Building for the Future

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1 Building for the Future FEA 2018 Annual Conference Scott Saunders Asset Preservation, Inc. Creative and Non Real Estate Exchanges September 12 14, 2018 Marriott Country Club Plaza Kansas City, Missouri Qualified Use and Like Kind Real Property Qualified Use: Real property must be held either for investment or used in a trade or business. Like Kind Real Property: As long as both relinquished and replacement property are qualified use properties, any real property will be considered as like kind to any other real property. Any real property will be considered like kind real property as long as held for investment, rental income or use in a trade or business. The taxpayer s intent to hold for investment or use in a trade or business is more important than the time a property is held. [Bolker v. Commissioner 81 T. C. 782, 804 (1983), aff d. 760 F.2d 1039 (9th Cir 1985); Click v. Commissioner, 78 T. C. 225, 231 (1982); Reesink v. Commissioner, (April 23, 2012) T.C. Memo ] Creative and Non Real Estate Exchanges State Law State law property classification does not necessarily control whether exchanged properties are considered of like kind property under Section Federal tax law controls and requires an analysis of all facts and circumstances, including state law and federal tax law classifications, as appropriate. For example, in Rev. Rul , the IRS determined that interests in a Delaware Statutory Trust could be like kind to a fee interest in real property. This approach ignored state law classifications and favored a federal standard. 1

2 Easements It is important to look to the treatment of easements under the applicable state laws, generally an easement is considered like kind to any other real property held for productive use in a trade or business or for investment. EXAMPLES OF QUALIFYING EXCHANGES OF EASEMENTS An agricultural conservation easement in perpetuity in a farm found to be real property, for a fee simple interest in real property. [IRS Letter Ruling ] An exchange of agricultural use easements over two farms for fee simple title in a different farm. [IRS Letter Ruling ] A perpetual conservation easement encumbering real property for the fee simple interest in either farm land, ranch land, or commercial real property. [IRS Letter Ruling ] A conservation easement, found to be real property under state law, for fee simple interest in timber, farm land, or ranch land. [IRS Letter Ruling ] Easements EXAMPLES OF QUALIFYING EXCHANGES OF EASEMENTS The conveyance of an easement for land. [Rev. Rul , C.B. 212] An easement and right of way granted to a utility company [Rev. Rul , C.B. 472] A scenic conservation easement, found to be real property under state law, for fee simple interest in timber, farm land, or ranch land. [IRS Letter Ruling ] Exchange of a perpetual conservation easements on a ranch for other ranch property. [IRS Letter Ruling ] A perpetual stewardship easement was like kind to a fee interest in other real property. [IRS Letter Ruling ] Perpetual Communications Easement A perpetual communications easement, sometimes referred to as a communications easement, constitutes a transfer of an interest in the real property under state law and is like kind to a fee interest in real property. What Doesn t Qualify as Perpetual Communications Easement The creation of a lease or the grant of a license results in a contract right to receive rent or license fees over time. Rents and license fees are generally included in the owner s income when received and are taxed as ordinary income, at rates that are generally higher. The grant of a communications easement is not terminable by the owner since the grantee acquires a deeded interest in the real property itself. 2

3 Perpetual Communications Easement The grant of a license or fee, on the other hand, will be terminable upon the expiration of the lease or license term. Given the greater limitations on the owner s future use of a property subject to a perpetual communications easement, the grant of an easement generally commands a much greater premium than the grant of a terminable license or term lease. Air Rights (Transferable Development Rights) Are Transferable Development Rights ( TDRs ) like kind to a fee interest in real property? In PLR , the IRS noted that [t]he types of property rights and interests that constitute interests in real property... for purposes of 1031 are broad and that [w]hether property constitutes real or personal property generally is determined under state or local law. The IRS analyzed two issues commonly addressed in a real property like kind analysis: (1) the nature of the rights represented by the TDRs (e.g., whether TDRs constitute an interest in real property), and (2) the duration of the rights obtained under the TDRs. Air Rights (Transferable Development Rights) The IRS considered the duration of the rights obtained under the TDRs since an interest in real property must be of sufficient duration to be considered like kind to a perpetual fee interest in real property. The IRS found that various sections of the local ordinances cited by taxpayer provide that development rights are as of right and not discretionary, meaning that they exist permanently rather than at the discretion of a city agency or other decision making authority. As such, these rights appear to be analogous to perpetual rights. 3

