Staying Even With Property Transfers
Death and taxes are still a certainty in life, but some property transfers fare better than others when it comes to the Internal Revenue Service (IRS). Of course, property transfers between owners can occur in a variety of ways and for a variety of reasons, so two recent developments help clarify the tax implications of transfers.
Transfer to Satisfy Debt
In 1939, Congress enacted the first statute dealing directly with income from the discharge of indebtedness. Under current law, §108 of the Internal Revenue Code generally allows some taxpayers to exclude cancellation-of-indebtedness (COD) income from their gross income. Taxpayers receive COD income whenever they transfer property to a creditor in satisfaction of all or part of a debt and the value of the debt exceeds the value of the transferred property. Taxpayers can exclude this income from their gross income if the transfer is either a discharge as part of a Chapter 11 bankruptcy case or if the taxpayer is insolvent.
In June 1994, the Tax Court ruled in Gehl v. Commissioner, 102 T.C. 784 (1994), that transferring property in satisfaction of a debt is not necessarily tax-free because transfers of this type may generate taxable gain in addition to COD income.
In Gehl, the taxpayers were in debt for approximately $150,000 on a recourse note. According to a restructuring agreement, the taxpayers paid a small amount of cash and transferred two parcels of property to satisfy the debt. The two parcels of transferred property had a total fair market value of approximately $117,000 and a basis of approximately $46,000. The taxpayers were not debtors under Chapter 11, but they were insolvent both before and after the transfer. The taxpayers treated the entire gain realized through the exchange as COD income, which they excluded from their income under §108.
The IRS agreed that the difference between the debt and the fair market value of the surrendered properties represented COD income which could be excluded by insolvent taxpayers. However, the IRS argued that the taxpayers must recognize income on the exchange for the properties' built-in gain (the fair market value over the adjusted basis) because the transfer to the creditor constituted a sale or exchange of property. The taxpayers claimed the entire amount should be treated as COD income because they received nothing of value from the gains on the property.
The Tax Court agreed with the IRS, saying that the entire gain should be bifurcated into its two separate elements before determining tax treatment. The court also concurred that the transfer of the property in satisfaction of a debt represents a sale or exchange of the debtors' assets. Consequently, any built-in gain on such property is distinct from the gain on the canceled debt.
The court gave the following checklist for the characterization and possible bifurcation of any gain or loss:
- Is there a gain or loss on the property?
- Is there cancellation-of-indebtedness income?
- Can the COD income be excluded from the taxpayer's income based on §108?
Simplification of Family Property Holdings
In PLR 9439007, the IRS responded favorably to a taxpayer's proposal to simplify real estate holdings and make the transaction exempt from taxes. The taxpayer and related parties owned undivided interests in different tracts of land. The ownership of the properties was fragmented, which impeded the owners from pursuing their separate objectives for development and complicated the related settlement of the family and estate affairs.
The taxpayers proposed that they convey their fractional land interests to an intermediary who would simultaneously transfer back to the taxpayers whole interests in specific tracts of land. The proposed transaction was structured to comply with the provisions of §1031, which allows taxpayers to not recognize gain or loss on the exchange of like-kind property. To comply with §1031, the taxpayer established seven points.
- All the relinquished properties were held either for investment or use in a trade or business.
- All the replacement properties will be held either for investment or use in a trade or business.
- The qualified intermediary will acquire legal title to all exchange properties and then transfer the properties to the appropriate parties for replacement.
- The exchange properties will not be subject to any liens or encumbrances that the parties will assume.
- The taxpayer owns the property with the power to hold, manage control, sell, transfer, assign, invest, or reinvest it, or any part or portion.
- Only property of like kind will be exchanged.
- The value of the relinquished property of each of the other parties will be nearly equal to the value of the respective replacement property.
Additionally, neither the taxpayer nor a disqualified person could serve as the intermediary, and the intermediary must perform the transfer according to a written agreement with the taxpayer.
The regulations define a disqualified person as someone who is the agent of the taxpayer at the time of the transaction. A person who has acted as the taxpayer's employee, attorney, accountant, investment broker, or real estate agent or broker within the two-year period preceding the first exchange is treated as an agent of the taxpayer at the time of the transaction. Two exceptions exclude people who have provided services for other §1031 transactions, as well as a financial institution, title insurance company, or escrow company that provided routine financial, title insurance, escrow, or trust services for the taxpayer.
Furthermore, the written agreement must give the qualified intermediary legal title to the transferred properties and replacement properties. The IRS ruled that the simultaneous transfer involving a qualified intermediary would be treated as an exchange, and consequently the transfer would qualify for nonrecognition of gain or loss.
However, the IRS cautioned in a footnote to its ruling that the value of the relinquished and replacement properties must be approximately the same. Otherwise the transaction would not qualify for nonrecognition treatment. Additionally, the IRS warned of the implications of §1031(f) because the taxpayers were related. Under this provision of the code, the IRS will recognize gain or loss if taxpayers are related and one of them disposes of received property within two years of the last transfer. §1031(f)(2) allows exceptions for the following dispositions:
- the death of the taxpayer or the related person;
- a compulsory or involuntary conversion;
- a disposition that convinces the Treasury Secretary that neither the exchange nor the disposition had as one of its principal purposes the avoidance of federal income tax.