Category: Partnerships & LLCs; Nontaxable Exchanges;
Real Estate Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Taxpayer purchased land in April 1996 and constructed a commercial building thereon. A certificate of occupancy (CO) was issued for the building in March of 1997 and the building was rented to tenants shortly thereafter. In October, 1997, the taxpayer entered into a like-kind exchange whereby the land and commercial building described above were exchanged for two parcels; A) land with a commercial building; and B) a parcel of land suitable for development of three residential lots. On this parcel of land there is a residence which the taxpayer has the option, but not the obligation, to rehabilitate. If the taxpayer renovates, the building would be sold at the end of the renovation process. This transaction is hereinafter referred to as Exchange No. 1. The replacement properties are encumbered by mortgages. A portion of the loan proceeds was retained (presumably in escrow) to construct tenant improvements on the commercial property and to make various improvements on the residential property. The taxpayer originally planned to hold the residential property for appreciation and possible future development as commercial property. It appears now that the local authorities will allow only residential development. This does not meet the taxpayer's long-term goals. Accordingly, the taxpayer plans within the next few months to exchange the residential property for land with a commercial building or for land on which a commercial building could be constructed. This transaction will hereinafter be referred to as Exchange No. 2. Issues 2. What is the holding period of the replacement property? 3. Is it necessary for the improvement funds to be used within the 180-day replacement period? 4. Is there a problem with entering into Exchange No. 2 so soon after Exchange No. 1? Is there any rule regarding successive exchanges? 5. Will the taxpayer's holding period for the residential property received in Exchange No. 1 tack on to any property received in Exchange No. 2? 6. What is the depreciation recapture potential of a commercial building either received as part of Exchange No. 2 or subsequently constructed? 7. Would the gain from any subsequent sale of these commercial buildings be eligible for the 20% long-term capital gains rate? If so, what is the necessary holding period and when does it begin? 8. Would holding the land and buildings in question for a period of only 18 months be sufficient to satisfy the "held for investment" requirement of Section 1031? What is the effect of the short holding period on dealer versus investor status? Answers 2. Assuming a valid Section 1031 exchange, the taxpayer's holding period for the property relinquished in the exchange tacks to both parcels received in the exchange. 3. The improvement funds must be spent within the 180-day replacement period. In addition, it is necessary that the improvements were identified within the 45-day identification period. 4. There are no explicit constraints on successive like-kind exchanges, and there is no explicit rule against using property received in a like-kind exchange to effect a subsequent like-kind exchange shortly after the first. That notwithstanding, there is significant risk associated with this fact pattern. 5. Assuming Exchange No. 2 is a valid like-kind exchange, the holding period of the residential property tacks on to the property received in Exchange No. 2. 6. Generally, disposition of real property depreciated under MACRS does not give rise to Section 1250 recapture. However, if the any of the taxpayer's members are C corporations, Section 291(a) applies to their portion of any depreciation claimed on the property. 7. Assuming the taxpayer is not viewed as a dealer, gain from the sale of commercial real estate (except for unrecaptured Section 1250 gain) should be taxed as Section 1231 gain at a rate of 20% for individual LLC members. Unrecaptured Section 1250 gain--i.e., gain to the extent of any depreciation claimed--should be taxed at 25%. The necessary holding period is 18 months. Assuming both like-kind exchanges are valid, the holding period for any realty received in such exchanges includes the holding periods of the property relinquished in Exchange No. 1. See Discussion Two. 8. As discussed under Issue Four, there is no minimum holding period in order to qualify for Section 1031. This is question if really no different from Issue Four. On the dealer issue, it is clear that the more transactions that occur in a fairly short period of time, the harder it is to support the idea that the taxpayer is not a dealer. Discussion: Issue One Discussion: Issue Two There are two relevant dates for the property relinquished in the exchange--the acquisition date for the land and the placed in service date for the building. Both are relevant. While this result is not entirely clear, it seems to be necessary to determine acquisition dates by a weighted average based on fair market value. In this case, suppose the land component is 20% of the fair market value of the relinquished property. The acquisition date of the land would carry over to 20% of the value of the properties received in the exchange. The balance of the properties received in the exchange would take on the later placed in service date of the building. Discussion: Issue Three Failure to meet the 45-day identification rule with respect to the improvements would result in the loan proceeds retained for the improvements to be viewed as boot. In addition, proceeds not expended to improve the property by the end of the receipt period would also be treated as boot. The 45-day identification rule and the 180-day receipt rule apply equally to both the commercial and the residential property received in Exchange No. 1. From the facts set forth above, it is not clear what if any identifications were made with respect to improvements and whether such improvements were completed within the necessary period. I have one specific comment about the residential parcel. It appears from the settlement statements provided that approximately $429,000 was retained in escrow for improvement of the residential lot property. As I understand it, the taxpayer is not certain how the residential lot property will be handled--i.e., will the existing house be renovated and sold or will the property be developed into residential lots. Given the apparent uncertainty that exists even now regarding the residential lot property, I have reservations about whether a proper identification could have been made. Discussion: Issue Four If exchange property is disposed of shortly after the initial exchange, it is often helpful to point out some change of circumstances that could account for the taxpayer's change of intent as to the property. In this case, the taxpayer's discovery that local officials will not allow commercial development could be viewed as such a change of circumstances and could thus prove very helpful. This is not an issue that can be reliably predicted. Clearly, there is significant risk. The taxpayer's intent is a question of fact. What evidence can the taxpayer produce to support its intent? I wonder what representations were made in the loan application for this property. Has the taxpayer attempted to obtain building permits or to secure the necessary zoning rights for commercial development? If so, what representations were made? I suggest dealing with this question now while the documents are readily available and the facts are fresh in the minds of the parties involved. Discussion: Issue Five Discussion: Issue Six Discussion: Issue Seven Discussion: Issue Eight Whether the taxpayer is holding the property in question for investment or for sale to customers in the ordinary course of business is a question of fact. One must look not only at the facts of the transactions described above, but also the totality of the facts surrounding the taxpayer's entire history in dealing with property. I do not think that one transaction whereby the taxpayer bought, developed, and sold a single property within an 18 month period necessarily makes the taxpayer a dealer, although the facts do point in that direction given the development activity involved. If, on the other hand, there is a pattern of regular, continuous, and substantial sales whereby the taxpayer acquires land, constructs a building, leases it, sells the property within a short period of time, and then repeats the process, then such a pattern would almost certainly indicate dealer status. |
