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Revisiting the Definition of "Real Property" After Tax Reform: Structuring 1031 Like-Kind Exchanges
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, AUGUST 15, 2018
Presenting a live 90-minute webinar with interactive Q&A
Professor Bradley T. Borden, Professor of Law, Brooklyn Law School, Brooklyn, N.Y.
Marie C. Flavin, Senior Vice President/Northeast Regional Manager,
Investment Property Exchange Services, Armonk, N.Y.
Peter J. Mannarino, Partner, Federman Steifman, New York
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FOR LIVE EVENT ONLY
Tax-Free Exchanges under IRC Section 1031
FEDERMAN STEIFMAN LLP
INVESTMENT PROPERTY EXCHANGE (IPX)
www.federmansteifman.com
Presenters
6Federman Steifman LLP
➢ Bradley T. Borden
• Professor, Brooklyn Law School
• Special Counsel, Federman Steifman LLP
• bborden@federmansteifman.com
➢ Marie C. Flavin
• Senior Vice President/Northeast Regional Manager, Investment Property Exchange Services
• Marie.Flavin@ipx1031.com
➢ Peter J. Mannarino
• Partner, Federman Steifman LLP
• pmannarino@federmansteifman.com
Overview of Contents
7Federman Steifman LLP
➢ Introduction to Section 1031
➢ Tax Savings Under Section 1031
➢ Elements of Section 1031
➢ Identification and Receipt
➢ General Exchange Structures
➢ Related-Party Exchanges
➢ Advanced Exchange Structures
➢ Exchanges and Business Transactions
➢ Concurrent Ownership Structures (TICs and DSTs)
Introduction to Section 1031
8Federman Steifman LLP
Reasons to do a Section 1031 Exchange
9Federman Steifman LLP
➢ Obtain property with more potential appreciation
➢ Alleviate joint tenancy or partnership problems
➢ Reduce management problems by exchanging into NNN property
➢ Diversify property holdings
➢ Consolidate properties
➢ Estate planning
Fundamentals of Section 1031
10Federman Steifman LLP
➢ Dispositions of real property generally trigger gain and tax
➢ No gain on disposition that qualifies for Section 1031 treatment
• Satisfy all Section 1031 requirements
• Acquire Replacement Property of equal or greater value
➢ Section 1031 preserves net worth
➢ Section 1031 defers gain
Taxable Sale of Real Property
11Federman Steifman LLP
Example 1
• Allen owns Ranch
• Purchased for $50,000
• Fair value = $250,000
• Allen sells for $250,000
• Uses proceeds plus $100,000 to purchase Apartment Building
Cash Received (Amount Realized) $250,000
Adjusted Basis $50,000Gain Realized $200,000
Gain Recognized $200,000Tax Rate 20%Tax Owed $40,000
Cost Basis in Apartment Building $350,000Deferred Gain $0
Net Worth $310,000
Exchange of Real Property
12Federman Steifman LLP
Example 2
• Allen owns Ranch
• Purchased for $50,000
• Fair value = $250,000
• Exchanges Ranch plus $100,000 for Apartment Building
Fair Value of Apartment Building $350,000Cash Paid $100,000Adjusted Basis $50,000Gain Realized $200,000
Gain Recognized $0Tax Rate 20%Tax Owed $0
Cost Basis in Apartment Building $150,000Deferred Gain $200,000
Net Worth $350,000
Section 1031 Tax Accounting
13Federman Steifman LLP
Exchange or Sell?
14Federman Steifman LLP
Example 3
• Property value = $45,000,000
• Adjusted basis = $10,000,000
• Tax rate = 20%
• Sale = receive cash
• Exchange = receive like-kind property
Taxable SaleSection 1031
Exchange
Sale Proceeds $45,000,000 $45,000,000
Gain $35,000,000 $0
Tax ($7,000,000) NONE
Available for Re-investment
$38,000,000 $45,000,000
Effect of Receiving Boot
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➢ Gain• Realize = receive economic value• Recognize = report on tax return
➢ Boot
• Money • Non-like-kind property• Net liability relief
➢ Gain recognition• Realized gain > boot = recognize amount of boot• Realized gain < boot = recognize realized gain
Gain Realized Greater Than Boot
16Federman Steifman LLP
Example 4
• Company C owns Old Building
• Value = $25,000,000
• Adjusted basis = $12,000,000
• Wants to acquire New Building
• Value = $20,000,000
• Additional cash = $5,000,000
Value of New Building $20,000,000
Cash Boot $5,000,000
Amount Realized $25,000,000
Adjusted Basis of old building $12,000,000
Gain Realized $13,000,000
Boot Received $5,000,000
Gain Recognized $5,000,000
Gain Deferred $8,000,000
Gain Realized Less Than Boot
17Federman Steifman LLP
Example 5
• Company C owns Old Building
• Value = $25,000,000
• Adjusted basis = $22,000,000
• Wants to acquire New Building
• Value = $20,000,000
• Additional cash = $5,000,000
Value of New Building $20,000,000
Cash Boot $5.000,000
Amount Realized $25,000,000
Adjusted Basis of old building $22,000,000
Gain Realized $3,000,000
Boot Received $5,000,000
Gain Recognized $3,000,000
Gain Deferred $0
Basis and Adjustments (Mechanics of Gain Deferral)
18Federman Steifman LLP
Example 4A
• Company C owns Old Building
• Value = $25,000,000
• Adjusted basis = $12,000,000
• Wants to acquire New Building
• Value = $20,000,000
• Additional cash = $5,000,000
Adjusted Basis in Old building $12,000,000
Plus Gain Recognized $5,000,000
Less Money Received ($5,000,000)
Basis in New Building $12,000,000
Boot Received $5,000,000
Gain Recognized $5,000,000
Gain Deferred $8,000,000
Gain Deferred =$20,000,000 value of replacement property
- $12,000,000 basis in replacement property
Exchanges Involving Liabilities
