The definition of net investment income applies the tax to MAGI above the threshold levels “to the extent taken into account in computing taxable income.”  Thus, gain deferred under Section 1031 should not be subject to the tax, although regulations have yet to be issued.

Example A:

A single taxpayer has MAJI of $150,000, including $100,000 of gain from a rental home. The tax does not apply because the MAJI is less than $200K.

Example B:

A single taxpayer has MAJI of $250,000, including $100,000 of gain from a rental home.  The tax applies to $50,000 of the gain (the net investment income in excess of MAJI).

Example C:

A single taxpayer has MAJI of $300,000, including $100,000 of gain from a rental home.  The tax applies to the full $100,000 of gain.

The Tax Court concluded the exchange was disallowed based on the provisions of Section 1031(f)(4), that the transaction, or series of transactions, were structured solely to avoid the purposes of the related party rules under Section 1031(f).

Ocmulgee, in its appeal, argued the Tax Court’s factual findings were erroneous and that neither the Taxpayer nor the related party intended to subvert the related party rules, and provided a list of explanations for why the exchange was structured as it was.

The Circuit Court found Ocmulgees’ explanations non-persuasive and concluded the Tax Court did not err in its holding.

Industry’s only trade association supports strong regulation, looks forward to working with Consumer Financial Protection Bureau to craft consumer protection measures.

(From FEA press release issued June 24, 2010)

President Obama is slated to sign the Consumer Financial Protection Act of 2010 (“CFPA”) into law in the coming days, and the Federation of Exchange Accommodators (“FEA”) believes the move is an important first step toward assuring comprehensive protection for all consumers. The FEA, the trade association representing the exchange facilitator industry, says it looks forward to working with the Consumer Financial Protection Bureau to develop regulations governing exchange facilitators, also known as Qualified Intermediaries, who facilitate tax-deferred exchange transactions under Internal Revenue Code §1031. Regulations are needed especially with respect to the security of client funds.

The CFPA will include a provision requiring the Director of the Consumer Financial Protection Bureau to conduct a study and propose legislation and/or regulations to protect consumers using exchange facilitators. The study and recommendations must be completed with 1 year after the new law takes effect, and a program or proposed regulations must be implemented within 2 years after the Director’s report.

“This is a great beginning. However, there is much more work to be done to achieve our goal of comprehensive federal regulation that will cover all exchange clients and transactions,” stated FEA President David Gorenberg. “The FEA has previously communicated to legislators our support for this bill along with our technical concerns that many transactions will not fit the definitional scope of the CFPA. We are looking forward to working with the Director and the legislative sponsors to identify and suggest regulations or legislation that will not be limited to transactions solely involving individuals engaged in exchanges for ‘personal, family or household use,’” echoed Suzanne Goldstein Baker, chairperson of the FEA’s Federal Legislative Committee. “The FEA intends to work with the Director to ensure that all taxpayers, regardless of whether they are individuals or business entities, benefit from mandatory protections,” added Mr. Gorenberg.

The FEA has been a strong supporter of federal regulation of its industry to require prudent funds management standards and other protections for its clients. In 2007 the FEA petitioned the FTC for regulatory oversight and submitted to it a comprehensive draft regulation. The FTC denied the petition, concluding that there was no evidence of pervasive fraud throughout the industry and thus, the burdens of regulation would outweigh the potential benefits. The FEA has since been actively involved in passing state legislation to regulate exchange facilitators. The FEA drafted a “model law” which the states of California, Colorado, Maine, Nevada, Oregon, Virginia and Washington have adopted with slight variations. The FEA has also submitted to the Secretary of the Treasury and the Internal Revenue Service a proposed amendment to Treasury Regulations which would impose reasonable, understandable standards of prudent funds management requiring that funds held by Qualified Intermediaries be invested in a manner that maintains liquidity and preserves principal.

About the FEA

The Federation of Exchange Accommodators (“FEA”) is the industry association for exchange facilitators. FEA member companies facilitate tax-deferred exchanges of investment and business use properties under IRC §1031 for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and business entities. Members range from small, privately held businesses to large, publicly traded companies and banks. Transactions range from less than $100,000 to hundreds of millions of dollars involving commercial and residential real estate, aircraft, trucks, trailers, containers, railcars, heavy equipment and other assets. To comply with tax rules, exchange facilitators typically hold proceeds from the sale of relinquished assets until they can be reinvested in replacement assets to complete the exchange. Section 1031 exchanges must be completed within 180 days. More information is available on the FEA’s website, www.1031.org.

(From FEA E-Bulletin dated April 8, 2010)

In a Chief Counsel Advice Legal Memorandum, the IRS advised that a heavy equipment lessor could not acquire replacement property (RP) in an exchange from its related party dealer when the buyer of the relinquished property (RQ) was an unrelated party.  The IRS ruled that transaction was structured (in part) to avoid the § 1031(f) restrictions on exchanges between related parties. Further, the taxpayer did not establish that the transaction met the § 1031(f)(2)(C) exception to the restrictions on exchanges between related parties.

