Hard Rock Case Still Up in the Air Though Some Elements Well Grounded

MORTON v. U.S., Cite as 107 AFTR 2d 2011-XXXX

I promised myself that if I got far enough ahead on my Monday, Wednesday, Friday commitment, I would start doing more posts.  The MWF posts have been done on a roughly FIFO (first in, first out) basis so some of them have aged a bit.  I'm going to grab from the top of the pile for any Tuesday Thursday bonus posts, so they might be a little fresher.

This is a bit of a celebrity case.  Peter Morton was one of the founders of Hard Rock Cafe.  His Los Angeles restaurant, Mortons, was the setting for the Julia Phillips novel "You'll Never Eat Lunch in this Town Again".  He sold the Hard Rock Hotel in Las Vegas in 1995, but he continues to own the brand.  The dollars involved are pretty respectable.  It is a refund claim for $9,755,483.  Absent all that, I would still find the case intresting.  There are three issues two of them somewhat sophisticated and one fairly mundane.  Ironically the taxpayer was able to get summary judgement on the sophisticated issues but the mundane one remains undecided.

The question is about the deductibity of private jets and whether a like-kind exchange of jets was blown.  One aspect of the like-kind exchange issue is very straightforward:

In 1999, Plaintiff sought to exchange the G-III for the G-IV aircraft. The main reasons for this exchange were concerns about the safety and the level of noise generated by the G-III. Plaintiff entered into an agreement with a qualified intermediary for the exchange and an escrow agreement with an escrow agent. The agreement was executed on September 30, 1999, but the escrow agent accidentally and in contravention of the escrow agreement wired funds from the escrow account to RWB. Mr. Ogaz returned the funds the following day.

Ooops. Don't you hate when that happens ?  The Court ruled, however, that with a properly drafted exchange facilitation agreement, an error by one of the parties will not void exchange treatment.

Defendant acknowledges that Plaintiff abided by these requirements and would have effected a valid like-kind exchange but for the accidental placement of funds into RWB's account instead of the escrow agent's account.  Defendant stresses that before the funds were placed in escrow, the money was deposited into RWB's checking account; thus Defendant contends that because RWB had possession and control over the funds, Plaintiff had “actual receipt” of them. 

We disagree that an accidental transfer followed by an immediate return of funds would constitute actual or constructive receipt. Significantly, Plaintiff was bound by contract not to “receive, pledge, borrow or otherwise obtain the benefits of the Exchange Value” for at least 45 days.. Legally, he could not do anything but return the funds to the proper account. If he had done anything other than return the funds, he would have been liable for conversion, or even theft.
Additionally, Plaintiff should not be penalized for another's mistake when he took every step to validly effect a deferred like-kind exchange. Plaintiff complied with all the requirements of the qualified intermediary safe harbor over which he had control; he did not have control over the mistaken actions of a third party. Because he complied with the requirement in all other aspects, we conclude that he validly effected a deferred like-kind exchange.

In many cases good documents cannot salvage poor execution.  One of my earliest posts illustrates this principle in the case of family limited parnterships.  Of course in the like-kind exchange area, the right documents are crucial as Ralph Crandall discovered much to his chagrin.  I would say, however, that "poor execution" might be a little harsh for a mistake like depositing in the wrong account and fixing the mistake the next day.  Compare it to the Estate of Sylvia Riese where the property of a terminated QPRT was not retitled for months and no rent was ever paid by the grantor.  If the Tax Court can forgive that, having the money in the wrong account for a day should also be forgivealbe.  Let's call it less than perfect execution.

This was also a Section 183 case, sometimes referred to as "hobby loss". but the actual title is "Activities Not Engaged in For Profit":

In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed under this chapter except as provided in this section.

It is not surprising that Mr. Morton owned several entities for several different purposes- ownership of different property, management, etc.  He picked one of them RWB, an S corporation, to own the jet.  He provided the corporation with the funds to pay related expenses.  A different corporation 510 Development Corporation hired the flight team of pilot, co-pilot and flight attendant.  We don't need to get into the details of the purposes of the various entities to frame the issue.  RWB, all by itself, was not about to make a profit from owning the plane.  So the IRS wants to disallow any expenses over and above some charter income.  Mr. Morton maintains that the plane was being used for his overall enterprise - himself and all his various entities.  The Court approves of the latter approach:


Case law supports Plaintiff's “unified business enterprise” theory and would allow him to take deductions for aircraft use that furthers the business purpose of entities other than RWB. This deduction may be allowed despite the fact that the aircraft is titled in RWB's name, and RWB did not use the aircraft to further its particular profit motive. As long as Plaintiff used it to further a profit motive in his overall trade or business, the deduction is allowed.

