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.

Renting Real Estate to a Related Corporation May Cause PAL Rule Tax Problems

The passive activity loss (PAL) rules were enacted as part of the Tax Reform Act of 1986. They were intended to prevent taxpayers from using losses and credits from tax shelters to offset income from such sources as wages, interest and dividends. Congress felt that taxpayers who were simply investors in a business activity (and not actively participating) should use deductible tax benefits only against income from such passive activities.

Rental real estate activities are passive activities subject to the passive activity rules. Losses from rental activities, after including expenses such as interest and depreciation, are not deductible unless a taxpayer has passive activity income from other sources. There is an exception. Taxpayers are generally allowed to take a net deduction of $25,000 from ordinary income if they actively participate in the rental activity. This special rule is phased out for high-income taxpayers.

Taxpayers with passive activity losses have a natural desire to create sources of passive activity income which can be used for deduction of losses from other passive activities. Taxpayers who are doing business as a corporation frequently own the real property which the corporation uses and receive rents from the corporation for the property use. This lease income to their corporation is reported on their individual income tax return as rent income. Taxpayers would normally expect that this income is passive activity income because rental activities are defined as passive activities.

However, the IRS does not like the possibility that a taxpayer could create artificial passive income by renting property to a controlled corporation and use this income to offset losses from other passive activity investments. The sole owner/taxpayer of an S Corporation could also compensate himself through the artificial use of rent and diminish W-2 compensation (which is subject to payroll taxes). To stop this perceived abuse possibility, the IRS recently issued new regulations classifying net rental income from a corporation owned by the taxpayer as active income (and not passive activity income). Therefore, rents from a corporation owned by the taxpayer could not be used to offset losses from other passive activity investments.

But what happens if the rents from the taxpayer-owned corporation result in a rental loss after rental-related expenses? The IRS has said the activity IS a passive activity and losses can only be deducted against other passive activity income. If there is no passive activity income from other sources, the loss cannot be used to shelter ordinary income.

In a recent Tax Court Case ( Senra, TC Memo. 2009-79) the taxpayer argued that a rental loss should be deductible against wages the taxpayer reported from the same corporate activity. The taxpayer argued that the rental activity was related to the business activity of the corporation and, when combined, the two activities formed one economic unit. They argued that it should be treated as a single activity for purposes of measuring gain and loss for netting purposes.

The Tax Court disagreed and said that the passive activity loss rules cannot be escaped under the "one economic unit" argument. The taxpayers were stuck with a rental loss which could not be used to offset wage income from the same corporation. This court case is something to consider when dealing with a related party transaction between a controlling taxpayer and a corporation having rental income.

When dealing with related parties, the water can get murky. 1031 Corporation has information on exchanging properties between related parties and can help you understand the issues that may be present. See our website for information on structuring issues when parties related to each other are buying and selling and making efforts to defer capital gains taxes. Of course, you can always give us a call at 888-367-1031. While we can't advise you on passive activity loss rules, we can provide related party exchange-related consultation...and both the information and phone call are free!

How do you report a 1031 Like-Kind Exchange to the IRS?

We often are asked for assistance from taxpayers and accountants on how to report a like-kind exchange. While we are unable to give tax advice, we do have obvious experience with this somewhat complicated and difficult form to complete. So, we can provide some assistance with YOUR completion of the form.

You must report an exchange to the IRS on Form 8824 and file it with your tax return for the year in which the exchange occurred. For example, if you sold property on November 5, 2008 as part of a 1031 exchange, and you purchased the new property on February 7, 2009, you would need to file Form 8824 with your 2008 tax return. This is a two page form that you submit with your federal tax return to report the details of your 1031 exchange.

Form 8824 asks for:

·Descriptions of the properties exchanged

·Dates that replacement properties were identified and transferred

·Any relationship between the parties to the exchange

·Value of the like-kind and other property received

·Gain or loss on sale of other (non-like-kind) property relinquished

·Cash received or paid; liabilities relieved or assumed

·Adjusted basis of like-kind property relinquished; realized gain

When you complete an exchange with 1031 Corporation you will receive a summary of your 1031 Exchange. Included with this summary is a worksheet to assist you in completing the Form 8824. Our worksheet and the 8824 form are also provided on our website under Accounting Topics.

Of course, we'll also walk you through all the steps of the exchange and make you aware of any obstacles and work with you to hurdle them. Plus, our clients receive pre- and post-consultation at no additional cost. That comes in handy when you are trying to fill out that Form 8824.

Give us a call today at 888-367-1031 with your 1031 exchange needs!

1031 Drop and Swap Distributions Receiving New IRS Attention

Partnerships which are selling property often have one or more partners who want to structure a 1031 exchange for their share of the property owned by the partnership (or LLC). Sometimes all of the partners will wish to go separate ways and either sell for cash or do their own 1031 exchange. Sometimes one or two partners of a multi-partner firm will wish to leave the partnership arrangement.

A sale of a partnership interest does not qualify for a 1031 exchange. So, individual partners who want to structure a 1031 exchange for the sale of their interest in the partnership real estate need to position themselves appropriately. They can do so by receiving a deed to their share of the real estate from the partnership. This is done by the partnership conveying a tenancy-in-common interest in the real estate to the individual partner in redemption of his interest in the partnership. This leaves the real estate co-owned by the partnership and the individual member of the partnership who received the deed. Each of the co-owners proceeds to close on the sale of the real estate to the buyer and the individual member proceeds to do a 1031 exchange for the sale of his interest. Of course, the partnership and its remaining members are also positioned to do their own 1031 exchange if they wish to do so. This procedure is known in the industry as a “Drop & Swap.”

The Drop & Swap commonly takes place at the same closing table at which the property is conveyed to the buyer with back-to-back closings. The individual member partner who received a tenancy-in-common deed from the partnership has, technically, only owned his piece of the for sale real estate a few minutes. The first question that comes up is whether a few minutes of ownership is adequate for qualification of the sale for a 1031 exchange. The requirements for a 1031 exchange include the condition that the property being sold has to have been held by the taxpayer for investment or business purposes. This is commonly known as the “held-for requirement.” The Code and Regulations provide no guidance on how long a taxpayer has to have “held” the property for the required purposes.

In the past, the IRS has challenged taxpayers who have done a Drop & Swap with only momentary ownership prior to a sale. However, the courts have been favorable to the taxpayer holding that a distribution of property to a taxpayer is merely continuing the investment in a different form. In recent years, the IRS has not been aggressive in challenging Drop & Swaps.

However, commencing with 2008, Partnership Income Tax Returns include two new questions in Schedule B –

13. Check this box, if during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (including a disregarded entity).

14. At any time during the taxpayer year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?

Based on these new questions - which clearly include Drop & Swaps, it appears that the IRS wants to know how frequently this is being done and is giving it their attention. Will the IRS select partnership returns for audit based on the answers to these questions? We don’t know. At a recent industry conference, an IRS agent indicated it was Treasury and not the IRS that had added these questions. Further, the IRS has offered no explanation for these new questions. Whatever the case, it appears some study is being done on the subject.

Taxpayers involved in a Drop & Swap will have to accept some risk of challenge by the IRS based on these new questions on the Partnership Income Tax Return. Taxpayers should always consult with their tax and law professionals if they are contemplating a Drop & Swap for consultation on this issue as well as other business and tax issues affecting the partnership and its members.

For more answers to your questions regarding partnership interests and 1031 exchanges, please visit our website or give us a call at 888-367-1031.