This article originally appeared in the June 27, 2022, issue of Tax Notes Federal.
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Bradley T. Borden is a professor of law at Brooklyn Law School and principal of Bradley T. Borden PLLC.
In this report, Borden explains the ways in which fixed-price put options disqualify tenant-in-common interests as eligible property in like-kind exchanges under section 1031.
Copyright 2022 Bradley T. Borden.
All rights reserved.
I. Introduction
Owners of real property will go to great efforts to obtain the benefits of section 1031 nonrecognition. That often includes structuring the ownership of co-owned property as a tenancy in common (TIC). The economics of TICs generally are not as attractive as the economics of partnerships or other interests in real property. Consequently, in some arrangements that take the form of a TIC, the co-owners add provisions to their TIC agreements or use side letters to create economics that are inconsistent with TIC classification for federal income tax purposes. As a result, those arrangements are susceptible to challenge by the IRS. An example is an arrangement that results in a sharing of profits or sharing of revenue and expenses in any manner other than in proportion to ownership percentages.
Because the economics of TICs can be undesirable, a person buying into a co-ownership arrangement that is otherwise structured as a TIC may want to have an escape route that permits the easy disposition of a purported TIC interest. That person may seek to obtain a put option that would allow him to divest himself of a purported TIC interest with relative ease, and perhaps at a predetermined price. Before seeking that arrangement, the person should consider the deleterious effect that a fixed-price put option would have on the classification of the co-ownership arrangement and the purported TIC interest as viable section 1031 property.
A fixed-price put option exercisable against a co-owner or manager disqualifies a TIC interest from eligibility as replacement property under section 1031. Such a fixed-price put option strikes against each requirement of section 1031. Failure of any of those requirements would cause a transaction to fail to qualify for section 1031 nonrecognition. When the possibility of failing the requirements is considered in the aggregate, the prospect of a court treating a TIC interest subject to a fixed-price option as valid replacement property is extremely remote.
Classification of arrangement. A co-ownership arrangement that includes an owner with a fixed-price put option exercisable against another co-owner or the arrangement’s manager is not a TIC for federal income tax purposes. That arrangement is either a tax partnership or a financing arrangement.
Tax ownership. Tax ownership does not pass to a person who takes legal title to property and simultaneously obtains a fixed-price put option exercisable against another person who holds a call option that will be exercisable concurrently with the fixed-price put option.
Holding intent. A person who acquires property subject to a fixed-price put option that will be offset by a concurrent call option cannot, at the time of acquisition, establish that the person acquired the property with the intent to hold it for productive use in a trade or business or for investment.
Exchange requirement. A person seeking section 1031 treatment on the acquisition of property subject to a put option would ensure that the put option could be exercised only in exchange for like-kind replacement property.
II. Section 1031: Purpose; Basic Requirements
Section 1031 provides the advantage of deferring gain on the disposition of property in exchange for like-kind property. Congress and the courts understand that the primary purpose for granting nonrecognition of gain or loss to exchanges that satisfy the section 1031 requirements is that they represent a continuation of an investment in like-kind property. Shortly after the predecessor of section 1031 was enacted, a discussion on the House floor between Rep. Fiorello La Guardia and the then-Ways and Means Committee Chair William Green emphasized the formalistic requirement that an exchange require no receipt of cash:
La Guardia: Under this paragraph is it necessary to exchange property? Suppose the property is sold and other property immediately acquired for the same business. Would that be a gain or loss, assuming there is greater value in the property acquired? . . .
Green: If the property is reduced to cash and there is a gain, of course it will be taxed.
La Guardia: Suppose that cash is immediately put back into the property, into the business?
Green: That would not make any difference.1
Further, a 1934 report from the Ways and Means Committee provides:
If the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value.2
From these early congressional statements and the development of section 1031, courts came to understand that “Congress was primarily concerned with the inequity, in the case of an exchange, of forcing a taxpayer to recognize a paper gain which was still tied up in a continuing investment of the same sort.”3 Thus, the purpose of section 1031 is to provide nonrecognition for transactions that result in a continuing investment of the same sort. As the discussion above between La Guardia and Green illustrates, the continuation of investment prohibits even the momentary access to exchange proceeds.
Section 1031 nonrecognition applies to transfers of property held for productive use in a trade or business or for investment in exchange for like-kind property to be held for productive use in a trade or business or for investment.4 Three fundamental requirements derive from this general rule: (1) the exchange requirement; (2) the like-kind requirement; and (3) the holding and use requirement. Section 1031 also denied section 1031 nonrecognition to gain from exchanges of specified disqualified assets, including property held primarily for sale, evidences of indebtedness, and interests in partnerships (the qualified-asset requirement).5 Section 1031(a)(1) provides that no gain or loss is recognized on that transaction. My opinion is based primarily on these four requirements of section 1031: (1) the exchange requirement; (2) the like-kind requirement; (3) the holding and use requirement; and (4) the qualified-asset requirement. The analysis begins with the like-kind and qualified-asset requirements.
A. Like-Kind and Qualified-Asset Requirements
The like-kind requirement and the qualified-asset requirement often serve as two sides of the same coin. Some property on the list of disqualified assets, including an interest in a partnership and evidence of indebtedness,6 most likely would not be like-kind to the real property. The qualified-asset requirement precludes from section 1031 treatment property held primarily for sale,7 securities or evidences of indebtedness or interest,8 and interests in partnerships.9 A central question of every purported TIC interest that is part of an intended section 1031 exchange is whether it is a TIC interest or an interest in a partnership for federal income tax purposes.
If a co-owner has a fixed-price put option exercisable against another co-owner or the arrangement’s manager, the co-ownership arrangement of commercial or residential real property is not a TIC and is either a tax partnership or a financing arrangement.10
1. TIC or tax partnership?
Analyzing whether a purported TIC interest is a TIC interest or an interest in a tax partnership requires considering the definitions of TIC and tax partnership. The definition of tax partnership is one of the most difficult questions of partnership taxation, but some facts, such as a fixed-price put option held by a co-owner, simplify its application.11
The Internal Revenue Code does not provide a workable definition of tax partnership,12 so the definition is supplemented by the regulations.13 Under the regulations, an arrangement with at least two participants that is not a corporation or trust for tax purposes is a tax partnership if it is a “separate entity.”14 The question whether an arrangement is a separate entity is a matter of federal tax law and does not depend on whether the arrangement is recognized as an entity under state law.15 A contractual arrangement generally may create a “separate entity for tax purposes if the participants carry on a trade, business, financial operation, or venture and divided the profits therefrom.”16 However, a mere co-ownership of property does not constitute a separate entity.17 Case law and IRS guidance provide a framework for examining whether an arrangement is a mere co-ownership or a separate entity.
