The IRS released revenue procedure 2002-22 in March to address the use of fractional ownership interests as replacement property in IRC section 1031 exchanges. Commonly referred to as “tenancy-in-common” or TIC interests, these fractional interests offer significant advantages to taxpayers completing 1031 exchanges.
Under section 1031, a taxpayer may defer gain recognition by exchanging for like-kind property. The replacement property cost must equal or exceed the net sales price of the relinquished property and the taxpayer must replace all debt and equity. To successfully complete the exchange, the taxpayer must meet certain requirements. Specifically, he or she must identify potential replacement property within 45 days of selling the relinquished property.
Finding an attractive replacement property in the right price range in such a short time can be difficult, and a taxpayer must take title to the property he or she ultimately buys in the same manner as the relinquished property. (For example, a taxpayer tired of the hassles of owning and managing a rental house cannot exchange it for a partnership interest in a professionally managed shopping center.) This title requirement often precludes taxpayers from buying a share in a larger, potentially more attractive property.
In response to the need for “ready-to-buy” investment products that taxpayers could purchase with varying amounts of cash and debt, a small group of companies began offering TIC interests as replacement property. To address the title issue, they used a co-ownership structure. Despite this arrangement, many CPAs were still concerned the IRS might see the TIC interests as essentially partnership interests, jeopardizing the benefits of an exchange.
After declining to answer several letter ruling requests on this matter, the IRS decided not to issue any more rulings pending further review. Revenue procedure 2002-22 is the result of this review. Although the IRS did not establish a safe harbor provision, it did spell out some requirements for TIC interests to qualify as co-ownership interests.
* The maximum number of tenants-in-common permitted is 35.
* The sponsor or organizer of the interests may own the property (or an interest therein) for only six months before selling 100% of the units.
* Unanimous decisions are required on anything of material or economic impact to the property or its owners.
* The management agreement (if applicable) must be at a market rate and renewable annually.
The pronouncement urges taxpayers wanting a definitive blessing on a particular product to seek a letter ruling. The IRS will make such a ruling based on the specific facts of the TIC offering.
Observation. Given this new information, many companies selling TIC interests are likely to structure their offerings to comply with the new guidelines, as well as seek an individual blessing from the IRS on their product. For the group offering the product, revenue procedure 2002-22 appears to provide a foundation to build on. For taxpayers, the guidance opens the door to a new product that may allow them more choice and flexibility when completing a section 1031 exchange.
Education Expense Deduction: “Unemployed” Taxpayer May Be “Employed”
I n today’s economy, thousands of people are unemployed. While looking for work, many have returned to college to improve their skills and to make themselves more competitive in the job market. It’s likely many of these taxpayers are unsure if they can deduct the cost of this education on their federal tax return.
Deductible education expenses are defined in Treasury regulations section 1.162-5. They include costs the individual incurs to maintain or improve skills required in his or her employment or other trade or business. This confuses many taxpayers because being unemployed would seem to eliminate any possible deduction. However, assuming the education meets the requirement of maintaining or improving skills required in their profession and the taxpayer meets certain tests, such expenses may in fact be tax deductible.
A taxpayer who is temporarily unemployed under certain circumstances may fall within the description of someone who is employed or conducting a trade or business. The Tax Court has held that someone who temporarily ceases to actively participate in a trade or business during a transition period between one job and another may be “carrying on” a trade or business during that time ( Haft v. Commissioner, 40 TC 2, 1963). The taxpayer may have to prove he or she was established in a trade or business before attending school. A petitioner was in his position for two years; the court found on the facts that this was a sufficient period to have been established in his employment. ( Sherman, 36 TC Memo 1191).
The Seventh Circuit Court of Appeals previously had held that a taxpayer who leaves a position temporarily to attend school full time may be carrying on a trade or business while in school. In Furner v. Commissioner (68-1 USTC ¶9234, 393 F2d 292, 1968, rev’g 47 TC 165, 1966), a teacher requested-but was denied-a leave of absence to attend graduate school. She resigned, and after completing her graduate education took a different teaching job at another school. The court found the taxpayer was carrying on her trade or business of being a teacher while she was in graduate school.
In John Gallo, 75 TC Memo 1963, a civilian employee of the Army and Air Force Exchange Service left his position to pursue a master’s degree after being denied a leave of absence. When he left his job he had completed his specified employment period, was no longer under an employment contract and did not receive a salary. His employer denied his later reemployment application because of a reduction in personnel.
The Tax Court cited Haft and Furner in finding that an approved leave of absence is not essential to be considered as carrying on a trade or business while attending school; nor is it essential to return to the same position after completing school. The court said even an unemployed taxpayer may be considered to be carrying on a trade or business if he or she was previously involved with and intended to return to it. To take advantage of this “hiatus principle,” however, a taxpayer must show that during the hiatus he or she had intended to resume the same trade or business.
The key factor in qualifying for the education deduction is intent to return to the same trade or business or employment. This does not mean the taxpayer must return to the same employer or to an identical job. The person must intend to return to the same or similar employment with the same or similar responsibilities that requires similar skills and training. But CPAs should beware that education that qualifies the person for a new trade, business or employment is not deductible, regardless of intent. To establish intent to continue in the same trade or business, clients should document efforts to obtain employment. The ultimate evidence of intent would be actual reemployment.
Regarding the meaning of “temporarily,” in revenue ruling 68-591, 1968-2 CB 73, the IRS said it would follow Furner in situations where an individual temporarily ceased to engage actively in employment to undertake education or training to maintain or improve required skills. While the IRS defines temporarily as a period of a year or less, the Tax Court has said there is no magic in a one-year limit on “temporary” and a facts-and-circumstances test is appropriate to determine whether a hiatus is temporary rather than indefinite.
The unemployment period of a person whose employment ended involuntarily but who actively pursues employment, whether with the same employer or any other, should qualify under the hiatus principle as being a temporary absence. Given the decisions discussed here, it would not be beyond reason to believe a person could even discontinue the search for a reasonable period of time while obtaining additional education. Again, clients should document their efforts to obtain employment to establish the reasonableness of the hiatus.
Observation. The focus here is on determining whether an individual’s education expenses qualify as deductible under regulations section 1.162-5. If they do, CPAs should be cautious of two overriding factors in the regulations that eliminate any hope for the deduction:
* The education must not be obtained to meet the minimum education requirement for the taxpayer’s employment.
* The education must not qualify the individual for a new trade or business (a mere change of duties in the same general type of work does not constitute a new trade or business).
-Ronald J. Blair, CPA, director of financial affairs, School of Management and lecturer in federal taxation, University of Texas at Dallas.