More Flexibility for Reverse Exchanges

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1 miller nash llp Fall 2014 brought to you by the tax law practice team Tax-Free Exchange Advisor More Flexibility for Reverse Exchanges by Jeneé Hilliard When the real estate market is hot, it can be a great time to sell real property. And because people don t want to pay tax unless they have to, it can be attractive to complete a 1031 exchange with the proceeds from the sale. But a hot real estate market can be a difficult time to buy real estate, and if a taxpayer sells real estate, it doesn t necessarily mean that acceptable replacement property can be found within the timelines required by Section Private Letter Ruling , issued earlier this year, provides a little additional flexibility for taxpayers with multiple real estate holdings who complete a reverse 1031 exchange. Reverse exchanges are typically accomplished by complying with the parking rules in Revenue Procedure In a typical reverse exchange, a taxpayer will enter into a qualified exchange accommodation agreement (referred to as a QEAA ) with an exchange accommodation titleholder (referred to as an EAT ; this role is typically played by a single-member limited liability company formed by the 1031 accommodator). This approach can be used to ensure that the taxpayer isn t under any time pressure to find and purchase replacement property, but replaces that risk with the fact that the exchange will fail if the taxpayer cannot find someone to buy his or her relinquished property within the 180-day period. This structure also requires that the taxpayer have the cash and financing available to acquire the replacement property before the relinquished property is sold; for many taxpayers, this is a difficult hurdle to overcome. A typical reverse exchange can be illustrated as follows. Our taxpayer, Leonard, finds an apartment complex that he d like to buy as investment property, and he also wants to sell his current investment duplex without paying tax. Leonard can sign a QEAA and have an EAT buy the apartment complex for him, and then Leonard can list his duplex for sale. If the duplex sells within 180 days after the apartment complex is purchased, he can complete the exchange and have the apartment complex serve as replacement property for his duplex. But if Leonard has multiple duplexes, owns them through various partnerships, and is willing to sell any of the duplexes as part of a 1031 exchange, it increases Leonard s chances of completing a 1031 exchange if he can use whichever duplex sells first as the relinquished property in an exchange with the apartment complex. Private Letter Ruling has opened the door to allow more flexibility in designating relinquished property in reverse exchanges. The facts of Private Letter Ruling can be illustrated as follows. Leonard owns three duplexes and also owns 51 percent of the Howard Leonard Partnership and 51 percent of the Sheldon Leonard Partnership. Each of the partnerships also owns three duplexes. Leonard finds the apartment complex and wants it to serve as replacement property for whichever of the nine duplexes sells first. Leonard has an EAT acquire the apartment complex as potential replacement property. He then enters into three QEAAs with the EAT. One QEAA is with Leonard personally, one QEAA is with the Howard Leonard inside this issue (continued on page 5) 2 Many Related-Party Exchanges Are Perfectly Legal 2 Jeneé Hilliard Named Editor 3 Exchanges and Single- Member LLCs 4 Exchanging Adjacent Parcels: One Exchange or Two?

2 Many Related-Party Exchanges Are Perfectly Legal! by Ronald A. Shellan In the good old days, a taxpayer could exchange his high-basis relinquished property for his wife s lowbasis replacement property. Thereafter, the taxpayer could sell the replacement property (which now has a substituted high basis) with little or no gain. This technique is known as a basis swap. Years ago, Congress changed the law to plug the basis-swap loophole by banning many related-party exchanges. But one can still complete many types of exchanges with related parties! The law actually allows tax-free exchanges with related parties if both the taxpayer and the related party hold on to the properties received in the exchange for two years. But obviously, that exception has only limited utility. Who can wait two years? Another exception is that a taxpayer can transfer his relinquished property to his child or other related party and acquire the replacement property from an unrelated person. It works, and there is no risk, as long as both the taxpayer and the related party hold the replacement property and the relinquished property respectively for at least two years. Thus, while you generally cannot complete an exchange by acquiring the replacement property from a related person, you can complete an exchange by selling the relinquished property to a related party. Another work-around is to acquire the replacement property from a related party who does not technically meet the requirements for being a related party under the tax rules. Let s say that Joe wants to help out his daughter Sally by buying her house as replacement property in a tax-free exchange and financing the purchase by selling relinquished property that he owns to a third party. While he can t do that, he could buy the house from Sally s husband, Clyde, since Clyde is not related to Joe in such a way that it triggers the relatedparty rules. Of course, if Sally transfers the house to Clyde the