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.

Transferable Development Rights are 1031 Like Kind to Real Estate

Transferable Development Rights (TDRs) are a relatively modern land use planning tool that are encountered in many jurisdictions. Where they are authorized, governments can grant TDRs in order to limit or to entirely prevent development in special zoning districts. When properly structured, governments can accomplish these land use goals without having to pay for what might otherwise constitute costly partial – or even total – condemnations. TDR programs can also be used to reduce political and legal opposition to a restrictive zoning plan. In a TDR program, a governmental entity grants owners of property in the special use zone TDRs in exchange for either voluntary or compulsory new restrictions on the development of property within the zone. These TDRs can be sold on the open market to owners of other real property in a receiving zone, permitting development of the property in the receiving zone beyond what would otherwise have been permitted.

In a recent IRS Letter Ruling (2008-05012), a taxpayer proposed to sell a fee interest in relinquished property and use the proceeds to acquire TDRs. Those TDRs would be used to enhance construction on property the taxpayer already owned within a designated receiving zone. The taxpayer sought a ruling that the TDRs were like-kind to a fee interest in real property.

The IRS ruled that the TDRs could be like-kind to a fee interest under section 1031, despite the fact that the taxpayer intended to use the them to enhance real property it already owned, as long as the TDRs were acquired in an arm’s length transaction. They cited a prior Revenue Ruling from 1968 that said a leasehold with more than 30 years left to run on the property the taxpayer already owned was like-kind to a fee interest under section 1031 as long as the taxpayer acquired the leasehold in an arm’s length transaction.

Next, relying almost entirely on their classification under state and local law, the ruling held that the TDRs are like-kind to a fee interest in real property. While TDRs may not be treated identically to real property for all purposes, they are treated like real property in a number of important ways including: a) the fact that their grant is not discretionary; b) they appear to be permanent; c) they are transferred in a manner similar to the transfer of a deed or an easement; and d) they are recorded and indexed against the granting and receiving sites. Further, the state where the taxpayer was located had a tax statute and transfer tax provisions that seemed to define TDRs as real estate.

Because TDR programs vary considerably from one state to another, it is by no means certain that the laws of a particular jurisdiction will comply sufficiently with the standards presented in this letter ruling. As is always the case with private letter rulings, the ruling itself cannot be cited as precedent, and the IRS has the right to rule differently on subsequent occasions. However, the ruling is useful for the purpose of demonstrating the current thinking on this important subject. To receive a copy of the PLR involving TDRs, give us a call at 888-367-1031 or send us a message at 1031@1031cpas.com.

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.

Depreciation using Cost Segregation

The following information was graciously provided by Jeff Pinkerton of U.S. Cost Segregation.

You may be able to easily take cash out of the investment properties you currently own. It's actually quite easy.

You're probably depreciating those properties at 27.5 years (if residential) or 39 years (if commercial). There is a section of the IRS code that allows you to depreciate certain assets within that building at 15 or 7 or even 5 years. That faster depreciation means more of a tax writeoff which means less taxes. You can even go back in time and recapture this 'lost' depreciation that you haven't been taking.

The technique is called cost segregation analysis and has been a part of the tax law for the past decade. This analysis needs to be performed by a qualified engineering firm, which identifies and "costs out" those assets which qualify for faster depreciation. For example, carpet, electrical for computer equipment and decorative elements can be depreciated over 5 years. Site utilities, paving and landscaping can be depreciated over 15 years.

Imagine you purchased a 15 year old four-plex five years ago and paid $500,000 for it. Assume 20% of that went to land, that means you are depreciating $400,000 over 27.5 years (that's 3.6% per year). But of that $400,000 you paid for the building itself, how much went to the carpet? To the plumbing and kitchen fixtures? To the interior non-load bearing walls?

The answer, of course, is "I don't know". Cost segregation analysis answers those questions and provides data your CPA can use to apply the deductions you've been missing. Extra deductions means less taxes. In fact, it's common that 25% of the assets in an apartment can be depreciated more rapidly. Compare that with the 3.6% you're depreciating now and you can see how this technique can benefit you.

Further, leasehold improvements have even a more profound impact. Typically about 50% of those assets are amenable to accelerated depreciation. This means that you can write off the cost of the original carpet that came with the building, as well as the new carpet you installed. Similarly the new cabinets, the new bathroom and the new electrical wiring and so forth.

This is a time-tested and IRS-accepted method of helping improve your cash flow.

For more information, contact Jeff at 303.694.3924 or visit their website at U.S. Cost Segregation Services.

FDIC Insurance on 1031 Exchange Funds

So you are considering a 1031 exchange and you have selected a Qualified Intermediary (QI) to facilitate your exchange. The property you are selling is under contract and the closing is next week. You have begun the search for suitable replacement property but have not yet found anything appropriate. The money from your sale, it appears, is going to be held by the Qualified Intermediary for some time. But what will that QI do with the funds while you await the need for those proceeds in a replacement property purchase? How do you know your funds are secure?

The range of investments a Qualified Intermediary can make with your exchange funds is not currently regulated. Therefore, the funds can be accounted for and placed in many different investment vehicles. Knowing how your exchange funds are protected is vital when selecting a intermediary partner. While we've previously explored the security features of bonding and making sure you deal with a firm that is financially stable and uses segregated accounts, we haven't discussed the issue of Federal Deposit Insurance as a security vehicle when discussing 1031 exchange funds.