I think that both the holdings in this case are pretty important.

Mr. Morton has not, however, entirely won - at least not yet and the reason is pretty mundane:

Given that Plaintiff may impute his business activities and the business activities of one entity to his other entities, the Court must still examine whether the evidence shows that the aircraft expenses were for legitimate business purposes. The facts are in dispute. Defendant contests the purpose of many of the trips, and specifically takes issue with Plaintiff's trips to the Hamptons because his children, girlfriends, and friends of his children traveled with Plaintiff on the aircraft and stayed with Plaintiff at his vacation homes. RWB kept flight logs that identified the date and time of the trip, the number of passengers, the departure and arrival airports, the time in flight, and the pilots. However, RWB did not keep systematic records of the identity of the passengers on its flights nor the reasons why any passengers were on its flights.  The lack of information about the people included on the trip makes it difficult to say at this point definitively that the flights were or were not for business purposes.


Though Plaintiff met with his accountant sometime after the trips to categorize them as “personal” or “business,” , the Court cannot definitively say that these meetings were sufficiently contemporaneous to regard these categorizations as conclusive. Plaintiff said little at oral argument to enlighten the Court about the process of determining the business or personal nature of the trips. Because the Court is unconvinced of Plaintiff's categorizations, it defers judgment on the nature of the individual trips. The Court also must defer a determination as to whether depreciation deductions are allowed because this determination is dependent on substantiating the business usage of the aircrafts.

If the Gulfstream is classified as personal use property, it would be disqualified from 1031 treatment.  I will hazard a guess that 1031 would not be that imporant in that case as the plane would not have been depreciable.

Note that this is a refund case so Mr. Morton must have spent over $20,000,000 or so of after tax dollars on his jets.  In case you are wondering what other perks go with being the founder of the Hard Rock Cafe, check out his super model on again off again girl friend Linda Evangelista

It's OK To Tell Them Why You Want Them to Hold Your Money

Ralph E. Crandall, Jr., et al. v. Commissioner, TC Summary Opinion 2011-14

This case really mystifies me.  It is about a failed tax-free exchange.  So here's the deal.  One of the most general rules of income tax is that if you trade one thing for another thing and the thing you get is worth more than the basis of the thing you gave up, you have taxable income.  When the thing you get is money, most people understand that, but it is true regardless of what you get.  Like any good general rule, there are many exceptions.  Part III of Subchapter O contains a host of them including Section 1031.  Section 1031, like 401(k) and 501(c)(3), has worked its way into common conscious enough to rate a Wikipedia entry.  It's basic holiding is:

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Although it has very broad applicability the biggest action in 1031 is in the area of real estate.  This is because all real estate in the United States is considered to be of like-kind with all other real estate in the United States.  So you can't swap your cow for a bull and have it qualify as a like kind exchange, but you can swap your farm land for an office builing.  I swear I don't make this stuff up.  I don't have enough imagination.

Since it is unlikely that somebody who wants your property is going to have property you want, taxpayers began devising schemes to do three way swaps.  Eventually this was regularized.  You can arrange to sell your property and have a "qualified intermediary" receive the proceeds.  You then have up to 45 days to designate a target property and 180 days (You may have to extend your return to have the full 180 days) to close on the target property.  Exchange facilitation is a minor industry.  I gave a cautionary tale about exchange facilitators a few months ago.  Basically you want to use one that keeps your money in a segregated account.  You won't go too far wrong using the likes of Wells Fargo, but you can shop around. 

What happened to Ralph Crandall is a classic case of somebody getting half the story and going ahead and acting on it.  Maybe he heard about 1031 from his barber.  He didn't hear about it from my barber, certainly, because then he would have called me.  Actually, my barber cuts most of the CPA hair in central Massachusetts, so maybe he would have called somebody else, but he would not have flown blind.

