I hope that our readers on the Eastern Seaboard are doing alright in the aftermath of Hurricane Sandy. It was very difficult watching the destruction caused by Sandy, particularly because I had lived in New York City and Washington, DC for over 20 years before moving to California to join NES Financial. So I wanted to write a blog to disseminate some tax information that I hope will be helpful to persons affected by Hurricane Sandy. I’ll begin this blog by explaining how the IRS handles the various announcements regarding tax deadline extensions for persons and businesses resident in the areas affected by Hurricane Sandy. Then I’ll discuss how these extensions affect Section 1031 exchanges in progress and how Section 1031 applies to repairs to damaged property.
Extensions for Tax Deadlines
The IRS has issued Revenue Procedure 2007-56 which puts together a comprehensive list of the time sensitive acts for which a deadline for performance is extended when a taxpayer is affected by a federally declared disaster such as Hurricane Sandy. You can access that document by clicking here. By itself, Rev. Proc. 2007-56 is merely a list of the time sensitive acts that are extendable in the event of a disaster. To actually trigger the extensions of the deadlines applicable to those time sensitive acts requires two additional steps: (1) the President of the United States issues a determination that the disaster warrants assistance by the federal government and (2) the IRS publishes a news release, notice or other guidance authorizing the extensions, specifying the duration of the extensions, defining eligible taxpayers and describing the affected acts. Once triggered, the extensions are granted automatically with no need for any application by the affected taxpayer.
At the time of the writing of this blog, many Sandy-ravaged areas have been declared disaster areas by President Obama, and the IRS has issued a number of news releases (available on this link) extending several imminent tax deadlines for taxpayers in those areas. For example, the IRS has already extended the tax filing and payment deadlines that have occurred since late October, allowing the affected individuals and businesses to have until February 1, 2013 to file the returns and pay any taxes due. This includes not only payroll and excise tax returns and accompanying tax payments ordinarily due on October 31, 2012 and January 31, 2013, but also the fourth quarter individual estimated tax payments due on January 15, 2013. Further IRS news releases with additional extensions applicable to the Hurricane Sandy disaster area should be forthcoming.
Effect on Section 1031 Exchanges in Progress
Section 4.01 of Rev. Proc. 2007-56 provides that unless the notice or other guidance for a particular disaster provides that the relief is limited, the guidance will generally extend all the deadlines listed in the revenue procedure. Although the guidance lists specific examples of the types of deadlines extended, it does not actually limit the relief. Although the IRS may follow up with a more comprehensive notice, such as it did with Hurricane Katrina, the news release itself is probably sufficient to trigger the application of the extensions to all the time sensitive acts listed in Rev. Proc. 2007-56. This means that the special extension rules applicable to 1031 exchanges are now in effect.
Section 17 of Rev. Proc. 2007-56 deals specifically with Section 1031 exchanges and provides special rules for extensions for these exchanges. To be eligible for an extension, the taxpayer’s 1031 exchange must be in progress at the time of the disaster. This means that the taxpayer’s relinquished property was transferred on or before the date of the federally declared disaster or in a reverse exchange pursuant to Rev. Proc. 2000-37, the qualified indicia of ownership of either the relinquished or replacement property was transferred to the exchange accommodation titleholder on or before that date. If applicable, section 17 extends the 45-day identification period and the 180-day exchange period for forward exchanges and all of the time limited acts described in Rev. Proc. 2000-37, which governs reverse exchanges, by 120 days or the last day of the general disaster extension period authorized by IRS guidance, whichever is later. However, the extension provided by this section cannot extend beyond the due date (including extensions) of the taxpayer’s tax return for the year of the transfer or one year.
Generally speaking, as with the other types of tax deadlines, a taxpayer can qualify for the 1031 extensions merely by residing in the disaster area, if an individual taxpayer, or having a principal place of business in the disaster area, if a business taxpayer. It’s also possible to qualify if the taxpayer is not resident in the disaster area, but has records located in the disaster area that are necessary to meet the deadline for one of the time sensitive acts. So for taxpayers with businesses, records or residences in the disaster area, qualification is mostly a matter of making sure that they are located in one of the counties listed in the IRS news release.
