REVENUE PROCEDURES

 

INTERNAL REVENUE BULLETIN:  2010-12  REVENUE  PROCEDURE. 2010-14

2010-14 (safe harbor method of reporting gain or loss for certain taxpayers who initiate deferred like-kind exchanges under § 1031 of the IRC but fail to complete exchange due to qualified intermediary default)

 

INTERNAL REVENUE BULLETIN: 2008-10 REVENUE PROCEDURE. 2008-16

2008-16 (This revenue procedure provides a safe harbor under which the Internal Revenue Service (the “Service”) will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment for purposes of § 1031 of the Internal Revenue Code.)

 

REVENUE PROCEDURE 2005-14, EFFECTIVE JANUARY 27, 2005: GUIDANCE ON THE APPLICATION OF SECTIONS 121 AND 1031 TO A SINGLE EXCHANGE OF PROPERTY.

Rev. Proc. 2005-14 applies to Taxpayers who exchange property that satisfies the requirements for both the exclusion of gain from the exchange of a principal residence under Section 121 and the nonrecognition of gain on the exchange of like-kind property under Section 1031. Thus, Rev. Proc. 2005-14 applies only to Taxpayers who satisfy (i) the two-year principal residence test of Section 121, and (ii) the held for productive use in a trade or business or for investment requirement of Section 1031(a)(1) with respect to the relinquished property and the replacement property.

Computing Gain:  Section 121 is applied to gain realized before applying Section 1031.

Gain from Depreciation:  Under Section 1031(d)(6), the exclusion under Section 121 does not apply to gain attributed to depreciation deductions claimed for the business or investment portion of a residence (for periods after May 6, 1997).  Section 1031 may apply to such gain.

Treatment of Boot:  In applying Section 1031, cash or other non-like kind property received (boot) is taken into account to the extent the boot received exceeds the gain excluded under the Section 121 portion of the property.

Calculating Basis:  In determining the Taxpayer’s basis in its investment portion of the Replacement Property, any gain excluded under Section 121 is treated as gain recognized by the Taxpayer.  Under Section 1031(d) then the basis of the replacement property is increased by any gain attributable to the investment portion of the relinquished property that is excluded under Section 121.

Example:  Taxpayer purchases a home for $200,000 that it occupies as its principal residence from 2000 to 2004.  In 2004, Taxpayer rents the house to tenants and claims depreciation deductions totalling $20,000.  In 2006 Taxpayer exchanges the house in a Section 1031 exchange and receives $10,000 in cash boot and Replacement Property townhouse worth $450,000.  Taxpayer has $280,000 in realized gain with the following result:

 

	Relinquished Property		Replacement Property
Original Cost	$200,000	FMV of property received	$450,000
Less: Depreciation	($20,000)	Cash Boot received:	$10,000
Adjusted Cost Basis	$180,000	Total Value	$460,000
		Less: Adj. Cost Basis of Relinquished Property	($180,000)
		Realized Gain	$280,000

 

Section 121 does not require that the property be the Taxpayer’s principal residence at the time of the exchange – just that Taxpayer had occupied the residence as its principal residence for a period aggregating 2 of the last 5 years.  The property is eligible for exclusion of gain under Section 121.

Additionally, because the house was held for investment “at the time of the exchange” [note that it was held for 2 years as investment property, though this does not appear to be a requirement from the language] the Taxpayer may also defer gain under Section 1031.

Applying the gain exclusion under Section 121 first, Taxpayer may exclude $250,000 of the $280,000 gain.  The remaining $30,000 of gain is deferred under Section 1031 (including the $20,000 attributed to depreciation deductions).

And the $10,000 cash “boot” received by the Taxpayer is also tax-deferred.  The cash boot received is recognized only to the extent the boot exceeds the amount of the excluded gain (in this example, $250,000).

The Rev. Proc. also provides an example where 2/3rds of a single dwelling unit is residence and 1/3rd is business/investment property.  Taxpayer exchanges the property for a new residence and a separate investment property.  The exchange is eligible for tax-deferral under Section 1031.

