A Like-Kind Exchange To Avoid Tax

 

Let’s talk about like-kind exchanges.

A key point is - if done correctly - it is a means to exchange real estate without immediate tax consequence.

There was a time when one could exchange either personal property or real property and still qualify under the tax-deferral umbrella of a like-kind exchange. Congress removed the personal property option several years ago, so like-kinds today refer only to real estate.

The Code section for like-kinds is 1031, but today let’s focus on Section 1031(f):

(f) Special rules for exchanges between related persons

(1) In general If—

(A) a taxpayer exchanges property with a related person,

(B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

(C) before the date 2 years after the date of the last transfer which was part of such exchange—

(i)  the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,

there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

(2) Certain dispositions not taken into accountFor purposes of paragraph (1)(C), there shall not be taken into account any disposition—

(A) after the earlier of the death of the taxpayer or the death of the related person,

(B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or

(C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

(3) Related person

For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).

(4) Treatment of certain transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.

This verbiage came into the tax Code in 1989.

What is the issue here?

Let’s use an easy example:

CTG owns a hotel building worth $1 million. Its adjusted basis is $175,00.

CTG II owns a warehouse worth $1 million and an adjusted basis of $940,000.

If CTG sells its building, the gain is $825,000 ($1 million minus 175,000).

If CTG II sells its building, the gain is $60,000 ($1 million minus 940,000).

Say that someone wants to buy CTG’s hotel. Can we beat down that $825,000 gain?

What if we have CTG and CTG II swap buildings? CTG Jr would then own the hotel but keep its $940,000 adjusted basis. CTG II would then sell the hotel at a gain of $60,000.

Yeah, no. Congress already thought of that.

You better wait at least two years before the (second) sale, otherwise you have smashed right into Section 1031(f)(1)(C). The Code then says that- unless you can sweet talk the IRS - there was never a like-kind exchange. You instead have taxable income. Thanks for playing.

Let’s look at the Teruya Brothers case.

This case requires us to determine whether two like-kind exchanges involving related parties qualify for nonrecognition treatment under 26 U.S.C. § 1031.

This appeal concerns the tax treatment of real estate transactions involving two of Teruya's properties, the Ocean Vista condominium complex (“Ocean Vista”), and the Royal Towers Apartment building (“Royal Towers”).

We will look at the Ocean Vista (OV) transaction only.

Someone wanted to buy OV.

Teruya was initially not interested. It relented – IF it could structure the deal as a Section 1031 like-kind exchange.

So far this is relatively commonplace.

Teruya wanted to buy property from Times Super Market (Times) as the replacement.

Issue: Teruya owned 62.5% of Times.

The gain (which Teruya was trying to defer) was in excess of $1.3 million.

Teruya exchanged and filed its tax return accordingly.

The IRS balked.

The IRS argued that Teruya went foul of Section 1031(f)’s “established to the satisfaction” and “structured to avoid” prohibitions.

Teruya argued that the IRS was making no sense: Times reported the gain on its tax return. It had no deferred gain from the like-kind exchange. Who would structure a transaction to avoid tax when one of the parties reported gain?

On first impression, the argument makes sense.

The Court noted that Times had a net operating loss that wiped out the gain from the sale. There was no tax.

Teruya had a problem. It sold the property within two years, meaning that the IRS had a chance to challenge. The IRS challenged, both under Section 1031(f)(2)(C) and (f)(4).

Here is the Court:

We conclude that these transactions were structured to avoid the purposes of Section 1031(f).

Teruya lost.

Teruya went into this transaction in 1995, when Section 1031(f) was relatively new. There would not have been much case law on working and planning with this Code section.

Teruya provided practitioners some of that case law. 

We now know that an advisor must expand his/her perspective beyond just the Section 1031 exchange and consider other tax attributes sitting on the tax returns of the related parties.

And sales within two years are courting death.

Dodge that and Section 1031(f)(4) might still nab you.

Our case this time was Teruya Brothers, LTD v Commissioner, 124 TC No. 4.

Donating Cryptocurrency

 

I was reading something recently, and it reminded me how muddled our tax Code is.