day of closing so Clyde can sell it to Joe, the IRS can argue that in essence it is a related-party transaction. But if Sally transfers the house to Clyde, waits a month or two, and there is no agreed-on plan that the house will be purchased by Joe, it will probably pass IRS muster. Another exception relates to situations that in effect have no basis swap. Thus, Joe can complete an exchange by purchasing the replacement property from his daughter Sally, a transaction that is generally not allowed, provided that Sally s taxable gain on the transaction is roughly equal to the gain that Joe will defer by completing the exchange. Thus, there is no basis swap, since someone within the related family group is paying taxes; Uncle Sam is happy! Note, however, that if Sally has a net operating loss and won t pay taxes (continued on page 5) Jeneé Hilliard Named Editor Miller Nash LLP partner Jeneé Hilliard has been named editor of the Tax-Free Exchange Advisor. Ronald Shellan is stepping down as editor in anticipation of his retirement this December. Jeneé, whose primary practice focus is on real estate and tax-free exchanges, has worked for almost a decade in the tax-free exchange arena. She is currently finalizing the Like-Kind Exchanges chapter in the Principles of Oregon Real Estate Law handbook published by the Oregon State Bar. Engaged Guidance, Exceptional Counsel. EXPERIENCE PRACTICE TEAMS Practice Leader: William S. Manne bill.manne@millernash.com Tax Tax Tax Search SHARE Attorneys in Miller Nash s tax practice represent clients ranging from national companies to individuals and closely held businesses. We add value by helping our clients plan their business and investment activities to attain their business objectives while minimizing their local, state, and federal taxes. Our tax attorneys deal with the Internal Revenue Service, the Oregon Department of Revenue, and the Washington Department of Revenue, as well as many local governments, and are actively involved with local, state, federal, and international tax issues. Additionally, Miller Nash represents national, regional, and local companies in administrative hearings and in state and federal courts in tax disputes with revenue authorities. Miller Nash tax attorneys are recognized leaders in their fi eld, from having served (or serving) on the executive committee of the Oregon State Bar s Tax Section (three as its chair) and from being regular speakers at a variety of industry and professional seminars. Our tax attorneys work behind the scenes on legislative and regulatory matters and represent clients through all stages of appeals and in tax court. learn more about our tax team at 2 miller nash llp Tax-Free Exchange Advisor

3 Exchanges and Single-Member LLCs by Jeneé Hilliard While a multimember limited liability company ( LLC ) is treated as a partnership for tax purposes, a single -member limited liability company ( SMLLC ) is not. Its existence is ignored for tax purposes, and its income, expenses, and other tax attributes are reflected on the tax return of its sole member. SMLLCs are a great tool to solve various exchange issues. In particular, an SMLLC can avoid issues when structuring a reverse or improvement exchange and provide added flexibility for spouses in community property states. One often-used technique is to form an SMLLC to be used to hold title to the replacement property in an exchange. When a taxpayer sells the relinquished property, the replacement property can be purchased by an SMLLC owned by the taxpayer. If the relinquished property is owned by tenants in common or by a husband and wife, each of the owners can form his or her own separate SMLLC and hold the replacement property as a tenant in common with the other owners. There are quite a few advantages to using this technique. For example, many lenders require loan collateral to be placed in a single-asset entity, and this is an easy way to accommodate the lender. Additionally, holding title to the replacement property in an SMLLC can help shield other assets of the taxpayer from liability created by the replacement property (e.g., environmental contamination or slip-and-fall injuries). SMLLCs are a great tool to solve various exchange issues. In particular, an SMLLC can avoid issues when structuring a reverse or improvement exchange and provide added flexibility for spouses in community property states.. In an improvement exchange or a reverse exchange, the use of an SMLLC has additional advantages. A typical structure for an improvement exchange is that the accommodator builds improvements on real estate and then transfers the completed or partially completed structure to the taxpayer as replacement property. If an SMLLC is used to acquire title to the replacement property by the accommodator, when the improvements are completed, the transfer of the replacement property to the taxpayer can be completed by the accommodator transferring the membership interests in the SMLLC to the taxpayer instead of transferring fee title to the replacement property. Since no deed is recorded when the real estate is transferred from the accommodator to the taxpayer, in some jurisdictions real estate transfer taxes can be avoided. And because the SMLLC continues to own the real estate, the original title insurance obtained when the property was first acquired remains in effect. Title insurance could be lost if the property were simply deeded over by the accommodator to the taxpayer. Another advantage to using an SMLLC in an improvement