Category: Real Estate; Nontaxable Exchanges Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer owned mixed-use rental property (partly residential and partly commercial. The property was completely destroyed by fire in August, 1995. The underlying land was subsequently sold (at a gain) because it was unsuitable for rebuilding due to zoning restrictions. The taxpayer received net insurance proceeds of approximately $180,000 consisting of $184,000 of gross proceeds net of a collection commission of $4,000. In addition, the taxpayer will pay demolition costs of up to $28,000. The actual amount is in dispute, and payment will occur whenever the dispute is resolved. The taxpayer plans to replace the destroyed property with residential rental property. Questions 2. What type of property must be purchased in order to qualify as replacement property under Section 1033? a) Does purely residential rental property qualify? b) Would REIT stock qualify? 3. Can the gain on sale of the underlying land be deferred under Section 1033? 4. How does the collection commission affect the minimum replacement cost? 5. How is the collection commission treated? 6. What is the treatment of the subsequent payment of the demolition costs? Answers/Discussions 2. The question is essentially whether residential rental property is suitable replacement property for commercial rental property? It is clear that the change from commercial to residential does not by itself preclude the benefits of Section 1033. Nonetheless, the taxpayer should be cautious in choosing replacement property. For leased property, it is not the end use to which the tenant puts the property that must be similar; rather, it is the relationship between the taxpayer and the property itself. The relevant inquiries are the nature and extent of the lessor's management activity, the amount and kind of service rendered to the tenants, and the nature of the business risk connected with the properties. Liant Records, infra. Since both the destroyed property and the replacement property were held as an investment to produce rental income and (hopefully) income through appreciation of the property, the fact that the destroyed property was residential and the replacement property will be commercial should be of no consequence as far as Section 1033 is concerned. Numerous cases have so held. See Liant Records v. Comr., 303 F.2d 326, 64-2 USTC ¶9494 (2d Cir. 1962); Ponticos v. Comr., 338 F.2d 477, 64-2 USTC ¶9868 (6th Cir. 1964); and Pohn v. Comr., 309 F.2d 427, 62-2 USTC ¶9774 (7th Cir. 1972). Even though conversion from commercial rental to residential rental is not per se disqualified, I think considerable caution is warranted when choosing replacement property. It is not sufficient to replace a rental property with just any other rental property: the relevant inquiries under Liant must be taken into account. For example, I suspect that replacement of a triple-net-leased commercial warehouse property with a commercial office building where the taxpayer provides the services normally available to office tenants would not qualify under Section 1033. Even though both properties are held for investment and production of rental income, the character of these two investments is significantly different. In one case, the taxpayer simply collects rent checks and has no further responsibilities with respect to the property. In the other case, the office building, the taxpayer (or his agent) must be actively involved in managing the building and providing services to the tenants. The owner of the office building is financially responsible for all the expenses related to the building. Accordingly, the financial risk is materially different as between the triple-net-leased warehouse and the office building. Language from the Filippini v. United States, 318 F. 2d 841, 63-2 ustc ¶9548, (9th Cir. 1963), seems particularly relevant. There the court stated: Where the taxpayer leases both properties to produce rental income it is enough that the physical uses to which the lessees put the property, although relevant, cannot be controlling. It is equally clear that the fact that the taxpayer leases both properties is not alone enough to justify non-recognition of the gain, for both properties might be leased yet represent materially different investments to the taxpayer-lessor. The test is a practical one. The trier of fact must determine from all the circumstances whether the taxpayer has achieved a sufficient continuity of investment to justify non-recognition of the gain, or whether the differences in the relationship of the taxpayer to the two investments are such as to compel the conclusion that he has taken advantage of the condemnation to alter the nature of his investment for his own purposes. Id. at 844-45 (emphasis supplied by the court; footnote omitted). With respect to REIT stock as a qualified replacement, clearly such stock is not qualified replacement property. See Lakritz v. U.S., 418 F. Supp. 210, 1976-2 USTC ¶9624, (E.D. Wis. 1976). While it is possible under Section 1033 to purchase a controlling interest in a corporation which owns qualified replacement property, it is not possible under the REIT rules for a controlling interest to be owned by five or fewer individuals. Hence, the controlling interest requirement of Section 1033 and the REIT requirements are mutually exclusive. 