IRS Guidance and 1031 exchanges

Many times in this blog, we refer to different Internal Revenue Service publications that provide guidance on issues involving real estate and 1031 exchanges. The IRS provides a number of publications and written correspondence that provide guidance. These documents are essentially a translation of tax laws that Congress enacts. we often refer to these when consulting clients on 1031 exchanges. I've listed the top 5IRS publications we use - starting at the highest and moving down according to their "rank".

Regulation
Regulations are the highest form of guidance to new legislation. They are are issued by the IRS and Treasury to also address issues that arise with respect to existing Internal Revenue Code sections. Regulations interpret and give directions on complying with the law.

Revenue Ruling
A Revenue Ruling generally states an IRS position. It is an official interpretation of the Regulation Code or statute. It is, basically, how the IRS applies the law.

Revenue Procedure
A Revenue Procedure is an official statement affecting the duties or rights of taxpayers under the Code, statute, and/or regulations. A Revenue Procedure might provide return filing or other instructions concerning an IRS position. It may also provide a "safe harbor" umbrella with which a taxpayer can structure and complete a transaction.

Private Letter Ruling
A Private Letter Ruling, or PLR, is a statement written to a specific taxpayer that interprets/applies tax law to that taxpayer's specific set of facts. It is issued to establish the tax consequences of a particular transaction before the transaction is completed or before the filing of a taxpayer's return. To receive a PLR, a taxpayer must request a written response from the IRS. It is binding to that taxpayer's circumstances only if the taxpayer is fully and accurately describing the proposed transaction in the request and carries it out as described. It should be noted that while a PLR may provide guidance, it can not be relied on as precedent by other taxpayers or IRS personnel.

Technical Advice Memorandum
A Technical Advice Memorandum, or TAM, is guidance furnished by the Office of Chief Counsel in response to technical or procedural questions that develop during a proceeding. A request for a TAM generally comes from an exam of a taxpayer's return or a taxpayer's claim for a refund or credit. TAMs are issued on closed transactions and interpret the application of tax laws, treaties, regulations, Revenue Rulings or other precedents. The advice is deemed a final position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued.

There are, of course, many other additional publications and pronouncements that provide taxpayer guidance. Robert F. Reilly, CPA, CFA - in a two part article for the AICPA's Practicing CPA, detailed a number of these various publications. Part I covers publications presenting official IRS positions, IRS instructional publications, and announcements, notices, and news releases. While Part II covers advance rulings and determinations as well as new types of IRS pronouncements.

When seeking tax and litigation guidance, tax professionals (CPAs and attorneys) first consider statutory authority. When that is insufficient, they look to these official publications of the IRS as well as judicial precedent (Tax Court rulings)regarding the specific matter.

With respect to 1031 exchanges, your Qualified Intermediary should be monitoring various tax law updates and publications to have the most current weapons to provide you in your arsenal. 1031 Corporation Exchange Professionals has a full time CPA on staff and retains expert tax and real estate attorneys that constantly monitor and update like-kind exchange strategy. While we do not provide tax or legal advice, we can consult with you and your tax professionals and provide guidance as to the proper IRS publications and court case precedent in reviewing your individual exchange facts and circumstances. Further, this consultation is provided as a part of our services and no fee is paid unless an exchange is initiated.

Primary Residence Gain Exemption Rule Changing

Most homeowners are aware of the primary residence exclusion. It is a provision in the tax law that allows a homeowner to sell their primary residence and exempt the gain if certain conditions are met. The gain is available up to $250,000 - if you file your taxes individually - or $500,000 - if you file your taxes if married filing jointly. To be eligible, you must own the home and live in it - as a primary residence - for at least two of the last five years prior to the sale.

The law previously permitted you to convert a vacation, secondary residence or investment property into your principal residence, live in it for two years, sell it and take the full exclusion even though a portion of the gain might have been attributable to periods when the property was used as a vacation, second home or investment property.

This strategy was used for 1031 exchange investors to exempt up to $500,000 of deferred gain in an investment property. In 2004, the Jobs Creation Act made an additional requirement that if a 1031 exchange was involved, you had to own the property for a minimum of five years. thus you could rent a home out for three years, move in it for two and exempt the exclusionary gain.

The Housing Assistance Tax Act of 2008 changes all that. While many provisions within the new law assist struggling homeowners, a provision added takes away from the primary residence exemption rules.