 

REVENUE PROCEDURE 2004-67:  REPORTABLE TRANSACTIONS

Sec.1031 transactions are not "reportable transactions" for purposes of the disclosure rules, provided the Taxpayer "fully complies with the filing and reporting requirements ...including any requirement in the regulations or in forms."

 

REVENUE PROCEDURE 2004-51; 2004-33 IRB, AUGUST 16, 2004, MODIFICATION TO REVENUE PROCEDURE 2000-37: EFFECTIVE FOR TRANSFERS TO AN EAT ON OR AFTER JULY 20, 2004.

Background – Rev. Proc. 2000-37:  In September of 2000, the IRS issued formal guidance on structuring reverse like-kind exchanges under IRC Section 1031 (Revenue Procedure 2000-37; 2000-40 IRB 1 September 15, 2000). The Revenue Procedure was the culmination of many years of study and consideration of the best way to address the situation where a Taxpayer has located and needs to close on its Replacement Property before transferring its Relinquished Property while structuring the transaction as a tax-deferred exchange under the provisions Section 1031.

The Service created a safe harbor “parking arrangement” that allows the Taxpayer to arrange for either Relinquished Property or Replacement Property to be acquired by a third party Exchange Accommodation Titleholder (EAT) for a period of up to 180 days.  During that time the EAT, while not bearing any economic benefits or burdens of ownership, must nevertheless be the owner for federal (and as appropriate state) income tax purposes.

The Revenue Procedure specifies that the IRS will not challenge the qualification of property as either Replacement Property or Relinquished Property, as defined in the Treasury Regulations, or the treatment of an EAT as the beneficial owner of such property for federal income tax purposes, if the property is held in a “Qualified Exchange Accommodation Arrangement” (QEAA).  Property is deemed to be held in a QEAA if the following requirements are met:

1.      Qualified indicia of ownership is held by someone other than the Taxpayer (i.e.: the Exchange Accommodation Titleholder) who is subject to federal income tax.

2.      Qualified indicia of ownership can be demonstrated by: (a) legal title held by the EAT, (b) other indicia of ownership such that the EAT is treated as the beneficial owner of the property, as in a contract for deed, or (c) a single member LLC that holds legal title to the property (or some other entity that is disregarded for Federal income tax purposes), the membership interest of which is owned by the EAT.

At the time the property is transferred to the EAT, the Taxpayer must have bona fide intent that the property represents either Replacement Property or Relinquished Property that is intended to qualify for non-recognition of gain under Section 1031.

This language in the Rev. Proc. was interpreted by some practitioners and Taxpayers as permitting a transaction where a Taxpayer owns property, transfers it to an EAT who constructs improvements on the property, and transfers it back to the Taxpayer as replacement property in a 1031 exchange.  As a result, the Service issued Rev. Proc. 2004-51 with the following modification to the language re: qualifying replacement property:

“The Service will treat an exchange accommodation titleholder as the beneficial owner of property for federal income tax purposes if the property is held in a QEAA.  Property held in a QEAA may, therefore, qualify as either “replacement property” or “relinquished property” (as defined in §1.1031(k)-1(a)) in a tax-deferred like-kind exchange if the exchange otherwise meets the requirements for deferral of gain or loss under §1031 and the Regulations thereunder.”

Additionally, new Section 4.05 was added to Rev. Proc. 2000-37 which provides the following:

“This revenue procedure does not apply to replacement property held in a QEAA if the property is owned by the
  Taxpayer within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to
  an Exchange Accommodation Titleholder.”

Thus, the new section provides for a 180-day look-back at the ownership of the intended Replacement Property.

Rev. Proc. 2004-51 was aimed, in part, at the “disappearing lease” transaction.  Assume Taxpayer owns Property A and would like to construct improvements with proceeds from the sale of Property B [low basis property also owned by Taxpayer].  In order to avoid recognizing gain on the sale of Property B, Taxpayer transfers a 30-year leasehold interest in Property A to an EAT who constructs improvements on Property A.  Taxpayer then sells Property B through a qualified intermediary, who acquires the leasehold interest and improvements from the EAT and transfers them to Taxpayer.