Dealer sold a certain brand of equipment at retail. Taxpayer, a related party to dealer under IRC § 267(b), leased that type of equipment to unrelated customers in the course of its trade or business.  Under a master exchange agreement described in Rev. Proc. 2003-39, Taxpayer used a QI to exchange its old equipment for new equipment acquired from Dealer. Basis shifting occurred because Dealer sold inventory into the exchange at its cost (realizing no gains), while Taxpayer attempted to defer its gain from the disposition of RQ by taking a substituted basis (the high basis of RP for the low basis of RQ).

Taxpayer acknowledged that it could have obtained RP directly from the unrelated manufacturer of RP or an unrelated dealer. Taxpayer represented that it had independent business reasons for always acquiring its RP from Dealer. These included the proximity of Dealer’s inventory to Taxpayer’s business, the possibility of financing discounts for patronizing Dealer, and the stability of supply due to the good will and established business relations between Dealer and the manufacturer. In addition, the manufacturer provided incentives to Dealer for each unit of equipment sold by Dealer.

The Memorandum first finds that the transaction falls within § 1031(f)(4) and Rev. Rul. 2002-83. Thus, it is an invalid exchange unless Taxpayer can show, under § 1031(f)(2)(C), that Taxpayer’s independent business reasons established that tax avoidance was not one of Taxpayer’s principal purposes for structuring the transaction as an exchange. The legislative history of 1031(f) lists three examples of transactions that fit within 1031(f)(2)(C) as non tax avoidance exceptions: an exchange of undivided interests, a disposition of property in a nonrecognition transaction by one of the related parties, or a non basis-shifting transaction. The Memorandum states that the Taxpayer’s exchange clearly resulted in basis shifting and thus did not fit within the listed exceptions. The Memorandum further states that the Service has consistently limited § 1031(f)(2)(C) to the situations described in the legislative history, and the Service is not willing to expand the exception to cover Taxpayer’s situation.

The Memorandum goes on to state that while the Taxpayer cited its independent business reasons as evidence that tax avoidance was not its sole objective, 1031(f)(2)(C) excepts transactions only if none of the principal purposes for the structure is tax avoidance.  Thus, even though Taxpayer may have had some non-tax-avoidance reasons for structuring the exchange, immediate tax reduction was also clearly one of Taxpayer’s principal objectives.

Comment:  The Service has set a high bar for non tax avoidance exceptions other than those listed in the legislative history.  The tax deferral in such a situation would have to be minimal for it not to be a principal objective of the exchange. Or perhaps the business reason would have to be so overriding that the tax deferral is only a side effect.

(From FEA Press Release dated April 7, 2010)

The Tax Court held that property acquired by taxpayers in a Section 1031 exchange did not qualify as replacement property when the taxpayers moved into the property two months after acquiring it.  Taxpayers were also held liable for the accuracy-related penalty.

In October 2002 taxpayers signed a purchase agreement to acquire a single family property in Georgia (the Pebble Beach property). The purchase agreement was contingent upon sale of taxpayers’ personal residence in California. In February 2003 taxpayers sold their principal residence in California and began living with their in-laws in Georgia. In March 2003 taxpayers sold rental property located in California and used a QI to structure an exchange. Taxpayers purchased the Pebble Beach property as replacement property.

The court ruled that taxpayers did not intend to hold the Pebble Beach property for productive use in a trade or business or for investment at the time of exchange, and therefore it was not valid replacement property. The court first noted that taxpayers moved into the Pebble Beach property two months after acquiring it. Further, they did not move into it temporarily until renters could be found. Their efforts to rent the Pebble Beach property were minimal. They merely placed an advertisement in a neighborhood newspaper for a few months, and no further efforts were made to gain more exposure for the Pebble Beach property. Moreover, taxpayers began preparations to finish the basement of the Pebble Beach property, having a builder obtain permits for construction, within two weeks of purchase.

The court surmised that taxpayers were contemplating use of the Pebble Beach property as a personal residence before the exchange. It noted that taxpayers made purchase of the Pebble Beach property contingent upon sale of their personal residence in California. They sought advice from the QI regarding whether they could move into the property if renters could not be found.   Taxpayers did not research whether covenants of the homeowners association would allow for rental of the Pebble Beach property before the exchange. They also did not research rental opportunities in the area prior to the exchange.

Taxpayers contended that purchase of the Pebble Beach property was not extravagant when compared to costs of California properties. The court responded that the relative values of properties were irrelevant. Taxpayers also argued, as evidence of their intent not to reside at the Pebble Beach property that they lived with their in-laws upon their move to Georgia.  The court dismissed this argument as non-persuasive.

The court also found the taxpayers liable for the accuracy related penalty due to a substantial understatement of tax.  Taxpayers failed to present any evidence that they acted with reasonable cause and in good faith.  The taxpayers did not use counsel and represented themselves.

