$$


Reverse Exchange Parking Transactions

Exchanger

Buyer

3 5

1. Exchanger loans money to EAT to acquire Rep. Prop.2. EAT acquires and holds title to Rep. Prop. while Exchanger identifies Rel. Prop. within 45 days.3. Exchanger assigns rights in sales contract to QI and transfers Rel. Prop.4. QI is treated as selling Rel. Prop. to Buyer via direct deed from Exchanger, and QI receives exchange proceeds.5. Exchanger assigns rights in QEAA to QI. QI acquires Rep. Prop. from EAT within 180-day period and transfers it to

Exchanger. 6. EAT pays off the loan.

Rel. Prop

Rep. Prop

.

QI4

Rel. Prop

$$

EAT

2Rep. Prop.

$$

$$

$$

Rep. Prop.

1 & 6

Note

Seller


Special Issues


(g)(6) Restrictions on Exchange Proceeds


➢ (g)(6) restrictions• Exchange Agreement must expressly limit the

exchanger's right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI

➢ Failure to follow this requirement• Current exchange fails Section 1031 exchange

requirement

• QI status lost for all exchanges—language in exchange agreement is illusory

➢ Allowed lapse of restrictions• At end of 45-day identification period, if no

property identified

• When exchanger receives all possible replacement property

• Occurrence of a material and substantial contingency

Use of Exchange Proceeds for Ordinary Income Items


➢ QI may distribute exchange proceeds for ordinary income items

➢ Ordinary Income Item

• Payments on the transfer or receipt of property that are not included in

the basis or amount realized

• Prorated rent

• Property taxes

• Utilities and property insurance debited to the exchanger

➢ Best to make all distributions only upon the closing of transfers

➢ Use of proceeds to pay such items could be boot to exchanger

➢ Deductions may offset gain from boot

Use of Exchange Proceeds for Transactional Items


➢ QI may distribute exchange proceeds for transactional items➢ Use exchange proceeds for transactional items only at closing of

transactions• Costs incurred for surveys, title examinations, physical inspection reports,

environmental studies, brokerage commissions, and financing fees• Loan fees, points, loan application fees, mortgage insurance, lender's title

insurance, assumption fees, and other costs related to the acquisition of a loan • These items are generally capitalized and amortized over the life of the loan• Do not affect the basis of the property received • May be boot if paid for using exchange proceeds

➢ Must appear on closing statement to be transactional item➢ Transactional Items reduce amount realized or increase adjusted

basis

Improvements on Replacement Property


➢ QI may distribute exchange proceeds for the construction of improvements on replacement property in limited circumstances

• If seller holds title to the replacement property, QI may advance funds to seller to construct improvements

• Exchanger should be aware of seller’s control of funds and construction

• QI should be able to advance funds to an EAT to construct improvements on property the EAT holds

Earnest Money Payments


➢ To ensure compliance with (g)(6) restrictions• QIs should use exchange proceeds to

make earnest money payments for replacement property only if

• QI signs the purchase sale agreement

• Earnest money is not refundable to the exchanger

• If the exchanger pays earnest money, the QI should not reimburse the earnest money payments to the exchanger until after the (g)(6)restrictions expire

Installment-Sale Treatment of Some Busted Exchanges


➢ Installment-sale treatment applies to an exchange that straddles tax years

• Exchanger disposes of property in second half of tax year• Exchanger does not complete exchange• Exchanger receives exchange proceeds at the end of the 180-day

period in subsequent tax year• Exchanger recognizes gain in year of receipt

➢ Planning to obtain installment-sale treatment

• Delay transfer of relinquished property until after July 5 or so• Identify replacement property, if transfer is before November 15 or so• Receive exchange proceeds at end of 180-day identification period in

subsequent year

Seller Financing


➢ Exchanger might finance purchaser’s acquisition of relinquished property

➢ Exchanger’s receipt of purchaser’s note will be boot—gain recognized under installment method

➢ Exchanger may structure financing to avoid receipt of note• Purchaser draws note to QI, QI factors note

(perhaps to exchanger), QI acquires replacement property

• Replacement property seller could accept the note as part of the sales proceeds

• In some cases the note could be paid in full during the exchange period

Section 199A and Section 1031


➢ Overview of Section 199A

➢ Unadjusted Basis Immediately After Acquisition (UBIA)

➢ Depreciable Period

➢ Qualified Trade or Business and Rental Real Estate

Overview of Section 199A Deduction


➢ 20% of qualified business income

➢ Subject to wage and UBIA limits

➢ Only apples to qualified business income (QBI)

• QBI is not from: o Specified service trade or business (SSTB)

▪ Law▪ Accounting▪ Medical practice▪ Etc.

o Services as an employee• QBI is from a trade or business under section 162.

Treas. Reg. § 199A-1(a)(14).o Includes rental of property that is not

section 162 activity, if rented to a trade or business controlled by the property owner

o Safe harbor from rental real estate enterprise (RREE, discussed below)

Effect of Section 199A Deduction


Marginal Tax Rates Before and After Section 199A Deduction

Marginal Income Tax Rate Before 199A

Deduction

Marginal Income Tax Rate After 199A

Deduction

10% 8.0%

12% 9.6%

22% 17.6%

24% 19.2%

32% 25.6%

35% 28%

37% 29.6%

Wage and UBIA Limit


➢ Deduction limit

• 50% of W-2 wages

• 25% of W-2 wages + 2.5% of UBIA of qualified property

➢ Qualified property

• Subject to depreciation

• Used in a qualified trade or business

• Depreciable period has not ended

o Longer of 10 years and recovery period

UBIA of Replacement Property


➢ Replacement property must be qualified property

➢ Step-in-the-shoes rule. Treas. Reg. § 1.199A-2(c)(3)(ii).

