Dig: I’m Jewish.
Count Basie’s Jewish.
Ray Charles is Jewish.
Eddie Cantor’s goyish.
B’nai Brith is goyish;
Marine corps — heavy goyim, dangerous.
Kool-Aid is goyish.
All Drake’s cakes are goyish.
Pumpernickel is Jewish, and, as you know, white bread is very goyish.
Instant potatoes — goyish. Black cherry soda’s very Jewish. Macaroons are very Jewish — very Jewish cake.
Fruit salad is Jewish. Lime jello is goyish. Lime soda is very goyish.
Trailer parks are so goyish that Jews won’t go near them.
All Italians are Jewish. If you’re from New York, you’re Jewish, even if you’re Catholic.
If you’re from Butte, Montana, you’re goyish even if you’re Jewish.
— Lenny Bruce (1926-1966) ‘Beat’ era stand-up comic
The Internal Revenue Code is goyish. S Corps are goyish. Alternative minimum tax is goyish. Qualified retirement plan rules are, as you know, very goyish.
But not everything in the Internal Revenue Code is goyish. Without question, partnerships are Jewish, as are capital gains. While trust income taxation is, on the whole, goyish, grantor trusts are Jewish. Estate and gift taxes are like someone who was raised as a Gentile, but who always felt Jewish. As for ordinary and necessary business expenses, well, can anything be more Jewish than the write-off rules of Section 162?
Like-kind exchange rules started out as goyish, but are trending Jewish. And therein lies the beginning of understanding of why a single Code section, Section 1031, persists in confounding tax planners and real estate professionals at every level of experience.
Take for example the requirement that both the relinquished property and the replacement property in a like-kind exchange be ‘held for investment.’
In the whiteshoe world of portfolio investment (white belt and whiteshoe if your world is the ‘burbs), holding for investment means not allocating a speed dial button on the den phone to the family’s stockbroker. In the more opportunistic world of real estate entrepreneurs, holding for investment means one thing in one deal, something else in another, and a third thing altogether when tax rates go up or down. As Lenny Bruce would say, it’s ‘heavy Jewish.’
This is part of a three part article on issues relating to the “held for” requirement of Section 1031. Lenny Bruce and matters of the Jewish faith notwithstanding, I call upon you, as I called upon you in the summer, 2006 issue of Tax Talk, to suspend disbelief and assume that the held for issue breaks down neatly into three discrete problems.
The first is the “shovel in the ground” problem. Phrased as a question, when do value enhancing actions, such as installing sewer and water infrastructure, constitute a change in motive from investment to held for sale? For my take on this question, consult the summer, 2006 issue of Tax Talk.
The second is the “guilt by association” problem. Phrased as a question, when are the activities of an entity’s owners or affiliates attributed to the entity for purposes of discerning whether property is held for investment or for sale? This will be discussed in a future issue of Tax Talk.
The third, discussed below, is the “tax shoes” problem. Phrased as a question, when the taxpayer transfers either relinquished or replacement property to affiliates immediately before or immediately after an acquisition or disposition, does the transferee inherit the investment motive of the transferor?
The Tax Shoes Problem
Dealing with like-kind exchanges when one or more owners wish to reinvest under Section 1031 and one or more wish to cash out is an unpaved stretch of the like-kind superhighway. Dealing with partnerships in which all partners wish to reinvest, but wish to do so separately from their current partners, is an especially rutted portion of this unpaved tax-deferral right of way.
Special allocation of gain to the cashing out partner doesn’t work, because the point of a like-kind exchange is to defer rather than to specially allocate gain. An installment sale to the retiring partner works, the step transaction taint notwithstanding, but only with the right facts. Transfers of part interests in relinquished or replacement properties either immediately before or after a sale or purchase2 not only reek of step transaction, but fly in the teeth of the requirement that each of the relinquished and replacement property be held for investment by the same taxpayer. Besides, even a tenant-in-common arrangement can look like a de facto partnership to a distrustful, determined IRS.
What to do? Listen to the courts. The huffing and puffing of the IRS notwithstanding, courts have ruled for the taxpayer in each case involving the issue of transfers to or from the tax partnership in connection with a like-kind exchange.
Courts have done a poor job, however — or, more charitably, have struggled with the difficult issue — of formulating a principle around which consistent planning and court decisions can flow. The issue is not only critical to determining a taxpayer’s investment or non-investment motive in the context of like-kind exchanges but is also relevant to tax minimization strategies which do not involve Section 1031.
