Conformity, the Lockdown, and New York’s Audit of Like-Kind Exchanges
June 08, 2020
Conforming
About sixty years ago, New York revised its personal income tax law to achieve close conformity with the Federal system of income taxation. The stated purpose for the revision was to simplify tax return preparation, improve compliance and enforcement, and aid in the interpretation of tax law provisions.[i] In furtherance of this policy of conformity, as the Code is amended by Congress, New York automatically adopts the Federal changes.[ii]
However, New York’s Tax Law does not conform to the Code in all respects. Indeed, there are a number of instances in which New York has chosen not to conform to – where it has “decoupled” from – specific provisions or amendments of the Code.[iii]
Federal AGI
By far, the most significant example of New York’s conformity to the Code is found in the State’s computation of a New York taxpayer’s State income tax liability; this begins with the taxpayer’s Federal adjusted gross income,[iv] which is then modified by certain New York “additions” and subtractions”[v] – basically, items for which New York has decided a different tax treatment is appropriate for its own purposes.
In general, a taxpayer’s adjusted gross income is determined by reducing their gross income by certain deductions attributable to the taxpayer’s trade or business, deductions attributable to the production of rental income, and losses from the sale or exchange of certain property.[vi]
Of course, a taxpayer’s gross income includes gain realized on the sale or exchange of property,[vii] unless such gain is excluded by law.[viii]
For example, the Code provides that no gain is recognized by a taxpayer on the exchange of real property held by the taxpayer for use in a trade or business, or for investment, if such real property is exchanged solely for real property of like-kind which is to be held by the taxpayer either for productive use in a trade or business or for investment.[ix]
Because the gain realized from a like-kind exchange is excluded from the exchanging taxpayer’s Federal adjusted gross income, it is also excluded from the taxpayer’s New York adjusted gross income and, thus, is not considered in determining the taxpayer’s New York income tax liability.[x]
IRS Audit of Exchange
A corollary to the conformity principle requires that any changes to the taxpayer’s Federal income tax liability[xi] be accounted for in re-determining the taxpayer’s New York income tax liability.
For example, what happens if the IRS successfully challenges a taxpayer’s treatment of an exchange as a tax-deferred like-kind exchange?[xii] How will New York learn of the resulting increase in the taxpayer’s New York income tax liability?
According to New York’s Tax Law, if the amount of a taxpayer’s Federal taxable income is changed by the IRS, the taxpayer must report such change within ninety days after the “final determination” of such change, and must concede the accuracy of such determination.[xiii] If the taxpayer fails to comply with this reporting requirement, then the resulting New York income tax liability may be assessed at any time – the applicable statute of limitations on the assessment of a deficiency is tolled.[xiv]
Based on the foregoing, one might think that it would behoove New York to wait for the IRS to examine a taxpayer’s Federal income tax return, and then assess any resulting deficiency in New York income tax.
After all, most of the substantive tax issues presented in a New York income tax return arise under the Code – Federal tax law – as a result of New York’s application of the conformity principle, described above. In addition, the taxpayer is required to report any such deficiency to New York, failing which New York may assess the deficiency at any time the State learns of it.
Such an approach would also allow the State to allocate its limited resources to presumably more productive revenue-generating applications including, for example, the examination of uniquely New York income tax issues, such as questions of residency and the allocation of income within and without the State.
New York Audit of Exchange
Over the last few years, however, it appears that New York may have relaxed its “wait-and-see-what-the-IRS-finds” attitude. Rather than piggy-backing onto the IRS’s efforts, New York has been initiating the audit of taxpayers’ income tax returns and, in the process, has been examining the Federal tax issues presented in those returns with the goal of collecting more New York income taxes.[xv]
Indeed, this year alone I have become aware of several challenges by New York to the tax-deferred treatment of transactions which, according to the taxpayers, qualified – and were reported on both their Federal and New York income tax returns – as like-kind exchanges.[xvi]
A couple of these have included transactions with partnership overtones including, for example, so-called “drop-and-swap” transactions[xvii] which the taxpayers’ advisers assured them were routine and not likely to be challenged by the IRS.