Here's how it went:

Petitioners owned an undeveloped parcel of property in Lake Havasu City, Arizona (Arizona property). Petitioners held the Arizona property for investment. Petitioners desired to own investment property closer to their California residence. After receiving some limited advice concerning a tax-free exchange of properties, petitioners took steps to sell the Arizona property and purchase new property with the intention of executing a tax- free exchange. On March 4, 2005, petitioners sold the Arizona property for $76,000. The buyers of the property paid petitioners $10,000, and the remaining $66,000 was placed in an escrow account with Capital Title Agency, Inc. (Capital Title). At petitioners' direction $61,743.25 was held in the escrow account. Capital Title initially released $4,256.75 to petitioners. Petitioners' basis in the Arizona property was $8,500.



In furtherance of the purchase petitioners made payments to Chicago Title Co. (Chicago Title) and placed in an escrow account as follows:
Jan. 4, 2005 10,000.00
Mar. 14, 2005 (three separate payments)24,700.00, 4,256.75, 294.00
Mar. 18, 2005 61,550.00

The Capital Title and Chicago Title escrow agreements did not reference a like-kind exchange under section 1031, nor did they expressly limit petitioners' right to receive, pledge, borrow, or otherwise obtain the benefits of the funds

This is the part that mystifies me.  Capital Title is a name used by several companies so I can't be sure about it. Chicago Title , though,has a division that does 1031 exchanges.  Didn't Mr. Randall think to tell the company that he was trusting his money with that he was doing a 1031 exchange ?  Didn't they think to ask him why he was escrowing money?

I could go on at length about what is and is not allowed in handling 1031 exchanges but I generally don't.  The reason is that if you have a plain vanilla deal you should contact a company that does a lot of exchanges and do what they tell you.  It really doesn't matter what I think.  If you have a complicated transaction then give me a call. 

The Tax Court felt sorry for Mr. Randall, but they couldn't help him:

Neither escrow agreement expressly limited petitioners' right to receive, pledge, borrow, or otherwise obtain the benefit of the funds nor made any mention of a like-kind exchange. Because of the lack of limitations, neither escrow account was a qualified escrow account. See Hillyer v. Commissioner, T.C. Memo. 1996-214 [1996 RIA TC Memo ¶96,214]; Lee v. Commissioner, supra. Although petitioners used the funds in the Capital Title escrow account to purchase the California property, the lack of express limitations in the escrow agreement results in petitioners' being treated as having constructively received the proceeds.


We conclude that the disposition of the Arizona property was a sale and the funds deposited in the Capital Title escrow account represent the receipt of the proceeds. See sec. 1001(c). Consequently, this transaction does not qualify for section 1031 nonrecognition, and petitioners must recognize gain for 2005. See sec. 1001(c). The Court notes that the tax consequences are not what petitioners intended and the result may seem somewhat harsh. However, Congress enacted strict provisions under section 1031 with which taxpayers must comply. We also note that respondent has conceded the accuracy-related penalty.

How could he have avoided this problem ?  He could have told the people escrowing the money that he was doing a 1031 exchange.  If they didn't know what he was talking about, he could have found somebody else.

Saying Goodbye to 2010

I know that you haven't been wondering how I do my blog, but I am going to tell you anyway.  I look at every federal court tax decision and an alphabet soup of IRS pronouncements (PLR, CCA, PMTA etc) as they are released by the Research Institute of America.  A small percentage of them strike me as interesting for one reason or the other (practical utility, humor, cause for reflection).  Those I copy into a draft post, which I will then labor over as the spirit moves me.  Having the full text in my draft post allows me to easily paste quotes into the body of my post.  The effect of this method is to leave me with a collection of draft posts.  Sometimes when I look at them I wonder why I thought they were interesting in the first place.  I've committed to a Monday Wednesday Friday schedule.  If something seems of immediate interest, I will put it up as a bonus post.  The side effect of this process is the accumulation of material that doesn't quite turn into a full length post.  Rather than consign it to the dustbin (You might be surprised at the number of developments than nobody would write about if I didn't), I will group a bunch of them together.  So in this post and maybe a subsequent one I will clean out anything left over from last year.  The only thing the items have in common is that they came out in the waning days of 2010.  If you can detect a theme, congratulations.

TAX PRACTICE MANAGEMENT, INC. v. COMMISSIONER OF INTERNAL REVENUE JOSEPH ANTHONY D'ERRICO v. COMMISSIONER OF INTERNAL REVENUE, TC Memo 2010-266

This was a fairly run of the mill substantiation case although the numbers were respectable (over 200k in deficiencies).  The fact that it was a tax preparation business added a touch of irony.  The most interesting feature was an airplane.  It was purchased in December.  Mr. D'Errico took it on a test flight which allowed him to visit some clients.  He then leased it out, because he was to busy to fly around during tax season.  He sold his tax business before he got to use the airplane to visit clients.  He, of course, took a 179 deduction in the year of acquisition.  The tax court didn't buy it.

