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1 FEDERAL INCOME TAXATION OF REAL ESTATE TRANSACTIONS THE NEW ENGLAND GRADUATE ACCOUNTING STUDIES CONFERENCE, INC. JUNE 20, 2013 PRESENTED BY: F. MOORE MCLAUGHLIN, IV, ESQ., CPA 148 WEST RIVER STREET SUITE 1E PROVIDENCE, RHODE ISLAND 02904 [401] 421-5115 MMCLAUGHLIN@MCLAUGHLINQUINN.COM WWW.MCLAUGHLINQUINN.COM 1 [877] 395-1031 WWW.ALLSTATES1031.COM
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Page 1: FEDERAL INCOME TAXATION OF REAL ESTATE TRANSACTIONS …

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FEDERAL INCOME TAXATION OF REAL ESTATE

TRANSACTIONS

THE NEW ENGLAND GRADUATE ACCOUNTING STUDIES

CONFERENCE, INC.

JUNE 20, 2013

PRESENTED BY:

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

148 WEST RIVER STREET – SUITE 1E

PROVIDENCE, RHODE ISLAND 02904

[401] 421-5115

[email protected]

WWW.MCLAUGHLINQUINN.COM

1 [877] 395-1031

WWW.ALLSTATES1031.COM

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FEDERAL INCOME TAXATION OF REAL ESTATE TRANSACTIONS JUNE 20, 2013

F. MOORE MCLAUGHLIN, IV, ESQ., CPA MCLAUGHLIN & QUINN, LLC

TABLE OF CONTENTS

1. PRIMER ON CANCELLATION OF INDEBTEDNESS INCOME

2. CANCELLATION OF INDEBTEDNESS INCOME: UPDATES

3. SECTION 1031 EXCHANGES

4. SECTION 1031 EXCHANGES: UPDATES

5. REAL ESTATE PROFESSIONALS

6. SELF-DIRECTED IRAS

7. SELF-DIRECTED IRAS: UBIT

8. SELF-DIRECTED IRAS: UPDATES

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PRIMER ON CANCELLATION

OF INDEBTEDNESS INCOME

June 20, 2013

Presented By:

F. Moore McLaughlin, IV, Esq., CPA

148 West River Street – Suite 1E

Providence, Rhode Island 02904

[401] 421-5115

[email protected]

www.mclaughlinquinn.com

1 [877] 395-1031

www.AllStates1031.com

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I. Introduction

A. Almost every form of gross income required to be included under Section

61 entails the receipt of money, property or services of value. The

requirement that a debtor pay taxes when a loan goes unpaid is one of only

a few situations in which a tax obligation arises without the

contemporaneous receipt of valuable consideration. That the debtor must

pay taxes in the year in which it is determined that a loan will not be

repaid follows from the proposition that a borrower is not required to

include loan proceeds in gross income upon receipt and thus not required

to pay taxes at that time.

B. If the loan transaction is viewed as a whole, when a borrower receives

money in a loan transaction and is later discharged from the liability

without repaying the debt, the borrower has realized an accession to

wealth. Recognizing the existence of income in this situation generally is

not a problem for the income tax system. The receipt of the proceeds of a

loan is not income because the receipt is offset by an obligation to repay

the borrowed amount. If the obligation to repay the borrowed amount is

eliminated or reduced without the concomitant repayment, the borrower

realizes an accession to wealth that, as a matter of tax theory, should be

included in gross income. See, Commissioner v. Tufts, 461 U.S. 300

(1983).

1. If borrowed money is used to acquire property, the taxpayer's basis

in the property under Section 1012 is the full purchase price,

including the borrowed funds applied to the purchase price.

2. The same principles apply whether the loan is a recourse loan or a

nonrecourse loan. No gross income is realized upon the receipt of

the proceeds of a nonrecourse loan, even if the amount of the loan

exceeds the basis of the property. And, if the acquisition of

property is financed through nonrecourse borrowing, the taxpayer

generally acquires a normal Section 1012 cost basis in the debt-

financed property.

II. General Rules

A. Section 61(a)(12) requires a taxpayer who renegotiates the amount of the

debt owed or is otherwise able to discharge the debt for less that its

original amount must recognize gross income, subject to the various

exclusions and special rules under Section 108. Section 61(a)(12) is a

PRIMER ON CANCELLATION OF INDEBTEDNESS INCOME

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

JUNE 20, 2013

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codification in 1954 of the decision in the Kirby Lumber case. See United

States vs. Kirby Lumber Co., 284 U.S. 1 (1931).

1. COD income includes any discharge of debt in exchange for cash,

new debt or significantly modified debt, or for an interest in a

partnership, LLC or corporation with a value less than the

outstanding face amount of the debt.

B. Recourse vs. Nonrecourse

1. Nonrecourse - Lender's only recourse for repayment is the asset

securing the loan; Lender has full risk of loss

a. If a nonrecourse debt secured by real estate or other

property is compromised for less than its principal amount

and the borrower retains ownership of the property, the

entire amount of the cancelled portion of the debt is

realized as COD income, without regard to the value of the

released collateral, unless the lender also sold the property

to the taxpayer.

b. If property subject to a nonrecourse debt is deeded to the

lender in lieu of foreclosure, the entire amount of the

nonrecourse debt is included in the amount realized on the

sale of the property, even if the debt exceeds the FMV of

the property at the time of the transfer.

(1) If the FMV of the property exceeds the amount of

the non-recourse debt, the amount realized is the FMV of

the property.

c. The transfer of property subject to a nonrecourse debt that

is deeded to the lender in lieu of foreclosure is accorded the

same treatment as a transfer of the property to a third party

who merely takes the property subject to the debt.

d. An actual foreclosure proceeding involving a nonrecourse

debt will result in a taxable disposition, similar to the deed

in lieu of foreclosure scenario described above.

2. Recourse - Lender can pursue a judgment for a deficiency against

the borrower personally; i.e. the lender may go after borrower's

other assets

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a. If the mortgage on the property is with recourse,

foreclosure can result in a combination of capital gain or

loss and COD income.

b. COD income is measured as the excess of the debt over the

FMV of the property transferred from the taxpayer to the

creditor in partial satisfaction of the mortgage.

c. The repossession of a property by the lender in a mortgage

foreclosure is a taxable disposition. Gain from the

disposition of property is the excess of the amount realized

on the sale over the asset's adjusted basis, with loss being

the excess of the asset's adjusted basis over the amount

realized. In the case of a foreclosure of a recourse

mortgage, the amount realized is deemed to be the

property's FMV(presumed to be the sale price at the

foreclosure sale)

C. When has a debt been cancelled?

1. Reduction of amount due

a. In many cases, the taxpayer may find that the lender has

significant pressure to reduce its exposure to real estate and

is willing to restructure the debt to provide more favorable

terms, including a reduction in the principal balance of the

debt.

2. Significant modification of debt instrument

a. Any significant modification of existing debt or

replacement of new debt for an old debt is deemed a

discharge of debt for an amount equal to the issue price of

the new debt, determined in accordance with original issue

discount and imputed principal rules of section 1273 and

1274.

3. Acquisition of debt by a related party– Section 108(e)(4)

a. A debtor is treated as acquiring its own debt if such debt is

acquired by persons related to the debtor.

b. Whether or not the person is “related” to the debtor is

determined under section 267(b) and 707(b)(1) with a

modified definition of “family.”

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c. The debt may be acquired directly by a related person or

“indirectly” in a transaction in which a holder of the debt

becomes related to the debtor after having acquired the debt

in anticipation of becoming related to the debtor.

(1) Although whether a debt was acquired by a holder

in anticipation of becoming related to the debtor is

generally a question to be determined based on the

facts and circumstances, debt is deemed to be

acquired in anticipation of becoming related to the

debtor if the holder of the debt acquired the debt

less than six months before becoming related to the

debtor.

4. Lapse of creditor's rights/Expiration of Statute of Limitations

a. The debtor realizes COD income if a debt becomes

unenforceable by operation of law.

5. Compromise of disputed liabilities

a. Settlement of a claim does not result in realization of COD

income if there is a bona fide dispute regarding the debtor’s

liability for the amount claimed by the creditor. In such a

case, the amount of the debt is viewed ab initio as whatever

amount the parties agree upon or a tribunal determines is

the amount due.

b. Recognize the fact that a debt was compromised, standing

alone, does not establish the existence of a dispute over its

amount or validity. To successfully involve the disputed

debt doctrine, the taxpayer must introduce direct evidence

that he disputed the debt with the creditor in reaching the

compromise.

6. Transfer of property

a. If a debtor transfers property to satisfy a recourse debt

owed to the transferee, the transfer is treated as a sale or

exchange of the property. The debt is included in the

amount realized under Section 1001. The debtor-transferor

realizes either a gain or a loss, as long as the FMV of the

property transferred is at least equal to the amount of the

debt satisfied.

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7. Compromise of loan guarantees

a. Generally, COD income is not recognized by a guarantor

when the obligation is reduced or satisfied for less than full

value.

b. When a loan is satisfied by a guarantor, the primary obligor

can realize COD income. However, if the guarantor has a

right of subrogation, the primary obligor does not realize

COD income until the resulting obligation to the guarantor

is cancelled or compromised.

D. Determination of the amount of COD income

1. If the debt is simply discharged in exchange for a cash payment of

less than the full amount of the debt, the amount of the COD

income is easily determined. - it is the amount by which the debt

exceeds the cash payment.

2. Debt-for-debt exchanges

a. When a debtor gives new debt in satisfaction of old debt,

the debtor realizes no COD income if the new debt is

equivalent to the old debt. However, COD income arises

when the new debt is less than the old debt.

3. Conversion of Debt into Equity

a. Corporate debtor – If a corporation acquires its debt from a

shareholder as a contribution to capital (as opposed to in

exchange for additional equity in the corporation), the

corporation is treated as satisfying the debt with an amount

of money equal to the shareholder’s basis in the debt.

Section 108(e)(6)

b. Partnership debtor – If a debtor partnership transfers an

interest in capital or profits to a creditor in satisfaction of

an indebtedness, the partnership will be treated as having

satisfied the indebtedness for an amount of money equal to

the fair market value of the interest. The partnership will

then recognize discharge of indebtedness income to the

extent that the indebtedness exceeds the fair market value

of the interest transferred. The income will be included in

the distributive shares of the partners to the extent that they

were partners immediately before the discharge.

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Under regulations effective for debt-for-equity exchanges

occurring after November 17, 2011, the value of the

partnership interest transferred in partial or total

consideration of debt will be the liquidation value of the

interest (meaning the amount the recipient of the interest

would receive if, immediately after the transfer, the

partnership sold all assets for cash at fair market value).

However, the liquidation value will only be allowed if (1)

the creditor, partnership and individual partners treat the

fair market value of the indebtedness as being equal to the

liquidation value of the interest in determining the tax

consequences of the exchange, (2) if the debtor partnership

transfers more than one debt-for-equity interest to one or

more creditors as part of the same overall transaction, each

creditor, debtor partnership, and its partners treat the fair

market value of each debt-for-equity interest transferred as

equal to its liquidation value, (3) the exchange is an arm's

length transaction, and (4) after the exchange, there is no

redemption or purchase by a related party of the interest

meant to avoid income from the cancellation of

indebtedness. If the exchange fails one of these four

requirements, all facts and circumstances will be

considered in determining the value of the interest.