2. Not a TIC.
The IRS provides the following definition of TIC, which includes several elements:
The central characteristic of a tenancy in common, one of the traditional concurrent estates in land, is that [1] each owner is deemed to own individually a physically undivided part of the entire parcel of property. [2] Each tenant in common is entitled to share with the other tenants the possession of the whole parcel and has the associated rights to [3] a proportionate share of rents or profits from the property, to [4] transfer the interest, and to [5] demand a partition of the property. These rights generally provide a tenant in common the benefits of ownership of the property within the constraint that [6] no rights may be exercised to the detriment of the other tenants in common.18
A co-ownership arrangement that includes a fixed-price put option exercisable against another co-owner or the arrangement’s manager lacks the fundamental aspects of a TIC.19 First, as shown below, a party with a fixed-price put option on a TIC interest offset by a market value call option with overlapping exercise periods most likely is not the owner of the TIC interest. Thus, the holder of a fixed-price put option offset by a call option would not own an undivided part of the entire parcel of property.
Second, a fixed-price put option diminishes the rights of other co-owners to share in possession of the whole property. Co-owners of commercial or residential rental property often do not take possession of that property, but they share the right of possession through management arrangements that give co-owners a voice in decisions related to the property.20 Those decisions include who will be tenants, the creation or modification of blanket liens, the hiring of managers and the negotiation of management contracts, and whether to dispose of the property.21 The holder of a fixed-price put option can use the threat of exercising the option to influence the decisions of an option obligor, whether that obligor is a co-owner or manager. If the option obligor is the manager, that person would be inclined to follow the direction of the option holder over direction from other co-owners, diminishing those co-owners’ influence. If the option obligor is another co-owner, the option holder could use the leverage of a fixed-price put option to influence that person’s vote, effectively co-opting that vote. The loss or diminution of a vote restricts the obligor co-owner’s share in possession of the property.
Third, a fixed-price put option eliminates proportionate sharing of a co-owned property’s revenue and expenses. If the property is sold for a value that is less than the exercise price, the option holder would exercise the fixed-price put option. An option obligor co-owner would draw from its share of the sale proceeds to pay the difference between the option price and the value of the option holder’s interest in the property. The option holder’s share of revenue from the sale would equal the exercise price of the option, and the option obligor’s share of revenue from the sale would equal the difference between the option obligor’s share of the proceeds and the exercise price of the option.22 If the manager is the option obligor, the option holder can exercise the fixed-price put option at closing and receive a higher price per owned percentage of the property than the other co-owners, in which case the option holder’s revenue would be disproportionately larger than the other co-owners’ shares. Thus, a fixed-price put option fundamentally affects the revenue sharing of co-ownership arrangements, creating disproportionate profit sharing.
Proportionate sharing of revenue and expenses is critical to the classification of an arrangement as a TIC for tax purposes.23 Thus, the Tax Court found that a co-ownership arrangement was not a TIC and was a tax partnership when “economic benefits to the individual participants were not derivative merely of their coownership” of the property.24 The economic benefits of an arrangement derive from something other than co-ownership of the property if one co-owner holds a fixed-price put option exercisable against another co-owner.
Fourth, if the option obligor is a co-owner, a fixed-price put option impedes its rights to transfer its TIC interest. If the option obligor were to sell its interest and the option holder is unhappy with the new co-owner, the option holder will exercise the fixed-price put option. Thus, the fixed-price put option has a chilling effect on the option obligor’s transfer of interests, negatively affecting its rights to transfer them.
Fifth, if the option obligor is a co-owner, a fixed-price put option hampers that co-owner’s effectiveness to demand partition. If the fair market value of the property is below the option’s exercise price, the option holder could exercise the option when the option obligor demands partition and require the option obligor to pay the difference between the exercise price and the FMV. To avoid that obligation and its effect on the option obligor’s right to benefits of partition, the option obligor would be unlikely to exercise a partition right. Thus, the option holder could effectively stop the option obligor from partitioning the property. If the option obligor moves forward with a partition action and the option holder exercises the fixed-price put option, that exercise fundamentally alters the economic aspects of the partition effort.
Finally, this discussion shows that a fixed-price put option allows one co-owner to exercise rights to the determinant of another co-owner. The option holder can cause that determinant whether the option obligor is a co-owner or manager. Thus, a co-ownership arrangement with a fixed-price put option exercisable against another co-owner or the arrangement’s manager does not come within the definition of a TIC.
To conclude, a co-ownership arrangement of commercial or residential rental property that includes a co-owner with a fixed-price put option exercisable against another co-owner of the arrangement or the arrangement’s manager is not a TIC for federal income tax purposes.
3. Tax partnership.
A co-ownership arrangement with a fixed-price put option exercisable against a co-owner or the arrangement’s manager is most likely a tax partnership. Because co-ownership arrangements are not corporations or trusts, they are tax partnerships if they are separate entities.25 A co-ownership arrangement of commercial or residential rental property with a co-owner who holds a fixed-price put option exercisable against a co-owner or the arrangement’s manager is a contractual arrangement under which the participants (the co-owners and managers) carry on a trade, business, financial operation, or venture and divide the profits therefrom, so it is a separate entity.26 Because that arrangement is a separate entity, it would be classified as a tax partnership for federal income tax purposes.
A co-ownership arrangement that comes within the definition of tax partnership would also be a separate entity taxed as a partnership. Although the courts adopt several tests to determine whether a co-ownership arrangement is a tax partnership,27 to keep the analysis simple, this report adopts courts’ inclination to consider the parties’ intent,28 which often turns to applying multifactor tests.29 Courts appear to understand that to consider whether parties intended to enter into a tax partnership, they must first have a definition of tax partnership. Multifactor tests can serve the purpose of establishing whether an arrangement is a tax partnership.30 Based on that case law, a court would find that the parties intended for an arrangement to be something other than a TIC if it included a fixed-price put option because that arrangement has fundamental characteristics of a tax partnership.
First, a fixed-price put option exercisable against another co-owner or the arrangement’s manager, as explained above, would create a profit-sharing arrangement that differs from proportionate sharing of revenue and expenses. Second, a fixed-price put option creates mutual control over the property that strips TIC possession rights from the option obligor, as explained above, because the option holder can influence the option obligor. Co-ownership of property mixed with sharing of profits and mutual (or common) control is a fundamental aspect of tax partnerships.31
Stated more generally, a fixed-price put option held by one co-owner and exercisable against another co-owner or a manager adds entity characteristics to the arrangement. Entities provide opportunities for members to share risk of loss and profits in ways that differ from the proportionate sharing of those items. For instance, limited partnerships limit the liability of limited partners and give general partners joint and several liability for the obligations of the partnership. Joint ventures often include profit-sharing arrangements that provide preferred returns and capital returns to some members, while other members receive distributions from residual equity.32 A co-ownership arrangement with one co-owner holding a fixed-price put option exercisable against another co-owner or the arrangement’s manager is something akin to a joint venture with a preferred return for some members or a limited partnership. With all these arrangements, some members’ exposure to the downside risk of the arrangement is limited, and other members’ is increased. Thus, a fixed-price put option held by one co-owner and exercisable against another co-owner or the arrangement’s manager makes the co-ownership arrangement a tax partnership.