TPM has not demonstrated that the airplane was acquired with the requisite intent or motive of making a profit. Other than D'Errico's self-serving testimony, TPM has not presented any evidence that it contemplated using the airplane for purposes of TPM's management or marketing operations. Further, the airplane leasing agreement specifically provides that TPM entered into the agreement with the intention of generating revenue to offset the airplane's operating costs.

Private Letter Ruling 201048025

This was a fairly convoluted like-kind exchange that was allowed.  As far as I could make out an entity swapped with a related party, which then acquired property.  The key to the whole thing seemed to be that as a group there was no net increase in cash.

Related Party intends to reinvest an amount equal to the total sale price of the Related Party Relinquished Properties less exchange costs. In the event that Related Party acquires replacement properties having a value less than 100 percent of the value of the Related Party Relinquished Properties, the difference will result in the Related Party recognizing gain arising from the exchange in the full amount of such difference, but the amount of gain so recognized will not exceed x% of the gain realized by Related Party on its transfer of the Related Party Relinquished Properties.

If somebody has studied this ruling and could post a comment I'd really appreciate it.

Edward Daoud, et ux. v. Commissioner, TC Memo 2010-282

This was also a substantiation case.  It was notable for two reasons.  The first was the introduction:

The Daouds owned two Wienerschnitzel franchises in Southern California, both of which gobbled up unusually large amounts of money. These expenses grabbed the Commissioner's attention and during his audit of the Daouds' 2000 and 2001 returns, he found that they had reported a large loss on kitchen equipment they never owned, and lacked substantiation for many of the other deductions that they claimed. The Commissioner determined a large deficiency for each year, and wants to add fraud or at least accuracy-related penalties. We make our way through the resulting menu of possibilities to determine the correct taxes and penalties.

You don't read a lot of stories about Tax Court judges shooting themselves, so you know that they have to have a sense of humor.  Sometimes it comes through.

The story of the unallowed loss on the kitchen equipment is one that Robert Flach, The Wandering Tax Pro will love.  (Mr. Flach still prepares returns by hand rather than use expensive and unreliable software):

Mr. Daoud conceded that he and his wife were not entitled to the loss on the sale of kitchen equipment, but he tried to explain why he reported a loss for equipment he had neither bought nor sold. He testified that he was unsure how the $110,015 loss got on his return, but he speculated that the bid was mixed up with all the other paperwork on his desk, which caused him to enter it into Turbo Tax by mistake. He also testified that the date he recorded on the Form 4797, Sales of Business Property, as the date that he sold the equipment was simply one that he chose at random after Turbo Tax prompted him to enter a date. He went on to explain that he gave the altered document to the revenue agent "out of panic."

The Turbotax made me do it defense was unavailing:

This case is a good example of why we allow the Commissioner to prove fraudulent intent using circumstantial evidence and the taxpayer's entire course of conduct. Mr. Daoud claims that he reported the loss by mistake, and he asks us to believe that he first learned about it when the revenue agent brought it to his attention. We do not believe him--Mr. Daoud's credibility suffered during trial. His testimony was often suspect, and the records he provided have proven not to be what he said they were on many subjects.

The judge elaborated on the credibility theme.  He didn't yell "Pants on fire", but it was close.

Private Letter Ruling 201051025

In my more paternalistic moments, there is a provision of the tax law that I would keep secret from some people.  One of the ways that you can avoid a 10% penalty on early withdrawal from you IRA is by committing to a series of distributions.  I just turned 59, myself, and I am looking forward to my 1/2 birthday so I wouldn't need to consider something like that myself.  And of course I'm glad my younger self never thought about it.  Nonetheless, there might be circumstances where it makes sense.  The ruling was about someone who adopted that course then managed to screw it up.  The IRS was forgiving.

1. The failure to distribute the entire required distribution amount for Year 6, and a proposed makeup distribution for Year 7 will not be considered a modification of a series of substantially equal periodic payments and will not be subject to the 10 percent additional tax imposed on premature distributions under section 72(t)(1) of the Code.
2. The fact that the amount of the annual payment computed pursuant to section 72(t)(2)(A)(iv) of the Code was paid in a single sum in Year 1 and in monthly distributions in Year 2 through Year 7 will not be considered a modification of a series of periodic payments and will not be subject to the 10 percent additional tax imposed on premature distributions under section 72(t)(1) of the Code.