Unfortunately for these taxpayers, it is New York that is examining their transactions, not the IRS – apparently, New York is unaware of the “routine” nature of such exchanges and, so, is putting the taxpayers through their paces.[xviii]
In any event, the taxpayers were unrealistic in believing that any exchange involving a tenancy-in-common (“TIC”) interest – whether as a relinquished property or as a replacement property – which necessarily implicates partnership-related issues, could be beyond the reach of the IRS’s interest,[xix] as a recent decision of the U.S. Tax Court made clear.[xx]
Deferred Exchange
Taxpayer sold a real property in New York City at a significant gain. In order to defer recognition of the gain realized on the sale, Taxpayer sought to structure the sale as part of a deferred like-kind exchange. Treating the property sold as the “relinquished property,” Taxpayer began a search for “replacement property” that would qualify for like-kind exchange treatment.[xxi]
Taxpayer deposited the proceeds from the sale of the relinquished property into a “qualified escrow account” with a qualified intermediary (“QI”), which acted as an escrow agent.[xxii]
TIC (?) Replacement Property
Taxpayer identified a possible replacement property (the “Property”), and then formed a limited liability company (the “LLC”), of which Taxpayer was the sole member, to acquire the Property. The LLC was treated as a disregarded entity for Federal income tax purposes; thus, Taxpayer would be treated as acquiring the replacement property.[xxiii]
Taxpayer executed a contract in which it purported to acquire a 12.5% interest in the Property. The contract listed the LLC as the purchaser. The contract described the asset acquired as an “undivided interest of 12.5% as a Tenant in Common” in the Property.
Attached as an exhibit to the purchase contract was a copy of a document captioned “Tenancy in Common Agreement.” This agreement was executed by the families that held interests in the apartment building at that time. The agreement recited the parties’ desire to form a venture to “maintain, manage and operate the Property” and to “lease the Property in its entirety to a person or entity.”
Shortly thereafter, the LLC entered into a second, substantially similar contract, with a second seller in which it purported to acquire another 12.5% interest in the Property. This contract recited that the LLC thereby acquired an “undivided 12.5% interest as a Tenant in Common.”
In accordance with the IRS’s deferred like-kind exchange regulations,[xxiv] the LLC then assigned to QI its rights under the two purchase contracts. This agreement described the asset to be acquired as a “25% tenancy-in-common interest” in the Property. Acting as escrow agent, QI completed the transaction by delivering proceeds to the sellers from Taxpayer’s “qualified escrow account.”
Tax Reporting
Taxpayer filed Form 1040, U.S. Individual Income Tax Return, to which it attached IRS Form 8824, Like-Kind Exchanges, on which Taxpayer stated they had engaged in a like-kind exchange and, among other things, described the replacement property.
However, Taxpayer’s reporting was not consistent with the reporting that the IRS received from Partnership, an “entity” that identified itself as a partnership for Federal income tax purposes.[xxv] Partnership’s returns reported that it owned the Property and that the LLC acquired a partnership interest in Partnership, as opposed to a direct ownership interest in the Property.
The Court explained how, for several years, including the one at issue, Partnership had filed returns on Form 1065, U.S. Return of Partnership Income. The returns stated that Partnership was engaged in a rental real estate business. According to the Court, it was originally formed as a family partnership and, over successive generations, interests were divided and subdivided among family members and their heirs.
Partnership’s return included an IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, which identified the Property as Partnership’s sole rental property.
Partnership attached to its return a Schedule K-1 for each of the partners that owned an interest during the year at issue. These schedules showed that each of the two sellers, from whom the LLC acquired the replacement property, owned a 12.5% interest in Partnership at the beginning of that year and a 0% interest at the end. The LLC was shown as owning a 0% interest in Partnership at the beginning of the year, and a 25% interest at the end of the year. After selling the relinquished property, Taxpayer designated as the replacement property a purported 25% interest in the Property.
The Schedule K-1 that Partnership issued to the LLC reported that the LLC had contributed capital, had received distributions, and was allocated a share of Partnership’s net rental real estate income. Taxpayer acknowledged receipt of this Schedule K-1.
However, Taxpayer did not report their distributive share of Partnership income on their Form 1040, but nor did Taxpayer file with the IRS a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, in order to highlight Taxpayer’s “omission” (inconsistent treatment) of Partnership’s K-1 items from Taxpayer’s return.[xxvi]
Failed 1031
The IRS examined Taxpayer’s return. By claiming like-kind exchange treatment on that return, Taxpayer treated the LLC as having acquired a direct ownership interest in the Property.
Based on the foregoing, however, the IRS determined that the replacement property acquired by the LLC – i.e., by Taxpayer – was, in fact, an interest in a partnership. Of course, like-kind exchange treatment does not apply “to any exchange of . . . interests in a partnership.”[xxvii] Thus, the IRS concluded that Taxpayer was taxable on the sale of the relinquished property, having failed to acquire qualified replacement property.
