The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In PLR 201302009, the IRS ruled that a taxpayer's assignment of its rights in its transfer agreement with lenders to a qualified intermediary would be a transfer of relinquished property for purposes of determining whether there is an "exchange of property held for productive use in a trade or business or for investment" under §1031; notwithstanding that the fair market value of the property was less than the principal amount of the outstanding nonrecourse debt. This private letter ruling is the first ruling to expressly authorize the use of a like-kind exchange for over encumbered property.
Pursuant to §1031, a taxpayer may generally exchange property that has been used productively in a trade or business or held for investment for other like-kind property used in a trade or business or held for investment property without recognizing the taxable gain on the sale of the property. In order to fully defer the gain, a taxpayer must acquire the replacement property that is equal to or greater than the value of the relinquished property.
Section 1031(a)(3) provides that like-kind non-recognition treatment may be extended to deferred transactions otherwise meeting the like-kind exchange requirements, if the replacement property is received within 180 days of the date the relinquished property is transferred. In a deferred exchange, under Regs. §1.1031(k)-1(f), the taxpayer is prohibited from actually or constructively receiving the sale proceeds ("exchange funds") until the exchange has been completed. However, there is a safe harbor provision under Regs. §1.1031(k)-1(g)(4) where a qualified intermediary (QI) is permitted to hold the exchange funds for the benefit of the taxpayer during the exchange process and to disburse funds for purchase of the replacement property and return any unused portion of the funds to the taxpayer at the end of the exchange. Regs. §1.1031(k)-1(g)(4)(iii) provides that a QI is a person who (i) is not the taxpayer or a disqualified person with respect to the taxpayer under Regs. §1.1031(k)-1(k) and (ii) enters into a written exchange agreement with the taxpayer and, in accordance with that agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property and transfers the replacement property to the taxpayer.
Taxpayer, a limited liability company treated as a partnership for federal income tax purposes, was the sole member of another limited liability company (LLC), a disregarded entity. LLC owned a complex, which it used in its trade or business. Taxpayer refinanced existing mortgages and encumbered the buildings in complex with 10-year nonrecourse loans issued by Lenders. Because the current fair market value of complex was less than the outstanding principal debt, Taxpayer negotiated to transfer title of complex, subject to the debt, to lenders pursuant to a transfer agreement.
Taxpayer proposed to enter into an exchange agreement with a QI, whereby Taxpayer would assign to a QI its rights in the Transfer Agreement with notice being given to Lenders. Taxpayer would then enter into a contract for the acquisition of the replacement property and the rights will be assigned to the QI with notice being given to the seller of the replacement property. The replacement property will then be acquired with cash and/or debt.
The IRS ruled that Taxpayer's assignment of its rights in the Transfer Agreement to a QI will be a transfer of relinquished property for purposes of determining whether there is an "exchange of property held for productive use in a trade or business or for investment" under §1031(a), notwithstanding that the fair market value of the complex was less than the principal amount of the outstanding nonrecourse debt.
Prior to this ruling, practitioners were concerned that the IRS would rule that a §1031 like-kind exchange requires a transfer of property, and there is no such property transfer where there is no net value. Although private letter rulings are not binding authority, this ruling gives practitioners some assurance that like-kind exchange in lieu of a foreclosure would be respected if all other conditions for a like-kind exchange are satisfied.
For more information, in the Tax Management Portfolios, see Levine, 531 T.M., Taxfree Exchanges Under Section 1031, and in Tax Practice Series, see ¶1510, Like-Kind Exchanges.
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