1. Fate of Bush-era tax cuts unresolved

2011 ended without any resolution of the fate of the Bush-era tax cuts. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Relief Act) extended the Bush-era tax cuts through 2012. President Obama and House Speaker John Boehner, R-Ohio, reportedly came close to an agreement in August 2011 to extend some of the Bush-era tax cuts as part of a comprehensive deficit reduction package. When their agreement fell apart, many Washington observers predicted the Joint Select Committee on Deficit Reduction would address the Bush-era tax cuts in a deficit reduction package. The Deficit Reduction Committee announced in November that it failed to reach an agreement and disbanded.

Comment

The fate of the Bush-era tax cuts may ultimately be decided by the lame-duck Congress, which will meet after the November 2012 elections. The outcome of the presidential election and which party controls the House and Senate will undoubtedly influence whatever decision lawmakers take over the Bush-era tax cuts.

2. Rollback of tax legislation

Congress repealed three tax laws in 2011: expanded business information reporting, real property expense reporting and three percent government withholding.

Business information reporting. The Patient Protection and Affordable Care Act (PPACA) required businesses, charities and government entities to file information returns (Forms 1099) for all payments of $600 or more in a calendar year to a single vendor, other than a tax-exempt vendor. The PPACA also repealed the long-standing reporting exception for payments made to corporations. The PPACA’s expansion of business information reporting proved universally unpopular. Congress passed the Comprehensive 1099 Taxpayer Protection Act in April 2011. The Comprehensive 1099 Taxpayer Protection Act repeals the expanded business information reporting provisions in the PPACA as if they have never been enacted.

Rental property expense reporting. The Small Business Jobs Act of 2010 required landlords to file a Form 1099 to report certain rental property expense payments of $600 or more. The Comprehensive 1099 Taxpayer Protection Act also repealed rental expense reporting as if it had never been enacted.

Government withholding. The Tax Increase Prevention and Reconciliation Act of 2007 imposed three percent withholding on payments for goods or services to contractors made by federal, state and local governments. In November 2011, President Obama signed the 3% Withholding Repeal and Job Creation Act, which repeals three percent government withholding as if it had never been enacted.

3. Foreign accounts

The Treasury Department and the IRS continued to focus on foreign account reporting in 2011. Three developments were interconnected: implementation of the Foreign Account Tax Compliance Act (FATCA), FBAR filings and the 2011 Offshore Voluntary Disclosure Initiative (OVDI).

FATCA. The IRS continued to implement the Foreign Account Tax Compliance Act (FATCA) in 2011. FATCA generally requires certain U.S. taxpayers holding specified foreign financial assets to report information about these assets on a new form to be attached to the taxpayer’s return. Additionally, foreign financial institutions must report certain information about accounts held by U.S. taxpayers. In July 2011, the IRS announced it intended to provide for a phased implementation of the FATCA requirements for foreign financial institutions. In December 2011, the IRS issued guidance about new Form 8938, Statement of Specified Foreign Financial Assets.

FBAR. The Treasury Department issued final rules on Form TD-F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR) in February 2011. The final rules retain and clarify the requirement to report signature or other authority over a foreign financial account. The final rules also reserved the treatment of investment companies other than mutual funds or similar pooled funds. In related news, the Treasury Department announced that taxpayers may electronically file the FBAR; previously, electronic filing was not an option for the FBAR.

OVDI. The IRS launched a campaign in 2011 to encourage taxpayers to voluntarily disclose unreported offshore accounts. The 2011 Offshore Voluntary Disclosure Initiative (OVDI) rewarded taxpayers who came forward voluntarily with a reduced penalty framework (although not as generous as a similar program in 2009). The 2011 OVDI closed on September 9, 2011. In December, IRS Commissioner Douglas Shulman reported that the agency has received more than 33,000 voluntary disclosures since 2009.

4. IRS help for distressed taxpayers

The IRS announced in February 2011 a series of measures intended to help good-faith taxpayers who cannot meet their tax obligations. The IRS “Fresh Start” initiative generally allows lien withdrawals for taxpayers entering into direct debit installment agreements (and for taxpayers who convert from a regular installment agreement to a direct debit agreement). The IRS also announced it would make streamlined installment agreements available to more small businesses. Qualified small businesses with $25,000 or less in unpaid taxes can participate in the streamlined installment agreement program.

Comment

According to Commissioner Douglas Shulman and other top agency officials, IRS personnel have been instructed to be more flexible in helping distressed taxpayers.

