Deceased Sister’s Trust is not Related Party to Siblings

Related parties are defined by IRC Section 267(b) or 707(b) of the IRS code. Special rules apply to related parties who are involved in a 1031 exchange.

If related parties exchange like-kind property with each other each party must hold the property received for two years before any subsequent disposition occurs, and

A taxpayer cannot sell to an unrelated party and receive replacement property from a related party.

Related parties include ancestors, descendents, siblings and spouses. Related parties do not include the spouse or children of a sibling. A taxpayer doing an exchange with a spouse or child of a sibling is not subject to the related party restrictions and requirements.

In a recent Private Letter Ruling ( PLR 2009192007), a trust for a deceased sibling’s spouse and children was held to not be a “related party” to the surviving siblings for the purposes of Section 1031. This allowed a portion of the inherited farm ownership to be sold while also allowing the other two siblings to retain their ownership and continuing their taxable gain deference.

In this case, the Taxpayer and two siblings co-owned equal shares of farmland as tenants in common. Ownership was held in trusts for each of them (Trusts A, B and C). Child C died and beneficial ownership of assets in trust passed to Child C’s surviving spouse and children. Trust C now wanted to sell its share of the farmland.

The tenancy in common interest of each trust was converted to fee simple interests in the same property through subdivision. This was technically an exchange between the three trusts. After the exchange of the undivided interests for whole parcels, the husband of the deceased sister, via Trust C, quickly sold its parcel to an outside, third party. The other two siblings retained their respective parcels. If the deceased sibling's trust was a 'related party' under section 1031, the exchange of the interests for the whole parcels could have been found to be a taxable event to the other two siblings due to nonn-compliance of the two year-rule reference above.

Although her trust sold within two years of the swap in ownership, the IRS said the sale did not trigger tax on the exchange by the other two trusts. The ruling held that the exchange and subsequent sale was not a transaction to which section 1031 applies because the sibling taxpayers are not related to the Trust within the meaning of section 1031.

This ruling provides some insight into who is NOT considered a Related Party within the context of 1031 exchanges. However, rules on related parties should be reviewed with your tax professional before relying on any Private Letter Ruling for definition. You may also give us a call at 888-367-1031 if you have any questions regarding 1031 exchanges between related parties.

Mutual Irrigation Ditch, Reservoir or Irrigation Company Stock

With the recent passage of the Food and Energy Security Act of 2007 (commonly referred to as the Farm Bill), mutual irrigation ditch, reservoir or irrigation stock (“ditch stock”) MAY now be considered like-kind to a fee interest in real estate.

Section 1031 clearly spells out that corporate stock, bonds and notes are not eligible for a like kind exchange. However, the recently passed Farm Bill amends section 1031 to exclude mutual irrigation ditch, reservoir or irrigation company stock from “stocks, bonds, or notes”. With this passage, these water rights may now be eligible for a 1031 exchange - depending on state statute and previous court rulings.

Mutual irrigation ditch, reservoir or irrigation stock is generally considered to be a water right which is used on farm land to irrigate crops. Water, as a mineral, is generally considered to be an interest in real estate. As an interest in real estate, it is generally considered to be like-kind to a fee interest in real estate. Farm land which is sold or exchanged sometimes includes ditch stock that has benefits and value to the sale of that land. Particularly in the western United States, these water rights are critical to the ongoing production ability of the property and are typically sold with the real estate.

In order to qualify, the new law clearly indicates that such ditch stock has to be recognized as real property, or an interest in real property, in the state in which the corporation is located. Recognition can be by the highest court of the state or by applicable state statute. Mutual irrigation ditch companies are organized under separate sections of state statutes and ditch stock has been recognized as an interest in real property by the District Court of Colorado and other court cases. However, ditch stock in other states may or may not qualify.

Exchange clients should be familiar of the state laws and court rulings in the state their exchange property is located. Of course, they should also discuss their circumstances with a knowledgeable real estate attorney or qualified tax professional before embarking on an exchange of water rights. A Qualified Intermediary that is familiar with the special closing and exchange-related issues involving ditch and water stock should also be consulted and engaged to ensure the exchange is completed properly. To learn more about this topic, please consult our 1031 Exchange Manual or give 1031 Corporation Exchange Professionals a call at 888-367-1031.

Family Limited Partnerships

In managing federal estate taxes, the use of Family Limited Partnerships (FLPs) has proven to be a beneficial planning technique. During the last two decades, FLPs gained popularity. They also attracted the attention of the Internal Revenue Service (IRS).