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➢ Exchanger’s liability relief is boot (liability-relief boot)
• Liability relief
• Transfer property subject to a nonrecourse liability
• Transferee assumes recourse liability as part of transfer
• Sale proceeds pay down existing liability at time of closing
➢ Exchanger’s liability assumed offsets liability relief
• Liability assumed reduces liability-relief boot
➢ Exchanger’s cash paid for replacement property offsets liability relief
• Cash paid reduces liability-relief boot
➢ Exchanger’s liability assumed does not offset cash received
Liability Relief Treated as Cash Received
20Federman Steifman LLP
Example 6
• Company E owns Property A
• Value = $20,000,000
• Adjusted basis = $12,000,000
• Liability = $10,000,000
• Wants to acquire Property B
• Value = $10,000,000
Value of Property B $10,000,000
Liability Relief $10,000,000
Total amount realized $20,000,000
Adjusted Basis of Property A $12,000,000
Gain Realized $8,000,000
Boot (liability relief) $10,000,000
Gain Recognized $8,000,000
Computing Boot with Liability-Netting
21Federman Steifman LLP
Example 7:
• Company F owns Property A• Value = $20,000,000• Adjusted basis = $12,000,000• Mortgage = $10,000,000
• Wants to acquire Property B• Value = $18,000,000• Mortgage = $8,000,000
Value of Property B $18,000,000
Liability ReliefLiability assumed
$10,000,000$8,000,000
Total amount realized $20,000,000
Adjusted Basis of Property A $12,000,000
Gain Realized $8,000,000
Boot (net liability relief) $2,000,000
Gain Recognized $2,000,000
Cash Paid Offsets Liability Relief
22Federman Steifman LLP
Example 8:
• Company G owns Property A• Value = $20,000,000• Adjusted basis = $12,000,000• Mortgage = $10,000,000• Cash = $4,000,000
• Wants to acquire New Building• Value = $14,000,000
Amount Realized Property B $14,000,000
Liability Relief $10,000,000
Total amount realized $24,000,000
Adjusted Basis of Property A $12,000,000
Cash $4,000,000
Total Adjusted Basis $16,000,000
Gain realized $8,000,000
Boot (liability relief – cash paid) $6,000,000
Gain Recognized $6,000,000
Liability Assumed Does Not Offset Cash Received
23Federman Steifman LLP
Example 9:
• Company H owns Property A • Value = $20,000,000• Adjusted basis = $12,000,000
• Wants to acquire New Building• Value = $24,000,000• Mortgage = $10,000,000
Amount Realized Property B $24,000,000
Cash $6,000,000
Liability assumed $10,000,000
Total amount realized $20,000,000
Adjusted Basis of Property A $12,000,000
Gain realized $8,000,000
Boot (cash received) $6,000,000
Gain Recognized $6,000,000
Loss Disallowed
24Federman Steifman LLP
➢ Inadvertent exchange of loss-property = nonrecognition of loss
➢ IRS may recast structures that are designed to defeat the exchange requirement
Elements of Section 1031
25Federman Steifman LLP
General Requirements
26Federman Steifman LLP
1. Exchange Requirement
2. Real-Property Requirement
3. Like-Kind Property Requirement
4. Holding and Use Requirement
5. Qualified-Asset Requirement
Exchange Requirement
➢ Exchange• Reciprocal transfer of property
for property
• Not a transfer of property for money consideration
➢ Structure typically exists in exchange structures• In multi-party exchanges, the QI
generally becomes the exchange partner
27Federman Steifman LLP
Exchanger
Rel. Prop
Rep. Prop.
Exchange Partner
Real-Property Requirement
28Federman Steifman LLP
➢ TCJA of 2017 added Real-Property Requirement
➢ No Section 1031 definition of real property• Generally accepted Real Property
• Land
• Permanent structures
Real-Property Definition
29Federman Steifman LLP
➢ Section 512 (UBTI)• All real property• Any property that is not personal property• Three types of real property
• Intangibles—leaseholds• Building and structural components• Other tangible real property
➢ Section 263A (capitalization rules)• Land• Unsevered natural products of land• Buildings• Inherently permanent structures
➢ Section 856 (REIT)• Land
• Water, air space, natural products, deposits unsevered from the land
• Improvements to land• Inherently permanent structures and their
structural components
Real-Property Definition
30Federman Steifman LLP
➢ Section 897 (FIRPTA, ECI)• Land• Unsevered natural products of the land• Improvements• Personal property associated with the
use of real property• Property used in mining, farming,
forestry• Property used in improvement of
real property• Property used in operation of
lodging facility• Property used in the rental of
furnished office and other work space
Like-Kind Property Requirement
31Federman Steifman LLP
➢ Nature and character
➢ Not grade or quality
➢ General interests in real property (land and permanent structures) are like-kind
All Real Property Like Kind?
32Federman Steifman LLP
➢ Each partial interest must be examined • Natural resources
• Water rights
• Leasehold interest of less than 30 years
• Easements
• Life estates & remainder interests
• Carve-outs
➢ Foreign Property not like-kind to U.S. real property
Holding & Use Requirements
33Federman Steifman LLP
➢ Replacement Property and Relinquished Property must be• Investment property or • Business-use property
➢ Excluded• Personal-use property • Property held for sale
➢ Holding Period• No minimum period• Determine intent at the time of exchange
➢ Business-Use Property• Held for productive use in trade or business.