5. Worker classification

The IRS launched a new program in September 2011 to enable employers to voluntarily reclassify their workers for federal employment tax purposes and take advantage of a reduced penalty framework. The Voluntary Classification System Program (VCSP) is open to employers currently treating their workers as independent contractors or other nonemployees and who want to prospectively treat the workers as employees. The employer must not be under audit and satisfy other requirements. The IRS has not announced an end-date to the VCSP.

6. Basis overstatement regs

The Supreme Court agreed in September 2011 to resolve a split among the federal courts of appeal over IRS regs (TD 9515) that impose a six-year limitations period on assessments due to overstated basis (Home Concrete & Supply, LLC, 2011-1 ustc ¶50,207). The government asked the Supreme Court to decide, among other questions, whether an understatement of gross income attributable to an overstatement of basis in sold property is an omission from income that can trigger the six-year assessment period.

Comment

In March 2011, the Court of Appeals for the Federal Circuit upheld the basis overstatement regs under Chevron-deference (Grapevine Imports, Ltd., 2011-1 ustc ¶50,264).

7. Mid-year mileage rate increase

For the third time in six years, the IRS announced a mid-year adjustment to the business standard mileage rate because of rising gasoline prices. The business standard mileage rate increased from 51 cents-per-mile to 55.5 cents-per-mile for the second half of 2011. The medical/moving standard mileage rate increased from 19 cents-per-mile to 23.5 cents-per-mile for the second half of 2011. Congress did not make a mid-year adjustment to the charitable standard mileage rate, which remained at 14 cents-per-mile for the second half of 2011.

Comment

For 2012, the business standard mileage rate is 55.5 cents-per-mile and the medical/moving standard mileage rate is 23 cents-per-mile. The statutorily-determined charitable standard mileage rate remains at 14 cents-per-mile for 2012.

8. Return preparer oversight

The IRS moved forward with its return preparer oversight initiative in 2011, defining the new designation “registered tax return preparer” and launching the registered tax return preparer competency examination. In June, the IRS issued final Circular 230 regulations, which clarified professional standards for certified public accountants (CPAs), enrolled agents (EAs) and registered tax return preparers. The IRS also fine-tuned its online preparer tax identification number (PTIN) registration system. Additionally, the IRS announced it would revisit its proposal to fingerprint certain PTIN applicants; a proposal which many tax professionals criticized as duplicative of their own employee background checks and too costly.

9. Mandatory e-file for preparers

Beginning January 1, 2011, specified tax return preparers who reasonably expected to file 100 or more covered returns in calendar year 2011 were required to file those returns electronically. The e-filing requirement was put in place by Congress in 2009. The IRS phased-in the requirement over two years (2011 and 2012). For calendar year 2012 (and subsequent years), the threshold for mandatory e-filing by specified tax return preparers is 11 or more covered returns. Firms must compute the number of covered returns in the aggregate that they reasonably expect to file as a firm. If the number is 11 or more in calendar year 2012 and subsequent years, all members of the firm must electronically file covered returns.

10. Updated PAL rules

The IRS issued proposed regs in November 2011 updating the definition of an interest in a limited partnership as a limited partner for purposes of the Code Sec. 469 passive activity loss (PAL) rules. Under the proposed regs, an interest in a limited liability company is treated as a limited partnership interest for the PAL rules.

Comment

The proposed regs reflect the evolution of the rules for limited partners since passage of the Uniform Limited Partnership Act of 1916.

Honorable mention

• Congress bans tax strategy patents;
• IRS helps organizations regain tax-exempt status after automatic revocation;
• IRS responds to Hurricane Irene and many other natural disasters in 2011;
• FUTA surtax expires mid-year;
• Congress expands Work Opportunity Tax Credit (WOTC) for veterans;
• Supreme Court agrees to hear arguments on PPACA;
• IRS issues final regs on Code Sec. 6707A penalty.

Background. A taxpayer generally recognizes gain or loss upon the sale or exchange of property. However, neither gain nor loss is recognized under Code Sec. 1031 on an exchange of property if:

… the taxpayer exchanges property held for productive use in a trade or business or for investment for other property to be held for productive use in a trade or business or for investment;

… the relinquished property and the replacement property are of “like kind”; and

… the replacement property is identified and the exchange is completed within statutory time limits.