III. Exclusions

A. Bankruptcy - Section 108(a)(1)(A) excludes from the debtor's gross

income any amount that would otherwise be includible as COD income by

reason of the discharge of the taxpayer's indebtedness if the discharge

occurs in a bankruptcy case, provided that the taxpayer is under the

jurisdiction of the court and the discharge is granted either by the court or

pursuant to a plan approved by the court.

1. The exclusion of COD income is allowed when the discharge

occurs in a Title 11 case. Title 11 refers to Title 11 of the U.S.

Code and is also known as the Bankruptcy Code. There are

different types of bankruptcies available to entities and individuals,

which are typically referred to by the chapter outlining the

provisions of each type (e.g. Chapter 7, 11 or 13) Don't confuse

Title 11 with Chapter 11.

B. Insolvency - Section 108(a)(1)(B) excludes COD income realized while

the debtor is insolvent, as defined by Section 108(d)(3).

1. Insolvency is defined as the excess of the taxpayer's liabilities over

the FMV of the taxpayer's assets immediately prior to the

cancellation or discharge.

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a. Taxpayer's assets includes assets exempt from creditors

under state law, such as pension plans and retirement

accounts (401(k)s, IRAs and others).

b. If the taxpayer is engaged in a trade or business, the value

of all of the taxpayer's intangible assets, such as goodwill

and going concern value of the business, must be included

in the calculation.

2. Contingent or uncertain liabilities are not taken into account.

a. Taxpayer bears burden of proving that liabilities qualify.

At least one case has used the "more likely than not" test in

determining whether the taxpayer is liable for a debt in

making the insolvency determination.

b. While assets are to be valued at their FMV, no such

language is found with respect to liabilities.

3. Insolvency is determined immediately prior to the COD.

4. This exclusion is limited to the amount by which the taxpayer is

insolvent. Thus, any COD income in excess of the taxpayer's

insolvency must be included in the taxpayer's gross income.

C. Qualified Real Property Business Indebtedness - Section 108(a)(1)(D)

1. Sections 108(a)(1)(D) and 108(c) allow non-C corporation

taxpayers to elect to exclude income arising from cancellation of

"qualified real property business indebtedness." ("QRPBI")

a. This election is made by checking box 1d on Form 982.

b. Generally, the effect of the exclusion for discharged

QRPBI is to give an eligible taxpayer, not in bankruptcy or

insolvent, an election to reduce the basis of depreciable real

property by the amount of discharged qualified real

property business indebtedness, in lieu of recognizing

income.

2. QRPBI is indebtedness incurred in connection with, and secured

by, real property used in a trade or business (including the business

of operating and managing the property).

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3. The exclusion is limited to the amount by which QRPBI exceeds

the FMV of property secured by the debt.

4. Section 108(c)(2)(B) further limits the amount of the exclusion to

the aggregate adjusted basis of depreciable real property held by

the taxpayer immediately before the cancellation.

5. QRPBI includes only:

a. Debt incurred or assumed by the taxpayer before 1993 "in

connection with" real property used by the taxpayer in a

trade or business and secured by the real property; and

b. Debt incurred or assumed after 1992 to acquire, construct,

reconstruct, or substantially improve the property secured

by the debt or to refinance pre-1993 indebtedness to the

extent the refinancing does not exceed the original debt.

6. QRPBI includes indebtedness resulting from the refinancing of

QRPBI, but only to the extent that the refinanced indebtedness

does not exceed the indebtedness being refinanced.

7. If the taxpayer elects to apply the QRPBI exception, the taxpayer

must reduce the basis of depreciable real property by the excluded

amount under the rules of Section 1017.

a. The basis reduction occurs at the beginning of the taxable

year following the year of the debt cancellation.

b. Basis reduction must first be applied to the property

securing the debt that is discharged.

c. QRPBI does not have to secure depreciable property, only

real property used in a trade or business, which can include

land.

8. If the cancelled debt is partnership debt, section 108(d)(6) requires

that the QRPBI exception and the concomitant attribute reduction

rules be applied at the individual partner level, rather than at the

partnership level.

9. In the case of an S corporation, the QRPBI exception and the

concomitant attribute reduction rules are applied at the corporate

level.

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D. Purchase price adjustment - Section 108(e)(5)

1. This exclusion is reserved for a purchaser of property who, as a

result of the purchase, owes a debt to the seller. If that debt is

subsequently reduced for reasons other than bankruptcy or

insolvency, the reduction is treated as a purchase price adjustment.

a. This provision allows an individual to adjust the basis of

his or her property rather than recognize an immediate gain

as COD.

b. The purchaser’s basis in the property is reduced by the

amount of the purchase price adjustment.

E. Qualified Principal Residence Indebtedness - Section 108(a)(1)(E)

1. Section 108(a)(1)(E), which was added by the Mortgage

Forgiveness Debt Relief Act of 2007 and amended by the

Emergency Economic Stabilization Act of 2008, excludes from

gross income the cancellation of "qualified principal residence

indebtedness" ("QPRI") if the cancellation occurs on or after

January 1, 2007 and before January 1, 2013.

2. QPRI is limited to acquisition indebtedness with respect to a

taxpayer's principal residence that does not exceed $2,000,000 for

married couples filing joint returns and $1,000,000 for other

taxpayers.

3. Section 108(a)(1)(E) does not apply to

a. Indebtedness on a home that is not the taxpayer's residence,

or

b. Home equity indebtedness

4. The definition of QPRI has three parts:

a. The debt was used to acquire, construct or substantially

improve a residence,

b. The debt is secured by that residence,

c. The residence is used by the borrower as his or her

principal place of abode for two out of the most recent five

years.

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5. Section 108(a)(1)(E) applies only if the debt cancellation was on

account of either

a. A decline in the value of the home, or

b. The taxpayer's financial condition.

6. The taxpayer's basis in the residence must be reduced by the

excluded amount.

a. This basis reduction will not result in any subsequent

income recognition as long as the taxpayer does not dispose

of the residence; and even if the taxpayer does sell the

residence, the taxpayer could exclude all or part of the

realized gain under section 121.

7. If only a portion of the cancelled debt is QPRI, the exclusion

applies only to the extent that the cancelled debt exceeds the

portion of the debt that is not QPRI.

8. If both the QPRI exclusion and the insolvency exclusion apply, the

QPRI exclusion applies, unless the taxpayer elects to apply the

insolvency exception.

F. Deductible Debt - Section 108(e)(2)

1. There is no income from cancellation of deductible debt. For

example, if a lender cancels home mortgage interest that could

have been claimed as an itemized deduction on Schedule A of

Form 1040, there is no income.

IV. Reduction of Tax Attributes

A. When COD income is excluded under Section 108(a)(1), the taxpayer is

required to reduce certain tax attributes by the amount of the income

excluded under Section 108. Thus, to the extent tax attributes are reduced,

section 108(a)(1)(A) and (B) operate only to defer tax liability, rather than

as an absolute exclusion.

B. Section 108(b)(2) requires the taxpayer to reduce favorable tax attributes

in the following order:

1. Net operating losses - 108(b)(2)(A)

2. General business credit carryovers - 108(b)(2)(B)

3. Minimum tax credits - 108(b)(2)(C)

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4. Net capital loss carryovers - 108(b)(2)(D)

5. Basis of property - 108(b)(2)(E)

6. Passive activity loss and credit carryovers - 108(b)(2)(F)

7. Foreign tax credit carryovers - 108(b)(2)(G)

C. The affected tax attributes are reduced dollar-for-dollar for COD income,

except for credits which are reduced by one-third of excluded COD

income.

D. If the amount of excluded COD income cannot be absorbed by the

taxpayer's tax attributes, the excess is effectively exempt from tax.

E. In lieu of the attribute reductions mandated by section 108(b)(2), the

taxpayer may elect under Section 108(b)(5) to first reduce the basis of

depreciable property.

1. A basis reduction under Section 108(b)(2)(E) attributable to COD

income excluded under Section 108(a) can apply to property that is

not depreciable.

F. Section 1017 and the regulations thereunder provide the rules regarding

basis reductions.

V. Election to defer COD Income - Section 108(i)

A. The American Recovery and Reinvestment Tax Act of 2009 added section

108(i), which allows a taxpayer to irrevocably elect to defer and include

COD income realized during 2009 and 2010 ratably over five years, rather

than in the year the discharge occurs, if the debt was issued in connection

with the conduct of a trade or business or by a corporation.

1. Under the section 108(i) election, income from debt cancellation in

2009 is recognized beginning in the fifth taxable year following the

debt cancellation; the income is recognized ratably in each of 2014

through 2018. Income from debt cancellation in 2010 is

recognized beginning in the fourth taxable year following the debt

cancellation; the income is recognized ratably in each of 2014

through 2018.

B. Although the statute refers to COD income arising from "reacquisition" of

an "applicable debt instrument," the statutory definitions of "reacquisition"

and "applicable debt instrument," respectively, are broad enough for the

provision to apply regardless of the manner in which the debt is cancelled.

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C. "Acquisition" is defined to include:

1. An acquisition of the debt instrument for cash,

2. The exchange of the debt instrument for another debt instrument,

including an exchange resulting from a modification of the debt

instrument (which includes a reduction of the principal amount of

the debt),

3. The exchange of the debt instrument for corporate stock or a

partnership interest,

4. The contribution of the debt instrument to capital, and

5. The complete forgiveness of the indebtedness by the holder of the

debt instrument.

D. The term "acquisition" also includes an acquisition of the debt instrument

for other property.

1. For example, the cancellation of debt in connection with a deed in

lieu of foreclosure qualifies as a reacquisition.

E. "Applicable debt instrument" is broadly defined to include a bond,

debenture, note, certificate, or any other instrument or contractual

arrangement constituting indebtedness within the meaning of section

1275(a).

1. An "applicable debt instrument" is defined in Section 108(i)(3) as

any debt instrument issued by a C corporation or by any other

person in connection with the conduct of a trade or business by

such person.

a. There is no guidance in either the Code or the legislative

history as to the meaning of a "trade or business" for

purposes of this provision, but presumably this would

include debt issued in connection with the acquisition of

depreciable rental real estate. It is unclear, however,

whether the rental of undeveloped land will qualify as a

"trade or business" for purposes of Section 108(i).

F. The section 108(i) election is made separately for each debt instrument

and is irrevocable.

1. The election must be made on the tax return filed for the year in

which the reacquisition of the debt instrument occurred and must

(1) clearly identify the debt instrument and (2) set forth the amount

of income being deferred.

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2. An election may be made for one debt instrument, but not for

another.

G. A taxpayer may elect to defer only a portion of the COD income from the

reacquisition of any applicable debt instrument.

1. Any COD income that the taxpayer does not elect to defer may be

excluded from income under section 108(a)(1)(A), (B), (C) or (D),

if applicable.

H. For partnerships and S corporations, the election is made by the

partnership or S corporation, not by the individual partners or

shareholders.

1. If a partnership elects to defer less than all of the COD income

realized from the reacquisition of an applicable debt instrument,

the partnership may allocate among the partners, in any manner,

a. The deferred COD income and the COD income that is not

deferred,

b. The portion, if any, of each partner's COD income amount

that is deferred, and

c. The portion, if any, of each partner's COD income amount that

is not deferred.

2. For example, all of one partner's share of COD income can be

deferred while none (or only part) of another partner's share of

COD income is deferred.

