Conformity
New York’s personal income tax law, like that of other states, conforms with the federal system of income taxation.[i] The reason typically given for such conformity is to simplify tax return preparation, improve compliance and enforcement, and aid in the interpretation of tax law provisions.[ii]
The most significant example of New York’s conformity to the Code[iii] is found in the state’s computation of a resident taxpayer’s state income tax liability, which begins with the taxpayer’s federal adjusted gross income, and is then modified by certain additions and subtractions which reflect New York’s unique tax treatment of certain items.[iv]
A corollary to the conformity principle requires that any changes to the taxpayer’s federal adjusted gross income[v] be accounted for in re-determining the taxpayer’s New York income tax liability.
Wait-and-See
According to New York’s Tax Law, if the amount of a taxpayer’s federal taxable income is adjusted by the IRS the taxpayer must report such adjustment to New York within ninety days after the “final determination” of such change.[vi]
If the taxpayer fails to comply with this reporting requirement, then the New York income tax liability resulting from the federal adjustment may be assessed at any time the state learns of it – the applicable statute of limitations on the assessment of the deficiency is tolled.[vii]
Based on the foregoing, one might think it behooves New York to wait for the IRS to assert a tax deficiency following its examination of a new York taxpayer’s federal income tax return. At that point, most of the substantive tax issues presented in the taxpayer’s New York return will have been addressed by the IRS, thanks to the conformity principle, thus leaving the state with a deficiency to collect.
A New Reality
Over the last few years, however, New York has relaxed its “wait-and-see-what-the-IRS-finds” approach. Instead of piggybacking onto the IRS’s efforts, New York has been initiating the audit of many of its taxpayers’ income tax returns and, in the process, has been examining federal tax issues with the goal of collecting more New York income tax. After all, the IRS doesn’t examine every return. Why shouldn’t New York help itself?
The state’s more proactive[viii] attitude toward the enforcement of the federal income tax laws it has adopted as its own has its genesis in the fiscal headwinds that have been buffeting New York and other states with expensive budgets for some time. The Administration’s proposed cuts to various federal programs promises to increase the financial pressure on New York.[ix]
Moreover, the Administration’s reduction of the IRS’s enforcement budget, including personnel, will likely result in fewer instances of federal adjustments that generate increased tax liabilities owed to the state.
Under these circumstances, New York will likely be taking a greater interest in determining whether its residents are complying with federal tax law as it affects the computation of these residents’ New York income tax liabilities.
It is inevitable that some tax returns may challenge a state examiner’s or court’s knowledge of, and comfort level with interpreting, the federal tax law.
Notwithstanding this challenge, there may be times that a taxpayer will wish that the New York judge charged with analyzing the strength of the taxpayer’s reporting position were sitting on the federal bench instead. That was certainly the case in a recent decision out of the Division of Tax Appeals[x] that considered the application of the Code’s like-kind exchange rules.[xi]
An LLC and Its Members
Taxpayer was an individual resident of New York City (“NYC”) during the taxable year in question (the “Tax Year”).
Taxpayer, Member-2, and Member-3 were individual members (the “Members”) of Old-LLC, a limited liability company that was treated as a partnership for income tax purposes.[xii] Taxpayer and Member-2 were original members of Old-LLC; Member-3 inherited her interest from a family member.[xiii] The Members held their Old-LLC membership interests for investment purposes.
More than 30 years prior to the Tax Year, Old-LLC had purchased an apartment building in NYC (the “Property”) for less than a million dollars. Old-LLC held and managed the Property as a long-term, income producing investment.
Although the Property did not produce significant income, it appreciated significantly in value over the years.
Let’s Sell the Property
A couple of years before the Tax Year, the Members decided to sell the Property.
Both Taxpayer and Member-2 expected to recognize significant gain from the sale; thus, they planned to engage in like-kind exchanges to defer recognition of their respective shares of the gain from the sale.[xiv]
At the same time, Taxpayer and Member-2 wanted to go their separate ways – they did not want to keep investing together, in part because they had “different issues . . . different situations . . . each one needed something more suitable for his family.”[xv]
Member-3 decided not to engage in a like-kind exchange.[xvi]
Drop-&-Swap
Taxpayer understood that he could still sell his share of the Property as the first step of a like-kind exchange, provided Old-LLC distributed the Property to the Members as tenants in common (“TIC-owners”).[xvii]
Thus, before they found a buyer for the Property, the Members decided that Old-LLC would distribute the Property to them as TIC-owners, and they would subsequently sell the Property as TIC interests.[xviii] The Members never planned to have Old-LLC sell the Property.