➢ UBIA of replacement is UBIA of relinquished property

• Decreased by

o Excess boot

▪ Boot – appreciation in relinquished property

• Increased by

o Cash or other property transferred by exchanger

➢ Apportion UBIA among multiple replacement properties based upon their FMV

➢ UBIA of non-like-kind property is its FMV

Depreciable Period of Replacement Property


➢ Replacement property must be qualified property

➢ Step-in-the-shoes approach. Treas. Reg. §1.199A-2(c)(2)(iii).

➢ For carryover UBIA

• Begin with date relinquished property placed in service

➢ For new UBIA

• Begin with date replacement property placed in service

➢ Non-like-kind property

• Begin with date placed in service

Qualified Trade or Business and Rental Real Estate


➢ Does owning rental real estate come within the section 199A definition of trade or business?

➢ Common law does not answer:

• Holding property for rental is use in trade or business (Hazard v. Comm’r, 7 T.C. 372 (1946))

• Holding property for rental is NOT trade or business (Grier v. U.S., 120 F.Supp. 395 (D. Conn. 1954))

Proposed Safe Harbor for Rental Real Estate Qualified Trade or Business


➢ Rev. Proc. 2019-38

• If requirements satisfied rental real estate enterprise (RREE) will be treated as a trade or business for section 199A purposes

o RREE: “[A]n interest in real property held for the production of rents and may consist of an interest in multiple properties.”

o Treat each property as separate enterprise, or treat similar properties as single enterprise

o Commercial and residential cannot be part of same enterprise

o Mixed-use property may treated as single RREE, but then can’t be in RREE with either commercial or residential

o Need significant change in facts to vary from year to year

o Effective for taxable years ending after Dec. 31, 2017

Rental Real Estate Enterprise (Safe Harbor Requirements)


➢ Rental real estate enterprise (RREE) treated as trade or business if• Separate books and records for each RREE• Prior to Jan. 1, 2023

o In service less than 4 years▪ At least 250 hours of rental

services per year with respect to RREE

o In service at least 4 years▪ In any 3 of 5 years, at least 250

hours of rental services with respect to RREE

o Contemporaneous records▪ Hours of all services performed▪ Description of services▪ Dates on which services performed▪ Who performed services

Rental Real Estate Enterprise (Rental Services)


➢ Included Services• Advertising to rent or lease the real estate• Negotiating and executing leases• Verifying information contained in

prospective tenant applications• Collection of rent• Daily operation, maintenance, and repair of

the property• Management of the real estate• Purchase materials• Supervision of employees and independent

contractors➢ Performance by owners, employees, agents,

contractors• Can a tenant be an agent or contractor for

some services?

Rental Real Estate Enterprise (Rental Services)


➢ Excluded Services• Financial or investment management

activities• Arranging financing• Procuring property• Studying and reviewing financial

information• Planning, managing, or constructing long-

term capital improvements• Hours spent traveling to and from the real

estate

Rental Real Estate Enterprise (Safe Harbor)


➢ Excluded Arrangements• Real estate used by the taxpayer as a

residence for any part of the year under section 280A

• NNN propertyo Lease agreement that requires the

tenant or lessee to ▪ Pay taxes▪ Pay fees▪ Pay insurance▪ Be responsible for maintenance

activities for a property in addition to rent and utilities

o Applies to portions of rented property➢ Disclosure Requirement

• Include statement attached to return claiming section 199A deduction

Rental Real Estate Enterprise (Safe Harbor)


➢ Procedural requirements• Must include statement attached to return,

including• A description of all rental real estate

properties that are included in each RREE

• A description of all rental real estate acquired and disposed of during the taxable year

• A representation that the requirements of this Rev. Proc. have been satisfied

Section 199A and Exchanges that Straddle Tax Years


➢ Defer gain to subsequent year if exchange straddles tax years and boot received in subsequent year

➢ Must sell replacement property in second part of year

➢ Section 199A UBIA limited based upon property held on the last day of the taxable year• Apparently no relief for pending 1031

exchanges➢ If strategic (exchange intent must be bona fide)

about straddle exchanges, weigh whether straddle will affect section 199A deduction

Related-Party Exchange


Basis-Shifting and Cashing-Out


➢ Exchanger owns Greenacre—Low-basis property• Buyer offers to purchase exchanger’s property

• Sale would trigger gain and tax

➢ Related Party owns Blackacre—High-basis property

➢ Exchanger and Related Party Exchange Properties• Greenacre takes high basis

• Blackacre takes low basis

➢ Exchanger sales Greenacre for No Gain

Situation Preceding Related-Party Exchange

Buyer

ExchangerRelated Party

Greenacre BlackacreFMV = $150,000

AB = $50,000

FMV = $150,000AB = $150,000

$$

• Exchanger and Related Party each own property

• Exchanger’s has low basis; Relate Party’s has high basis

• Buyer has an interest in acquiring Exchanger’s property


Section 1031(f)(1) Example

Buyer


Greenacre Blackacre

Exchange and Shift Bases


FMV = $150,000AB = $50,000

FMV = $150,000AB = $150,000

Situation Following Related-Party Exchange

Buyer

Exchanger

Related Party

GreenacreFMV = $150,000AB = $150,000

BlackacreFMV = $150,000

AB = $50,000

$$

Exchanger and Related Party could cash out of Greenacre investment tax-free, but for Section 1031(f)(1)


Related-Party Rules—Section 1031(f)(2)


Disregard the following subsequent dispositions

• After the death of the exchanger or related party

• Section 1033 compulsory or involuntary conversion• Exchange must occur prior to the threat or

imminence of such conversion

• No tax avoidance motive for exchange or subsequent disposition • More on non-avoidance exception later



