Beware of Future Withholding On §1031 Exchanges with Governmental Entities

By Alan S. Lederman, Esq.

Alan S. Lederman is a shareholder in the Ft. Lauderdale office of Gunster, Yoakley & Stewart.

Final regulations under §3402(t), which generally requires 3% withholding on payments by large U.S. governmental entities for acquiring personal property and services from U.S. vendors, were issued on May 9, 2011. 1 Unless modified, these regulations will, beginning on their January 1, 2013 effective date, create difficulties for taxpayers seeking to undertake a §1031 exchange with respect to personal property, including associated personal property exchanged with real property, transferred to governmental entities. 2

1 T.D. 952476 Fed. Reg. 26583 (5/9/11). Regs. §31.3402(t)-2 applies the withholding obligation to the federal government, state governments, and generally state political subdivisions that make at least $100 million of annual payments for goods and non-employee services. See, e.g. Or. Admin. R. 125-247-0288(9) (2011) (State of Oregon rule concerning permitted procurement of used personal property).

2 Similarly, §3402(t) withholding seems to be required with respect to governmental condemnation payments for personal property which are deferrable under §1033, since §1033 is likewise not mentioned in §3402(t) or T.D. 9524. Further, Regs. §31.3402(t)-4(p) seems to require withholding on governmental debt issued for personal property which is deferrable under the §453 installment sale rules.

Neither §3402(t), nor the final regulations, nor their preamble, mention §1031. Accordingly, §1031 issues of major concern to exchangors, qualified intermediaries (QIs), and governmental entities are left unresolved.

No Exception for §1031-Deferrable Proceeds

For example, no mention is made in the §3402(t) regulations for any possible exception from §3402(t) withholding for payments made by the governmental entity in like-kind property, in connection with a simultaneous exchange, that the taxpayer certifies to the acquiring governmental entity is eligible for §1031 non-recognition. 3 Similarly, there is no exception from §3402(t) withholding for cash payments made by a governmental entity to a QI, in connection with a deferred exchange, that the taxpayer demonstrates to the IRS will be converted into replacement property that is eligible for§1031 non-recognition. 4

3 Such an exception from withholding exists in the FIRPTA regulations. Regs. §1.1445-2(d)(2). Regs. §31.3402(t)-4(p), holding that a third-party obligation issued as payment is to be withheld based on the obligation’s fair market value, suggests that, for purposes of §3402(t), withholdable “payments” include payments in property other than cash.

4 Such an exception from withholding exists in the FIRPTA regulations. Regs. §1.1445-3(b)(6).

Regs. §31.3402(t)-4(s) allows the IRS to exempt otherwise withholdable payments by notice in the Internal Revenue Bulletin. Thus, exchangors can still hope that withholding exceptions for §1031 exchange proceeds appear before 2013. 5 Moreover, as noted by the preamble, the 2013 effective date for§3402(t) withholding in Regs. §31.3402(t)-1(d) represents a regulatory postponement of the 2012 statutory effective date, which 2012 effective date itself was the result of 2009 legislation postponing the 2011 effective date contained in the original 2006 legislation enacting §3402(t). Taxpayers may hope for another postponement of §3402(t)‘s effective date, or even its repeal by Congress. 6

5 But see the preamble to T.D. 9524, stating “section 3402(t) withholding does not depend on whether an amount is includable in gross income. The entire amount paid for property … is subject to withholding regardless of whether the vendor realizes a profit on transactions covered by the payments.”

6 See Rothman, “Withholding: Businesses Cheered by Upcoming Vote to Repeal 3 Percent Withholding Rule,” 165 BNA Daily Tax Rpt. G-4 (8/25/11).

The §3402(t) regulations explicitly reject certain general exemptions from withholding which, if such exemptions hypothetically had been adopted by the IRS, would coincidentally have often eliminated withholding on like-kind exchange proceeds. For example, Regs. §31.3402(t)-5(a) provides that withholding is generally required from payments to partnerships and other pass-through entities, even though the seller cannot possibly have any entity-level income tax liability. Pass-through entities are often used by investors and QIs.

A taxpayer will be unlikely to convince governmental entities not to withhold by arguing that it intends to structure the transaction so that its transfer qualifies in its entirety for §1031 non-recognition. A governmental entity would note that if the exchange, contrary to the taxpayer’s expectations, is found to be partially or wholly taxable, the governmental entity would be liable for the tax it failed to withhold, and possibly interest and penalties. 7

7 Regs. §§31.3402(t)-7(a)31.3402(d)-1.

Is Withholding Credited to QI or Taxpayer?