3. Any portion of a partner's share of COD income that is not

deferred may be excluded under section 108(a)(1)(A), (B), (C) or

(D), if applicable.

4. Two sets of Temporary Regulations concern the application of

Section 108(i) to (1) partnerships and S corporations (TD 9498,

8/11/10; also issued as Proposed Regulations (REG-144762-09))

and (2) other corporations (TD 9497, 8/11/10; also issued as

Proposed Regulations (REG-142800-09)).

a. The new guidance addresses three questions raised by the

statutory language that apply to both partnerships and S

corporations:

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When is a debt instrument issued by a partnership

or an S corporation issued in connection with a

trade or business? (If a debt instrument is not so

issued, it cannot be an "applicable debt instrument"

eligible for deferral under Section 108(i))

How is deferred OID determined by an entity?

How does Section 108(i) relate to the at-risk rules

under Section 465?

I. If a taxpayer elects to defer COD income under section 108(i), the section

108(a) exclusions for bankruptcy, insolvency and qualified real property

business indebtedness do not apply to the year of the election or any

subsequent year. Thus, the election cannot be used to move the year of

inclusion to a year in which it is expected that one of those exclusions

might apply. Once the election is made, inclusion is inevitable.

J. Deferred recognition is accelerated in to the year of death of an individual

taxpayer, the liquidation or termination of a business entity, the year of

sale of substantially all of the assets of the taxpayer, or the cessation of the

taxpayer's business.

1. The acceleration rule also applies in the event of a sale, exchange

or redemption of an interest in a partnership or S corporation by a

partner or shareholder.

K. Potential issues to consider in making the election to defer

1. The interplay with pre-ARRA COD income relief

2. The impact of the applicable high-yield debt obligation regime

3. The impact on a corporation’s earnings and profits

4. The impact of a transfer of substantially all of the assets of an

electing corporation to a successor entity

L. Rev. Proc. 2009-37 provides the exclusive procedures for electing to defer

COD income under Section 108(i), including the time and manner for

making the election and specific procedures for partnerships, S

corporations, and tiered pass-through entities and foreign entities.

1. The general rule stated in Rev. Proc. 2009-37 is that a taxpayer

makes the election by attaching a statement (described below) to

the taxpayer's timely filed (including extensions) original tax

return for the tax year in which the reacquisition of the applicable

debt instrument occurs. Nevertheless, in section 4.01(2) of the

Procedure the IRS added an additional 12-month automatic

extension from the due date set forth in section 4.01(1), using the

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rules applicable to an automatic extension under Reg. 301.9100-

2(a).

M. Rhode Island Treatment of COD Income Deferral

1. Rhode Island does not conform to the provision of the American

Recovery and Reinvestment Act of 2009, which adds IRC §108(i)

by giving taxpayers an election to have debt discharge income

from the reacquisition of an applicable debt instrument at a

discount in 2009 and 2010, included in gross income ratably over

five tax years, effective for reacquisitions after December 31,

2008, and before January 1, 2011.

2. Effective June 30, 2009, Rhode Island requires the recognition of

income from the discharge of business indebtedness deferred under

the American Recovery and Reinvestment Act of 2009 for federal

tax purposes to be reported as a modification increasing federal

income for Rhode Island tax purposes in the year it occurred.

When claimed as income on a future federal tax return, it may be

reported as a modification decreasing federal income for Rhode

Island tax purposes to the extent it had been added back. [R.I. Gen.

Laws §44-67-1.]

N. Massachusetts Treatment of COD Income Deferral

1. Effective for discharges in taxable years ending after December 31,

2008, Massachusetts decouples from Section 108(i) for

Massachusetts corporate excise tax purposes. For Massachusetts

personal income tax purposes, it follows Section 108(i) as

amended and in effect on January 1, 2005 and does not adopt the

new Section 108(i) provision allowing an exclusion from gross

income for COD income from the reacquisition of business debt as

a discount. Consequently, for corporate excise and the personal

income tax purposes, a taxpayer that makes the federal election

allowed by Section 108(i) is required to add back to gross income

any COD income that is deferred under Section 108(i). In future

years when the deferred COD income is recognized for federal

purposes, the taxpayer is allowed to make a corresponding

subtraction, since the recognition event will have already taken

place for Massachusetts tax purposes.

VI. COD Income and S Corporations

A. In the case of S corporations, the insolvency and bankruptcy exceptions in

Section 108(a) are applied at the corporate level.

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B. Section 108(d)(7) provides that amounts excluded under Section 108(a)

will not be taken into account as a separately stated item of tax exempt

income under Section 1366(a)(1)(A). As a result, the S corporation's

shareholders do not receive any step-up in the basis of their shares under

Section 1367.

VII. COD Income and Partnerships

A. Section 108(d)(6) requires that the bankruptcy and insolvency exception to

COD income be applied at the individual partner level rather than at the

partnership level.

1. Thus, partnership COD income is a separately stated item under

Section 702(a).

B. COD income realized by an insolvent or bankrupt partnership or LLC may

be excluded only by those partners that are themselves insolvent and the

attribute reduction rules of Section 108(b) are applied at the individual

partner level.

C. If a partnership realizes COD income, it is income that is allocated to the

partners as part of the partners’ distributive shares of income in

accordance with the partnership agreement.

D. The cancellation of the partnership debt giving rise to the COD income

will also result in a decrease in the share of partnership liabilities of each

partner to whom the debt was allocated.

VIII. COD Income and Grantor Trusts and Disregarded Entities

A. On April 12, 2011, the IRS issued proposed regulations that would

provide guidance in applying the Section 108 bankruptcy and insolvency

exclusions for COD income to grantor trusts and disregarded entities.

Specifically, the proposed regulations would clarify the meaning of the

term “taxpayer,” as used in Section 108, with regard to a grantor trust or a

disregarded entity.

1. The regulations would apply to COD income occurring on or after

the date they are published as final regulations.

B. The proposed regulations would provide that, for purposes of applying

Section 108(a)(1)(A) and Section 108(a)(1)(B) to discharge of

indebtedness income of a grantor trust or a disregarded entity, the term

“taxpayer,” as used in Section 108(a)(1) and Section 108(d)(1) through

Section 108(d)(3), refers to the owner(s) of the grantor trust or disregarded

entity. The proposed regulations clarify that, subject to the special rule for

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partnerships under Section 108(d)(6), the insolvency exception is available

only to the extent the owner is insolvent, and the bankruptcy exception is

available only if the owner of the grantor trust or disregarded entity is

subject to the bankruptcy court's jurisdiction. Further, the proposed

regulations would provide that grantor trusts and disregarded entities

themselves will not be considered owners for this purpose.

C. In addition, the proposed regulations would provide that in the case of a

partnership, the owner rules would apply at the partner level to the

partners of the partnership to whom the discharge of indebtedness income

is allocable.

1. For example, if a partnership holds an interest in a grantor trust or

disregarded entity, the applicability of Section 108(a)(1)(A) and

Section 108(a)(1)(B) to COD income of the grantor trust or

disregarded entity is tested by looking to the partners to whom the

income is allocable. If any partner is itself a grantor trust or

disregarded entity, the applicability of Section 108(a)(1)(A) and

Section 108(a)(1)(B) is determined by looking through the grantor

trust or disregarded entity to the ultimate owner(s) of the partner.

IX. Reporting Requirements (Forms 982, 1099-C, 1099-A)

A. Form 982 must be filed with a taxpayer's tax return when the taxpayer has

excludable COD income for a tax year.

1. Form 982 provides the taxpayer with the opportunity to classify the

excludable COD income as well as to designate the amount and the

resulting tax attributes of such exclusion.

B. When a federal agency, financial institution, credit union, finance

company or credit card company cancels or forgives a taxpayer's debt of

greater than or equal to $600, the taxpayer will receive Form 1099-C,

"Cancellation of Debt." The amount of the cancelled debt is shown in box

2. Any forgiven interest included in the amount of cancelled debt in box 2

will also be shown in box 3.

1. An individual who does not agree with the amount shown on Form

1099-C should contact the lender in writing and request it to issue

a correct Form 1099-C showing the proper amount of cancelled

debt. Even if the lender refuses to issue a corrected report, there

still may be recourse if the taxpayer has adequate documentation to

show that the lender incorrectly reported the amount cancelled.

C. Form 1099-A, "Acquisition or Abandonment of Secured Property," is filed

by a lender who acquires an interest in the taxpayer's property in a

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foreclosure or repossession and shows information that the taxpayer will

need to figure the gain or loss. If the lender also cancels part of the

taxpayer's debt of $600 or more as part of the transaction, that lender must

file Form 1099-C and may elect to include the Form 1099-A information

on Form 1099-C.

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CANCELLATION OF DEBT INCOME:

UPDATES

June 20, 2013

Presented By:

F. Moore McLaughlin, IV, Esq., CPA

148 West River Street – Suite 1E

Providence, Rhode Island 02904

[401] 421-5115

[email protected]

www.mclaughlinquinn.com

1 [877] 395-1031

www.AllStates1031.com

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CANCELLATION OF DEBT INCOME: UPDATES

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

JUNE 20, 2013

1. American Taxpayer Relief Act of 2012, P.L. 112-240 (Jan. 2, 2013)

The American Taxpayer Relief Act of 2012 (2012 Taxpayer Relief Act) provides

a one year extension of the exclusion from gross income applicable to "qualified

principal residence indebtedness." The exclusion now applies to discharges of

qualified principal residence indebtedness occurring on or after January 1, 2007,

and before January 1, 2014 (Code Sec. 108(a)(1)(E), as amended by the 2012

Taxpayer Relief Act).

2. McAllister v. Comm., T.C. Memo 2013-96 (Apr. 8, 2013)

An individual who borrowed money from his employer but was not required to

pay it back received cancellation-of-debt income. The IRS characterization of the

cancelled income as a constructive bonus and, therefore, compensation was

rejected. A portion of the income was excludable from gross income under Code

Sec. 108(a)(1)(B) because the taxpayer was insolvent. The amount excluded was

limited to the amount by which the taxpayer’s liabilities exceeded his assets

3. Pinn v. Comm., T.C. Memo 2013-45 (Feb. 11, 2013)

There was no cancellation of debt income in the tax years at issue during which

the taxpayers, who were owners of a construction firm, failed to repay plan loans

they took out from the firm’s welfare benefits fund.

4. Rev. Proc. 2013-16

The IRS has issued guidance for borrowers, mortgage loan holders and loan

servicers who are participating in the Principal Reduction Alternative offered

through the Home Affordable Modification Program (HAMP-PRA), a program

offered by the Departments of Treasury and Housing and Urban Development.

The IRS concluded that a HAMP modification with a PRA principal reduction is

a significant modification to the mortgage loan that results in a deemed Code Sec.

1001 debt-for-debt exchange, in which the borrower satisfies the old loan by

issuing a new one. The borrower realizes Code Sec. 108 cancellation of

indebtedness (COI) income on the exchange, equal to the excess of the adjusted

issue price of the old mortgage over the issue price of the new mortgage.