That is not a complete wrap on 2010, but it will do for now.

You Don't Need a Matchmaker at the Family Reunion

I have these silly rules that I make up and then go ahead and break all the time.  One is to not use the word only in association with any sum of money greater than $4.00 (Yes there is a decimal point. Four dollars).  Another is to rule out of the discussion the concepts of "making sense" and "being fair" when discussing what the tax rules actually are.  I compound this latter rule by not paying much attention to theories about what the tax laws should be.  This comes from some hard experience I had in 1987, trying to keep straight what actually made it into the Tax Reform Act of 1986 as opposed to the "Treasury II Proposals". 

I somewhat relax the "making sense" and "being fair" proscriptions for purpose of enunciating one of my general rules of tax planning.  "Any clever idea you have has been thought of and probably ruled against."  An extension of this is that most of the thing that you think don't make sense actually do make sense.  They are there to squelch an abusive transaction dreamed up by someone even more clever than you are.  All of this is just me apologizing for saying that the Eleventh Circuit's decision in Ocmulge Fields v. Com (106 AFTR 2d 2010-5820) makes sense.

The case concerns like-kind exchanges, a topic which I discuss here and  there.  At issue is the application of the related party resale rules.  Suppose you owned two companies (Call them Highoco and Lowco)and each one owned a piece of real estate worth $1,000,000.  Further suppose that the basis of one property (High-B)was $900,000 and the other (Low-B) was $100,000.  Along comes buyer who perversely is willing to pay $1,000,000 for Low-B, but has no interest in High-B.  Wouldn't it be nice if you could move the basis in High-B over to Low-B ?  Well you can.  Highco and Lowco can do a like-kind exchange.  Highco's basis in Low-B will be $900,000, its basis in the property that it surrendered.  Clever.

Unfortunately, if Highco disposes of Low-B within two years of the exchange Lowco has to recognize gain.

There is another set of rules involving like-kind exchanges.  Since the person that has the property you want is rarely the person who wants your property many exchanges use qualified intermediaries.  The qualified intermediary receives the money from the sale of your property and uses it to purchase another property.  You have 45 days from the date of sale to identify the target property and you must receive it within 180 days of the sale (If the sale is later in the year you may have to extend your tax return in order to have the full 180 days).

Ocmulgee Fields Inc decided that they should go the qualified intermediary route. The hired Security Bank of Bibb County to serve as qualified intermediary. The bank received the proceeds for the sale of Ocmulgee's property known as Wesleyan Station to the McEachern Family Trust.  Ocmulggee then searched high and low for a replacement property.   They used up all of six days. Finally they identified a Barnes and Nobles.  It just kind of happened, sort of by coincidence, that the Barnes and Nobles was owned by a company named Treaty Fields.  Come to find out, Treaty Fields was pretty much owned by the same people as owned Ocmulgee.

Seems like since they already were acquainted with one another, they did not really need a qualified intermediary.  Just as well they used one, though, since it got them out of that nasty related party resale rule.  Well that's what they thought.  It's not what the IRS thought, though.  And the Tax Court and the Eleventh Circuit agreed with the IRS.  Treaty Fields, surprise, surprise, had higher basis in the Barnes and Nobles than Ocmulgee had in the Weslyan property.  But that's not all.  Ocmulgee was a C corp and Treaty Fields was a partnership.

I would have been awfully upset if Ocmulgee won this case.  Not because I root for the IRS.  I would have been upset at myself for not telling my own clients about such an obvious end run around the related party resale rules.  The resale rules have this nice little ending (1031(f)(4)), which disallows any exchange which is a part of a transaction or series of transactions to avoid the purposes of the resale rules. It reads:

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection

Read by itself, it doesn't make a lot of sense.  What it says is that you can't fix a bad exchange by throwing in a couple of extra seemingly good ones.

IRS Declines Rubbing Salt in The Wound

It's getting a little stale, so I think I should post now on Rev Proc 2010-14 (issued March 5, 2010) or forever hold this piece.  Although it is a taxpayer favorable ruling, its recipients are probably not dancing in the streets.  They are probably even more miserable than the beneficiaries of PMTA 2010-05 whom I discussed back in June.