In response, Taxpayer argued there was no partnership. Taxpayer asserted that “it would have been impossible for . . . [them] to have any suspicion that certain other . . . [owners] had filed a partnership return.” This was certainly not the case. The Court observed that Taxpayer or their advisers presumably did due diligence before finalizing the decision to invest in the Property. Moreover, Partnership issued a Schedule K-1 to the LLC – with the information described above – and Taxpayer acknowledged that they received this document.
Having received a Schedule K-1 that Taxpayer evidently thought was incorrect, Taxpayer should have filed a Form 8082 with their tax return, notifying the IRS that they believed the Schedule K-1 to be erroneous and that they were adopting a position inconsistent with it. Taxpayer failed to do so. But even if they had, there seemed to have been enough facts to undermine any claim that Taxpayer did not acquire an interest in a partnership and, thus, failed to complete a like-kind exchange.
Looking Ahead[xxviii]
Inconsistent tax and information returns like those considered by the Tax Court, above, raise the proverbial red flag, and will be picked up by the IRS. So will accurate disclosures on a partnership tax return; for example, in response to the question on Line 12, Schedule B, of Form 1065: “. . . did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”
As a matter of applying the like-kind exchange rules, this information raises the question of whether the taxpayer disposed of or acquired, as the case may be, a partnership interest rather than a direct interest in real property.[xxix]
But what about New York?
Independent NY Exam
It is likely that New York has only just begun to delve into the substantive Federal income tax issues presented by its taxpayers’ returns – including the qualification of an exchange as a like-kind exchange – and that its efforts in this regard will be expanded.
A number of factors support this statement, not the least of which is the reduction in the IRS’s overall enforcement capabilities, which will reduce the number of opportunities for New York to benefit from the IRS’s examination efforts.
To this must be added the fiscal crisis in which New York finds itself following the government-ordered economic shutdown as part of the State’s efforts to contain the spread of the coronavirus. The revenue losses experienced by the State,[xxx] when coupled with the extraordinary expenses incurred in coping with the virus, have placed a premium on the generation of additional revenue.
Given these conditions, New York will seek to increase its tax collection efforts, including its audit activity of income tax returns and, in particular, the determination of whether taxpayers have correctly reported their Federal (and, thereby, their New York) adjusted gross income.
Real Property Exchanges in NY
Which brings us back to the like-kind exchange and partnerships. Is New York focusing on such transactions? Probably. Consider the number of situations in which these arise, whether you’re talking about a rental property in the Hamptons or a building in Manhattan.
One should also consider the significant amount of income tax that the State – not to mention the IRS – probably loses to such transactions. Is it any wonder that, throughout the Obama Administration, its annual budget proposals sought to eliminate the like-kind exchange, or to limit the amount of gain that may be deferred under such an exchange?[xxxi]
Although New York does not impose any special reporting requirements for like-kind exchanges, there are many other returns that may help the State to identify, and then examine, a purported like-kind exchange.
For one thing, both New York and New York City impose transfer taxes on the transfer of an interest in real property. These require the filing of returns on Form TP-584 and Form NYC-RPT.
In addition, partnerships must file Form IT-204, which asks whether the partnership (i) had an interest in New York real property during the last three years, (ii) engaged in a like-kind exchange, (iii) sold property that had a deferred gain from a previous like-kind exchange, (iv) made an in-kind distribution, and (v) was under audit by the IRS or was previously audited by the IRS.[xxxii]
Armed with the information provided by these returns, and driven by the need to raise tax revenues, we can expect that New York will become more familiar with like-kind exchanges that involve a partnership or its partners, more methodical in its examination of such transactions, and more aggressive in pursuing outstanding income tax liabilities.
[i] Thus, New York’s Tax Law provides that: “Any term used in this article shall have the same meaning as when used in a comparable context in the laws of the United States relating to Federal income taxes, unless a different meaning is clearly required but such meaning shall be subject to the exceptions or modifications prescribed in this article or by statute.” N.Y. Tax Law 607(a). Consistent with the foregoing, a taxpayer’s taxable year and accounting method for purposes of the Tax Law are the same as for Federal income tax purposes. N.Y. Tax Law Sec. 605.
[ii] So-called “rolling conformity.”
[iii] For example, New York elected not to conform to parts of the 2017 Tax Cuts and Jobs Act (P.L. 115-97; the “TCJA”), including the limitation on certain itemized deductions. By decoupling, N.Y. effectively became a “fixed date” conformity jurisdiction: it applies the Federal law as it was prior to the Federal changes.
[iv] IRC Sec. 62.
[v] Start with Tax Law Sec. 612(a), (b) and (c).
[vi] IRC Sec. 62(a). Yes, there are also a few other, very targeted items.
[vii] IRC Sec. 61; Reg. Sec. 1.61-6; IRC Sec. 1001.
