Page 20AA —
COLORADO REAL ESTATE JOURNAL
— December 17, 2014-January 6, 2015
Professional Services
W
hen I review the
tax returns of indi-
viduals who are
active investors in real estate
partnerships, it is not unusual
to find investments that have
been held for quite some time,
well past the intended invest-
ment life.
This is often an indicator that
they have a “burnt-out” real
estate investment; an invest-
ment that is limping along
but really doesn’t have much
prospect of recovery. It runs
counter to most investors to
consider abandoning an asset,
but with burnt-out partnership
interests, it might be the only
way to recoup at least some of
the investment in the form of
tax losses. I will speak first to
an issue I see often in the real
estate context and then brief-
ly cover other situations that
could be equally beneficial.
If you have a real estate
investment in which you are
passive – either as a limited
investor or an investor in for-
rent real estate – where the
investment has, shall we say,
“not gone well,” you likely
have the following scenario.
You have received K-1s year
after year with substantial loss-
es, which you can’t use because
they are passive to you and
therefore are suspended for tax
purposes until you have pas-
sive income to offset or you
dispose of the asset. As a lim-
ited investor, your options are
often “limited” as well if the
asset has marginal or no value
(assets worth less than the debt
against the property). There are
no buyers for your interest and
the sponsor of the deal will
keep the partnership going as
long as possible. This allows
them to continue to collect fees
and hope against hope that
market forces will bail them
out.
However, they likely can use
the passive losses to offset that
management fee income and
may be faced with phantom
income if they sell the asset.
The lender is predisposed to
pretend and extend (the loan)
to avoid having to take the
property and deal with it on
their
own
time
and
dime. A less
than
ideal
but potential-
ly practical
solution for
the investor
who is out of
the decision-
making loop
and
can’t
force a dis-
position is
to abandon
the asset (the
partnership
interest in this case).
An abandonment of a part-
nership interest is as straight-
forward as notifying the part-
nership that you have conclud-
ed the interest has no value
and you have chosen to relin-
quish the partnership interest.
Obviously, you would not take
this step unless you believe
that statement to be true. The
tax result will be to free up
the suspended passive losses,
making them available to you
to offset ordinary income (the
holy grail of tax planning). If
you have held the investment
for some time, you will like-
ly benefit by some of those
losses offset not by your cash
investment, but by capital gain,
benefiting further from the tax
rate arbitrage inherent in that
result (capital gain offset by
ordinary loss in equal amount).
This results from the likely fact
that much of the passive loss-
es were funded by borrowed
funds, and certainly have been
if they exceed your cash invest-
ment in the deal.
If you have a partnership
interest that you believe to be
worthless and it does not fit
the description of a passive
interest in operating real estate
described above, you may still
be able to create an ordinary
loss.
One approach is to abandon
the asset, claim that it is worth-
less, and treat it as such under
Section 165 of the Internal Rev-
enue Code. The ordinary loss
treatment will hinge on if you
are “at risk” for any partner-
ship liabilities under the part-
nership tax rules.
Failing that, holding the
investment as simply worth-
less (not abandoned) might
allow an ordinary deduction
under Section 165 even if you
are “at risk” for partnership
liabilities. Yes, some research
into your particular situation
is required in these instances to
see if you qualify.
You should consult with your
tax adviser before pursuing
any of the concepts discussed
above since the concepts and
calculations are tricky. How-
ever, don’t ignore an asset that
no longer has value; figure out
a way to make it work for you.
Better yet, identify those assets
that in your judgment might
be deemed worthless and ask
your tax adviser to quantify
the tax benefit to you. Remem-
ber, if you intend to abandon a
partnership interest, you must
notify the partnership before
year-end if you want the aban-
donment to benefit your 2014
tax return.
s
Zane Dennis
Tax partner/director
of real estate services,
Richey May & Co.,
Englewood
I
n a delayed exchange
transaction structured
to satisfy the require-
ments of §1031, an exchanger
has up to 180 calendar days
to acquire like-kind replace-
ment property. Once initiated,
the delayed exchange may be
successfully completed (result-
ing in complete tax deferral),
partially completed (resulting
in recognition of some capi-
tal gain) or it may fail if no
like-kind replacement property
is acquired (resulting in the
recognition of all capital gain
generated by the sale).
If the exchange begins in one
tax year and extends into the
subsequent tax year, the ques-
tion arises whether the gain
realized on the sale is recog-
nized in the year in which the
relinquished property was sold
or in the subsequent year in
which the exchanger receives
cash proceeds from the quali-
fied intermediary. In a perfect
world, gain would be recog-
nized in the subsequent year
when the proceeds were actu-
ally received by the exchanger.
In many cases, this turns out to
be wholly or partially true.
The regulations under §1031
treat an exchange as an install-
ment sale to the extent that
the exchanger receives cash or
other non like-kind property
(known as
“boot”) in a
subsequent
tax year. See
Treas. Reg
§1 . 1031 ( k ) -
1(j)(2). The
cash received
from the QI
at the end of
the exchange
is treated as
a payment
in the year
it is actually
received by
the exchanger for purposes
of the §453 installment sale
reporting rules rather than in
the year the relinquished prop-
erty was sold. On the other
hand, any mortgage debt that
is paid off on the sale of the
relinquished property is treat-
ed as a payment in the year
of the sale to the extent the
exchanger does not incur an
offsetting liability in its acqui-
sition of replacement property.
