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 in acquiring 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. In the event the owner of the special purpose entity goes into bankruptcy on unrelated debt, the lenders hope the separate entity will not come within the bankruptcy court's jurisdiction. There is a potential problem, however, in structuring tax-free like-kind exchanges when using a special purpose entity.

Example: Taxpayer A owns real property acquired in 1989. The property has a fair market value (FMV) of $10 million and an adjusted tax basis of $3 million, and is subject to a $5 million mortgage. A enters into an exchange agreement with a qualified intermediary, who executes the transfer of the relinquished property to an unrelated purchaser for $10 million and pays off the mortgage, leaving $5 million for use in acquiring the replacement property. A locates property that has an FMV of $15 million. To finance the purchase of this property, A requests 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 million, because a different taxpayer would have completed the exchange.

As an alternative, the bank could loan the funds to A through an intermediary, which would acquire the replacement property and then immediately transfer it to the special...