4 Air Rights (Transferable Development Rights) In determining whether the TDRs constituted an interest in real property, the IRS noted that certain tax statutes in the state in which the TDRs were located treated TDRs as real property. A local administrative agency had held that a transfer of development rights was subject to State gains tax as a transfer of real property. The IRS also noted that, similar to a deed, the transfer of development rights was subject to transfer taxes imposed by both the city and state in which the TDRs were located. The IRS found that the TDRs constituted an interest in real property under the state s laws. Air Rights (Transferable Development Rights) A taxpayer can sell development rights for other like kind real property just as easily as the taxpayer might purchase development rights as replacement property. [See PLR in which taxpayer sold agricultural land development rights to State as relinquished property.] A taxpayer s interest as a shareholder in a California co op would not be treated under the Section 1031 (a) definition excluding stocks. [IRS Ruling ] Careful consideration of local laws governing TDRs in the jurisdiction in which the taxpayer owns property held for investment is key. Water Rights In states that consider water rights an interest in real property, perpetual water rights are considered like kind to a fee interest in real property. [Rev. Rul , CB 295; IRS Ruling ] Water rights that are limited in the amount or duration may not be considered like kind to a fee interest. [Wiechens v. U.S. 228 F. Suppl 1080 (Arizona 2002)] 4

5 Energy: Gas, Oil and Mineral Rights An exchange of real estate for mineral rights is permitted if the mineral rights relinquished or acquired in a tax deferred exchange constitute an interest in real property that is like kind to a fee interest. The determination of whether a mineral right will be considered like kind to a fee interest in real estate depends on: (i) the specific nature of the rights granted under the mineral contract, (ii) the duration of those rights, and (iii) whether the law of the State in which the mineral interests are located would characterize the mineral rights as an interest in real property rather than an interest in personal property. [Oregon Lumber Co, 20 TC 192 (1953), acq.] A production payment is not like kind since it is a right to receive income rather than an ownership interest in the minerals comprising the underlying real property. [Comm. v. Lake Inc, P.G., 356 US 260 (1958)] Energy: Oil, Gas and Mineral Rights A royalty interest is considered like kind property and can be exchanged under Section [Anderson v. Helvering, 309 US 645 (1940)] The primary distinction between these two interests is the term of the respective interest. Usually with a royalty interest, the royalty continues until the oil or gas or mineral deposit is exhausted. Usually a production payment terminates when a specified quantity of oil or gas or mineral has been produced or a stated amount of proceeds have been received. Energy: Oil, Gas and Mineral Rights The following 1031 exchanges qualified for tax deferral: An overriding royalty interest in oil, gas and mineral rights exchanged for an undivided one half interest as tenant in common owner in a parcel of improved property. [Crichton, 42 BTA 490 (1940), affd 122 F2d 181 (1941, CA5)] An interest in a producing oil lease extending until the exhaustion of the deposit exchanged under Section 1031 for a fee interest in a ranch. [Rev. Rul (1968)] A producing oil leasehold interest whose term extended until the deposit was exhausted. [Rev.Rul , C.B. 352] 5