➢ Section 1031(f)(4)• Section 1031(a) does not apply if a

transaction (or series of transactions) is structured to avoid purposes of Section 1031(f)



➢ Acquisition of high basis property from a related party in QI-facilitated exchange comes within Section 1031(f)(4)• Rev. Rul. 2002-83, 2002-2 CB 927 • Teruya Broters, Ltd. v. Comm’r, 124 T.C

45 (2005)• Ocmulgee Fields, Inc. v. Comm’r, 613

F.3d 1360 (11th Cir. 2010)

➢ Prior to exchange• Exchanger holds low-basis property;

related party holds high-basis property

➢ Following exchange• Exchanger holds low-basis property;

related party holds cash

Situation Preceding Related-Party Exchange

Buyer


Greenacre BlackacreFMV = $150,000

AB = $50,000

FMV = $150,000AB = $150,000

$$

• Exchanger and Related Party each own property

• Exchanger has low basis; Related Party has high basis

• Buyer has an interest in acquiring Exchanger’s property


Prohibited Multiple-Party Transactions (Teruya & Ocmulgee)

QI

Buyer



Prohibited Flattened Transaction (§ 1031(f)(1))

Buyer

Exchanger Related Party

High-basis property

Low-basis property

Exch.-b

asis p

rop

erty

$$

, no

ga

in

End result same as Teruya and Ocmulgee


Situation following Related-Party Exchange

• Exchanger and Related Party could cash out of Greenacre investment tax-free, but for Section 1031(f)(1)

• Exchange altered property-cash situation

Buyer

ExchangerRelated

Party

Greenacre


AB = $50,000

FMV = $150,000AB = $150,000

$$




➢ Related-party purchase of exchanger’s property is not a basis-shifting transaction

• P.L.R.s 201027036 (Mar. 30, 2010); 200728008 (Apr. 12, 2007); 200709036 (Nov. 28, 2006); 200712013 (Nov. 20, 2006)

➢ Prior to exchange• Exchanger holds property; related

party holds cash

➢ Following exchange• Exchanger holds property; related

party holds cash

Situation PrecedingRelated-Party Exchange

ExchangerRelated

Party


AB = $50,000

$$

• Exchanger has low-basis property

• Related party has cash


Allowed Multiple-Party Transaction(PLR 200709036)

QI

Buyer

Exchanger Related Party

Seller

Co

st-basis p

rop

erty

$$, n

o g

ain


Situation following Related-Party Exchange Related

Party

$$

Exchanger

Replacement Prop.

FMV = $150,000AB = $50,000

• Exchanger has low-basis property; related party has cash

• Exchange did not alter property-cash situation


Malulani v. Comm’r, TC Memo 2016-209

➢ Exchanger acquired replacement property from related party• Related party had NOLs• Related party had small amount of

AMT• Related party paid a little bit of tax

➢ Ruling• Not 1031(f)(2)(C) because amount

of actual tax is less than the amount of tax the exchanger would have recognized if it had sold in taxable transaction

➢ Court ignored• Effect of using of NOLs currently

➢ Is 1031(f)(4) a mechanical test?


Emerging Mechanical Analytical Framework of Code Sec. 1031(f)(4) QI-Facilitated Exchanges

Exchanger: (1) hired QI to facilitate exchange,(2) transferred relinquished property to unrelated party,

(3) acquired replacement property from related party

Maybe not § 1031(f)(4) transaction

Yes

No

Compare aggregate actual tax to tax from hypothetical sale

§ 1031(f)(4) transaction

Hypo Tax > Actual Tax

(1) Round-robin exchange or (2) subsequent nonrecognition transfer?§ 1031(f)(2)(C)?

Actual Tax > Hypo Tax

§ 1031(f)(2)(C) non-avoidance

Yes

No

Section 1031 Exchanges

86

Advanced Exchange Structures


Types of Advanced Exchange Structures


➢ Build-to-Suit Exchanges

➢ Leasehold Improvements Exchanges

Services and Personal Property Concern


➢ Like-Kind Property• Real property is not like kind to

services (including production services) or building materials

• Any additional construction on the replacement property after the property is acquired by the taxpayer will not be like kind (Reg. § 1.1031(k)-1(e)(4))

➢ Real Property• Services and building materials

are not real property

Build-to-Suit Exchanges


Build-to-Suit Exchanges


➢ Exchanger has property to sell

➢ Exchanger would like to use proceeds to • Acquire property from third party

• Construct improvements on property held by third party

➢ Concerns• If seller-facilitated, will seller

complete construction on time, as specified

• If exchanger has too much control, does tax ownership pass to exchanger

Seller-Facilitated Build-to-Suit Exchange


➢ Exchanger enters into agreement to purchase replacement property

➢ Seller agrees to construct improvements to Exchanger’s specifications

Safe-Harbor Build-to-Suit Exchanges


➢ EAT takes title to property

➢ Construction happens while EAT is on title

Build-to-Suit Exchange Exchange

r

Buyer Seller

1 6

1. Exchanger assigns rights in Rel. Prop. sales contract to QI and transfers property.2. QI is treated as selling Rel. Prop., and QI receives exchange proceeds. Exchanger identifies Rep. Prop. within 45-day ID period.3. QI advances exchange proceeds to EAT. 4. EAT acquires Rep. Prop., constructs improvements. Exchanger identifies Rel. Prop. Within reverse-exchange 45-day ID period.5. EAT transfers improved Rep. Prop. to QI in satisfaction of note within 180 days after Exchanger transferred Rel. Prop.6. Exchanger receives improved Rep. Prop.

Rel. Prop

QI2

Rel. Prop

$$

EAT

4 Rep. Prop.$$

Builder4

$$

Rep. Prop.