Nevertheless, the tax deferral
afforded by the coordination
of §1031 and §453 can produce
a significant advantage where
gain must be recognized as the
result of a wholly or partially
failed exchange; sort of a heads
I win, tails you lose tax benefit
in favor of the exchanger.
n
An illustration straddling
2 0 1 4 / 2 0 1 5
tax years.
For example,
suppose an
e x c h a n g e r
i n i t i a t e s
a
§1031
e x c h a n g e
with a QI
by transfer-
ring invest-
ment prop-
erty worth
$900,000 with
no mortgage
debt. The exchanger's QI com-
pletes the relinquished proper-
ty sale on Nov. 20, 2014. On Jan.
15, 2015, the qualified inter-
mediary acquires a like-kind
replacement property with a
fair market value of $600,000
and transfers the replacement
property to the exchanger
together with the remaining
$300,000 in cash boot. In this
example, the exchanger has
completed a partial §1031
exchange and will recog-
nize gain to the extent of the
$300,000 payment received at
the end of the exchange. Under
the installment sale reporting
rules, gain is recognized in the
year of the payment, 2015. Con-
sequently, the capital gain is
reported on the exchanger's tax
return for 2015 (filed in 2016)
and not on the 2014 return for
the year in which the gain was
realized.
n
Bona fide intent.
An
exchanger should not engage
a QI for the principal purpose
of deferring tax under §453 as
§1031 is inapplicable unless
the exchanger has a “bona
fide intent” to complete the
exchange. An exchanger has
a bona fide intent if, based
upon all the facts and circum-
stances at the beginning of the
exchange, it is reasonable to
believe that like-kind replace-
ment property will be acquired
during the exchange period.
The exchangerʼs intent, how-
ever, need not be pure and
there is no requirement that the
exchange be wholly or partial-
ly successful. For example, in
Smalley v. Commissioner 116
TC 29, 2001, a case involving a
failed exchange that straddled
two tax years, the Tax Court
upheld the IRS’s determination
that the replacement property
acquired by the exchanger was
not like-kind. On that basis, the
IRS argued that the exchang-
er’s gain on the sale of the
relinquished property should
be recognized in the year of
the sale. The Tax Court held,
however, that the exchanger
was entitled to installment sale
treatment because he engaged
in the transaction with the
requisite intent notwithstand-
ing his failure to acquire like-
kind property. In this case, the
exchangerʼs bona fide intent
made the difference, at least as
to the deferral afforded under
§453.
An investor contemplating
an exchange in which there
may be some cash boot should
review their situation with
competent tax and/or legal
advisors.
s
Erin Crowley
Colorado division
manager, Asset
Preservation Inc.
Scott Saunders
Vice president, Asset
Preservation Inc.
the property on the down-low,
because Wilson didn’t want the
word to get out to his employees,
many of whom had been with
him for decades, to get wind of
the sale and become worried, he
said.
“I was not allowed to put it on
CoStar or LoopNet or create a
brochure and send it out broad-
ly,” he said.
Instead, he had to contact pro-
spective buyers individually.
“Everyonewho looked at it had
to sign a very strict confidentiality
agreement,” Leino said.
Given the size of the property
Wilson might have been able to
sell it for more if he sold it to a
developer that would raze the
buildings and redevelop it, he
said.
“That’s quite possible,” Leino
said.
“Knowing Charlie, he never
would have sold it to a devel-
oper,” even for more dollars.
In fact, Leino said one person
was interested in buying it who
planned a different use than
White Fence Farm, which would
have meant slashing about half
the staff.
“I know Charlie would have
turned him down,” no matter
what the price, Leino said.
In addition to keeping White
Fence Farm open during Janu-
ary, Leino said he suspects the
new owners also will open on
Mondays.
“Charlie closed it onMonday to
give his staff time off after a busy
weekend,” Leino said.
In addition to the dining area,
“they sell a wide variety of retail,
from clothing and stuffed toys,
jams and jellies and fudge,” Leino
said.
“While you are waiting for din-
ner on a Friday or Saturday night,
the kids can go to the petting zoo
… it’s really fun. Kind of a touch
of Disney in Lakewood,” Leino
said.
Wilson was as picky about the
buyers as he was about the qual-
ity of his chicken dinners.
“It took me a long time to find
the right owner,” Wilson said.
While he spoke to several pro-
spective buyers, “it never felt
right until I met Tom and Craig.”
He said Piercy had childhood
memories similar to his own.
“He understands the joy, chal-
lenges and surprises,” Wilson
said.
“I never wanted this place to
grow stale and old; I needed
someone with enthusiasm and
innovation and these guys
were perfect.”
s
The tax deferral
afforded by the
coordination of
§1031 and §453 can
produce a significant
advantage where gain
must be recognized as
the result of a wholly
or partially failed
exchange; sort of
a heads I win,
tails you lose tax
benefit in favor of
the exchanger.