➢ Investment Property• Held for future appreciation • Not personal-use property (i.e., not principal
residence and vacation home)
➢ Mixed-use property
Qualified-Asset Requirement
34Federman Steifman LLP
➢ Qualified Asset—any real property not held primarily for sale
➢ Dealer Property v. held for sale• Dealer: Hold property primarily for sale to customers in ordinary course of trade or
business
• Dealer property factors:
1. Nature & purpose of the acquisition of the property & duration of ownership
2. Extent & nature of taxpayer’s efforts to sell property
3. Number, extent, continuity, and substantiality of the sales
4. Extent of subdividing, developing, and improving the property
5. Use of a business office and advertising for the sale of the property
6. Supervision or control over representative selling the property
7. Time and effort the taxpayer actually devotes to the sale of the property
Identification and Receipt
35Federman Steifman LLP
Timing Requirements
180 Days
45 Days
Identification Period
Transfer of Relinquished
Property
Exchange Period
36Federman Steifman LLP
Identification Period
37Federman Steifman LLP
➢ Three-Property Rule• Any three properties regardless of value
➢ 200% Rule• Any number of properties, but total value
not greater than 200% of relinquishedproperty value
➢ 95% Rule• Acquire at least 95% of value of identified
property
➢ Property Received Rule• Property received prior to the end of the
identification period will be deemed properly identified
Identification Requirements
38Federman Steifman LLP
➢ Received before the end of identification period = properly identified
➢ Written identification
• Signed by the exchanger
• Designating a property as replacement property
• Delivered to an allowed recipient before the end of the identification period
• An allowed recipient
• Person obligated to transfer replacement property
• Any other person involved in the exchange, other than exchanger or a disqualified person
• Document signed by all the parties should satisfy the delivery requirement
Exchange Period
39Federman Steifman LLP
➢ Begins upon transfer of relinquished property
➢ Ends on the earlier of
• 180 days after relinquished property was transfer date
• tax return due date for the tax year of relinquished property transfer
Receipt Requirement
40Federman Steifman LLP
➢ Property is received before the end of the Exchange Period if • Exchanger receives the replacement property before the
end of the exchange period and
• Property received is substantially the same property as identified
• Property being constructed
• Property may be identified before in existence
• Exchanger must provide as much detail of the nonexistent property as practicable at the time of identification
• Fair market value of property to be produced is its estimated fair market value as of the date it is expected to be received by exchanger
General Exchange Structures
41Federman Steifman LLP
General Exchange Structures
42Federman Steifman LLP
Two-Party Exchange
Multi-Party Exchanges
Deferred Exchanges
Reverse Exchanges
Two-Party Exchange
43Federman Steifman LLP
Exchanger
Rel. Prop
Rep. Prop.
Exchange Partner
Multi-Party Exchange (Starker)
Exchanger
Buyer Seller
1 3
2
1. Exchanger transfers Rel. Prop. to Buyer in exchange for Buyer’s Promise to acquire Repl. Prop. and transfer it to Exchanger. Exchanger identifies Rep. Prop. within 45-day period.
2. Within 180 days after transferring the Rel. Prop., Buyer acquires Repl. Prop. from Seller.3. Buyer transfers Rep. Prop. to Exchanger.
Rel. Prop
Rep.
Prop.
$$
Transfer of Rel. Prop.
Rep. Prop.
44Federman Steifman LLP
45-Day I.D. Period
180-Day Exchange Period
Deferred Multi-Party Exchange
Exchanger
Buyer Seller
1 4
3
1. Exchanger assigns rights in sales contract to QI. QI is treated as acquiring Rel. Prop. from Exchanger.2. QI is treated as transferring Rel. Prop. to Buyer; receives sale proceeds. Exchanger identifies Rep. Prop. within 45-day
period.3. Exchanger assigns rights to acquire Rep. Prop. to QI. QI uses exchange proceeds to acquire Rep. Prop. from Seller.4. Exchanger is treated as acquiring Rep. Prop. from QI. Transaction is complete within 180-day exchange period.
Rel. Prop
Rep. Prop
.
$$
Transfer of Rel. Prop.
180-Day Exchange
Period
45-Day I.D. Period
Rep. Prop.
QI2
Rel. Prop
$$
45Federman Steifman LLP
Reverse Exchange Parking Transactions
Exchanger
Buyer
3 5
1. Exchanger loans money to EAT to acquire Rep. Prop.2. EAT acquires and holds title to Rep. Prop. while Exchanger identifies Rel. Prop. within 45 days.3. Exchanger assigns rights in sales contract to QI and transfers Rel. Prop.4. QI is treated as selling Rel. Prop. to Buyer via direct deed from Exchanger, and QI receives exchange proceeds.5. Exchanger assigns rights in QEAA to QI. QI acquires Rep. Prop. from EAT within 180-day period and transfers it to
Exchanger. 6. EAT pays off the loan.
Rel. Prop
Rep. Prop
.
QI4
Rel. Prop
$$
EAT
2Rep. Prop.
$$
$$
$$
Rep. Prop.