We are talking here about like-kind exchanges.  I'll give you just a bit of context.  A common misconception is that you only have taxable income when you get money.  In reality, the most general rule is that when you exchange one thing for anything else you should recognize gain or loss by comparing the fair market value of what you received to the basis (generally what you paid) of the thing you gave up.  There are of course many exceptions.  One of the better known is the like-kind exchange.  It is well known enough that its section number 1031 has like 401(k) and 501(c)(3) become part of the language.  (You will find wikipedia entries on each of those three.  Don't go looking for 704(b) in wikipedia).  In order for an exchange to be deferred under 1031 both the relinquished and acquired property must be held for investment or used in a trade and they must be of like-kind.  Also there are several types of property that cannot be the subject of a like-kind exchange (e.g. securities, stock in trade and choses in action (whatever they are)). Whether property is of like kind can be a huge complicated question.  There is, however, a huge simplification.  All real estate in the United States is like-kind to all other real estate.  So although you might have rental car companies exchanging their fleet vehicles  and the like, much of the action and excitement in the 1031 area concerns real estate.

Out there in the real world you don't have many instances of the two farmers exchanging pasture land that are contemplated in the old 1031 regulations,  The chance that someone who wants to buy your property would have a property for sale that you want is pretty slim.  People began using middlemen to facilitate exchanges.  There was a lot of creativity in the area.  Beginning in 1984, which I guess is getting to be a while ago, the Code was amended to place limits on deferred exchanges.  Cutting through a lot of complexity you can have a third party receive the money from the sale of your property.  You have 45 days to identify a replacement property and they have to get it to you within 180 days (or by the due date of your return including extensions. (You can always get 180 days, but if the sale is later in the year you have to extend your return)). 

There are rules about who can hold the money for you.  A simple summary of the rules is that if it somebody who pops into your head, they probably can't do it.  Can't be the realtor, can't be your lawyer or your accountant, etc.  It doesn't matter.  Exchange facilitation is an industry.  You want to use a company that has done many exchanges.  Now we are finally getting to Rev Proc 2010-14.  What happens if some time during the 180 days your facilitator goes bankrupt ?

People used to worry that you would be really screwed if that happened.  Since your exchange wasn't any good you would recognize gain from the sale of the property.  Of course you wouldn't have any money from the sale to pay the tax, which is why you are really screwed.  The IRS isn't quite as malevolent as some people make them out to be, though.  Rev. Proc. 2010-14 says, in part :

The Internal Revenue Service and the Treasury Department are aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI and were unable to complete these exchanges within the exchange period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the proceeds of the sale of the relinquished property. The Service and the Treasury Department generally are of the view that a taxpayer who in good faith sought to complete the exchange using the QI, but who failed to do so because the QI defaulted on the exchange agreement and became subject to a bankruptcy or receivership proceeding, should not be required to recognize gain from the failed exchange until the taxable year in which the taxpayer receives a payment attributable to the relinquished property.

Whoopee.  So now you are just screwed as opposed to really screwed. 

There is really no excuse for people having gotten themselves in this situation.  It is true that some facilitators have a sort of black box business model in which the money disappears when you sell the relinquished property.  In that model, its none of your concern where the money is in the mean time as long as they deliver the target property.  That is not the only the model though.  It is also permissible for the funds to be segregated in separate bank accounts and some facilitators are affiliated with major banks.  Your transaction costs might be a little higher, but it is definitely the way to go.

Just Because They Won't Let You Do it Doesn't Make it a Good Idea

 I promised the above title in my last installment, so I will stick with it.  I apologize if it seems that I am being disrespectful to someone who is barred from being married. In my defense, when it comes to taxes, my viewpoint is totally pragmatic.  It is what is is.  Whenever I hear somebody say that "That doesn't make sense", my resposnes is "That is not a requirement."  In my last installment, I commented on CCA 201021050 which indicates that registered domestic partners in California should be splitting their community income in filing federal tax returns.  This will often given them a better deal than if they were married filing a joint return.  I have seen commentary that the ruling should apply to California same sex married couples who are barred from federal joint filing by DOMA.  I indicated that there are signifiant tax planning opportunities for unmarried couples in all states.  As in my previous post, I find it easiest to talk about this in terms of a hypothetical couple called Robin and Terry.  Gets around those awkward pronoun problems.  Robin and Terry are a highly committed couple who view themseves as an economic unit. For some reason or other, they are not married.  So what can they do that a married couple can't ?