If a two-party like-kind exchange is impractical or undesirable, a taxpayer may still be able to get the benefits of Code Sec. 1031 by arranging a multi-party deferred exchange. In a deferred exchange, the replacement property must be (i) identified within 45 days after the taxpayer transfers the relinquished property, and (ii) received by the earlier date of 180 days after the taxpayer transfers the old property or the due date of the taxpayer’s return for the year (including extensions).

To qualify as a deferred exchange, the transaction must be an exchange of property, not a transfer of property for money. The reinvestment of the proceeds from a cash sale of one property into a second property of like-kind will not qualify as a Code Sec. 1031 exchange.

The taxpayer isn’t treated as actually or constructively receiving money or other property before he receives like-kind replacement property solely because the obligation of the transferee to transfer replacement property to the taxpayer is secured by cash or its equivalent, provided the security is held in a qualified escrow account or qualified trust.  An escrow account is “qualified” if the escrow holder is not the taxpayer (or a disqualified person) and the escrow agreement expressly limits the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the cash or its equivalent held in the account.

Facts. Ralph E. Crandall, Jr. and Dene D. Dulin owned an undeveloped parcel of property in Arizona. The property was held for investment purposes and had a basis of $8,500. They wanted to own investment property closer to their California residence, so they decided to sell the Arizona property and purchase new property with the intention of executing a tax-free exchange.

On March 4, 2005, the taxpayers sold the Arizona property for $76,000. The buyers of the property paid petitioners $10,000, and the remaining $66,000 was placed in an escrow account with Capital Title Agency, Inc. (Capital Title). At the taxpayers’ direction, $61,743.25 was held in the escrow account, and $4,256.75 was released to the taxpayers.

The taxpayers made a series of payments to an escrow account with Chicago Title Co. (Chicago Title) from January–March of 2005. Neither the Capital Title nor the Chicago Title escrow agreements mentioned a like-kind exchange under Code Sec. 1031 or expressly limited the taxpayers’ right to receive, pledge, borrow, or otherwise obtain the benefits of the funds.

Parties’ arguments. IRS contended that, since the Capital Title escrow agreement didn’t restrict the taxpayers’ access to and use of the funds held in the escrow account, it wasn’t a “qualified escrow account.” Thus, the taxpayers were in constructive receipt of the proceeds from the sale of the Arizona property. The disposition of the Arizona property was a taxable sale, and recognized gain should have been reported on the taxpayers’ 2005 return.

The taxpayers claimed that the funds in the Capital Title escrow account were held solely for the purchase of the California property and that they received no proceeds from the sale of the Arizona property.

Conclusion. The Tax Court agreed with IRS that the disposition of the Arizona property was a sale, the proceeds of which were constructively received by the taxpayers upon deposit into the Capital Title escrow account. Although the taxpayers in fact used the funds in the Capital Title escrow account to purchase the California property, they failed to comply with the Code Sec. 1031 requirements for nonrecognition. The Capital Title escrow account wasn’t a “qualified escrow account” within the meaning of the Regulations due to the lack of express limitations on the taxpayers’ use of the funds.  As a result, the taxpayers had taxable gain in 2005 from the sale of the Arizona property.

For more information about this case or 1031 exchanges in general, contact Partner F. Moore McLaughlin, IV, Esq., CPA at 401-421-5115 ext. 212 or by e-mail at mmclaughlin@mclaughlinquinn.com.

Background. Under Code Sec. 6072(a), income tax returns must be filed on April 15. When April 15 falls on a Saturday, Sunday, or legal holiday, a return is considered timely filed if filed on the next succeeding day that is not a Saturday, Sunday, or legal holiday, defined as legal holiday in DC.

Under DC law, Emancipation Day, April 16, is a legal holiday. The twists and turns in DC law regarding this holiday produce the following results for filing deadlines for all tax forms and payments that must be filed or completed on or before April 15, including the Form 1040 series tax returns:

• When April 16 falls on Saturday, then Friday, April 15, is the observed date for Emancipation Day and the filing deadline for all tax forms and payments required to be filed or completed on or before April 15, is Monday, April 18.

That’s the situation this year, when April 16 falls on a Saturday, which means Emancipation Day will be observed on Friday, Apr. 15, 2011. Thus, the filing deadline for all tax forms and payments required to be filed or completed on or before April 15 will be Monday, April 18, 2011.

