Tuesday, November 13, 2018
My recent post on like-kind exchanges and the definition of real estate received a lot of attention, positive comments and questions. Several of those questions involved the issue of whether real estate that is held in a trust can qualify for like-kind exchange treatment. It’s an important question, particularly because the Tax Cuts and Job Act makes like-kind exchange treatment only applicable to real estate trades after 2017.
Whether real estate held in trust can qualify for like-kind exchange treatment – that’s the topic of today’s post.
Real Property – What Is It?
As noted above, real estate remains eligible property for a like-kind exchange under I.R.C. §1031. Often, state law determines whether an item of property is real property. For instance, in Oregon Lumber Co. v. Comr., 20 T.C. 192 (1953), the court held that the right to cut timber was not an interest in real property under state (Oregon) law. Thus, the exchange of land for the right to cut timber on national forest land was not a like-kind exchange under I.R.C. §1031. Also, in Priv. Ltr. Rul. 200424001 (Dec. 8, 2003), the IRS determined that components of a railroad track that are assembled and attached to the land and are real estate under state law are not like-kind to unassembled and unattached components because the latter is considered personal property under state law. But, where a water right under state law (Kansas) constitutes a perpetual interest in real property, the trade of the water right for a fee simple interest in farmland does qualify for like-kind exchange treatment. Priv. Ltr. Rul. 200404044 (Oct. 23, 2003). In addition, an agricultural conservation easement, if it is an interest in real property under state law, can be exchanged for like-kind real estate and qualify for deferral of tax under I.R.C. §1031. Priv. Ltr. Rul. 9851039 (Sept. 15, 1998); Priv. Ltr. Rul. 200201007 (Oct. 2, 2001).
But, state law doesn’t always determine the outcome. Sometimes state law may treat a particular interest as a real property interest, but the interest may be a “chose in action” (rights associated with personal property) for Federal income tax purposes. Thus, rights under a sales contract that are exchanged for real property may not qualify as a like-kind exchange. See, e.g., Coupe v. Comr., 52 T.C. 394 (1969).
The Treasury Regulations specify that a land lease of 30 years or more is the equivalent of an interest in real property. Treas. Reg. §1.1031(a)-1(c). In addition, real property involved in an exchange must be located in the United States (the 50 states and D.C.) to qualify for non-recognition treatment. I.R.C. §1031(h); but also see I.R.C. §932 and Priv. Ltr. Rul. 200040017 (Jun. 30, 2000).
What About Trusts?
Trusts are a popular part of many farm and ranch (and other) estate plans. If farmland or ranchland is contained in a trust, is it still eligible to be exchanged for other real property and have the gain (or loss) on the transaction deferred under I.R.C. §1031? If so, that means that placing land in a trust for estate planning (or other) reasons doesn’t eliminate the favorable tax consequences of I.R.C. §1031.
1992 IRS ruling. There is some guidance on the issue of whether real estate contained in a trust is eligible for I.R.C. §1031 treatment. In 1992, the IRS issued a Revenue Ruling taking the position that an interest in an Illinois Land Trust was real property that could be exchanged for like-kind real estate. Rev. Rul. 92-105, 1992-2 C.B. 204. While a beneficiary’s interest in a land trust was deemed to be personal property under state (IL) law, that characterization didn’t control the outcome. The IRS looked at the facts of the particular situation and noted that the trustee was only acting at the discretion of the taxpayer (beneficiary). The trustee merely held title and could only potentially transfer that title. Thus, the trust was an agency relationship between the trustee and beneficiary involving the holding and transferring of the title to the real estate contained in the trust. The taxpayer/beneficiary retained the right to manage and control the trustee, and remained the direct owner of the property for tax purposes. It was the beneficiary that remained obligated to pay the taxes and other liabilities associated with the trust property, and it was the beneficiary that had the exclusive right to the trust property’s earnings and profits. Based on those facts, the IRS determined that the beneficiary’s interest in the trust was an interest in real property that could be exchanged for other real property and qualify for deferral of gain (or loss) via I.R.C. §1031.
The trust and the relationship of the parties in the 1992 ruling was not determined to be a partnership. If the IRS had determined that a partnership was involved, that would have meant that the beneficiary’s interest in the real estate in the trust would not have qualified for like-kind exchange treatment – partnership interests are not eligible. Important to that point, only one beneficiary was involved under the facts of the ruling. With multiple beneficiaries, it may be easier for the IRS to asset that a partnership exists and deny I.R.C. §1031 eligibility.
Based on Rev. Rul. 92-105, if a trust (or similar arrangement created under state law) is merely an investment vehicle, it can qualify as like-kind to real property under I.R.C. §1031. That’s certainly the case for a trust if the trustee has title to the real property in the trust; the beneficiary has the exclusive right to direct or control the trustee in dealing with title to the property; and the beneficiary has the exclusive control of the property’s management as well as the obligation to pay any taxes and other liabilities that relate to the property. When those factors are present, an exchange transaction actually involves the exchange of the underlying trust property rather than an exchange of a certificate of trust beneficial interest, and the gain or loss on the transaction can be eligible for deferral under I.R.C. §1031.
2004 IRS ruling. Twelve years after Rev. Rul. 92-105, the IRS issued another revenue ruling on the issue. Rev. Rul. 2004-86, 2004-2 C.B. 191 involved a Delaware Statutory Trust (DST). A DST is a form of business trust. Under the facts of the ruling, the trustee’s powers were limited to only collecting and distributing income. As such, the DST was merely an investment trust and its interests could be exchanged for real property in an I.R.C. §1031 transaction. However, with more retained powers in the trustee, the IRS said that the trust would be a business trust rather than an investment trust and would not qualify for like-kind treatment. Consequently, Rev. Rul. 2004-86 is quite limited. But, if all of the interests in the trust are of a single class that represent undivided beneficial interests of the trust and the trustee cannot vary the trust’s investments, the trust will be an investment trust and its assets can be exchanged for real property with any gain qualifying for deferral under I.R.C. §1031. On the other hand, if the trustee has greater discretion with respect to the trust property, those additional powers could cause disqualification from I.R.C. §1031 treatment. Those additional powers could include, for instance, the power to dispose of the real property in the trust and acquire new property, the power to renegotiate leases on the trust property, or approve more than minor modifications or improvements to the property. If those powers are present, the IRS could take the position that the trust constitutes a business entity not eligible for I.R.C. §1031 treatment.
An additional important aspect of the 2004 Rev. Rul. is that the IRS at least impliedly classified the DST as a grantor trust. Thus, real estate contained in a grantor trust could be exchanged for interests in a grantor trust containing real property and the transaction would qualify for deferral treatment under I.R.C. §1031. That has important estate planning implications. A revocable living trust is a grantor trust. Such trusts are a part of many estate plans. Irrevocable trusts are also a popular estate planning tool. An irrevocable trust can be a grantor trust if the grantor retains, for example, the “power to control beneficial enjoyment.” I.R.C. §674.
For real property contained in trust, if the trustee’s powers are limited, the real property can be exchanged for other real property and qualify for gain (or loss) deferral under I.R.C. §1031. Land contained in a grantor trust is deemed to be owned by the individual grantor and remains eligible for I.R.C. §1031 treatment. For land contained in a non-grantor trust, the language of the trust is critical. For non-grantor trusts, the trust language must place sufficient limitations on the trustee’s powers to allow the trust beneficiary to receive like-kind exchange treatment under I.R.C. §1031.