This was originally published on PAOO on 6/17/10. Note this is the origin of Reilly’s Second Law of Tax Planning.
Commercial Real Estate by Nick Youngson CC BY-SA 3.0 Alpha Stock Images
PMTA 2010-05
PMTA 2010-05 is a reasonably taxpayer-friendly statement. It is, however, reasonable to infer that the affected taxpayers are not exactly jubilant. PMTA stands for Program Manager Technical Assistance. True tax junkies are not satisfied with the various rulings issued by the IRS for public consumption – Revenue Rulings, Revenue Procedures, Notices, etc. We have to use the Freedom of Information Act to eavesdrop when the IRS is talking to itself. Of course Research Institute of America does the heavy lifting. The question that the PMTA addressed was :
Whether the temporary pooling of funds on a non-pro rata basis and the appointment of a tenant-in-common owner (“TIC Owner”) as a payment and/or communications agent because of the bankruptcy of the master tenant will cause the tenants-in-common to become partners in a partnership for federal income tax purposes?
The answer was no. With typical IRS hedging, the no was qualified with the assumption that the arrangements weren’t actually partnerships, to begin with.
I suspect that there are many sad stories hidden behind this ruling. The TIC structure is a creature of tax law. The most general rule of tax law is that when you exchange one thing for something else, you recognize gain if any. There are of course exceptions. Several of them are collected in Part III of Subchapter O under the heading “Common Non-Taxable Exchanges” including Section 1031 which calls for non-recognition of gain or loss when the properties exchanged are of “like-kind”. Of course, exceptions wouldn’t be real exceptions if they didn’t have their own exceptions. Among the items that cannot be on either side of a qualified like-kind exchange along with stocks, bonds, animals of different sexes, and “choses in action”(whatever they are) are interests in a partnership.
The 1031 exception is particularly significant in real estate because, for the most part, all real estate in the United States is like-kind to all other real estate in the United States. So if you trade your stallion for a broodmare that is not like-kind, but if you trade your horse farm for an office building it is. You can even exchange your whole horse farm for part of an office building. Which is where the partnership thing comes in. What is the difference between a piece of real estate owned by diverse persons and a partnership of diverse persons that owns a piece of real estate? Such questions keep tax attorneys awake at night and also well fed. Revenue Procedure 2002-22 tells you the conditions your arrangement must meet to be worthy of asking the IRS to rule that it is not a partnership.
That revenue procedure was part of the birth of a veritable industry. Someone selling rental or investment property had always had the opportunity to structure the sale as an exchange by inserting a third party facilitator and is even allowed time after selling the initial property to identify to the facilitator (45 days) the replacement property and for the facilitator to acquire the property (lesser of 180 days or the extended due date of the taxpayer’s return). Someone tired of being a landlord might however view that as exchanging one headache for another. By having a TIC interest as their target there was a broader range of properties available and there would be someone else to deal with all the tenant problems and repairs. Someone else to go bankrupt and leave the TIC members holding the bag.
The saddest part in the PMTA is the reference to the fact that there will be non-pro-rata cash contributions. Reading between the lines one can infer that some of the owners are a bit resentful at having to kick money in to straighten out the mess that they have landed in.
A couple of observations and then a moral. Even if the subsequent events converted the TICs into partnerships, this should not affect the validity of the like-kind exchanges that had the TIC’s as their targets. Presumably, the investors did not have the master tenant’s bankruptcy as part of their plans, They might want the ruling anyways since preparing a partnership return in these circumstances would be somewhat challenging. Since 1031 defers both losses and gains, some investors might want to argue that the arrangement really was a partnership, to begin with and the partnership interest they received was worth less than their basis in their relinquished properties. That would be a real tough argument to make though,
The moral is that tax savings are money. If buying something allows you to save taxes then the thing that you buy doesn’t cost you as much. It doesn’t make it free. And it is possible that, even with the discount that the tax savings create the thing is not worth what you are paying for it. I might go so far as to speculate that if the thing is designed with tax savings in mind that the designer feels entitled to a goodly share of your tax savings. In some cases, it might be your tax savings and then some. In which case, as the title says, it would be better to have just paid the taxes.
Oh by the way :
Any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.