6 Energy: Oil, Gas and Mineral Rights The following did not qualify for Section 1031 tax deferral: A limited oil payment right exchanged for an overriding oil and gas royalty where the oil payment was a limited interest and the overriding royalty was perpetual. [Midfield Oil Co, (1939) 39 BTA 1154, acq; IT 4093, CB 130] A leasehold measured in terms of a fixed percentage of oil that might be produced from the leasehold for a fixed number of barrels of oil. [Bandini Petroleum Co, (1951) PH TCM 51310, 10 CCH TCM 999] A carved out oil payment right for a fee interest in a ranch, even though local law treated these rights as interests in real property. [Fleming, William, 24 TC 818 (1955)] Real Property Outside the 50 States In 2005, the Treasury adopted atemporary regulation under 935 that extended the application of 1031 deferral to exchanges of U.S. property to property situated in Guam and the Northern Mariana Islands. How can real property inside the U.S. be like kind to property outside the 50 states? The answer is hinted at in the legislative history accompanying the adoption of 1031(h) where the committee recommended the adoption of that subsection stating that no inference [from the adoption of 1031(h)] is intended to override or otherwise modify Code Sec. 932 [Conference Committee Report No (PL ) at p. 614] Real Property Outside the 50 States Section 932 provides rules intended to coordinate the application of U.S. tax laws with those of the Virgin Islands. Section 932(a)(3) generally provides that the U.S. shall be treated as including the Virgin Islands if the requirements of 932(a) are met. Consequently, if a person is subject to the coordinating provisions of 932 (a person subject to tax in both the U.S. and the Virgin Islands) then the term Unites States, as used in the IRC, includes the Virgin Islands. Section 932(c) provides reciprocal treatment for bona fide residents of the Virgin Islands. Until 2008, only property located in the U.S. Virgin Islands enjoyed this status for purposes of Section

7 Real Property Outside the 50 States A U.S. citizen or resident domiciled in the U.S. who exchanges real property situated in the U.S. for real property located in the Virgin Islands, Guam or the Northern Mariana Islands (collectively, the Coordinated Territories) may do so only if the person is subject to tax in both the U.S. and the respective Coordinated Territory for the year in which the exchange is completed. Real property in Puerto Rico is not included in the list of Coordinated Territories and is not considered part of the United States under the special rules that exist under 932 and 935 that apply narrowly to the Northern Mariana Islands, Guam, and the U.S. Virgin Islands. Cooperatives (Co ops) When buying into a cooperative ( co op ), the taxpayer acquires stock in the cooperative corporation that owns or leases an entire building. As a stockholder of the cooperative corporation, the taxpayer receives a long term proprietary lease and the right to exclusive possession of an apartment. The co op board acts very much like a landlord and the taxpayer is entitled to demand from the board many of the same services they expect in a rental building. The co op board bills the taxpayer every month for a pro rated share of the total cost of running the building, which usually includes the monthly mortgage payment for the entire building. The taxpayer pays this monthly bill, called maintenance, in addition to any bank loan they may have obtained to purchase their specific apartment. Cooperatives (Co ops) The IRS has consistently ruled that a New York co op is like kind to real estate, even though ownership is held in the form of stock in a corporation. In PLR , the IRS approved a proposed exchange of co op stock for real property and improvements to be acquired by family members and family owned entities. [See, e.g., Rev. Rul , C.B. 295.] Various New York statutes treat an interest in a cooperative as equivalent to an interest in real property. [N.Y. Civ. Prac. L.& R. 5206(a)] Homestead exemption [N.Y. Real Prop. Law 279(5) (McKinney 1989] Mortgage for cooperation interest [N.Y. Pub. Auth. Law 2402(5) (McKinney Supp. 2006] Real property tax for senior citizens [N.Y. Real Prop. Tax Law 467(3 a) (McKinney Supp. 2006] Mansion tax [N.Y. Tax Law 1402 a(a) (McKinney 2004)] 7

8 Cooperatives (Co ops) The IRS viewed the interest in a co op, which included a proprietary lease of more than 30 years duration, and a deeded interest to the condominium as real property interests. The New York Court of Appeals ruled that an interest in a co op is an interest in real property. [State Tax Comm. vs Shor, 43 NY 2d. 151, 371 N.E. 2d 523] For other rulings involving the characterization of New York co ops as real property interests under Section 1031, see IRS Letter Rulings , and REIT Shares: Do Not Qualify for Section 1031 A share in a REIT (Real Estate Investment Trust) is excluded from 1031 exchange deferral. A share in a REIT is a personal property interest and therefore does not qualify as real property for Section Many REITS, at the entity level, perform 1031 exchanges on assets owned by the REIT. REITs are required to distribute most of their cash at year end so they have an incentive to redeploy capital into better performing assets via Section 1031 versus holding cash on their books. However, there is a creative approach for taxpayers, in certain situations, to do a 1031 exchange into a DST and later essentially end up with the economic equivalent of REIT shares if they are willing to contemplate several steps over time using several IRC tax sections Exchange/DST/721 UPREIT Three steps are involved using different aspects of the tax code: First, the taxpayer performs a 1031 exchange. [IRC Section 1031] Second, the taxpayer acquires through a 1031 exchange replacement property in a beneficial interest in a Delaware Statutory Trust ( DST.) [Revenue Ruling ] Third, after holding the DST interest for a period of time, the taxpayer has the option to potentially perform a tax deferred exchange of the DST interest into an Umbrella Partnership REIT UPREIT by contributing the DST interest into a new tiered ownership structure that includes an Operating Partnership ( OP ) and the REIT. [IRC Section 721] 8