Presumably Taxpayer would assert that under Section 4.01 of Rev. Proc. 2000-37, as originally issued, the Service has agreed not to challenge the qualification of Property A with the constructed improvements as “Replacement Property”, or the treatment of the EAT as the beneficial owner of the property since it was held in a Qualified Exchange Accommodation Arrangement.  However, based on the DeCleene case and the step transaction doctrine, it is doubtful that a court would respect either a lease to an EAT or a transfer of the property to the EAT where the EAT is obligated to construct improvements on the property, funded solely by the Taxpayer with no economic risk to the EAT and with the Taxpayer managing and directing the construction.

In DeCleene v. Commissioner, 115 T.C. No. 34 (November 17, 2000).  Taxpayer transferred property it previously owned (Lawrence Drive) to WLC, in exchange for which WLC was to construct improvements on Lawrence Drive and transfer it back to Taxpayer. At the time of the transfer back to Taxpayer, Taxpayer would transfer McDonald Street property to WLC to complete the two party exchange.  Taxpayer proceeded to quit claim the Lawrence Drive property to WLC.  WLC gave Taxpayer a non-recourse note and mortgage on the property which was assigned to a bank who provided construction financing.  When WLC completed the construction three months later, WLC transferred Lawrence Drive to Taxpayer, Taxpayer transferred McDonald Street to WLC.  The Tax Court held that Taxpayer never disposed of Lawrence Drive, and remained its owner during the construction period. Because Taxpayer 1. previously owned the property, 2. was obligated to pay for the construction of the improvements and 3. was obligated to re-acquire the property on the completion of the improvements, the Taxpayer remained the beneficial owner of the property.

 

REVENUE PROCEDURE 2003-39:  ONGOING LKE PROGRAMS

The Rev. Proc. provides a series of safe harbor for programs involving ongoing exchanges of tangible personal property using a single intermediary.  The highlights of the Rev. Proc. are as follows:

An LKE Program is defined as an ongoing program involving multiple exchanges of 100 or more properties with the following characteristics:

(i)          Taxpayer regularly and routinely enters into agreements to sell and purchase tangible personal property.

(ii)        Taxpayer uses a single unrelated Qualified Intermediary to accomplish the exchanges in the program.

(iii)      Taxpayer and Qualified Intermediary enter into a written master exchange agreement.  The master exchange agreement expressly limits the Taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefit of the money or other property held by the intermediary.

(iv)     The master exchange agreement provides a blanket assignment of the Taxpayer’s rights (but not necessarily its obligations) in some or all of its existing and future agreements to sell relinquished property and/or to purchase replacement property to the Qualified Intermediary.

(v)       Taxpayer provides written notice of the assignment to the other party to each existing and future agreement to sell and purchase property.

(vi)      Taxpayer implements a process by which replacement property is identified prior to the end of the identification period for the relinquished property or group of relinquished properties in each exchange or complies with the identification requirement by receiving replacement property prior to the expiration of the identification period.

(vii)    Taxpayer implements a process for collection, sorting, holding and disbursement of proceeds which may include a joint Taxpayer/Qualified Intermediary account or an account in the name of a third party for the benefit of both Taxpayer and Qualified Intermediary where in the QI controls the receipt holding and disbursement of funds.

(viii)  Relinquished Properties are matched with replacement properties received to calculate any recognized gain and to determine basis in replacement properties.

(ix)      Taxpayer recognizes gain on the sale of relinquished properties that are not matched with replacement properties and takes cost basis in replacement property acquired that is not matched to any relinquished property disposition.

A Taxpayer may have more than one LKE Program in place at one time.  Each program will be evaluated separately to determine whether it qualifies under the safe harbors of the Revenue Procedure.

The Safe Harbors 

1.           Separate and Distinct Exchanges:  each relinquished property or group of relinquished properties transferred in exchange for replacement property or group of replacement properties will be evaluated on its own merit.  If a relinquished property (or group of relinquished properties) fails to qualify under Section 1031, that will not affect the validity of the overall LKE program.

2.           Identification Issues/Matching Properties:  property that is received or otherwise identified within the 45-day period will be treated as replacement property notwithstanding the fact that it may not be matched with relinquished property until after the end of the identification period.  Replacement property must be matched no later than the due date (determined with regard to extensions) of the Taxpayer’s return.