This case highlights that taxpayers should not be too quick to move into property acquired in an exchange. They should make substantial efforts to rent the property and avoid evidence of intent to use it as a residence.   The taxpayers asked the QI if they could move into the property if renters could not be found.  You probably get this or similar questions from clients frequently.  Be careful with your answers and let the client know about the fate of the Goolsbys.

(From FEA Press Release dated March 11, 2010)

Rev. Proc. 2010-14 provides a safe harbor method for reporting gain or loss for taxpayers who initiate deferred like-kind exchange under IRC §1031 but fails to complete the exchange because the qualified intermediary (QI) defaults on its obligation to transfer replacement property as a result of entering bankruptcy or receivership.   Previously, taxpayers who were unable to complete deferred exchanges as a result of QI default were required to recognize gain triggered upon transfer of relinquished property in the tax year in which the transfer occurred.  Rev. Proc. 2010-14 provides that when a taxpayer is unable to complete an exchange because the QI entered bankruptcy or receivership, gain is deferred until the tax year net liability relief exceeds basis and/or payments attributable to relinquished property are received as a result of the bankruptcy or receivership proceeding.  Rev. Proc. 2010-14 is retroactively effective for like-kind exchanges that fail due to QI default on or after January 1, 2009.  It can also be used by taxpayers involved in earlier QI defaults by filing an original or amended return, subject to the limitations on credit or refund under IRC § 6511.

In order to qualify for the safe harbor method for reporting gain under Rev. Proc. 2010-14, taxpayers must meet four conditions:

1)      Transfer (or be deemed to transfer) relinquished property to a QI in accordance with § 1.1031(k)-1(g)(4) (the QI safe harbor);

2)      Properly identify replacement property within the 45 day identification period (unless the QI default occurs during that period);

3)      Fail to complete the like-kind exchange solely due to a QI that becomes subject to a bankruptcy or receivership proceeding; and

4)      Do not have actual or constructive receipt of proceeds from sale of relinquished property (other than liability relief) prior to QI’s bankruptcy or receivership proceeding.

Taxpayers meeting these criteria may report gain (including gain as a result of depreciation recapture under IRC §§1245 and 1250) on relinquished property as payments are received based on a gross profit ratio method.  The gross profit ratio method allows taxpayers to first apply tax basis to liability relief and then proportionally to cash payments as they are received.  Accordingly, if relinquished property was unencumbered or if total debt did not exceed basis, no taxable gain must be recognized until cash payments are received from the bankruptcy or receivership.

For example, taxpayer A has an investment property with a fair market value of $160, an adjusted basis of $90 and which is encumbered by a mortgage of $60.  On May 6, Year 1, via a written exchange agreement, A transfers property to QI and QI transfers property to buyer for $160.  QI uses $60 of buyer’s proceeds to retire the mortgage and places the remaining $100 in an exchange account.  Within 45 days A identifies a single replacement property.  Before A can direct QI to acquire replacement property and within 180 days of the initial transfer, QI informs A that it has filed for bankruptcy.  As of December 31, Year 1, A has received none of the $100 of exchange funds.  On September 1, Year 2, QI exits from bankruptcy.  The bankruptcy plan of reorganization specifies that QI will pay A $35 in October of Year 2 and $35 in February of Year 3 (or $70 total of A’s original $100 of exchange funds).

Under Rev. Proc. 2010-14, A would not be required to recognize gain in Year 1 because the $60 of liability relief did not exceed A’s adjusted basis in investment property of $90.  A would then be required to recognize $20 of gain ($60 liability relief + $70 from QI = $130 – $90 adjusted basis = $40 total taxable gain) for each $35 payment made in Year 2 and 3.   See Rev. Proc. 2010-14, example 2.

Interest may be imputed on payments later received from a QI bankruptcy under §483 or §1274.  For purposes of calculating imputed interest the “sale date” is the date of confirmation of the bankruptcy plan or other court order that resolves the taxpayer’s claim against the QI (the “Safe Harbor Sale Date”) not the date of the original transfer of property from taxpayer to QI.

Similarly, if exchange funds held by QI were treated as an exchange facilitator loan under Treas. Reg. §1.468B-6(c)(1) but the loan otherwise met the requirements of § 1.7872-5(b)(16) ($2 million or less and with a term six months or less) then the IRS will continue to treat the loan as meeting the requirements of Treas. Reg. §1.7872-5(b)(16) until the Safe Harbor Sale Date even if the duration exceeds six months solely due to QI default.  If the loan exceeds $2 million (thereby failing to qualify under Treas. Reg. §1.7872-5(b)(16)) then no additional interest will be imputed under §7872 after the date of QI default.  However interest may be imputed under §483 or §1274.

Finally, if the total amount received by taxpayer from QI is less than the original sale price of relinquished property (as may often be the case) then the gross profit ratio is adjusted downward accordingly.  Taxpayers may claim a loss deduction under IRC §165 if the amount received from QI plus liability relief does not exceed tax basis of relinquished property transferred.