Taxpayer assumed responsibility for finding a buyer and negotiating the sale of the Property. The other Members understood that Taxpayer was acting on their behalf as individual owners of the Property, not as a representative of Old-LLC.
Sale Contract
Eventually, Taxpayer found a buyer (“Investor”) who, in a letter addressed to Taxpayer (not to OLD-LLC), offered to acquire the Property from the TIC-owners for $65 million.[xix]
A contract for the sale of the Property was executed (the “Sale Contract”) in which Old-LLC – not the TIC-owners – was identified as the seller because it was still the legal owner of the Property as of the contract date. Investor assigned its rights to purchase the Property to an affiliate (“Purchaser”).[xx]
Finding Replacement Property
Taxpayer began looking for replacement properties for his TIC interest in the Property, which he eventually identified and entered into contracts for their purchase prior to the sale of the Property.[xxi]
The Drop
Each Member formed a new limited liability company (the “TIC-LLCs”) – of which such Member was the sole owner, and each of which was treated as a disregarded entity for income tax purposes[xxii] – to receive the Member’s share of the Property from Old-LLC as a TIC interest, to sell such TIC interest, and, in the case of Taxpayer (and Member-2), to acquire replacement properties.[xxiii]
To facilitate the like-kind exchange of Taxpayer’s TIC interest in the Property, Taxpayer’s TIC-LLC entered into an exchange agreement with a qualified intermediary.[xxiv]
At the direction of the Members, Old-LLC distributed the Property to the three TIC-LLCs as TIC-owners.[xxv] The distribution occurred subsequent to the date the Sale Contract was entered into and prior to the sale of the Property to Purchaser.
The distribution to the TIC-LLCs was recorded for New York State and NYC real property transfer reporting and tax purposes.[xxvi]
The TIC-LLCs entered into a TIC Agreement with respect to the Property.[xxvii]
The Sale
Also at the direction of its Members, Old-LLC assigned the Sale Contract for the Property to the three TIC-LLCs, which assumed all of Old-LLC’s obligations under the Sale Contract.
The Property was sold to Purchaser. The Bill of Sale listed the TIC-LLCs as the sellers of their respective TIC interests in the Property.
All of the documents relating to the transfer of the Property to Purchaser were executed by the TIC-LLCs as the owners and sellers of the Property, and not by Old-LLC.[xxviii]
Taxpayer, acting through his TIC-LLC, timely identified[xxix] certain replacement properties, thus satisfying the identification requirement under the like-kind exchange rules.[xxx]
Tax Year Reporting
On its federal partnership return[xxxi] for the Tax Year, Old-LLC reported rental income and expenses from the Property through the date of the distribution of the TIC interests.
In addition, Old-LLC responded “yes” to the question on its federal return, whether “[a]t any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”[xxxii]
Thus, Old-LLC’s return reported the distribution of the Property to the TIC-LLCs, and each Member’s federal schedule K-1 included the Member’s share of this in-kind distribution.
Old-LLC’s federal return did not report a like-kind exchange with respect to the Property. Indeed, Old-LLC did not continue to do business after it transferred the Property to the TIC-LLCs, and its federal and state partnership returns for the Tax Year were each marked as a “final return.”
However, Taxpayer – as owner of one of the TIC-LLCs – reported the sale of his TIC interest in the Property (the “relinquished” property in the exchange), as well as the purchases of the “replacement” properties, on IRS Form 8824, Like-Kind Exchanges, attached to his federal income tax return for the Tax Year, and reported deferred gain.[xxxiii]
NY Audit
The N.Y. Division of Taxation (the “Division”) audited Taxpayer’s return for the Tax Year.[xxxiv] The Division also audited Old-LLC’s partnership tax return for that year. These audits were performed for the purpose of reviewing the sale of the Property and the like-kind exchange reported on Taxpayer’s returns.
The Division acknowledged that Old-LLC did not report a like-kind exchange on its federal tax return for the Tax Year. In addition, the Division conceded that, based on the bill of sale, Purchaser knew it was acquiring the Property from the TIC-LLCs and not from Old-LLC. The Division also conceded that Taxpayer respected the form of the transaction, and that Taxpayer, through his TIC-LLC, had timely acquired replacement properties to close out what Taxpayer had reported as a deferred like-kind exchange. Finally, the Division recognized that drop-and-swap transactions may be qualified like-kind exchanges.
