Like-Kind Exchange? Bulk Up Your Files

I met with a client a couple of weeks ago. He owns undeveloped land that someone has taken an interest in. He initially dismissed their overtures, saying that the land was not for sale or – if it were – it would require a higher price than the potential buyer would be interested in paying.

Turns out they are interested.

The client and I met. We cranked a few numbers to see what the projected taxes would be. Then we talked about like-kind exchanges.

It used to be that one could do a like-kind exchange with both real property and personal property. The tax law changed recently and personal property no longer qualifies. This doesn’t sound like much, but consider that the trade-in of a car is technically a like-kind exchange. The tax change defused that issue by allowing 100% depreciation (hopefully) on a business vehicle in the year of purchase. Eventually Congress will again change the depreciation rules, and trade-ins of business vehicles will present a tax issue.

There are big-picture issues with a like-kind exchange:

(1)  Trade-down, for example, and you will have income.

(2)  Walk away with cash and you will have income.

(3)  Reduce the size of the loan and (without additional planning) you will have income.

I was looking at a case that presented another potential trap.

The Brelands owned a shopping center in Alabama.

In 2003 they sold the shopping center. They rolled-over the proceeds in a like-kind exchange involving 3 replacement properties. One of those properties was in Pensacola and becomes important to our story.

In 2004 they sold Pensacola. Again using a like-kind, they rolled-over the proceeds into 2 properties in Alabama. One of those properties was on Dauphin Island.

They must have liked Dauphin Island, as they bought a second property there.

Then they refinanced the two Dauphin Island properties together.

Fast forward to 2009 and they defaulted on the Dauphin Island loan. The bank foreclosed. The two properties were sold to repay the bank

This can create a tax issue, depending on whether one is personally liable for the loan. Our taxpayers were. When this happens, the tax Code sees two related but separate transactions:

(1) One sells the property. There could be gain, calculated as:

Sales price – cost (that is, basis) in the property

(2) There is cancellation of indebtedness income, calculated as:

Loan amount – sales price

There are tax breaks for transaction (2) – such as bankruptcy or insolvency – but there is no break for transaction (1). However, if one is being foreclosed, how often will the fair market value (that is, sales price) be greater than cost? If that were the case, wouldn’t one just sell the property oneself and repay the bank, skipping the foreclosure?

Now think about the effect of a like-kind exchange and one’s cost or basis in the property. If you keep exchanging and the properties keep appreciating, there will come a point where the relationship between the price and the cost/basis will become laughingly dated. You are going to have something priced in 2019 dollars but having basis from …. well, whenever you did the like-kind exchange.

Heck, that could be decades ago.

For the Brelands, there was a 2009 sales price and cost or basis from … whenever they acquired the shopping center that started their string of like-kind exchanges.

The IRS challenged their basis.

Let’s talk about it.

The Brelands would have basis in Dauphin Island as follows:

(1)  Whatever they paid in cash

(2)  Plus whatever they paid via a mortgage

(3)  Plus whatever basis they rolled over from the shopping center back in 2003

(4)  Less whatever depreciation they took over the years

The IRS challenged (3).  Show us proof of the rolled-over basis, they demanded.

The taxpayers provided a depreciation schedule from 2003. They had nothing else.

That was a problem. You see, a depreciation schedule is a taxpayer-created (truthfully, more like a taxpayer’s-accountant-created) document. It is considered self-serving and would not constitute documentation for this purpose.

The Tax Court bounced item (3) for that reason.

What would have constituted documentation?

How about the closing statement from the sale of the shopping center?

As well as the closing statement when they bought the shopping center.

And maybe the depreciation schedules for the years in between, as depreciation reduces one’s basis in the property.

You are keeping a lot of paperwork for Dauphin Island.

You should also do the same for any and all other properties you acquired using a like-kind exchange.

And there is your trap. Do enough of these exchanges and you are going to have to rent a self-storage place just to house your paperwork.

Our case this time was Breland v Commissioner, T.C. Memo 2019-59.

Fewer Like-Kind Exchanges in 2018

The new tax bill changed like-kind exchanges.

This is Section 1031, which was and is a tax provision that allows one to defer taxes on a property sale - if one follows the rules.

I suspect that almost every practicing tax accountant has met with a client who said the following:

·      I sold property last year,

·      I hear that there is a tax break if I buy another piece of property

Well, yes there MIGHT be a tax break, but you have to follow the rules from the beginning, not just months later when you meet with your accountant.

The normal sequence is to sell the property first. It doesn’t have to be that way – you can start with the buy – but that is unusual. The tax nerds refer to that as a “reverse.”

There are ropes:

(1)  You want the money held by a third party, such as an attorney or title company;

(2)  You have to identify the replacement property within 45 days (there is some latitude in identifying replacement properties); and

(3)  You have to complete the whole transaction – sell and buy – within 180 days.

