Tax Deferral for Highly Appreciated Real Estate through TICs and Like-Kind Exchanges
Posted on 11.18.15
By: Amanda Mills, CPA, Tax Manager | Real Estate & Construction Industry Team
Earlier this year, we discussed an alternative 1031 like-kind exchange strategy which described a Tenant in Common arrangement also known as a “TIC”. This type of structure provides many benefits for taxpayers looking to exchange real estate and to defer paying taxes on appreciated value. Related parties can also take advantage of a TIC for a 1031 like-kind exchange provided special rules are followed.
In general, the mandatory nontaxable exchange treatment applies if the following criteria are met:
- Both the property transferred and the property received are held either for productive use in a trade or business or for investment purposes and must be like-kind,
- The form of the transaction is a sale or exchange and meet the timeline for both the identification and exchange periods,
- Proceeds from a sale must go through the hands of a qualified intermediary and be reinvested in the replacement property, and
- The replacement property must be subject to an equal level or greater level of debt than the relinquished property.
Exchanges between related parties further stipulate a two-year holding period for the exchanged properties. If either related party disposes of their property within two years, the nonrecognition rules deferring the tax will no longer apply and the deferred gain will be recognized in the year of the disqualifying disposition; however, losses are disallowed. A related person generally includes family members (brothers, sisters, spouse, ancestors, and lineal descendents), more than 50% controlled corporations, and certain fiduciary relationships.
A disposition during the two-year holding period will not trigger the unrecognized gain or loss if the disposition is after the death of the taxpayer or the related person, is in a compulsory or involuntary conversion (as long as the exchange occurred before the threat or imminence of the conversion), or it is established to the satisfaction of the IRS that neither the exchange nor the disposition had tax avoidance as one of its principal purposes. The taxpayer has the burden of proof to qualify for the non-tax avoidance exception and must attach an explanation to its return in the year of disposition.
The non-tax avoidance exception is intended to apply to:
- A transaction involving an exchange of undivided interests in different properties that results in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of the properties,
- Dispositions of property in nonrecognition transactions, and
- Transactions that don’t involve the shifting of basis between properties.
Because the non-tax avoidance exception is dependant upon a taxpayer’s facts and circumstances, case law and various interpretations of the code and regulations have developed throughout the years. Although PLR 200706001 may not be used or cited as precedent, the analysis of the law as it relates to the taxpayer’s facts and circumstances is an interesting illustration of how a TIC was effectively utilized to satisfy the non-tax avoidance exception and that the IRS did not rigidly apply the related party rules. In this ruling, the IRS determined that the taxpayer’s undivided 25% interest in Parcel #1 exchanged for 100% interest unencumbered fee simple interest in Parcel #3 constituted a like-kind exchange and did not conflict with the related party rules despite the exchange between related parties and the subsequent sale of Parcel #1 following the exchange. The IRS not only considered that the requirements for a like-kind exchange were met but also the taxpayer’s motive and whether the taxpayer was shifting basis from a low basis asset to a high basis asset in anticipation of the sale.
Other commentary and case law suggests that related taxpayers arranging a deferred exchange cannot escape the non-tax avoidance exception via the usage of an unrelated qualified intermediary. In these instances, the IRS has looked to the economic substance of the transaction and whether the economic positions of the related parties showed that the exchange was used to “cash out” of an investment in low-basis real property.
The intricate tax law and stringent rules surrounding TICs and like-kind exchanges for related parties can be very complex but when structured properly can result in tax deferral for highly appreciated real estate.
For more information on this topic, or if you have any other questions on a 1031 Like-Kind Exchange, please consult your opportunity advisor at Keiter or firstname.lastname@example.org | 804.747.0000
Sources: RIA Checkpoint, PLR 200706001
Amanda serves construction, specialty contractors, real estate development, and service businesses and their owners. Her responsibilities include income tax compliance, tax planning and consulting, and tax and accounting research. Amanda also has multi-state tax experience and has successfully assisted taxpayers in various Internal Revenue Service and state tax examination proceedings. Read more of Amanda's tax insights on our blog.