Originally published on Forbes.com June 11th, 2014
It is very sad to see someone getting hammered by two non-recognition provisions in the same case, but that is what happened to Frank Blangiardo in a recent Tax Court decision. Code Section 1031 (like-kind exchange) would have helped him avoid recognition of a large capital gain, but a fairly obvious flaw in the execution of his plan threw his transaction outside of the comfortable safe harbor into the howling winds of gain recognition.
Code Section 1041 (Transfer of property between spouses or incident to divorce) worked exactly as it is supposed to, but sadly it worked not for Mr. Blangiardo, but against him. The magic of Section 1041 had worked for Mr. Blangiardo’s ex-spouses, who did not have to recognize gain when he transferred cash to them, but as Rumplestiltskin/Mr. Gold is wont to remark – All magic comes with a price
The price of non-recognition for the ex-spouses was that Mr. Blangiardo did not get additional basis in his property for the $580,000 in cash that he had paid his exes.
Who can be your exchange facilitator?
There are a couple of Internal Revenue Code Sections that have worked their way into common language. Even people who don’t have 401(k) plans probably know what they are and they know that if they want to deduct donations it better be to a 501(c)(3). I believe. though, that there is only one Code Section that is actually used as a verb. That would be Code Section 1031 – Exchange of property held for productive use or investment. Although the applicability of 1031 is much broader, it is probably best known in the real estate industry. 1031 requires non-recognition of gain or loss when qualifying property is exchanged for other qualifying property of like-kind and as long as it is in the United States, most real estate is considered to be of “like-kind” to other real estate. So even though a mare is not like-kind to a stallion, a horse farm might be like-kind to an office building.
When I first learned about like-kind exchanges many years ago, the regulations seemed to always be talking about a couple of farmers exchanging Whiteacre for Blackacre to ease the commuting that their flocks had to do or something like that. Clever tax planners had by then taken the section to new levels. What prevented 1031 from being a powerful tool is the simple fact that it is rare that the person who wants to buy something from you has something that you want to buy. That’s why money was invented. Planners came up with all sorts of ways around this, but probably the best was the “Starker deal” which allowed for an indefinite deferral.
The Deficit Reduction Act of 1984 put in some fairly sharp limits. With a deferred exchange, you only have up to 45 days after the sale of your relinquished property to identify your target property and 180 days (possibly less if you don’t extend your return) to acquire it. In the meantime, the money can be held by a “qualified intermediary”. Getting your own hands sullied by that filthy lucre blows the exchange.
Taxes are complicated and I do my best to simplify things when I can. The important concept about the “qualified intermediary” was that it not be someone who was your agent, since your agent touching the money was as bad as you touching the money. “Qualified intermediary” was to some extent defined negatively. I distilled it to a fairly simple rule. Anybody that a reasonable business person would trust to hold his money and follow his instructions to acquire the replacement property was disqualified. The QI could not be his lawyer, his accountant, his brother or his partner.
The rules spawned something of a mini-industry of exchange facilitators, some of whom turned out to be rather sketchy resulting in disappearing sales proceeds. The IRS kindly agreed that those folks should not have to pay on their failed exchanges, which was probably small comfort. With that said, it is worth noting, that after nearly thirty years, there are plenty of responsible exchange facilitators backed by substantial financial institutions.
Just as an example there is Wells Fargo. I’m not recommending them specifically, although there is no reason I know of that makes them any worse than any of the others. There is a charge, of course, but whenever I have priced it, it has always seemed reasonable. There is probably a bit less flexibility than if you just had your brother holding the money for you, but that is probably the point of the regulations, I would think.
There are still facilitators, some quite substantial, that are a black box. The sales proceeds go in and out comes your replacement property or money if the exchange does not complete. They don’t charge as much as the facilitators that put the money in an insured bank account. In my mind, it is worth it to pay a little extra for the peace of mind.
For some reason or other, the existence of this mini-industry escaped Mr. Balangiardo’s notice or he had some reason for spurning them. He used a lawyer, which would be OK, if the lawyer was not otherwise representing him. Only the lawyer was Mr. Balangiardo’s son – a lineal descendant – and thus not a QI. The Tax Court cut him no slack.
Petitioner also acknowledges that the intermediary used in the transaction was his son. However, petitioner asserts that he meets the requirements of the regulation’s safe harbor because (1) his son is an attorney; (2) the funds from property A were held in an attorney trust account; and (3) the real estate documents refer to the transaction as a section 1031 exchange. We do not accept petitioner’s argument. The regulation is explicit: A lineal descendant is a disqualified person, and the regulation makes no exception based on his/her profession. Consequently, petitioner’s disposition of property A and subsequent acquisition of property B is not a deferred exchange within the purview of section 1031, and he must recognize income on the gain from the sale of property A.
Breaking up is hard to do and sometimes expensive
The other disappointment Mr. Balangdiro faced was that the amounts that he paid his ex-spouses to get clear title to his relinquished property did not affect his basis in the property. This is a subtle trap in marital dissolution.
Petitioner acknowledges that the $580,000 of payments he made to his former spouses were in connection with his divorces. In the context of the exchange transactions between petitioner and his ex-spouses, petitioner is the transferee of whatever interests his ex-spouses had in property A, and each ex-spouse is the transferor of that interest. Petitioner’s first former spouse released her claim to the interest she had in property A in exchange for a $500,000 settlement payment, and his second former spouse released her claims against him for an $80,000 settlement payment. Petitioner asserts that respondent is incorrect in treating these transactions as gifts. But section 1041(b)(1) clearly provides that these transfers are treated as gifts, and section 1041(b)(2) provides that the basis of the transferee of the property is the same as the adjusted basis of the transferor. Consequently, petitioner may not increase his basis in property A by $580,000 of settlement payments.
According to this story Mr. Blangiardo is himself an attorney. He represented himself in Tax Court. I’ll spare you the joke about what kind of a client that makes him. Joe Kristan also covered the case using “When doing a like-kind exchange, keep the kids away.”
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