4. Put option restriction in Rev. Proc. 2002-22.
A market value put option should not cause a co-ownership arrangement to be a tax partnership. A market value put option does not significantly shift the TIC or tax partnership factors toward tax partnership. The holder of a market value put option does not have significant influence over the option obligor because the option obligor would incur relatively little cost to acquire the TIC interest at market value and sell it or to acquire like-kind property of the same value, exchange it with the option holder, and sell the TIC interest on the market.33
When considering whether a syndicated TIC is a tax partnership, the analysis often relies on Rev. Proc. 2002-22, 2002-1 C.B. 733, even though it does not state substantive law. Rev. Proc. 2002-22 provides a set of conditions that the IRS expects taxpayers to satisfy if they seek a private ruling that a proposed TIC arrangement is a TIC.34 Nonetheless, advisers use Rev. Proc. 2002-22 as a roadmap for structuring TIC arrangements, believing that compliance with the conditions in the revenue procedure will satisfy the IRS that the arrangement is a TIC and not a tax partnership.35 There are two reasons for this rationale. First, the IRS listed the conditions, so most observers believe that the IRS would not challenge the classification of an arrangement that satisfies all the conditions. Second, when taken as a whole, the conditions in Rev. Proc. 2002-22 present a conservative view of what constitutes a TIC.36 Experts would not dispute that an arrangement that satisfies all the conditions in Rev. Proc. 2002-22 is a TIC and not a tax partnership.
Because the list of conditions in Rev. Proc. 2002-22 exceeds those required to have a TIC, an arrangement that deviates from some of the conditions in the revenue procedure could still be a TIC. In fact, most practitioners familiar with this area of the law would conclude that some arrangements that deviate from some of the conditions in Rev. Proc. 2002-22 are TICs.37
One of the conditions in Rev. Proc. 2002-22 provides that “a co-owner may not acquire an option to sell the co-owners’ undivided interest (put option) to the sponsor, the lessee, another co-owner, or the lender, or any person related to the sponsor, the lessee, another co-owner, or the lender.”38 The analysis to this point of this report has focused on fixed-price put options, and it establishes that a co-ownership arrangement that includes a fixed-price put option exercisable against another co-owner or the arrangement’s manager would preclude that arrangement from TIC classification for federal income tax purposes. The condition against put options in Rev. Proc. 2002-22 includes all put options, both market value and fixed-priced. The following analysis shows that including a market value put option in a co-ownership arrangement should not preclude the arrangement from TIC classification and would be an acceptable deviation from Rev. Proc. 2002-22. Indeed, the IRS has privately granted TIC classification to an arrangement with a put option exercisable at a price that approximated FMV using an appreciation factor and was exercisable under a contract to transfer property in fractional interests over time.39
The IRS does not state why Rev. Proc. 2002-22 precludes all put options, including market value put options, as a ruling condition. When Rev. Proc. 2002-22 was issued, other commentators and I speculated that perhaps the IRS conditioned advanced rulings on the absence of put options because it did not want to be in the position of granting TIC status to arrangements that would allow exchangers to use TIC interests to park exchange proceeds.40 A market value put option does not affect the rights of the option obligor or other co-owners. For instance, a market value put option does not affect co-owners’ shares of revenue from the property. If property is being sold, and the holder of a market value put option exercises it at the time of sale, the option obligor pays market value for the TIC interest and immediately sells the TIC interest for the same price. In some respects, a market value put option is economically similar to a right to partition. With either mechanism, a co-owner can force a sale of the co-owner’s interest in the property.
A fair market put option is even more innocuous if the exercise consideration is property that is like-kind to the TIC interest. With that transaction, the exchanger would only have the option to put the TIC interest in exchange for like-kind property. As discussed below, that arrangement does not preclude an exchanger that acquires a TIC interest with such a put option from claiming investment intent regarding the property subject to the option.
5. TIC or indebtedness.
The question whether an arrangement is a TIC or tax partnership is relevant only if a co-ownership arrangement exists — that is, the purported co-owners must be the tax owners of their respective TIC interests. As shown below, a fixed-price put with an offsetting call option calls into question whether the holder of the put option has tax ownership of the property. If a person transfers money in a transaction designated as a purchase but the person does not acquire tax ownership of the property, the put option creates a right to repayment of money. That right would be an evidence of indebtedness. Thus, a fixed-price put option with an offsetting call option causes the arrangement to be a financing arrangement, or evidence of indebtedness, for tax purposes.
6. Put option not like-kind.
Put options are not specifically identified as real property and do not appear to be like-kind to real property. The section 1031 real property regulations list several types of intangibles that come within the section 1031 definition of real property, including options to acquire real property (call options).41 Noticeably, the regulations do not list options to sell real property (put options) as coming within the section 1031 definition of real property, raising the question whether put options are different enough from call options to disqualify as valid section 1031 property. To qualify as real property, unlisted intangible property must derive its value from real property or an interest in real property and be inseparable from the real property.42 Options to sell real property might be able to satisfy these two elements of the definition of real property (they derive value from real property and are inseparably connected to real property), but they would also have to be like-kind to real property to qualify as valid section 1031 exchange property.
The determination of whether property such as an option to sell real property is like-kind to general interests in real property (that is, land and improvements) often turns on the duration of the interest. For instance, a U.S. district court ruled that a water right of limited duration was not like-kind to a general interest in real property.43 Options to sell real property have limited duration, and once they are exercised, the holder’s interests in real property terminate. Put options are therefore distinguished from call options. Whereas a call option allows the holder to exercise the call option and come into possession of a fee in real property, the exercise of a put option terminates rights in real property. Thus, options to acquire real property are akin to options to renew leases, which tax law takes into account in determining the duration of a lease.44 If the fee is taken into account in determining the duration of a call option, options to acquire a fee in real property would be considered to run in perpetuity and can be like-kind to general interests in real property. Put options lack that continuity feature because exercise of the put option terminates the interest in real property. Thus, while options to acquire real property may be valid exchange property, options to sale real property would not appear to be valid exchange property.
The IRS recognizes and treats put options as separate property.45 Because put options are not real property or like-kind to real property, they would be boot if received as part of a section 1031 exchange. The amount of boot would equal the value of the put option.46
B. Holding and Use Requirement
As its name suggests, the holding and use requirement has two elements: the holding element and the use element.