1 & 6
Note
Seller
46Federman Steifman LLP
Special Issues
48Federman Steifman LLP
(g)(6) Restrictions on Exchange Proceeds
49Federman Steifman LLP
➢ (g)(6) restrictions• Exchange Agreement must expressly limit the
exchanger's right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI
➢ Failure to follow this requirement• Current exchange fails Section 1031 exchange
requirement
• QI status lost for all exchanges—language in exchange agreement is illusory
➢ Allowed lapse of restrictions• At end of 45-day identification period, if no
property identified
• When exchanger receives all possible replacement property
• Occurrence of a material and substantial contingency
Use of Exchange Proceeds for Ordinary Income Items
50Federman Steifman LLP
➢ QI may distribute exchange proceeds for ordinary income items
➢ Ordinary Income Item
• Payments on the transfer or receipt of property that are not included in
the basis or amount realized
• Prorated rent
• Property taxes
• Utilities and property insurance debited to the exchanger
➢ Best to make all distributions only upon the closing of transfers
➢ Use of proceeds to pay such items could be boot to exchanger
➢ Deductions may offset gain from boot
Use of Exchange Proceeds for Transactional Items
51Federman Steifman LLP
➢ QI may distribute exchange proceeds for transactional items➢ Use exchange proceeds for transactional items only at closing of
transactions• Costs incurred for surveys, title examinations, physical inspection reports,
environmental studies, brokerage commissions, and financing fees• Loan fees, points, loan application fees, mortgage insurance, lender's title
insurance, assumption fees, and other costs related to the acquisition of a loan • These items are generally capitalized and amortized over the life of the loan• Do not affect the basis of the property received • May be boot if paid for using exchange proceeds
➢ Must appear on closing statement to be transactional item➢ Transactional Items reduce amount realized or increase adjusted
basis
Improvements on Replacement Property
52Federman Steifman LLP
➢ QI may distribute exchange proceeds for the construction of improvements on replacement property in limited circumstances
• If seller holds title to the replacement property, QI may advance funds to seller to construct improvements
• Exchanger should be aware of seller’s control of funds and construction
• QI should be able to advance funds to an EAT to construct improvements on property the EAT holds
Earnest Money Payments
53Federman Steifman LLP
➢ To ensure compliance with (g)(6) restrictions• QIs should use exchange proceeds to
make earnest money payments for replacement property only if
• QI signs the purchase sale agreement
• Earnest money is not refundable to the exchanger
• If the exchanger pays earnest money, the QI should not reimburse the earnest money payments to the exchanger until after the (g)(6)restrictions expire
Installment-Sale Treatment of Some Busted Exchanges
54Federman Steifman LLP
➢ Installment-sale treatment applies to an exchange that straddles tax years
• Exchanger disposes of property in second half of tax year• Exchanger does not complete exchange• Exchanger receives exchange proceeds at the end of the 180-day
period in subsequent tax year• Exchanger recognizes gain in year of receipt
➢ Planning to obtain installment-sale treatment
• Delay transfer of relinquished property until after July 5 or so• Identify replacement property, if transfer is before November 15 or so• Receive exchange proceeds at end of 180-day identification period in
subsequent year
Seller Financing
55Federman Steifman LLP
➢ Exchanger might finance purchaser’s acquisition of relinquished property
➢ Exchanger’s receipt of purchaser’s note will be boot—gain recognized under installment method
➢ Exchanger may structure financing to avoid receipt of note• Purchaser draws note to QI, QI factors note
(perhaps to exchanger), QI acquires replacement property
• Replacement property seller could accept the note as part of the sales proceeds
• In some cases the note could be paid in full during the exchange period
Related-Party Exchange
56Federman Steifman LLP
Basis-Shifting and Cashing-Out
57Federman Steifman LLP
➢ Exchanger owns Greenacre—Low-basis property• Buyer offers to purchase exchanger’s property
• Sale would trigger gain and tax
➢ Related Party owns Blackacre—High-basis property
➢ Exchanger and Related Party Exchange Properties• Greenacre takes high basis
• Blackacre takes low basis
➢ Exchanger sales Greenacre for No Gain
Situation Preceding Related-Party Exchange
Buyer
ExchangerRelated Party
Greenacre BlackacreFMV = $150,000
AB = $50,000
FMV = $150,000AB = $150,000
$$
• Exchanger and Related Party each own property
• Exchanger’s has low basis; Relate Party’s has high basis
• Buyer has an interest in acquiring Exchanger’s property
58Federman Steifman LLP
Section 1031(f)(1) Example
Buyer
ExchangerRelated Party
Greenacre Blackacre
Exchange and Shift Bases
59Federman Steifman LLP
FMV = $150,000AB = $50,000
FMV = $150,000AB = $150,000
Situation Following Related-Party Exchange
Buyer
Exchanger
Related Party
GreenacreFMV = $150,000AB = $150,000
BlackacreFMV = $150,000
AB = $50,000
$$
Exchanger and Related Party could cash out of Greenacre investment tax-free, but for Section 1031(f)(1)
60Federman Steifman LLP
Related-Party Rules—Section 1031(f)(2)
61Federman Steifman LLP
Disregard the following subsequent dispositions
• After the death of the exchanger or related party
• Section 1033 compulsory or involuntary conversion• Exchange must occur prior to the threat or
imminence of such conversion
• No tax avoidance motive for exchange or subsequent disposition • More on non-avoidance exception later
Related-Party Rules—Section 1031(f)(4)
62Federman Steifman LLP
➢ Section 1031(f)(4)• Section 1031(a) does not apply if a
transaction (or series of transactions) is structured to avoid purposes of Section 1031(f)
Related-Party Rules—Section 1031(f)(4)
63Federman Steifman LLP
➢ Acquisition of high basis property from a related party in QI-facilitated exchange comes within Section 1031(f)(4)• Rev. Rul. 2002-83, 2002-2 CB 927 • Teruya Broters, Ltd. v. Comm’r, 124 T.C
45 (2005)• Ocmulgee Fields, Inc. v. Comm’r, 613
F.3d 1360 (11th Cir. 2010)
➢ Prior to exchange• Exchanger holds low-basis property;
related party holds high-basis property
➢ Following exchange• Exchanger holds low-basis property;
related party holds cash
Situation Preceding Related-Party Exchange
Buyer
ExchangerRelated Party
Greenacre BlackacreFMV = $150,000
AB = $50,000
FMV = $150,000AB = $150,000
$$
• Exchanger and Related Party each own property
• Exchanger has low basis; Related Party has high basis
• Buyer has an interest in acquiring Exchanger’s property
64Federman Steifman LLP
Prohibited Multiple-Party Transactions (Teruya & Ocmulgee)
QI
Buyer
ExchangerRelated Party
65Federman Steifman LLP
Prohibited Flattened Transaction (§ 1031(f)(1))
Buyer
Exchanger Related Party
High-basis property
Low-basis property
Exch.-b
asis pro
perty
$$
, no
gai
n
End result same as Teruya and Ocmulgee
66Federman Steifman LLP
Situation following Related-Party Exchange
• Exchanger and Related Party could cash out of Greenacre investment tax-free, but for Section 1031(f)(1)
• Exchange altered property-cash situation
Buyer
ExchangerRelated
Party
Greenacre
BlackacreFMV = $150,000
AB = $50,000
FMV = $150,000AB = $150,000
$$
67Federman Steifman LLP
Related-Party Rules—Section 1031(f)(4)
68Federman Steifman LLP
➢ Related-party purchase of exchanger’s property is not a basis-shifting transaction
• P.L.R.s 201027036 (Mar. 30, 2010); 200728008 (Apr. 12, 2007); 200709036 (Nov. 28, 2006); 200712013 (Nov. 20, 2006)
➢ Prior to exchange• Exchanger holds property; related
party holds cash
➢ Following exchange• Exchanger holds property; related
party holds cash
Situation PrecedingRelated-Party Exchange
ExchangerRelated
Party
BlackacreFMV = $150,000
AB = $50,000
$$
• Exchanger has low-basis property
• Related party has cash
69Federman Steifman LLP
Allowed Multiple-Party Transaction(PLR 200709036)
QI
Buyer
ExchangerRelated
Party
Seller
Co
st-basis p
rop
erty
$$
, no
gai
n
70Federman Steifman LLP
Situation following Related-Party Exchange Related
Party
$$
Exchanger
Replacement Prop.