• When April 16 falls on Sunday, then Monday, April 17, is the observed date for Emancipation Day, and the filing deadline for all tax forms and payments required to be filed or completed on or before April 15 is Tuesday, April 18.
• When April 16 falls on Monday, then that day is the observed date for Emancipation Day, and the filing deadline for all forms and payments required to be filed or completed on or before April 15 is Tuesday, April 17.

The last time this happened was in 2007.

IRS said it will widely publicize the Emancipation Day rules in affected years to remind the public that the filing deadline is extended.

In all likelihood, the new Notice was issued in response to a flood of questions about why the filing deadline was deferred to April 18, even though April 15 will fall on a Friday this year.

The deadline deferral to April 18, 2011, applies to a host of deadlines for filing and paying, including:

… Requests for an automatic six-month tax-filing extension on an individual return for calendar-year 2010.

… Tax-year 2010 balance-due payments.

… For calendar-year taxpayers, individual estimated tax payments for the first quarter of 2011.

… For calendar-year taxpayers, tax-year 2010 contributions to a Roth or traditional IRA.

… Corporation income tax returns, including S corporations, for a fiscal year ending on January 31, 2011, and any balance due.

… For calendar-year corporations, the estimated tax payment for the first quarter of 2011.

… Calendar-year estate and trust income tax returns (Form 1041) and any balance due.

… Calendar-year 2010 partnership returns (Form 1065).

• The current income tax rates will be retained for two years (2011 and 2012), with a top rate of 35% on ordinary income and 15% on qualified dividends and long-term capital gains.
• Employees and self-employed workers will receive a reduction of two percentage points in Social Security payroll tax in 2011, bringing the rate down from 6.2% to 4.2% for employees, and from 12.4% to 10.4% for the self-employed.
• A two-year AMT “patch” for 2010 and 2011 will keep the AMT exemption near current levels and allow personal credits to offset AMT. Without the patch, an estimated 21 million additional taxpayers would have owed AMT for 2010.
• Key tax credits for working families that were enacted or expanded in the American Recovery and Reinvestment Act of 2009 will be retained. Specifically, the new law extends the $1,000 child tax credit and maintains its expanded refundability for two years, extends rules expanding the earned income credit for larger families and married couples, and extends the higher education tax credit (the American Opportunity tax credit) and its partial refundability for two years.
• Businesses can write off 100% of their equipment and machinery purchases, effective for property placed in service after September 8, 2010 and through December 31, 2011. For property placed in service in 2012, the new law provides for 50% additional first-year depreciation.
• Many of the “traditional” tax extenders are extended for two years, retroactively to 2010 and through the end of 2011. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes; the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers; and the research credit.
• After a one-year hiatus, the estate tax will be reinstated for 2011 and 2012, with a top rate of 35%. The exemption amount will be $5 million per individual in 2011 and will be indexed to inflation in following years. Estates of people who died in 2010 can choose to follow either 2010′s or 2011′s rules.
• Omitted from the new law: Repeal of a controversial expansion of Form 1099 reporting requirements.
• Also not included: Extension of the Build America Bonds program, which permits state and localities to issue federally-subsidized municipal bonds.

Watch for upcoming posts containing more detail on this new law.  In the meantime, feel free to contact us with any questions you may have.

Financial reform package changes mark-to-market rule.

The “Restoring American Financial Stability Act of 2010” was signed into law on July, 21, 2010. This landmark financial reform package contained a tax provision broadening the list of contracts that are excepted from mark-to-market treatment. Taxpayers must report gains and losses from regulated futures contracts and other “Section 1256 contracts” on an annual basis under the “mark-to-market” rule. The term Section 1256 contract means: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. It does not include any securities futures contract or option on such a contract unless the contract or option is a dealer securities futures contract. Under the new law, for tax years beginning after July 21, 2010, all of the following also are excepted from the definition of a Section 1256 contract: any interest rate swap; currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement.

For more information, please contact Partner Moore McLaughlin at 401-421-5115 ext 212 or by e-mail at mmclaughlin@mclaughlinquinn.com. 

Rhode Island Flooding

The IRS has announced on its website that victims of the recent severe storms and flooding in counties in Massachusetts and Rhode Island are designated as federal disaster areas qualifying for individual assistance have more time to make tax payments and file returns. Certain other time-sensitive acts also are postponed. The following is a summary of the relief that is available.