3.           Actual or Constructive Receipt of Money or Other Property:  for purposes of the following provisions, any requirement that the Taxpayer transfer money to the QI will be satisfied if the amount of money held by the QI, or held in a joint account equals or exceeds the amount of proceeds from the sale of the relinquished properties (including the amount that is required to be transferred by the Taxpayer) that has not yet been used to acquire replacement property.

4.           Receipt of Checks or other Negotiable Instruments:  a Taxpayer will not be deemed to be in actual or constructive receipt of money or other property as a result of receiving a check made payable to a person other than the Taxpayer if: (a) the check has not been endorsed by the person to whom it is made payable, (b) the person to whom the check is made payable is not a disqualified person, and (c) the check is forwarded to or for the benefit of a QI or deposited into an account in the name of the QI, a joint account or an account in the name of a third party for the benefit of the Taxpayer and the QI.

5.           Joint Accounts:  a Taxpayer will not be deemed to be in constructive or actual receipt of proceeds from the sale of relinquished property if such funds are held in a joint account in the name of the Taxpayer and a QI or in the name of a third party for the benefit of the Taxpayer and the QI if: (a) the account is used to collect, hold and disburse proceeds from the sale of the relinquished property for the benefit of the QI; (b) the account agreement requires authorization from the QI to transfer funds; and (c) the agreement expressly limits the Taxpayer’s right to receive, pledge, borrow or otherwise obtain the benefit of the funds in accordance with the restrictions under Treasury Reg. 1.1031(k)-1(g)(6).

6.           Funds Netting:  a Taxpayer engaged in an LKE program will not be deemed in constructive receipt of money as a result of transferring relinquished property solely because an amount owed by the Taxpayer to the buyer (other than a lease security deposit) is netted against the sale price of the relinquished property as long as funds equal to the full value of the relinquished property are transferred to the QI by the opening of the next business day.  Additionally, a Taxpayer will not be deemed in constructive receipt of money solely because an amount owed to a Taxpayer by a seller of replacement property is netted against the purchase price of replacement property that results in the QI transferring funds to the Taxpayer in an amount equal to the amount owed by the seller so that the QI expends the full amount of the purchase price for the replacement property.

7.           Taxpayer as Lender to Purchaser:  if a Taxpayer engaged in an LKE program loans funds to a buyer to purchase Taxpayer’s relinquished property, Taxpayer’s receipt of buyer’s note will not be considered actual or constructive receipt if: (a) Taxpayer makes similar loans in the ordinary course of its business;(b) The buyer is not obligated to obtain financing from Taxpayer; (c) Taxpayer’s loan to buyer is arm’s length; and (d) Taxpayer promptly transfers funds equal to the loan proceeds to the QI.

8.           Application of Lease Security Deposit to Purchase Price:  where Taxpayer is lessor of relinquished property in an LKE program, the application of the buyer/lessee’s lease security deposit to the purchase price will not be constructive or actual receipt by Taxpayer provided Taxpayer promptly transfers the lease security deposit to the QI.

9.           Qualified Intermediary Safe Harbor:  in determining whether a QI is a “disqualified person:, the intermediary will not fail to be a qualified intermediary merely because the intermediary (a) is assigned the Taxpayer’s rights in relinquished or replacement properties that ultimately are not matched, (b) received funds with respect to the transfer of a relinquished property that ultimately is not matched with replacement property, or (c) pays funds for the acquisition of property that ultimately is not matched with relinquished property.

10.      Assignment Safe Harbor:  a Taxpayer’s assignment in the Master Exchange Agreement to the QI of the Taxpayer’s rights in some or all of its existing and future agreements to sell relinquished property and/or to purchase replacement property and Taxpayer’s written notice to the other party of each agreement on or before the date of the transfer of the property will satisfy the Assignment Safe Harbor and Notice requirement under the deferred exchange Reg. 1.1031(k)-1(g)(4)(v). 

  

REVENUE PROCEDURE 2003-25:  TAX SHELTER REPORTING REQUIREMENTS 

Rev. Proc. 2003-25 (February 28, 2003) provides that certain book/tax differences are not taken into account in determining whether a transaction is a reportable transaction for purposes of the tax shelter reporting/disclosure rules under Section 1.6011-4.  The Rev. Proc. specifically excludes any transactions structured under Section 1031 if the Taxpayer fully complies with the filing and reporting requirements for this section, including any requirement in the Regulations or in any IRS forms.