Improve-ment

Improve-ment

Rep. Prop.

Improve-ment


Non-Safe-Harbor Build-to-Suit Exchanges


➢ Titleholder holds title for more than 180 days

Bartell v. Commissioner


➢ Tax Court holds that a non-safe harbor improvements exchange qualifies for Section 1031 nonrecognition

➢ Accommodator held title to replacement property for more than 180 days

➢ Benefits and burdens appear to pass to exchanger

➢ Tax Court applies a formalistic test to determine that accommodator is the tax owner of the property for Section 1031 purposes

IRS Nonacquiesence


➢ Claims Tax Court was wrong

➢ Benefits and burdens should determine who is the tax owner of property

➢ Nonacquiesence versus appeal

Effect of Nonacquiesence


➢ Effect on penalty analysis (substantial authority?)

• Likelihood of reporting position being upheld

• Tax Court opinion v. IRS nonacquiesence

• Tax Court reasoning v. IRS reasoning

• Path to IRS victory

• Taxpayer can ensure dispute goes through Tax Court

• Would Tax Court disregard its precedent?

• How would circuit courts rule?

• Will IRS appeal to a circuit court that is not the Ninth Circuit?

Economic Decision


➢ Paying the tax is most likely more costly than doing a Bartell transaction

➢ Probability of paying the tax on a Bartell is less than 1

➢ T < P • B + R• Where

• T = the cost of paying the tax, i.e., not doing a Bartell transaction

• P = probably of paying the tax if taxpayer does a Bartelltransaction

• B = the tax that would be owed if IRS audits return and challenges the Bartell reporting position

• R = cost of structuring Bartell transaction

• If P < T ÷ (B + R), Bartell structure costs less than paying the tax

Example


➢ Tax = $1,000,000

➢ Transaction Cost = $60,000

➢ Probability threshold: $1,000,000 ÷($1,000,000 + $60,000) = 94%

➢ Proof: $1,000,000 = 0.94 • $1,000,000 + $60,000

➢ If the probability of paying the tax with the Bartell structure is less than 94%, the expected cost of doing the Bartellstructure is less than the cost of paying the tax without doing the Bartellstructure

Leasehold Improvements Exchanges


Leasehold Improvement Situation

Exchanger Exchanger

Related Party

Real Property for Sale

Raw LandReal Property

for SaleRaw land

OR


Objective


Exchanger would like to use the proceeds from the sale of its property to construct improvements on the raw land

Exchanger wants Section 1031 nonrecognition

Relevant Section 1031 Elements


➢ Keys to improvement exchanges• Like Kind

• Real Property

• Exchange

➢ Related-Party Rules

Already-Owned Property Not Eligible for Exchanges


➢ Exchange• Reciprocal transfer of property

• Cannot acquire already-owned property as part of an exchange

• Transfer to an EAT does not cleanse the pre-owned status (Rev. Proc. 2004-51)

• Ownership by a related party for at least 180 days may cleanse pre-owned status, but beware of the related-party exchange rules

Planning Strategy


➢ Avoid building on already-owned property• Use related party’s property

➢ Avoid basis shifting and cashing out• Ensure that improvements, not already-

owned property, are the replacement property

Leasehold Improvement Exchange Structure


➢ Related party leases property to EAT

➢ EAT constructs leasehold improvements

➢ Exchanger acquires leasehold with improvements from EAT in exchange for relinquished property

Leasehold Improvements Exchange

Exchanger

Buyer

4 5Rel. Prop

QI4

Rel. Prop

$$

EAT

2$$

Builder3

$$

Improve-ment

Improve-ment

Related Party

1. Exchanger lends funds to EAT.2. Related Party grants an arms-length 32-year leasehold in raw land to EAT.3. EAT constructs improvements on the leased raw land, and Exchanger identifies Rel. Prop. within 45 days.4. Exchanger transfers Rel. Prop., and QI is treated as selling Rel. Prop. to Buyer, and QI receives exchange proceeds.5. QI uses exchange proceeds to purchase improved Rep. Prop. leasehold from EAT and transfer it to Exchanger.6. EAT pays off construction loan.

$$

1 & 6

Note

Lease

Lease

Improve-ment

Lease


IRS Approved Leasehold Improvement Exchange


➢ IRS approved leasehold improvement exchange in PLR 200251008• Unrelated party owned fee • Related party had a 45 year ground sublease• Related party subleased property for 32 years to EAT to make

improvements• Within 180 days EAT transferred leasehold and improvements to

exchanger

➢ IRS approved similar structure in PLR 200329021• Related party owned long-term lease of property • Related party assigned the lease to the EAT to make improvements• EAT assigned leasehold and improvements to exchanger• IRS approved, but required each party to hold for two years

Need for Long-Term Lease


➢ Only leases with a term of 30 years or more are like kind to real property• Count optional renewal periods

➢ Lease must provide for FMV rent of leased property, exchanger continues to pay rent

➢ Value to exchanger is difference between rent without improvements and use of property with improvements

Acquisition of Identified Property


➢ The replacement property received must be substantially the same property as identified

➢ Receipt of incomplete construction okay if property received would (if completed) be substantially the same as that identified

Avoids Related-Party Rules


➢ No basis shifting or cashing out• Related party does not transfer property to EAT, so no

basis shifting

• Related party enters into FMV lease with EAT, so cash related party receives is ordinary income to related party

➢ Value of replacement property is use of improved property for unimproved rent• EAT creates the value by constructing improvements

A Caveat . . .