Who gets relief.  Only taxpayers considered to be affected taxpayers are eligible for the postponement of time to file returns, pay taxes and perform other time-sensitive acts. Affected taxpayers are those listed in Treas. Reg. § 301.7508A-1(d)(1) and thus include:

• any individual whose principal residence, and any business entity whose principal place of business, is located in the counties designated as disaster areas;
• any individual who is a relief worker assisting in a covered disaster area, regardless of whether he is affiliated with recognized government or philanthropic organizations;
• any individual whose principal residence, and any business entity whose principal place of business, is not located in a covered disaster area, but whose records necessary to meet a filing or payment deadline are maintained in a covered disaster area;
• any estate or trust that has tax records necessary to meet a filing or payment deadline in a covered disaster area; and
• any spouse of an affected taxpayer, solely with regard to a joint return of the husband and wife.

What may be postponed. Under Internal Revenue Code §7508A, the IRS gives affected taxpayers until the extended date (specified by county, below) to file most tax returns (including individual, estate, trust, partnership, C corporation, and S corporation income tax returns; estate, gift, and generation-skipping transfer tax returns; and employment and certain excise tax returns), or to make tax payments, including estimated tax payments, that have either an original or extended due date falling on or after the onset date of the disaster (specified by county, below), and on or before the extended date.

The IRS also gives affected taxpayers until the extended date to perform other time-sensitive actions described in Treas. Reg. §301.7508A-1(c)(1) and Rev. Proc. 2007-56, 2007-34 IRB 388, that are due to be performed on or after the onset date of the disaster, and on or before the extended date.  This relief also includes the filing of Form 5500 series returns, in the way described in Rev. Proc. 2007-56, Sec. 8.  Additionally, the relief described in Rev. Proc. 2007-56, Sec. 17, relating to like-kind exchanges of property, also applies to certain taxpayers who are not otherwise affected taxpayers and may include acts required to be performed before or after the period above.

The postponement of time to file and pay does not apply to information returns in the W-2, 1098, 1099 or 5498 series, or to Forms 1042-S or 8027.  Penalties for failure to timely file information returns can be waived under existing procedures for reasonable cause. Likewise, the postponement does not apply to employment and excise tax deposits.  The IRS, however, will abate penalties for failure to make timely employment and excise deposits, due on or after the onset date of the disaster, and on or before the deposit delayed date (specified by county, below), provided the taxpayer made these deposits by the deposit delayed date.

Affected areas and dates for storms, floods and other disasters as published on the IRS’s website:

Massachusetts:  The following are federal disaster areas qualifying for individual assistance on account of severe storms and flooding beginning on March 12, 2010: Bristol, Essex, Middlesex, Norfolk, Plymouth, Suffolk and Worcester counties.  For these Massachusetts counties, the onset date of the disaster was March 12, 2010, the extended date is May 11, 2010, and the deposit delayed date was March 29, 2010. [Note:  In response to the IRS' tax deadline extension, the Massachusetts Department of Revenue has announced that the new filing deadline for state tax returns will be midnight May 11, 2010 for residents of the counties that were federally-declared disaster areas. (Release, Massachusetts Department of Revenue, 03/31/2010 ; Massachusetts Severe Storm and Flooding Victims Have Until May 11 to File Their Tax Returns, 03/31/2010).]

Rhode Island: The following are federal disaster areas qualifying for individual assistance on account of severe storms and flooding beginning on March 12, 2010: Kent, Newport, Providence and Washington counties. For these Rhode Island counties, the onset date of the disaster was Mar. 12, 2010, the extended date is May 11, 2010, and the deposit delayed date was Mar. 29, 2010.

For more information, please contact your CPA or our office.

The IRS received many comments on this issue and has been promising action on it for a long time.  As far back as 2007, when the real estate market started heading south in many areas, the IRS wrote Rep. Barney Frank (D-MA) to say that IRS was considering whether it was appropriate for it to extend relief where QIs went bankrupt.  In substantially similar letters written to a number of Washington legislators in mid-2009, the IRS again said it was considering relief measures.

Background.  In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. (Code Sec. 1031 )  Under Code Sec. 1031(a)(3), for a deferred exchange to be treated as tax-free, a taxpayer must identify the replacement property within 45 days of the transfer of the relinquished property and must acquire the replacement property by the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or the due date (determined with regard to extensions) of the taxpayer’s federal income tax return for the year in which the transfer of the relinquished property occurs.  Absent relief, if the statutory timing requirements are met, a taxpayer would have to treat the relinquished property as having been disposed of in a taxable sale or exchange.

