Special-purpose entities and tax-free exchanges.

• Author: Bottiglieri, Tom

Under Sec. 1031, a taxpayer can, on a tax-free basis, exchange real property used in a trade or business or held for investment for like-kind real property to be held in a trade or business or for investment.

In practice, a taxpayer acquiring replacement property must often augment the proceeds from the sale of the relinquished property to acquire the replacement property.

Banks and other lenders, mindful of the bad real estate mortgage loans of the 1980s and resultant foreclosures, are increasingly requiring borrowers to form "special-purpose entities" to own the collateral.

If the owner of a special-purpose entity goes into bankruptcy on unrelated debt, the lenders hope the separate entity will remain separate and not become part of the bankruptcy court's jurisdiction. The potential problem in structuring tax-free like-kind exchanges caused by the use of a special-purpose entity can be illustrated as follows.

Example: Taxpayer A owns real property acquired in 1989 and located in New York City. The property has a fair market value (FMV) of $10,000,000, an adjusted tax basis of $3,000,000, and is subject to a $5,000,000 mortgage.

A enters into an exchange agreement with a qualified intermediary. The intermediary executes the transfer of the relinquished property to an unrelated purchaser for $10,000,000 and pays off the mortgage, leaving $5,000,000 for use in acquiring the replacement property.

A property with an FMV of $15,000,000 is found. To finance the purchase, A request a mortgage loan from a bank. The bank advises A that it will make the loan only to a special-purpose entity (e.g., a corporation) that must buy and own the replacement property.

If A forms a corporation as a special-purpose entity and completes the exchange, the transaction would most likely result in a taxable gain of $7,000,000, because a different taxpayer (the corporation) would have completed the exchange.

As an alternative, the bank could loan the funds to A through the intermediary, which would acquire the replacement property and then immediately transfer the property to the special purpose corporation. Assuming the bank would agree to this arrangement...