In a typical safe harbor deferred like-kind exchange involving a QI outlined in Regs. §1.1031(k)-1(g)(4)(v), the taxpayer directly contracts with the governmental entity and transfers the exchange property directly to the governmental entity. The taxpayer, however, assigns the taxpayer’s rights in the agreement, including the right to receive the purchase price, to the QI. The governmental entity, pursuant to a notification from the taxpayer of such assignment, pays the purchase price to the QI. 8

8 Regs. §1.1031(k)-1(g)(4)(v).

In such circumstances, it is not entirely clear that the tax is to be deposited for credit to the account of the taxpayer rather than the QI. 9 As a matter of pretax economics, if the taxpayer believes there is a possibility that the IRS will treat the withholding as a credit to the tax of the QI, the taxpayer will need some contractual agreement to receive the QI’s tax credit or refund created by such deposit.

9 Cf. “ABA Members Submit Report on Like-Kind Exchanges By Foreign Persons,” 94 TNT 141-50 (7/21/94) (“under [Regs. §1.1031(k)-1(g)(4)] … there is some uncertainty as to whether the qualified intermediary or the subsequent buyer is the ‘transferee’ of the relinquished property for purposes of FIRPTA withholding”).

Regs. §31.6051-5 requires the governmental entity to file a Form 1099-MISC with the IRS containing the taxpayer identification number of, and tax withheld with respect to, the “person receiving the payment.” Regs. §31.3402(t)-3(d) states that the person subject to withholding is the person who is in privity with the government and who supplies the government with property, suggesting that the “person receiving the payment” would be the taxpayer and not the QI. In the first of two examples in the regulations illustrating who is the “person receiving the payment,” the taxpayer, a general contractor, and not any of its subcontractors, is held to be the “person receiving the payment,” where the taxpayer contracts directly with the governmental entity and supplies the property to a governmental entity. However, in that first example, the taxpayer, unlike the exchangor and like a QI described in Regs. §1.1031(k)-1(g)(4)(v), receives the payment directly from the governmental entity. 10 In the second example in the regulations, the taxpayer, who contracts directly with the governmental entity and supplies the property to a governmental entity, likewise is held to be the “person receiving the payment,” even though the taxpayer, like the exchangor and not the QI described in Regs. §1.1031(k)-1(g)(4)(v), does not receive funds directly from the governmental entity but rather though a third party. 11 However, in that second example, the third party, a payment agent, unlike a typical QI, has a contractual payment agent agreement with the governmental entity and not the taxpayer, and is compensated by the governmental entity and not the taxpayer. Moreover, the rights assigned by the taxpayer to the QI contemplated by Regs. §1.1031(k)-1(g)(4)(v) arguably include the full purchase price, including the amount of §3402(t) withholding deposited by the QI with the IRS.

10 Regs. §31.3402(t)-3(f), Ex. (1).

11 Regs. §31.3402(t)-3(f), Ex. (2).

Nevertheless, even if the QI is the “person receiving the payment” for purposes of identifying the QI as the person with respect to which the tax is withheld on the Form 1099-MISC issued by the governmental entity, it is arguable that the taxpayer, not the QI, should receive the credit for that withheld tax. Regs. §31.3402(t)-6(a) provides that the withheld tax is creditable by the “recipient of the income” in accordance with Regs. §1.31-1. Under Regs. §1.31-1(a), the “recipient of the income” is the person subject to tax on the payment, even if that tax is withheld on payments made to another person. To illustrate this point, Regs. §1.31-1(a) states that half the taxes withheld from payments of community property income to the payee spouse are creditable by the non-payee spouse. Since the tax withheld from the QI’s payment typically would, outside the Regs. §1.1031(k)-1(g) safe harbor applied for purposes of granting the taxpayer §1031(a) non-recognition, be viewed as income of the taxpayer and not the QI, arguably the taxpayer, not the QI, is, in such typical case, entitled to the credit for the tax withheld under §3402(t)12

12 See Regs. §1.1031(k)-1(g)(4) (QI non-agency safe harbor applies “for purposes of §1031(a)”); Regs. §§1.61-14(a)1.164-2(a) (tax withheld from wages under §3402 neither reduces taxpayer’s pre-withholding includible wage income nor is deductible from such wage income).

Possible Withholding on Real Property Sales

Absent future relief from §3402(t) withholding, exchangors of personal property such as used aircraft leased out or used in a business, transferred to a governmental entity, would be subject to withholding. Indeed, even exchangors of real property transferred to a governmental entity, such as non-dealer land and building rented out or used in a business, would likewise be subject to withholding, to the extent of the value of any associated personal property transferred along with that real property.

Regs. §31.3402(t)-4(r) provides that if a single payment is made by a governmental entity for both personal property subject to §3402(t) withholding and other property not subject to §3402(t) withholding, the governmental entity can withhold on the entire payment, but only if the seller agrees. However, nothing seems to prevent a governmental buyer, as a purchase condition, from requiring the seller to agree. A governmental purchaser of both realty and associated personal property might insist on withholding on the entire price in order to protect that governmental entity against any IRS upward reallocation of the purchase price to personalty. 13

13 Cf. FSA 199951006 (IRS could reallocate exchange proceeds from non-taxable realty to taxable personalty, and could take into account buyer’s lack of adverse tax interests in finding that exchangor’s allocation of proceeds to personal property was inadequate).