The regulations allow a taxpayer to use a QI to facilitate a like-kind exchange. (Reg. §1.1031(k)-1(g)(4))  When a taxpayer uses a QI, generally he will transfer the relinquished property to the QI, who sells the property to a buyer.  The QI then takes the proceeds of the sale of the relinquished property, buys the replacement property, and transfers the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period in Code Sec. 1031(a)(3) and meets the other Code Sec. 1031 requirements, he is treated as having engaged in a like-kind exchange of property with the QI and he will not recognize gain on the exchange.

Victims of the recession and the troubled real estate markets. In Rev Proc 2010-14, IRS says it is aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI but were unable to complete the exchanges within the statutory time period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the relinquished property’s sale proceeds.

The IRS says it’s generally of the view that in such situations, a taxpayer should not have to recognize gain from the failed exchange until the tax year in which he receives a payment attributable to the relinquished property.

Who is entitled to relief. A taxpayer is entitled to relief under Rev Proc 2010-14 if he:

(1) Transferred relinquished property to a QI in accordance with Reg. §1.1031(k)-1(g)(4).

(2) Properly identified replacement property within the identification period (unless the QI default occurs during that period).

(3) Did not complete the like-kind exchange solely because of a QI default involving a QI that becomes subject to a bankruptcy proceeding or a receivership proceeding under federal or state law.

(4) Did not, without regard to any actual or constructive receipt by the QI, have actual or constructive receipt of the proceeds from the disposition of the relinquished property or any property of the QI before the QI entered bankruptcy or receivership. For purposes of this condition, relief of a liability under the exchange agreement before the QI default, either through the assumption or satisfaction of the liability in connection with the transfer of the relinquished property or through the transfer of the relinquished property subject to the liability, is disregarded.

Relief provisions. Rev Proc 2010-14, Sec. 4, provides that a taxpayer meeting the above conditions recognizes gain on the disposition of the relinquished property only as required under the safe harbor gross profit ratio method, and only as he receives payments attributable to that property.

Under the safe harbor gross profit ratio method, the portion of any payment attributable to the relinquished property that is recognized as gain is found by multiplying the payment by a fraction, having the taxpayer’s gross profit as the numerator, and having the taxpayer’s contract price as the denominator. For this purpose:

• A payment attributable to the relinquished property means a payment of proceeds, damages, or other amounts attributable to the disposition of the relinquished property (other than selling expenses), whether paid by the QI, the bankruptcy or receivership estate of the QI, the QI’s insurer or bonding company, or any other person. Unless it exceeds adjusted basis, satisfied indebtedness is not a payment attributable to the relinquished property.
• Gross profit means the selling price of the relinquished property, minus the taxpayer’s adjusted basis in it (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
• The selling price of the relinquished property is generally the amount realized on its sale, without reduction for selling expenses. But if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver specifies, by the end of the first tax year in which the taxpayer receives a payment attributable to the relinquished property, an amount to be received by the taxpayer in full satisfaction of his claim, the selling price of the relinquished property is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
• The contract price is the selling price of the relinquished property minus the amount of any satisfied indebtedness not in excess of the property’s adjusted basis. Satisfied indebtedness means any mortgage or encumbrance on the relinquished property that was assumed or taken subject to by the buyer or satisfied in connection with the transfer of the relinquished property.

Rev Proc 2010-14, Sec. 4, has detailed rules covering situations involving satisfied indebtedness exceeding adjusted basis, recapture income, and imputed interest.

A Code Sec. 165 loss deduction may be claimed for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of (1) the payments attributable to that property (including satisfied indebtedness in excess of basis), plus (2) the amount of any satisfied indebtedness not in excess of basis. Those claiming a loss deduction may also claim a Code Sec. 165 loss deduction for the amount of any gain recognized in accordance with Rev Proc 2010-14, Sec. 4, in a prior tax year.

Illustration: Mr. Able, a calendar year taxpayer owned investment property (Property 1) with a fair market value of $1.5 million and an adjusted basis of $500,000.  He entered into an agreement with QI to facilitate a deferred like-kind exchange. On May 6, Year 1, Able transferred Property 1 to QI and QI transferred the property to a third party in exchange for $1.5 million. Able intended that the QI use the money held by it to acquire Able’s replacement property. On June 1, Year 1, Able identified Property 2 as replacement property. On June 15, Year 1, QI notified Able that it filed for bankruptcy protection and could not acquire replacement property. As a result, Able failed to acquire Property 2 or any other replacement property within the exchange period. As of December Year 1, QI’s bankruptcy proceedings are on-going and Able has received none of the $1.5 million proceeds from QI or any other source.

