Three Recent Developments

"A newsletter devoted to the education of those involved in section 1031 exchanges"

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THREE RECENT DEVELOPMENTS

Congress and the IRS have recently taken action that significantly affects §1031 exchanges. Congress and the President enacted the Jobs and Growth Tax Relief Reconciliation Act of 2003 affecting depreciation of the replacement property acquired in a §1031 exchange. In December 2002, the IRS issued Revenue Ruling 2002-83 regarding exchanges between related parties. In May of this year, the IRS released Revenue Ruling 2003-56 providing guidance relating to liability relief in §1031 exchanges by partnerships. All three of these recent developments have a considerable impact on §1031 exchanges.

1. Depreciation Under the 2003 Tax Act

The 2003 Tax Act increases the special first-year bonus depreciation for certain qualifying property from 30% to 50%. A question had existed as to how to apply the bonus depreciation to §1031 replacement property. The IRS had previously indicated that the 30% deduction only applied to the "boot" paid to acquire the replacement property.

The 2003 Act Committee Report clarifies that the entire depreciable basis of qualifying property acquired in a like-kind exchange qualifies for the 30% or 50% depreciation deduction.

Although this Committee Report provides clarification as to bonus depreciation, questions still exist regarding other depreciation issues. In Notice 2000-4 the IRS provided guidance for taxpayers who acquire MACRS property in exchange for MACRS property in a §1031 exchange. The acquired MACRS property should be treated in the same manner as the exchanged MACRS property, to the extent that the taxpayer's basis in the acquired property does not exceed the adjusted basis in the exchanged property. Thus, the acquired MACRS property is depreciated over the remaining recovery period of, and using the same method as that of, the exchanged MACRS property. Any excess basis in the acquired property is treated as newly purchased MACRS property. A taxpayer must follow the principles set out in Notice 2000-4 for acquired MACRS property placed in service after January 2, 2000, in a like-kind exchange. The Treasury intends to issue regulations under §168 that will further address these transactions.

For acquired MACRS property placed in service before January 3, 2000, in a like-kind exchange, the IRS will allow a taxpayer to continue to use certain methods of depreciating the acquired property. However, a taxpayer presently treating the acquired property as newly purchased MACRS property may change to treating the property under the principles in Notice 2000-4, provided the property has been treated by the taxpayer as acquired in a like-kind exchange and the change is made for the first or second taxable year ending after January 3, 2000.

Notice 2000-4 does not address how depreciation expense for the year is allocated between the relinquished property and the replacement property.

Please contact one of our tax attorneys if you or your clients have any questions regarding the proper approach for depreciation. Also, be sure to check our website regularly for updates.

2. Exchanges Between Related Parties

On December 9, 2002, the IRS published Revenue Ruling 2002-83 on related party exchanges in an attempt to clarify the circumstances under which a taxpayer would be considered to have structured a transaction to avoid the related party rules of §1031(f)(1). The general rule regarding exchanges between related parties is that each party must hold their replacement property for at least two years, otherwise the gain is recognized by both parties in the tax year of the disqualifying disposition. For further discussion, see our website newsletter entitled "Related Parties."

In order to prevent a circumvention of this general rule, §1031(f)(4) was enacted to nullify indirect transfers, the purpose of which is to avoid the related-party rules.

Prior to the issuance of this latest ruling, the IRS had made several pronouncements setting forth their position. Meanwhile, taxpayers were devising more creative transactions which involved related parties.

The IRS, in this new ruling, states that a 1031 exchange structured through the qualified intermediary safe harbor set forth in the regulations will fail if the replacement property is acquired from a related party. The IRS disqualifies this transaction broadly without a consideration as to the facts and circumstances that resulted in the acquisition from the related party.As a result, any exchange that may possibly involve related parties must be scrutinized from the perspective of this new ruling.

Before undertaking any exchange that may involve a related party, please contact one of our tax attorneys to confirm that validity of such a transaction.

3. Exchanges by Partnerships

Partnerships may transact 1031 exchanges. Although §1031 does not apply to partnership interests, no restrictions exist on the ability of partnership to effect §1031 exchanges. In fact, it has been estimated over 10,000 exchanges are effectuated annually by partnerships involving more that $11 billion in property value.

Most of the real estate exchanged by these partnerships was encumbered by debt. Anytime that the §1031 exchange by one of these partnerships involved two tax years, an issue arose regarding the allocation of partnership liabilities under §752 and the receipt of boot under §1031. Until the issuance of Revenue Ruling 2003-56, no guidance existed as to whether the debt relief associated with the relinquished property could be offset by the debt associated with the replacement property.

Revenue Ruling 2003-56 clarifies this issue by answering the following questions - If a partnership enters into a qualifying §1031 exchange in which property subject to a liability is transferred in one taxable year and property subject to a liability is received in the following taxable year, are the liabilities netted for purposes of §752, and if so, when is any net change in a partner's share of partnership liability taken into account?

If a partnership enters into a §1031 exchange, consideration given in the form of the receipt of the replacement property subject to a liability (replacement liability) is offset against consideration received in the form of the transfer of the relinquished property subject to a liability (relinquished liability) in determining the amount of boot received in the exchange that is used to calculate gain recognized. If the exchange straddles two taxable years of the partnership, the amount of the relinquished liability that exceeds the amount of the replacement liability is treated as boot received in the first taxable year of the partnership, since the excess is attributable to the transfer of the relinquished property subject to the relinquished liability in that year. In addition, any gain resulting from the receipt of boot in the first taxable year of the partnership must be recognized and reported in that year.

The liability offsetting rule also is taken into account for purposes of determining the amount of any decrease in a partner's share of partnership liability, which is treated as a deemed distribution of money to the partner. Accordingly, if a partnership enters into a §1031 exchange that straddles two taxable years of the partnership, each partner's share of the relinquished liability is offset with each partner's share of the replacement liability for purposes of determining any decrease in a partner's share of partnership liability. Any net decrease is taken into account in the first taxable year of the partnership since it is attributable to the transfer of the relinquished property subject to the relinquished liability in that year.

Any deemed distribution of money to the partners in the first taxable year of the partnership is treated as an advance or drawing of money to the extent of each partner's distributive share of partnership income for that year. For this purpose, any gain recognized by the partnership from the net decrease in liability resulting from the exchange is included in the partners' distributive share of partnership income for the first taxable year of the partnership. An amount treated as an advance or drawing of money is taken into account by the partners at the end of that year.

In addition, if a partner's share of the replacement liability exceeds the partner's share of the relinquished liability, only the net increase in liability is taken into account for purposes of determining the increase in the partner's share of partnership liability. The net increase is taken into account in the second taxable year of the partnership since it is attributable to the receipt of the replacement property subject to the replacement liability in that year.

In summary, if a partnership enters into a qualifying exchange in which property subject to a liability is transferred in one taxable year of the partnership and property subject to a liability is received in the following taxable year of the partnership, the liabilities are netted for purposes of §752. Any net decrease in a partner's share of partnership liability is taken into account in the first taxable year of the partnership, and any net increase in a partner's share of partnership liability is taken into account in the second taxable year of the partnership.

If you or your clients are considering §1031 exchanges involving partnerships, please contact our tax attorneys to ensure that no unintended tax consequences arise.