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5. Bross v. Comm., T.C. Summary Opinion 2012-122 (Dec. 26, 2012)

Taxpayers realized cancellation of indebtedness (COD) income when they agreed

to settle their debt to a credit company for less than its face value. The taxpayers

claimed that the credit card company misrepresented the terms of the financing

arrangement for the purchase of furniture; however, they agreed to the terms of

the arrangement at the time of the purchase, and the terms were included in each

monthly credit card statement. The individuals could not treat the COD as a

purchase price adjustment as the debt discharged was between them as purchasers

and a credit card company that financed the purchase. The taxpayers’ statement

that they did not receive a Form 1099-C reflecting the discharge of the debt did

not convert the income into a nontaxable item.

6. CCA 201250022

The IRS Chief Counsel, in a second response to a request for advice superseding

its previous response, ruled that a holding company was not required to recognize

cancellation of indebtedness (COD) income arising from insolvency proceedings

in which some of its insurance subsidiaries participated to the extent the

subsidiaries were insolvent.

7. PLR 201240001

A financial institution was required to file Forms 1099-C with respect to write-off

of balances and charges pursuant to its settlement agreement because the

discharge was the result of an identifiable event as listed in Reg. §1.6050P-

1(b)(2), and not by operation of state law.

8. PLR 201301013

The IRS has revoked IRS Letter Ruling 201021018 that held a discharge of

indebtedness that occurred by operation of law did not trigger the information

reporting requirements of Code Sec. 6050P. Concluding that this view was not in

accord with the current views of the IRS, the agency ruled that the discharges

occurred not by operation of state law, but as a result of an agreement by the

parties to discharge the debt. Therefore, the transaction was an "identifiable

event" under Reg. §1.6050P-1(b)(2) and the reporting requirements applied.

9. Abarca v. Comm., T.C. Memo 2012-245 (Aug. 28, 2012)

Taxpayer was not liable for discharge of indebtedness income related to the sale

of one property for which the sales proceeds were insufficient to cover the

outstanding mortgage. No Form 1099-C, Cancellation of Debt, was entered into

evidence against the taxpayer, and the letter from the financial institution that

stated that the loan had been "charged off" also stated that the taxpayer remained

"obligated for the repayment of the debt."

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SECTION 1031 EXCHANGES

June 20, 2013

Presented By:

F. Moore McLaughlin, IV, Esq., CPA

148 West River Street – Suite 1E

Providence, Rhode Island 02904

[401] 421-5115

[email protected]

www.mclaughlinquinn.com

1 [877] 395-1031

www.AllStates1031.com

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INTERNAL REVENUE CODE SECTION 1031

LIKE-KIND EXCHANGES

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

JUNE 20, 2013

I. Introduction

A. Section 1031 provides an exception from the general rule requiring the current

recognition of gain or loss realized upon the sale or exchange of property.

B. 1031 (a)(1) - no gain or loss shall be recognized on the exchange of property held

for productive use in a trade or business or for investment if such property is

exchanged solely for property of like kind which is to be held either for

productive use in a trade or business or for investment.

C. Like the other "nontaxable exchange provisions," §1031 provides an exception

only from current recognition of gain realized. The realized gain is deferred until

the "exchange property" is disposed of in a subsequent taxable transaction.

II. Statutory Requirements For Tax-Free Exchange

A. In general

1. Section 1031 provides that no gain or loss is recognized if certain

qualifying property is exchanged solely for "like-kind" property. Property

qualifying for nonrecognition is limited to "property held for productive

use in a trade or business or for investment."

2. §1031 is not subject to election or waiver.

3. The transaction need not be tax free to both parties for §1031 to apply. An

exchange may be taxable to one party and tax free to the other.

B. Relinquished Property must be held for productive use in a trade or business or

for investment

1. In general

a. Held for productive use in a trade or business

(1) Neither the Code nor the regulations define "held for

productive use in a trade or business."

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(2) Qualifying property must be used in a trade or business in

which the taxpayer is engaged.

b. Held for investment

(1) Neither the Code nor the regulations define "held for

investment" for purposes of §1031.

(2) Unproductive real estate that is held by a nondealer for

future use or future realization of the increment in value is

held for investment.

(3) The test is applied at the time of the exchange without

regard to the taxpayer's motive before the exchange.

2. Recent acquisitions

a. The words "held for" are a key element of the definition of

property qualifying for exchange under §1031. Property acquired

for an exchange is not "held for" the prescribed purpose and

cannot be exchanged tax free.

b. How long one must "hold" property before an exchange is

uncertain.

c. Neither section 1031 nor the regulations specify whether the

original property owner's qualifying purpose flows through or is

carried over to a donee or heir. The donee or heir is required to

independently qualify the property before the donee or heir can

exchange the property under section 1031.

C. The exchange requirement

1. In general

a. Ordinarily, a transaction constitutes an exchange if there is a

reciprocal transfer of property, as distinguished from a transfer of

property for money consideration only.

b. The mere intent to effectuate an exchange is not dispositive.

c. The receipt of property intended to compensate the taxpayer for his

services or the use of his property will be so characterized.

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2. Exchange of recently constructed property

a. The transfer of property in exchange for property with

improvements constructed according to the taxpayer's

specifications may qualify as an exchange.

3. Receipt of improvements on taxpayer-owned land

a. If improvements are constructed on property already owned by the

taxpayer, the transaction is unlikely to be treated as a nontaxable

exchange.

D. Relinquished Property and Replacement Property must be of like-kind

1. In general

a. The words "like kind" refer to the nature or character of the

property and not to its grade or quality. One kind or class of

property may not be exchanged under §1031 for property of a

different kind or class.

b. Not all property transferred in an exchange must be like kind.

Other property or money can also be transferred without taking the

entire transaction outside of §1031. The receipt of money or other

(non-like-kind) property causes the realized gain, if any, to be

recognized to the extent of the sum of the money and the fair

market value of the other property received. The transfer of both

like-kind property and other property in exchange solely for like-

kind property does not result in the recognition of gain to the

transferor.

2. Personal property

a. An exchange of business or investment personal property for other

such personal property clearly comes within §1031.

3. Real estate

a. The kind of real estate that can be exchanged within §1031 is

extremely broad. The fact that any real estate is improved or

unimproved is not material, for that fact relates only to the grade or

quality and not to its kind or class.

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b. Improved real estate can be exchanged for unimproved real estate.

Thus, land with buildings thereon and unimproved land are like-

kind property. Assets on land which are in the nature of real estate

can also be exchanged for real estate.

c. Real property located in the United States and real property located

outside the United States do not qualify as like-kind property.

Foreign property can be exchanged for foreign property.

d. A tenants-in-common interest may be exchanged for a fee simple

interest, and vice versa.

E. Replacement Property must be held for productive use in a trade or business or for

investment

1. Nonrecognition under §1031 is premised on the receipt of like-kind

property to be held for productive use in trade or business or for

investment.

2. Holding requirement

a. An exchange of like-kind property will qualify provided the

property received is "to be held for" productive use or investment,

which reflects the continuity of ownership concept underlying

nontaxable exchanges. How long the property received must be

held by the taxpayer is uncertain.

b. Subsequent taxable sales or exchanges

(i) An immediate subsequent taxable disposition of property in

a Section 1031 exchange is evidence that the property was

not intended to represent a continuation of the taxpayer's

investment still unliquidated.

(ii) The Code requires only that the property be acquired "to be

held." The language is addressed to the taxpayer's motives

at the time of the exchange. Subsequent events which alter

the taxpayer's motivation should not operate to disqualify a

prior completed transaction.

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c. Subsequent nontaxable transactions

(i) A transaction may not qualify under §1031 if the property

acquired is immediately disposed of in a subsequent

nontaxable transaction, particularly if the disposition is

prearranged.

(ii) The IRS will not necessarily view a transaction as outside

of §1031 merely because it is prearranged or because the

property received is disposed of shortly thereafter.

3. Replacement Property must be taken in the same name as held the

relinquished property

a. If the relinquished property is held in the name of one spouse, the

replacement property cannot be taken in the name of both spouses.

Title to the replacement property must be taken in the spouse’s

name that owned the relinquished property.

b. The IRS has ruled that title to the replacement property may be

taken in the name of a single-member LLC, which is properly

treated as a disregarded entity for federal tax purposes, even where

title to the relinquished property was in the name of an individual

taxpayer.

4. The use of the exchange proceeds to pay off existing debt on property

already owned by the taxpayer does not qualify as replacement property.

F. Personal Use and Mixed Use Property

1. Property held as personal residence and for qualifying use

a. An exchange may qualify under section 1031 where the taxpayer's

property is partially a personal residence and partially qualifying

property. Allocation of the value between the two types of

property becomes important.

b. That portion of the value allocation attributable to the personal

residence may be eligible for gain exclusion under section 121.

2. Exchanges involving vacation homes

a. Vacation homes may qualify as investment property if personal use

in minimal or the home is also rented.

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3. Converting personal residences to qualifying use

a. A taxpayer may originally have acquired property for the purpose

of constructing a principal residence. Such property may be

treated as an investment property following a taxpayer's

abandoning his or her original use purpose. A property previously

occupied as a principal residence is converted to a qualifying use

when the taxpayer abandons the personal use and thereafter holds

it for rental income and appreciation in value.

b. The residence may be exchanged after it has been rented for a

sufficient period of time to establish abandonment of personal use

and the holding for a qualified use. There is no bright line test for

the length of time the residence must be rented out. The rental

must be more than temporary.

4. Converting qualifying use to personal residence

a. Similar issues arise when a taxpayer exchanges into land for

investment or into a residence for rental income and appreciation,

and subsequently converts the property to a personal residence.

The subsequent conversion should not prevent the exchange from

satisfying the qualifying use requirement provided the taxpayer did

not have a concrete intention to convert the property to personal

use at the time of the exchange.

III. Excluded Property

A. In a §1031 exchange, realized gain is recognized to the extent of the sum of any

money received and the fair market value of any "nonqualifying property."

B. Stock in trade - property which would be included within the inventory of a dealer

of that type of goods.

C. Other property held primarily for sale

1. Whether property is "held primarily for sale" is a question of fact.

2. The term "primarily" has been construed to mean "principally" or "of first

importance." The qualifying language of §1031 omits the phrase "to

customers in the ordinary course of his trade or business" contained in

both §§1221 and 1231. Thus, investment property which would entitle the

taxpayer to long-term capital gains treatment upon sale may not qualify

for a nontaxable exchange.

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3. This exclusion from qualifying property applies to property transferred or

received in an exchange. Thus, one cannot exchange or receive property

held primarily for sale.

D. Stocks, bonds, notes

E. Choses in action

F. Certificates of trust or beneficial interest or other securities or evidences of

indebtedness

G. Partnership interests

IV. Deferred Exchanges

A. Overview

1. The desirability of a delayed exchange (i.e., nonsimultaneous transfers)

can result from several different considerations. For example, the

exchangor may be unwilling, or unable, to wait until suitable exchange

property can be located and acquired; the taxpayer, or the exchangor, may

be unwilling, or unable, to wait until an improvement, to be financed by

the exchangor, is completed on the exchange property.

2. Any property received by the taxpayer will not be treated as like-kind

property if (1) "such property is not identified as property to be received in

the exchange on or before the day which is 45 days after the date on which

the taxpayer transfers the property relinquished in the exchange," or (2)

"such property is received after the earlier of (i) the day which is 180 days

after the date on which the taxpayer transfers the property relinquished in

the exchange," or (ii) "the due date (determined with regard to extensions)

for the transferor's return . . . for the taxable year in which the transfer of

the relinquished property occurs."