On July 1, Year 2, QI exits from bankruptcy and the bankruptcy court approves the trustee’s final report, which shows that Able will be paid $1.3 million in full satisfaction of QI’s obligation under the exchange agreement. Able receives the $1.3 million on August 4, Year 2 and does not receive any other payment attributable to the relinquished property.

Under Rev Proc 2010-14, Able is not required to recognize gain in Year 1 because he did not receive any payments attributable to the relinquished property in that year. He recognizes gain in Year 2, as follows:

… His selling price is $1.3 million, i.e., the payments attributable to the relinquished property (the amount specified by the trustee before the end of the first tax year in which he receives a payment attributable to the relinquished property).

… His contract price also is $1.3 million because there is no satisfied or assumed indebtedness.

… His gross profit is $800,000 (the selling price of $1.3 million less his $500,000 adjusted basis).

… His gross profit ratio is 80/130 (gross profit over the contract price).

… Able’s recognized gain in Year 2 is $800,000 (the $1.3 million payment attributable to the relinquished property multiplied by the gross profit ratio (80/130)).

Even though the payment attributable to the relinquished property ($1.3 million) is less than the $1.5 million that the QI received, Able is not entitled to a Code Sec. 165 loss deduction because the payment attributable to the relinquished property exceeds his adjusted basis in the relinquished property ($500,000). (Rev Proc 2010-14, Sec. 4.10, Ex. 1)

Rev Proc 2010-14 carries four other detailed examples illustrating nuances of the new safe-harbor relief.

Effective date of relief. Rev Proc 2020-14 is effective for taxpayers whose like-kind exchanges fail due to a QI default occurring on or after January 1, 2009.  A taxpayer who is within the scope of Rev Proc 2020-14 may, subject to the Code Sec. 6511 limitations on credit or refund, file an original or amended return to report a deferred like-kind exchange that failed due to a QI default in a tax year ending before January 1, 2009, in accordance with Rev Proc 2010-14.

Supreme Court of the United States of America

The Supreme Court has declined to review a Ninth Circuit holding that a taxpayer could not avoid the Code §1031 like-kind-exchange related-party rule by using a qualified intermediary (QI). Teruya Brothers, Ltd. & Subsidiaries , (CA 9 2/11/2009) 104 AFTR 2d ¶ 2009-5345 , cert denied 2/22/2010.

Background. If statutory identification and replacement period requirements are met, gain or loss is not recognized currently on the exchange of property held for productive use in a trade or business or for investment for property of like kind that will be held for productive use in a trade or business or for investment. (Code §1031) QIs may be used to structure like-kind exchanges. However, under Code §1031(f), gain or loss on an exchange between related persons (under Code §267(b) or Code §707(b)(1)) must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. Nonrecognition treatment under the like-kind exchange rules does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule. (Code §1031(f)(4)) However, under Code §1031(f)(2)(C), a disposition will not trigger the related party bar if it is established to IRS’s satisfaction that neither the original transaction nor the later disposition had as one of its principal purposes the avoidance of federal tax.

Facts. Teruya Brothers Ltd. (Teruya) owned 62.5% of the common shares of Times Super Market Ltd (Times), so the two entities were related.  In 1995, in one series of planned transactions, Teruya transferred Real Property 1 to TGE, a QI, which then sold it to an unrelated third party. TGE used the sale proceeds, as well as additional funds from Teruya, to buy like-kind Replacement Property 2 for Teruya from Times, and then transferred Replacement Property 2 to Teruya. In another series of planned transactions, Teruya transferred Real Property 3 to TGE, which sold it to an unrelated party. TGE used the sale proceeds from Real Property 3, plus some cash from Teruya, to buy like kind Replacement Properties 4 and 5 from Times.

Teruya realized a $1.3 million gain on Property 1 and a $10.7 million gain on Property 3. Times realized and recognized a $1.3 million gain on Property 2 and a $2.2 million gain on Property 5, but these gains were offset by a large net operating loss. Times realized a $6.4 million loss on Property 4, but did not recognize it because of the Code §267 related-party restriction on loss recognition.

Teruya treated its transactions as tax-deferred like-kind exchanges under Code §1031, but IRS said the transactions ran afoul of the Code §1031(f)(4) related-party rule and hit Teruya with a $4 million deficiency.