Possible Disqualification of the Exchange

An issue could arise as to whether, when the IRS receives the withheld funds from the governmental entity, or allows the taxpayer (or allows the QI, who by contract transfers the benefit of the tax credit to the taxpayer) an income tax credit under Regs. §1.31-1(a) for such withheld funds, before the exchange is completed, there has been a prohibited economic benefit to the taxpayer of QI funds described in Regs. §1.1031(k)-1(g)(6), thereby entirely disqualifying the exchange from non-recognition. However, various exceptions, such as for transactional items customarily appearing in closing statements described in Regs. §1.1031(k)-1(g)(7) could arguably apply to prevent disqualification. 14

14 See also Levine, 567 T.M., Taxfree Exchanges Under Section 1031, at VI.D.3.l.(12) (questioning whether substantial compliance with Regs.§1.1031(k)-1(g)(6) could be a defense to disqualification); Regs. §1.1031(k)-1(g)(6)(iii)(B) (generally permitting post-identification releases of boot for reasons beyond the exchangor’s control); Weller, “Early Distributions from 1031 Exchange Accounts – Another Look at a Strange New Ruling,” 93 J. of Tax’n 73 (2000); Thompson, Jr., “Safe Harbors, Ease of Use, Encourage Deferred Exchanges,” 49 Tax’n for Accountants 196 (October 1992) (payments directly from acquirer do not violate Regs. §1.1031(k)-1(g)(6)).

Possible Taxation of Withholding as Boot

Taxation of the §3402(t) withholding as boot becomes an issue. It would be helpful for the IRS to clarify that the taxpayer could avoid characterization of the §3402(t) withholding as non-reinvested cash proceeds, if the taxpayer supplies this amount to the QI from other sources, for the QI’s reinvestment in like-kind property. 15 If such funds were needed by the QI before the taxpayer received any cash benefit of the §3402(t) withholding (such as by reducing the taxpayer’s otherwise required tax payment or by the taxpayer’s receipt of a refund of over-withheld tax), the taxpayer would need bridge financing for this period.

15 See Regs. §1.1031(d)-2, Ex. (2) (cash transferred by exchangor offsets boot received in the form of mortgages assumed, which itself is treated as cash received).

Governmental Entity Shortfall

Conversely, the governmental entity may need to locate external cash sources to fund its §3402(t) withholding obligation. 16 In a direct exchange where the governmental entity exchanges entirely property (or pays cash boot, but in an amount less than 3% of its consideration), that governmental entity would have to arrange to be paid by the taxpayer to reimburse to the governmental entity its cash payment of withholding to the IRS at the time of closing.

16 See Regs. §31.3402(t)-4(p) (fair market value of third-party debt obligation paid to vendor subject to §3402(t) withholding).

Newly Constructed Buildings Are Not Qualifying §1031 Replacement Property

On another point of interest to §1031 exchangors, the preamble to Regs. §31.3402(t)-4(d) restates the longstanding IRS position that a payment for constructing a building on land already owned by the taxpayer is not a non-withholdable payment for “real property,” but rather is a withholdable “payment for the services and materials used to construct a building.” Thus, one can expect the IRS to adhere to its position in Rev. Proc. 2004-51 that “an exchange of real estate owned by a taxpayer for improvements on land owned by the same taxpayer does not meet the requirements of section 1031.” 17 Exchangors seeking to accomplish a §1031 rollover of their exchange proceeds into the construction of a building on land controlled by an affiliate of that exchangor will presumably continue to use the structure, approved by the IRS in PLR 200251008, of creation of a land lease. 18

17 2004-2 C.B. 294 at §2.05.

18 See Borden, Lederman and Spear, “Build-to-Suit Ruling Breaks New Ground for Taxpayers Seeking Swap Treatment,” 98 J. of Tax’n 22 (2003).

Conclusion

The §3402(t) regulations appear to require 3% withholding on exchange proceeds that are otherwise entitled to income tax deferability under §1031. This creates a potential short-term cash deficit for an exchangor needing its QI to promptly reinvest the entire pre-withholding exchange proceeds. Moreover, issues arise as to proper Form 1099-MISC reporting by the acquiring governmental entity, claiming of the credit for §3402(t) withholding as between the QI and the exchangor, implications of the corresponding credit for the withholding on the determination of the exchangor’s boot, and, where boot exists, possible disqualification of the entire exchange. The IRS should consider granting favorable guidance and regulatory relief in this area.

 

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