When property is transferred immediately before or immediately after a step in a like-kind exchange, the taxpayer typically would like to see an attribution of motive, the “tax shoe” issue which is the subject matter of this article. In contrast, partnerships, and LLC’s taxed as partnerships, sometimes attempt to lock in appreciation at capital gains rate, and yet still dispose of the asset in the form of inventory, such as building lots, finished homes or apartment units.3 Consequently, taxpayers and their tax advisors can find themselves on both sides of this attribution issue. What is necessary, therefore, is not only a path “in” to the held for investment promised land, but also a proper boundary survey of the premises, for those instances in which it serves the client to steer clear of the ‘held for’ status.
The issue, broadly stated, is whether the transferee steps into the “tax shoes,” as Congress and the IRS have phrased it, for purposes of satisfying the held for investment requirement.
Tax shoes don’t wear as well in the world of corporations as in the world of partnerships. In Rev. Rel. 75-292, the IRS that a taxpayer who transferred the replacement property in an attempted like-kind exchange to a corporation immediately after closing out the like-kind exchange did not qualify for deferral under Section 1031. Similarly, in Rev. Rel. 77-337, the IRS ruled that the sole shareholder in a corporation did not inherit the corporation’s held-for investment status with respect to the property distributed to him in liquidation of the corporation.
But even with corporations, there is not much bad news out there beyond those two revenue rulings and a stray, somewhat dated Tax Court opinion.4 In Maloney v. Commissioner,5 a corporation exchanged like-kind properties and immediately thereafter transferred the replacement property to its owners in complete liquidation. The IRS argued that the intent to liquidate and distribute profit to shareholders was akin to an intent to sell the property or to gift it. The court disagreed, relying on Magneson and Bolker, discussed below, reasoning that the liquidation under old Section 333 did not constitute a liquidation of the investment.
The court contrasted the facts in Maloney to those of Regals Realty Co. v. Commissioner.6 In Regals Realty, the court found as a matter of fact that the corporate exchangor intended to sell the real estate which it had just received in a like-kind exchange and to distribute the proceeds in liquidation of the corporate taxpayer. While the corporation did not in fact sell the replacement property, and instead dropped it into a subsidiary and then spun the subsidiary stock out to the shareholders, the court concluded that the taxpayer had intended to sell the property received rather than to hold it for investment. The court in Regals did, however note that even if the taxpayer’s intention should have been gauged by what was actually done rather than by the expression of an intent, the drop down into the subsidiary and subsequent distribution to shareholder “made it impossible for [the taxpayer] to hold the property as an investment.
In response to the IRS’ argument based on Regal, the Maloney court stated that “we need not decide in the instant cases whether we agree with the Regals Realty’s alternative holding that a Section 351 transaction would be incompatible with a Section 1031 tax free exchange. In so stating, the court might, ideally, have explained why it viewed as important the distinction between a transfer from a corporation and a transfer to a corporation.
So there you have it on transfers between corporations and their individual shareholders immediately before or after completion of a like-kind exchange. The worse that can be said is that such transfers are not clearly impermissible. The best advice is to steer clear of the tangled thicket of cases involving transfers to and from corporations, advice that, in light of conventional real estate practices and the repeal of Court Holding,7 is easy to follow.
In contrast to questions involving transfers to and from corporations, there is some coherence in evidence in the context of tax free reorganizations.8 In PLR 9152010, a corporation exchanged relinquished properties and then merged with a REIT in a tax free reorganization, following which the successor corporation purchased the already identified replacement properties. The IRS reviewed the legislative history of the pertinent division, Section 381, noting that its legislative history “reveals that the purpose of Section 381 was to put into practice the policy that ‘economic realities rather than … such artificialities as a legal form of the reorganization ought to control in the question of whether a tax attribute from an acquired corporation is to be carried over to the acquiring one.’” The ruling also notes legislative history under Section 1031 which justifies deferral under that provision because the taxpayer has not “cashed in” on the investment in the relinquished property.
Significantly, the ruling concludes by stating that the “policy concerns that gave rise to Section 1031 are no less applicable when the acquiring corporation filing a Section 368(a)(1)(C) reorganization receives like-kind replacement property.” Stating that the policy concerns under the tax free reorganization rules are “no less applicable” to those which give rise to like-kind exchanges is a significant confession by the IRS.
In an equally generous spirit, the IRS issued PLR 9751012, which involved a deferred like-kind exchange initiated by a corporate member of a consolidated group. Prior to closing out the exchange, the corporation liquidated into its parent, and then its parent was merged into a brother-sister corporation as part of a tax-free reorganization. The ruling echoes the approving sentiments expressed in the 1991 private letter ruling discussed above toward the intent of Congress under Section 381; that is, that successor corporations should be able to step into the “tax shoes” of a predecessor corporation. Significantly, Section 381 lists certain tax attributes that carry over to a successor corporation, but the list does not include the “held for investment” state of mind required for a proper like-kind exchange. The IRS concluded all the same that allowing for such a carryover intent was consistent with the legislative purpose.