Special Rules for 1031 Exchanges
In addition to residing in the disaster area, a taxpayer may also qualify for the extension if he has a reason associated with the disaster that makes it difficult to meet the relevant 1031 deadline. The IRS provides a non-exclusive list of reasons that establish the required difficulty: (i) the relinquished property or the replacement property is located in the disaster area; (ii) the principal place of business of any party to the transaction (for example, the qualified intermediary, the exchange accommodation titleholder, transferee of the property, settlement attorney, lender, financial institution, or title insurance company) is located in the disaster area; (iii) any party to the transaction (or an employee of such a party who is involved in the transaction) is killed, injured or missing as a result of the disaster; (iv) a document prepared in connection with the exchange (for example, the exchange agreement or the deed to the relinquished property or the replacement property) or a relevant land record is destroyed, damaged or lost as a result of the disaster; (v) a lender decides not to fund, either temporarily or permanently, a real estate closing due to the disaster or refuses to fund a loan to the taxpayer because flood, disaster or other hazard insurance is not available due to the disaster; or (vi) a title insurance company is not able to provide the required title insurance policy to settle or close a real estate transaction due to the disaster.
This alternative test has the potential to greatly expand the geographic scope of the 1031 extension, but it adds the subjective factor of difficulty. It is also noteworthy that the IRS specifically provides that other reasons “similar” to the six described above would qualify for the extension. Thus, it behooves a taxpayer located outside the disaster area to make sure that he documents why he had difficulty meeting the 1031 deadline and how the difficulty was related to Hurricane Sandy.
Section 1031 and Repairing Disaster-Damaged Property
Since we are on the topic of Section 1031 exchanges, some of you may be wondering if an exchange could be used to help repair or rebuild damaged property in a tax advantageous manner. As great a tax planning tool as 1031 normally is, unfortunately it is not nearly as helpful in disaster times.
If a taxpayer sells one property and wants to use the sale proceeds to repair or improve other damaged real estate that he owns, the IRS would most likely disallow 1031 treatment. One line of attack for the IRS where repairs are involved is that the taxpayer has not reinvested in like-kind property; rather the taxpayer has purchased a combination of services, which are never like kind to property, and construction materials and supplies, which also are not like kind to real property. Another line of attack where improvements rather than mere repairs are involved would be Rev. Rul. 67-255 in which the IRS takes the position that capital improvements, such as a building, on land that the taxpayer already owns are not like kind to land.
One response to this problem would be to attempt a reverse exchange using Rev. Proc. 2000-37 as modified by Rev. Proc. 2004-51 to park the property that the taxpayer would like to repair or improve and have the exchange accommodator, rather than the taxpayer, make the repairs or improvements to the damaged property. This would allow the taxpayer to receive completed property as his replacement property in the exchange, rather than non-qualifying services and construction materials. Further, by utilizing a 30+ year ground lease of the land to the exchange accommodator, the taxpayer could also make the argument that the property received, which consists of the 30+ year leasehold, which is considered like kind to real property under the 1031 regulations, and the improvements, is like kind to real property and was not already owned by him.
The problem for both scenarios is that the IRS clarified Rev. Proc. 2000-37 by issuing Rev. Proc. 2004-51, which specifically takes on the issue of whether an “improvements” exchange qualifies where the relinquished property includes land and the taxpayer already owns the land on which the improvements are to be constructed. The IRS made it clear that the revenue procedure does not apply to replacement property if the property is owned by the taxpayer within the 180-day period ending on the date of the transfer of that property to the parking exchange accommodator. Although the language in Rev. Proc. 2004-51 could be viewed as ambiguous, the IRS has stated publicly that the intent of Rev. Proc. 2004-51 is to shut down leasehold improvements exchanges as well. So proceed with extreme caution and consult your tax advisor if you want to try to make this work for your situation.
Other Tax Benefits Applicable to Disasters
Stay tuned for the second installment of this blog where I’ll talk about other tax advantageous ways of coping with the Hurricane Sandy disaster.