➢ The Service and Treasury Department are continuing to study the application of Rev. Proc. 2000-37 to exchanges with related parties (Rev. Proc. 2004-51, §2.06)

• Does not prohibit application

• No action in 18 years

• Many advisors and exchangers do leasehold improvement exchanges

Conclusion


➢ Leasehold must be from related party, who did not acquire property from exchanger within 180 days

➢ Lease to EAT must be FMV

➢ Shovel-ready when EAT enters into lease allows for considerable improvement

➢ Rent payments continue after exchange

➢ Numerous variations of structure

Exchanges and Business Transactions


Types of Exchanges of Business Transactions


PARTNERSHIPS CORPORATIONS➢ Drop-and-Swaps

• Typical drop-and-swap scenario• Section 1031 issues and law• Judicial doctrines

➢ Drop-Swap Cash-Outs• Tax Treatment of various

alternatives

➢ Swap-and-Drops• Typical swap-and-drop• Section 1031 issues and law• State-law theory of partnerships• Partnership tax issues

➢ Drop-and-Swap/Swap-and-Drop Variant

➢ Corporate Tax Basics• Double-Tax Problem• Entity-Tax Problem

➢ Corporate Liquidations

• C-to-S Conversions• Built-in-Gains Tax

➢ S-Corporation-to-Partnership Conversions

• Constructive Liquidation

➢ S Corporation Divisions

➢ Other Strategies

Drop-and-Swaps


• A, B, and C are equal members• A, B, and C wish to sell Office• A wishes to reinvest individually• B and C wish to reinvest together

Typical Drop-and-Swap Scenario

A B C

Office

LLC

Each Member’s Unrealized Gain

Fair Value $300,000

Adjusted Basis $100,000

Unrealized Gain $200,000

Share Unrecap § 1250 Gain $150,000

Outside Basis = Share of Adjusted Basis

Capital Accounts = Outside Basis

LLC’s Unrealized Gain

Fair Value $900,000



Unrecaptured § 1250 Gain $450,000


❖ Same issues if B and C also wish to reinvest individually

Typical Drop-and-Swap Strategy (distribute first)

A B C

2/3 Office

1/3 Office

LLC’s Exchange

1/3 Office LLCQI

QI


Section 1031 Issues


➢ Exchange Requirement• Same person must transfer and receive

• Lose Section 1031 nonrecognition if LLC transfers relinquished property, and A receives replacement property

➢ Holding Requirement• A must be the tax owner of real property

➢ Use Requirement• A must hold 1/3 Office for business use

or investment

➢ Qualified-Asset Requirement• Cannot be tax-partnership interest

• Rev. Proc. 2002-22, Condition 3

• No prior entity ownership

Use Requirement


➢ Negative Authority• Rev. Rul. 77-337, 1977-2 C.B. 305

➢ Positive Authority“[T]he intent to exchange property for like-kind property satisfies the [use] requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits.”

Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985)

• Mason v. Commissioner, 55 T.C.M. (CCH) 1134 (1988)

➢ Form 1065, Schedule B, Line 14• “At any time during the tax year, did

the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”

Holding Requirement


➢ LLC must distribute interest in Office to A

• Commissioner v. Court Holding, 324 U.S. 331 (1945)

• Tax-free distribution from corporation followed by sale to avoid entity-level tax

➢ A must be tax owner of the interest in Office

• Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)

• Chase v. Commissioner, 92 T.C. 874 (1989)

• Bad facts. Substance over form?

➢ Holding period requirement?• Tax ownership is all or nothing—not transfer by

degrees as closing approaches

Qualified-Asset Requirement


➢ TIC under state law, tax partnerships?• Rev. Proc. 2002-22

• Dozens of cases (more than 100)

➢ Basic Strategies• Limit management activity

• Do not file tax return

• Do not treat as a partnership

• Do not hold in separate entity unless it is a DST that is compliant with Rev. Rul. 2004-86

Drop-Swap Cash-Outs


Drop-Swap Cash-Out Scenario

A B C

Office

• A, B, and C are equal members• A, B, and C wish to dispose of Office• A wishes to cash out• B and C wish to reinvest together in like-kind property• B and C might consider bringing in right person as a new member

LLC


Fair Value $300,000







Fair Value $900,000





Cash-Out Concerns


➢ A not concerned about Section 1031 requirements

➢ LLC concerned about transfer of tax ownership on distribution

➢ LLC does not want A’s actions to taint its Section 1031 exchange

➢ What is character of A’s recognized gain?

➢ What is character of LLC’s deferred gain?

➢ What are the various cash-out alternatives and what are their tax consequences?

Cash-Out Alternatives


1) Distribution-first cash-out

2) LLC exchanges/sells, uses regular allocations, distributes cash

3) LLC exchanges/sells, uses special allocations, distributes cash

3(a) LLC exchanges/sells, uses fill-up allocations, distributes cash

4) LLC exchanges/sells, receives installment note, distributes note

5) Member sells tax-partnership interest

6) Other members buy cash-out member’s tax-partnership interest

7) Single other member buys cash-out member’s tax-partnership interest

8) Leveraged cash-out

Swap-and-Drops


Swap-and-Drop Scenario

A B C

OfficeLand

• A owns Land• B and C own Office as tenants-in-common• A would like to sell Land and acquire an interest in Office• A, B, and C would like to own Office in an LLC

❖ Alternatively, B and C could own Office in a tax partnership❖ A would like to sell Land and become a member of LLC❖ Or A, B, and C may wish to exchange their respective

properties and acquire property together to hold in an LLC


Typical Swap-and-Drop Strategy

A B C

2/3 Office

1/3 Office

Land

1/3 Office

1/3 Office

2/3 Office

LLC

QI


Section 1031 Issues


➢ Use Requirement• A must hold Office interest for

business use or investment

➢ Holding Requirement• A must acquire tax ownership of

interest in Office, not a tax-partnership interest

• Similar to drop-and-swap issues

➢ Exchange Requirement• A must transfer Land and acquire

interest in Office

• Similar to drop-and-swap issues

Use Requirement


➢ Negative Authority• Rev. Rul. 75-292, 1975-2 C.B. 333

➢ Positive Authority• § 1031 and § 721 represent “continuation,

not liquidation, of old investment”

• Use requirement: “So long as . . . the taxpayers continue to own the property and to hold it for investment, a change in the mechanism of ownership which does not significantly affect the amount of control or the nature of the underlying investment does not preclude nonrecognition under section 1031(a).”