Let’s talk about cryptocurrency. I know that there is bad odor to this topic after Sam Bankman-Fried and FTX, but cryptocurrencies and their exchanges are likely a permanent fixture in the financial landscape.

I admit that I think of cryptos – at least the main ones such as Bitcoin, Ethereum or Binance Coin – as akin to publicly traded stock. You go to www.finance.yahoo.com , enter the ticker symbol and see Bitcoin’s trading price. If you want to buy Bitcoin, you will need around $23 grand as I write this.

Sounds a lot like buying stock to me.   

The IRS reinforced that perspective in 2014 when it explained that virtual currency is to be treated as property for federal income tax purposes. The key here is that crypto is NOT considered a currency. If you buy something at Lululemon, you do not have gain or loss from the transaction. Both parties are transacting in American dollars, and there is no gain or loss from exchanging the same currency.

COMMENT: Mind you, this is different from a business transaction involving different currencies. Say that my business buys from a Norwegian supplier, and the terms require payment in krone within 20 days. Next say that the dollar appreciates against the krone (meaning that it takes fewer dollars to purchase the same amount of krone). I bought something costing XX dollars. Had I paid for it then and there, the conversation is done. But I did not. I am paying 20 days later, and I pay XX minus Y dollars. That “Y” is a currency gain, and it is taxable.

So, what happens if crypto is considered property rather than currency?

It would be like selling Proctor and Gamble stock (or a piece of P&G stock) when I pay my Norwegian supplier. I would have gain or loss. The tax Code is not concerned with the use of cash from the sale.

Let’s substitute Bitcoin for P&G. You have a Bitcoin-denominated wallet. On your way to work you pick-up and pay for dry cleaning, a cup of coffee and donuts for the office. What have you done? You just racked up more taxable trades before 9 a.m. than most people will all day, that is what you have done.

Got it. We can analogize using crypto to trading stock.

Let’s set up a tax trap involving crypto.

I donate Bitcoin.

The tax Code requires a qualified appraisal when donating property worth over $5,000.

I go to www.marketwatch.com.

I enter BTC-USD.

I see that it closed at $22,987 on January 27, 2023. I print out the screen shot and attach it to my tax return as substantiation for my donation.

Where is the trap?

The IRS has previously said crypto is property, not cash.

A donation of property worth over $5 grand generally requires an appraisal. Not all property, though. Publicly-traded securities do not require an appraisal.

So is Bitcoin a publicly-traded security?

Let’s see. It trades. There is an organized market. We can look up daily prices and volumes.

Sounds publicly-traded.

Let’s look at Section 165(g)(2), however:

    (2)  Security defined.

For purposes of this subsection, the term "security" means-

(A)  a share of stock in a corporation;

(B)  a right to subscribe for, or to receive, a share of stock in a corporation; or

(C)  a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form.

The IRS Office of Chief Counsel looked at this and concluded that it could not see crypto fitting the above categories.

Crypto could therefore not be considered a security.

As property not a security, any donation over $5 grand would require a qualified appraisal.

There was no qualified appraisal in our example. All I did was take a screen shot and include it with the return.

That means no charitable deduction.

I have not done a historical dive on Section 165(g)(2), but I know top-of-mind that it has been in the Code since at least 1986.

Do you know what did not exist in 1986?

The obvious.

Time to update the law, me thinks.

This time we were discussing CCA 202302012.

Abandoning A Partnership Interest

I suspect that most taxpayers know that there is a difference between long-term capital gains and ordinary income. Long-term capital gains receive a lower tax rate, incentivizing one to prefer long-terms gains, if at all possible.

Capital losses are not as useful. Capital losses offset capital gains, whether short-term or long-term. If one has net capital losses left over, then one can claim up to $3,000 of such losses to offset non-capital gain income (think your W-2).

That $3,000 number has not changed since I was in school.

And there is an example of a back-door tax increase. Congress has imposed an effective tax increase by not pegging the $3,000 to (at least) the rate of inflation for the last how-many decades. It is the same thing they have done with the threshold amount for the net investment income or the additional Medicare tax. It is an easy way to raise taxes without publicly raising taxes.

I am looking at a case where two brothers owned Edwin Watts Golf. Most of the stores were located on real estate also owned by the brothers, so the brothers owned two things: a golf supply business and the real estate it was housed in.