The tax shelter reporting Regulations define specific transaction types that require further disclosure and are deemed reportable transactions.  Transactions with “significant book/tax differences” are one of six categories of reportable transactions.  The transaction has a significant book/tax difference where the amount of any gain or income for tax purposes differs, on a gross basis by more than $10 million from the amount of gain or income for book purposes in any taxable year.

In exchange for IRC Section 1031 transactions making the “angel list” of transactions that do not require further disclosure, it was agreed that modifications would be made to IRS Form 8824 in an attempt to limit abuse of the Section and increase compliance.

 

REVENUE PROCEDURE 2002-69:  CLASSIFICATION OF CERTAIN BUSINESS ENTITIES

This Revenue Procedure provides useful guidance on the classification of “qualified entities” for federal income tax purposes.  A business entity is a “qualified entity” if:  

(i)     The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country, or a possession of the United States;

(ii)   No person other than one or both spouses would be considered the owner for federal tax purposes; and

(iii) The business entity is not treated as a corporation under Section 301.7701-2.   

The Revenue Procedure holds that if the entity in question is a qualified entity, and husband and wife, as community property owners, treat the entity as a disregarded entity, the Service will respect that position.

If the entity in question is a qualified entity and husband and wife, as community property owners, treat the entity as a partnership for Federal tax purposes, the Service will respect that position.

The widespread use of Special Purpose Entities (SPE) in real estate transactions creates a unique issue for 1031 investors.  Husband and wife who desire to acquire title to replacement property through an SPE would not be deemed a disregarded entity and would likely be considered a partnership for Federal tax purposes.  The acquisition of a partnership interest is non-qualifying property for purposes of IRC Section 1031.  This Rev. Proc. would allow community property owners to utilize the SPE and not run afoul of this restriction.

 

REVENUE PROCEDURE 2002-22: UNDIVIDED FRACTIONAL INTERESTS IN RENTAL REAL ESTATE

The Internal Revenue Service issued Revenue Procedure 2002-22 on March 19, 2002 providing guidance in the context of undivided fractional interests (UFI) in real property.  The purpose of the guidance is to establish a bright line test for determining generally whether an undivided fractional interest in rental real property is (i) an interest in a business entity (i.e. a partnership), or (ii) a tenancy in common, the central characteristic of which is that each owner is deemed to own individually a physically undivided part of the entire parcel of property. 

The Rev. Proc. does not provide a safe harbor, and it is not a substantive statement of law, but rather specifies the conditions under which the Internal Revenue Service will consider a request for an advance ruling that a UFI in rental real property is not an interest in a business entity.  The Rev. Proc. states that where a sponsor meets all of the conditions, the Service may decline to issue a ruling where appropriate and in the interests of sound tax administration.  Alternatively, where the conditions of the Rev. Proc. are not satisfied, the Service may still consider a request for a ruling. 

Following are the conditions for an advance ruling: 

1.      Tenancy in Common Ownership:  Each of the co-owners must hold title to the property (either directly or through a disregarded entity) as a tenant in common under local law.

2.      Number of Co-Owners:  The number of co-owners must be limited to no more than 35 persons.

3.      No Treatment of Co-Ownership as an Entity:  The co-ownership may not file a partnership or corporate tax return, conduct business under a common name, or hold itself out as a partnership or other form of business entity.

4.      Co-Ownership Agreement:  The co-owners may enter into a limited co-ownership agreement that may run with the land.  For example, a co-ownership agreement may provide that a co-owner must offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair market value before exercising any right to partition.

5.      Voting:  The co-owners must retain the right to approve the hiring of any manager, the sale of other disposition of the Property, any leases or a portion or all of the Property, or the creation or modification of a blanket lien. Any sale, lease, or re-lease of a portion or all of the Property, any negotiation or re-negotiation of indebtedness secured by a blanket lien, the hiring of any manager, or the negotiation of any management contract must be by unanimous approval of the co-owners. For all other actions on behalf of the co-ownership, the co-owners may agree to be bound by the vote of those holding more than 50 percent of the undivided interests in the Property.