9 1031 Exchange/DST/721 UPREIT This 1031/DST/721 UPREIT option is only available to accredited taxpayers within the meaning of Rule 501 of Regulation D. The DST replacement property is offered by financial advisors registered with the Securities and Exchange Commission (SEC) and the sponsor of the DST offering provides a Private Placement Memorandum ( PPM ) to the taxpayer for the specific offering. The taxpayer exchanges into a DST through a 1031 exchange. The DST holds the replacement property for a period of time (often around two (2) or more years Exchange/DST/721 UPREIT Some DST/721 UPREIT programs require all taxpayers to convert their DST interest into a Operating Partnership Units ( OP Units ) while other DST providers have the option for taxpayers to exchange out of their DST interest in another 1031 exchange or, alternatively, to use Section 721 and contribute their DST interest in exchange for OP units in the REIT. The OP Units are economically the equivalent of shares in the REIT and the taxpayer earns dividend income Exchange/DST/721 UPREIT Advantages of a 721 UPREIT into OP Units of a REIT: Tax Deferral: A Section 721 UPREIT is a tax deferred transaction. Diversification: The taxpayer now owns units representing the REITs diversified portfolio versus a single asset or only several assets. Flexibility: If the shares of the REIT are publicly traded, the taxpayer can sell OP Units as needed to generate cash (a taxable event.) Management: No management responsibilities as the REIT manages all assets and the taxpayer should receive distributions from the REIT. Estate Planning: OP Units can be divided among heirs and heirs also receive a step up in basis. 9

10 1031 Exchange/DST/721 UPREIT Disadvantages of a 721 UPREIT into OP Units of a REIT: No further 1031 exchanges are permitted: Once a taxpayer elects to perform a 721 UPREIT, they will own OP units and no longer have the option to continuing doing 1031 exchanges and deferring taxes by acquiring additional replacement properties. Other Real Property Timeshares Is the timeshare personal property or real property? If a real property timeshare, the taxpayer still must substantiate the primary purpose is holding for investment and not personal use. [Dewey v. Commissioner TC Memo , 66 TCM 1899; Rev. Proc ] Vacation Homes Personal use clearly excluded from 1031 exchange tax deferral. Tax Court looks at the primary purpose in holding the property. The mere hope or expectation that property may be sold at a gain cannot establish an investment intent if the taxpayer uses the property as a residence. Taxpayer in Moore v. Commissioner, T.C. Memo did not claim maintenance expenses on their Federal tax return and claim interest deductions. Rev. Proc established a safe harbor ( Rule of 2 s ) 10

11 Leaseholds A leasehold interest with a remaining term of 30 years or more is considered likekind property to a fee interest. If the leasehold interest is less than 30 years but provides for optional renewal periods, these renewal periods can be included in determining if the leasehold interest has 30 years or more remaining. In one case, a leasehold interest with an initial term of 5 years and 10 optional renewal periods of 5 years each was held to be like kind property since the taxpayer had the right to use the property for up to 55 years. [R&J Furniture Co. v. Comm., 20 T.C. 857 (1953)] Leaseholds Leaseholds that Do Not Qualify A 1031 exchange out of a leasehold interest in real property with 21 years remaining for fee interest in real property did not qualify under Section [VIP's Industries Inc. v. Commissioner, T.C. Memo ] Exchange into Property Already Owned? No... Rev. Proc clearly states that a taxpayer cannot do a 1031 exchange into a property already owned. An exchange of real estate owned by a taxpayer for improvements on land owned by the same taxpayer does not meet the requirements of See DeCleene v. Commissioner, 115 T.C. 457 (2000); Bloomington Coca Cola Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951). Rev. Rul , C.B. 270, holds that a building constructed on land owned by a taxpayer is not of a like kind to involuntarily converted land of the same taxpayer. 11