FMV = $150,000AB = $50,000
• Exchanger has low-basis property; related party has cash
• Exchange did not alter property-cash situation
71Federman Steifman LLP
Advanced Exchange Structures
73Federman Steifman LLP
Types of Advanced Exchange Structures
74Federman Steifman LLP
➢ Build-to-Suit Exchanges
➢ Leasehold Improvements Exchanges
Services and Personal Property Concern
75Federman Steifman LLP
➢ Like-Kind Property• Real property is not like kind to
services (including production services) or building materials
• Any additional construction on the replacement property after the property is acquired by the taxpayer will not be like kind (Reg. § 1.1031(k)-1(e)(4))
➢ Real Property• Services and building materials
are not real property
Build-to-Suit Exchanges
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Build-to-Suit Exchanges
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➢ Exchanger has property to sell
➢ Exchanger would like to use proceeds to • Acquire property from third party
• Construct improvements on property held by third party
➢ Concerns• If seller-facilitated, will seller
complete construction on time, as specified
• If exchanger has too much control, does tax ownership pass to exchanger
Seller-Facilitated Build-to-Suit Exchange
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➢ Exchanger enters into agreement to purchase replacement property
➢ Seller agrees to construct improvements to Exchanger’s specifications
Safe-Harbor Build-to-Suit Exchanges
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➢ EAT takes title to property
➢ Construction happens while EAT is on title
Build-to-Suit Exchange Exchange
r
Buyer Seller
1 6
1. Exchanger assigns rights in Rel. Prop. sales contract to QI and transfers property.2. QI is treated as selling Rel. Prop., and QI receives exchange proceeds. Exchanger identifies Rep. Prop. within 45-day ID period.3. QI advances exchange proceeds to EAT. 4. EAT acquires Rep. Prop., constructs improvements. Exchanger identifies Rel. Prop. Within reverse-exchange 45-day ID period.5. EAT transfers improved Rep. Prop. to QI in satisfaction of note within 180 days after Exchanger transferred Rel. Prop.6. Exchanger receives improved Rep. Prop.
Rel. Prop
QI2
Rel. Prop
$$
EAT
4 Rep. Prop.$$
Builder4
$$
Rep. Prop.
Improve-ment
Improve-ment
Rep. Prop.
Improve-ment
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Non-Safe-Harbor Build-to-Suit Exchanges
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➢ Titleholder holds title for more than 180 days
Bartell v. Commissioner
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➢ Tax Court holds that a non-safe harbor improvements exchange qualifies for Section 1031 nonrecognition
➢ Accommodator held title to replacement property for more than 180 days
➢ Benefits and burdens appear to pass to exchanger
➢ Tax Court applies a formalistic test to determine that accommodator is the tax owner of the property for Section 1031 purposes
IRS Nonacquiesence
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➢ Claims Tax Court was wrong
➢ Benefits and burdens should determine who is the tax owner of property
➢ Nonacquiesence versus appeal
Effect of Nonacquiesence
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➢ Effect on penalty analysis (substantial authority?)
• Likelihood of reporting position being upheld
• Tax Court opinion v. IRS nonacquiesence
• Tax Court reasoning v. IRS reasoning
• Path to IRS victory
• Taxpayer can ensure dispute goes through Tax Court
• Would Tax Court disregard its precedent?
• How would circuit courts rule?
• Will IRS appeal to a circuit court that is not the Ninth Circuit?