1. Holding element.
The holding element requires an exchanger to be the tax owner of the relinquished property before the exchange and to become the tax owner of the replacement property as part of the exchange. Tax law typically looks to the locus of the benefits and burdens of a property to determine who its tax owner is, and courts have developed a multifactor test to analyze who holds the benefits and burdens of a property.47 Whether legal title passes is just one of those several factors.48 Courts look to factors such as who bears the risk of loss, who receives profits, and whether an obligation to make payments and transfer legal title is present.49
If property is subject to put and call options, courts use a behavioral economics analysis to predict the effect options will have on the parties’ behavior to determine the tax owner of the property. That analysis considers the likelihood that at least one of the parties will exercise one of the offsetting options (offsetting-option analysis).50
The determining factor of offsetting-option analysis is the likelihood that at least one of the parties will exercise one of the options. To illustrate, assume that the transferor of legal title has the option to call the legal title for a fixed price on a designated day and that the transferee has the option to put the legal title back to the transferor on that same day for the same price. Applying offsetting-option analysis, courts conclude that one of the parties is highly likely to exercise its option. If the value of the property on the exercise date is less than the exercise price, the transferee will exercise the put option, and if the value of the property is greater than the exercise price, the transferor will exercise the call option. Because one of the parties is likely to exercise one of the options, a court would conclude that tax ownership had not passed from the transferor to the transferee.51 Thus, the transferee would not be the tax owner of the property subject to offsetting put and call options exercisable on the same date for the same price.
Courts apply offsetting-option analysis judiciously. To illustrate, assume a transferee of legal title holds a fixed-price put option on the property exercisable for a specified period, and the transferor holds a call option exercisable at the same price for a period immediately after the lapse of the put option. In that situation, the possibility that neither party will exercise one of the options is more than remote. For instance, if the value of the property were sufficiently high during the put option exercise period, its holder would not exercise the put, and if the property decreased in value during the call option exercise period, its holder would not exercise the call.52 Thus, the holder of the call option may not end up with the property at the end of both option periods. With that arrangement, a court would likely hold that tax ownership stayed with the holder of the put option.53
In the TIC context, a court applying offsetting-option analysis should conclude that tax ownership does not transfer if the transferee holds a fixed-price put option for a specified period followed by the transferor’s concurrently holding a market value call option. To demonstrate, assume that a TIC agreement includes a call option that allows a sponsor to purchase TIC interests for FMV after 18 months after the transfer of the TIC interests (call option restrictions).
Applying offsetting-option analysis as of the transaction date (that is, the date the put option holder took title to the TIC interest), one would predict that either the put option holder would exercise the fixed-price put option immediately before, or the call option holder would exercise the call option immediately after, the expiration of the call option restrictions. If the market value of the TIC interests were to decline before the lapse of the call option restrictions,54 the put option holder would exercise the fixed-priced put options before the lapse of the restrictions to force the put option obligor to reacquire legal title to the TIC interests for more than their market value. Immediately after the call option restrictions lapsed, the put option obligor would exercise its market value call option to reacquire legal title to the TIC interests at an amount less than the original purchase price and to preempt the put option holder from exercising any of its remaining put options. At the transaction date, if the put option holder held a fixed-priced put option and the put option obligor held a concurrent call option, legal title to the TIC interests likely would have reverted to the put option obligor, assuming that the value of the TIC interests were to decline. Thus, the put option obligor would be deemed to be the tax owner of the TIC interest on the transaction date.55
Offsetting-option analysis reaches the same result if it assumes that the TIC interest would have increased in value. If the TIC interest were to increase in value, offsetting-option analysis would predict that the put option obligor would exercise its call option as soon as the option restrictions lapsed. If the value of the TIC interest were to be greater than the exercise price of a fixed-price put option, the fixed-price put option would still present the threat of a future obligation. If the property were to suddenly decrease in value,56 the put option obligor could immediately become liable for the difference between the property’s value and the put option’s exercise price. The put option obligor would prefer not to be exposed to that potential liability, so it would exercise its call option as soon as the call option restrictions lapsed. Thus, the likelihood that one of the offsetting options would be exercised would have been unaffected by the anticipated direction change of the value of the TIC interest.
Offsetting-option analysis is unaffected by the option consideration being like-kind real property. Offsetting-option analysis would have predicted that immediately before the end of the lapse of the call option restrictions, the put option holder would have exercised its fixed-price put options to obtain property that, at the time of the exercise, would be greater in value than the value of the TIC interests. With declining values, the put option obligor would be expected to exercise its call option and sell the acquired TIC interest on the market to avoid the put option obligation. If both options were exercisable at market value, however, offsetting-option analysis would not preclude transfer of tax ownership.57
Offsetting-option analysis shows that if property is subject to a fixed-price put option and a simultaneous market value call option, one of the parties will exercise its option. Because the transfer is expected to occur under one of the options, offsetting-option analysis places the benefits and burdens with the holder of the call option. Thus, the holder of the call option is the tax owner of the property. Consequently, on the transaction date, the put option holder would not have been the tax owner of the TIC interests if it held fixed-price put options on those interests. If the put option holder were not the tax owner at that time, it would not have satisfied the holding element for the TIC interests, and the purported acquisition of the TIC interests would not have qualified for section 1031 nonrecognition.
The requirement that the exchanger be the tax owner of the property is absolutely fundamental to satisfying the section 1031 requirements. The Seventh Circuit confirmed the importance of the exchanger acquiring benefits and burdens of intended replacement property in Exelon.58 More specifically, the court stated:
To be entitled to the section 1031 exception, [the exchanger] had to acquire a genuine ownership interest in the replacement [property]. Ownership for tax purposes is not determined by legal title. “To qualify as an ‘owner’ for tax purposes, the taxpayer must bear the benefits and burdens of property ownership.”59
2. Use element.
The use element requires exchangers to hold property being transferred for productive use in a trade or business or for investment and to acquire property to be held for productive use in a trade or business (business use) or for investment.60 The purpose for which replacement property is acquired is measured at the time of acquisition.61
Although the intent is measured at the time of acquisition, a transfer of property shortly after acquisition can be evidence that the intent at the time of acquisition was to hold the property primarily for sale, not for business use or investment.62 A transfer shortly after acquisition is not, however, conclusive that the acquirer lacked business-use or investment intent if the exchanger can produce evidence that the intent changed between the time of the acquisition and the subsequent transfer.63
A fixed-price put option on property acquired as part of an exchange undermines business-use and investment intent. Case law provides an exception to this rule, supporting investment or business-use intent if a market value put option is exercisable only for like-kind property that the exchanger will hold for investment or business use. On this issue, the Ninth Circuit held as follows:
If a taxpayer owns property which he does not intend to liquidate or to use for personal pursuits, he is “holding” that property “for productive use in trade or business or for investment” within the meaning of section 1031(a). Under this formulation, the intent to exchange property for like-kind property satisfies the holding requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits. Under this formulation, the intent to exchange property for like-kind property satisfies the holding requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits. [The taxpayer] acquired the Montebello property with the intent to exchange it for like-kind property, and thus he held Montebello for investment under section 1031(a).64 [Emphasis in original.]