B. Identification and receipt requirements

1. Replacement property is treated as property which is not of a like kind to

the relinquished property if the replacement property is not "identified"

before the end of the "identification period," or if the identified

replacement property is not received before the end of the "exchange

period." The identification period and the exchange period both begin on

the date the taxpayer transfers the relinquished property, but the

identification period ends at midnight on the 45th day thereafter, whereas

the exchange period ends at midnight on the earlier of the 180th day

thereafter or the due date (including extensions) for the taxpayer's return

for the taxable year in which the transfer of the relinquished property

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occurs. If the taxpayer transfers more than one relinquished property as

part of the same deferred exchange and the relinquished properties are

transferred on different dates, the identification period and the exchange

period are determined by reference to the earliest date on which a transfer

occurs.

a. The payment of earnest money deposit or other amounts with

respect to the replacement property prior to the sale of the

relinquished property does not cause the 45 day identification

period or the 180 replacement period to begin.

2. Identification procedures

a. To properly identify replacement property, the property must be

designated as replacement property in (i) a written document

signed by the taxpayer and hand delivered, mailed, telecopied, or

otherwise sent before the end of the identification period to any

person involved in the exchange other than the taxpayer or a

"disqualified person" or (ii) a written agreement for the exchange

of properties signed by all of the parties to the exchange before the

end of the identification period. The person to whom the written

identification may be sent includes the transferor of the

replacement property (even if that person is a disqualified person)

or any other person "involved" in the exchange (other than a

disqualified person), such as an intermediary, an escrow agent, or

the title company.

b. Any replacement property that is received by the taxpayer before

the end of the identification period is treated as identified before

the end of the identification period.

c. The replacement property must be "unambiguously described" in

the written document or agreement. This requirement is generally

satisfied, in the case of real property, with a legal description or

street address or by a "distinguishable" name.

3. Identification of multiple properties

a. The maximum number of replacement properties that the taxpayer

may identify is (a) three properties without regard to their fair

market values, or (b) any number of properties as long as their

aggregate fair market value as of the end of the identification

period does not exceed 200% of the aggregate fair market value of

all the relinquished properties as of the date the relinquished

properties were transferred by the taxpayer.

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b. With certain exceptions, if at the end of the identification period

the taxpayer has identified more properties than permitted, the

taxpayer is treated as if no replacement property had been

identified. Exceptions are provided with respect to (i) replacement

property received by the taxpayer before the end of the

identification period, and (ii) replacement property identified

before the end of the identification period and received before the

end of the exchange period, but only if the taxpayer receives

identified replacement property constituting at least 95% of the

aggregate fair market value of all identified replacement

properties. The fair market value of replacement property is

determined as of the earlier of the date that the property is received

by the taxpayer or the last day of the exchange period.

4. Revocation of identification

a. An identification of property as replacement property may be

revoked at any time before the end of the identification period if

certain formalities are followed.

5. Receipt of substantially the same property and constructed property

a. For replacement property to be treated as property that is of a like

kind to the relinquished property, the taxpayer must receive the

identified replacement property before the end of the exchange

period, and the replacement property that is received must be

substantially the same property as that which was identified as the

replacement property.

C. Use of safe harbors

1. Four safe harbors are allowed which state that certain issues, such as

agency and constructive receipt, will, in effect, be ignored for purposes of

determining whether the taxpayer is in actual or constructive receipt of

money or other property before the taxpayer actually receives like-kind

replacement property.

2. Security or guarantee arrangements

3. Qualified escrow accounts and qualified trusts

4. Qualified intermediaries

a. The taxpayer's transferee may be the taxpayer's agent provided that

the transferee is a "qualified intermediary" and the taxpayer's rights

to receive money or other property from the qualified intermediary

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are limited to the circumstances specified in the regulations. A

qualified intermediary is a person who is not the taxpayer or a

"disqualified person" and enters into an agreement ("exchange

agreement") with the taxpayer, and as required by the exchange

agreement, acquires the relinquished property from the taxpayer,

transfers the relinquished property, acquires the replacement

property, and transfers the replacement property to the taxpayer.

5. Growth factor

a. A taxpayer is permitted to receive interest or a growth factor with

respect to the deferred exchange, provided the taxpayer's rights to

receive such interest or growth factor are expressly limited to

certain circumstances specified in the regulations. A taxpayer is

treated as being entitled to receive interest or a growth factor if the

amount of money or property the taxpayer is entitled to receive

depends on the length of time elapsed between the transfer of the

relinquished property and receipt of the replacement property.

6. Additional restrictions

a. For purposes of the qualified intermediary safe harbor, a taxpayer

must not have the right to receive, pledge, borrow, or otherwise

obtain the benefits of money or property until:

(i) if the taxpayer has not identified replacement property

before the end of the identification period, after the end of

the identification period;

(ii) if the taxpayer identifies replacement property, after the

taxpayer has received all of the identified replacement

property to which the taxpayer is entitled;

(iii) if the taxpayer identifies replacement property, after the

later of the end of the identification period and the

occurrence of a material and substantial contingency that -

(A) relates to the deferred exchange

(B) is provided for in writing, and

(C) is beyond the control of the taxpayer or any

disqualified person, or

(D) otherwise, after the end of the exchange period.

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7. Disqualified person

a. The qualified intermediary must not be a "disqualified person." A

person is a disqualified person if:

(i) The person is the agent of the taxpayer at the time of the

transaction

(ii) The person and the taxpayer bear a relationship described

in either §267(b) or §707(b) (determined by substituting in

each section "10%" for "50%" each place it appears).

(iii) The person and a person described above in (1) bear a

relationship described in either §267(b) or §707(b)

(determined by substituting in each section "10%" for

"50%" each place it appears)

(iv) Persons who acted as the taxpayer's employee, attorney,

accountant or real estate agent or broker during the two-

year period immediately preceding the taxpayer's transfer

of the first relinquished property are treated as agents of the

taxpayer at the time of the transaction. Performance of the

following services for the taxpayer are not taken into

account in determining whether a person is the taxpayer's

agent: (1) services for the taxpayer with respect to

exchanges intended to qualify under §1031; and (2) routine

financial, title insurance, escrow or trust services performed

for the taxpayer by a financial institution, title insurance

company or escrow company.

D. Death of Taxpayer during exchange period

1. If a taxpayer dies during the exchange period, the taxpayer's estate or

trustee may complete the exchange. The deceased taxpayer's estate defers

the tax and also receives a stepped up basis in the replacement property. If

the exchange is not completed with the acquisition of replacement

property by the personal representative or testamentary trust of the

taxpayer, the disposition of the relinquished property would be taxable to

either the taxpayer on his final income tax return, or to the estate or

testamentary trust as income with respect to a decedent.

V. Boot

A. If an exchange would be within the provisions of §1031(a) but for the fact that the

property received consists of qualifying property and other property or money, the

gain, if any, to the recipient is recognized to the extent of the sum of the money

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and the fair market value of the other property received. This "money or other

property" is commonly called "boot," and includes liabilities assumed or attaching

to property received in an exchange. "Other property" is either property

specifically excluded (stock or trade, stock, etc.) or property which is not of like-

kind with property given in the exchange.

B. Giving boot

1. Giving "boot" or nonqualifying property along with qualifying property in

an exchange will not take the transaction out of §1031.

C. Receiving boot

1. If the taxpayer receives nonqualifying property in addition to qualifying

property, the gain, if any, is recognized to the extent of the sum of the

money and the fair market value of the other property received.

2. The amount of any of the taxpayer's liabilities assumed in the exchange or

the amount of any liabilities attaching to the property transferred by the

taxpayer is treated as money received by the taxpayer in the exchange.

3. Netting boot and refinancing

a. If each party to an exchange either assumes a liability of the other

party or acquires property subject to a liability, then, in

determining the amount of money received, consideration given in

the form of an assumption of liabilities or a receipt of property

subject to a liability is netted against consideration received in the

form of an assumption of liabilities or a transfer subject to a

liability

b. Application of netting rules

(1) Consideration given in the form of cash or other property is

netted against consideration received in the form of an

assumption of a liability or a transfer of property subject to

a liability. Consideration received in the form of cash or

other property is not, however, netted against consideration

given in the form of an assumption of liabilities or a receipt

of property subject to a liability.

4. Summary of the boot offset rules

a. Liabilities assumed by the taxpayer in the exchange offset liability

relief of the taxpayer in the exchange. This rule applies in a

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deferred exchange even though the liability relief occurs days or

months before the new liability is incurred.

b. Cash paid by the taxpayer in the exchange offsets liability relief of

the taxpayer in the exchange.

c. Cash paid by the taxpayer in some circumstances offsets cash

received by the taxpayer. In a deferred exchange, the regulations

take the position that cash received by the taxpayer during the

exchange period may not be offset by cash subsequently paid by

the taxpayer for the acquisition of the replacement property.

d. Cash received by the taxpayer does not offset debt incurred by the

taxpayer. The taxpayer cannot take cash out of the exchange at the

closing by incurring a liability on the replacement property greater

than the liability on the relinquished property.

VI. Basis

A. The basis of property received in an exchange qualifying under §1031 is the basis

of the property surrendered increased by any additional consideration given,

decreased by the amount of any money received, and increased by any gain or

decreased by any loss recognized on the exchange.

VII. Holding Periods

A. The holding period of property acquired in a §1031 exchange includes the holding

period of the qualifying property transferred, provided that (i) the property

transferred was either a capital asset or §1231 property and (ii) the basis of the

property acquired is determined in whole or in part by the basis of the property

exchanged. If the property acquired does not fall within these provisions, the

holding period commences on the date of the exchange.

VIII. Related Party Exchanges

A. Taxpayers who directly or indirectly exchange property with a related party must

hold the exchanged property for at least two years after the exchange in order for

the exchange to qualify for nonrecognition treatment.

B. If either party to the exchange disposes of its replacement property in the two-

year period, the gain or loss deferred on the original exchange will be taken into

account on the date that the disqualifying disposition occurs. A disqualifying

disposition does not include dispositions by reason of the death of either party, the

compulsory or involuntary conversion of the exchanged property, or any

disposition if neither the disposition nor the exchange had as one of its principal

purposes the avoidance of federal income tax.

C. Related persons are defined by reference to IRC section 267(b) and 707(b)(1).

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D. Further Restrictions on Exchanges Between Related Parties; Basis Shifting

1. Even where the general rules applicable to direct exchanges between

related parties are satisfied, an indirect exchange of like-kind property

between related parties may not qualify under §1031, especially where a

shifting of basis occurs.

IX. Reverse Exchanges

A. A taxpayer occasionally must acquire a replacement property before the

disposition of the relinquished property. The contingencies in the sale of the

relinquished property may not be removed prior to the date of closing on the

replacement property. Perhaps a buyer has not been found for the relinquished

property. Perhaps the taxpayer must close on the replacement property or lose a

substantial earnest money deposit. Perhaps the taxpayer’s financing commitment

at favorable rates will expire if the replacement property fails to promptly close

before the relinquished property closes. Sometimes the replacement property will

require construction of improvements that will take more than 180 days to

complete, so the replacement property must be acquired by an accommodator

prior to the transfer of the relinquished property to, in effect, extend the 180-day

replacement period.