Economic Decision
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➢ Paying the tax is most likely more costly than doing a Bartell transaction
➢ Probability of paying the tax on a Bartell is less than 1
➢ T < P • B + R• Where
• T = the cost of paying the tax, i.e., not doing a Bartell transaction
• P = probably of paying the tax if taxpayer does a Bartelltransaction
• B = the tax that would be owed if IRS audits return and challenges the Bartell reporting position
• R = cost of structuring Bartell transaction
• If P < T ÷ (B + R), Bartell structure costs less than paying the tax
Example
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➢ Tax = $1,000,000
➢ Transaction Cost = $60,000
➢ Probability threshold: $1,000,000 ÷($1,000,000 + $60,000) = 94%
➢ Proof: $1,000,000 = 0.94 • $1,000,000 + $60,000
➢ If the probability of paying the tax with the Bartell structure is less than 94%, the expected cost of doing the Bartellstructure is less than the cost of paying the tax without doing the Bartellstructure
Leasehold Improvements Exchanges
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Leasehold Improvement Situation
Exchanger Exchanger
Related Party
Real Property for Sale
Raw LandReal Property
for SaleRaw land
OR
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Objective
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Exchanger would like to use the proceeds from the sale of its property to construct improvements on the raw land
Exchanger wants Section 1031 nonrecognition
Relevant Section 1031 Elements
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➢ Keys to improvement exchanges• Like Kind
• Real Property
• Exchange
➢ Related-Party Rules
Already-Owned Property Not Eligible for Exchanges
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➢ Exchange• Reciprocal transfer of property
• Cannot acquire already-owned property as part of an exchange
• Transfer to an EAT does not cleanse the pre-owned status (Rev. Proc. 2004-51)
• Ownership by a related party for at least 180 days may cleanse pre-owned status, but beware of the related-party exchange rules
Planning Strategy
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➢ Avoid building on already-owned property• Use related party’s property
➢ Avoid basis shifting and cashing out• Ensure that improvements, not already-
owned property, are the replacement property
Leasehold Improvement Exchange Structure
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➢ Related party leases property to EAT
➢ EAT constructs leasehold improvements
➢ Exchanger acquires leasehold with improvements from EAT in exchange for relinquished property
Leasehold Improvements Exchange
Exchanger
Buyer
4 5Rel. Prop
QI4
Rel. Prop
$$
EAT
2$$
Builder3
$$
Improve-ment
Improve-ment
Related Party
1. Exchanger lends funds to EAT.2. Related Party grants an arms-length 32-year leasehold in raw land to EAT.3. EAT constructs improvements on the leased raw land, and Exchanger identifies Rel. Prop. within 45 days.4. Exchanger transfers Rel. Prop., and QI is treated as selling Rel. Prop. to Buyer, and QI receives exchange proceeds.5. QI uses exchange proceeds to purchase improved Rep. Prop. leasehold from EAT and transfer it to Exchanger.6. EAT pays off construction loan.
$$
1 & 6
Note
Lease
Lease
Improve-ment
Lease
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IRS Approved Leasehold Improvement Exchange
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➢ IRS approved leasehold improvement exchange in PLR 200251008• Unrelated party owned fee • Related party had a 45 year ground sublease• Related party subleased property for 32 years to EAT to make
improvements• Within 180 days EAT transferred leasehold and improvements to
exchanger
➢ IRS approved similar structure in PLR 200329021• Related party owned long-term lease of property • Related party assigned the lease to the EAT to make improvements• EAT assigned leasehold and improvements to exchanger• IRS approved, but required each party to hold for two years
Need for Long-Term Lease
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➢ Only leases with a term of 30 years or more are like kind to real property• Count optional renewal periods
➢ Lease must provide for FMV rent of leased property, exchanger continues to pay rent
➢ Value to exchanger is difference between rent without improvements and use of property with improvements
Acquisition of Identified Property
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➢ The replacement property received must be substantially the same property as identified
➢ Receipt of incomplete construction okay if property received would (if completed) be substantially the same as that identified
Avoids Related-Party Rules
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➢ No basis shifting or cashing out• Related party does not transfer property to EAT, so no
basis shifting
• Related party enters into FMV lease with EAT, so cash related party receives is ordinary income to related party
➢ Value of replacement property is use of improved property for unimproved rent• EAT creates the value by constructing improvements
A Caveat . . .
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➢ The Service and Treasury Department are continuing to study the application of Rev. Proc. 2000-37 to exchanges with related parties (Rev. Proc. 2004-51, §2.06)
• Does not prohibit application
• No action in 18 years
• Many advisors and exchangers do leasehold improvement exchanges
Conclusion
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➢ Leasehold must be from related party, who did not acquire property from exchanger within 180 days
➢ Lease to EAT must be FMV
➢ Shovel-ready when EAT enters into lease allows for considerable improvement
➢ Rent payments continue after exchange
➢ Numerous variations of structure
Exchanges and Business Transactions
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Types of Exchanges of Business Transactions
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PARTNERSHIPS CORPORATIONS➢ Drop-and-Swaps
• Typical drop-and-swap scenario• Section 1031 issues and law• Judicial doctrines
➢ Drop-Swap Cash-Outs• Tax Treatment of various
alternatives
➢ Swap-and-Drops• Typical swap-and-drop• Section 1031 issues and law• State-law theory of partnerships• Partnership tax issues
➢ Drop-and-Swap/Swap-and-Drop Variant
➢ Corporate Tax Basics• Double-Tax Problem• Entity-Tax Problem
➢ Corporate Liquidations
• C-to-S Conversions• Built-in-Gains Tax
➢ S-Corporation-to-Partnership Conversions
• Constructive Liquidation
➢ S Corporation Divisions
➢ Other Strategies
Drop-and-Swaps
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• A, B, and C are equal members• A, B, and C wish to sell Office• A wishes to reinvest individually• B and C wish to reinvest together
Typical Drop-and-Swap Scenario
A B C
Office
LLC
Each Member’s Unrealized Gain
Fair Value $300,000
Adjusted Basis $100,000
Unrealized Gain $200,000
Share Unrecap § 1250 Gain $150,000
Outside Basis = Share of Adjusted Basis
Capital Accounts = Outside Basis
LLC’s Unrealized Gain
Fair Value $900,000
Adjusted Basis $300,000
Unrealized Gain $600,000
Unrecaptured § 1250 Gain $450,000
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❖ Same issues if B and C also wish to reinvest individually
Typical Drop-and-Swap Strategy (distribute first)
A B C
2/3 Office
1/3 Office
LLC’s Exchange
1/3 Office LLCQI
QI
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Section 1031 Issues
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➢ Exchange Requirement• Same person must transfer and receive
• Lose Section 1031 nonrecognition if LLC transfers relinquished property, and A receives replacement property
➢ Holding Requirement• A must be the tax owner of real property
➢ Use Requirement• A must hold 1/3 Office for business use
or investment
➢ Qualified-Asset Requirement• Cannot be tax-partnership interest
• Rev. Proc. 2002-22, Condition 3
• No prior entity ownership
Use Requirement
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➢ Negative Authority• Rev. Rul. 77-337, 1977-2 C.B. 305
➢ Positive Authority“[T]he intent to exchange property for like-kind property satisfies the [use] requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits.”
Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985)
• Mason v. Commissioner, 55 T.C.M. (CCH) 1134 (1988)
➢ Form 1065, Schedule B, Line 14• “At any time during the tax year, did
the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”
Holding Requirement
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➢ LLC must distribute interest in Office to A
• Commissioner v. Court Holding, 324 U.S. 331 (1945)
• Tax-free distribution from corporation followed by sale to avoid entity-level tax
➢ A must be tax owner of the interest in Office
• Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)
• Chase v. Commissioner, 92 T.C. 874 (1989)
• Bad facts. Substance over form?
➢ Holding period requirement?• Tax ownership is all or nothing—not transfer by
degrees as closing approaches
Qualified-Asset Requirement
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➢ TIC under state law, tax partnerships?• Rev. Proc. 2002-22
• Dozens of cases (more than 100)
➢ Basic Strategies• Limit management activity
• Do not file tax return
• Do not treat as a partnership
• Do not hold in separate entity unless it is a DST that is compliant with Rev. Rul. 2004-86
Drop-Swap Cash-Outs
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Drop-Swap Cash-Out Scenario
A B C
Office
• A, B, and C are equal members• A, B, and C wish to dispose of Office• A wishes to cash out• B and C wish to reinvest together in like-kind property• B and C might consider bringing in right person as a new member
LLC
Each Member’s Unrealized Gain
Fair Value $300,000
Adjusted Basis $100,000
Unrealized Gain $200,000
Share Unrecap § 1250 Gain $150,000
Outside Basis = Share of Adjusted Basis
Capital Accounts = Outside Basis
LLC’s Unrealized Gain
Fair Value $900,000
Adjusted Basis $300,000
Unrealized Gain $600,000
Unrecaptured § 1250 Gain $450,000
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Cash-Out Concerns
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➢ A not concerned about Section 1031 requirements
➢ LLC concerned about transfer of tax ownership on distribution
➢ LLC does not want A’s actions to taint its Section 1031 exchange
➢ What is character of A’s recognized gain?
➢ What is character of LLC’s deferred gain?
➢ What are the various cash-out alternatives and what are their tax consequences?
Cash-Out Alternatives
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1) Distribution-first cash-out
2) LLC exchanges/sells, uses regular allocations, distributes cash
3) LLC exchanges/sells, uses special allocations, distributes cash
3(a) LLC exchanges/sells, uses fill-up allocations, distributes cash
4) LLC exchanges/sells, receives installment note, distributes note
5) Member sells tax-partnership interest
6) Other members buy cash-out member’s tax-partnership interest
7) Single other member buys cash-out member’s tax-partnership interest
8) Leveraged cash-out
Swap-and-Drops
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Swap-and-Drop Scenario
A B C
OfficeLand
• A owns Land• B and C own Office as tenants-in-common• A would like to sell Land and acquire an interest in Office• A, B, and C would like to own Office in an LLC
❖ Alternatively, B and C could own Office in a tax partnership❖ A would like to sell Land and become a member of LLC❖ Or A, B, and C may wish to exchange their respective
properties and acquire property together to hold in an LLC
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Typical Swap-and-Drop Strategy
A B C
2/3 Office
1/3 Office
Land
1/3 Office
1/3 Office
2/3 Office
LLC
QI
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Section 1031 Issues
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➢ Use Requirement• A must hold Office interest for
business use or investment
➢ Holding Requirement• A must acquire tax ownership of
interest in Office, not a tax-partnership interest
• Similar to drop-and-swap issues
➢ Exchange Requirement• A must transfer Land and acquire
interest in Office
• Similar to drop-and-swap issues
Use Requirement
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➢ Negative Authority• Rev. Rul. 75-292, 1975-2 C.B. 333
➢ Positive Authority• § 1031 and § 721 represent “continuation,
not liquidation, of old investment”
• Use requirement: “So long as . . . the taxpayers continue to own the property and to hold it for investment, a change in the mechanism of ownership which does not significantly affect the amount of control or the nature of the underlying investment does not preclude nonrecognition under section 1031(a).”
• Step-transaction doctrine: “Between two equally direct ways of achieving the same result, [taxpayers are] free to choose the method which entail[s] the most tax advantages to them.”
Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985)
State-Law Entity Theory
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➢ Magneson Court’s Distinctions Overstated• Entity v. Aggregate View
• Always have both entity and aggregate aspects, especially with closely-held entities
• Control and Management• Shareholders of close corporations
control
• General partners’ control can be limited
• Distinctions with closely-held entities is often nominal
Partnership Tax Issues
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➢ Section 704(c) for contributed property• Does Section 1250 follow Section 704(c)
allocation?
➢ LLC’s holding period could vary with different interests• A’s holding period could be long term• B’s and C’s holding periods could be short
term
➢ Character Taint• Section 724(b) applies if B and C held as
inventory/dealer property—ordinary income for 5 years after contribution
➢ Form 1065, Schedule B, Line 13
• “Check this box if, during the current or prior tax year, the partnership . . . contributed [property received in a like-kind exchange] to another entity (other than disregarded entities . . . .)”