• Step-transaction doctrine: “Between two equally direct ways of achieving the same result, [taxpayers are] free to choose the method which entail[s] the most tax advantages to them.”

Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985)

State-Law Entity Theory


➢ Magneson Court’s Distinctions Overstated• Entity v. Aggregate View

• Always have both entity and aggregate aspects, especially with closely-held entities

• Control and Management• Shareholders of close corporations

control

• General partners’ control can be limited

• Distinctions with closely-held entities is often nominal

Partnership Tax Issues


➢ Section 704(c) for contributed property• Does Section 1250 follow Section 704(c)

allocation?

➢ LLC’s holding period could vary with different interests• A’s holding period could be long term• B’s and C’s holding periods could be short

term

➢ Character Taint• Section 724(b) applies if B and C held as

inventory/dealer property—ordinary income for 5 years after contribution

➢ Form 1065, Schedule B, Line 13

• “Check this box if, during the current or prior tax year, the partnership . . . contributed [property received in a like-kind exchange] to another entity (other than disregarded entities . . . .)”

Drop-and-Swap/Swap-and-Drop Variant(exchange-first Drop-and-Swap)

A B C

RP 1

LLC Exchanges

RP 1 RP 2

• Does LLC satisfy use requirement?

• Does LLC satisfy holding requirement?

• What about non-tax concerns of LLC holding RP 1? Office

LLC

QI


Section 1031 Issues


➢ Exchange and Holding Requirements • Same as distribution-first

➢ Use Requirement• Exchange followed by liquidation of

corporation under old § 333

• “Instant case can be viewed as a variant of Magneson . . . or as a variant of Bolker.”

• “[Corporation’s] purpose was the purpose of [the shareholders].”

• “[W]here a taxpayer surrenders stock in his corporation for real estate owned by the corporation, he continues to have an economic interest in essentially the same investment, although there has been a change in the form of ownership.”

Maloney v. Commissioner, 93 T.C. 89 (1989)

Section 1031 Issues


➢ Use Requirement (continued)• “A trade of property A for property B,

both of like kind, may be preceded by a tax-free acquisition of property A at the front end, or succeeded by a tax-free transfer of property B at the back end.”

Maloney v. Commissioner, 93 T.C. 89 (1989)

➢ Form 1065, Schedule B, Line 13

• “Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange” or contributed such property to another entity (other than disregarded entities wholly owned by the partnership throughout the tax year)”

Corporations: Tax Basics


Fundamentals of Corporate Taxation


➢ Generally• Corporate-level tax

• Shareholder-level tax on dividends

• Contributions of property generally taxed

• Distributions of property

• Taxed at corporate level

• Taxed at shareholder level

➢ S-Corporations• No entity-level tax—Income flows through to

shareholders

• Contributions and distributions subject to general corporate rules

Taxation of C-Corporation Income

Office

C-Corporation

A B C

Corporate-Level Tax

Corporate Income $100,000

Tax Rate 21%

Tax $21,000

Distributable Income $79,000

Aggregate Shareholder-Level Tax

Distributed Income $79,000

Tax Rate 23.8%

Tax $18,802

Net Cash to Shareholders $60,198

$

$

$


Distributions are dividends.

Fundamentals of S-Corporation Taxation


➢ Corporate-level income, gain, and losses flow through to shareholders

➢ Allocated corporate items affect shareholder basis• Allocated income and gain increase basis

• Allocated losses decrease basis

➢ Nonliquidating distributions• Nontaxable return of basis to extent of basis

• Distributions in excess of basis treated as gain

➢ Liquidating distributions treated as consideration for stock

S-CorporationRequirements


➢ No more than 100 shareholders

➢ Shareholders are individuals• Some exceptions for trusts and estates

➢ Shareholders are U.S. residents or citizens

➢ One class of stock• Voting-nonvoting not relevant

➢ Elect to be treated as S-corporation

➢ Terminated S-corporation becomes a C-corporation

Taxation of S-Corporation Income

Office

S-Corporation

A B C

Corporate-Level Tax

Corporate Income $100,000Tax Rate 0%Tax $0

Distributable Income $100,000

Taxation to Each Shareholder on Allocated Gain

Share of Income $33,333Sec. 199A Deduction (20%) $6,667

Taxable Income $26,666Tax Rate 37%Tax $9,866

Shareholder Tax Attributes

Stock Value $300,000Basis in Stock $250,000Unrealized Gain $50,000

$

$

$

Effect on Each Shareholder’s Basis

Beginning Basis $250,000Allocation of Income $33,333Basis After Allocation and Distribution $283,333


Corporate income is allocated to shareholders.

Each shareholder has share of income.

Income increases shareholder basis.

Taxation of S-Corporation Distribution

Office

S-Corporation

A B C

Effect on Each Shareholder’s Basis

Basis After Allocations $283,333Distribution ($33,333)Basis After Distribution $250,000

$$

$


Distributions decrease shareholder basis.

No gain on distribution because basis is greater than distribution.