B. If the taxpayer closes on the replacement property before closing on the

disposition of the relinquished property, the transaction is a reverse exchange. A

reverse exchange is not authorized by IRC § 1031(a)(3), nor the Regulations, but

the IRS issued Revenue Procedure 2000-37 which provides the authority for

reverse exchanges.

C. Rev. Proc. 2000-37 provides that a reverse exchange will not be challenged if the

taxpayer, who will be the ultimate owner of the parked property, satisfies two

requirements: (i) the taxpayer enters into a written Qualified Exchange

Accommodation Arrangement ("QEAA"), and (ii) the taxpayer engages the

services of an exchange accommodation titleholder ("EAT") which is typically a

qualified intermediary.

X. Exchanges Involving Partnerships

A. Real estate is often held by co-owners in a partnership containing two or more

partners or by co-owners as tenants in common or joint tenants.

1. Exchanges of partnership interests generally do not qualify for

nonrecognition treatment under IRC § 1031. Therefore, when partners

want to end their relationship, they cannot each exchange out of their

partnership interests into another partnership interest or real property

under IRC § 1031. Similarly, when an individual real property owner

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wishes to acquire property in a partnership form, he or she cannot

exchange the real property interest for a partnership interest under IRC §

1031.

2. Such transactions can be structured as exchanges, however, by converting

the partnership interest into a real property interest. Such structuring is

not without tax risk.

XI. Exchanges Involving Undivided Fractional Interests in Real Property

Under Revenue Procedure 2002-22

A. Rev. Proc. 2002-22 specifies the conditions under which the Internal Revenue

Service will consider a request for a ruling that an undivided fractional interest in

rental real property is not an interest in a business entity, within the meaning of

Treas. Reg. § 301.7701-2(a).

XII. Financing Issues

A. If the taxpayer trades down in equity in an exchange by receiving cash at the

closing of the acquisition of the replacement property, the cash will be taxable

boot to the taxpayer. The cash received will be taxed even if the taxpayer offsets

the trade down in equity with an increase in debt on the replacement property.

B. Placing Mortgages on Relinquished Property Prior to Exchange

1. In order to avoid the receipt of taxable boot, the taxpayer may consider

taking equity out of the relinquished property by placing additional debt

on the relinquished property prior to the closing of the exchange. Given

the IRS’s position with respect to increasing debt prior to an exchange in

order to receive tax-free cash, a cautious taxpayer will increase the debt

on the relinquished property before listing the property for sale or entering

into a contract to sell or exchange the property. The taxpayer can also

support its tax position by having an independent business reason for the

debt increase, such as some immediate need for the cash.

C. Refinancing Debt at Closing

1. Sometimes taxpayers wish to take advantage of the equity which they will

have in the replacement property and, simultaneous with the closing,

borrow against the equity and receive cash.

2. In order to avoid an assertion by the IRS that such additional borrowing is

boot in the form of cash received as a result of the exchange, the closing

documentation should reflect (i) that all of the cash from the exchange

account was used to acquire the replacement property and (ii) any

additional borrowings, in excess of the debt needed to acquire the

replacement property, should be separately stated on a separate HUD-1

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settlement sheet. Out of an abundance of precaution, the taxpayer may

borrow just enough to acquire the replacement property and then

subsequently borrow the additional amounts.

D. Placing Mortgages on Replacement Property After Exchange

1. Alternatively, the taxpayer could complete the exchange without increasing

the debt or receiving any cash at closing, but could receive tax-free cash by

placing additional debt on the replacement property after the closing of the

exchange.

2. Increasing the debt on the replacement property after closing of the

exchange appears less risky than doing so on the relinquished property

before closing.

XIII. Improvement or Build to Suit Exchanges

A. Often, the taxpayer will want to make improvements to the replacement property

and have the cost of the improvements included in the exchange value of the like-

kind replacement property. The improvements may consist of repairs or

remodeling of an existing building, or the construction of a new building on raw

land. The construction period may be a matter of weeks for repairs, or months or

years for a newly built building.

B. Improvements constructed after the taxpayer has acquired the replacement

property do not qualify as like-kind replacement property.

C. If the exchange value of relinquished property is less than completed value of the

replacement property, the replacement property may be conveyed to taxpayer

when enough construction has occurred to cover the relinquished property

exchange value. With real property, the improvements do not need to be

completed for a valid exchange. The partially completed improvements are like

kind to the relinquished property.

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SECTION 1031 EXCHANGES: UPDATES

June 20, 2013

Presented By:

F. Moore McLaughlin, IV, Esq., CPA

148 West River Street – Suite 1E

Providence, Rhode Island 02904

[401] 421-5115

[email protected]

www.mclaughlinquinn.com

1 [877] 395-1031

www.AllStates1031.com

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SECTION 1031 EXCHANGES: UPDATES

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

JUNE 20, 2013

1. PLR 201252018

Notice procedures used by a corporation in like-kind exchanges were acceptable under

the requirements of Reg. §1.1031(k)-1(g)(4) and Rev. Proc. 2003-89, 2003-1 CB 971, for

certain transfers and acquisitions. The taxpayer was in the business of leasing vehicles

and issuing loans for the purchase of vehicles. The taxpayer engaged in a number of like-

kind exchanges under Code Sec. 1031 involving vehicles that it received from and sold to

other dealers and other unrelated parties. The taxpayer provided notice of its assignment

of rights when a vehicle was sold or purchased through inclusion of a notice on credit

applications, lease agreements, invoices, certificates of title, and other documents, which

was a satisfactory procedure.

2. PLR 201308020

A partnership that was an affiliate company of a tax and business advisory firm was not a

disqualified person with respect to a like-kind exchange (LKE) program client. The

partnership provided software to its LKE program clients because the provision of the

software did not create an agency relationship.

3. FAA 20124801F

The taxpayer’s like-kind exchange (LKE) program failed to qualify for tax-deferred

treatment because the taxpayer controlled the liquidation proceeds of vehicles in its LKE

program, reflecting receipt of the funds. The taxpayer purchased cars that it leased to a

car rental company. The taxpayer sold its automobiles (relinquished property) to

manufacturers, dealers, or brokers, and the proceeds from the sales moved through three

accounts. The qualified intermediary had no rights over the repayment account, and that

account was not a qualified escrow account because the escrow holder owned more than

10 percent of the taxpayer and was a disqualified person. Additionally, the taxpayer had

an unrestricted right to the funds.

4. PLR 201242003

The taxpayer, a limited partnership, and its affiliated limited partnership were each

determined to have had a bona fide intent to acquire a property pursuant to their qualified

exchange accommodation arrangements (QEAAs). Therefore, the taxpayer’s QEAA to

acquire the property constituted a separate and distinct QEAA as defined in Rev. Proc.

2000-37 (with separate application of the identification rules of Reg. §1.1031(k)-1(c)(4)),

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even though the affiliate simultaneously entered into a separate QEAA with the same

exchange accommodation titleholder (EAT) to acquire the same property.

5. PLR 201220012

A limited partnership was not disqualified from the benefits of like-kind exchange

benefits under Code Sec. 1031(a) provided that each related party transferring

replacement property into the exchanges described in the ruling was also engaged in its

own like-kind exchange, and the limited partnership, the affiliate and its related party all

held their replacement properties for at least two years after the date of the last transfer of

property in the exchanges. The parties were all separate taxpayers and they reported the

results of their exchanges separately, including the realization and recognition of gain or

loss on the dispositions. The transfer of each relinquished property by the three entities in

its separate exchange resulted in a separate application of the limits on identification of

multiple or alternative replacement properties provided in Reg. §1.1031(k)-1(c)(4).

6. CCA 201238027

The IRS Chief Counsel assessed several situations in which law of two states differed as

to the classification of property as real or personal, and determined that federal law is

determinative as to whether the property is of the same nature and character for purposes

of like-kind exchanges under Code Sec. 1031.

7. Yates v. Comm., T.C. Memo. 2013-28 (Jan. 24, 2013)

A couple’s real property was not used either for productive use in a trade or business or

for an investment at the time of a like-kind exchange. It was characterized as boot for

purposes of determining gain on the exchange. The IRS failed to satisfy its burden of

proof regarding the valuations used in the exchange. The taxpayers’ allocations of the fair

market values to the exchanged properties best represented the sellers’ and buyer’s views

of the fair market values. Liability for the substantial understatement penalty awaited

recomputation of the deficiency.

8. Adams v. Comm., T.C. Memo. 2013-7 (Jan. 10, 2013)

The taxpayer sold a house that he had rented to an unrelated party and purchased another

house that he rented to his son. The IRS argued that one house was purchased as an

investment, as it was rented out, while the other was a residence for his son. However, the

rent paid by his son was at fair market value in light of the work he did on the house

while living there. Therefore, sale of one house and purchase of another therefore

constituted a valid Code Sec. 1031 exchange. The taxpayer was liable for tax on the boot

he received in the exchange, which was the difference between the price received from

selling the first house and the price paid for the second, minus costs. The gain was

ordinary income to the extent of the depreciation recaptured on the property, and capital

gain in excess of that amount.

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9. PLR 201302009

An LLC’s exchange agreement with a qualified intermediary to transfer the title and deed

to a complex used in its trade or business for replacement property qualified as a like-

kind exchange. The taxpayer’s assignments of rights in the transfer agreement was the

transfer of the relinquished property for purposes of an exchange of property held for

productive use in a trade or business or for investment.

10. Han, CA State Board of Equalization, No. 577081 (February 25, 2013)

Taxpayers were unable to defer the gain from the sale of their company on their

California personal income tax return because their sale of the company’s stock and

subsequent purchase of an annuity contract did not qualify as an IRC §1031 like-kind

exchange and did not qualify for deferral under IRC §72.

11. Danielson v. Comm., MN T.C., No. 8349-R (Mar. 1, 2013)

For personal income tax purposes, the Minnesota Tax Court has concluded that the gain

from the sale of a taxpayer’s property did not qualify as a like-kind exchange and should

have been recognized in the year of sale because the replacement lake property acquired

by the taxpayer was not held for productive use in a trade or business or for investment.

12. Stringer, CA State Board of Equalization, Nos. 609814, 610020 (Dec. 20, 2012)

Taxpayers did not show that the gain realized from certain property transactions should

be deferred for California personal income tax purposes based on their claimed like-kind

exchange pursuant to IRC §1031. The Franchise Tax Board (FTB) reviewed the claimed

like-kind exchange and determined that the gain on the transaction was actually taxable

compensation for the taxpayers’ efforts in putting together a land deal, which did not

qualify for deferral under IRC §1031.

13. Bragg, CA State Board of Equalization, No. 567669 (Nov. 14, 2012)

Gain from the sale of a California taxpayer’s property did not qualify for an IRC §1031

like-kind exchange tax deferral because the replacement property "purchased" by the

taxpayer was not purchased within the IRC §1031 safe-harbor time provisions and the

transaction did not qualify as a reverse like-kind exchange under the guidelines outlined

in a governing federal tax court decision. The evidence indicated that the taxpayer

entered into an arrangement with a third party to "purchase" the replacement property

prior to the period that the taxpayer sold his other properties in anticipation of the

taxpayer then exchanging his original properties for the replacement property and

qualifying for an IRC §1031 like-kind exchange tax deferral. However, to qualify as a

reverse like-kind exchange, the third party must actually have ownership rights and

responsibilities in relation to the property and not be merely an agent for the taxpayer, as

a taxpayer may not effectuate a like-kind exchange with himself.