The Magneson and Bolker cases, decided by the Ninth Circuit in 1983 and 1985 respectively, are part of the founding myth that transfers immediately before and immediately after like kind exchanges are risky, high wire schemes. Like many founding myths, it sometimes pays to reexamine the primary text. Doing so in the case of Bolker and Magneson yields an interesting harvest of insight into how much flexibility there in fact is in this area of the law.
In Magneson v. Commissioner the taxpayer took title to replacement property and then immediately contributed it to a partnership in exchange for a general partnership interest. The foundation of the court’s finding that Section 1031 applied was the continuity of interest and continuity of control. The court did note that a transfer to a corporation is different from a transfer to a partnership, because the change in the legal status is more pronounced in the case of transfers to corporations than is the case with transfers to general partnerships. Specifically, the court reasoned that a transfer to a partnership in exchange for a general partnership interest does not “significantly affect the amount of control or the nature of the underlying investment.” The court also rejected the government’s attempt to apply the step transaction doctrine, concluding that the steps taken were not circuitous.10
So Magneson tells us that when you have good facts — a partnership rather than a corporation and a carryover of all the incidents of control (that is, a general rather than a limited partnership interest) — the investment motive of the transferor carries over to the transferee. The fault line does seem to boil down, under Magneson, to the intersection of corporations and partnerships.
Two years later, however, the same Ninth Circuit softened its position on corporations, ruling in Bolker v. Commissioner11 that a corporate taxpayer could liquidate tax free, and the taxpayer could exchange the property received in the liquidation for like-kind property in a transaction qualifying under Section 1031. Despite facts involving the harder case of a transfer from a corporation, the court decided that in the absence of an intent to either convert the property to personal use or to liquidate it, that is, turn it into cash, the taxpayer could satisfy the held-for requirement.12
The Bolker court also stated that the order of the Section 1031 exchange and the other transaction, standing alone, is “insufficient” to affect the result.
The thrust of the case law,13 together with the studied (and admitted) indifference of the IRS to the technique,14 suggests that taxpayers are fairly safe in using the swap and drop and drop and swap, provided they pay attention to the technical demands of the art.
The foremost technical demand of the art is to not treat a tenant in common interest distributed from a partnership (or limited liability company taxed as a partnership) as if the distribution never occurred. Note in this regard that the IRS and the courts, in both the tax and non-tax context, apply the duck rule to the question of whether or not an arrangement constitutes a partnership. If two or more parties join together for the purpose of carrying on a business and sharing profits and losses, it’s a partnership. Culbertson v. Commissioner,15 and see Madison Gas & Electric Co. v. Commissioner,16 in which the court ruled that a joint ownership arrangement involving electrical cogeneration constituted a partnership because of the extensive management activities required by the undertaking.
In the context of owning real estate, the issue — provided the parties take care of the easy points such as pro rata sharing of debt — comes down to the level of management. This in turn, involves both the question of (i) whether or not there is centralization of management, which by itself suggests a partnership, and (ii) whether or not management of the property in question requires activities over and above those normally seen in connection with straight rental property.
Rev. Rul. 75-374 provides a safe harbor on this issue. In that ruling, unrelated parties owned equal tenant in common shares in an apartment building. The two owners entered into an agreement which covered the necessary points for managing the property, consisting of routine rental and maintenance matters, but no extraordinary management demands, such as those required by a hotel, senior housing or a parking garage. The IRS concluded that the arrangement lacked sufficient indicia of a partnership and therefore constituted a tenant in common relationship.
Another important area where competent advice given earlier in the process pays is on the question of who contracts with the outside parties. It is difficult, for example, for Partner A in what was formerly ABC Partnership to claim that his or her recently distributed tenant common interest in the partnership’s real estate is truly an interest held separate from the partnership if ABC Partnership signs a contract to sell all the ownership interests in the property, and Partner A’s name appears nowhere in the documents.
Ideally, the ownership group will hold itself out as separate owners, and most importantly, in connection with negotiating and executing a contract of sale, each tenant in common interest is separately represented and separately reflected in the documents. For example, in Chase v. Commissioner,17 a partnership distributed a tenant in common interest out to a partner in redemption of that partner’s interest in the partnership. The transferee partner did not record the deed immediately. Instead, the partnership negotiated and concluded a contract with a purchaser, and held itself out throughout the negotiation and settlement process as the sole owner of the property. Pending settlement, for example, funds needed to manage the property were held solely in the name of the partnership. The redeemed partner, moreover, only recorded his deed once it was clear that the sale was going to take place.