Still, after observing that drop-and-swap transactions were “[h]ighly marketed transactions,” the Division concluded that the transactions in which Taxpayer had engaged were not parts of a valid like-kind exchange and did not qualify for deferral of the gain realized on the sale.
The Division stated that the timing of when the drop-and-swap
occurs in a purported like-kind exchange was an important factor to consider, and that the “tax legitimacy” of a same-day drop-and-swap was questionable.
According to the Division, in order for the drop-and-swap to qualify as a like-kind exchange, the TIC-LLCs needed to have held the Property for investment purposes for a “minimum of a couple of months” before they sold it to Purchaser.
In other words, in order for the “drop” portion of the transaction (i.e., the distribution from Old-LLC) to be effective, the TIC-LLCs must “act as owners of the property and receive all benefits and burdens of property ownership, so that would include receiving rental income, expenses, them putting themselves out to be the owners of the property. And these things – it’s very hard to do if it all occurs within now just a matter of hours or even seconds.”
The Division concluded that “the benefits and burden[s] of ownership did not transfer to [Taxpayer] or to the [TIC-LLCs]. The [TIC-LLCs] did not receive any of the rental income. They did not incur any of the rental expenses.”
Based on the foregoing, the Division determined that Old-LLC was the true seller of the Property.
Because the party that sold the Property, the Division continued, was not the same party that purchased the alleged replacement property, neither Old-LLC nor Taxpayer could have qualified for nonrecognition of gain under Section 1031 of the Code.
The Division issued a notice of deficiency to Taxpayer for the Tax Year, asserting additional tax owing, plus interest and penalties.[xxxv]
Taxpayer petitioned the Division of Tax Appeals, and a hearing was held before an administrative law judge.[xxxvi]
The ALJ’s Analysis
Because the starting point for determining an individual taxpayer’s New York income tax liability is the taxpayer’s federal adjusted gross income,[xxxvii] the ALJ stated it was appropriate to refer to federal law in addressing the substantive questions presented.
Gain Deferral
Section 1031 of the Code, the ALJ explained, allows for non-recognition of gain upon the sale of certain real property (or certain interests therein). That provision, the ALJ continued, provides for gain deferral where the real property held by a taxpayer for investment or for “productive use” in a trade or business is transferred in exchange for other real property of like-kind to be held by the taxpayer for such a purpose.
Deferral is accomplished by requiring the selling taxpayer to carry over its basis in the relinquished property[xxxviii] to the like-kind property for which the relinquished property is exchanged (replacement property), thereby preserving in the replacement property the gain then-inherent in the relinquished property.[xxxix]
According to the ALJ, nonrecognition is accorded by the Code – including under the like kind exchange rules – only if the exchange is one which satisfies both (1) the Code’s specific requirements for an excepted exchange, and (2) the underlying purpose for which such exchange is excepted from the general recognition rule.[xl]
Strictly Construed . . . to a Point
Based on the foregoing, the ALJ continued, the Code’s nonrecognition provisions must be strictly construed against the taxpayer, who must clearly establish that they are entitled to the exception from recognition of gain, as in the case of a like-kind exchange under Section 1031 of the Code.
Significantly, however, the ALJ remarked that while the exception must be narrowly construed, the interpretation should “not be so narrow and literal as to defeat its settled purpose.”[xli]
Continued Investment
The ALJ explained the legislative purpose and intent behind the deferral of gain under Section 1031. Where a taxpayer in a like-kind exchange continued their investment in the same kind of property, the ALJ stated, they realized only a “theoretical profit.” Therefore, “in equity,” they should qualify for nonrecognition treatment.[xlii]
The ALJ then noted that several federal cases have recognized this “continued investment” rationale. Those courts found that a taxpayer in a like-kind exchange who has continued their investment in the same kind of property should qualify for nonrecognition treatment because they have realized only a theoretical profit.[xliii]
According to the ALJ, Taxpayer continuously held an interest in the Property for investment purposes, first indirectly through their interest in the Property as a member of Old-LLC and then, albeit briefly, as a TIC-owner[xliv] who exchanged that interest for an interest in like-kind replacement property.
The fact that the form of Taxpayer’s ownership changed, from owning the Property through their partnership interest to owning it “directly” (through a disregarded entity) as a TIC-owner and then exchanging their tenant-in-common interest in the Property for other investment property, did not invalidate nonrecognition treatment of the exchange.[xlv]
Furthermore, merely because Taxpayer held the Property only momentarily following its distribution from Old-LLC – indeed, Taxpayer received the Property from Old-LLC with the intent to exchange it for like-kind property – did not disqualify the transaction from nonrecognition treatment under Section 1031.[xlvi]
Although not expressly stated by the ALJ, though implicit in the continuous investment rationale is the conclusion that Old-LLC’s qualifying use of the Property was attributed to its Members.