In 2003 a private equity firm (Wellspring) offered the brothers $93 million for the business. The brothers took the money (so would I), kept the real estate and agreed to certain terms, such as Wellspring having control over any sale of the business. The brothers also received a small partnership position with Wellspring.

Why did they keep the real estate? Because the golf businesses were paying rent, meaning that even more money went their way.

The day eventually came when Wellspring wanted out; that is what private equity does, after all. It was looking at two offers: one was with Dick’s Sporting Goods and the other with Sun Capital.  Dick’s Sporting already had its own stores and would have no need for the existing golf shop locations. The brothers realized that would be catastrophic for the easy-peasy rental income that was coming in, so they threw their weight behind the offer by Sun Capital.

Now, one does not own a private equity firm by being a dummy, so Wellspring wanted something in return for choosing Sun Capital over Dick’s Sporting.

Fine, said the brothers: you can keep our share of the sales proceeds.

The brothers did not run the proposed transaction past their tax advisor. This was unfortunate, as there was a tax trap waiting to spring.  

Generally speaking, the sale or exchange of a partnership interest results in capital gain or loss. The partners received no cash from the sale. Assuming they had basis (that is, money invested) in the partnership, the sale or exchange would have resulted in a capital loss.

Granted, one can use capital losses against capital gains, but that means one needs capital gains.   What if you do not have enough gains? Any gains? We then get back to an obsolete $3,000 per year allowance. Have a big enough loss and one would need the lifespan of a Tolkien elf to use-up the loss.

The brothers’ accountant found out what happened during tax season and well after the fact. He too knew the issue with capital losses. He played a card, in truth the only card he had. Could what happened be reinterpreted as the abandonment of a partnership interest?

There is something you don’t see every day.

Let’s talk about it.

This talk gets us into Code sections, as the reasoning is that one does not have a “sale or exchange” of a partnership interest if one abandons the interest. This gets the tax nerd away from the capital gain/loss requirement of Section 741 and into the more temperate climes of Section 165. One would plan the transaction to get to a more favorable Code section (165) and avoid a less favorable one (741). 

There are hurdles here, though. The first two are generally not a problem, but the third can be brutal.

The first two are as follows:

(1) The taxpayer must show an intent to abandon the interest; and

(2)  The taxpayer must show an affirmative act of abandonment.

This is not particularly hard to do, methinks. I would send a letter to the tax matters or general partner indicating my intent to abandon the interest, and then I would send (to all partners, if possible) a letter that I have in fact abandoned my interest and relinquished all rights and benefits thereunder. This assumes there is no partners’ meeting. If there was a meeting, I would do it there. Heck, I might do both to avoid all doubt.

What is the third hurdle?

There can be no “consideration” on the way out.

Consideration in tax means more than just receiving money. It also includes someone assuming debt you were previously responsible for.

The rule-of-thumb in a general partnership is that the partners are responsible for their allocable share of partnership debt. This is a problem, especially if one is not interested in being liable for any share of any debt. This is how we got to limited partnerships, where the general partner is responsible for the debts and the limited partners are not.

Extrapolating the above, a general partner in a general partnership is going to have issues abandoning a partnership interest if the partnership has debt. The partnership would have to pay-off that debt, refinance the debt from recourse to nonrecourse, or perhaps a partner or group of partners could assume the debt, excluding the partner who wants to abandon.

Yea, the planning can be messy for a general partnership.

It would be less messy for a limited partner in a limited partnership.

Then we have the limited liability companies. (LLCs). Those bad boys have a splash of general partnership, a sprinkling of limited partnership, and they can result in a stew of both rules.

The third plank to the abandonment of a partnership interest can be formidable, depending on how the entity is organized and how the debts are structured. If a partner wants an abandonment, it is more likely than not that pieces on the board have to be moved in order to get there.   

The brothers’ accountant however had no chance to move pieces before Wellspring sold Edwin Watts Golf. He held his breath and prepared tax returns showing the brothers as abandoning their partnership interests. This gave them ordinary losses, meaning that the losses were immediately useful on their tax returns.

The IRS caught it and said “no way.”

There were multiple chapters in the telling of this story, but in the end the Court decided for the IRS.