This black-letter law from the Ninth Circuit establishes that an exchanger who acquires replacement property with the intent to exchange it for like-kind property can show the requisite investment intent and satisfy the use requirement. This law supports investment intent for an exchanger who acquires replacement property subject to a market value put option exercisable solely for like-kind property to be held for investment or business use.
As established above, offsetting-option analysis shows that one of the option holders will exercise an option if the put option is exercisable at a fixed price and is offset by a call option, so tax ownership rests with the holder of the call option. For the sake of analysis, this part of the report assumes, contrary to law, that tax ownership can pass to the holder of a fixed-price put option offset by a call option. Offsetting-option analysis would also show that at the time the purported replacement property is acquired, the subsequent transfer of the property is inevitable. If cash is the consideration for both options, the exercise of an option would liquidate the investment. With that outcome established at the time of the purported acquisition, the exchanger could not establish investment or business-use intent. Consequently, the property subject to the offsetting options would not be valid replacement property.
Even if the consideration for a fixed-price put option is like-kind property, an exchanger would have difficulty establishing investment or business-use intent upon acquisition of property subject to that put option. If the value of the TIC interest were less than the exercise price, exercising the option fundamentally changes the taxpayer’s investment. With that transaction, the exchanger moves from low-value property to like-kind property of greater value, so the transaction would appear to be something other than a continuation of the taxpayer’s investment in property of the same sort.
In particular, the exchanger moves from holding a fixed-price put option and real property to holding only real property. Stated generally, the value of the put option at the time of exercise should equal the difference between the exercise price and the value of the property transferred upon exercise of the put option.65 The value of the replacement property should be allocated between the put option and the transferred real property. The portion of the real property equal in value to the transferred real property could qualify for section 1031 nonrecognition. The portion of the real property equal in value to the put option might not qualify for section 1031 nonrecognition, and the exchanger might be required to recognize gain based on an amount realized equal to that value.66
C. The Exchange Requirement
The regulations provide that “ordinarily, to constitute an exchange, the transaction must be a reciprocal transfer of property, as distinguished from a transfer of property for a money consideration only.”67 Case law and legislative history establish that even the momentary receipt and possession (actual or constructive) of exchange proceeds will defeat the exchange requirement.68 The exchange requirement would also require the exchanger to become the tax owner of replacement property. And the exchange requirement informs how an exchanger would structure a put option on property acquired as part of an intended exchange.
Courts and the IRS have found that multiparty transactions can be structured to satisfy the exchange requirement. For instance, an exchange occurs when a purchaser of relinquished property acquires property and transfers it to the exchanger,69 and when an intermediary acquires the exchanger’s relinquished property, transfers it to a buyer, uses the proceeds to acquire replacement property from a seller, and transfers the replacement to the exchanger.70 These transactions are form-driven and must be structured to ensure that the exchanger is not in actual or constructive receipt of proceeds, even for an instant.
An exchanger has up to 180 days (which can be cut short by the exchanger’s tax return due date) after the transfer of the relinquished property to acquire replacement property (the exchange period).71 To take advantage of the 180-day period, the exchanger must also identify replacement property within 45 days after the transfer of the relinquished property (the identification period).72 If an exchanger fails to identify replacement property within the identification period or fails to acquire replacement property within the exchange period, the transaction will not qualify for section 1031 nonrecognition.73
Multiparty and delayed exchanges raise concerns about the security of exchange proceeds and the exchange partner’s ability to acquire replacement property. An exchanger who takes measures to secure exchange proceeds could be in actual or constructive receipt of exchange proceeds. The IRS provides several safe harbors that allow exchangers to take measures to secure exchange proceeds with confidence that the IRS will not treat the exchanger as being in actual or constructive receipt of exchange proceeds. The principal safe harbor used in section 1031 exchanges is the qualified intermediary safe harbor.
An arrangement satisfies the QI safe harbor if the exchanger enters into a written agreement with a person who comes within the definition of a QI74 and the agreement restricts the exchanger’s access to exchange proceeds held by the QI.75 If an arrangement satisfies the QI safe harbor, (1) the QI will not be treated as the exchanger’s agent, (2) the exchanger’s transfer of relinquished property and subsequent acquisition of replacement property will be treated as an exchange, and (3) whether the exchanger is in actual or constructive receipt of money or property held by the QI will be determined as though the QI is not the agent of the exchanger.76 The QI safe harbor allows the exchanger to assign its rights in purchase-sale contracts to the QI, directly deed property to the buyer of the relinquished property, and receive legal title directly from the purchaser of the replacement property.77
The typical exchange occurs as follows: The exchanger enters into an agreement to sell the relinquished property (the relinquished property contract); the exchanger enters into an exchange agreement with the QI; the exchanger assigns its rights under the relinquished property contract to the QI; and the exchanger directs the buyer of the relinquished property to transfer proceeds to the QI. At closing, the exchanger transfers legal title to the relinquished property directly to the buyer. The exchanger then separately identifies replacement property, enters into a contract to acquire the replacement property (the replacement property contract), assigns its rights in the replacement property contract to the QI, and directs the QI to disburse funds to acquire the replacement property. At closing, the seller transfers title to the replacement property directly to the exchanger. Thus, the buyer’s and seller’s involvement in an exchange is limited.
The restrictions required to be in an exchange agreement must expressly limit the exchanger’s right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI.78 These restrictions are known as the “(g)(6)” restrictions, and they generally must apply until the end of the exchange period, but if the exchanger fails to identify replacement property during the identification period, the restrictions cease to apply at the end of the identification period.79
The inclusion of the (g)(6) restrictions in an exchange agreement creates a so-called Ulysses contract or Ulysses pact.80 By executing an agreement that includes the (g)(6) restrictions, the exchanger engages the QI to ensure that the exchanger does not receive, pledge, borrow, or otherwise obtain the benefits of the exchange proceeds before the expiration of the (g)(6) restrictions. Exchangers therefore hire QIs to disregard their future requests for exchange proceeds while the (g)(6) restrictions are effective to ensure that the IRS will not treat them as being in actual or constructive receipt of exchange proceeds.
Parties to purchase-sale agreements often include section 1031 cooperation clauses in those agreements. TIC agreements may also include language that is typical of section 1031 cooperation clauses found in purchase-sale agreements:
The Buyer shall cooperate, at no cost or expense, with any of the selling Tenants in Common who wish to structure the sale of their Interests as a tax-deferred exchange pursuant to Section 1031 of the Code. The Buyer shall, upon direction of the Tenants in Common electing to exchange, consent to the assignment of the Purchase Option or Call Option to a qualified intermediary of their choosing and the payment of their net proceeds into customary exchange escrow accounts.