The Partnership
Taxpayer held his partnership interest in Old-LLC for investment purposes and Old-LLC invested in the Property as a long-term income producing investment.
The ALJ observed that from the time Taxpayer and Member-2 began discussions for the sale of the Property, he intended to continue his investment in like-kind real properties.
The Members decided to distribute the Property to themselves as TIC-owners prior to selling it, and they structured the transaction in a way to accommodate their interests.[xlvii] The ALJ noted that the plan to distribute the Property to Old-LLC’s Members, as TIC-owners, was adopted before a purchaser was found for the Property.[xlviii]
According to the ALJ, Taxpayer acted on his intent to exchange his interest in the Property for other like-kind investment property by finding replacement property and a qualified intermediary for the exchange. Taxpayer’s “intent to exchange property for like-kind property satisfie[d] the holding requirement,” the ALJ stated, “because it [was] not an intent to liquidate the investment or to use it for personal pursuits.”[xlix]
In furtherance of Taxpayer’s plan to exchange a separate TIC interest in the Property for like-kind investment property, Old-LLC distributed the Property to its Members as TIC-owners prior to the sale to Purchaser. What’s more, the chain of title clearly showed that the TIC-owners were the owners of record of the Property prior to the sale to Purchaser and that title was transferred from them to Purchaser. In addition, Taxpayer’s share of the proceeds from such sale was wired to his qualified intermediary, and not to Old-LLC.
The ALJ remarked that, while Taxpayer held title to the Property as a TIC-owner only briefly, the plain language of Section 1031 does not require ownership of the relinquished property for any particular period of time.[l] Thus, the ALJ observed that federal courts have found valid like-kind exchanges in situations where title to relinquished property was held only momentarily and only for the exchange. Furthermore, courts have allowed immediate transfers of the replacement property following an exchange.[li] Additionally, nonrecognition treatment was accorded where the form of ownership changed,[lii] and where a taxpayer’s exchange was preceded by a tax-free acquisition of the relinquished property, or followed by a tax-free transfer of the replacement property.[liii]
Benefits & Burdens
The ALJ next turned to the Division’s assertion that Old-LLC had not effectively transferred the Property to the Members as TIC-owners, and that Old-LLC, rather than the Members, had sold the Property to Purchaser. Further, because Old-LLC – as the exchanging party, according to the Division – did not acquire replacement property, the transaction did not qualify for nonrecognition treatment under Section 1031.[liv]
Specifically, the Division contended that Old-LLC had not effectively transferred the Property to its Members as TIC-owners because the “benefits and burdens of ownership” were not transferred to them. The Division asserted that, in order for the drop-and-swap to qualify as a like-kind exchange, the TIC-owners needed to have held the Property for investment purposes for a “[m]inimum of a couple of months” before they sold it to Purchaser.[lv] In other words, Taxpayer had to establish his own qualifying use of the Property, and could not rely on his previously indirect ownership and “use” of the Property through Old-LLC.[lvi]
In response to the Division’s requirement that the relinquished property must be held for a “[m]inimum of a couple of months,” the ALJ stated that the Division had read into Section 1031 a “duration requirement” that did not exist in the plain language of the Code.[lvii]
To the contrary, the ALJ continued, a similar argument had already been rejected by the federal Ninth Circuit.[lviii] In that case, the taxpayer liquidated his wholly-owned corporation and received a tax-free distribution of real estate.[lix] On the same day, the taxpayer contracted to exchange the distributed property for other like-kind property. The IRS argued that the corporation, not the individual taxpayer, exchanged the property. The IRS had argued that, because the taxpayer acquired the property with the intent and an almost immediate contractual obligation to exchange it, the taxpayer did not satisfy the qualified use requirement of Section 1031. The Court rejected that view, noting that any such rule “would be nonsense as applied to the property given up, because at the time of the exchange the taxpayer’s intent in every case is to give up the property” and, thus, “[n]o exchange could qualify”. Instead, the Court held that the plain language of the statute prevailed and stated that, giving the words of the statute their ordinary meaning, “a taxpayer may satisfy the ‘holding’ requirement by owning the property, and the ‘for productive use in trade or business or for investment’ requirement by lacking an intent either to liquidate the investment or to use it for personal pursuits.”[lx] Under this formulation, the intent to exchange property for like-kind property satisfies the holding requirement because it is not an intent to liquidate the investment or to use it for personal pursuits.