exchange can occur if the construction to complete the improvements will continue after the exchange is completed. By transferring only the membership interest in the SMLLC, there is no need to amend or assign construction contracts or loan agreements to the taxpayer (although it may be necessary to negotiate into construction or loan agreements that a transfer of the SMLLC to the taxpayer will not violate antiassignment provisions or trigger a due-on-transfer clause). One exception to the normal rules that an SMLLC must be owned by a single member relates to community property. If an LLC is owned by a husband and wife as community property, it is treated as an SMLLC for tax purposes, because, for tax purposes, the husband and wife together are treated as a single member. Very difficult issues can occur, however, if it is not clear whether the LLC is community property. For example, if the LLC documents indicate that the LLC is owned by only the wife, but the parties are in a long- term marriage and all their assets have been acquired during the marriage, the husband might still have a communityproperty interest in the LLC, even though he isn t listed as an owner in the LLC documents. Or, alternatively, if both husband and wife are shown as the LLC s owner, but the husband acquired some of the LLC assets before marriage or from an inheritance, the LLC membership interests might not be community property. The 1031 issue for a communityproperty LLC is that the same entity, for tax purposes, must sell the relinquished property and purchase the replacement property. Thus, if the operating agreement lists husband as the sole member, the LLC could be a community-property SMLLC that would allow husband and wife to jointly acquire the replacement property, or the LLC could be an SMLLC that qualifies as husband s (continued on page 5) Tax-Free Exchange Advisor miller nash llp 3

4 Exchanging Adjacent Parcels: One Exchange or Two? by Ronald A. Shellan When an exchange involves two parcels of real estate that are adjacent to each other, it can be tricky to figure out whether they should be treated as two exchanges or a single exchange. This is a distinction with a difference! It matters because the 45-day identification rules and the 180-day replacementproperty rules cover only a single property, which might or might not include two adjacent properties. It can also matter for purposes of the carryover holding period, the rules regarding when and how boot is taxed, and other related rules. Example: Rebecca owns Blackacre and Whiteacre, which are adjacent to each other. Rebecca purchased Blackacre for $500,000, and it is currently worth $500,000. She purchased Whiteacre for $400,000, and it is currently worth $1 million. Can she sell Blackacre in a taxable transaction for $500,000 (since no gain would be recognized), and also sell Whiteacre as part of a tax-free exchange? What factors determine whether the two parcels should be treated as a single property for exchange purposes or as multiple properties? As it turns out, a lot of factors should be considered. The factors include the following: 1. Are the two properties part of a single economic or business unit? For example, if a hotel was located on two parcels that were owned by the same owner, they would be treated as the sale of a single property. On the other hand, if the hotel had vacant land next to it that was not used as part of the hotel, it is more likely that the hotel property and the vacant-land could be treated as two separate properties. 2. How adjacent were the properties? Did they have a common property line? Or were they separated by a road or a river? 3. Should a farm that is operated as a single operating unit, but that has properties scattered over one or more tax lots, be treated as a single property or multiple properties? It is very hard to tell. 4. Was the transaction documented as a single sale or two sales? If they were documented as two single sales instead of one, it is more likely that they will be treated as two sales. This presumption could be overcome if the two sales were contractually linked to each other so that one sale could not close unless the other sale closed. 5. Were the properties sold to two buyers or one? If sold to two buyers, especially if they are not related to each other, treatment as two transactions is more likely. 6. Will the two transactions close on the same day or different days? 7. Were the sales closed in one escrow or two? 8. Were two separate exchanges set up with two accommodators or just one? 9. Were the properties listed with a broker as a single property or two? 10. Were the properties advertised for sale as a single property or two? In general, if the properties are part of the same economic unit, are adjacent to each other, and are sold to the same buyer under the same purchase agreement and close on the same day, they should be treated as a single property for exchange purposes. If the properties are not part of the same economic unit, are sold to different buyers, and are in different closings on different days, they should be treated as two properties for exchange purposes. Often the facts are not clear, and a decision must be made. A tax professional should be retained who can help structure the transaction to help achieve the desired result. Tax-Free Exchange Advisor miller nash llp 4