This typical section 1031 cooperation language contemplates the possibility of an exchange but ensures that the seller would direct the exchange that would likely be facilitated by a QI. First, the cooperation clause puts the onus on the seller to structure the sale of their interests as part of the exchange. The language “who wish to structure the sale” requires the seller to structure the exchange. Second, the cooperation clause specifies that the buyer shall consent to assignment of the seller’s right in the option agreement to a QI. Third, the cooperation clause provides that the buyer shall pay the net proceeds to the customary exchange escrow account, which would generally be with a QI. The typical cooperation clause language thus places the onus on the seller to structure the exchange and limits the buyer’s obligations to consenting to the assignment and transfer of proceeds to a QI.
With transactions governed by typical cooperation clauses, once ownership of the property transfers and the QI holds the proceeds, the buyer’s obligations cease and the seller has the responsibility to identify and acquire replacement property to complete an exchange. If the seller fails to identify replacement property or is unable to complete the exchange, the seller will receive the exchange proceeds and recognize gain at that time.81 In other words, the buyer’s transfer of proceeds to a QI does not ensure that the seller will consummate a tax-free exchange under section 1031. The possibility of not completing a section 1031 exchange upon transfer of property would be problematic if the property being transferred was acquired as replacement property in a prior exchange and was acquired subject to a put option.
As shown above, if property is subject to a put option, the option should be exercisable only for like-kind property to ensure that the exchanger can satisfy the holding element. The IRS and courts are sophisticated enough to recognize that the transfer of proceeds to a QI upon exercise of a put option followed by a failure to identify or acquire replacement property within the relevant periods would be evidence that the exchanger acquired the property with the right to put it to the option obligor for cash.
To obtain section 1031 treatment on the acquisition of property subject to a put option, the exchanger would require that the option be exercisable only for like-kind property. The exchanger would therefore eschew a typical cooperation clause that does not obligate the option obligor to remain engaged in the transaction until the exchange is completed. The exchanger would insist that the option obligor agree to cooperate with the exchanger until the exchange of the property subject to the put option is completed. That arrangement would require a Ulysses contract under which the option obligor could provide consideration for the property subject to the option only if the exchanger could complete a section 1031 exchange out of the property subject to the option into like-kind replacement property.
III. Conclusion
A fixed-price put option held by a co-owner on an undivided interest in real property causes the undivided interest to lose its TIC status for federal income tax purposes. That option, if offset by a call option, may also signal an intent to sell the underlying property, resulting in the interest being held primarily for sale or resulting in tax ownership residing with the holder of the call option. Consequently, a purported TIC interest that is subject to a fixed-price put option most likely cannot qualify as valid section 1031 exchange property.
FOOTNOTES
1 65 Cong. Rec. 2799 (1924).
2 H.R. Rep. No. 73-704, at 13 (1934).
3 Jordan Marsh Co. v. Commissioner, 269 F.2d 453, 456 (2d Cir. 1959). See also Bradley T. Borden, “The Like-Kind Exchange Equity Conundrum,” 60 Fla. L. Rev. 643 (2008).
4 See section 1031(a)(1).
5 See reg. section 1.1031(a)-3(a)(5)(i)(B), (C).
6 Property held primarily for sale could be like-kind to real property, but it would fail to meet the holding and use requirement, as described below.
9 Reg. section 1.1031(a)-3(a)(5)(ii)(C).
10 Unless stated otherwise, for the sake of analysis, this part of the report assumes that the party holding a fixed-price put option on a TIC interest is the tax owner. As shown below, however, the holder of legal title to a TIC interest that holds a fixed-price put option offset by the put option obligor’s market value call option would not be the tax owner of that TIC interest.
11 See William S. McKee, William L. Nelson, and Robert L. Whitmire, Federal Taxation of Partnerships, para. 3.01 (describing the definition of tax partnership as the most basic and one of the most difficult questions of partnership taxation); Borden, “Open Tenancies-in-Common,” 39 Seton Hall L. Rev. 387, 392 (2009); and Borden, “The Federal Definition of Tax Partnership,” 43 Hous. L. Rev. 925, 940-941 (2006). More than 100 cases and rulings have considered whether an arrangement is a tax partnership. See Borden, “A Catalogue of Legal Authority Addressing the Federal Definition of Tax Partnership,” 746 Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures & Other Strategic Alliances 477 (2007).
12 See section 761(a) (“For purposes of this subtitle, the term ‘partnership’ includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate.”); section 7701(a)(2) (“The term ‘partnership’ includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term ‘partner’ includes a member in such a syndicate, group, pool, joint venture, or organization.”).
13 Reg. section 1.761-1(a) (defining partnership by reference to reg. section 301.7701-1 through -3).
14 Reg. section 301.7701-1 through -3.
15 Reg. section 301.7701-1(a)(1). Nonetheless, if a court finds that an arrangement is something other than a TIC under state law, it is likely to rule that the arrangement is a tax partnership. See, e.g., Luckey v. Commissioner, 334 F.2d 719 (9th Cir. 1964) (ruling that a joint venture was a tax partnership); Podell v. Commissioner, 55 T.C. 429 (1970) (applying the following elements of joint venture (a state law concept) to find that an arrangement was a tax partnership: (1) contract showing intent to establish business venture; (2) joint control and proprietorship; (3) contributions of money, property, and/or services; and (4) sharing of profits); and Estate of Langer v. Commissioner, 16 T.C. 41 (1951) (finding that an arrangement that was a joint venture was a tax partnership).
16 Reg. section 301.7701-1(a)(2).
17 Id.
18 Rev. Proc. 2002-22, 2002-1 C.B. 733, section 2. An early Treasury regulation provided that a “joint investment in and ownership of real and personal property not used in the operation of any trade or business and not covered by any partnership agreement does not constitute a partnership.” Reg. 74, art. 1317 (Dec. 1, 1931).
19 The implications of the fixed-price put option are clear if the exercise price is greater than the market value of the property. Even if the exercise price is less than the market value, the option obligor would know that the option holder could keep score and use the option to even the score if the value of the property falls below the exercise price.
20 See, e.g., Bussing v. Commissioner, 89 T.C. 1050 (1987) (recognizing that under state law, co-owners may use and enjoy the property as if sole owner, subject to each co-owner’s exercise of the same right).
21 Rev. Proc. 2002-22, section 6.05 (listing these actions that require unanimous voting as a condition to seeking an advance ruling on whether an arrangement is a TIC).
22 This analysis assumes that the option obligor’s share of the sale proceeds exceeds the difference between the option exercise price and the value of the option holder’s share of sale proceeds. If the option obligor’s share of the sale proceeds were less than that difference, that obligor would have to draw from other sources (including previously received rents) to cover its obligation under the fixed-priced put option. That obligation is similar to a deficit restoration obligation found in partnership tax law. See reg. section 1.704-1(b)(2)(b)(3). This is a fundamental entity and partnership characteristic that exists, even if the partnership is profitable.