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14. Marcil, CA State Board of Equalization, No. 458832 (December 5, 2012)

The sale and purchase of properties by a limited partnership in which the taxpayers held a

99% direct interest and a 1% indirect interest satisfied the requirements for a "like-kind"

exchange pursuant to Internal Revenue Code §1031 for California personal income tax

purposes. The State Board of Equalization (BOE) determined that the subsequent

nontaxable transfer of the replacement rental property, under state law, to an LLC of

which the taxpayer-husband was the managing member and in which the taxpayer-wife

had a community property interest through her husband’s interest, and which continued

to hold the rental property for investment purposes, did not disqualify the sale and

purchase of the properties from meeting the requirements of IRC §1031.

15. Gossage, CA State Board of Equalization, No. 546541 (Aug. 22, 2012)

A taxpayer did not show error in the proposed assessments of California personal income

tax by the Franchise Tax Board (FTB), which were based on the taxpayer’s shareholder

income from an S corporation resulting from failed like-kind exchanges and built-in gains

from the sales of properties. The FTB determined that the S corporation’s transactions did

not meet the requirements for like-kind exchanges under Code Sec. 1031 because the S

corporation did not receive replacement property within 180 days. The resulting tax

liability for the additional income was assessed upon the taxpayer based on his

proportionate share of ownership in the S corporation.

16. PLR 201234018

A wholly-owned LLC, formed by a corporation to provide intermediary services to

corporation shareholders who maintain like-kind exchange programs using safe harbors

in the regulations under Code Sec. 1031 and Rev. Proc. 2003-39, was not a disqualified

person as to the exchange services it was organized to perform for the shareholders. The

earnings by the LLC for services provided to the shareholders were patronage source

income eligible for distribution as deductible patronage dividends.

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REAL ESTATE PROFESSIONALS

JUNE 20, 2013

Presented By:

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

148 West River Street – Suite 1E

Providence, Rhode Island 02904

[401] 421-5115

[email protected]

www.mclaughlinquinn.com

1 [877] 395-1031

www.AllStates1031.com

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REAL ESTATE PROFESSIONALS

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

JUNE 20, 2013

I. Passive Activity Rules – IRC §469.

A. Overview of IRC §469.

Individuals, trusts, estates, and personal service corporations may not use losses from

passive activities to offset salary, dividends, interest, royalties, portfolio gains, and

income from active business activities. Closely held corporations (a corporation is

closely held for this purpose if 50 percent of the stock is owned by five or fewer

shareholders) that are not personal service corporations may not use passive losses to

offset portfolio income, but may use passive losses to offset active business income.

Passive activities include any business activities in which the taxpayer does not

materially participate (i.e., is not involved on a regular, continuous, and substantial

basis) and any rental activities (not merely rental real estate) regardless of the extent

to which the taxpayer participates. A limited partnership interest is generally treated

as intrinsically passive; limited partners are deemed for the most part not to materially

participate in the activity of the partnership.

B. Current Developments.

1. Patient Protection and Affordable Care Act and Health Care and

Education Reconciliation Act of 2010

Code Sec. 1411, as added by P.L. 111-152, applies to tax years beginning

after December 31, 2012 and imposes an unearned income Medicare

contribution tax on individuals as well as estates and trusts. Proposed

Amendments of Regulations (REG-130507-11), were published in the Federal

Register on December 5, 2012 (corrected 1/31/2013).

For individuals, the tax is the 3.8 percent of the lesser of net investment

income or the excess of modified adjusted gross income over the threshold

amount. In the case of a trade or business, the tax applies if the trade or

business is a passive activity (within the meaning of Sec. 469) with respect to

the taxpayer.

2. CCA 201312041

IRS Chief Counsel, in a request for advice concerning a position in Anjum

Shiekh v. Comm’r, 99 TCM 156, Dec. 58,239(M), TC Memo. 2010-126,

stated that the gain from the disposition of property used in a passive activity

is treated as passive income for purposes of the application of passive loss

rules. The character of such gain or loss as capital or ordinary had no

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relevance for application of Code Sec. 469, because the passive loss rules are

only concerned with whether the relevant income and loss are from passive

activities. Code Sec. 469 is merely a loss disallowance provision. The rules

under Code Sec. 1211 would determine whether the capital gain from certain

property must offset the ordinary losses produced by the property, and Code

Sec. 469 would not play a role in the determination.

3. Ghilardi v. Comm., T.C. Summary Opinion 2013-15 (Feb. 21, 2013)

Married taxpayers were allowed partial deductions for losses from residential

rental property in which the husband owned a 50-percent interest. The rental

real estate activity was a per se passive activity because the husband, a

licensed real estate salesperson during the tax years at issue, did not qualify as

a real estate professional. During that period, the husband closed no real estate

transactions, reported no income from that work, and worked 15-18 hours per

week as a driver education instructor. The taxpayers failed to prove that the

husband spent more than 750 hours performing services in real property trades

or businesses, and that he spent more time at those services than he did

teaching driver education. Calendars and a narrative that the taxpayers

provided regarding the time the husband spent performing real estate

salesperson services were not a good-faith attempt to reconstruct his activities,

but instead were a "post-event ballpark guesstimate" that was not credible.

The taxpayers could deduct a portion of their losses, however, because the

IRS conceded in its deficiency notice that the taxpayers had "actively

participated" in the rental real estate activity that gave rise to losses.

4. Hudzik v. Comm., T.C. Summary Opinion 2013-4 (Jan. 17, 2013)

An individual was not a real estate professional for purposes of the passive

activity rules because she failed to show that she performed more than one-

half of her personal services in real property trades or businesses in the tax

years at issue. During these years, the taxpayer had a full-time job at which

she worked 1,650 hours per year. She had logs of hours showing that she

spent more hours than that in her real estate rental activities in each of the

years at issue. However, these hours were implausible given the amount of

time she worked at her regular job. In addition, she failed to provide any

underlying documentary evidence to substantiate the hours reflected in the

logs.

5. Dirico v. Commissioner, 139 T.C. 16, (Nov. 13, 2012)

Gain and loss from an individual’s rental to his S corporation of land and

telecommunications towers, access to which the S corporation leased to third

parties, were characterized as being from a passive activity, except for income

or loss related to land-only leases. The S corporation’s rental of tower access

to third parties was a rental activity, and not a trade or business. The "self-

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rental rule" was inapplicable. Further, losses from unprofitable rentals were

classified as passive activity losses under Reg. §1.469-2(f)(6), which applies

to the net income from "an item of property" rather than net income (after

taking losses into consideration) from the taxpayer’s entire rental activity.

Finally, the "30-percent test" of Reg. §1.469-2T(f)(3) mandated

recharacterization of income from the land-only leases as nonpassive activity

income

6. CCA 201244017

The IRS Chief Counsel stated that a trust cannot meet the qualifying tests of

Code Sec. 469(c)(7)(B) because those tests apply only to individuals. The

statute provides special rules for taxpayers in the real property business, and

specifically those who perform personal services during the tax year. Since

only individuals can perform personal services, the statute is inapplicable to

trusts, estates, and personal service corporations.

7. Veriha v. Comm., 139 T.C. No. 3, (Aug. 8, 2012)

Income from an individual’s trucking business was recharacterized as

nonpassive after trucks leased to the individual were recharacterized as

multiple "item[s] of property" under Reg. §1.469-2(f)(6). The taxpayer owned

and materially participated in a trucking business, and controlled two

companies from which the trucking business leased its tractors and trailers. He

classified income from one leasing company and a net loss from the other as

passive. Income from an "item of property" rented to, and for use in, a

nonpassive activity in which the taxpayer materially participates, like the

taxpayer’s trucking business, is treated as nonpassive. His contention that the

entire fleet of trucks from both leasing companies was a single item of

property was rejected. Rather, each tractor and each trailer was an item of

property.

8. Samarasinghe v. Comm., T.C. Memo. 2012-23, (Jan. 19, 2012)

Rental income attributable to a couple’s rental of a commercial office building

to the husband’s wholly-owned medical corporation was nonpassive income

under the self-rental rule of Reg. §1.469-2(f)(6). Therefore, it could not be

offset against accumulated and unused passive losses. The application of the

written binding contract exception, which provides transitional relief for

written binding contracts entered into before February 19, 1988, would have

characterized the couple’s rental income as passive income because they

entered into the lease agreement with the husband’s medical corporation in

1980. However, under state (New Jersey) law, an enforceable agreement only

exists when the two parties agree on essential terms and agree to be bound by

them. Therefore, the lease agreement did not remain in force and was not

binding for the tax years at issue because the couple did not pay the rent cited

in the lease and did not pay it monthly. Furthermore, the husband did not

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consult the lease in making his annual allocation between his salary and rental

income. Finally, the rental income included on the couple’s returns and the

rental expense deducted on the medical corporation’s returns for the tax years

at issue were not what should have been reported under the 1980 lease.

II. Self-Employment Taxes for Real Estate Owners.

A. Overview of IRC §1401 and 1402.

Self-employment taxes generally apply to individuals who have self-employment

income from a trade or business carried on by the individual as a sole

proprietorship, or as a partnership of which the individual is a partner.

B. Application to Real Estate.

1. Rental of real estate as a business. If the rental of houses, apartments, or

commercial buildings is a trade or business, then the sale of such properties

held for more than one year gives rise to Code Sec. 1231 gains or losses. If the

rental of such properties is not a trade or business, the gains and losses on

their sale represent capital gains or losses. In determining whether rental real

estate is a capital asset or an asset used in a trade or business, a taxpayer must

look at all the facts and circumstances and applicable case law.

2. Self- Employment Tax Issues. Rental income is excluded from self-

employment income for purposes of calculating the self-employment tax,

unless the taxpayer received the rental income in the course of business as a

real estate dealer. (Code Sec. 1402(a)(1)). A self-employed individual

excludes the gains on the sale of real estate from self-employment income

unless the taxpayer realized the gains from property held primarily for sale to

customers in the ordinary course of business. (Code Sec. 1402(a)(3)(C)(ii)). If

a self-employed individual held real estate primarily for sale to customers in

the ordinary course of business, the individual should include the gains and

losses on the sale of such real estate in calculating self-employment income.

The nominal self-employment tax rate is 15.3% (Code Sec. 1401), but a self-

employed individual may subtract 7.65% of the unadjusted self-employment

income in determining the base for the self-employment tax. A self-employed

individual also may deduct one-half of the self-employment tax liability for

the year in calculating AGI. Therefore, the distinction between whether a

taxpayer held real estate for sale to customers in the ordinary course of

business or for investment can be significant.

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SELF-DIRECTED IRAs: UPDATES

JUNE 20, 2013

Presented By:

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

148 West River Street – Suite 1E

Providence, Rhode Island 02904

[401] 421-5115

[email protected]

www.mclaughlinquinn.com

1 [877] 395-1031

www.AllStates1031.com

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SUMMARY OF RECENT CASES AND RULINGS AFFECTING SELF-DIRECTED IRAS

F. MOORE MCLAUGHLIN, IV, ESQ., CPA

JUNE 20, 2013

Bankruptcy Court Cases

1. In re Nessa (Bankruptcy Appellate Panel CA 8, 4/9/2010) (105 AFTR 2d ¶2010-724)

A bankruptcy appellate panel in the Eighth Circuit has held that a debtor's inherited IRA

was an exempt asset of her bankruptcy estate under Bankruptcy Code §522(d)(12).