The taxpayer argued that the partnership had been acting as his agent, but the court found no evidence that that was so. Instead it concluded that there had not been a true redemption or any other change of the relationship of the owners of the original partnership.18
If, as happens sometimes, the partnership contracts only in its own name to sell the property, if at all possible, the contract should be rescinded and a new contract reflecting the names of all the tenants and common owners should be signed in its stead. That is not as good as getting it right the first time, but it is better than running afoul of the standard reflected in Chase.
Some Lenny Bruce monologues endure because they are clever and not, as his live audiences might have supposed, because they retain the power to shock mainstream sensibilities. With apologies to his remaining admirers, there’s an element of Lenny Bruce in the swap and drop ‘tax shoes’ issue. As with stand up comedy, it pays to be clever — which means in the Section 1031 context designing your transaction to follow the known, worn paths along this pitted road — but the problem, and the solutions, have gone mainstream. As even the IRS admits, the great battles lie in the past.19
Part of this article originally appeared in the summer, 2006 issue of Tax Talk, a publication of the MSBA Tax Section. All rights reserved.
2Drop and swaps, or swap and drops, as Richard Lipton called them in The State of the Art in Like-Kind Exchanges, 2006, Journal of Taxation, March 2006.
3This involves selling the project in gross to an affiliated corporation, and having the corporation engage in the final stages of development prior to sell out. If the trade or business activities of the purchasing corporation are attributed back either to the selling partnership or to its owners, then the gain on the sale from the partnership to the corporation should be taxed as income ordinary rates.
4In Brown v. Commissioner, 448 F.2d 514 (10th Cir. 1971), the court ruled that the business of a corporation is not ordinarily attributable to its shareholders. [need to explain]
593 T.C. 89 (1989).
643 B.T.A. 194 (1940).
7324 U.S. 331 (1945). As a result of the legislative repeal of the Supreme Court’s decision in Court Holding, the distribution of appreciated property by a corporation to its shareholders with respect to its stock will trigger gain to the corporation as if it had sold the property to a third party for cash. The rule even applies to S corps.
8That makes some sense, in that transfers in and out of corporate solution — that is, crossing the boundary between the corporate world and the non-corporate world — implicates deeper policy issues concerning the purpose and integrity of the corporate tax rules.
9753 F.2d 1490 (9th Cir. 1983).
10It is worth noting that this is more or less the last we have heard from the IRS in attempting to apply the step transaction doctrine in the context of transfers to and from entities before and after like-kind exchange. It does appear that arguing step transactions is unlikely to get the IRS out of the barn, in that in the typical swap and drop or drop and swap, there is no pretense about what is going on. Circuity, it should be noted, however, always makes the IRS mad. See Crenshaw v. United States, 450 F.2d 472 (5th Cir 1971), and see Decleene v. Commissioner, 115 T.C. No. 34 (2000)
11760 F.2d 1039 (9th Cir. 1985).
12This brings to mind the old joke about how the starting premise of laws in Italy is that what is not prohibited is allowed, while in Germany, the starting premise is what is not expressly allowed is prohibited. The Ninth Circuit, more Italian than Germanic in its sensibility, opted for the broad permissive rule, that is, every kind of transfer immediately before and immediately after is permitted, provided there is no intent to do what is prohibited — converting to the property personal use or turning it into non-like-kind property, such as cash.
13See also Miles H. Mason, TC Memo 1998-273, in which partners in two real estate partnerships liquidated each partnership in kind to the two partners, following which the partners exchanged properties on a tax deferred basis under Section 1031. One partner recognized gain, but owing to his being relieved of debt rather that on a theory that the parties exchanged partnership interests.
14“Although we disagree with the conclusion that taxpayer that receives property subject to a prearranged agreement to immediately transfer the property “holds” the property for investment, we are no longer pursuing this position in litigation in view of the negative precedent [of Bolker and Magneson].” FSA 199951004 Dec. 24, 1999, at p. 19.
15337 U.S. 733 (1949).
16633 F.2d 512 (7th Cir. 1980).
1792 T.C. 874 (1989).
18See Kinney v. United States, 228 F.Supp. 656 (W.D.La 1964), aff’d 358 F.2d 738 (5th Cir. 1966), in which, in a non-Section 1031 context, the court ruled that an operating partnership had not truly redeemed on of its partners in kind because the other partner continued to operate the partnership’s business as he had before the purported redemption.
19See FSA 199951004, infra.