Tax Court. In 2005, the Tax Court held that the transactions were economically equivalent to direct exchanges of properties between Teruya and Times (with boot from Teruya to Times), followed by the sales of the properties by Times to unrelated third parties. The interposition of a QI couldn’t obscure the end result.

Observation: In 2009, the Tax Court applied its Teruya reasoning and decision to rule against another taxpayer on the QI- Code §1031(f) issue (see Ocmulgee Fields, Inc., (2009) 132 TC No. 6).

Ninth Circuit. In 2009, the Ninth Circuit concluded that the Tax Court did not err in determining that the transactions were structured to avoid the purposes of Code §1031(f)(4). It rejected Teruya’s contention that the economic consequences of the transactions to Times were irrelevant, and that Teruya’s continued investment in real property was dispositive. Code §1031(f)(1)(C)(i) disallows nonrecognition treatment if a related party disposes of exchanged property within two years, regardless of whether the taxpayer does as well. Thus, examining the taxpayer and related party’s economic position in the aggregate is often the only way to tell if Code §1031(f) applies.

The legislative history indicating Congress’s desire to bar like-kind exchange treatment where related parties have, in effect, cashed out of the investment, confirmed that a taxpayer and a related party should be treated as an economic unit to see if Code §1031(f) applies. The Ninth Circuit pointed out that the changing economic positions of Teruya and Times readily showed that the related parties used the exchanges to cash out of an investment in low-basis real property. Before the exchanges, Teruya owned Property 1 and Property 3, and Times owned Properties 2, 4, and 5. After the exchanges, Properties 1 and 3 had been sold, Teruya owned Properties 2, 4, and 5, and Times had the cash from the sale of Properties 1 and 3 (along with boot from Teruya). All in all, Teruya and Times decreased their investment in real property by approximately $13.4 million, and increased their cash position by the same amount. By allowing Teruya and Times to cash out of a significant investment in real property under the guise of a nontaxable like-kind exchange, the Ninth Circuit concluded that the transactions were undoubtedly structured to contravene Congress’s desire that nonrecognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.

The Ninth Circuit said Teruya could have exchanged its properties directly with Times, followed by Times’s selling Property 1 and Property 3 to the third-party purchasers, but this would not have had a tax-free result, since direct exchanges between related parties are ineligible for nonrecognition treatment when the exchanged property is sold within two years. Instead, Teruya employed TGE; the latter’s involvement as a QI served no purpose besides rendering simple, but tax disadvantageous, transactions more complex in order to avoid Code §1031(f)’s restrictions.

The Ninth Circuit also affirmed the Tax Court’s conclusion that Code Sec. 1031(f)(4) applied because improper avoidance of federal income tax was one of the principal purposes of the transactions.

Late in 2009, Teruya appealed the Ninth Circuit’s decision to the Supreme Court. However, on February 22, 2010, the Supreme Court declined to review the decision.

For more information on 1031 exchanges, or to ask specific questions regarding the related party rule of §1031, please contact Alexandra L. Hart, CES® at All States 1031 Exchange Facilitator, LLC by e-mail at AHart@AllStates1031.com or McLaughlin & Quinn, LLC Managing Partner and Owner of All States 1031 Exchange Facilitator, LLC Moore McLaughlin, Esq., CPA, CES® by e-mail at FMM@AllStates1031.com or either of them by phone toll-free at 877-395-1031.

Click here for Providence Journal article.

At the new higher rates, 1031 exchanges and other tax-deferral techniques will see a rebound in popularity.  For more information on 1031 exchanges, visit the All States 1031 Exchange Facilitator, LLC website by clicking here.

A self-directed IRA is merely an IRA with the ability to invest in any types of qualified investment. Most IRAs have restrictions on the types of investments that are allowed. These restrictions are in place because the custodian of the IRA, for a variety of reasons, does not want to allow these alternative investments, even though the law clearly allows them.

The only restriction on the type of investment found in the law is that an IRA cannot invest in collectibles, life insurance or own stock of an S corporation. Other than that, it is wide open. People are investing in LLCs that buy leveraged real estate, run start-up companies and buy tax lien certificates.

Care must be taken to avoid so-called prohibited transactions and dealings with disqualified persons, but if these can be avoided, investors can realized enormous returns on thier investments, on an after-tax basis.

I will be writing more about self-directed IRAs in the near future in an attempt to spread the word. Like with 1031 exchanges a few years ago, a signficant number of professionals and investors are still not aware of this very powerful tool.