Drop-and-Swap/Swap-and-Drop Variant(exchange-first Drop-and-Swap)
A B C
RP 1
LLC Exchanges
RP 1 RP 2
• Does LLC satisfy use requirement?
• Does LLC satisfy holding requirement?
• What about non-tax concerns of LLC holding RP 1? Office
LLC
QI
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Section 1031 Issues
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➢ Exchange and Holding Requirements
• Same as distribution-first
➢ Use Requirement
• Exchange followed by liquidation of corporation under old § 333
• “Instant case can be viewed as a variant of Magneson . . . or as a variant of Bolker.”
• “[Corporation’s] purpose was the purpose of [the shareholders].”
• “[W]here a taxpayer surrenders stock in his corporation for real estate owned by the corporation, he continues to have an economic interest in essentially the same investment, although there has been a change in the form of ownership.”
Maloney v. Commissioner, 93 T.C. 89 (1989)
Section 1031 Issues
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➢ Use Requirement (continued)
• “A trade of property A for property B, both of like kind, may be preceded by a tax-free acquisition of property A at the front end, or succeeded by a tax-free transfer of property B at the back end.”
Maloney v. Commissioner, 93 T.C. 89 (1989)
➢ Form 1065, Schedule B, Line 13
• “Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange” or contributed such property to another entity (other than disregarded entities wholly owned by the partnership throughout the tax year)”
Corporations: Tax Basics
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Fundamentals of Corporate Taxation
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➢ Generally• Corporate-level tax
• Shareholder-level tax on dividends
• Contributions of property generally taxed
• Distributions of property
• Taxed at corporate level
• Taxed at shareholder level
➢ S-Corporations• No entity-level tax—Income flows through to
shareholders
• Contributions and distributions subject to general corporate rules
Taxation of C-Corporation Income
Office
C-Corporation
A B C
Corporate-Level Tax
Corporate Income $100,000
Tax Rate 21%
Tax $21,000
Distributable Income $79,000
Aggregate Shareholder-Level Tax
Distributed Income $79,000
Tax Rate 23.8%
Tax $18,802
Net Cash to Shareholders $60,198
$
$
$
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Distributions are dividends.
Fundamentals of S-Corporation Taxation
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➢ Corporate-level income, gain, and losses flow through to shareholders
➢ Allocated corporate items affect shareholder basis• Allocated income and gain increase basis
• Allocated losses decrease basis
➢ Nonliquidating distributions• Nontaxable return of basis to extent of basis
• Distributions in excess of basis treated as gain
➢ Liquidating distributions treated as consideration for stock
S-CorporationRequirements
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➢ No more than 100 shareholders
➢ Shareholders are individuals• Some exceptions for trusts and estates
➢ Shareholders are U.S. residents or citizens
➢ One class of stock• Voting-nonvoting not relevant
➢ Elect to be treated as S-corporation
➢ Terminated S-corporation becomes a C-corporation
Taxation of S-Corporation Income
Office
S-Corporation
A B C
Corporate-Level Tax
Corporate Income $100,000Tax Rate 0%Tax $0
Distributable Income $100,000
Taxation to Each Shareholder on Allocated Gain
Share of Income $33,333Sec. 199A Deduction (20%) $6,667
Taxable Income $26,666Tax Rate 37%Tax $9,866
Shareholder Tax Attributes
Stock Value $300,000Basis in Stock $250,000Unrealized Gain $50,000
$
$
$
Effect on Each Shareholder’s Basis
Beginning Basis $250,000Allocation of Income $33,333Basis After Allocation and Distribution $283,333
129Federman Steifman LLP
Corporate income is allocated to shareholders.
Each shareholder has share of income.
Income increases shareholder basis.
Taxation of S-Corporation Distribution
Office
S-Corporation
A B C
Effect on Each Shareholder’s Basis
Basis After Allocations $283,333Distribution ($33,333)Basis After Distribution $250,000
$$
$
130Federman Steifman LLP
Distributions decrease shareholder basis.
No gain on distribution because basis is greater than distribution.
Concurrent Ownership Structures (TICs and DSTs)
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Economic Reasons for TICs and DSTs
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➢ Re-investment choices for people selling real property• Stocks, bonds, other financial instruments—no Section 1031 • Real estate—if properly structured, qualifies for Section
1031 deferral
➢ Re-investment objectives• Bigger property• Better property• Passive involvement• Tax deferral
➢ TICs and DSTs allow exchangers to • Join together on a single piece of property• Sell their interests and separately enter into exchanges or
cash-out of investments
Typical Real Estate Re-Investment Alternatives
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➢ Rental house or shopping center• Qualifies for Section 1031 treatment• Same type of property as previously owned• Probably requires active involvement
➢ REITs • Lose Section 1031 treatment• UPREIT for high-quality relinquished property
➢ LPs/LLCs• Lose Section 1031 treatment
➢ TICs and DSTs• May provide opportunity to do Section 1031
exchange
Legal Reasons for TICs and DSTs
134Federman Steifman LLP
➢ Section 1031 only applies to real property• Interests in properly structured TICs and DSTs are
interests in real property
➢ Partnership and LLC interests are not real property• Interests in poorly structured TICs and DSTs can be
partnership interests
➢ Cannot directly exchange into or out of partnership and LLC interests
Fundamental Legal Questions
135Federman Steifman LLP
➢ Is a TIC a default partnership or a TIC?• Answer turns on the definition of tax partnership
• Arrangement is a TIC, if it is not a tax partnership
• Federal-tax question, not a state-law question
• Tenants-in-common own interests in the underlying property
➢ Is a DST a business trust or an investment trust?• DST is a separate entity for tax purposes
• DST with multiple members is partnership or investment trust
• Investment trusts are disregarded for tax purposes
• Beneficiaries of investment trusts are treated as owning interests in trust property
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