3. The gain from the sale of land underlying the destroyed structure cannot be deferred under Section 1033. Amazingly, it seems that this issue has never been directly addressed. Rev. Rul. 96-32, 1996-25 IRB 5, holds that a gain from the sale of land underlying a personal residence destroyed by a tornado can be deferred under Section 1033. The ruling relies on the logic of Reg. Sec. 1.165-7(b)(2)(ii) which provides that for casualty loss purposes, residential real property and its improvements (i.e., a house) are considered one single unit. Thus, destruction of the house and the subsequent sale of the underlying land need not be separated. One is sorely tempted to apply the holding of Rev. Rul. 96-32 to the present situation; however, I believe that would be a mistake. Having cited Reg. Sec. 1.165-7(b)(2)(ii) in support of its holding with respect to residential property (i.e., a taxpayer's principal residence), the ruling points out that a different regulation applies with respect to business property. Regulation Section 1.165-7(b)(2)(i) provides that the casualty loss from destruction of property used in a trade or business is determined by reference to the separate fair market value of and basis of each single, identifiable property damaged or destroyed. [Emphasis supplied.] It is rather clear that the IRS intended to draw a sharp distinction between residential property and business property, and it is clear that the IRS did not intend to extend the single-unit theory of Reg. Sec. 1.165-7(b)(2)(ii) to casualties involving business assets. 4. The treatment of expenses related to collection of insurance proceeds is surprisingly unsettled. Section 1033 requires the "amount realized" to be reinvested in property similar in service or use to the converted property. It is clear that the cost of collecting insurance proceeds reduce the amount realized from the transaction and thus reduce the amount that must be reinvested. See Revenue Ruling 71-146, 1971-2 CB 308. Accordingly, it would be necessary for the taxpayer in this case to reinvest only $180,000, not the full $184,000 in order to defer the full amount of gain from the involuntary conversion. Once such amounts are expended, however, the situation becomes very murky. Some courts have allowed an ordinary deduction for such costs on the theory that they represent simply the cost of collecting a debt owed to the taxpayer. See Ticket Office Equipment Co., 213 F. 2d 318 ( 2d Cir. 1954); and U.S. v. Pate, 254 F. 2d 480 (10th Cir. 1958). Other courts have held that such expenses must be capitalized in the cost of the replacement property. See Towanda Textiles v. U.S., 180 F. Supp. 373 (Ct. Cl. 1960). Finally, the Supreme Court spoke on this subject in 1970 in the case of Woodward v. Commr., 397 U.S. 572 (1970). Under Woodward, the proper approach is to examine the underlying origin of the claim producing the expenses (i.e., the collection commission). While that case definitively sets forth the proper standard to apply in making the determination, it is far from clear what the answer should be with respect to any given fact pattern. It seems to me, although the matter is far from clear, that collection of insurance proceeds should be treated the same as the collection expenses related to any other debt owed to the taxpayer. Accordingly, I feel the collection fees should be deductible as an ordinary business expense. 6. I refer now to the subsequent payment of demolition fees. Under the Woodward standard, I think these fees relate to the land on which the converted property stood. As such, I feel the demolition fees should be included in the basis of the land underlying the property and would thus decrease any gain recognized when the land is sold. In addition to Woodward, there is Notice 91-21, 1990-1 CB 332, which provides that demolition costs with respect to property destroyed by a casualty are not deductible as part of the casualty loss by virtue of Section 280B; rather, these costs must increase the basis of the land. While Notice 90-21 does not specifically address an involuntary conversion gain, it seems clear that at least as far as the IRS is concerned, the demolition costs are not part of the related casualty. In this case, the land was sold prior to payment of the demolition costs. Here, I think the Arrowsmith rule applies (derived from the case F.D. Arrowsmith 52-2 USTC ¶9527, 344 U.S. 6). Simply put, any subsequent payment related to a prior event is treated as having the same character as the prior event. I believe the gain on the land arguably should be Section 1231 gain under Section 1231(b)(1), real property used in a trade or business. Under the Arrowsmith doctrine, subsequent payment of demolition costs should also be treated as a Section 1231 loss under the theory that had the costs been incurred prior to the sale, the costs would have decreased the Section 1231 gain with respect to the property.
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