1. The standard deduction - Even if property is held jointly, either one can pay the real estate and mortgage interest and deduct it. (You cannot deduct somebody else’s taxes, but you can deduct all of the taxes on a property you own part of, if you pay all of it.) Robin and Terry each maintain a separate checking account. (This is a step I have found some couples find difficult to implement.). Robin pays for the groceries, home repairs, country club dues, etc. Terry makes the mortgage payments, pays the real estate taxes and makes their charitable contributions. (Terry cannot pay Robin’s state income tax, but if they have a significant diversified portfolio, Robin should own the US obligations and exempt obligations of their state of residence.) Through these steps, Robin and Terry will between them be able to deduct all their itemized deductions and one standard deduction.

2. The deferred salary - If Robin owns a C corporation (call it Robco), Robco can employ Terry. Robco should pay Terry once a year. If Robco is an accrual basis corporation it can accrue the salary due to Terry and pay it to Terry, a cash basis taxpayer in the subsequent year.

3. The free basis step-up - If Robin owns a rental property, Terry can buy it by giving Robin a long-term installment note. Robin will recognize no income until the principal is paid. Terry will have a stepped up basis for purposes of depreciation or even sale. (Thus it would even be worth doing with a vacation property, if it is likely to be sold.)

4. The basis swap - If Robin owns a high basis property and Terry owns a low basis property and they wish to sell the latter, they can do a like-kind exchange prior to the sale, thereby reducing the gain.

5. The wash sale - If Robin wants to maintain a securities position but harvest capital losses, Terry can purchase the identical security on the same day that Robin sells.

6. Forget the trade-in - If Robin has a luxury automobile that is used for business, that they would like to hang onto, Robin can sell it to Terry at loss, which unlike depreciation is not subject to luxury limitations.


If a couple chooses to use any of these techniques, the most likely way they would fail on audit is through poor execution. Everything must be done in the same way as it would be done in a truly arms-length transaction. If there is a note for a property sale a mortgage should be recorded. Payments should be made regularly as defined by the terms of the contract. Separate accounts should be maintained and receipts and disbursements should be scrupulously deposited or disbursed from the correct account (e.g. After the free basis step up, rents should go into Terry’s account and property expenses, including the interest due Robin, should be paid out of that account).

A further caveat is that I have not worked out how CCA 201021050  might affect the workings of theses techniques for California registered domestic partners.

Sometimes You Should Just Pay The Taxes

PMTA 2010-05



PMTA 2010-05 is a reasonably taxpayer friendly statement. It is, however, reasonable to infer that the affected taxpayers are not exactly jubilant. PMTA stands for Program Manager Technical Assistance. True tax junkies are not satisfied with the various rulings issued by the IRS for public consumption - Revenue Rulings, Revenue Procedures, Notices, etc. We have to use the Freedom of Information Act to eavesdrop when the IRS is talking to itself. Of course Research Institute of America does the heavy lifting. The question that the PMTA addressed was :


Whether the temporary pooling of funds on a non-pro rata basis and the appointment of a tenant-in-common owner (“TIC Owner”) as a payment and/or communications agent because of the bankruptcy of the master tenant will cause the tenants-in-common to become partners in a partnership for federal income tax purposes?

The answer was no. With typical IRS hedging the no was qualified with the assumption that the arrangements weren’t actually partnerships to begin with.

I suspect that there are many sad stories hidden behind this ruling. The TIC structure is a creature of tax law. The most general rule of tax law is that when you exchange one thing for something else, you recognize gain, if any. There are of course exceptions. Several of them are collected in Part III of Subchapter O under the heading “Common Non-Taxable Exchanges” including Section 1031 which calls for non recognition of gain or loss when the properties exchanged are of “like kind”. Of course exceptions wouldn’t be real exceptions if they didn’t have their own exceptions. Among the items that cannot be on either side of a qualified like kind exchange along with stocks, bonds, animals of different sexes and “choses in action”(whatever they are) are interests in a partnership.

The 1031 exception is particularly significant in real estate because, for the most part, all real estate in the United States is like-kind to all other real estate in the United States. So if you trade your stallion for a brood mare that is not like-kind, but if you trade your horse farm for an office building it is. You can even exchange your whole horse farm for part of an office building. Which is where the partnership thing comes in. What is the difference between a piece of real estate owned by diverse persons and a partnership of diverse persons that owns a piece of real estate? Such questions keep tax attorneys awake at night and also well fed. Revenue Procedure 2002-22 tells your the conditions your arrangement must meet to be worthy of asking the IRS to rule that it is not a partnership.