S-Corporation Drop-and-Swaps


• A, B, and C are equal shareholders• A, B, and C wish to sell Office• A wishes to reinvest individually• B and C wish to reinvest together❖ Same issues if B and C also wish to reinvest individually

Typical S-Corporation Drop-and-Swap Scenario

A B C

Office

Each Shareholder’s Unrealized Gain

Fair Value $300,000






S-Corporation’s Unrealized Gain

Fair Value $900,000




S-Corporation


Tax Considerations for S-Corporation Drop-and-Swaps


➢ Distributions from S-corporations trigger gain recognition

➢ S-corporations must allocate gain pro rata to shareholders

➢ Stock redemptions can trigger gain to the redeemed shareholder

➢ Consider tax-free division discussed below

Consequences of Typical S-Corporation Drop-and-Swap Strategy

A B C

2/3 Office

1/3 Office

LLC’s Exchange

1/3 Office

QI

QI

S-Corporation’s Gain on Distribution

Fair Value of 1/3 Interest $300,000


Gain Recognized $200,000


Consequences to Shareholders

Gain Allocated to Each Shareholder $66,667

Stock Basis Following Allocations $166,667

Value of 1/3 Interest Dist. to A $300,000

A’s Gain on Redemption $133,333

A’s Basis in 1/3 Interest $300,000

A’s Tax Deferred on Exchange $0

S-Corporation

Deferred Gain $400,000

Deferred § 1250 Gain $250,000


C-to-S Conversions


➢ C-corporation elects to be S-corporation

➢ Built-in-gains tax• Pre-conversion gain is subject to corporate

rate for 5 years following conversion

• Ensure pre-conversion gain is subject to double tax for at least 5 years following conversion

➢ Earnings and profits carryover• Pre-conversion earnings and profits

carryover

• Distributions from pre-conversion earnings and profits treated as dividends from the S-corporation

S-Corporation-to-Partnership Conversions


➢ Mechanics• Transfer assets

• Assets-up• Assets-over• Interests-over

• Revoke S-election and check-the-box election of non-corporate entity

• State law conversion of S-corporation to noncorporate entity• Revokes S-election • Revokes check-the-box election

➢ Tax Consequences• Constructive liquidation• Follow the assets

Assets-Up Conversion

Office

S-Corporation

A B C

1/3 Office

1/3 Office

1/3 Office

1/3 Office 1/3

Office1/3

Office

1

2

Office

LLC


Following Assets-Up Conversion

Office

A B C

LLC


Tax Consequences of Assets-Up Conversion


➢ Distribution is liquidating distribution• Entity-level gain*

➢ Distribution is redemption of shareholder interests• Gain to shareholders on receipt of interests in Office*• Shareholders take fair-value basis interests in Office

➢ Shareholders enter chain of title

➢ Contribution to LLC should be tax-free• LLC takes fair-value basis in Office

*Assume facts from examples above

Assets-Over Conversion

Office

S-Corporation

A B C

1

2

Office

Office

1/3 LLC

1/3 LLC

1/3 LLC

LLC


Following Assets-Over Conversion

Office

A B C

LLC


Tax Consequences of Assets-Up Conversion


➢ Contribution to new LLC can be tax free• LLC takes carryover basis in Office

➢ Distribution is a liquidating distribution• Entity-level gain*• Shareholders take fair-value basis in distributed LLC interests

➢ Distribution is redemption of shareholder interests• Gain to shareholders on receipt of distributed LLC interests*

➢ Shareholders do not enter chain of title

➢ Asset basis• Outside basis = fair value• Inside basis = carryover basis• 754 election = inside basis step-up?

*Assume facts from examples above

Interests-Over Conversion—Step 1

Office

S-Corporation

A B C

LLC

1/3S-Corp 1/3

S-Corp 1/3S-Corp


Interests-Over Conversion: Step 2

Office

S-Corporation

A B C

LLC


Tax Consequences of Interests-Over Division


➢ Contribution of interests to LLC is tax-free• LLC takes shareholders’ carryover bases in contributed

stock

➢ Distribution of Office is a liquidating distribution• Entity-level gain*

➢ Distribution is redemption of LLC’s interest in S-Corporation• Gain to LLC on distribution of Office*• LLC takes fair-value basis in Office

*Assume facts from example above

Conversion to Partnership by Revocation of Election


➢ Non-corporate entity • Partnership by default• Can elect to be corporation—check-the-box election• Can elect to be S-corporation

➢ Revocation of S-election and check-the-box election• Constructive conversion to partnership

➢ Constructive conversion • Treated as assets-up conversion

• Entity-level gain on deemed distribution

• Shareholder gain on deemed redemption

Inadvertent S-Corporation Conversion to Partnership


➢ Shareholders wish to divide S-corporation as drop-and-swap

➢ Form LLCs to hold respective interests

➢ Transfer of property to the LLCs is a liquidation of S-corporation or conversion to tax partnership• If form is ambiguous, assets-up conversion

• All forms trigger gain

S-Corporation Divisions


• A, B, and C are equal members• A, B, and C wish to sell Office 2• C wishes to reinvest individually• A and B wish to retain Office 1 and potentially do

something with it later

Potential Division-Exchange Scenario

A B C


Fair Value $300,000







Fair Value $900,000





Distributing, Inc.

Office 1 Office 2

Corporate Split-Off

A B C


Office 1

A B C

Office 2

Controlled 2 Corp.

Step 2

Step 1

Distributing, Inc.

Controlled 2 Stock

Office 1

Controlled 2 Corp.

Office 2

Before/Split-Off After

Distributing, Inc.

Corporate Split-Up

A B C


Office 1

A B C

Office 2

Controlled 1 Corp.

Controlled 2 Corp.

Step 2

Step 1

Distributing, Inc.