Beginning on January 1, 2009, homeowners will now be required to pay tax on gains made from the sale of a second home, vacation or investment property the portion of time after that date that the home was not used as a primary residence. The amount taxed will be based on the portion of time that the house was not used as a primary residence. The rest of the gain remains eligible for the "up to $500,000" exclusion as long as the two out of five year usage and ownership tests are met. The new law thus reduces the exclusion to the ratio of time used as a principal residence to the total time of ownership.

For example, suppose a married couple filing a joint tax return purchases an investment property after January 1, 2009 and rents it for seven years. They then convert it into a primary residence for three years before selling it. In this situation, only 30% (3/10 years) of the gain would be eligible for the $500,000 exclusion and 70% 7/10 years) of the gain would be subject to tax. Quite a difference.

There is some good news. It is not retroactive. The period of investment use before 2009 is ignored. So is the period of time it is rented after you move out of the residence. Only periods of time it is rented before you made it your residence (after January 1, 2009) count. So, if you've owned an investment property for the past twenty years, move into it before January 1, 2009, and live in it for two years before you sell it, the entire gain remains eligible for the tax exclusion. So, too, is the primary residence that you lived in on January 1, 2009 but later rent out for two years before selling it. The entire gain is eligible for the exclusion.

The Act complicates deferred gains on 1031 exchanges and changes investor strategy for moving into an investment property. 1031 Corporation Exchange Professionals can provide guidance on the issue and, of course, you should speak with your tax advisor to ensure you fully understand your options.

Land Banking & 1031 Exchange

Land banking is not a new concept. It is described as the process of separating real estate activities by forming different business entities that perform investment functions while others complete development activities.

Let's say an investment group forms an LLC and purchases a tract of land for a long-term investment. Over the years, development moves closer to the land and the land increases in value. Perhaps the property is annexed into a municipality, the zoning is changed and a new four lane highway appears. The group decides that, rather than sell it "as is", they would further profit by taking the land through development of the parcel. But wait, they've held it for a long time and they realize that if they develop it, they will get taxed at ordinary tax rates instead of the long term capital gain rate - which is significantly lower. But what if they form a new entity to develop the property? Ah....land banking!

Thanks to a series of favorable court rulings over the past couple decades, owners can sell a property to a separate corporation they control. This corporation then develops the horizontal (and perhaps vertical) improvements and markets the land. By doing so, the former entity - in our example, the LLC - can potentially save significant tax liability on the appreciated value of the land when it is sold to the related corporation by classifying the investment as a long-term capital gain! Jim Walker, the senior tax partner of at the firm Rothgerber Johnson & Lyons LLP explains this process more fully in his article "Land Banking:" A Structured Approach to Capital Gains Planning.

So what would happen if the owners of the LLC decide ahead of the sale that they'd like to reinvest the proceeds of the land sale, to the related corporation, via a 1031 exchange rather than pay the 15% Fed cap gains tax (plus any applicable state or local tax) in order to fully defer the tax?

There is a special rule for exchanges between related parties which requires related taxpayers exchanging property with each other to hold the exchanged property for at least two years following the exchange to qualify for non-recognition treatment. If either party disposes of the property received in the exchange before the running of the two year period, any gain or loss that would have been recognized on the original exchange must be taken into account on the date that the disqualifying disposition occurs. Under this thinking, the development corporation would be compelled to hold the land purchased from the LLC for two years before reselling it.

Tax and exchange professionals have historically advised their clients to comply with the two year rule. However, three Private Letter Rulings (PLRs) released in 2007 say that the two year rule did not apply to a related party who purchased the relinquished property from the taxpayer. The legislative history of Section 1031 identifies several situations intended to qualify under this provision. It includes a non-tax avoidance exception that applies to transactions not involving the shifting of basis between properties.

The purpose of the rule is to prevent related parties from shifting basis from a high basis asset to a low basis asset in anticipation of the sale of the low basis asset that would reduce gain recognition. However, the exchanges in the three PLRs treated the exchanges as valid even though the related buyer voluntarily disposed the property it acquired within two years of the purchase. The rationale used in the 2007 Private Letter Rulings was that the exchanging taxpayer was the only entity that owned property before the exchange. The development corporation did not own property prior to the exchange. Thus, the subsequent disposal did not result in "basis shift" or "cashing out".

So is it possible to land bank a property separating the investment and development activities between entities and then subsequently have the investment entity exchange property? It would appear so - based on recent rulings. Clearly, one need get their legal and tax professional included early on in this process to ensure that you've structured a case that will stand up to potential audit. You also should use the services of a Qualified Intermediary that understands related party issues and knows how to properly process the exchange.