23 See, e.g., Reynolds v. McMurray, 60 F.2d 843 (10th Cir. 1932) (“Where one co-owner makes advances for the benefit of the other, to be repaid from earnings from the property before any division of profits is to be made but without personal obligation on the part of the other to repay any such advances, thus making them subject to the risks of the business, the co-owners are joint adventurers in the operation of the property.”). Even with proportionate sharing of revenue, expenses, and profits, a co-ownership arrangement could be a tax partnership if, for instance, the co-owners share control in a manner that deviates from TIC ownership. Nonetheless, proportionate sharing of revenue, expenses, and profits is a fundamental prerequisite for TIC classification — i.e., proportionate sharing is necessary, but not sufficient, to establish a TIC.
24 Alhouse v. Commissioner, T.C. Memo. 1991-652, aff’d sub nom. Bergford v. Commissioner, 12 F.3d 166 (9th Cir. 1993).
25 Reg. section 301.7701-2 and -3.
26 Reg. section 301.7701-1(a)(2).
27 See Borden, “Definition of Tax Partnership,” supra note 11 (identifying 10 different tests that courts use to determine whether an arrangement is a tax partnership).
28 See id. at 978 (citing Commissioner v. Tower, 327 U.S. 280, 287 (1946); Lusthaus v. Commissioner, 327 U.S. 293, 297 (1946); and Commissioner v. Culbertson, 337 U.S. 733, 738-739 (1949)).
29 See id. at 981 n.301 and n.303 (citing many cases, including Luna v. Commissioner, 42 T.C. 1067 (1964); Bergford, 12 F.3d 166; Bussing, 89 T.C. 1050; and Alhouse, T.C. Memo. 1991-652.
30 Although the number of factors that courts consider can vary, the following are eight factors courts commonly use: (1) the agreement of the parties and their conduct; (2) the parties’ contributions; (3) the parties’ control over income and capital, including each party’s right to make withdrawals; (4) whether the parties were co-proprietors, employee and employer, or principal and agent; (5) whether the parties conducted business under a joint name; (6) whether the parties filed a partnership tax return; (7) whether the parties exercised mutual, although perhaps unequal, control and assumed mutual responsibilities; and (8) whether the arrangement maintained separate books. See id. at 981 n.303.
31 See Joe Balestrieri & Co. v. Commissioner, 177 F.2d 867 (9th Cir. 1949) (finding that an arrangement was a loan and not a tax partnership because the California definition of joint venture required common control and joint sharing of profits and losses); and Podell, 55 T.C. 429.
32 See Borden, “Equity Structure of Non-Corporate Entities,” 31 Real Est. Fin. J. 35 (Summer/Fall 2016).
33 In fact, the purchase of the replacement property could be scheduled to occur simultaneously with the exercise of the put option, followed immediately by the sale of the acquired option property. The sale of the acquired option property would help to establish its market value.
34 Rev. Proc. 2002-22, section 1. The IRS has issued a few private letter rulings under Rev. Proc. 2002-22. See, e.g., LTR 200327003 (allowing renewal of management contracts by notice and no response); LTR 200625009 (permitting specified buy-sell agreements and right to indemnification of payment exceeding proportionate interest); LTR 200829012 (permitting specified buy-sell agreements); and LTR 200826005 (permitting specific buy-sell agreements).
35 See Kevin Thomason and Todd Keator, “IRS Offers Lenience for Beleaguered Tenancy-in-Common Investors,” 38 Real Est. Tax’n 4, 5 (4th Q. 2010) (“Although presented by the government as a guideline for obtaining advance private letter rulings on the critical tax issue, it was immediately treated by the industry as a quasi-safe harbor (a la Rev. Proc. 2000-37 regarding reverse exchanges).”).
36 See Borden, “Definition of Tax Partnership,” supra note 11, at 981-982 (identifying option restrictions as factors the IRS added to Rev. Proc. 2002-22 that do not appear in case law).
37 See Borden and Keator, “Tax Opinions in TIC Offerings and Reverse TIC Exchanges,” 23 Tax Mgt. Real Est. J. 88 (Mar. 2007) (presenting some common and significant deviations and how they might affect those writing opinions regarding whether an arrangement is a TIC for federal income tax purposes).
38 Rev. Proc. 2002-22, section 6.10.
39 LTR 201622008. The facts of the ruling do not reveal the extent to which the exercise price of the option approximated FMV. The letter ruling provides that the put option obligor was net leasing the property. If the lessee was a credit tenant, perhaps the rent revenue was predictable, helping to establish value. That conclusion would be consistent with the IRS’s view that income from a high-quality net lease helps determine the value of a profits interest in a partnership. See Rev. Proc. 93-27, 1993-2 C.B. 343 (providing that the IRS will not treat the receipt of a profits interest in a partnership as a taxable event, but taking exception to this general position if “the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease”).
40 See, e.g., Borden, Tax-Free Like-Kind Exchanges, para. 8.3[1][b][x]; Jacob Stein, “Tax-Free Exchanges and Fractional Interests: TICs, Tax, Go!” 45 Orange County Law. 18, 20 (Aug. 2003); Borden, “Exchanges Involving Tenancy-in-Common Interests Can Be Tax-Free,” 70 Prac. Tax. Strategies 4, 13, 14 (Jan. 2003); and Terrence Floyd Cuff, “Tenancy in Common Arrangements,” 66-12 New York Univ. Annual Inst. on Fed. Tax. section 12.08 (2007). Parking exchange proceeds would allow exchangers to effectively extend their identification and exchange periods.
41 See reg. section 1.1031(a)-3(a)(5)(i).
42 See id.
43 Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Ariz. 2002).
44 Century Electric Co. v. Commissioner, 192 F.2d 155 (8th Cir. 1951); R. & J. Furniture Co. v. Commissioner, 20 T.C. 857 (1953); and Rev. Rul. 78-72, 1978-1 C.B. 258.
45 See Rev. Rul. 78-182, 1978-1 C.B. 265.
46 See sections 1001(b) and 1031(b).
47 See Grodt & McKay Realty Inc. v. Commissioner, 77 T.C. 1221 (1981) (listing the following factors: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity was acquired in the property; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property).
48 Id.
49 Id.
50 Courts can apply a similar analysis to arrangements with a single option to determine the likelihood that the option will be exercised. See, e.g., Oesterreich v. Commissioner, 226 F.2d 798 (9th Cir. 1955) (applying an analysis similar to the offsetting-option analysis to a fixed-price call option to determine whether the holder of the option was the tax owner of the underlying property).
51 See, e.g., Comtel Corp. v. Commissioner, 376 F.2d 791 (2d Cir. 1967) (disregarding a sale when the holder of an exclusive option to reacquire property was likely to exercise the option); and Rev. Rul. 72-543, 1972-2 C.B. 87.
52 Penn-Dixie Steel Corp. v. Commissioner, 69 T.C. 837 (1978) (disregarding the taxpayer’s argument that nonconcurrent put and call options created a current transfer of property).