Due to the FLPs extraordinary tax benefits, the IRS has audited many FLPs. But this IRS challenge should not be viewed as their demise. Rather, IRS audits reveal proper FLP use and maintenance.

Benefits of the FLP
An FLP is a powerful estate planning tool that can help reduce future taxes. This tool may be very handy as estate taxes may soon be at an all time historic high. For those who pass away after 2010, the tax law would impose a steep estate tax or "death tax" burden of up to 55% of ranch value!

Using an FLP can help ease this tax burden. Through an FLP, a senior family member can reduce the estate tax and keep control of the family operation.

An FLP is often formed by a member of the senior generation who transfers family assets to the partnership in exchange for both general and limited partnership interests. Some or all of the limited partnership interests are then gifted to the junior generation. The general partner need not own a majority of the partnership interests. In fact, the general partner can own only 1 or 2% of the partnership, with the remaining interests owned by the limited partners.

This structure produces several advantages:

The senior family member can gift limited partnership interests to junior family members at less than the full fair market value of the underlying assets.

The use of the partnership entity allows a senior family member to shift some of the form and ranch income and future appreciation to other members of the family.

The senior family member retains management and control while transferring away limited ownership interests.

The senior family member can also place restrictions within the partnership agreement that ensure continuous family ownership.

At death, the senior family member's estate tax bill may be reduced since only the value of the decedent's partnership interest will be taxed.

IRS Scrutiny: Potential Concerns with the FLP
The IRS has taken a more aggressive stance regarding FLPs. Over the past several years, the IRS has had success in attacking FLPs with the most common problems being:

Failure to Follow Formalities. FLPs are required to have Partnership Agreements that must be followed. Although FLPs have far fewer formalities than corporations, the partners should have regular meetings, take minutes, and treat the entity with the formality expected of a non-family business.

Inadequate Valuation Reports. The IRS is often critical of both the quality and content of the family's valuation appraisals. To avoid the IRS attention, the family should retain accredited appraisers experienced with the requirements of estate tax appraisals.

Non-business Assets or Activities. FLPs are business entities and are not meant for personal use. The family homestead should not be placed into an FLP, nor should normal family expenses (utilities, clothing, educational expenses, etc.) be paid from the FLP.

Other "red flags" include commingling FLP and personal income, preparing FLP financial records after death and forming "deathbed" FLPs.

FLPs need annual care and regular maintenance. With this care, FLPs can achieve substantial federal estate and gift tax savings. For farm and ranch families with large illiquid estates, FLPs can be a very beneficial tax savings tool.

Denise Hoffman is a senior associate with the law firm Rothgerber Johnson and Lyons LLP. If you or your family has questions concerning Family Limited Partnerships, please call Denise at 303-628-9523 or contact her by e-mail at dhoffman@rothgerber.com.

Proposed Farm Bill would limit agricultural exchanges

The United States Senate has unveiled the “Food and Energy Security Act of 2007”, otherwise known as the “Farm Bill,” which combines agricultural program proposals with tax proposals formerly included in the “4-H Bill.” The Farm Bill is currently under consideration by the full Senate. The proposed bill, as currently crafted, has a potentially negative impact for farmers and ranchers with respect to 1031 exchanges. It will limit their options to do a tax-deferred exchange out of farmland and into other real estate investment property.

As part of the bill, the Senate is proposing to change the 'like-kind' standard to provide that “unimproved agricultural real property” is not like-kind to “improved real property”. “Unimproved agricultural real property” is defined as agricultural land that is enrolled in certain farm subsidy programs, unless the agricultural land is permanently retired from the farm subsidy programs prior to the date of an exchange transaction. Much of America's agricultural land is subject to these subsidy programs.

What does this mean for exchanges of agricultural properties? It prevents farmers, ranchers and owners of agricultural property from exchanging out of improved agricultural property (livestock facilities, grain elevators, machine sheds, fence, tile etc.) and into the subsidized agricultural land. It also prevents farmers and ranchers from exchanging the subsidized agricultural land for any improved real property, including commercial, residential and tenancy-in-common (TIC) properties. Finally, it prevents owners of commercial and residential investment properties from exchanging into the subsidized agricultural land.

Most likely, these provisions will result in agricultural land owners having limited choices in exchanging their farm or ranch land. If they decide they'd like to reinvest their land sale proceeds into an improved investment property they will be forced to pay the tax or exchange and lose the land's future ability to qualify for subsidies (thus potential reducing the value in the land). As you can see, this provision will have a significant impact on those that work with agricultural land and on those communites that are located in agricultural-based areas.

We believe this is a bad provision. If you agree, please let your Senator know that you oppose Section 12504 too.