Why?

Because the brothers had the option of structuring the transaction to obtain the tax result they desired. If they wanted an abandonment, then they should have taken the steps necessary for an abandonment. They did not. There is a long-standing doctrine in the Code that a taxpayer is allowed to structure a transaction anyway he/she wishes, but once structured the taxpayer has to live with the consequences. This doctrine is not tolerant of taxpayer do-overs.

The brothers had a capital and not an ordinary loss. They were limited to capital gains plus $3 grand per year. Yay.

Our case this time for the home gamers was Watts, T.C. Memo 2017-114.

It’s A Cliff, Not A Slope

It is one of my least favorite areas of individual tax practice.

We are talking about health insurance. More specifically, health insurance purchased through the exchanges, coupled with advance payment of the premiums.

Why?

Because there is a nasty tax trap in there, and I saw the trap again the other day. It caught a client who gets by, but who is hardly in a position to service heavy tax debt.

Let’s set it up.

You can purchase health insurance in the private market or from government-sponsored marketplaces – also called exchanges. The exchanges were created under the Affordable Care Act, more colloquially known as Obamacare.

If you purchase health insurance through the exchange and your income is below a certain level, you can receive government assistance in paying the insurance premiums. Make very little income, for example, and it is possible that the insurance will be free to you. Make a little more and you will be expected to contribute to your own upkeep. Make too much and you are eliminated from the discussion altogether.

The trap has to do with the dividing line of “too much.”

Let’s look at the Abrego case.

Mr and Mrs Abrego lived in California. For 2015 he was a driver for disabled individuals, and he also prepared a few tax returns (between 20 and 30) every year. Mrs Abrego was a housekeeper.

They enrolled in the California exchange. They also did the following:

(1)  They provided an estimate of their income for 2015. Remember, the final subsidy is ultimately based on their 2015 income, which will not be known until 2016. While it is possible that someone would purchase health insurance, pay for it out-of-pocket and eventually get reimbursed by the IRS when filing their 2015 tax return in 2016, it is far more likely that someone will estimate their 2015 income to then estimate their subsidy. One would use the estimated subsidy to offset the very real monthly premiums. Makes sense, as long as all those estimated numbers come in as expected.

(2)  They picked a policy. The monthly premiums were $1,029.

(3)  The exchange cranked their expected 2015 numbers and determined that they could personally pay $108 per month.

(4)  The difference - $ 1,029 minus $108 = $921– was their monthly subsidy.

The Abregos kept this up for 10 months. Their total 2015 subsidy was $9,210 ($921 times 12).

Since the Abregos received a subsidy, they had to file a tax return. One reason is to compare actual numbers to the estimated numbers. If they guessed low on income, they would have to pay back some of the subsidy. If they guessed high, the government would owe them for underestimating the subsidy.

The Abregos filed their 2015 return.

They reported $63,332 of household income.

How much subsidy should they have received?

There is the rub.

The subsidy changes as income climbs. The subsidy gets to zero when one hits 400% of the poverty line.

What was the poverty line in California for 2015?

$15,730 for a married couple.

Four times the poverty line was $62,920.

They reported $63,332.

Which is more than $62,920.

By $412.

They have to pay back the subsidy.

How much do they have to pay back?

All of it - $9,210.

Folks, the tax rate on that last $412 is astronomical.

It is frustrating to see this fact pattern play out. The odds of a heads-up from the client while someone can still do something are – by the way – zero. That leaves retroactive tax planning, whose success rate is also pretty close to zero.

Our client left no room to maneuver. Why did her income go up? Because she sold something. Why did she not call CTG galactic command before selling – you know: just in case? What would we have done? Probably advised her to NOT SELL in the same year she is receiving a government subsidy.

How did it turn out for the Abregos?

They should have been toast, except for one thing.

Remember that he prepared tax returns. He did that on the side, meaning that he had a gig going. He was self-employed.

He got to claim business deductions.

And he had forgotten one.

How much was it?

$662.

It got their income below the magic $69,920 level.

They were on the sliding scale to pay back some of that subsidy. Some - not all.

It was a rare victory in this area.

Our case for the homegamers was Abrego v Commissioner.