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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.