53 Id.
54 The TIC market does indeed appear to have declined following its $3.7 billion peak in 2006. Thomason and Keator, supra note 35, at 6 (chronicling the TIC “meltdown” from the high-water mark of 2006); Borden, “Open Tenancies,” supra note 11, at 434 n.261 (citing “TIC Industry Quarterly Statistics,” TICtalk Q., Omni Real Estate Services LLC, at 4 (Fall 2008), to show that TIC sales had decreased significantly by the first quarter of 2008 compared with sales in 2006).
55 Kwiat v. Commissioner, T.C. Memo. 1992-433 (ruling that the holder of a call option was the owner of property subject to a put option exercisable at a higher price followed immediately by a call option exercisable at a lower price).
56 The drop in the value of property was in fact precipitous in the years following 2006.
57 See, e.g., Lockhart Leasing Co. v. Commissioner, 54 T.C. 301 (1970) (finding that if an option is exercisable at market value, the option holder is less likely to exercise it).
58 Exelon v. Commissioner, 906 F.3d 513 (7th Cir. 2018).
59 Id. at 524.
60 This part of the report regarding the use element, contrary to the findings regarding the holding element, assumes that the put option holder could be the tax owner of the TIC interest, even if that interest were subject to a fixed-price put option and offsetting call option. This part of the report focuses on the effect that a fixed-price put option would have on holding intent, so it could reach its conclusions for an arrangement that included a fixed-price put option but did not include an offsetting call option.
61 See Magneson v. Commissioner, 753 F.2d 1490, 1493 (9th Cir. 1985).
62 Regals Realty Co. v. Commissioner, 127 F.2d 931 (2d Cir. 1942) (holding that a corporate resolution to sell the property two weeks after acquisition was evidence of intent to sell); Click v. Commissioner, 78 T.C. 225 (1982) (denying section 1031 nonrecognition to an exchanger who allowed adult children to move into residential property immediately after acquisition); Lindsley v. Commissioner, T.C. Memo. 1983-729 (finding that a decision to transfer property to charity before acquisition and subsequent transfer was evidence that the property was not acquired with the intent to hold for investment).
63 Wagensen v. Commissioner, 74 T.C. 653 (1980); and Land Dynamics v. Commissioner, T.C. Memo. 1978-259.
64 Bolker v. Commissioner, 760 F.2d 1039, 1045 (9th Cir. 1985). See also Mason v. Commissioner, T.C. Memo. 1988-273; and Maloney v. Commissioner, 93 T.C. 89 (1989) (“A trade of property A for property B, both of like kind, may be preceded by a tax-free acquisition of property A at the front end, or succeeded by a tax-free transfer of property B at the back end.”).
65 This valuation follows from the fact that consideration received should equal the sum of the value of the property transferred and the value of the put option. The difference also reflects the amount a buyer would pay for an exercisable put option.
66 Upon the sale of stock under the exercise of a put option, the cost of the put option is added to the basis of the transferred stock to determine the gain on the sale of the stock. Rev. Rul. 78-182. Guidance does not establish whether this same method of computing gain would apply under section 1031 to classify the transferred property. On the one hand, because the put option is treated as property separate from the real property, section 1031 could account for the value received in exchange for the put option and separately account for the value received in exchange for the real property. On the other hand, the general treatment of capitalizing the cost of the put option into the basis of the transferred property could apply for section 1031 purposes, resulting in the exchanger being treated as receiving replacement property solely as consideration for the real property. In the face of uncertainty, the exchanger must account for the difference between the fair value of the real property transferred and the fair value of the property received, and the amount of consideration exceeding the value of real property could be boot.
67 Reg. section 1.1002-1(d).
68 See, e.g., supra text accompanying note 15; Carlton v. United States, 385 F.2d 238 (5th Cir. 1967) (denying section 1031 nonrecognition because the exchanger received sale proceeds as part of a transaction clearly designed to be an exchange); and Halpern v. United States, 286 F. Supp. 255 (N.D. Ga. 1968) (denying section 1031 nonrecognition because the exchanger was in constructive receipt of exchange proceeds when the exchanger’s attorney received the proceeds). But see Morton v. United States, 98 Fed. Cl. 596 (2011) (granting section 1031 nonrecognition even though the exchanger received exchange proceeds in error).
69 See, e.g., Starker v. United States, 602 F.2d 1341 (9th Cir. 1979); and Coastal Terminals Inc. v. United States, 320 F.2d 333 (4th Cir. 1963).
70 See, e.g., Biggs v. Commissioner, 632 F.2d 1171 (5th Cir. 1980); W.D. Haden Co. v. Commissioner, 165 F.2d 588 (5th Cir. 1948); and Mercantile Trust Co. v. Commissioner, 32 B.T.A. 82 (1935).
72 Section 1031(a)(3)(A). The IRS also provides a safe harbor for structuring so-called reverse exchanges. See Rev. Proc. 2000-37, 2000-2 C.B. 308.
73 Section 1031(a)(3). The timing requirements reflect Congress’s view that a transaction that is not completed within the prescribed periods is effectively a transfer of one property and a separate acquisition of another property. See H.R. Rep. No. 98-432, pt. 2, at 1232 (1984) (“To the extent that the taxpayer is able to defer completion of the transaction — often retaining the right to designate the property to be received at some future point — the transaction begins to resemble less a like-kind exchange and more a sale of one property followed, at some future point, by a purchase of a second property or properties. . . . The committee believes that like-kind exchange treatment is inappropriate in such situations and that the general rule requiring recognition of gain on sales or exchanges of property should apply to these cases.”).
74 Reg. section 1.1031(k)-1(g)(iii).
77 Reg. section 1.1031(k)-1(g)(4)(iv) and (v).
78 Reg. section 1.1031(k)-1(g)(4)(ii) and (6)(i).
79 Reg. section 1.1031(k)-1(g)(6).
80 A “Ulysses contract strikes a deal between your present self and your future self, binding your future self not to do something stupid or self-destructive.” Zvi H. Triger, “For the Love of Contract,” 51 Tulsa L. Rev. 407, 409 (2016) (citing Martha M. Ertman, Love’s Promises: How Formal and Informal Contracts Shape All Kinds of Families (2015)). “The ‘Ulysses’ contract gets its name from the Homeric legend, The Odyssey. Before sailing past the bewitching Sirens, Ulysses commanded his crew to lash him to the mast and to disobey his orders to release him in order to avoid being lured to his own destruction by the creatures’ irresistibly beautiful songs.” Delila M.J. Ledwith, “Jones v. Gerhardstein: The Involuntarily Committed Mental Patient’s Right to Refuse Treatment With Psychotropic Drugs,” 1990 Wis. L. Rev. 1367, 1395-1396 n.158 (1990).
81 See reg. section 1.1031(k)-1(j)(2)(ii).
END FOOTNOTES