[viii] It should be noted that many non-recognition rules apply automatically, provided their requirements are satisfied; in those cases, the taxpayer does not have the option of electing out of non-recognition.
For a discussion on inadvertently tax-free exchanges, see https://www.taxlawforchb.com/2015/06/tax-free-thats-not-what-i-wanted/
[ix] IRC Sec. 1031. The TCJA limited the benefit of this provision to the like-kind exchange of real property. This change is generally applicable to exchanges completed after December 31, 2017.
[x] N.Y. Tax Law Sec. 612(a).
[xi] This may be attributable to the inclusion in the taxpayer’s gross income of a previously omitted item of income, or to the disallowance of a deduction previously claimed by the taxpayer.
[xii] For example, by establishing that the taxpayer did not hold the relinquished property for use in a trade or business or for investment.
[xiii] N.Y. Tax Law Sec. 659.
[xiv] N.Y. Tax Law Sec. 683(c)(1)(C). The regular three-year statute of limitations on assessment, which begins to run with the filing of the tax return, will not apply. Tax Law Sec. 683(a).
[xv] New York has displayed a similar approach with respect to the N.Y. estate tax, especially after decoupling from the Federal estate tax exemption amount.
[xvi] Please note that an exchange of N.Y. City real property that qualifies for “tax-free” treatment under the income tax will likely be subject to N.Y. real estate transfer tax (maximum rate of 0.65%) and N.Y. City real property transfer tax (maximum rate of 2.625%).
[xvii] https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-i/
[xviii] Remember “The Hustler” episode from The Odd Couple? Oscar is playing a local pool shark, Sure-Shot Wilson, who also happens to be weight-challenged and is a chain-smoker. For starters, Felix correctly states that “pool is the same as golf – you just put a ball in the hole.” In any case, with Oscar in danger of losing, Felix talks to Sure-Shot about his awful cough and the deadly effects of smoking four packs a day. Felix explains how his uncle, who died very young, was also a smoker. Sure-Shot becomes so distracted and concerned with his well-being that he loses the game to Oscar. When Oscar asks Felix what he said to Sure-Shot that so unnerved him, Felix replies that he told Sure-Shot about his uncle. “Your uncle?” Oscar says, not understanding the reference, to which Felix replies (and I paraphrase), “yes, my uncle [XYZ] who was killed by a bus while crossing the street.”
[xix] It’s old news now, but take a look at U.S. Return of Partnership Income, IRS Form 1065, Schedule B, Lines 11 and 12.
[xx] Gluck v. Commissioner, T.C. Memo 2020-66.
[xxi] See Reg. Sec. 1.1031(k)-1(a).
[xxii] Reg. Sec. 1.1031(k)-1(g).
[xxiii] Reg. Sec. 301.7701-3(a).
[xxiv] Reg. Sec. 1.1031(k)-1(g)(4)(v).
[xxv] IRC Sec. 761; Reg. Sec. 301.7701-3.
[xxvi] IRC Sec. 6222(c). Taxpayers are instructed to file Form 8082 if they “believe an item was not properly reported on the Schedule K-1 you received from the partnership.” Instructions for Form 8082.
[xxvii] IRC Sec. 1031(a)(2)(D).
[xxviii] I am assuming that IRC Sec. 1031 will remain in the Code. There are no assurances this will be the case. For one thing, the Obama administration’s last Green Book sought to limit the amount of capital gain deferred under IRC Sec. 1031 to $1 million (indexed for inflation) per taxpayer per taxable year. Then, in 2017, the Trump administration succeeded in limiting like-kind exchanges to real property.
Following the lost tax revenues resulting from the Covid-19 economic shutdown, and given the drain on the fisc resulting from like-kind exchanges, it should come as no surprise if Congress decides to completely eliminate IRC Sec. 1031.
Likewise, it should come as no surprise if N.Y. enacts a claw-back rule similar to California’s. If a taxpayer disposes of California real property and acquires replacement property outside California, the like-kind exchange will be respected, but the taxpayer must continue to report the deferred gain and, when the replacement property is ultimately sold, California will seek to collect its tax on such deferred gain.
[xxix] It also raises the issue of whether the taxpayer held the property for the requisite business or investment purpose prior to disposing of it, whether to a third party or as contribution to a partnership.
[xxx] For example, in terms of lost or deferred tax collections.
[xxxi] https://www.taxlawforchb.com/2016/03/1833/
[xxxii] A nonresident who disposes of N.Y. real property as part of a like-kind exchange must disclose this information on Form IT-2663, Nonresident Real Property Estimated Income Tax Payment Form.