2. Chilton v. Moser (DC TX 3/16/2011) 107 AFTR 2d ¶2011-594

The district court reversed the bankruptcy court and held that taxpayer’s inherited IRA

could be exempted from her bankruptcy estate. Since the bankruptcy court's March 5,

2010 decision, five other courts have found that inherited IRAs do meet the requirements

for a Bankruptcy Code exemption. (See, e.g., In re Nessa).

Agreeing with the reasoning of Nessa and the other cases, the district court concluded

that the funds in a debtor's inherited IRA do not have to be the “retirement funds” of the

debtor to satisfy the bankruptcy exemption requirements. The court emphasized that 11

USC 522(b)(4)(C), which had not been discussed by the bankruptcy court, provides that a

direct transfer of funds from one account that is tax-exempt under Section 408 to another

such account (like the type of transfer that created taxpayer’s inherited IRA) does not

make the funds ineligible for a bankruptcy exemption.

The district court also concluded that inherited IRAs are among the IRAs that are exempt

from taxation under Section 408(e)(1), which provides that any IRA is exempt from

taxation. Thus, because an inherited IRA meets this requirement, any differences between

a traditional IRA and an inherited IRA are irrelevant for purposes of the bankruptcy

exemption.

3. In Re Willis (Bankruptcy Court FL, 104 AFTR 2d ¶2009-5195), affirmed CA 8th

,

107AFTR 2d 2011-1918 (4/21/2011)

Trustee and creditor were largely sustained in their objections to taxpayer's bankruptcy

estate exemption of third IRAs: although favorable IRS determinations under Code

§7805 had been received for IRAs, and although such determinations created

presumption of exemption pursuant to 11 USC 522(b)(4)(A), presumption was rebuttable

with proof that taxpayer/fiduciary was disqualified person in respect to and engaged in

prohibited transactions with first IRA/self-directed IRA, by using that IRA to fund

purchase of mortgage assignment and by engaging in another series of transactions with

IRA to fund shortfall in his and wife's joint brokerage account. So, that IRA was

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considered non-exempt. And, because the taxpayer also used that IRA to fund entirety of

second IRA and portion of third IRA, exemptions for those IRAs were also denied, albeit

only up to stated amount for third IRA.

4. In Re Johnson (Bankruptcy Court WA, 107 AFTR 2d ¶2011-2086) (05/04/2011)

Married Chapter 7 debtors' bankruptcy estate exemption, under 11 USC 522(d)(12) 's

“retirement funds” provision for inherited IRA funds which were transferred in direct

trustee-to-trustee transfer from husband's deceased parents' accounts to his accounts, was

allowed over trustee's objection: inherited IRA funds, which were clearly retirement

funds when held in parents' accounts, didn't lose that character when transferred to

husband's accounts; further, those accounts were clearly tax exempt under Code Sec. 408.

Trustee's argument to limit 11 USC 522(d)(12) 's exemption to only those funds coming

from taxpayer's own contributions was contrary to 11 USC 522(d)(12) 's plain language.

Also, exemption was otherwise supported by 11 USC 522(b)(4)(C) 's provision regarding

direct Code Sec. 408 account transfers.

5. In Re Mathusa (Bankruptcy Court FL, 107 AFTR 2d ¶2011-2086) (03/28/2011)

The court applied the Eighth Circuit's decision in In re Nessa, holding that an inherited

IRA is exempt under §522(b)(3)(C) of the Bankruptcy Code if: (1) funds held in the

account are retirement funds; and (2) the account is exempt under §§401, 403, 408, 408A,

414, 457, or 501(a) of the IRC. The court reasoned that T's IRA is a retirement fund

under §522(b)(3)(C) of the Bankruptcy Code because it holds retirement funds that are

exempt from taxation under §408 of the IRC, and thus meets the requirements of

§522(d)(12) of the Bankruptcy Code.

Further adopting the reasoning in Nessa, the bankruptcy court explained that §522(d)(12)

of the Bankruptcy Code does not require the retirement funds for which the debtor is

seeking exemption to be funds that were earned or contributed by the debtor. The court

further reasoned that under §522(b)(4)(C) of the Bankruptcy Code a direct transfer of

retirement funds from a fund or account that is exempt from taxation under §408 of the

Internal Revenue Code does not terminate the exemption under §522(d)(12) of the

Bankruptcy Code. Thus, the court held that the trustee-to-trustee transfer of funds from

T's mother's IRA to T's IRA did not destroy T's ability to claim the funds as exempt under

§522(b)(3)(C) of the Bankruptcy Code.

6. In Re James (Bankruptcy Court TN, 2013-1 U.S.T.C. ¶50,201) (Feb. 22, 2013)

Chapter 7 trustee failed to show that a debtor’s grant of a security interest lien in her IRA

to her brokers/dealers was a prohibited transaction under Code Sec. 4975(c)(1)(B). The

trustee’s claim that the debtor engaged in a prohibited transaction under Code Sec.

4975(c)(1)(B) by signing an IRA account application that provided the broker/dealers

with a security interest lien against the account. The parties expressly agreed that the

security interest lien provisions were not applicable if it conflicted with the Tax Code.

Moreover, the debtor complied with the Employment Retirement Income Security Act

(ERISA) since she did not seek loans against those accounts and the evidence showed

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that the lien was never enforced against the debtor. Moreover, the application form was

modeled on IRS Form 5305-A, Traditional Individual Retirement Custodial Account.

Tax Court Cases

7. James H. Swanson, 106 TC 76 (1996)

IRS was not substantially justified in arguing transfer of 100% of DISC's original issue

stock and DISC's dividend payment to taxpayer's first IRA, and transfer of 100% of

FSC's original issue stock to taxpayer's second IRA, were Code §4975 prohibited

transactions: DISC could not be disqualified person prior to initial stock issuance;

taxpayer-fiduciary did not deal with IRA’s assets in his own interest and only realized

benefits from the payments as IRA participant; and IRS did not promptly concede its

position.

8. Robert Ancira, 119 TC 135 (2002)

Check payable from taxpayer's self-directed IRA to corporation for purchase of

corporation's non-publicly traded stock, but delivered 1st to taxpayer, wasn't taxable

account distribution under Code §408 or Code §72 : taxpayer was merely conduit or

trustee's agent, whose participation in both arranging stock purchase and ensuring check's

delivery to corporation merely reflected exercise of his right to direct IRA's investments

and trustee's particular policy to not purchase non-publicly traded stock himself. Also,

taxpayer could not have been in constructive receipt of check that he was not holder of

and could not negotiate under Louisiana law; case law involving account holder's receipt

of cash from IRA was distinguished; and corporation's delayed transfer of stock

certificate was at most clerical oversight and did not alter fact that IRA, not taxpayer, was

at all times stock's new owner.

9. Joseph R. Rollins, TC Memo 2004-260

A company owner that sponsored a §401(k) plan had to pay excise taxes and failure-to-

file penalties for his participation in prohibited transactions as a disqualified person,

where he approved a series of plan loans to other companies in which he owned a part-

interest. This was true even though he did not directly receive any of the income or assets

from the prohibited transactions.

10. Kenneth D. Woodard, TC Summary Opinion 2009-150

Taxpayer claimed that he relied on information found on unspecified Web sites written

by unidentified individuals or organizations. From the record, it was not clear that he

questioned the provenance or accuracy of the information he found through the Google

search engine. Without knowing the sources of the information, it was impossible for the

Court to determine that those sources were competent to provide tax advice. Accordingly,

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the Court could not conclude that Mr. Woodard exercised ordinary business care and

prudence in selecting and relying upon the information he found on line. As a result, the

Court found that he did not show reasonable cause for failing to report the distributions

from his IRA on the 2004 Federal income tax return. Not having found reasonable cause,

the Court did not need consider whether Mr. Woodard acted in good faith.

U.S. Supreme Court Cases

11. Rousey v. Jacoway, U.S. Supreme Court, 95 AFTR 2d 2005-1716 (2005)

Supreme Court determined that Chapter 7 debtors' interests in IRAs funded with rollovers

of accumulated pension plan contributions were exempt from bankruptcy estate under 11

USC 522(d)(10)(E): IRAs met exemption requirements where they conferred right to

payment “on account of age” and were “similar plans or contracts” within statute's

meaning. Taxpayers' right to payment was causally connected to their age where their

nonforfeitable right to IRA account balances under Code §408(a)(4) was restricted by

substantial 10% penalty for withdrawals before they turned 59 1/2. Also, IRAs were

similar to statute's enumerated plans because they provided income that substituted for

wages lost upon retirement; 10% penalty was substantial barrier to taxpayers' control

over accounts; and narrow Code §72(t)(2) penalty exemptions did not render IRAs akin

to savings accounts. And, 11 USC 522(d)(10)(E)'s grouping of Code §408 with other tax-

qualified retirement plans under Code §401(a), Code §403(a), and Code §403(b),

suggested that taxpayers' IRAs were exempt, as well as “similar plans or contracts”

within statute's meaning.

Trustee Cases

12. Mandelbaum, Rochelle v. Fiserv, Inc. (3/29/2011, DC CO) 107 AFTR 2d 2011-1651)

Court dismissed all of the federal common law, state law negligence, contract, and unjust

enrichment claims brought by holders of self-directed IRAs against the IRA trustees for

losses incurred by the IRAs for investments with Bernard Madoff's firm.

The district court dismissed all of the IRA owners' claims against the trustees. It rejected

the federal common law claims based on Code Sec. 408, finding that Code Sec. 408 does

not impose a specific duty of care on an IRA trustee, or create a private right of action for

fiduciary breaches. Further, the court found that there was no conflict between state law

and ERISA, because the IRAs were not employer-sponsored, so that Title I of ERISA did

not apply.

With regard to the IRA owners' negligence claim, the court found that the IRA trustees

owed no duties to the IRA owners independent of those in the IRA agreements, which

explicitly indemnified the IRA administrators from liability resulting from any claims

arising from the IRAs and made the IRA owners solely responsible for the investment of

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IRA funds. To the extent that the trustees might have had a pre-existing duty to provide

accurate account statements, investigate red flags, and retain control over the trust assets,

the court said that the IRA agreements exculpated the trustees from responsibility for the

failure to fulfill any such duties. The court also refused to invalidate the exculpatory

provisions on public policy grounds, noting the availability of choice in the IRA market.

The court also rejected the owners' state law contract claims. The trustees had fulfilled all

their obligations as delineated in the IRA agreements, having transferred IRA assets to

BMIS at the IRA owners' direction, and having provided account statements that

contained the information from Madoff's firm. Additionally, under the express terms of

the IRA agreements, the trustees had no duty to conduct appraisals of investments or

verify any values reported to them, and had no obligation to prevent Madoff or his firm

from commingling the IRA assets (which was done only after the assets were transferred

to Madoff).

ERISA Opinion Letter

13. ERISA Op. Letter No. 2011-04A

The DOL's Employee Benefits Security Administration (EBSA) determined that an IRA's

proposed purchase of the IRA owner's promissory note and a deed of trust held by the

bank which had financed the IRA owner's purchase of real estate would be a prohibited

transaction. EBSA reasoned that, so long as payments were due on the note, the

transaction would create an impermissible extension of credit from the IRA to

disqualified persons.