Thus, the ALJ rejected as unreasonable the Division’s interpretation that the “held for a qualifying use” language of Section 1031 required that the Property have been held for some arbitrary duration.[lxi]
Having dismissed the Division’s “minimum” holding period argument, the ALJ explained that Old-LLC had, in fact, transferred ownership of the Property to its Members, who had agreed to the distribution of the Property to themselves as TIC-owners, held title to the distributed Property, had assumed all obligations of Old-LLC under the Sale Contract, and were identified as the sellers on the Bargain and Sale deed and the Bill of Sale, which was signed by Purchaser. Additionally, Purchaser was informed that the Property would be sold by the TIC-owners and not by Old-LLC, the TIC-owners executed an Assignment and Assumption of Leases assigning their interests in the leases and security deposits relating to the Property to Purchaser, the receipt of which Purchaser acknowledged in correspondence to the TIC-owners. Taxpayer credibly testified that he negotiated on behalf of each Member and himself, in their individual capacities, and not on behalf of Old-LLC, because they did not intend to have Old-LLC sell the Property. Additionally, letters regarding potential offers for the Property were addressed to Taxpayer individually, and not to Old-LLC. In addition, the Members paid their share of the brokerage commission and other expenses. The proceeds and the expenses were allocated among the TIC-owners consistent with their deeded interests in the Property.
Observations On the ALJ’s Opinion
The general rule with respect to the gain realized upon the sale or exchange of property is that gain is recognized except where the Code specifically provides otherwise.[lxii]
Nonrecognition is accorded by the Code only if the exchange is one that satisfies the underlying purpose for which such exchange is excepted from the general recognition rule.
Among these excepted exchanges are the ones described in Sections 721(a), 731(a), and 1031 (not an exhaustive list).[lxiii] These provisions describe transactions in which any differences that may exist between the property relinquished by the taxpayer and the property acquired in exchange therefor are more formal than substantial.
In general, the Code effectively provides that such differences do not control the tax consequences of an exchange. Instead, the factor to consider in determining whether the exchange should be excepted from the recognition rule is whether it effects only a readjustment in the form of the taxpayer’s continuing interest in the property exchanged.
In the context of the like-kind exchange discussed above, the ALJ stated that Taxpayer continued their investment in the Property by acquiring the same kind of replacement property. According to the ALJ, Taxpayer realized only a “theoretical profit.”[lxiv] Stated differently, the property received by Taxpayer was substantially a continuation of his old, still unliquidated, investment.
Implicit in the ALJ’s opinion is the conclusion that the qualifying activities in which Old-LLC was engaged with respect to the Property were attributed to Taxpayer, as well they should have been – that’s the only way the ALJ could have rejected the “duration holding” requirement advanced by the Division. The Code provides that the character of any item of income, gain, etc., included in a partner’s distributive share is determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.[lxv] In other contexts, the Code provides that a partner is considered as being engaged in the trade or business in which their partnership is engaged,[lxvi] or is accorded the tax benefit of a Code provision if the partnership has satisfied the requirements therefor.[lxvii]
Regardless, the ALJ rendered a well-reasoned decision with which the federal IRS would most likely have disagreed.
Looking Ahead
I doubt Justice Brandeis was thinking about a state’s independent interpretation of federal tax law when he described the states, generally, as “laboratories” for “social and economic experiments.”[lxviii]
Then again, who could have imagined that the federal government would be intentionally undermining its ability to enforce the federal income tax.[lxix]
Under the circumstances, it is likely New York will continue to delve into the substantive federal income tax issues presented by its taxpayers’ returns – including the qualification of a purported like-kind exchange.[lxx]
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Thus, New York’s Tax Law provides that: “Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to Federal income taxes, unless a different meaning is clearly required but such meaning shall be subject to the exceptions or modifications prescribed in this article or by statute.” N.Y. Tax Law 607(a). Consistent with the foregoing, a taxpayer’s taxable year and accounting method for purposes of the Tax Law are the same as for Federal income tax purposes. N.Y. Tax Law Sec. 605.
However, New York’s Tax Law does not conform to the Code in all respects. Indeed, there are a number of instances in which New York has chosen to “decouple” from specific provisions or amendments of the Code.
[ii] In furtherance of this policy of conformity, as the Code is amended by Congress, New York automatically adopts the federal changes. So-called “rolling conformity.”