(4) Anticipate that you will be buying-up: buy more than what you sold.

(5)  Debt is tricky. To be safe, increase your debt, at least a little bit.  

(6)  You never want to receive cash from the deal. Cash is income – period.

If you wait to until you meet with your accountant, then you have probably blown requirement (1).

The most common like-kind that I see – I kid you not – is vehicle trade-ins. They happen every day, to the point that we do not even pay them attention. In the tax world, however, trade-ins are like-kind exchanges.

The next most common are real estate exchanges. I have probably seen at least one a year for the last couple of decades. Those usually go through a title company or attorney, and I have the pleasure of looking over a binder of paperwork that would weigh down a Clydesdale.

There are others. One can like-kind exchange personal property, for example. The rules are stricter than the rules for real estate, and for the most part I have not seen a lot of those.

The new tax bill made a big change to like-kind exchanges.

How?

Because personal property no longer qualifies for like-kind treatment.

So much for trade-ins.

But there is another kind that I thought of recently.

Think sports.

Yep, back in 1966 the IRS considered player contracts – if done correctly – to be property qualifying for like-kind.

I am unsure how professional sports will work-around this change. It is not an area I practice, although I would have loved to.

Why did Congress mess with this?

It wasn’t about player contracts. It rather had to do with art and collectibles. It had become de rigueur to like-kind exchange in the art world, as buyers had come to view art as just another tradable commodity. Think stocks, but with the option of delaying taxes until the end of time. This reached the attention of the Obama administration, which began the push to eliminate them.

It took another White House, but it finally got done.

Is Suing Your Tax Advisor Taxable?

For those who know me or occasionally read my blog, you know that I am not a “high wire” type of tax practitioner. Pushing the edges of tax law is for the very wealthy and largest of taxpayers: think Apple or Donald Trump. This is – generally speaking - not an exercise for the average person. 

I understand the frustration. A number of years ago I was called upon to research the tax consequence for an ownership structure involving an S corporation with four trusts for two daughters. This structure predated me and had worked well in profitable years, but I (unfortunately) got called upon for a year when the company was unprofitable. The issue was straightforward: were the losses “active” or “passive” to the trusts and, by extension, to the daughters behind the trusts. There was some serious money here in the way of tax refunds – if the trusts/daughters could use the losses. This active/passive law change happened in 1986, and here I was researching during the aughts – approximately 20 years later. The IRS had refused to provide direction in this area, although there were off record comments by IRS officials that were against our clients’ interests. I strongly disagreed with those comments, by the way.

What do you do?

I advised the client that a decision to claim the losses would be a simultaneous decision to hire a tax attorney if the returns got audited and the losses disallowed. I believed there was a reasonable chance we would eventually win, but I also believed we would have to be committed to litigation. I thought the IRS was unlikely to roll on the matter, but our willingness to go to Tax Court might give them pause. 

I was not a popular guy.

But to say otherwise would be to invite a malpractice lawsuit should the whole thing go south.

And this was a fairly prosaic area of tax law, far and remote from any tax shelter. There was no “shelter” there. There was, rather, the unwillingness of the IRS to clarify a tax law that was old enough to go to college.

I am reading about a CPA firm that decided to advise a tax shelter. It went south. They got sued. It cost them $375,000.

Here is a question that we have not discussed before: is the $375,000 taxable to the (former) client?

Let’s discuss the case.

The Cosentinos and their controlled entities (G.A.C. Investments, LLC and Consentino Estates, LLC) had a track record of Section 1031 exchanges and real estate.

COMMENT: A Section 1031 is also known as a “like kind” exchange, whereby one trades one piece of property for another. If done correctly, there is no tax on the exchange.

The Consentinos played a conservative game, as they had an adult disabled daughter who would always need assistance. They accumulated real estate via Section 1031 transactions, with the intent that – upon their death – the daughter would inherit. They were looking out for her.

They were looking at one more exchange when their CPA firm presented an alternative tax strategy that would allow them to (a) receive cash from the deal and (b) defer taxes. The Consentinos had been down this road before, and receiving cash was not their understanding of a Section 1031. Nonetheless the advisors assured them, and the Consentinos went ahead with the strategy.

OBSERVATION: It is very difficult to walk away from a Section 1031 with cash in hand and yet avoid tax.

Wouldn’t you know that the strategy was declared a tax shelter?

The IRS bounced the whole thing. There was almost $600,000 in federal and state taxes, interest and penalties. Not to mention what they paid the CPA firm for structuring the transaction.

The Consentinos did what you or I would do: they sued the CPA firm. They won and received $375,000. They did not report or pay tax on said $375,000, reasoning that it was less than the tax they paid. The IRS sent them a love letter noting the oversight and asking for the tax.

Both parties were Tax Court bound.