6.      Restrictions on Alienation:  In general, each co-owner must have the rights to transfer, partition and encumber the co-owners undivided interest in the Property without the agreement or approval of any person. However, restrictions on the right to transfer, partition, or encumber interests in the Property that are required by a lender and that are consistent with customary commercial lending practices are not prohibited.

7.     Sharing Proceeds and Liabilities upon Sale of Property:  If the Property is sold, any debt secured by a blanket lien must be satisfied and the remaining sale proceeds must be distributed to the co-owners.

8.      Proportionate Sharing of Profits and Losses:  Each co-owner must share in all revenues generated by the Property and all costs associated with the Property in proportion to the co-owners undivided interest in the Property.

9.      Proportionate Sharing of Debt:  The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.

10. Options:  A co-owner may issue an option to purchase the co-owners undivided interest (call option) provided that the exercise price for the call option reflects the fair market value of the Property determined as of the time the option is exercised. For this purpose, the fair market value of an undivided interest in the Property is equal to the co-owners percentage interest in the Property multiplied by the fair market value of the Property as a whole (with no discount for minority interests). A co-owner may not acquire an option to sell the co-owners undivided interest (put option) to the sponsor, the lessee, another co-owner, or the lender, or any person related to the sponsor, the lessee, another co-owner, or the lender.

11. No Business Activities:  The co-owners activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property. If the sponsor or a lessee is a co-owner, then all of the activities of the sponsor or lessee (or any person related to the sponsor or lessee) with respect to the property will be taken into account in determining whether the co-owners activities are customary activities.

12. Management and Brokerage Agreements:  The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually, with an agent, who may be the sponsor or a co-owner (or any person related to the sponsor or co-owner) but who may not be a lessee. The management agreement may authorize the manager to maintain a common bank account for the collection and deposit of rents and to offset expenses associated with the Property against any revenues before disbursing each co-owner’s share of net revenues. The management agreement may authorize the manager to obtain or modify insurance on the Property, and to negotiate modifications of the terms of any lease or any indebtedness encumbering the Property, subject to the approval of the co-owners.

13. Leasing Agreements:  All leasing arrangements must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the Property. The determination of the amount of the rent must not depend, in whole or in part, on the income or profits derived by any person from the Property leased (other than an amount based on a fixed percentage or percentages or receipts or sales).

14. Loan Agreements:  The lender with respect to any debt that encumbers the Property or with respect to any debt incurred to acquire an undivided interest in the Property may not be a related person to any co-owner, the sponsor, the manager or any lessee of the Property.

15. Payments to Sponsor:  Except as otherwise provided in the revenue procedure, the amount of any payment to the sponsor for the acquisition of the co-ownership interest (and the amount of any fees paid to the sponsor for services) must reflect the fair market value of the acquired co-ownership interest (or the services rendered) and may not depend, in whole or in part, on the income or profits derived by any person from the Property.

 

REVENUE PROCEDURE 2000-46: CO-TENANCY INTERESTS

Co-tenants of property in which some services are provided to tenants can, under certain circumstances, be treated for Federal income tax purposes, as partners in a partnership - even though no formal partnership agreement exists.

When a Taxpayer acquires a co-tenancy interest in property as his replacement property, the issue can arise as to whether he is acquiring a partnership interest, which is excluded property under Section 1031(a)(2)(d), or a true tenancy in common interest in property.

This issue has been of particular concern to the IRS because of the marketing of a vast number of co-tenancy interests by promoters, in which certain types of partnership characteristics may arguably exist (i.e. the waiver of partition rights and co-tenancy and management agreements which may resemble partnership type agreements). 

Faced with a number of applications for private letter rulings on tenancy in common programs, the IRS announced, in Rev. Proc. 2000-46, that it would no longer issue rulings on Section 1031 exchanges where a co-tenancy interest is acquired as replacement property in a Section 1031 exchange.  Instead, the Service would continue to study the issue and the facts and circumstances relevant to co-tenancy arrangements.  The product of that study was the issuance of Revenue Procedure 2002-22.