[iii] Any reason to be more specific? There’s only one Code. (Sorry again, Kris.)
[iv] Start with IRC Sec. 62, then look to Tax Law Sec. 612(a), (b) and (c).
[v] This may be attributable, for example, to: the inclusion in the taxpayer’s gross income of a previously omitted item of income, the recharacterization of a transaction that affects its tax treatment, or the disallowance of a deduction previously claimed by the taxpayer.
[vi] N.Y. Tax Law Sec. 659.
[vii] N.Y. Tax Law Sec. 683(c)(1)(C). The regular three-year statute of limitations on assessment, which begins to run with the filing of the tax return, will not apply. Tax Law Sec. 683(a).
[viii] Aggressive?
[ix] And other States, of course. The President has proposed cuts to various social and other programs that will likely have significant effects on state finances.
[x] In the Matter of the Petition of Benjamin Hadar and Rachel Hadar, State of New York Division of Tax Appeals,
Determination DTA NOS. 850122 AND 850123.
[xi] Section 1031.
[xii] This, LLC filed IRS Form 1065, U.S. Return of Partnership Income, and NY Form IT-204, New York State partnership return, for the year 2016.
[xiii] Thus, she received a step-up in her outside basis for the membership interest, equal to the FMV of the interest at the time of the decedent’s death plus the estate’s share of partnership liabilities. Reg. Sec. 1.742-1(a). It is not clear whether the partnership had an election in effect under IRC Sec. 754 or whether such as election was made for the year of death, which would have adjusted the estate beneficiary’s share of the partnership’s inside basis for its assets.
[xiv] And the payment of income tax imposed upon such gain.
[xv] For example, Member-2 wanted to continue her investment in real estate separately from the other members because she wanted to invest in smaller properties that would produce more income and require less upkeep, so that she could manage the renovations herself and make good investments for her children, and she realized it was difficult to own one building with partners.
[xvi] Member-3 was not interested in another real estate investment and preferred to invest her share of the sale proceeds in stocks and other investments. Moreover, because Member-3 had inherited her interest in Old-LLC only a few years earlier, she had a higher adjusted basis (a “stepped-up” basis) than the other Members and, as a result, was not as concerned about paying tax immediately on her share of the gain from the sale of the Property. IRC Sec. 1014 and Reg. Sec. 1.742-1(a).
The ALJ’s decision gives no indication of whether the LLC had an election in effect under IRC Sec. 754. Such an election would have given Member-3 a positive adjustment to her share of the LLC’s inside basis for the Property, thereby reducing her gain from the sale. IRC Sec. 743. Alternatively, without the election, the stepped-up basis may have resulted in a loss for Member-3 on the liquidation of Member-3’s interest in LLC after the sale (assuming only cash was distributed), which may be used to offset her share of the gain from the sale. IRC Serc. 731(a)(2).
[xvii] With each Member owning a tenancy-in-common (“TIC”) interest.
[xviii] This transaction is referred to as a “drop-and-swap”; i.e., as a transaction where a partnership distributes (drops) partnership property to the partners in a valid transfer of title, and the partners then complete separate like-kind exchanges (swaps) of their separate shares of the property.
[xix] Not a bad return.
[xx] The Sale Contract provided that it would apply to and bind the distributees and assigns of the parties.
[xxi] Member-2 did the same.
[xxii] Reg. Sec. 301.7701-3(b)(1)(ii).
[xxiii] Because Taxpayer’s TIC-LLC was a disregarded entity for tax purposes, Taxpayer continued to be treated as the owner of the TIC interest distributed to his TIC-LLC from Old-LLC. Likewise, he would be treated as the seller and purchaser, respectively, of the TIC interest (the relinquished property) and of the replacement property.
[xxiv] Reg. Sec. 1.1031(k)-1(g)(4). Member-2 did the same.
[xxv] Basically, a constructive distribution to the Members. It avoided recording the TIC interests twice – once in the name of each Member and then in the name of each limited liability company.
[xxvi] LLC filed a New York City real property transfer tax return (form NYC-RPT) to report the distribution of the Property to the TICs. LLC reported the transfer as “wholly or partly exempt as a mere change of identity or form of ownership” and reported no NYC transfer tax due.
LLC also filed a New York State combined real estate transfer tax return (form TP-584) to report the transfer of the Property to the TICs. LLC reported the transfer as a “[c]onveyance which consists of a mere change of identity or form of ownership or organization,” and reported no State transfer tax due.