Controlled 1 Stock

Controlled 2 Stock

Controlled 1 Corp.

Office 1

Controlled 2 Corp.

Office 2

Before/Split-Up After

Tax Aspects of Tax-Free Corporate Division


➢ Division is tax- free

➢ Members can retain their basis in stock of resulting entity

➢ Corporate assets retain tax attributes in resulting entity

➢ Consider whether division re-apportions gains and losses

Tax-Free Corporate Division


➢ Requirements. IRC § 355(a).

1. Distributing must distribute solely stock of a controlled subsidiary

2. Distributing must distribute

• All stock, or

• Controlling interest

3. Not used principally as a device to distribute E&P

• Device factors

• Nondevice factors

4. Satisfies the active trade or business requirement

5. Has a corporate business purpose

6. Satisfies continuity of business enterprise

7. Satisfies continuity of proprietary interest

Tax-Free Corporate Division—Device Test


➢ Device Factors. Presence of factors is evidence of device. Treas. Reg. § 1.355-2(d)(2).

• Pro rata distributions

• Subsequent sale or exchange of stock

o Agreed or negotiated before distribution = substantial evidence of device

o Not agreed or negotiated before = evidence of device

• Nature and use of assets immediately after the transaction

• Assets not used in T or B (cash, other liquid assets not related to reasonable needs of T or B)

• Assets of one of resulting entities are (1) secondary business of other entity and (2) can be sold without adversely affecting business of other corp.

Tax-Free Corporate Division—Device Test


➢ Non-Device Factors. Presence of factors is evidence of nondevice. Treas. Reg. § 1.355-2(d)(3).

• Corporate business purpose

o Need strong business purpose to overcome device factors

• Distributing corporation publicly traded or widely held

• Distribution to domestic corporation that qualifies for the dividend deduction

Tax-Free Corporate Division—Active Business Requirement


➢ Application of section 355(b)• Distributing and controlled corporation

engaged in active conduct of trade or business immediately following distributionor

• Distributing owned only two or more controlled and immediately after distribution both controlled entities engaged in active conduct of trade or business

➢ Active conduct of trade or business

• Engaged in active conduct

• Conducted throughout 5-year period preceding division

• Trade or business not acquired directly or indirectly in a taxable transaction

➢ Did distributing corporation hold exchange property and other properties for use in the active conduct of a trade or business?

Tax-Free Corporate Division—Corporate Business Purpose


➢ Division must have one or more corporate business purposes. Treas. Reg. § 1.355-2(b)• Motivated, in whole or in part, by one or

more corporate business purposes• Corporate business purpose: real and

substantial non-Federal tax purpose germane to the business ofo Distributing corporationo Controlled corporationo The affiliated group

• Shareholder purpose generally not a corporate business purpose, unless coextensive with corporate purpose

• Corporate business purpose can be evidence that division was not a device

➢ Is purpose of division more than to facilitate exchange?

Tax-Free Corporate Division—Continuity of Business Enterprise


➢ Continuity of business enterprise requires the business to continue following the division. Treas. Reg. §1.355-1(b)

➢ Must continue the business after division

➢ Must use significant portion of assets. Teas. Reg. § 1.368-1(d).

➢ Does an exchange of rental property affect requirement? T.A.M. 9252001 (allowing midstream tax-free reorg and section 1031 exchange)

➢ If one entity does not complete exchange, division is not tax-free

➢ Would a split-up or split-off of TIC interests satisfy requirement?

Tax-Free Corporate Division—Continuity of Proprietary Interest


➢ Continuity of proprietary interest. Treas. Reg. § 1.355-2(c)• Division must effect only a

readjustment of continuing interest in the property of distributing and controlled corporations

• One or more persons who were owners prior to the distribution must own stuck in the modified corporate forms sufficient to establish continuity of proprietary interestso No post-distribution requirement

of overlapo Does not preclude post-

distribution admission of new shareholders

➢ Not a concern if members wish to remain invested in existing or replacement property

Concurrent Ownership Structures (TICs and DSTs)


Economic Reasons for TICs and DSTs


➢ Re-investment choices for people selling real property• Stocks, bonds, other financial instruments—no Section 1031 • Real estate—if properly structured, qualifies for Section

1031 deferral

➢ Re-investment objectives• Bigger property• Better property• Passive involvement• Tax deferral

➢ TICs and DSTs allow exchangers to • Join together on a single piece of property• Sell their interests and separately enter into exchanges or

cash-out of investments

Typical Real Estate Re-Investment Alternatives


➢ Rental house or shopping center• Qualifies for Section 1031 treatment• Same type of property as previously owned• Probably requires active involvement

➢ REITs • Lose Section 1031 treatment• UPREIT for high-quality relinquished property

➢ LPs/LLCs• Lose Section 1031 treatment

➢ TICs and DSTs• May provide opportunity to do Section 1031

exchange

Legal Reasons for TICs and DSTs


➢ Section 1031 only applies to real property• Interests in properly structured TICs and DSTs are

interests in real property

➢ Partnership and LLC interests are not real property• Interests in poorly structured TICs and DSTs can be

partnership interests

➢ Cannot directly exchange into or out of partnership and LLC interests

Fundamental Legal Questions


➢ Is a TIC a default partnership or a TIC?• Answer turns on the definition of tax partnership

• Arrangement is a TIC, if it is not a tax partnership

• Federal-tax question, not a state-law question

• Tenants-in-common own interests in the underlying property

➢ Is a DST a business trust or an investment trust?• DST is a separate entity for tax purposes

• DST with multiple members is partnership or investment trust

• Investment trusts are disregarded for tax purposes

• Beneficiaries of investment trusts are treated as owning interests in trust property

structuring 1031 like-kind exchanges: revisiting real...

Documents