Many larger Qualified Intermediaries co-mingle client funds into one investment account. They do this to maximize the return on investment for the QI firm. From there, the funds may be invested with a brokerage or depository institution. Other QI firms segregate each client's funds into a separate account held at a commercial bank. While many of these brokerage accounts can be just as secure in the instruments they invest, it certainly pays to investigate whether your funds are co-mingled or segregated and exactly where and what the funds are being invested.

Okay, now you've determined that it is in your best interest to use a Qualified Intermediary that is depositing the funds into a segregated account at a commercial bank. But your exchange proceeds are more than $250,000. The amount you receive exceeds the amount of FDIC insurance and you are concerned with the added protection this level of insurance would provide. So, now what?

Some Qualified Intermediaries, including our firm, provide the ability to open multiple exchange accounts to the same client under separate bank charters. What this allows is the ability to increase the overall FDIC insurance coverage to the number of institutions times $250,000 at each charter. For example, 1031 Corporation Exchange Professionals is a subsidiary of FirstBank. With 26 separate charters in Colorado, Arizona and California, 1031 Corporation has the capacity to open multiple accounts and extend the FDIC coverage for any one exchange client up to $6.5 million.

Selecting a Qualified Intermediary that only uses segregated accounts banked at a financially solid, commercial bank (and further - owned by a larger financial parent) are important safety features to consider. Still, having a government-sponsored insurance, like the one the FDIC provides, for the amount of your exchange can certainly add an extra layer of confidence that your funds are secure.

Revoking an Inadvertent Opt-Out from Installment Method in a Failed 1031 Exchange

An interesting private letter ruling was just released that dealt with an installment sale as it relates to a 1031 exchange. In this case, a taxpayer sold real estate property as part of a planned exchange. However, they were unable to find suitable replacement property within the 180 day exchange period, and the exchange was not completed. The exchange was started in one calendar year and the 180 day period expired in the next year. This failed exchange qualified as an installment sale because the taxpayer did not have receipt of any portion of the sales proceeds in the year that the property was sold.

However, a slight problem occurred. Apparently, the taxpayer’s accountant failed to recognize that the transaction qualified as an installment sale and he reported the gain from the property sale on the tax return for the year the exchange started. Declaring the income on the taxpayer’s tax return amounted to an option to opt out of the installment method. Otherwise, the taxpayer would have been permitted to defer the tax payment on the proceeds from this transaction until the return year that the exchange funds were received.

A section of the Treasury regulations provides that an election to opt out of installment sale treatment is irrevocable, and that “An election may be revoked only with the consent of the Internal Revenue Service.”

When the taxpayer learned of the accountant’s error, it applied to the IRS for consent to revoke its "opt-out" election. The IRS was satisfied that the election to pay the taxes in the first year was inadvertent and the result of the accountant’s oversight - rather than hindsight by the taxpayer or some attempt to avoid taxes. Therefore, the taxpayer was permitted to revoke its election out of the installment method and defer the tax payment on the proceeds until the second filing year.

This reflects both the possibility of deferring capital gains tax over a calendar year on an exchange started late in the year as well as the ability to amend or revise taxes for something inadvertently overlooked by an unknowing accounting professional.

There is also another option for investors of failed exchanges called a Structured Sale Transaction. We'll write about that option next so stay tuned.

1031 Exchange Partnership Issues

Investment real estate is commonly owned by multiple owners in a partnership or by multiple owners as tenants in common to an undivided interest in the underlying real property. An exchange of a tenant-in-common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations. Careful forward planning is required to ensure a successful 1031 exchange where partnership issues are involved.

If a partnership owns property and desires to sell and exchange it, the partnership is the entity or party to the like kind exchange. Since the partnership will take title to the replacement property, no issues are apparent during the exchange period. However, if the partners wish to split up immediately after the exchange, the "held for" requirement may not be met on the replacement property. The partnership would need to retain ownership of the new property for an unspecified period of time (one year is commonly thought to be sufficient) to meet this qualification. Once sufficient time has passed, the partnership can then dissolve and distribute the property - through deed to individual properties or tenant-in-common ownership - to the former partners.

If a partnership wishes to exchange property but one or more of the partners want to "cash-out" or go their separate way(s), it is common for the partnership to split out the ownership before the sale. The partnership distributes tenancy-in-common title to the individual partners who wish to proceed in separate directions. The partnership (and its remaining partners) would then proceed with an exchange of the remaining ownership in the name of the partnership.

Frequently, individual partners desire to end the partnership relationship when the owned property sells. They would prefer to take their share of the partnership sale proceeds and buy qualifying 1031 replacement property in their own names. Far too frequently, the partnership gives each individual their undivided tenant-in-common interest in the old property just days or hours before closing. The plan is for each partner to take ownership in his or her name and individually complete a 1031 exchange. This lack of planning presents problems. The entire exchange could fail since the partnership could be seen as the selling entity that did not take title to qualifying replacement property. The individual owners have not met the "held for" requirement as they only owned the property in their individual names for a short period of time.

If partners wish to discontinue the partnership, sell the property and go their separate ways - with either the cash or a 1031 Exchange - it is necessary for the individual partners to receive deed to the property from the partnership in advance of the sale of the property. This is done through a distribution of property from the partnership to its individual partners. The partners are then generally required to hold the property as tenants in common for an unspecified period of time (decent interval of time) in order to comply with the "held-for" requirement of a 1031 Exchange that requires a taxpayer to have "held" qualifying property for business or investment purposes prior to the exchange.

The services of a tax professional are essential for tax planning purposes. An experienced Qualified Intermediary is also needed to ensure a successful exchange structure where partnership and co-ownership real estate interests are involved. To view more on partnership issues or other issues related to 1031 exchanges, take a look at this 1031 Exchange Manual or give us a call at 888-367-1031.