LLC also filed a New York State real property transfer report (form RP-5217NYC) to report the transfer of the Property to the TICs.
[xxvii] The Tenants in Common Agreement pre-dated the date of the conveyance of the Property to the TICs – there was no explanation in the record as to why. It is unclear how faithful the agreement was to Rev. Proc. 2002-22.
[xxviii] The TIC-LLCs filed form TP-584, as grantors, reporting the transfer of the Property to Purchaser. They also filed a form RP-5217 NYC, as grantors, reporting the transfer of the Property to Purchaser. A final settlement statement that was prepared by the Title Company for the sale of the Property mistakenly identified LLC as the seller of the Property to Purchaser. However, an escrow agreement, executed by the Title Company correctly identified the TIC-LLCs as the sellers of the Property. The final settlement statement identified the TIC-LLCs as recipients of the net “sale proceeds.”
As part of the closing with Purchaser, the mortgage held by Bank was paid in full out of the consideration paid by Purchaser for the Property to the TIC-LLCs.
The TIC-LLCs filed form NYC-RPT, as grantors, reporting the transfer of the Property to Purchaser.
Pursuant to an Assignment and Assumption of Leases, the TIC-LLCs assigned their interests in the leases and security deposits relating to the Property to Purchaser.
The TIC-LLCs provided notice to the tenants of the Property that the property was sold to Purchaser.
By letter to the TIC-LLCs, Purchaser acknowledged receipt of tenant security deposits and assignment and assumption of leases.
The Title Company recorded both the deed for LLC’s transfer of the Property to the TIC-LLCs and the deed for the sale of the Property by the TIC-LLCs to Purchaser.
[xxix] IRC Sec. 1031(a)(3)(A).
[xxx] Reg. Sec. 1.1031(k)-1(b)(4).
[xxxi] U.S. Return of Partnership Income, Form 1065.
[xxxii] Sch. B, Form 1065. The Schedule also asks whether, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity. These two questions first appeared on Form 1065 for the 2012 tax year to assist the IRS with identifying drop-and-swap transactions that purported to qualify for nonrecognition treatment under IRC Sec. 1031.
[xxxiii] Member-2 did the same.
[xxxiv] There was no federal audit.
[xxxv] Tax Law § 685 (p).
[xxxvi] The hearing is an adversarial proceeding. After the hearing, the administrative law judge (“ALJ”) will issue a determination that will decide the matters in dispute unless the taxpayer or the Tax Department request a review of the decision by the Tax Appeals Tribunal. If the taxpayer does not agree with the Tax Appeals Tribunal’s decision, they may seek court review in the Third Dept.
[xxxvii] N.Y. Tax Law Sec. 612 [a].
[xxxviii] Basically, its unrecovered investment in the property.
[xxxix] IRC Sec. 1031 [d]. See IRS Form 8824, Part III for the basis calculation. However, a portion of gain is recognized in a like-kind exchange transaction if non-like-kind property, such as cash, is received in addition to the replacement like-kind property received. IRC Sec. 1031 [b].
[xl] The ALJ also stated that the “exchange must be germane to, and a necessary incident of, the investment or enterprise in hand. The relationship of the exchange to the venture or enterprise is always material, and the surrounding facts and circumstances must be shown.” Reg. Sec. 1.1002–1 [b].
“As elsewhere,” the ALJ added, “the taxpayer claiming the benefit of the exception must show himself within the exception.”
[xli] Emph. added.
[xlii] “[I]f the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with the tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value (HR Rep 704, 73d Cong, 2d Sess at 13, reprinted in 1939-2 C.B. 564).”
[xliii] Citing Magneson v Commissioner, 753 F2d 1490, 1494 [9th Cir 1985] [“The case law, the regulations, and the legislative history are thus all in agreement that the basic reason for nonrecognition of gain or loss on transfers of property under sections 1031 and 721 is that the taxpayer’s economic situation after the transfer is fundamentally the same as it was before the transfer: his money is still tied up in investment in the same kind of property”]; Starker v. U.S., 602 F2d 1341, 1352 [9th Cir 1979] [“The legislative history reveals that the provision was designed to avoid the imposition of a tax on those who do not ‘cash in’ on their investments in trade or business property”]; Maloney v. Comm’r, 93 TC 89, 96 [1989], [“The purpose of section 1031 (and its predecessors) was to defer recognition of gain or loss on transactions in which, although in theory the taxpayer may have realized a gain or loss his economic situation is in substance the same after, as it was before, the transaction. Stated otherwise, if the taxpayer’s money continues to be invested in the same kind of property, gain or loss should not be recognized”].