That revenue procedure was part of the birth of a veritable industry. Someone selling rental or investment property had always had the opportunity to structure the sale as an exchange by inserting a third party facilitator and is even allowed time after selling the initial property to identify to the facilitator (45 days) the replacement property and for the facilitator to acquire the property (lesser of 180 days or the extended due date of the taxpayer’s return). Someone tired of being a landlord might however view that as exchanging one headache for another. By having a TIC interest as their target there was a broader range of properties available and there would be someone else to deal with all the tenant problems and repairs . Someone else to go bankrupt and leave the TIC members holding the bag.

The saddest part in the PMTA is the reference to the fact that there will be non-prorata cash contributions. Reading between the lines one can infer that some of the owners are bit resentful at having to kick money in to straighten out the mess that they have landed in.

A couple of observations and then a moral. Even if the subsequent events converted the TICs into partnerships, this should not affect the validity of the like kind exchanges that had the TIC’s as their targets. Presumably the investors did not have the master tenant’s bankruptcy as part of their plans, They might want the ruling anyways since preparing a partnership return in these circumstances would be somewhat challenging. Since 1031 defers both losses and gains, some investors might want to argue that the arrangement really was a partnership to begin with and the partnership interest they received was worth less than their basis in their relinquished properties. That would be a real tough argument to make though,

The moral is that tax savings are money. If buying something allows you to save taxes then the thing that you buy doesn’t cost you as much. It doesn’t make it free. And it is possible that , even with the discount that the tax savings creates the thing is not worth what you are paying for it. I might go so far as to speculate that if the thing is designed with tax savings in mind that the designer feels entitled to a goodly share of your tax savings. In some cases, it might be your tax savings and then some. In which case, as the title says, it would be better to have just paid the taxes.



Oh by the way :

Any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

All that glitters is not taxed ? Or is it ?

Given any thought to the tax implications of virtual transactions ? I didn't think so. Do you want some thoughts ? If not stop reading.

The IRS has not issued any guidance on the tax issues on virtual transactions. The issues will become more pressing as time goes on. Some of them are

Income Realization - When do you recognize income from virtual transactions? The simple answer seems to be when receiving some real money. This would be based on the theory that all you’re doing is playing a game and that trading with other players is part of the game. Given Blizzard’s terms of service, there is some merit in this argument. You don’t really own anything. There are however public companies more thinly traded than your WOW gold.

The approved market in Linden dollars trades a few hundred thousand real dollars per day. The price, which is market determined, has been hovering around 250 Linden dollars. Linden Labs plays the role of the central bank having the power to increase or decrease the money supply. It is interested in keeping the rate stable. Bottom line -The exchange rate between dollars and euros is much less stable than that between Lindens and dollars.

The only possible guidance on the realization of transactions within a virtual world are cases about whether casino gamblers recognize income before they cash in their chips (literally). Big help. There aren’t many cases and they go both ways.

As long as virtual items are in demand and companies are careful about controlling the money supply, virtual worlds have the potential to become tax havens.

Recognition – Assuming a virtual world transaction is realized could it avoid recognition because all virtual items, including gold or platinum or linden dollars, are of like-kind to all other virtual items? This entertaining thought experiment would be of limited relevance though since it would only apply to investors, not to hobby players or dealers (except in limited circumstances).

Nexus – Where do virtual world transaction take place? – Yuan, a free lance professional WOW player in China raids several tough dungeons and earns 10,000,000 gold. He sells it to a wholesaler for $10,000 who will sell small lots of 500 gold to recreational players in every state in the United States for them to buy better armor or epic mounts within the game. Where did this happen? Can the US tax Yuan? Can Massachusetts tax the wholesaler who is located in Texas? Can Illinois, where the server is located, tax everybody?

Nature of property - Can you invest your IRA funds in Linden dollars? Why not? Because it is a collectible? Collectibles are by definition tangible.

Transfer Taxes – Even WOW’s strict terms of service allow an account to be shared by a parent and a child. A dedicated player could create many avatars worth thousands of dollars (perhaps with dad buying a little gold now and then). Is the value of those avatars includible in dad’s estate since he paid the subscription fees, while junior did most of the monster killing that built the avatars.