12 Parking Arrangement Improvement Exchange on a New Leasehold Interest Making improvements on a new leasehold interest in a parking arrangement transaction has been validated in three private letter rulings. In 2002, IRS Letter Ruling In 2003, IRS Letter Ruling Rev. Proc In 2014, IRS Letter Ruling Parking Arrangement Improvement Exchange on a New Leasehold Interest Each PLR had similarities in structure but different facts: IRS Letter Ruling : Involved a reverse exchange parking arrangement; a 45 year leasehold and a 32 year sublease. IRS Letter Ruling : Involves a delayed parking arrangement exchange where the taxpayer s affiliate assigned an existing ground lease to the EAT. Rev. Proc : Treasury Department are continuing to study parking arrangement transactions, including transactions in which a person related to the taxpayer transfers a leasehold interest in land to an accommodation party and the accommodation party makes improvements tot the land and transfers the leasehold with the improvements to the taxpayer in exchange for other real estate. IRS Letter Ruling : Involved a delayed parking arrangement exchange with a new leasehold; the leasehold has a term that was over 30 years. Parking Arrangement Improvement Exchange on a New Leasehold Interest The three Letter Rulings indicate the structure should incorporate the following: The leasehold must be held by the taxpayer s affiliate and cannot be in the name of the taxpayer (or the taxpayer s disregarded entity). The lease must have fair market rent. The lease should have at least 30+ years remaining on the lease at the time of the transfer to the taxpayer along with improvements. The lease must remain for a minimum of two years after the 1031 exchange is complete and the taxpayer or taxpayer s affiliate should not transfer any interest in the property for at least two years. 12

13 Parking Arrangement Improvement Exchange on a New Leasehold Interest Leasehold improvement exchanges provide taxpayers the opportunity to use 1031 exchange proceeds to construct improvements on property owned by the taxpayer s affiliate or related party. The basic structure is the taxpayer s affiliate leases the land to an exchange accommodation titleholder (EAT). The EAT makes improvements and then transfers the leasehold and improvements to the taxpayer in exchange for the relinquished property within 180 days of the EATs acquisition of the leasehold from taxpayer s affiliate. Parking Arrangement Improvement Exchange on a New Leasehold Interest Steps 1. Taxpayer contributes land to taxpayer s affiliate. 2. Taxpayer deeds relinquished property to buyer and the QI receives the exchange proceeds from the sale. (Starts 45/180 day time periods) 3. QI forms an EAT (An SPE, typically a single member LLC.) 4. EAT enters into QEAA with the taxpayer. 5. Taxpayer s affiliate enters into a 31+ year lease with EAT. (fair market terms) 6. QI funds the improvements to the EAT. 7. Within 180 days of the EAT s acquisition of the leasehold interest, EAT assigns lease and improvements on leasehold to the taxpayer. (Taxpayer continues to lease from the taxpayer s affiliate for at least two years.) Parking Arrangement Improvement Exchange on a New Leasehold Interest Taxpayer satisfies QI and Rev. Proc safe harbors. Exchange involves a related party (the taxpayer s affiliate), but no gain recognized unless taxpayer or taxpayer s affiliate disposes of an interest in the property within 2 years. This approach provides a process for improvement exchanges on land owned by a related person or the taxpayer s affiliate. This approach does not apply to improvement exchanges on land owned by the taxpayer. Rev. Proc will not apply if the parked replacement property was previously owned by the taxpayer at any time in the 180 days before the transfer to the EAT. [Rev. Proc ] 39 13

14 Parking Arrangement Improvement Exchange on a New Leasehold Interest Construction of replacement property does not need not be complete. Safe harbor parking arrangement is limited to a maximum 180 calendar days. Improvements occurring to the replacement property after the 180 day exchange period do not count towards the value of replacement property. is not within the provisions of Section 1031(a) if the relinquished property is transferred in exchange for services (including production services). Thus, any additional production occurring with respect to the replacement property after the property is received by the taxpayer will not be treated as the receipt of property of like kind