[xliv] Through the TIC-LLC, which Taxpayer owned 100% and which was disregarded for tax purposes.
[xlv] Citing Magneson v Commissioner, 753 F2d at 1494-95.
[xlvi] Citing Bolker v Commissioner, 760 F2d 1039, 1045 [9th Cir 1985].
[xlvii] As stated earlier, although they wanted to continue investing in real properties, they wanted to do so separately and in different investment properties.
[xlviii] The distribution of the Property from Old-LLC was allowed by its operating agreement, which provided that the Property could be transferred by a two-thirds vote. In this case, all three members agreed to the distribution of the Property to TICs so that Taxpayer and Member-2 could exchange their interests in the Property for like-kind investment property as they intended.
[xlix] Again citing Bolker v Comm’r, 760 F2d at 1045. This only makes sense if the partnership’s use of the Property was attributed to Taxpayer.
[l] Assuming, of course, that the “holding” requirement was otherwise satisfied.
[li] Citing Magneson v Comm’r, 753 F2d 1490, and Mason v Comm’r, TC Memo 1988-273 [1988], aff’d 880 F2d 420 [11th Cir 1989] [Tax Court allowed nonrecognition treatment for exchange where two partners received property in a partnership liquidation, and then immediately exchanged the property].
[lii] Magneson v Comm’r, 753 F2d at 1494-95 [wherein taxpayers completed an exchange of property and then, on the same day, contributed the property to a limited partnership and, in return, became general partners of the limited partnership, the court found that the requirements of IRC Sec. 1031 were satisfied].
[liii] Maloney v Comm’r, 93 TC 89 (1989) [“A trade of property A for property B, both of like-kind, may be preceded by a tax-free acquisition of property A at the front end, or succeeded by a tax-free transfer of property B at the back end”].
[liv] The taxpayer that disposes of the relinquished property must be the taxpayer who acquires the replacement property.
[lv] The Division did not dispute that if Taxpayer’s TIC interest in the Property qualified as relinquished property, then Taxpayer acquired replacement property.
[lvi] I.e., there was no attribution from the partnership.
[lvii] The ALJ noted that the Division had cited no authority for the proposition that title to the property must be held for more than one day, or for any specific time period.
[lviii] Bolker v Comm’r, 760 F2d 1039 (9th Cir. 1985).
[lix] Mind you, this was before the repeal of General Utilities by the Tax Reform Act of 1986. P.L. 99-514.
[lx] The Circuit Court concluded: “The Commissioner’s position, in contrast, would require us to read an unexpressed additional requirement into the statute: that the taxpayer have, previous to forming the intent to exchange one piece of property for a second parcel, an intent to keep the first piece of property indefinitely.” The Court declined to do so.
[lxi] The Division also argued that Taxpayer’s failure to hold a “real interest” in the Property precluded the transactions from being construed as constituting a qualifying Section 1031 exchange.
The ALJ rejected this argument, stating there was no need for the exchanging taxpayer to acquire a “real” interest in the replacement property by assuming the benefits and burdens of ownership to make the exchange qualify under the Code. With that, the ALJ rejected the Division’s argument that Old-LLC had not effectively transferred the Property to the Members as TIC-owners because they did not assume the “benefits and burdens” of ownership.
[lxii] Reg. Sec. 1.1002-1(a).
[lxiii] Addressing, respectively, contributions of property to a partnership in exchange for an equity interest in the partnership, an in-kind distribution by a partnership to a partner in respect of their partnership interest, and a like-kind exchange.
[lxiv] To date, the Code has not imposed an income tax upon the appreciation in the fair market value of a property in the absence of a sale or taxable exchange, though there are many in Congress who would welcome it.
[lxv] IRC Sec. 702(b).
[lxvi] For example, IRC Sec. 875.
[lxvii] For example, IRC Sec. 1202(g).
[lxviii] New State Ice Co. v. Liebmann, 285 U.S. 262 (1932).
[lxix] The government’s most important source of revenue by far.
[lxx] Consider the number of situations in which these exchanges arise, whether we’re talking about a rental property in the Hamptons or a building in Manhattan.
Be aware that partnerships must file Form IT-204, which asks whether the partnership (i) had an interest in New York real property during the last three years, (ii) engaged in a like-kind exchange, (iii) sold property that had a deferred gain from a previous like-kind exchange, (iv) made an in-kind distribution, and (v) was under audit by the IRS or was previously audited by the IRS.
