Like-Kind Exchanges In A COVID-19 World (And What To Do About The Sharon Mitchell Decision)
Posted in Taxing Matters
Like-Kind Exchanges In A COVID-19 World (And What To Do About The Sharon Mitchell Decision)

COVID-19 is wreaking havoc worldwide. It has even infected the real estate industry, particularly the tax aspects of operating in the real estate industry such as Section 1031 like-kind exchanges.

The basics of like-kind exchanges remain unchanged, notwithstanding COVID-19: No gain is recognized if real property held for productive use in a trade or business or for investment is exchanged solely for real property of a like kind to be held for such purposes. But with deferred and reverse exchanges being the norm and simultaneous exchanges being the exception, it is now virtually impossible to successfully complete a 1031 exchange because the 45-day replacement property identification deadline and the 180-day exchange deadline cannot be satisfied in compliance with the “stay-at-home” orders and social distancing requirements imposed in most jurisdictions throughout California.

IRS Notice 2020-23 helped solve this problem by extending these two deadlines to July 15, 2020 if they otherwise would have expired on or after April 1st and before July 15th. For taxpayers who started their like-kind exchanges by selling the relinquished property between February 16, 2020, and May 31st, the 45-day replacement property identification deadline has been extended to July 15th. And for taxpayers who started their like-kind exchanges by selling the relinquished property between October 4, 2019, and January 16, 2020, the 180-day exchange deadline has been extended to July 15th. Fortunately, California has conformed to the federal relief. See the California Franchise Tax Board's COVID-19 frequently asked questions for tax relief and assistance.

Some members of the tax community are seeking to have the IRS exercise the maximum authorized extension of time permitted under Revenue Procedure 2018-58, the source of “Specified Time-Sensitive Actions” referred to in the Notice. Revenue Procedure 2018-58 would grant extension relief only to those who transferred the relinquished property on or before the date of the federally declared disaster. Be careful what you wish for! If this request is successful, the result may be to deny relief from the 45-day replacement property identification deadline to anyone who commenced their like-kind exchange on or after March 14th.

Unrelated to COVID-19 but potentially as catastrophic, the IRS announced that it has been reexamining the meaning of the term “real property” for 1031 exchange. For almost 100 years, exchanges of real property have been tax-free, and so we have known what real property is for a long time. Why do we need a new definition now? Proposed regulations with the new definition of “real property” for 1031 like-kind exchange purposes could be released soon now that the Office of Management and Budget finished its review of the guidance on April 20th. It generally is not beneficial when the IRS wants to define something that results in tax deferral.

My fear is that the definition will narrow what we thought was real property that could be exchanged on a tax-deferred basis. For example, is the 15% incidental personal property definition in the identification period regulations going to go? An IRS official said in November 2019 that the guidance would be modeled on Treasury regs that have defined real property under other code provision, for example, REIT qualification purposes. That is encouraging, but we won’t know until the release of the proposed regulations. Keep your fingers crossed – and clean and away from your face.

Also unrelated to COVID-19 but equally misunderstood is the recent decision of the California Office of Tax Appeals in Sharon Mitchell. California’s Franchise Tax Board (FTB) has historically been aggressively opposed to swap and drops and drop and swaps in the likekind exchange arena. See, Herman A. Ahlers, California State Board of Equalization, Docket No. 257952 (2005). These are techniques that were popular with some practitioners to separate partners who wanted to sell their partnership’s property but did not want to stay invested together. Over the last few years, however, there have been cases that the FTB has lost (e.g., Rago Development Corporation) challenging the exchange transaction and, with the recent decision of the Office of Tax Appeals in Sharon Mitchell, California (and presumably the FTB) has apparently done a 180.

Many tax practitioners are heralding the Sharon Mitchell decision as the greenlight to resume drop and swaps as a means to completing a like-kind exchange when some partners want to cashout, others want to exchange into their own property without partners and the remainder want to exchange and stay together.

My advice to you is “DO NOT BELIEVE IT!” and “DO NOT DO IT!” First, you should note that the Sharon Mitchell decision is “nonprecedential”. Second, it was decided 2-1 with a very strong and, in my view, properly reasoned dissent. Read the dissenting opinion in Sharon Mitchell and be guided by it. But, most importantly, the IRS will not follow the result of Sharon Mitchell and instead will attack, and I believe successfully attack, your like-kind exchange. The structure of the like-kind exchange in Sharon Mitchell was a perfect example of how best to do it wrong! So, if you think you’re home free with Sharon Mitchell, you may indeed save your 13.3% California tax after a costly fight with the FTB, but you will certainly incur federal taxes on your realized gain of 20% or 23.8% (plus interest and penalties). And, as they say in the world of like-kind exchanges, that is not a good trade!

Further commentary on the tax relief provisions of the CARES Act that may impact the real estate industry can be found here on ECJ's website.

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