The taxpayers relied upon several cases, a key one being Clark v Commissioner. The Clarks had filed a joint rather than a married-filing-separately return on the advice of their tax advisor. It was a bad decision, as filing-jointly cost them approximately $20,000 more than filing-separately. They sued their advisor and won.

The Court decided that the $20,000 was not income to the Clarks, as they were merely being reimbursed for the $20,000 they overpaid in taxes. There was no net increase in their wealth; rather they were just being made whole.

The Clark decision has been around since 1939, so it is “established” law as far as established can be.

The Court decided that the same principle applied to the Cosentinos. To the extent that they were being made whole, there was nothing to tax. This meant, for example:

·        To extent that anything was taxable, it shall be a fraction (using the $375,000 as the numerator and total losses as the denominator).

·        The amount allocable to federal tax is nontaxable, as the Cosentinos are merely being reimbursed.

·        The amount allocable to state taxes however will be taxable, to the extent that the Cosentinos had previously deducted state taxes and received a tax benefit from the deduction.

·        The same concept (as for state taxes) applied to the accounting fees. Accounting fees would have been deducted –meaning there was a tax benefit. Now that they were repaid, that tax benefit swings and becomes a tax detriment, resulting in tax.

There were some other expense categories which we won’t discuss.

By the way, the Court’s reasoning is referred to as the “origin of the claim” doctrine, and it is the foundation for the taxation of lawsuit and settlement proceeds.  

So the IRS won a bit, as the Cosentinos had excluded the whole amount, whereas the Court wanted a ratio, meaning that some of the $375,000 was taxable.

Are you curious what the CPA firm charged for this fiasco?

$45,000.

State Tax Absurdities: California's Time Travel Laugh-In

I do enjoy following tax developments out of California, as they are so … so…. How to be diplomatic? Think Rowan & Martin Laugh-In reruns – entertaining, but in a time-travel sense. Hearing “groovy” seems a bit imbecilic after all these years, and surely, McGovern is not still running for President, is he? Why then does California continue to give the same answer to every problem - “tax them more?”

Here are a couple of tax grenades that California has thrown out there recently:

1. There is an Iowa corporation (Swart) that owns farms in Kansas and Nebraska. It also has a few investments, one of which is a 0.02% interest in a California LLC (“Cypress”) that bought and sold capital equipment across several states.  Mind you, Swart did not exercise any management or control over its investment. This would be the equivalent of you investing in a California REIT (a REIT is an investment that owns real estate, such as apartment buildings). The California Franchise Tax Board nonetheless contacted Swart and told them that their investment in Cypress was “enough” to require them to file a California LLC tax return.

So what, you are thinking. Here is what: California imposes a minimum $800 annual fee on an LLC tax return.

Think about the numbers for a moment. Let’s say that Cypress made a tidy profit. We need a number. How about $4 million? Swart’s 0.02% share would be $800, which coincidentally is the same as California’s minimum fee. Not to mention the fee for an accountant to wade through this.

Swart filed suit on July 9, 2013, so we do not yet know the outcome.

California’s interest is obvious, duplicitous and mercenary: it wants money. Your money, if you stand on that street corner long enough. Cypress alone has 384 other members who are California nonresidents. 

It is also self-defeating. Tax Analysts summarized it well:

While states are always on the lookout for each and every dollar of tax revenue, taxing investments in California serves as a big disincentive for out-of-state companies to invest in the state.”

2. Do you know what a Section 1031 exchange is? This is where you exchange one property for another, and the government gets no taxes. More accurately, the tax effect is “deferred.” An easy example would be swapping one office building for another.

Don’t get me wrong here: a 1031 has all kinds of rules and sub-rules which, if you get them wrong, will transmute your tax-deferred exchange into a fully taxable event. I wanted only to introduce the concept.

Let’s say that you own an office building in Burbank. You swap it for another in San Antonio, Texas. The IRS doesn’t care that you moved states. California does care, though. The Laugh-In time travelers in Sacramento have passed a new tax law. Beginning in 2014, you will have to file an annual report if you exchange California property for non-California property in a Section 1031 exchange. The forms do not exist yet, but they will … and soon. You will have to acknowledge that you still own the replacement property. If you do not, California will assess you a tax.

Think about that for a moment. Let’s say that Steve Hamilton, a tax CPA in the Napa Valley swaps California for Florida real estate. Years go by, and as part of his estate planning, and preparatory to retiring to Ireland, he places the Florida real estate in a family limited partnership.  Is California REALLY going to send him a tax bill? And why would he pay it? What are they going to do: stop him at the airport?

In graduate school (many years ago), we discussed an efficient tax system as having the least drag on economic decision-making and the fewest reductio ad absurdum conclusions.  Sacramento needs to get back to the future with its tax policy, as they are stuck in a time warp.

Groovy.