Exchange With Caution
Understand the possible 1031 tax repercussions of IRC Section 470.
Congress addressed what it considered to be abusive sale-leaseback transactions involving tax-exempt entities, known as sale-in, lease-out, or SILO transactions, by creating Internal Revenue Code Section 470 as part of the American Jobs Creation Act of 2004. While Section 470 was enacted more than a year ago, commercial real estate professionals still are discovering the substantial and potentially adverse effects this statute may have on certain tax-deferred exchanges.
Section 470 created new limitations on the deductibility of losses relating to tax-exempt use property. With limited exceptions, Section 470(a) provides that a tax-exempt use loss for any taxable year is not allowed. Therefore, with respect to any taxable year, the amount by which the sum of the aggregate deductions other than interest directly allocable to tax-exempt use property, plus the aggregate deductions for interest properly allocated to the property, exceeds the aggregate income from the property would not be deductible. Any disallowed loss is treated as a deduction with respect to the property in the next taxable year and ultimately is allowed upon the taxable disposition of the property.
Property is considered to be tax-exempt use property if it is leased to a tax-exempt entity including charitable organizations, qualified employee benefit plans, certain foreign persons and entities that are not subject to income tax with respect to the property, and most governmental bodies.
If any property that is not otherwise tax-exempt use property is owned by a partnership that has both a tax-exempt entity and a person who is not a tax-exempt entity as a partner and any allocation to the tax-exempt entity of partnership items is not a qualified allocation, an amount equal to the tax-exempt entity's proportionate share of the property generally is treated as tax-exempt use property. Therefore, Section 470 is applicable to real estate investments that include tax-exempt partners.
In commercial real property, tax-exempt use property means the portion of the property that is leased to a tax-exempt entity in a disqualified lease, which is a lease that meets any of the following conditions:
- tax-exempt debt was used directly or indirectly to finance all or a portion of the property;
- the lease includes either a purchase or sale option at a fixed or determinable price;
- the term of the lease is in excess of 20 years; or
- there is a sale-leaseback with respect to the property.
As a general exception, nonresidential real property is not treated as tax-exempt use property unless more than 35 percent of the property is leased to tax-exempt entities.
The principal effect of Section 470 on 1031 exchanges is found in Section 470(e), which provides that Section 1031(a) and Section 1033(a) are not applicable to provide nonrecognition of gain (or loss) if the exchanged or relinquished property is tax-exempt use property subject to a lease that was entered into before March 13, 2004, and that would not have met the requirements for an exempt lease under Section 470(d) had such requirements then been in effect.
In addition, it stipulates that Section 1031(a) and Section 1033(a) are not applicable to an exchange if the replacement property is tax-exempt use property subject to a lease that is not an exempt lease under Section 470(d). Accordingly, every investor that acquires leased replacement property in a Section 1031 exchange now must determine whether there are any tax-exempt users of the property, and if so, determine if the leases satisfy the requirements of Section 470(d). Leases that meet the following criteria are considered exempt.
Available Funds. The tax-exempt lessee may not have more than an allowable amount of funds subject to either any arrangement described below or any arrangement by which a reasonable person would conclude that funds were set aside or were expected to be set aside. The term arrangement includes a defeasance arrangement, a loan by the lessee to the lessor or any lender, a deposit arrangement, a letter of credit collateralized with cash or cash equivalents, a payment undertaking agreement, prepaid rent, a sinking fund arrangement, a guaranteed investment contract, financial guaranty insurance, or any similar arrangement by which the tax-exempt lessee monetizes its lease obligations. An allowable amount of funds is generally equal to 20 percent of the lessor's adjusted basis in the property on the date it enters into the lease.
Substantial Equity Investment by Lessor. The taxpayer must make and maintain a substantial equity investment in the property. Under Section 470(d)(2), a taxpayer does not make or maintain the requisite investment unless on the date the lease is entered into the taxpayer makes an unconditional at-risk equity investment in the property of at least 20 percent of the taxpayer's adjusted basis in the leased property and the taxpayer maintains that equity investment throughout the lease term. Further, at all times during the lease term, the fair-market value of the property at the end of the lease term is reasonably expected to equal at least 20 percent of its initial value.
Minimal Risk of Loss for Lessee. There is no arrangement under which the lessee bears any portion of the loss that would occur if the fair-market value of the leased property were 25 percent less than its reasonably expected fair-market value at lease termination or more than 50 percent of the loss that would occur if the fair-market value of the leased property at the time the lease is terminated were zero.
Purchase Option. If the property has a class life of more than seven years and if the lessee has an option to purchase the property, the purchase price must equal the fair-market value of the property at the time the option to purchase is exercised.
If the requirements are satisfied, the lease is exempt and does not preclude nonrecognition under Section 1031.
In summary, Section 470 creates yet another tax trap for the unwary. Although it was designed to correct what is considered by most to be abusive transactions, as enacted Section 470 has a much broader effect.