5 More Flexibility for Reverse Exchanges Continued from page 1 Partnership, and the final QEAA is with the Sheldon Leonard Partnership. When the EAT acquires the apartment complex, it is not clear whether Leonard, the Howard Leonard Partnership, or the Sheldon Leonard Partnership will complete the exchange and acquire the apartment complex as replacement property. So each QEAA acknowledges that there are QEAAs outstanding with two other parties, and each QEAA provides that any of the three parties can give notice to the EAT of the intent to acquire the apartment complex, and upon doing so, the other two parties will have no right to acquire the apartment complex. Leonard signs 45-day designations for all three taxpayers, and each designation lists the three duplexes owned by that taxpayer as the relinquished property. This results in nine duplexes being designated as potential relinquished properties to pair with the apartment complex. The IRS This structure provides flexibility for a taxpayer with multiple potential relinquished properties held in various forms of ownership by increasing the number of potential relinquished properties that can be designated for a single replacement property. ruled that each of the three QEAAs was a separate QEAA meeting the requirements of Revenue Procedure and that each taxpayer was allowed to complete a separate 45-day designation. This structure provides flexibility for a taxpayer with multiple potential relinquished properties held in various forms of ownership by increasing the number of potential relinquished properties that can be designated for a single replacement property. There are, of course, a few limitations with this ruling. First, private letter rulings provide tax advisors with guidance about how the Internal Revenue Service might view an issue, but they can be relied on only by the taxpayer who requested the ruling and cannot be used or cited as precedent. Second, the taxpayer who requested the ruling asserted that each taxpayer had a bona fide intent to acquire the replacement property under the terms of the QEAA. In its ruling, the IRS specifically stated that it was relying on this representation in making its ruling. Ultimately only one taxpayer can acquire the replacement property, so it seems difficult for all three taxpayers to prove that they had a bona fide intent to acquire the property; this could be an area in which the IRS could challenge this type of arrangement. Nonetheless, this structure is interesting and worth considering in connection with reverse exchanges. Many Related-Party Exchanges are Perfectly Legal! Continued from page 2 even though she will have a taxable gain on the transaction, this technique will not work. A variation on the no-basis swap transaction occurs when both the taxpayer and the related party are completing a tax-free exchange. Thus, Joe can acquire replacement property from his daughter Sally as part of Joe s tax-free exchange, provided that Sally is selling her relinquished property to her father, Joe, as part of her own taxfree exchange. Thus, there is no basis swap because Sally will continue to own low-basis property that will generate substantial gain when she ultimately sells the replacement property that she acquired in the exchange. While the general rule continues to be that a taxpayer cannot complete a taxfree exchange with a related party, there are many potential ways to legitimately avoid the related-party rules. But don t try this at home! It is always best to seek competent tax advice when structuring any of these types of transaction. Exchanges and Single-Member LLCs Continued from page 3 separate property, which means that the replacement property could not be acquired by husband and wife jointly or through an LLC in which wife has an ownership interest. In any event, to prevent possible problems, it is generally best for the LLC that owned the relinquished property to acquire the replacement property directly or through an SMLLC that is owned only by the LLC, rather than adding the taxpayer s spouse as a new member of the LLC or creating a new LLC owned by husband and wife to acquire the replacement property, even in community-property states. 5 miller nash llp Tax-Free Exchange Advisor

6 Miller Nash LLP and Graham & Dunn PC have announced that they are combining to create the 160-attorney firm of Miller Nash Graham & Dunn LLP (MNG&D), effective January 1, The combined firm will have offices along the West Coast, offering clients expanded services and broadened capabilities. MNG&D will become the eighth-largest law firm in the Seattle market, with combined capabilities that are well positioned to serve the area s expanding business community. The new firm will combine its Seattle offices in the current scenic Graham & Dunn space at Pier 70 on Alaskan Way. The combined firm will continue to have offices in Vancouver, Washington, Portland and Bend, Oregon, and Long Beach, California. For more information about Graham & Dunn, visit If you have questions about the combination, please contact Drew Butler at drew.butler@millernash.com Tax-Free Exchange Advisor is published by Miller Nash LLP. This newsletter should not be construed as legal opinion on any specific facts or circumstances. The articles are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and any specific legal questions you may have. To be added to any of our newsletter or event mailing lists or to submit feedback, questions, address changes, and article ideas, contact Client Services at or at clientservices@millernash.com U.S. Bancorp Tower 111 S.W. Fifth Avenue Portland, Oregon Presorted First-Class Mail US Postage PAID Portland, OR Permit #1891