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.

As a tax attorney and CPA, I have studied the federal Internal Revenue Code extensively over the course of the last 20 years. Some people may tell me to get a life and that I could not have possibly chosen a more boring or inane field of study.

For my entire life, I have always loved puzzles. My mom tells my two young sons how good I was at solving puzzles as a kid. I think of the Internal Revenue Code as a puzzle, a big complex and multi-faceted puzzle. My understanding of this puzzle started to develop in great detail during my studies at New York University while obtaining my Masters of Law in Taxation. In particular, famed tax expert Prof. Martin Ginsberg taught my class on tax policy. For the first time, I started to see how the Internal Revenue Code is used not merely for the purpose of raising revenue for the federal government, but for social engineering.

If the sole purpose of the Internal Revenue Code was to raise money for the government to spend, then a flat tax, with no or few deductions, would seem to be appropriate. Perhaps that was the idea when the U.S. constitution was amended to allow the income tax. Now, however, things have changed. And, I don’t see them going back.

Here are some examples of social engineering through the tax laws. Some lawmaker determined that Americans should own their own homes and that the tax law should punish those that don’t. To impose this idea, homeowners can take tax deductions for interest and real estate taxes on their homes while renters, who pay these same costs indirectly, cannot. Another example is the credit for day care expenses for children. Where is the credit for stay-at-home moms? There are only about a million more examples.

These days the tax laws are so complicated that even the Treasury Secretary and other high-level administration officials cannot even understand and comply with the rules. How can the average person or business owner be expected to? Removing the social engineering provisions and other Congress-blessed goodies would be a good first step in the right direction.